Tesla Inc (TSLA) — Q3 2018 Earnings Call Transcript

Thank you, Sherry, and good afternoon, everyone. Welcome to Tesla's third quarter 2018 Q&A webcast. I'm joined today by Elon Musk, J.B. Straubel, Deepak Ahuja, and a number of other executives. Our Q3 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 portions of today's call, please limit yourself to one question and one follow-up. But before we jump into Q&A, Elon has some opening remarks. Elon?

Thanks, Martin. So I'll make some opening remarks, then we're going to talk about vehicle safety, Autopilot, and battery safety. We have a number of people from Tesla here to elaborate on that. I think there is just a lot going on that you would find interesting. But I want to start by thanking all of our customers, employees, and shareholders. This was an incredibly strong quarter for Tesla. Model 3 production stabilized. We delivered a total of 84,000 vehicles globally, which is more than 80% of the vehicles that we delivered in all of 2017. In fact, we delivered more cars in this quarter than we did in all of 2016, in a single quarter. Model 3 became the best-selling car in the U.S. in terms of revenue and the 5th best-selling car in terms of volume. We saw higher revenues and significantly better profitability in our Energy business. In fact, it may have been the best quarter ever for solar. We achieved GAAP net income of over $300 million, increased cash and equivalents by $731 million, and achieved a greater than 20% gross margin for Model 3. Moreover, we expect to again have positive net income and cash flow in Q4. I believe our aspirations will be for all quarters going forward. We can actually be positive cash flow and profitable for all quarters going forward, leaving aside quarters where we may need to do a significant repayment, for example in Q1 next year. I think even in Q1, we can be approximately flat in cash flow by the end of the quarter. This quarter was made possible by the incredible execution of our employees across the board from sales, production, delivery, service, energy, engineering, finance, and all of our G&A teams. Every part of the business executed incredibly well. I want to thank everyone again for your hard work. I especially want to thank our customers who helped us immensely, which is something I've never seen before—with a company's customers caring about the future of the company so much that they volunteer their time to help it succeed. I think that's amazing. You just don't see that anywhere. This quarter we started rolling out Version 9.0 of our software, the biggest software upgrade in three years. Model 3 received a 5-Star Safety Rating in every category and sub-category, with the lowest probability of injury of any car that the U.S. government has ever tested. Looking ahead, we expect to produce and sell even more Model 3s in Q4, and expect that trend to continue into Q1. We're excited to bring Model 3 to Europe and China early next year, given that the market for mid-sized premium sedans in those regions is even larger than in North America. I said before that we must prove that Tesla can be sustainably profitable. But this quarter was an important step towards that, and I'm incredibly excited about what lies ahead. I'm just so proud of the Tesla team and our customers. We really appreciate the support of our long-term shareholders, and I suppose, on behalf of the Tesla team, we're super appreciative of your support during what's been a very difficult time. Now, let's move to vehicle safety. Madan, our Lead Vehicle Safety Engineer, has been with the company for a long time. Madan, how many years has it been?

It's my 10th year.

Ten years, wow. I've been working with Madan for ten years. We have had so many conversations about vehicle safety. We really try to go the extra mile with vehicle safety. There are government-mandated tests, but some companies game the system by knowing where the site full impact is going to be, but at Tesla we're like, okay, what is the weakest point in the car? Let us test it at that position. The actual safety is not fully captured in the tests because we do not manipulate the system. Madan, if you…

Thank you, Elon. I just want to give you a very quick background about myself. Like I said, I joined Tesla ten years ago. I'm very happy to mention that I work with an extraordinary set of passionate and hard-working individuals, and that shows in our product. Our principle mission statement is about safety, because safety has been the most important factor for our vehicles, not just electric vehicles, any vehicles, period.

Yeah.

That fundamental difference differentiates us, which helps us keep adding new features and new safety technology. That's crucial, and it shows in Model 3. The design and architecture of our electric vehicles gives us a fundamental benefit over traditional vehicles. For example, we can work with an open architecture in the front instead of having an engine block, and the electrical and high-voltage components being placed low in the vehicle reduces rollover risk and improves safety.

Exactly. Architecturally, we have Newton on our side. Having Isaac Newton on your side is definitely the way to go.

In the latest series of tests, NHTSA conducted four different ones on Model 3: one frontal, two side, and one rollover test; hence they are calculating how to distinguish within the 5-Star ratings. Model 3 has the lowest probability of injury of all vehicles tested. Out of 900+ vehicles rated since 2011, Model 3 ranks as the best.

Not all 5-Star ratings are the same.

Exactly. The metric we developed as part of the US NCAP rating is a measure of the lowest probability of injury. I'd like to emphasize, we are not stopping our efforts. We are focusing on how we can integrate active safety and Autopilot features for further improvements.

It's worth noting that safety extends not just to the people in the car, but also to pedestrians.

Correct.

Having no large engine block in front provides extra safety for pedestrians, since if a car strikes a pedestrian, the hood can crumple in a way that cushions the impact. It serves as a cushion for pedestrian safety as well as protecting the occupants in the vehicle during a collision.

