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Tesla's Return to Profitability Is Not Sustainable

On Oct. 23, Tesla Inc. (NASDAQ:TSLA) shocked the financial media when it reported a surprise profit in the third quarter. Most Tesla watchers expected another grueling loss. Instead, in a veritable replay of its third quarter last year, the electric vehicle company announced $143 million in positive GAAP net income and $371 million in operating cash flow.


On the subsequent earnings conference call, CFO Zach Kirkhorn explained that Tesla's return to profitability was the result of operational improvements, supplemented by the absence of various one-off costs:


"We returned to profitability in Q3, aided by improved gross profit, reduced operating expenses and the absence of negative one-time items that weighed on our financials in the first half of the year. GAAP automotive gross margin improved sequentially to 22.8%."



At first glance, this result might seem to have wiped out much of the bear case against Tesla. However, a look beneath the surface reveals a far more complicated story. Indeed, a review of Tesla's 10-Q reveals the reported profit and positive cash flow to be little more than smoke and mirrors.

Quietly reducing warranty reserves

Auto manufacturers generally offer their customers warranty coverage for certain amounts of time, which creates a financial liability that must be accounted for in their financial statements. Tesla is no exception. However, Tesla has been quietly reducing its warranty reserve per car. As Barron's reported on Oct. 26, slashing warranty reserves had a major impact on the company's claimed profit:


"Tesla recognized $153 million in warranty expense for the second quarter of 2019. It sold $5.2 billion worth of cars, so warranty costs represented about 2.9% of that revenue, but the ratio fell to about 2.7% for the third quarter. Is this a big deal? If the warranty-expense rate hadn't changed, Tesla's pre-tax income would have been about $12 million lower. Tesla reported a pre-tax profit of $176 million during the second quarter. Tesla also reduced its overall accrual for previously existing warranties. It doesn't think it will have to provide as many warranty repairs as it once believed. It added another $37 million in third-quarter pretax income. The cumulative impact of these warranty-related revaluations resulted in a boost of $50 million to profit. That's material, compared with the $143 million profit Tesla reported."



In other words, Tesla's under-reserving for vehicles accounted for more than a third of its net profit last quarter.

Playing around with inventory values

Tesla's latest 10-Q does not directly disclose the impact of inventory revaluations by quarter, instead opting to simply disclose the aggregate impact for the first nine months of 2019, a net negative of $104 million. Yet, in the first half of 2019, Tesla recorded $106.2 million in inventory write-downs. In other words, inventory value adjustments during the third quarter actually contributed $2.2 million to Tesla's gross profit (about 1.5% of its reported net income). However, based on how inventory adjustments generally work, it makes little sense that Tesla's would be anything but negative. Thus, it seems clear that Tesla's decision to fold all three quarters into a nine-month figure in its third-quarter 10-Q was aimed at obfuscating this obvious red flag.

An inexplicable upward revaluation was not the only inventory trick that Tesla pulled in the third quarter. Tesla delivered nearly 1,000 more cars than it produced in the quarter, many of which were high-margin Model S and Model X vehicles. This ought to have resulted in reduction in overall inventory value. However, Tesla reported the exact opposite, claiming an overall increase in inventory value of about $200 million.

Conserving cash by cutting back

In addition to its surprise profit and claimed cash flow, Tesla has boasted about its new record cash reserves after the third quarter. However, the maneuvers needed to achieve this result do not appear to be sustainable. For example, Tesla's capital expenditure (capex) has been cut to the bone.

Conserving cash by deferring capex can be a fine strategy for some companies, but not Tesla, which must spend several billions of (unbudgeted) dollars just to meet its current obligations in Shanghai, Nevada and New York. Such cutbacks make sense for a company short on cash, yet Tesla claims to be more flush than at any time in its history. Moreover, Tesla's market capitalization assumes a trajectory of breakneck growth for years to come, a proposition that demands considerable capex in a capital-intensive industry.

Something clearly does not add up with Tesla's penny-pinching.

Stretching payables and liabilities

While choking off capex will have an impact on a company's cash balance, it will not translate into impacts to net income or operating cash flow. Other items will, however. Most notable in Tesla's case are accounts payable and accrued liabilities.

Tesla's accounts payable and accrued liabilities increased $208 million quarter-over-quarter, while the company's total debt load rose by $318 million. In essence, Tesla prevented about $200 million in negative cash flow from being reflected in its financials last quarter.

Ultimately, while stretching payables can boost a company's cash balance and operating cash flow, they can only be stretched so far before something breaks. Moreover, Tesla's rising debt, which nearly equalled its reported operating cash flow for the third quarter, presents reason for investor concern about long-term financial viability.

Dining out on stock

Like so many companies with chronic cash burn issues, Tesla is a big fan of stock-based compensation. Rather than paying employees in cash, a commodity seemingly always in tight supply at Tesla, it compensates employees with generous stock options, which they can exercise and sell for cash. From a purely internal company viewpoint, this seems like an obvious win-win: management can conserve cash while still meeting employee obligations, while employees can be sure they will get paid for their work. However, the stock issued as stock-based compensation is not free. Rather, it comes at the expense of shareholder dilution.

In the third quarter, Tesla paid out $199 million in stock-based compensation. In other words, two-thirds of Tesla's cash flow was paid for by shareholders. Thus far, dilution each and every quarter has evidently proven to be an acceptable cost as far as shareholders are concerned, but that is likely due to the continued resilience of Tesla's stock price. Were its financial engineering to unravel or its hype bubble pierced (or even deflated slightly), this attitude could change abruptly.

Verdict

Tesla's financial and operational woes were not dispelled by the latest "miracle quarter" result. The company's best efforts to engineer a profit came at the cost of the future.

For a company supposedly looking to the long-term, Tesla is remarkably short-sighted. That will end up biting the company down the line.

Disclosure: Author is short Tesla.

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This article first appeared on GuruFocus.