Q1 2018 Investor Letter

Source: https://ir.tesla.com/static-files/1b240f1e-b519-4b40-b14b-fea44698c3af

Release Text

Tesla First Quarter 2018 Update
*Model 3 production hit 2,270/week in April for the 3rd straight week over 2,000
*Q1 Auto GAAP gross margin up sequentially by 80 bp and non-GAAP by 500 bp
*Cash balance of $2.7 billion at the end of Q1
*2018 Capex projection reduced from >$3.4 billion to <$3 billion
*Expecting positive GAAP net income and positive cash flow in Q3 and Q4 2018

We made significant progress on the Model 3 ramp in the second half of Q1, and the momentum continued into early Q2. Prior to a planned shutdown in mid-April to further increase production, we produced more than 2,000 Model 3 vehicles for three straight weeks, and we hit 2,270 in the last of those weeks. Even at this stage of the ramp, Model 3 is already on the cusp of becoming the best-selling mid-sized premium sedan in the US, and our deliveries continue to increase. Consumers have clearly shown that electric vehicles are simply more desirable when priced on par with their internal combustion engine competitors while offering better technology, performance and user experience.

If we execute according to our plans, we will at least achieve positive net income excluding non-cash stock based compensation in Q3 and Q4 and we expect to also achieve full GAAP profitability in each of these quarters. This is primarily based on our ability to reach Model 3 production volume of 5,000 units per week and to grow Model 3 gross margin from slightly negative in Q1 2018 to close to breakeven in Q2 and then to highly positive in Q3 and Q4. Ultimately, the growth of Model 3 and the profit associated with it will help us accelerate the transition to sustainable energy even faster.

ADVANCING SUSTAINABLE TRANSPORT

As with all manufacturing, Model 3 production can only go as fast as the slowest part of the entire supply chain and production process. For months, the battery module line was our main production bottleneck. After deploying multiple semi-automated lines and improving our original lines, we have largely overcome this bottleneck. Consequently, we now expect to reach a module production rate of 5,000 car sets per week even before we install the new automated line designed and built by Tesla in Germany. Still, once installed, this new automated module line should significantly lower manufacturing costs. Our automation team in Germany is currently focusing on further capacity expansion where needed.

We continue to target Model 3 production of approximately 5,000 per week in about two months, although our prior experience has demonstrated the difficulty of accurately forecasting specific production rates at specific points in time because of the exponential nature of the ramp. In order to achieve this production rate, we plan to take additional days of downtime during Q2, just like we did in Q1. We have already done this several times during the Model 3 ramp, including once in the third week of April to fix several small, known constraints, enabling higher levels of output. Just before taking this latest downtime, we produced 2,270 Model 3 and 2,024 Model S and Model X vehicles in the prior seven days, which was a new record for us. Furthermore, in the just over two weeks between the beginning of April and the planned downtime, we had produced 4,750 Model 3 vehicles, which was already about half the production of the entire prior quarter. After achieving a production rate of 5,000 per week, we will begin offering new options such as all-wheel-drive and the base model with a standard-sized battery pack.

Once we hit the 5,000 per week milestone, we intend to incorporate our learnings to continue to increase output on our existing manufacturing lines beyond 5,000 units per week, and then in a capital efficient manner to add incremental capacity to ultimately get to a 10,000 unit weekly rate.

We’ve spoken at great length about the “machine that builds the machine” and why it is so important to Tesla’s long-term success. Fundamentally, we believe that thinking about a factory in the same way that people think about the product itself creates the potential for a step change in manufacturing that will create enormous benefits for quality, cost, efficiency and employee safety. It is human nature to take the best of what the automotive industry currently has to offer and assume that is the best that can be done. But we believe in first principles thinking. In the end, this is all about having factories that are producing the world’s highest quality cars as quickly and as cost-effectively as possible, and with as close to zero injuries as we can possibly get. Our automation strategy is key to this and we are as committed to it as ever.

