How Tesla is like a Startup in a Bad Way

TSLAs 2019 Stock Price (YTD) (Source: Yahoo Finance)

The word “startup” is usually associated with innovation and speed. But, from a financial perspective, the thing that most distinguishes a startup from other types of businesses is that startups are dependent on investors for cash to fund growth.

A common misconception here is that startups need investors because they are unprofitable. While many startups are indeed unprofitable (in many cases, rationally so), profitability does not shield a business from the need to invest capital (to build a factory, to build up inventory, to order raw materials for production in advance of sales, etc.) to grow. In the case of a rapidly growing, cash strapped startup, this problem is particularly acute as there are no certain past or future cash flows with which to finance growth and so startups have to turn to pitching investors.

By that definition, electric vehicle maker Tesla is a startup operating on an unprecedented scale. While it may have a valuation (over $40 billion market cap as of this writing) and revenues (over $20 billion in 2018) that look like a “grown up” company, as with virtually all startups, it is completely dependent on investors to finance its growth. Since Tesla went public in 2010, the company has raised over $15 billion of debt and equity (net of paying out dividends and repaying loans), over 2/3 of which has gone into funding the extensive capital expenditures (CAPEX: investments in tooling, equipment, factories, land, etc) they’ve needed to grow.

Note: the numbers / figures presented in this post are based on publicly available data provided by Tesla on its deliveries and financials. As Tesla has a penchant for revising old figures, some of these may be based on slightly outdated figures, but I have tried to use the most recent versions I could find. Tesla does not break out much detail by segment or, for automotive, by car model, and as a result most of the figures here are aggregate level. For revenues and gross profitability, I’ve used GAAP numbers from their automotive segment (inclusive of leasing) but for capital expenditures, operating expenditures, depreciation, and cash flows I’m using the entire entity. This is done both because Tesla does not provide breakouts by segment but also because burdening these costs on Tesla’s automotive business is likely both realistic (due to the fact that Tesla’s automotive segment is responsible for the vast majority of revenue and expenditure both today and in the past) and presents a more favorable view of the business (due to Tesla’s automotive segment consistently being more profitable than the others). Refer to this Google Sheet for additional information.

This has fueled an astonishing 76.4% compounded annual growth in revenue from 2009-2018, which is especially impressive considering that Tesla vehicles sell at a premium relative to the rest of the market.

However, because the company continues to require injections of investor cash (having raised $1.5B in the first two quarters of 2019, after burning $323M of cash in that same time), the key question for any current or prospective investor into Tesla is will all of this cash burn ever pay off?

This is a question that VCs are used to asking with the startups they pour money into, but it’s one that is a lot trickier for Tesla shareholders to answer. A small software startup looking for $10M in venture capital can find many patient sources of capital who are willing to bet that the company either turns profitable (because most of the cost lies in initial development and sales) or gets sold at an attractive valuation.

But, Tesla, with a valuation in the $10’s of billions (pricing out most buyers) and needing to raise $100’s of millions (if not more) each year from investors demanding near-term results (i.e. public market investors, large corporate debt holders and their rating agencies), will likely have to prove that it can generate real profits.

But, that isn’t happening today. While Tesla proudly boasts about record deliveries as a sign of healthy demand, the numbers show this is a direct result of Tesla’s choice to shift away from selling more profitable Model S/X vehicles to selling lower price, less profitable Model 3s. This has exacerbated a multi-year trend of declining per vehicle profitability:

Lower gross profits per vehicle are not the end of the world, provided that Tesla can sell enough Model 3s to make up for the lower unit profit and start covering their other costs. But that also isn’t happening. At a fundamental level, Tesla is just not getting any real operating leverage. While booming sales volumes have boosted Tesla’s gross profits, the company’s operating expenditures (OPEX; or spending on sales, administrative overhead, and research & development) have more than kept pace. Rational watchers can choose to interpret this as either an inability to maintain growth without spending huge amounts on R&D and SG&A or as smart, long-term bets on future technologies, but the data is clear that Tesla has a long way to go before proving it can fund its own growth just by selling more cars.

The chart below shows another way of looking at this — it graphs the number of vehicles Tesla needed to deliver to cover its OPEX in a given year against the number of vehicles Tesla actually delivered that year. What is astonishing is that the number of vehicles needed to cover OPEX has gone up dramatically each year. Only in one year since 2014 did Tesla close that gap — 2018 after two amazing quarters — and from the available data for the first half of 2019, it looks like, barring a dramatic shift in pricing or profitability, Tesla will need to hit its guidance of 360,000-400,000 cars to just breakeven.

*Multiplied 2019 H1 vehicles deliveries & deliveries to break-even by 2 to compare directly with data from past years

If Tesla is not clearly demonstrating improving profitability, then for the startup investment story to work, it needs to at least demonstrate improved capital efficiency (how effectively it spends investor cash on production). While one can point to Tesla’s more moderate CAPEX spend since 2017 as evidence for this, it is more relevant to understand how Tesla is progressing in its ability to turn CAPEX investments into profit.

While its difficult to calculate precise figures around capital efficiency in the absence of specific data on the cost to build a factory and how the factories are utilized, a ratio of Tesla’s annual automotive gross profits (adjusted to remove depreciation) to its annual depreciation (a way of measuring how current and past capital expenditures are utilized in a given year, albeit one which also factors in CAPEX from Tesla’s non-automotive businesses because Tesla does not break those out separately) can be instructive. The chart below shows that, where Tesla once generated nearly $5 in profit per $1 of depreciation in 2015, it generated only $2.69 in the first half of 2019 (over 40% less). In other words, if Tesla is improving its capital efficiency and utilization as it ramps production and learns from its past mistakes, its not apparent in the numbers.

Adj. Automotive Gross Profits are GAAP Automotive Gross Profits, Less Total TSLA Depreciation

All of this is not to say that Tesla is doomed — the company’s sales, despite missteps (happy one year anniversary of “funding secured”), continues to grow, and the company has clearly captured the American public’s imagination and mind-share as it pertains to electric vehicles, and equity/debt investors continue to extend Tesla more capital even at its current valuation and debt load.

But, in terms of capital requirements, Tesla is running the largest startup experiment of all time. Earlier this year, Bird raised $300M to invest in (what are currently) money-losing electric scooters. In a sense, Tesla is doing the same thing with the Model 3 but at a far greater scale, all the while trying to develop autonomous driving technology and financing the massive liabilities of its SolarCity business. As a result, Tesla needs to continue to sell the dream both to the public and to investors, and to continue to maintain the vision of future profitability and capital efficiency as a misstep here could cause things to rapidly unravel.

Special thanks Andrew Garvin and Derek Yang for reading an earlier version of this and sharing helpful comments!