Q2 2018 Investor Letter

Source: https://ir.tesla.com/static-files/7235e525-db16-470c-8dce-9ecac0ad7712

Release Text

Tesla Second Quarter 2018 Update
*Q2 Automotive gross margin increased to 20.6% GAAP and 21.0% non-GAAP
*Model 3 gross margin turned slightly positive in Q2, expecting roughly 15% in Q3
*Expecting to produce 50-55k Model 3s in Q3; deliveries should exceed that
*Major cost restructuring executed inQ2
*$2.2Bof cash and cash equivalents at Q2-end, expected to grow in Q3 and Q4
*Capex projection in 2018 adjusted to <$2.5B

It’s fair to say that no production ramp of any other product has been as closely watched and debated as that of Model 3. We are proud of our team for producing roughly 7,000 Model 3, Model S and Model X vehicles during the last week of June. We also want to thank all of our reservation holders who have waited patiently and who have been supportive of our mission. While we faced multiple obstacles during this ramp, our team worked hard to find solutions, and in the end, it was all worth it: A total vehicle output of 7,000 vehicles per week, or 350,000 per year, should enable Tesla to become sustainably profitable for the first time in our history -and we expect to grow our production rate further in Q3.

In July 2018, Model 3 not only had the #1 market share position in its segment in the US, it outsold all other mid-sized premium sedans combined, accounting for 52% of the segment overall. The popularity of Model 3 is a true testament to the product. Based on trade-ins that we’ve received so far, we can seethat the total addressable market for Model 3 is much larger than mid-sized premium sedans. We are drawing customers from many other segments, including non-premiums sedans and hatchbacks.

AUTOMOTIVE PRODUCTS

During the month of July, we have repeated weekly production of approximately 5,000 Model 3 cars multiple times while also producing 2,000 Model S and X per week. Having achieved our 5,000 per week milestone, we will now continue to increase that further, with our aim being to produce 6,000 Model 3 vehicles per week by late August. We then expect to increase production over the next few quarters beyond 6,000 per week, while keeping additional capex limited. We believe that increasing capacity by improving utilization of our existing lines and making selective improvements to address bottlenecks rather than creating entirely new duplicated lines will be the most capital efficient approach.

We aim to increase production to 10,000 Model 3s per week as fast aswe can. We believe that the majority of Tesla’s production lines will be ready to produce at this rate by end of this year, but we will still have to increase capacity in certain places and we will need our suppliers to meet this as well. As a result, we expect to hit this rate sometime next year.

Over the past 12 months, we have overcome bottlenecks across various stages of the Model 3 manufacturing process. Last quarter, it became clear that GA3, our main general assembly line, would likely become a production constraint if certain issues were notaddressed. This assembly line, which is where we add all the components to a painted metal body, was designed to work with hundreds of robotic lifters that bring components to the line. Due to the density of the line and the relatively high downtime of the lifters, ramping GA3 became substantially more complicated than we had anticipated. That said, significant progress has been made in the last few months,and GA3 is now expected to reach a production rate of 5,000 per week very soon.

To address the short-term issues with GA3, we built GA4 to help us reach our 5,000 units per week target earlier and ultimately to push us past that point. We were able to build GA4 quickly due to the designed simplicity of the Model 3 architecture. The layout and processes of GA4 are similar to those of the Model S and X assembly line, while quality and cost of production are roughly equal to those of GA3. General assembly, excluding the cost of components, accounts for approximately 3% ofModel 3 cost. The rest of our manufacturing processes remain highly automated, including stamping, body-welding, paint shop, powertrain assembly and battery pack assembly.

No production target is more important than sustained quality, which is why every vehicle we produce goes through a thorough set of measurements and tests before it reaches the customer. Model 3 quality continues to improve every month and is already on par with Model S and X.

At the end of Q2, we started to produce the performance version of Model 3 Dual Motor All-Wheel Drive. The Wall Street Journal called it a “thrilling, modern marvel” and a vehicle that is “magnificent, a spaceship, so obviously representative of the next step in the history of automobiles. The Model 3 is more than futuristic. It’s optimistic. This is what ordinary cars should be, which is to say, better than they are.” Motor Trendsaid: “In maybe 120 wheel revolutions, a high-performance hierarchy has been rattled. The European marques perennially atop the sport sedan podium are about to have trapdoors release beneath them….[T]he dual motor and all-wheel drive give the compact Tesla a tensed, hair-trigger potency for leaping ahead or around whatever’s in the way. It’s pure jungle cat.”The performance version accelerates from 0 to 60 mph in just 3.5 seconds, which puts it into supercar territory, and with a starting price of $64,000, it is no more expensive than other high-spec premium sedans on the market today. Traction control software of Model 3 Performance has been substantially modified and it now allows drivers to powerslide, something that true track enthusiasts have been craving.