We are already seeing many benefits from heavily increasing automation as part of the Model 3 production process. Through the vast majority of Model 3 production, including in body welding, general assembly, inverter and drive unit production, our automation effort has been very successful. Based on every measurable metric, Model 3 is already the highest quality vehicle we have ever produced, and this is unquestionably due in large part to automation. Additionally, we’ve been able to create significant safety benefits in the factory. For example, many steps in the assembly process, including “marriage” of the battery pack and drive unit with the body, and installation of the instrument panel, seats, and wheels, are ergonomically challenging for our employees, but by automating these processes, we have been able to solve this and significantly improve safety for our team.

That said, a step change in manufacturing doesn’t come without its challenges, particularly early in the process, and we made a mistake by adding too much automation too quickly. In those select areas where we have had challenges ramping fully automated processes, such as portions of the battery module line, part of the material flow system, and two steps of general assembly, we have temporarily dialed back automation and introduced certain semi-automated or manual processes while we work to eventually have full automation take back over. This flexibility has enabled us to continue to ramp Model 3 to new levels.

Automation is only half the story. Higher levels of automation have been enabled by a dramatic simplification of product design. Our Model 3 general assembly line consists of fewer than 50 steps, which is about 70% less than conventional assembly lines. All Model 3 vehicles use only one standard body frame, down from more than 80 for Model S, a wiring harness that has 50% less mass than average vehicles, and a fraction of the number of controllers, connectors and CPUs. All these elements are rooted in design and critical not only to our ability to reach higher levels of output in a smaller amount of factory space but also to achieve lower levels of cost. The Model 3 battery has sophisticated power electronics, cooling systems and structure that enables high level of safety, sports-car like acceleration, Supercharging, a 120,000 mile warranty and low cost.

Cells used in Model 3 are the highest energy density cells used in any electric vehicle. We have achieved this by significantly reducing cobalt content per battery pack while increasing nickel content and still maintaining superior thermal stability. The cobalt content of our Nickel-Cobalt-Aluminum cathode chemistry is already lower than next-generation cathodes that will be made by other cell producers with a Nickel-Manganese-Cobalt ratio of 8:1:1. As a result, even with its battery, the gross weight of Model 3 is on par with its gasoline-powered counterparts.

Demand for our flagship Model S and Model X vehicles remains very strong. After all-time record orders in Q3 and Q4 2017, we had our highest ever Q1 for orders. With demand exceeding supply, we are making considerable progress with margin improvement. InQ1, we produced 24,728 Model S and X and 9,766 Model 3 vehicles, and delivered 21,815 Model S and Model X vehicles and 8,182 Model 3 vehicles, totaling 29,997 deliveries. Short-term operational and logistical issues led to an increase in the number of Model S and Model X vehicles in transit to customers at the end of Q1. Model 3 net reservations, including configured orders that had not yet been delivered, continued to exceed 450,000 at the end of Q1 even though fewer than 20 stores worldwide had Model 3 on display.We are planning to deploy significantly more Model 3 vehicles in our stores in Q2 this year.

On March 15, we released a significant Autopilot update, which has been well received by our customers. Also, our mapping architecture has been upgraded and establishes a key platform to enable safer driving and the transition towards full autonomy. The latest mapping software in our cars is dramatically simpler and faster, providing a better user experience and superior performance.

During Q1, we opened nine new store and service locations, resulting in 339 locations worldwide at the end of the quarter. We continue to expand our service capacity mainly through growth of our electrified Mobile Service fleet. Such service capacity is quicker to deploy, incurs lower upfront and operating costs and has continued to generate significantly higher customer satisfaction rate at an average of 98%. There are about 300 mobile service vehicles in operation today, which is an equivalent of approximately 60 service locations. At the end of Q1, 25% of all service carried out in North America was done without customers having to visit a physical service center.

Last quarter, we opened 77 new Supercharger locations for a total of 1,205 Supercharger stations and more than 9,300 stalls worldwide. Most of the growth is currently focused on North America to support the initial Model 3 rollout. Nevertheless, in Europe, we already operate about 400 Supercharger stations. We continue to build Supercharger stations in locations with the highest demand and the most reservation holders. As a result, we are able to open new stations in specific locations even before fleet expansion takes place.

ADVANCING SUSTAINABLE ENERGY

While Model 3 is clearly in the spotlight both externally and internally, 2018 should be a very important year for our energy storage business. We continue to aim for a three-fold increase in MWh deployed for our energy storage products this year.

