Tesla Inc (TSLA) — Q2 2018 Earnings Call Transcript

Thank you very much, and good afternoon, everyone. Welcome to Tesla's second quarter 2018 Q&A webcast. I'm joined today by Elon Musk, JB Straubel, Deepak Ahuja, Robin Ren, our Head of Sales; Jerome Guillen, our VP of Trucks; and we also have our Autopilot team with us here, Andrej Karpathy, Director of AI; Stuart Bowers, our VP of Engineering; and Pete Bannon, our Director of Silicon Engineering. Our Q2 results were announced at about 1:00 PM Pacific Time in the Update Letter we published at the same link as this webcast. During this call, we will discuss our business outlook and make forward-looking statements. These comments are based on our predictions and expectations as of today. Actual events or results could differ materially due to a number of risks and uncertainties, including those mentioned in our most recent filings with the SEC. During the question-and-answer portion of today's call, please limit yourself to one question and one follow-up. Before we jump into Q&A, Elon has some opening remarks. Elon?

Hi. Thank you for joining. First of all, I'd like to say we're incredibly proud of the Tesla team for producing 7,000 Model 3, Model S, and Model X vehicles in the last week of June. It was an amazing effort. It's an honor to work with such a great team to produce that incredible result. It's mind-blowing. We continued to achieve 5,000 Model 3s per week, or 7,000 combined S, X and 3, multiple weeks in July, demonstrating that we can do this on a sustained basis. We expect to achieve an average of 5,000 Model 3s or above for Q3 and 2,000 Model S and Xs or above per week for Q3 as well. So essentially, 7,000 cars a week on average for Q3. That's an incredible jump from producing 2,000 vehicles a week just a year ago. It's truly a mind-blowing leap forward for a manufacturing company. The team worked incredibly hard – many late nights, weekends, extreme amounts of effort, and lots of smart ideas. One of the results you're seeing is that the Model 3 market share has surpassed all competitor premium midsized sedans combined. Model 3 market share is now a majority, in July, it was a majority of all premium sedans, and we believe this trend is likely to continue. We expect not to stop there. I have Robin Ren here, who is our worldwide head of sales, to talk about some of the interesting elements that we're seeing in terms of cars that people are trading in, the sales and demand trends; it looks really positive. We're receiving great feedback on Model 3 from our customers, and we're now delivering Dual Motor and All-Wheel Drive versions, and the Model 3 reviews are outstanding. We could not ask for better reviews from some of the toughest critics in the world. The more Model 3s we deliver to the field, it's causing parallel growth of our sales. Customers love their car and take their friends for a drive, and that's the fundamental driver of our sales. But not everyone has a Model 3, so we need to get the cars out there for test drives. As it is right now, not even all stores in North America have Model 3 for test drives. We prioritize getting cars to customers, but we're soon going to have Model 3s available for test drives in all stores, both the performance version and the rear-wheel-drive version. A lot of people will not buy a car until they test drive it, which is reasonable. On Sunday, when I delivered it, testing out a direct delivery, which I think is definitely the future, direct delivery from factory to customer's home or work, the guy who bought it had never actually sat in a Model 3. I was like, wow, okay. I mean I said, how do you feel about the car now that you have it and you've driven it? He's like, I love it. It's amazing. So, yes. It seems to be well-received. At a production rate of 7,000 cars a week, we believe we can be sustainably profitable from Q3 onwards. We're going to try to raise the Model 3 production rate steadily in the coming quarters and aim to get to the 10,000 cars a week number as soon as we can. We've spent a lot of time debugging a wide range of manufacturing issues, and the potential for our existing lines to produce far more cars is much greater than expected. By simplifying production lines, speeding them up, and modifying manual versus automatic processes, we've achieved dramatic improvements to the output of existing lines, making CapEx required to grow from 5,000 cars a week to 10,000 cars a week a tiny fraction of what is needed to grow from 0 to 5,000 Model 3s. This is, I think, very good news for the capital efficiency of the company. I want to emphasize that our goal is to be profitable and cash-flow positive for every quarter going forward. Obviously, if there's a big recession or a severe force majeure event that interrupts the supply chain, that's not always possible, but we're confident that provided the economy is roughly where it is today or reasonably strong and there are no big force majeure events, I feel comfortable achieving GAAP income positive and cash flow positive quarters moving forward. Once again, I want to thank the Tesla team for their incredible work and our customers for their support. Without the team and our customers who put their faith in us by buying our product, we would not be here today, and I'm really never been more excited about the future of Tesla. We have an exciting set of products to introduce. Sorry if I sound a little tired; I've been working like crazy in the body shop lately, but it's really going well, and I'm super excited. I've asked the three key leaders of the Tesla Autopilot team to be here, so I think it’s time to introduce them.