At the end of July, Gigafactory 1 battery production reached an annualized run rate of roughly 20 GWh, making it the highest-volume battery plant in the world by a significant margin. Consequently, Tesla currently produces more batteries in terms of kWh than all other carmakers combined.

In July, we announced our plan to build a wholly Tesla-owned Gigafactory 3 in Shanghai –our first Gigafactory outside the US. We are excited about this opportunity, as China is by far the largest EV market in the world and Chinese support for electric vehicles has been exceptionally strong. Initial capacity is expected to be roughly 250,000 vehicles and battery packs per year, and will grow to 500,000, with the first cars expected to roll off the production line in about three years. Vehicles produced at Gigafactory 3 will augment our existing capacity in order to meet growing local needs, which means our US manufacturing operations will not be affected. Construction is expected to start within the next few quarters, though our initial investment will not start in any significant way until 2019, with much of it expected to be funded through local debt. We will share more information about Gigafactory 3 in upcoming quarters.

Demand for Model S and Model X vehicles remains high, with Q2 2018 being our highest ever Q2 for Model S and Model X orders. In July 2018, we delivered our 200,000thvehicle in the US, which means that our US customers will have access to the full $7,500 federal tax credit until the end of 2018, at which point it will phase out over the course of 2019.

We produced 53,339 vehicles in Q2 and delivered 22,319 Model S and Model X vehicles and 18,449 Model 3 vehicles, totaling 40,768 deliveries.

Given that we are in full production mode for Model 3, we recently stopped taking Model 3 reservations in the US and Canada and moved to a direct order system, similar to our process for Model S and Model X. We continue to generate strong Model 3 demand despite having done almost nothing to try to sell it, and even though Model 3s have only been available to cash/loan purchasers of the long-range battery version with the premium interior package in North America. Demand will accelerate even further once we offer leases, less expensive variants, and orders outside of North America.

Additionally, we recently started taking requests for Model 3 test drives in July and have already received more than 60,000 Model 3 test drive requests in the US alone. Most stores in North America were just getting Model 3s for test drives in July 2018. Early results indicate that the Model 3 test drive-to-order conversion rate is higher than for Model S, so weekly orders should grow significantly in upcoming months. In recent weeks, orders from non-reservation holders have already become a significant portion of our total new Model 3 orders, suggesting that we have barely tapped the full potential of Model 3 demand.

While tariffs on vehicle imports to China have recently decreased to 15%, imports specifically from the US have increased to 40%. As a result, we had to adjust pricing in China in order to partially offset this increased cost. This will likely have some negative impact on our volumes in China in the near term. However, we do not expect our global vehicle deliveries to be heavily impacted since we will partially divert deliveries to North America and Europe if necessary.

Consistent with our mindset of continuous improvement for our products, we continued to add functionality to our vehicles in Q2. Thanks to the feedback we received, we significantly reduced braking distance of Model 3 through an over-the-air update. Summon and Wi-Fi functionality have also been added to Model 3 vehicles as well as an optional max speed limiter for all Tesla owners. We continue to analyze feedback from our customers on a regular basis and update functionality of our cars accordingly.

During Q2, we opened eight new store and service locations, resulting in 347 locations worldwide at the end of the quarter. Our electrified Mobile Service fleet continued to grow further to more than 340 service vehicles on the road today. While the majority of our mobile service network is based in the US, we are gradually rolling it out to other parts of the world. Our customers have shown a clear preference for getting their vehicles repaired at home or at work, which is why Mobile Service will continue to be a big lever for our service capacity expansion.

In Q2, we opened 103 new Supercharger locations for a total of 1,308 Supercharger stations and in late June celebrated our 10,000th Supercharger stall opening. To date, we have over 10,800 Superchargers and 19,200 Destination Charging connectors globally. We also continue to work with large employers to install chargers at their office locations so that customers lacking easy charging solutions at home can still switch to an electric vehicle.

ENERGY PRODUCTS

While we were largely focused on the Model 3 ramp in Q2, our energy business grew as well. Demand for our energy storage products remains significantly above our production rate even as we gradually add capacity. Overall, we expect our energy business revenue to improve in the second half of this year.