I'd like to mention how we consider real-world safety, which has always been important for Elon. We showed how we handle center pole impacts in front, which are outside the NCAP ratings—this represents how we go above and beyond standard testing for real-world scenarios.

Exactly. As I mentioned earlier, we test for the most damaging impact scenarios, rather than just strengthening areas where we know tests will occur. Obviously, for us, our friends and families are in these cars, so we care deeply about safety. Many people think safety is boring, but not at Tesla. Thanks, Madan, for your decade of hard work and to the entire Tesla safety team. Now let's move on to Autopilot updates. Stuart, can you give us an overview of our Autopilot software, AI, and hardware?

That's great. This is Stuart Bowers. We will soon begin the rollout of the team's most advanced Autopilot feature ever, Navigate on Autopilot. In our last release, we launched a new set of neural networks that provide a complete view of what’s happening around the car. With Navigate on Autopilot, we will use this information to understand precisely where the vehicle is on the highway and to automatically change lanes, handle forks, and take sharp exits. Initially, it will require drivers to confirm lane changes using the turn signal before the car maneuvers into another lane. Future versions will allow customers to waive this confirmation if they choose. One area I’m particularly excited to build upon is active safety. With advancements in neural networks and a complete 360-degree view around our car, we can achieve a constant vigilance that humans cannot match. This will enable us to warn or even intervene in a large percentage of modern accidents and deliver these improvements as software upgrades to our existing customers.

We see this often in the data where the cloud can perform automatic braking events and successfully prevent impacts with pedestrians or other cars. This happens frequently.

All the time.

Yes, potentially every day.

The team has done an incredible job. By incorporating more cameras around the car, we can detect objects approaching from all directions, not just directly in front.

Absolutely.

Hi, this is Pete Bannon. The Hardware 3 design is progressing well. Over the last quarter, we’ve completed silicon qualification and board qualification. We started the manufacturing line and qualified it. We've built test versions of Model S, X, and 3 in the factory to validate the fit and finish of the parts and the provisioning flows. There is still a lot of work ahead, but the team is doing a great job and we're on track to have it ready by the end of Q1.

Great! We anticipate a roughly 1000% increase in processing capability compared to the current hardware. It's an enormous improvement while maintaining similar cost, volume, and power consumption as the current hardware.

That's right.

And importantly, the only change needed between a car that's produced today and one produced in the second quarter of next year is swapping the Autopilot computer. This is a simple change that takes less than half an hour in service to upgrade the computer. Anyone will be able to upgrade their computer to full self-driving capability with a simple service visit. We expect all cars with a Hardware 2 sensor suite—basically anything made in the last two years—to be upgradeable to full self-driving.

In fact, many cars we’re using for testing today have been upgraded from Hardware 2.

It’s vital to emphasize that customers should not feel pressure to wait until Q2 to place an order. We want a seamless process, so there is no advantage to ordering now versus later.

Hi, everyone. My name is Andrej Karpathy. I'm the director of AI at Tesla. My team trains all neural networks that analyze the images from all cameras for Autopilot. These neural networks identify cars, lane lines, traffic signs, and much more. The team is incredibly excited about the upcoming upgrade for the Autopilot computer discussed earlier. It allows us to run current neural networks faster, and more importantly, deploy larger computationally intensive networks to the fleet. It's common in the industry, and we see this as well, that enlarging the networks by adding more neurons increases the accuracy of predictions. We are currently at a stage where we trained large networks that work well, but we couldn't deploy them due to computational constraints. This will entirely change with the next hardware iteration, marking a significant step in compute capability. The team is excited to get these networks out there.

Thank you. Speaking of the long-term future, we see a shared electric autonomy model. This will enable ride-hailing or car sharing, a model blending elements of Uber, Lyft, and Airbnb. There will be Tesla-owned cars for ride-hailing, as well as the option for customers to share their cars freely. This combination is effectively where things are headed long-term. Tesla will have millions of cars in the field with full autonomy, giving us a competitive edge that others won't have.

Yeah, thanks. The safest cars are made by the safest people. All car manufacturing factories have injuries, but at Tesla, our commitment is to reach zero injuries. Our target is focused on good reporting. We have good reporting of injuries, near misses, observations, and continuous improvements. To be the safest company in the world, we must be committed, and everyone here is dedicated to that goal, and we are steadily moving towards it.

Absolutely. People have mentioned that we have been underreporting injuries, but OSHA completed their investigation and confirmed we have not engaged in any such activity.

Correct, correct. The factory underwent a 4-month-long Cal-OSHA investigation, which proved we have been recording and operating properly, contrary to certain media reports.

Yes. And I'm proud of the team for achieving this.

One point I think people might not know is that I've been here for about a year now, and time flies when you're having fun.

It feels like five years.

When I joined, our injury rate was already a fraction of what it was when Toyota and GM ran the factory in earlier days. We are committed to continuous improvements from that point.

Yes, essentially we see muscular sprains and minor scrapes as most common injuries.

