Tesla (NASDAQ:TSLA) stock fell 14% after it reported its Q2 earnings on Wednesday afternoon. But I think that the drop should have been steeper. After all, Tesla stock had rallied into the report, gaining nearly 50% in less than eight weeks.
The Q2 results should make investors less upbeat about Tesla stock. The issue is not just that Tesla earnings missed expectations. It’s that its earnings, particularly in the context of its previously-announced deliveries number, raise real questions about Tesla’s operating model.
Meanwhile, long-running concerns about its management were only amplified by the departure of another key executive and more questions about the company’s strategy. Q2 was an important quarter for TSLA and for Tesla stock – and it was something close to a disaster. It seems likely, then, that TSLA stock will retest its early June lows.
Tesla’s Earnings Don’t Look Good Enough
Tesla’s earnings, like Tesla stock, are somewhat in the eye of the beholder. And optimists can point to good news within Tesla’s results. Automotive revenue rose 60% year-over-year, and jumped 44% versus the company’s disappointing Q1. Automotive gross margin did weaken quarter-over-quarter and year-over-year, but lower regulatory credits drove the sequential decline.
TSLA’s adjusted earnings were negative, but its free cash flow was nicely positive at $614 million. As the company highlighted in its Q2 shareholder letter, Tesla closed the quarter with $5 billion of cash and equivalents. Profitability might be pushed out a quarter, with some questions about Q3, but on the Q2 conference call, CEO Elon Musk projected a strong 2020, particularly in the second half.
That good news, however, is colored by a key fact: Tesla has launched what it expects will be its flagship product, so its revenue should be increasing. But, so far, Tesla is, as the old jokes goes, selling vehicles at a loss and trying to make it up on volume. Its automotive gross margin of 18.9% simply isn’t good enough.
And that margin is declining in large part because its sales mix is shifting from higher-priced S and X models to the Model 3. S and X deliveries were down 21% year-over-year in Q2. There’s a real question at this point as to whether the Model 3 is profitable , and yet Tesla keeps cutting the prices of the vehicle.
Bulls can point to Tesla’s Q2 free cash flow, but that cash flow isn’t sustainable. The company’s capital expenditures were just $250 million, versus full-year guidance of $1.5 billion-$2.0 billion. Q2 free cash flow was boosted by $150 million-plus as a result of the timing of that spending. Declines in its stock-based compensation added another $210 million. And changes in working capital – mostly inventory reduction – added another $287 million.
Those three factors drove all of the positive free cash flow and then some. And in the first half of the year, TSLA actually burned cash, excluding its new stock and debt offerings. Again, concerns about its profitability are realistic.
The Strategic Question Surrounding TSLA Stock
There’s little in Q2 to dispel the bearish argument that TSLA simply isn’t that profitable, if at all. The bullish response is that TSLA will become more profitable as it grows. A new factory in Shanghai, China is on the way. The Model Y should arrive next year. And Elon Musk has said that “robotaxis” should drive demand and earnings, once they’re ready, potentially at the end of 2020.
But any investor betting on growth needs to answer a simple question: why isn’t Tesla acting as if it expects that growth to come? Elon Musk has said that existing Tesla vehicles will be worth as much as $250,000 each in a matter of years, after they become self-driving automobiles.
Why, then, is Tesla cutting prices now? Musk was actually asked on the call why the company was cutting prices. His answer was “there’s a tremendous amount of desire to buy our cars, but people, obviously, they don’t have enough money to buy them, they cannot.” But if TSLA can’t make a profit by selling its cars at an affordable price point, that’s a real and obvious problem for Tesla stock.
Meanwhile, Tesla cut its full-year capital expenditure guidance. That’s another questionable move for a company that supposedly is growing. How is Tesla building its Shanghai factory, rolling out a new car, and developing autonomous vehicles by spending less capital? If its growth opportunity is so huge, shouldn’t Tesla be spending accordingly?
Tesla’s strategy just doesn’t make sense at this point. The company had planned to close almost all of its stores; now it’s not. Its cars will be worth $250,000, but Tesla is cutting prices. It’s hard for investors to believe in TSLA when its management is acting like it doesn’t.
Avoid Tesla Stock
Meanwhile, Tesla lost one of its co-founders, JB Straubel, who is stepping down. And that continues a steady exodus of Tesla executives, including former CFO Deepak Ahuja, who departed earlier this year.
Following Tes;a’s Q2 results, there are questions about the company’s fundamentals, its strategy, and its management. And while TSLA stock is cheaper than it was, it’s not cheap. The company still has a market capitalization of $40 billion, and an enterprise value not far from that of Ford (NYSE:F) and General Motors (NYSE:GM). But unlike Ford, GM, Toyota (NYSE:TM), and even Fiat Chrysler (NYSE:FCAU), Tesla isn’t profitable.
Maybe that will change. In fact, it’s likely that TSLA will become profitable again. But the Q2 earnings raise real questions about just how much profit Tesla can ever drive – and if those earnings can support a $40 billion valuation. I continue to believe that they can’t.
As of this writing, Vince Martin has a bearish options position in Tesla stock. He has no positions in any other securities mentioned.