On Monday, Seeking Alpha contributor “ALT Perspective” raised an interesting point in their article about Tesla’s (TSLA) potential plant in China and how this might change things for the company drastically and possibly save the day. The main idea was that since producing many physical consumer items from toys to cars in China offers a cost advantage to many global companies, Tesla might also be able to take advantage of that. In this article, I’ll take this idea and offer some further discussions to see costs and benefits Tesla might see by shifting some of its production to China.
In summary, while I agree that moving at least some of the production to China might provide some benefits for Tesla, the company is not really in a position to afford such move given its deteriorating balance sheet and cash flow situation. As I’ll discuss below, even in countries with relatively low cost of living like China, opening a new plant is not cheap and Tesla doesn’t have the resources necessary to invest in this country unless it raises more capital.
In order to see what Tesla could possibly do in China and how much it can get for its money, we must first see where Tesla is today compared to how much money it has spent. So far, Tesla has spent about $9 billion on capital expenditure with another $3 billion scheduled to be spent this year. This will take the company’s cumulative capex to $12 billion at the end of this year (excluding the capex of SolarCity prior to being acquired by Tesla). It is fair to ask this one simple question: where did spending $12 billion on capex take Tesla so far? Well, the company was able to increase the production of Model S and X to about 25,000 per year and Tesla is supposed to produce 6,000 Model 3s per week by the end of the year with a run-rate of 300,000 vehicles per year. Gigafactory is only 30% finished and it will continue absorbing money for years to come.
TSLA Capital Expenditures (Annual) data by YCharts
I’ll be fair to Tesla and mention that this capex also includes all the superchargers and service centers Tesla has built over the years but it might not include land value of these since Tesla tends to lease the real estate rather than buying (apart from its factories and a few office locations). Still, it costs money to build those superchargers, service centers and put the necessary tools in those places.
Now, if the company wants to start production in China, it has to build a new plant there. In last quarter’s conference call, Elon Musk said that future Tesla factories will be “combo factories” as they will produce batteries as well as cars. It’s a bit different from Tesla’s current production model where batteries are produced in Nevada and cars are assembled in California. A factory that is capable of producing batteries as well as assembling cars in mass numbers will have to be truly massive, much bigger than Tesla’s Gigafactory.
A few years ago, GM announced that it would invest $14 billion in 5 new factories in China. Since GM’s Chinese arm is a 50-50% joint venture, the true cost of these five factories would be $28 billion as half of the investment would come from GM’s Chinese partners. This would mean an investment of $5.6 billion per factory. Mind you that these factories don’t produce batteries and all they do is assemble cars. In other words, if GM intended on building “combo” factories, the cost would have been a lot higher, especially considering the Gigafactory and how much it cost Tesla to build 30% of it so far. As Tesla wants to enter the Chinese market without a partner, it will have to spend many billions just to get started in the country. Yes, production costs are a bit cheaper in China compared to the US, but China is not THAT cheap after all. For example, Volkswagen (OTCPK:VLKAY) is investing $12 billion with its local partners to produce electric cars in China.
Where will Tesla get this kind of money? The company’s current bond yield is above 7.5%, and if Tesla were to borrow $10 billion, its interest costs alone would be $750 million a year on top of the $500 million a year it already pays.
TSLA Total Interest Expense (TTM) data by YCharts
What if it pays for this by issuing more shares. Well, Tesla has already diluted its shareholders by 40% in the last 5 years which dwarfs dilution rates of even FANG (Facebook (FB), Amazon (AMZN), Netflix (NFLX), Alphabet (GOOG)) as you can see below. The company is not in a position to issue many more shares when its investors are already diluted to death and considering that the company was under SEC investigation until recently the agency might not let Tesla to proceed with this kind of an equity raise. You can only dilute your shareholders so much before SEC wants to have a say about that.