In Q1, energy storage deployments grew 161% from Q4 2017 to 373 MWh, which includes the 129 MWh South Australia project that was installed last year with final commercial transfer occurring in Q1. Electric utilities and power producers around the globe are increasingly appreciating the value proposition of our Powerpack storage systems based not only on economic benefits but also on the operational benefits of faster response time and greater reliability of the electric grid. In addition, we deployed a record number of residential Powerwall systems in Q1. In spite of the significant growth of Powerwall deliveries, our backlog in Q1 continued to grow.

We also deployed 76 MW of solar energy generation systems in Q1. Cash and loan system sales made up 66% of residential deployments in the quarter, up from 31% in Q1 2017 and 9% in Q1 2016. Due to higher upfront cash sales, lower emphasis on less profitable commercial projects and consolidation of our sales channels, our solar business had slightly positive cash flow throughout 2017. We are expecting cash flow from our solar business to remain at this level in the first half of 2018 and then improve significantly thereafter.

Solar deployments have declined over the last few quarters due in large part to our strategic decision to shutter certain sales channels and market segments. These decisions had a negative impact on our deployments but created a positive impact on our cash generation. Furthermore, a significant part of our customer base is waiting for a Powerwall before getting their solar panels installed. We continue to prioritize Powerwall deliveries when they are sold together with our retrofit solar panels, and this should have a positive impact on our solar deployments in upcoming quarters.

Our Solar Roof facility in Buffalo continued to ramp in Q1. We are working to enhance the product design and manufacturing process in order to improve the customer experience while reducing manufacturing cost and achieving high levels of quality. Production of Solar Roofs should accelerate significantly in the second half of this year.

Over the past couple of quarters, we have increased efforts to sell energy generation and storage systems in Tesla stores. We are seeing clear signs of a pickup in order rates for retrofit solar installations through Tesla stores. These are now being offered in over 90 Tesla stores in the US, and we continue to expand the offering to the rest of our stores across the US.

[TABLE OF Q1 FINANCIAL RESULTS REMOVED DUE TO LIMITED WEBSITE DESIGN SKILLS]

*Automotive revenue in Q1 2018 increased by 19% over Q1 2017, mainly due to Model 3 deliveries and adoption of the new accounting standard described below. ZEV credit sales in Q1 2018 were $50 million as compared to zero in Q1 2017.

*With the adoption of the new revenue recognition standard starting January 1, 2018, lease accounting generally applies only to vehicles directly leased by us without using bank partners. As a result of this change, only 8% of our deliveries in Q1 were subject to lease accounting. We are not expecting to offer a leasing option on Model 3 this year as we continue to focus on cash sales.

*Non-GAAP Automotive gross margin improved significantly to 18.8% in Q1 as compared to the prior quarter. Gross margins of Model S and Model X have increased to slightly above 25% due to better cost reductions, mix management, FX gains and pricing actions compared to Q4. GAAP Automotive gross margin improved to 19.7%.

*Model 3 gross margin remained negative in Q1 due to temporary underutilization of our manufacturing capacity, which was in line with our expectations.

*The recent voluntary recall of 125,000 Model S vehicles related to steering bolt corrosion was not material to our warranty reserves and is expected to be covered by the indemnification obligations of the supplier.

[TABLE OF Q1 FINANCIAL RESULTS REMOVED DUE TO LIMITED WEBSITE DESIGN SKILLS]

*Energy generation and storage revenue in Q1 2018 increased by 92% over Q1 2017 and by 38% compared to Q4 2017. This was mainly driven by substantial growth of our energy storage deployments and recognition of our large project in South Australia.

*GAAP energy generation and storage gross margin in Q1 2018 improved compared to Q4 2017 mainly due to an improvement of energy storage margin and fewer one-time items. We expect this improvement trend to continue in subsequent quarters.

Other Highlights

*Service and Other revenue in Q1 2018 increased by 37% compared to Q1 2017 primarily due to higher used car sales, but decreased by 9% sequentially as used car sales were lower in Q1 2018 compared to Q4 2017 due to a lower inventory of used cars available for sale during the quarter.

*Service and Other gross loss in Q1 2018 increased to $118 million as a result of the continued growth and maturation in our service infrastructure. Our used car sales had slightly positive gross margin.

