Tesla told critics Wednesday by reporting healthy earnings and significant positive cash flow in the third quarter.
In months, critics actually warned that cash flow problems threatened the company's survival. Many experts scoffed when CEO Elon Musk claimed in April that he would deliver positive cash flow and profits ̵
"They're going to be at the expense of bankruptcy because they need capital markets to survive," said Investor John Thompson Fox News that same month.
"With analysts estimating a slowdown, but still cash contraction in the second half of 2018, Tesla may have to borrow up to $ 2 billion at the end of the year to stay liquid," Reuters reported in August. 19659003] Wednesday's results showed that these analysts were wrong. Tesla has no risk of bankruptcy. With $ 3 billion in the bank and a growing cash pillow, Tesla will not need to raise money to pay the $ 920 million loan due next March.
Why critics underestimated Tesla
Analysts believed Tesla was in trouble earlier this year because the company had burned nearly a billion dollars quarter by the end of 2017 and early 2018 If that burn rate had passed, Tesla had only had a couple of quarters of cash left. People doubted that someone would borrow more money for a company that already had about $ 10 billion in debt.
But all this turned out to be misleading. The massive combustion rate Tesla led in 2017 and early 2018 was a temporary situation associated with ramp up of Model 3 production. This ramp is now largely over, so Tesla generates money, not using it.
"Tesla is 15 years old, but it's still fundamentally a startup," I wrote back in July. And this is important in understanding the company's financial situation. It might seem strange to describe a company with a value of $ 50 billion as a startup. But what I thought was that Tesla still made investments in companies to achieve rapid growth.
Building a car company from scratch is difficult because car production is both technically challenging and extremely expensive. It is not easy to convince investors to give $ billion to a company without traces of successful automotive production.
Tesla's strategy has been to attack the problem in stages. First, it built a low volume, high end sports car: Tesla Roadster. Then it built a medium luxury sedan: Model S (and similarly priced Model X). Finally, it built the high volume and relatively affordable model 3.
Each time, Tesla used revenues from a car generation to finance the development of the next. But more importantly, every success built investor confidence, allowing Tesla to increase more capital for the next vehicle. And Tesla needed more and more capital for each vehicle because it tried to achieve higher and higher production volumes.
Free Cash Flow, Explained
A chart of Tesla's cash flow illustrates this situation nicely:
Free cash flow is a measure of how Tesla's "cash in the bank" changes quarterly. When free cash flow is negative, a company needs a source of external capital – either borrowing or selling stocks – to finance continued expenses. On the other hand, positive cash flow means that more money comes in, so that a company can pay off its debts.
It is important to note that free cash flow is not the same as profit. If Tesla consumes $ 1 billion in a new factory, $ 1 billion will be counted against free cash flow in the next quarterly statement. On the other hand, an accounting calculation will treat the plant as an asset depreciated over many years. So when a company invests heavily, it's likely to have a big negative cash flow – even if the investments are profitable in the long run.
Someone has looked at Tesla's free cash flow chart and concluded that Tesla was sentenced to soft money for an indefinite period until it finally went bankrupt. But if you take into account changes in Tesla's free cash flow over time, you can see that it was the method of madness.
Every time Tesla has started work on a new vehicle, cash flow has been severely negative as Tesla used to design the vehicle heavily and build up its production capacity. Around the time each vehicle begins to get out of the assembly line, the negative free cash flow hits a peak. So a few blocks later, as the factory approaches capacity, the free cash flow becomes positive. Tesla achieved positive cash flow in late 2013, mid 2016, and now in mid 2018. And the company experienced profits, but small, also in each of these periods.
If Tesla had decided to rest on laurels in 2014 and did not start work on model X, Tesla could probably have had several years of positive free cash flow – and maybe profit – from sale of model S. But Musk was not interested in resting on their laurels.
After proving Wall Street that he could bring Model S on the market, Musk quickly increased the amount of money to start ramping up production on model X. With access to more capital, Musk could do this faster, generate a higher cash burn rate and bring Model X to market faster. So when Model X began to generate positive cash flow, he still raised more money and began the even more ambitious effort to build the mass market model 3.
So when Tesla burned a lot of money earlier this year, there was every reason to expect that the story to repeat themselves: for the major expenses ahead of model 3's launch to turn into positive cash flow, as production production of Model 3 had been hit up. I wrote so much back in April and again in July. But even though I was surprised at how dramatically Tesla's cover has been. I thought Tesla could exclude slim positive cash flow and get a small profit in the third quarter. Instead, Tesla exceeded its expectations, generating free cash flow of $ 881 million in the third quarter and earning $ 312 million.
Tesla says that it expects similar strong results in the fourth quarter, and there is little reason to doubt this. The company says that there were significant improvements in efficiency in the third quarter of 2018, and we can expect further improvements in the fourth quarter. These cost savings enabled Tesla to cut the price of the cheapest model 3 from $ 49,000 to $ 46,000, which would help secure strong demand in the fourth quarter.
Tesla is no startup