By Alex Pollak, CIO Loftus Peak
The news that Tesla will raise $1.5b in senior debt signals a new phase for the company – one in which equity issues are likely to be thin on the ground, if at all. On Tesla’s second-quarter earnings call with analysts, Musk telegraphed as much: “There may be some wisdom in having a cash cushion for unexpected events. But we’re not at this point considering an equity raise. We are thinking about debt.”
Previous financing rounds have mostly been equity, with some convertible bonds thrown in, diluting existing shareholders. But the willingness of debt markets to take a coupon which may be as low as 5% suggests that the electric car company is being viewed as highly likely to succeed without further shareholder financing.
So here is the bull case, which we outlined a few months ago.
It’s a fact that America’s newest car maker made 83,922 cars last year, from effectively a zero base in 2013.
Tesla has stated it intends to produce 500k cars next year, but it’s the longer term – five years or so – that investors should be focusing on: a number close to 1 million cars by 2020 or shortly thereafter.
The shorts say the company will miss these numbers – and that is probably the case – but it won’t be by much in number terms, or by long in terms of time.
Even at the 500,000 cars mark, Tesla is on track for sales of $25 billion. It is legitimate to ask whether the market is ready to accept that if the company gets to 1 million cars it will generate sales of $50 billion annually. The rising share price (it is up by more than half this year) suggests so.
Here is where the per unit economics of the Tesla really start to add up. The 2016 annual Tesla filing reveals that gross margin (i.e. sale price less cost of the components in the car) was 26%. This is a number most car companies would drool over, given their gross margins hover between the 10%-20% mark.
Part of the reason fossil fuel car companies traditionally have lower gross margins are the huge number of parts, and the supply chains involved in supporting the range. The Harvard Business Review noted it in a piece on why car company profitability had fallen – that car companies succeeded in boosting sales, but in the process had lost control of costs as model numbers had ballooned.
Of course, there are systems that are common to both technologies, like brakes and steering. But the internal combustion engine (or ICE) is really just a labyrinth of mechanical bits that control the explosive chemical energy created by burning petrol. Gearboxes, fuel injection systems, catalytic crackers are therefore part of the elaborate supply chain that make up the final product.
The electric car does away with literally 99% of the moving parts found in the ICE. What does removing most of the componentry in a car look like in financial terms? The answer is between 6c and 16c on the dollar of additional earnings.
Tesla’s elevated gross margin is struck on sales considerably below that will be achieved as it gets the economies of scale which are the hallmark of car companies. It is conceivable that the company’s margin could be in the order of 30%+. The current SGA – selling, general and administrative including the research spend (all the expense that comes below the actual cost of the raw materials in the cars) will grow proportionately smaller as a percentage of sales. This is the very definition of operating leverage.
Meanwhile, the Wall St Journal ran a piece on Volkswagen last week noting the difficulties the company is having flicking the switch to electric. In particular, senior managers are feeling distinctly unloved as the CEO Matthias Mueller tries to force the change.
Tesla’s projected cash burn for the second half of 2017 is about US$2 billion, which it believes would leave it with US$1 billion in reserve
The WSJ quoted Mueller at an industry gathering saying “There are definitely people who are longing for the old top-down leadership. I don’t know if you can imagine how difficult it is to change their mindset.”
The WSJ article went on to note that “the mindset included a conviction among many at VW that the internal-combustion engine, especially the diesel, is a proven and superior technology that can meet emission standards for years. That conviction, they say, helped lead engineers to rig diesel-engine software to appear to meet such standards — the crux of the scandal that emerged in 2015.
“It also left VW dragging its feet in electric vehicles and created internal scepticism about new ways customers were using cars — ride-hailing services such as Uber, car-sharing business like Zipcar and apps that help steer drivers to businesses and services.
We have seen this before. Ninety-nine percent of the company’s output is in internal combustion engines – petrol or diesel – with management geared to fix the myriad problems that arise in a company selling 10m cars a year. But the world is going electric – many European countries have already mandated that there will be no fossil fuel cars allowed for sale beyond a certain date. In Germany it’s 2030, while in France at the UK its ten years later. Diesel bans, which are a significant part of European cars range, come into effect even earlier. There is a radical plan to ban diesel cars in Paris from 2020.
Any fix requiring further investment is probably off the table: Why invest capital in an obsolete technology? VW’s ICE business is virtually in rundown- and what should management tell the dealer network?
The economics behind this are bad, obviously, with plant and equipment running to billions of dollars to be written off. Of course, VW – and Daimler and BMW – can and will make electric cars, but this is likely the only part of the business that will be growing in ten years, and as yet, production is a not even as much as that of Tesla.