*We expect Service and Other losses to reduce substantially in the coming quarters as our service infrastructure becomes significantly more utilized with the ramp of our Model 3 fleet size. There are also substantial revenue generating opportunities as we open our own body shops in 2018 to improve costs of out-of-warranty repairs and as we increase our offering of accessories and merchandise.

*Operating expenses in Q1 2018 increased by 14% compared to Q1 2017, and by less than 2% compared to Q4 2017 to a total of $1.05 billion in spite of significant revenue growth. Excluding stock based compensation, our operating expenses reached $930 million in Q1.

*Basic shares outstanding at the end of Q1 2018 were approximately 170 million.

Cash Flow and Liquidity

*Cash outflow from operating activities in Q1 2018 was $398 million primarily due to an increase in inventory and accounts receivable balances as a result of the timing of deliveries. Higher number of Model S and Model X vehicles in transit at the end of Q1 2018 compared to Q4 2017 had a negative impact of about $120 million on our working capital. Additionally, due to a substantial increase in our deliveries in the last few days of the quarter, our accounts receivables negatively impacted our operating cash flow by $169 million in Q1. Both of these factors provided cash inflows during April.

*We received $112 million in net funding from our vehicle lease warehouse lines, automotive asset-backed notes, auto tax equity fund and collateralized lease borrowings. When combined with free cash flow, this is a better indicator of the cash consumed in the quarter.

*More than half of our capex in Q1 was related to completion of work for Model 3 production capacity at Fremont and Gigafactory 1 plus payments to suppliers for tooling.

OUTLOOK

During Q2, we expect to shut down production for about 10 days, which includes the shutdown we took in April, to address bottlenecks across the lines and increase production to new levels. Our goal is to produce approximately 5,000 Model 3 vehicles per week in about two months.

We are in the process of changing the quarterly production pattern of Model S and X vehicles for the various worldwide regions to ensure a more linear flow of deliveries through the quarter. We believe this will provide a better customer experience and reduce the stress on our delivery system. Consequently, Model S and X deliveries in Q2 will likely be similar to Q1 but should pick up considerably in Q3 to achieve our goal of 100,000 deliveries for the full year.

Our long-term gross margin target of 25% for Model 3 has not changed. In the medium term, we expect to achieve slightly lower margin due to higher labor content in certain areas of manufacturing where we have temporarily dialed back automation, as well as higher material costs from recently imposed tariffs, commodity price increases and a weaker US dollar. On the other hand, our average selling price is significantly higher than prior projections, so we expect to achieve higher gross profit per vehicle than we previously estimated.

With increasing capacity for Powerwall and Powerpack products at Gigafactory 1, energy generation and storage revenues should continue to grow significantly throughout the year. Energy storage gross margins should therefore become positive in the second half of 2018. Our solar business is likely to experience mild growth for another quarter or two before our revised sales strategy starts to show its full impact in final deployments.

Quarterly non-GAAP operating expenses should grow sequentially at approximately the same rate as in the past four quarters, with our gross profit expected to grow much faster than our operating expenses. Thus, provided that we hit the 5,000 unit milestone in our projected time frame and execute to the rest of our plan, we will at least be profitable in Q3 and Q4 excluding non-cash stock based compensation and we expect to achieve full GAAP profitability in each of those quarters as well. Also, considering our capex targets, we expect to generate positive cash in Q3 and Q4, including the inflow of cash that we receive in the normal course of our business from financing activities on leased vehicle and solar products.

We have significantly cut back our capex projections by focusing on the critical near-term needs that benefit us primarily in the next couple of years. At this stage, we are expecting total 2018 capex to be slightly below $3 billion, which is below the total 2017 level of $3.4 billion. Ultimately, our capex guidance will develop in line with Model 3 production and profitability. We will be able to adjust our capital expenditures significantly depending on our operating cash generation.

Interest expenses in Q2 should amount to roughly $160 million and losses attributable to non-controlling interest should remain in line with the last quarter.

We have good visibility of our path to fully ramp and stabilize Model 3 production this year. Model 3 is already the best-selling electric vehicle and, more importantly, on the cusp of becoming the best-selling premium sedan in the US. The path to an electrified revolution is not easy, but what we’re trying to achieve is worth fighting for. Thanks for your continued support