Tesla Backtracks On Model 3 Forecasts, But Things Could Get Better

Tesla (NYSE:TSLA) published its Q3 2017 results on Wednesday, posting its largest-ever quarterly loss amid higher operating expenses and a slowdown in lucrative ZEV credit sales, although quarterly revenues grew year-over-year, driven partly by its premium Model X SUV. However, the key focus of the earnings was on the production ramp of the mass market Model 3 sedan, which we discuss below.

We have a $205 per share price estimate for Tesla, which is well below the current market price.

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Tesla Delays Model 3 Production Timeline, Margin Forecast Remains Intact

Tesla began Model 3 production in late July, manufacturing just 260 vehicles over Q3, well below its guidance of 1,500 units for the period. The shortfall is not entirely surprising, given that the Model 3 production process deploys significantly more automation compared to the production process for the high-end Model S and Model X vehicles, making it challenging to bring processes online at the early stages of the production ramp. Tesla said that the primary constraint related to the battery module assembly line at its Giga factory 1, where cells are packaged into modules. However, Tesla says that there is no fundamental issue with the supply chain or production process for the sedan.

While Tesla initially expected to ramp up production to a rate of 5k Model 3 vehicles a week by the end of 2017, the company now expects to see this achieved only by late Q1 2018. The company was non-committal about its previous goal of producing 10k Model 3s per week by the end of 2018, noting that it would see how it could accelerate production once it gets past the 5k per week mark. On a positive note, Tesla doesn’t expect the current production issues in the Model 3 line to impact its planned gross margin target of 25% in 2018, indicating that it had not witnessed any changes to projections for materials, labor and overhead costs per vehicle.

The Next Few Quarters Will Be Crucial For Tesla

We view Tesla’s ability to manufacture the Model 3 profitably, at large scale, as the most crucial valuation lever for the company, as the sedan accounts for roughly 65% of our price estimate for Tesla’s stock. Demand for the sedan has been very strong, with Tesla estimated to have garnered more than 450k reservations for the vehicle. Current waiting periods are estimated at as much as 18 months, and Tesla could risk alienating customers if its production issues persist. Moreover, the vehicle is crucial to Tesla’s overall financial well-being. The company has been burning through cash, with free cash flows standing at ($1.4 billion) over the last quarter. The company recently raised about $1.8 billion via bonds to finance the production of the Model and has about $1.4 billion in debt due by the end of 2018, making it imperative to kickstart cash flow generation from the new Model. Separately, sales of Tesla’s luxury cars also appear to be slowing down, with combined deliveries of the Model S and X growing by just about 4.5% year-over-year to 25,915 units. Tesla said that it plans to manufacture about 10% fewer Model S and Model X in the holiday quarter compared to Q3, as it reallocates some resources towards the Model 3 production ramp.

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