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Wednesday, April 26, 2017

Tesla: First the Cash, Then the Crash

Tesla recently (briefly) surpassed both Ford and General Motors in market capitalization. My own prognosis for Tesla's longer-run prospects aside, once the Model 3 launches cash flow will improve markedly. Financial markets may interpret that as validation of the high price they've put on Tesla shares. That however is a predictable result of the nature of cash for an automotive assembler, and will have nothing to do with Tesla itself. But it does mean that you shouldn't short Tesla yet.

...you shouldn't short Tesla yet...

Why do I believe this will happen? As our alumnus Bill Cosgrove emphasized in him many visits to Econ 244, in up cycles car companies spin off stupendous amounts of cash. In down cycles they're cash incinerators. Let's examine one source of that (there are others).

Historically dealerships financed the biggest asset in the auto industry, the inventory that sits on their lots. In particular, they pay for cars as they roll off the assembly line. (To be precise, dealerships' banks pay for them via the financing of "floor plan".) Suppliers contributed, too, because they are paid 90 days in arrears. In the early years of the industry they were the biggest cost of production. From the 1920s that role diminished, as Ford and General Motors integrated vertically into making their own engines and frames and bodies. But over the last 25 years car companies systematically spun off their internal parts into standalone operations, Delphi in the case of GM and Visteon in the case of Ford. So paying suppliers in arrears is again qualitatively important. Now when sales increase, for example up 2% in the month, car companies then take in 2% more cash, but pay out nothing more. It's only after 3 months do the payments to suppliers start to rise. That process continues as long as sales rise, irrespective of underlying profitability. A rising tide raises all ... wait, that's not the right image.

Or maybe it is. Because at some point the tide goes out, and with it goes the cash flow. The process reverses. Now car companies are taking in less money, but they're paying out the same amount or – if sales were rising and not just flat – amounts that will continue to increase for 3 months. Worse, it often takes a while to react, as a car company you don't want to slow production because of one odd month. And so the factory pushes metal onto dealership lots. As sales continue to fall, inventory piles up, and at some point the dealers push back, and stop ordering cars. In other words, inventory adjustment amplifies the pace of the downturn. Cars companies burn through cash. They turn from printing presses of profits into incinerators of money.

So when the Model 3 launches, Tesla will report a significant improvement in cash flow. Tesla investors will get good news for a few quarters, as the first 100,000 cars roll off the line and make their way into the garages of the more well-heeled of the enthusiasts who laid down their $1,000 advance deposit. This shift in finances will appear to validate the case for Tesla's high stock price.

But sales can't keep rising forever, particularly as Tesla will only have this one new model, and in a market where consumers are shunning sedans. At that point Tesla will begin hemorrhaging cash. They will have to pay suppliers more and more even as revenue stagnates and then falls. Worse, because they don't have independent dealerships, their debt will also explode as inventories build up. They won't be able to cut output fast enough, because they will have to keep paying suppliers for the higher level of orders prevalent 3 months earlier. They won't be able to cut sales staff, either, if they want to stay in business. Unlike traditional dealerships, their stores won't have service revenue, because most Tesla's will be new. That will be made worse by the nature of their product, as there won't be the oil changes that help service operations generate profits for dealerships even when car sales tank.

...don't short Tesla – yet...

So don't short Tesla – yet. But that time will come, because of the nature of the auto business.