Okay, hi, I'm Stuart. I joined the team relatively recently and I'm incredibly excited to see the foundation the team has built up until now, and we're building on top of that right now. A lot of the focus is on Autopilot v9, which is our on-ramp to off-ramp solution that will automatically attempt to change lanes, understand what lane the car is in, understand the user's desired route, take that route for the user, and ultimately hand back control to the user, allowing them to stay in control. We're also digging into some new safety features. The most exciting aspect for me is seeing the foundation built over the past two years. I think Andrej will cover some perception and vision work we've done that allows us to build on this very quickly, leading to new safety features that really only make sense with an extremely nuanced understanding of the world.

Hello everyone, my name is Andrej Karpathy, and I'm the Director of AI here at Tesla. I lead the vision team responsible for interpreting the video stream from all the vehicle cameras to understand the surroundings. I've worked with neural networks for about 10 years, mainly in that space. I'm very excited about building out computer vision infrastructure that underlies all neural network training, aiming to get these networks to work extremely well and create a strong foundation for developing Autopilot features, including the v9 release that Stuart mentioned.

Hi, this is Pete Bannon. My team is currently leading Hardware 3 development. The chips are up and running, and we have drop-in replacements for S, X, and 3, all tested in the field. They fully support the current networks running in the car at full frame rates with plenty of idle cycles to spare. I'm genuinely excited about what Andrej and his team will do with this hardware going forward. An anecdote: I gave a talk to Andrej's team last month explaining how Hardware 3 works and its capabilities, and one of the researchers said he was thrilled about exploiting this hardware, indicating a strong interest in working at Tesla to access these exciting developments.

Actually, Pete, it would be great if you could tell everyone about your background since some may not know it.

Sure. I started designing computers at Digital Equipment Corporation in 1984, back when they were refrigerator-sized, and I’ve been working on smaller designs ever since. I was an Intel Fellow for a time and later became VP of Architecture and Verification at PA Semi, which Apple acquired. I led the design of the first ARM 32-bit processor for the iPhone 5 and built the team that developed the first ARM 64-bit processor for the iPhone 5S. After that, I worked on performance modeling and improvements at Apple for eight years before coming to Tesla to design the neural network accelerator for Hardware 3 and architect the rest of the Hardware 3 solution that will be in the car next year.

It's essential to note some details about why the Tesla AI chip is the world's most advanced computer specifically designed for autonomous operation, achieving an order of magnitude better processing than anything else available.

Two years ago when I joined Tesla, we surveyed solutions for running neural networks, including GPUs. We discovered most were adding acceleration to existing systems instead of designing from scratch, which we committed to do. Leveraging our insights into Tesla’s neural network designs and future projections allowed us to produce a design that delivers significantly more performance and efficiency than what is currently available.

Exactly, the key is to run the neural net at a fundamental level, especially executing calculations in the circuits and avoiding emulation modes used by GPUs or CPUs. This means conducting massive, localized matrix multiplications right at the circuits where results are stored, yielding performance improvements.

You're welcome.

Thank you for your contributions. I want to introduce three key team members at Tesla doing incredible work that will help ensure Tesla's success in this arena.

Thank you, Elon. Shiree, let's go to the first question.

Yes, thank you. I have one question and one follow-up, please. First, just on gross margins, it looks like S & X gross margins were up maybe 500 basis points sequentially, could you articulate what drove that? More importantly, it looks like you're calling for Model 3 gross margins to go from about maybe 3% this quarter to 15% next quarter. That's about a $6,000 cost out per car. Can you help us understand the forces driving that improvement in a relatively short timeframe?

Absolutely. First of all, I'd like to apologize for being impolite during our last call—there's no excuse for bad manners. Regarding gross margin, there are significant inefficiencies when filling the production line. There's a lot of waiting involved, where some sections of the line move well, while others lag. We discovered parts that we thought were correct but were not; thus, they had to be sent back to suppliers. The production system is a giant cybernetic collector that moves as fast as the slowest part. As we address those slow parts and improve efficiency, gross margin and profitability per car improve dramatically. Deepak, would you like to add to that?

Elon, you described it extremely well. To summarize, this was a significant milestone for us in Q2, with Model 3's gross margin turning slightly positive, and we feel good about the path ahead. As Elon said, it's driven predominantly by manufacturing cost efficiencies, with labor hours used to produce each car decreasing, one-time ramp-up costs disappearing, and fixed costs being leveraged to a higher volume.

