Analysts react to Tesla Inc (TSLA)’s cash generation and stronger margin performance for the third quarter.
Tesla’s stronger margin performance in Q3
We believe the TSLA narrative is starting to change as the company transitions to becoming sustainably profitable. We think the flip to profitability in Q3 could be the start of a narrative shift, as the market focuses on earnings and FCF generation potential. We believe positive estimate revisions could be on the horizon.
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The cash generation (which we expected) and stronger margin performance (which we didn’t) put the ‘extreme’ bear case to rest for a while but doesn’t dispel the valuation debate. While the profit and improvement was impressive, it comes after a rich Model 3 mix that’s unlikely to be replicated on top of opex stinginess that may need to be relaxed to support current volumes and future product growth. Without the future growth, TSLA will soon be facing flat sequential revenue growth and by YE19 slower y/y growth. With momentum from the beat and dispelling liquidity fears, while we don’t have near-term hopes of seeing our $210 price target (reiterated with our UW), Tesla’s stabilizing growth makes our long-term valuation more realistic.
The cash generation (which we expected) and stronger margin performance (which we didn’t) put the ‘extreme’ bear case to rest for a while but doesn’t dispel the • Good pricing and good margin drive a strong quarter. Tesla delivered a strong third quarter, underpinned by Model 3 mix and ASP that was better than we had expected, which drove gross margin upside relative to our model. Operating costs were also significantly lower than our model. The overall outcome is results that exceeded our estimates by a decent margin on the top line and a dramatic margin at the earnings line. Tesla still faces a myriad of challenges, but has just demonstrated it is capable of generating positive earnings and cash flow as it shifts to a high- volume business model. That is significant. Our price target increases from $350 to $412, based on a moderately higher gross margin outlook for 2019 and 2020, as well as lower operating costs. Our valuation methodology, which is based on 2.5x EV/Revenue, 15x EV/EBITDA, and 35x free cash flow using our 2020 estimates remains unchanged. We discount those estimates back to the present at 10% per year to arrive at our $412 target.
We believe this is mostly working capital driven; and with the company’s growth targets, capital requirements, an expected slow improvement in gross margin trajectory, and our views on sustainability of demand (particularly when incentives dissipate) we still see downside risk to longer-term FactSet consensus estimates. Our 12-month price target becomes $200.
Long- term, believe TSLA remains uniquely positioned to emerge as a vehicle ecosystem platforms leader.
With TSLA delivering positive cash flow in 3Q18 well ahead of expectations at $740M in FCF (vs. consensus at $180M), all eyes now turn to the 2019 debt maturities, capital needs for its China capacity expansion, and depth of demand for Model 3. With ~ $890M in convertible notes due March 2019 with a strike price of $359.87 and ~$525M due November 2019 at $759.36, we expect TSLA to hope shares trade above the March 2019 conversion price and pursue a new fixed income instrument to address capex and the November 2019 converts. TSLA also highlighted its remaining 300k + Model 3 reservations indicating it expects strong sales as it introduces Model 3 in Europe in early 2019. We remain bullish and raise our PT to $418.
Tesla flexed its model leverage muscles in 3Q18, exhibiting a dramatic swing from negative to positive on a number of key metrics. These included: Model 3 gross margins, earnings, and most importantly, cash flow. The company reiterated its confidence in continued profitability and FCF positivity in every period going forward. In other words, 3Q18 may mark the quarter in which Tesla became a sustainably self-funded entity.
Q3 was a milestone quarter for Overweight-rated TSLA, with margins, earnings, and cash flow easily beating our expectations. There's still a lot of "hair" on this company - and TSLA remains the most volatile stock we've ever covered - but we think bears will struggle to poke holes in today's results. Now that Tesla has achieved high-volume production of Model 3 sedans, the company has begun demonstrating that - contrary to many skeptics' long-held beliefs - additional capital raises are probably not necessary. Thanks to operating leverage, opex control, and tight working capital management, Tesla appears increasingly likely to achieve financial self-sufficiency. Our price target is moving from $389 to $396, and we reiterate our Overweight rating.
While TSLA claims it will be profitable and cash flow positive going forward, we do not see that as likely with declining prices. TSLA also claims to have no plans for a capital raise; however our view on a Q4 or 2019 capital raise is unchanged as Tesla will need to invest to expand Fremont production, build a China factory, ramp Model Y and expand infrastructure.
Our view: Strong 3Q18 across the board helped by M3 mix. Results may be sustainable NT while TSLA figures out how to unlock lower-end M3 demand profitability. TSLA may have crossed the line to become self-funding, which would be another clear positive. Expect positive momentum. Tweak PT to $325 but valuation appears fair.