In May 2018, our energy storage business reached a significant milestone when we finished deploying 1 GWh of energy storage worldwide since the inception of our business. Having reached that milestone after less than 5 years, we are now aiming to repeat it with another GWh of energy storage deployed in just the next 9 to 12 months. Utilities and energy companies are quickly realizing the benefits of battery storage. According to third-party research, since we deployed our 129 MWh Powerpack project in South Australia, grid maintenance cost declined by 90%. This has been achieved due to the battery’s instantaneous response to electricity demand from our energy storage deployment. We continue to receive substantial interest for energy storage products from residential as well as commercial customers. In Q2, energy storage deployments grew to 203 MWh, an increase of 106% from Q2 2017. During the first half of 2018, our energy storage deployments were 450% higher compared to the same period last year. Our goal is to triple energy storage deployments in 2018 compared to last year.

We deployed 84 MW of solar energy generation systems in Q2, an 11% increase over Q1’18. Cash and loan system sales made up 68% of residential deployments in the quarter, up from 37% in Q2 2017.

Our solar sales strategy went through a significant change in Q2, as we prepare to sell energy products exclusively at Tesla retail locations and online. In the short run, our solar volumes should remain relatively stable, but we expect to rapidly grow our retrofit solar sales with our expanding customer base of Tesla vehicle owners. In spite of relatively low solar volumes expected in 2018, cash flow from this business should remain neutral.

We updated our Tesla app in Q2 to show the benefits of our solar + storage solution to every Tesla vehicle owner after a single swipe on the phone. We continue to see substantial cross-selling potential between our vehicles and energy products, and we now have over 80 Tesla stores in the US that offer our energy products. In Q3, this offering will expand outside of the US, as well.

We are steadily ramping Solar Roof production in Buffalo and are also continuing to iterate on the product design and production process, learning from our early factory production and field installations. We have deployed Solar Roof on additional homes in Q2 and are gaining valuable feedback from each new installation. We plan to ramp production more toward the end of 2018 and are working hard to simplify the production and installation process before deploying significant capital into factory automation.

[TABLE OF Q2 FINANCIAL RESULTS REMOVED DUE TO LIMITED WEBSITE DESIGN SKILLS]

*Automotive revenue in Q2 increased by 23% over Q1 and by 47% compared to Q2 2017, mainly due to Model 3 deliveries. There were no ZEV credit sales in Q2 as compared to $50 million in Q1.

*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 in Q2, only 6% of vehicles sold were subject to lease accounting. This is also a function of growing Model 3 sales that were all cash.

*GAAP Automotive gross margin improved to 20.6% in Q2, while non-GAAP Automotive gross margin improved to 21.0% in Q2 as compared to 18.8% in Q1.

*Model 3 gross margin turned slightly positive in Q2 even though we were still ramping production and did not yet deliver any All-Wheel-Drive or performance models. This was a significant achievement in the ramp of Model 3, as a result of dramatic reductions in manufacturing costs through lower labor hours per unit, reduction in ramp cost, higher leverage of fixed costs and lower material costs.

*Gross margin of Model S and Model X improved sequentially in spite of changes in FX rates. While average selling price of Model S and Model X remained flat sequentially, we achieved significant efficiencies in material cost and other manufacturing costs.

[TABLE OF Q2 FINANCIAL RESULTS REMOVED DUE TO LIMITED WEBSITE DESIGN SKILLS]

*Energy generation and storage revenue in Q2 increased by 31% over Q2 2017 and decreased by 9% compared to Q1. This year-over-year increase was mainly driven by substantial growth of our energy storage deployments while solar deployments declined. The decrease in energy storage deployments in Q2 versus Q1 was due to the revenue recognition on the completion of the large 129 MWh deployment in South Australia in Q1.

*GAAP gross margin of the energy business in Q2 improved further to 11.8% compared to 8.5% in Q1 mainly due to a higher mix of more profitable solar deployments. Other Highlights

*Services and Other revenue in Q2 increased by 25% compared to Q2 2017 primarily due to higher used car sales, but remained relatively stable sequentially.

*Services and Other gross loss in Q2 was in line with our expectations, and decreased slightly compared to Q1 to $116 million. This was a result of the continued growth and maturation in our service infrastructure attributed to the Model 3 ramp.

*Our total GAAP operating expenses increased to $1.24 billion in Q2, which was 18% more than in Q1. This increase was mainly driven by a $103 million restructuring cost. Part of the restructuring cost was related to a reduction in our workforce. Non-GAAP operating expenses in Q2 increased by roughly 3% compared to Q1 excluding the restructuring costs and stock based compensation.