Additional factors may affect gross margins. If we find that a part was poorly designed or built, sometimes we have to use low-volume tooling which may cost ten times more than using production tooling. When costs rise from low-volume tooling, it can have detrimental effects on margins.

I appreciate that, thank you.

Also, as we stabilize and grow production from these levels, we will achieve even more efficiencies. Q3 will also benefit from an improved mix, as we will sell more All-Wheel Drive and performance cars, and as we continue to achieve efficiencies, our gross margins will increase.

We've been seeing an encouraging trend, with roughly half of customers choosing the Dual Motor or All-Wheel Drive options—this has been a pleasant surprise.

When we opened the configurator and invited existing reservation orders, we saw tremendous excitement and response from our customers. We're observing more orders for All-Wheel Drive, Dual Motor cars combined than the rear-wheel drives.

It’s important to mention that we don’t want to assume this trend continues; we’re just showing what we're seeing right now.

Since we opened the configurator to the public in early July, we've seen increased demand from people who do not currently hold reservations. We've received over 60,000 test drive requests in the U.S. alone, and these potential customers are engaging with us and becoming excited after test drives.

Robin, you've been doing a great job managing worldwide sales. Your work in China has been next level. It's great to have you in this role.

We looked at what Model 3 buyers in the U.S. are trading in. From January to July, Toyota Prius, BMW 3 Series, Honda Accord, Honda Civic, and Nissan Leaf were in the top five traded cars.

It’s surprising that many of these traded cars are not traditional premium sedans. This is promising for the future, even though we haven’t yet launched our $35,000 car.

Hi. Good afternoon, thanks. I would like to discuss the Gigafactory coming in China. Regarding Gigafactory 1, I believe you mentioned a $5 billion investment. Could you give us an estimate on initial capacity and a linear extrapolation on the costs for the factory?

Sure, I'd also like to apologize for being impolite on the last call. It's not right, and I hope you can accept my apologies. Regarding Gigafactory CapEx, we've learned a tremendous amount from Gigafactory 1, and we are confident that we can do the Gigafactory in China for much less. I believe it will be closer to around $2 billion, which should reach a capacity of 250,000 vehicles per year. We are improving efficiency in CapEx.

I agree with all that. We've discovered numerous ways to improve efficiency and speed at Gigafactory 1; all those lessons will be shared with Gigafactory 3. Teams are already collaborating to do this more efficiently and with less CapEx than last time.

I'd estimate that it will cost less than half the previous amount, but probably not less than half, that would be a fair estimate for CapEx at the 250,000 level. We have learned a great deal about manufacturing during this time.

There are specific instances where we've accelerated production and improved efficiency with minimal additional CapEx.

One of the keys to Model 3 production success was the GA4 initiative led by Jerome. General Assembly is vital, especially focusing on zone one and two, which was crucial due to prior failures in production.

Thank you. It was a fun project that a lot of people contributed to. We aimed to create an assembly line that was straightforward, with good access for quality inspection and standards.

This tent is a significant improvement—it's commonly used as a permanent structure, and it challenged us to come up with creative solutions when GA3 could not produce at the required rate.

We designed a simple straight line assembly where cars enter at one point and finish at the other. This simplicity allowed for efficient quality checks swiftly.

Interestingly, we found out this setup required fewer labor hours per car than the GA3 system. The conveyor system's design enabled parts to be unloaded directly onto the line, eliminating unnecessary steps.

We've created an efficient assembly line where quality is maintained, and many people involved seemed happy and engaged in that area.

Joe, do you have a follow-up question?

Thank you for the insights. I wanted to explore capital spending given growth in China and future factories, how do you plan to fund this without going back to capital markets?

We will not be raising any equity going forward; I have no expectation of this. For China, our plan is to use loans from local banks to fund the Gigafactory in Shanghai.

We are executing an operating plan that keeps us self-funded despite our CapEx needs and maturing debts.

Our default plan is to pay off our debts with internally generated cash flow. We have no cash shortage.

Let’s go to the next question, please.

Hi, George. Are you on the line? Okay. Let's go to the next one.

Hey, everybody. There's so much love and respect for colleagues and Wall Street analysts on this call; it's lifting my spirits! I got two questions. First for the Autopilot team regarding fully autonomous cars and their potential military applications, do you worry that U.S. companies may ultimately not be allowed to operate weapons-grade AI-based tech in China and vice versa?