TSLA Shares Outstanding data by YCharts
So, who is going to pay for Tesla’s proposed plant in China? By the way, the company’s latest 10-Q filing only briefly mentions the Model Y, the new Roadster, Tesla’s Semi Truck, or any other future projects of the company. It pretty much says that all of the $3 billion capex will go towards Model 3. While there is nothing wrong with this, Tesla will obviously need to find more money to spend on those projects on top of a possible Chinese factory not to mention finishing up the remaining 70% of its Gigafactory. Below is what Tesla’s 10-Q says about its capex in 2018:
Capital expenditures in 2018 are expected to support increases in Model 3 production capacity at Gigafactory 1 and the Tesla Factory, and for building additional stores, service centers and Superchargers. However, we have significantly reduced our projections for capital expenditures by focusing on the critical near-term needs that will benefit us primarily in the next two years. At this stage, we are expecting total 2018 capital expenditures to be slightly below $3 billion. Ultimately, our capital expenditures will develop in line with Model 3 production, our profitability and our operating cash generation.
Who knew car industry could be so capital intensive? There is a reason car companies trade for single digit P/Es. This industry is heavily capital intensive and heavily cyclical. Tesla is no exception, but for some reason, Tesla bulls always believed that Tesla was an exception. Somehow Elon Musk would come up with something and Tesla would beat all its competition while saving the world at the same time. Well, actually, I will admit that there is one thing that makes Tesla an exception. When GM, Ford (NYSE:F), Volkswagen, and others invest in China, they are using their positive cash flow and profits. When Tesla is making capital expenditures, it is spending the money it raised in capital raises, so it’s spending investors’ money. When a company has several profitable products, it can survive in a capital intensive industry, but what if it doesn’t have any profitable products? GM and Volkswagen can have their ICE profits subsidize their electric car business while Tesla has to keep raising capital in order to grow.
During the earnings call for the 4th quarter (not the last quarter but the previous one), Elon Musk was asked about the ultimate capacity of the company’s Fremont plant. Back in the day when GM and Toyota (NYSE:TM) were running this plant, they were building 430,000 vehicles per year at the peak of production. This translates into 8,600 vehicles per week (assuming a 2-week down time). If Tesla were to produce 2,000 Model S/X and 6,000 Model 3s per week, it would reach the capacity of this factory. In response to this, Elon Musk said:
And I think we can get 10,000 vehicles a week out of Fremont without a significant – without creating really any new buildings of significance in the existing space. We will need to bring up the south paint shop, which is what we actually were using for S and X paint, and so we upgraded north paint to do S, X and 3. But with relatively small CapEx, like way less than we spent on north paint, we’re confident we can bring south paint up to achieve the approximately 600,000 vehicles per year rate. It’s a combined 100,000 S and X; 500,000 3, which would be 20% to 30% more than Toyota and GM produced in the same facilities. I mean, we’re a lot more vertically integrated as well.
Elon Musk sees Tesla building 100k S and X and 500k Model 3 when the factory reaches its peak capacity. If the company wants to grow any further than that, it will have to invest in a new factory even without factoring in a future Model Y, Tesla Semi, the new Roadster, or any other future product. In other words, even if Tesla doesn’t shift production in China, it will have to invest in a new factory sooner or later unless it wants to stop growing after reaching a capacity of 600k cars per year.
Between a future Chinese plant, finishing up the remaining 70% of Gigafactory, adding up additional capacity, launching Model Y, Tesla Semi, the new Roadster, and a possible Tesla pickup truck, the company will have to spend many billions on top of what it already spent so far. Considering that Tesla will have spent $12 billion between 2012 and 2018 just to launch Model S, X, and Model 3 at a current production capacity of ~300k per year, it will have to spend easily $25-30 billion to launch all those new products, build a massive Chinese plant that includes both battery and assembly operations and ramp up its production to 600k per year. Where will this money come from? Elon Musk says that Tesla will be profitable by the end of this year and that it won’t need to raise capital in order to funds its operations; however, will the profits be big enough to cover the future growth that will cost many billions of dollars?
Not to mention Elon Musk once said that Tesla will produce and sell a few million cars annually by 2025. This has been his long-term goal. If it took Tesla $12 billion capex to produce 300k cars annually, simple math tells me that it might take the company $120 billion of capex spending to reach an annual production rate of 3 million cars. Since we are 7 years away from 2025, we are looking at capex of $17 billion per year to get there. Bullish analysts always talk about how Tesla can sell millions of cars in the next decade, but they never talk about the capex that is required to get Tesla there. They talk as if Tesla can just ramp up its annual production from 300k to 3 million magically without spending any money. I’ve yet to see a bullish financial projection that takes this massive capex spending into account.