*Interest and Other expense of $108 million was in line with our expectations. Other income increased due to currency fluctuations.

*There were approximately 170 million basic shares outstanding at the end of Q2.Cash Flow and Liquidity

*Cash outflow from operating activities in Q2 2018 was $130 million, which was significantly better than outflows of $398 million in Q1. This improvement occurred despite a substantial increase in finished goods vehicle inventory of $579 million as a result of the timing of deliveries. Model 3 gross profit excluding non-cash items shifted from negative in Q1 to positive in Q2, driving significant improvement in cash profitability. Additionally, significant improvement in our other working capital needs helped to mitigate the impact of inventory growth.

*Customer deposits decreased slightly compared to Q1 to $942 million. This does not reflect the incremental deposits we received once we opened the Model 3 configurator for orders in early Q3 2018. Deposits impact the P&L only once the vehicle gets delivered to a customer.

*We received $33 million in net funding from our non-recourse vehicle lease warehouse lines, automotive asset-backed notes, auto tax equity fund and collateralized lease borrowings. When combined with operating cash flow, capital expenditures and solar lease payments, it is a better indicator of the cash consumed in the quarter.

*Our capital expenditures were $610 million, slightly below the Q1 2018 level.

OUTLOOK

Now that we have reached a production rate of 5,000 Model 3 vehicles per week, we are focused on further ramping production, and achieving profitability and continuous cost efficiencies. We expect to produce 50,000 to 55,000 Model 3 vehicles in Q3, which will represent an increase of 75% to 92% from the prior quarter. Deliveries should outpace production in Q3 as our delivery system stabilizes. Model 3 gross margin should grow significantly to approximately 15% in Q3 and to approximately 20% in Q4 predominantly due to continued reduction in manufacturing costs and to some extent an improving mix. Average selling price will remain high for several quarters as we expect a richer mix in the initial wave of Model 3 deliveries to Europe and APAC. We believe future Model 3 cost savings will more than offset the normalization of the Model 3 average selling price in the second half of 2019, resulting in improving gross margins and stable gross profit per vehicle.

Model S and Model X deliveries should accelerate inthe second half of this year as we have now finished realigning our delivery process. While historically most deliveries were made towards the end of each quarter, our delivery pattern should smooth outin the next two quarters. Our target of delivering 100,000 Model S and Model X vehicles this year remains unchanged.

We are expecting that the negative margin of our Services and Other business will narrow by the end of this year. As we generate more revenue from used car sales, merchandise & accessory sales, body shop and other paid repairs, we expect revenue to grow significantly. Used car sales in particular are growing rapidly and are becoming more profitable. Structurally, as our vehicles come off lease and as our fleet gradually ages, used car sales will become a significant portion of our Services and Other business. A vast majority of our customers coming off lease are either obtaining a new Tesla or keeping their existing car, which is well above industry best-in-class.

While capacity for our energy storage continues to improve, our solar deployments should remain stable in the second half of this year as we solely focus on our own retail channel.

For the rest of this year, total non-GAAP operating expenses should remain relatively stable at Q2 levels excluding restructuring costs, as a result of our overall drive towards operating efficiencies. The higher import duties on Chinese components and unfavorable currency movements are likely to cause negative pressures. That said, we still expect to achieve GAAP profitability in Q3 and Q4. Going forward, we believe Tesla can achieve sustained quarterly profits, absent a severe force majeure or economic downturn, while continuing to grow at a rapid pace. We expect to generate positive cash including operating cash flows and capital expenditures, as well as the normal inflow of cash received from non-recourse financing activities on leased vehicles and solar products.

We have significantly cut back on our capex projections as a result of our revised strategy to grow capacity with our existing Model 3 lines rather than adding all new lines. Our total 2018 capex is expected to be slightly below $2.5 billion, which is significantly below the total 2017 level of $3.4 billion. Ultimately, our capital expenditure guidance will develop in line with Model 3 production and profitability. We will be able to adjust our capital expenditures depending on our operating cash generation.

Interest expenses in Q3 should be roughly $170 million(with approximately half being non-cash) and losses attributable to non-controlling interest should remain in line with the last quarter.

It took 15 years to execute on our initial goal to produce an affordable, long-range electric vehicle that can also be highly profitable. In the second half of 2018, we expect, for the first time in our history, to become both sustainably profitable and cash flow positive. None of this would be possible without the incredible efforts of our employees and the support of our customers, suppliers and investors. We thank you for your unwavering support and we have never been more excited on what the next few years will produce.