This has never come up. I wouldn't call it weapons-grade. The car is largely designed to avoid collisions, so issues of bullying on the road would be more of a challenge than military applications. We have not encountered the concerns you mentioned.

Who do you consider to be a more formidable competitor over time, BMW or Amazon?

Neither are likely to be a significant threat. I would be shocked if Amazon entered the car business, but BMW has solid engineering and is making investments in electrification; it would be great to see more from them.

Let's go to the next question.

I wanted to clarify how you will stop burning cash moving forward. It appears to be a factor of working capital improvement from the Model 3 ramp. If I look at the quarter, it seems favorable working capital increased by $430 million while risk levels remained consistent. If I divide by the incremental cars produced in the quarter, I reach a $23,000 per car estimation; does that make sense?

The working capital benefit is one factor, but gross margin improvements on the business, higher sales volume, and stable operating expenses will contribute to our ability to generate cash flow from operations.

Does a $20,000 per car boost in payables over two months seem reasonable for breakeven and stopping cash burn?

That is roughly correct.

Let's go to the next question.

I have a question for the Autopilot team. Can you speak on the challenges holding back a fully autonomous coast-to-coast drive? Are we closer given the compute technology advancements?

We could do a coast-to-coast drive using a specific route and custom software, but we'd be gaming the system. The focus must be on the fundamental safety of existing features. We want multiple lines of reliability before releasing the feature to customers.

The challenge for the team is to improve autopilot safety and utility for more vehicles. Over the next 6 to 12 months, we will deploy features in the form of active safety components.

We might be able to pull off a coast-to-coast demo before the end of the year as the focus remains on releasing version 9 software with significant advancements in autonomy.

What are the current attach rates for autopilot, and what are you doing to increase the number of cars with that functionality?

Autopilot technology improvements will enable margin gains, but achieving this requires the functionality to truly make a difference; breakthroughs are expected soon.

Let’s go to the next question.

Is GA4 in the tent now essentially permanent? Could this potentially give us a new model for capacity additions that are much more capital efficient over time?

It's permanent for now unless something better arises, but it's undoubtedly a good model for product assembly as it offers flexibility and rapid iteration.

The tent allowed us to learn capital efficiency lessons in assembly that will influence our future processes.

We’re primarily aiming for steel-frame buildings, but this tent has taught us vital lessons about efficiency.

This methodology of simplicity informs our approach and encourages us to build assembly lines that can adapt and improve over time.

We have begun exploring how we can improve the paint shop and general assembly efficiency, and the focus is on maximizing future car production.

The simple answer is yes; it will still be around those transaction prices.

It'll be lower than the current average selling prices, but we will see a richer mix of All-Wheel Drive options.

Thanks very much. That'll be all from me.

Thank you. Let’s move to the next question.

Thank you, everyone. I would like to revisit the challenges faced by Tesla, particularly in manufacturing. How would you rate the learning curves in manufacturing processes versus technological development?

To be frank, I'm not sure about the methodologies others use. What I'm aware of is how we operate, and we've managed to find ways to enhance our efficiency significantly.

Technology and manufacturing are essentially intertwined, and we’re treating many of our production issues as technology problems.

Much of production is determined by software, and we’re proficient at software capabilities compared to traditional automakers.

One of the issues we've faced comes from outsourcing, where we often struggled with quotients we hadn’t directly controlled.

We've successfully engaged our design engineering teams with production tasks to simplify and improve efficiency.

Thank you for your answers. Let’s move to the next question.

How close are you to cash flow positive after July?

While we don’t have precise July results as of yet, for the entire quarter, we aim to be significantly cash flow positive. Ultimately, that is what counts.

We have abundant cash reserves; there’s no cash shortage on our hands.

What does the outlook for Q3 look like regarding cash flow positivity?

I’m highly confident in our ability to be cash flow positive and GAAP profitable in Q3. Barring unforeseen circumstances such as economic downturns, I think we can achieve this.

We expect the same for Q4, provided normal conditions persist.

Let’s take a final question from Tim Higgins of the Wall Street Journal.

Do you still plan on producing a total of 1 million vehicles in 2020?

Yes, if it’s not a million, it will be pretty close—750,000 or so seems likely if conditions remain favorable.

Will Shanghai be important for reaching that goal?

Yes.

Have you decided where to produce the Model Y?

Not yet, but we may have an announcement this year.

We hope to identify a Gigafactory location in Europe before the end of the year.

Thank you all for your questions, and we look forward to speaking with you next quarter.