By the way, it will be very interesting to see how Tesla becomes profitable in the third and fourth quarters of this year on GAAP basis. Last quarter, the company posted $3.41 billion in revenues and $784 million in net loss. The company’s gross profits were $456 million and its operating costs totaled $1.05 billion. During the quarter, Tesla sold roughly 8,000 Model 3s. By the end of 3rd quarter, the company hopes to reach a weekly production rate of 5,000. If it sells these many cars per week during the quarter, it will sell 60,000 cars at the end of the quarter (or more like 55k given some cars will be in transit not to mention any down time at the factory for whatever reason). At an average sales price of $50k and average gross margin of 20%, these cars will add about $600 million to Tesla’s gross profits. Even if we assign $0 in operating costs to these 60k cars sold at $50k (which is utterly impossible since every car sold will have an SG&A cost but let’s be nice to Tesla for the sake of argument), this results in Tesla’s loss to drop from $784 million to $184 million. Still no profits. Even at a generous operating margin of 10%, Tesla would have to sell 157,000 additional Model 3s per quarter just to cover the loss from the last quarter. We are looking at 14,000 Model 3s per week (at an average price of $50k) just to get Tesla to break-even from last quarter’s massive loss. How do you see Tesla swinging from a loss of nearly $800 million to a profit by selling 5,000 Model 3s per week? The math doesn’t add up.
|Last Quarter (Tesla’s numbers)||Optimistic Q3 (my projection)||Realistic Q3 (my projection)|
|Number of Model 3 sold||8,000||55,000||55,000|
|Average price of Model 3s||$50k||$50k||$50k|
|Total Revenues||$3.41 billion||$6.16 billion||$6.16 billion|
|Gross Profits||$456 million||$1.2 billion||$1.2 billion|
|Operating Costs||$1.05 billion||$1.05 billion||$1.4 billion|
|Interest & Taxes||~$200 million||~$200 million||$200 million|
|Net Income (Loss)||$(784) million||$(50) million||$(400) million|
Even if Tesla makes a tiny profit, it won’t be enough to support the huge capital expenditures it needs to make in the near future in order to grow. Without explosive growth rates (~50%), Tesla can’t justify its current valuation. Theoretically speaking, Tesla could cut virtually all of its capex, focus 100% on profitability, and eventually get there and survive as a company but without growth, Tesla would get valued the same way other car companies are: at a P/E of 5-7 or 1-1.5 times its book value. In that case, even at $1 billion of net profit, Tesla’s market cap would be 1/8th of what it is today.
In order to fund Tesla’s growth and keep the share prices from crashing, money has to come from somewhere. The company has no choice but to grow and growth in this capital intensive industry doesn’t come for cheap.
Apart from the initial capex costs, there might be other issues with Tesla shifting its production to China. The Asian country is not as cheap as it once was. Back in the ’80s and ’90s, China’s production costs were a fraction of those in America but due to high-inflation in China, shipping costs and automation in factories, the cost difference has been dropping like a rock. Now China is just slightly cheaper than America in manufacturing costs and there are states in the US (such as some states in “deep south” and “mid-west” regions) that might be able to manufacture things even cheaper than in China. Speaking of states, why is Tesla assembling its cars in the most expensive state in America if it wants to cut its costs down?
Honestly, I’ve yet to see a bullish scenario for Tesla where the math makes sense and makes Tesla appear cheap. I often hear arguments like “if Tesla sells 5 million cars at a gross margin of 25% it will be cheap”. Well, if Tesla had to spend $12 billion of capex to get to an annual production rate of 300k cars, it will have to spend more than $120-160 billion to eventually get to those 3-4 million annual production rate bulls always talk about. Who will pay for all that? Tesla bull thesis has too many “ifs” and even if all their “ifs” align together, the company still looks expensive.
These are the types of questions longs should be asking themselves if they want to justify their investment in this company.
Disclosure: I am/we are short TSLA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.