Exactly. Our team has been working alongside the leaders to enhance safety. We've built a strong EHS team. We have engaged with associates to learn the process firsthand and understand their needs. We've completed over 15,000 improvements this quarter, indicating our commitment to safety.

That's a significant achievement. We are expanding our health clinic at both Fremont and Giga, providing immediate first-class healthcare when needed, which is essential not just for workplace injuries.

We're excited. We want to be proactive in every aspect of safety, joining organizations and working with leading universities like California Berkeley to benchmark practices and find improvements.

Thanks, Laurie.

Thank you.

Let’s move on to questions.

Thank you very much. Let's start with the first question.

Hey, thanks for taking my questions. Congratulations on the quarter. It's amazing to see this landmark quarter after covering the company for so long. My question is about cell supply. There has been some noise about tight cell supply in Sparks and tight labor supply. Can you discuss whether demand is outpacing supply of battery cells and what's your long-term plan for cell supply expansion, especially in China?

JB, do you want to take this?

Sure. I can address that. We experienced a period where the cell supply was tight for Model 3, but it did not significantly constrain production. The impact was largely felt on energy products, and that remains somewhat tight. However, as we've noted in prior discussions, we also have third-party sources for energy cells, allowing us to continue energy production independently of Panasonic's supply in Sparks. Production is gradually increasing. In recent weeks, we started another cell production line with Panasonic, and more lines are coming online soon, leading to a steady increase in total supply. This should keep pace with Model 3 growth and enable a larger portion of energy supply to be sourced locally.

We are manufacturing a substantial portion of the world's lithium-ion batteries—around 60% or so?

Yep. For Q3, all electric vehicles worldwide totaled about 20 or 19 gigawatt hours of battery capacity; we produced roughly the same, so about half the world's batteries.

Got it. Are there plans for cell supply in China? Will that production take place in China?

Long-term, yes, cell manufacturing will take place in China. In the short run, there are uncertainties, but long-term plans are in motion.

Thank you. Let's go to the next question, please.

Thank you for taking my question. I was surprised by your gross margin performance on the Model 3. If I remember correctly, you were expecting around a 15% margin for this quarter, yet you performed better than 20%. Can you explain the improvements on the manufacturing line that were quicker or better than expected?

Our improvements on the cost side were across the board. Our manufacturing labor hours significantly improved, leading to an almost 30% sequential drop in overall manufacturing costs from Q2 to Q3. Increased volumes improved fixed cost absorption and reduced scrap and yield across both factories improved notably. There’s still more potential for optimization in Q4.

We also were conservative in our predictions; the expectation was more towards 15%.

Thanks, that’s great. I wanted to follow up on the announcement of the mid-range car with a smaller battery pack. You had two options: to broaden or to keep high-end vehicles, and I was curious about the reasoning behind the sequence you selected. Why was the lower-cost car prioritized, while expansion abroad is set for early next year?

Our goal is to provide the most affordable electric car options possible. Since we couldn't immediately get to the $35,000 vehicle, we decided this might serve as an intermediate step. We expect significant production for Europe in January, and while the shipping takes time, we will likely see substantial deliveries in Europe around the end of February and into March since we count delivery only when cars reach end customers.

Once a car is delivered, it’s officially counted.

We may or may not deliver cars in APAC in Q1, but certainly in Q2. It depends on logistics.

Let’s proceed to the next question.

Thank you. You indicated that you will be bringing the Model 3 to Europe early next year. What production volume do you feel is necessary to support this ramp?

Initially, at least vehicle production will occur at our plant in California for several months.

Where do you anticipate the weekly production rate needs to go to support that ramp?

It’s difficult to forecast accurately. With all the tariff issues as well, we can’t pinpoint the exact future demand for Model 3, but long-term expectations could fall between 500,000 to 1 million units yearly. For comparison, the BMW 3 series represents about 0.5 million units a year, so it would be logical to expect a similar, if not greater, demand over time.

Will you need to add new lines for that, or are you focused on removing bottlenecks currently?

We are definitely going to implement local production in China, rapidly progressing on that front. Model 3 production for the Greater China market will undoubtedly take place next year, in a capital-efficient manner. We'll also have a factory in Europe because making cars in California and shipping them to Europe is cost-inefficient.

Let’s move on to the next question.

Thank you. Is the target still to produce 10,000 Model 3s weekly at Fremont? After reaching a run rate of around 5,000, will you have a better understanding of the CapEx needed to get there?

We aren't ready to share precise figures right now, except that reaching this goal will require considerably less capital than what we initially spent to achieve 5,000.

Very minimal.

Exactly. Improving the uptime of existing lines should allow us to reach 7,000 units a week with minimal CapEx. Moving past that will require larger upgrades to the existing lines for a significant ramp to 10K, but we’re not discussing substantial CapEx for that either.

Understood. In the letter, you mentioned that the European market for premium mid-sized sedans is roughly twice that of the U.S. Are you expecting a richer mix of sales in Europe compared to the U.S., or do you expect it to be fairly similar?

We haven’t concentrated on that question. Martin, any insights?

I believe cold weather and demand for all-wheel drive and long battery range vehicles will be strong in Europe. However, we need to start selling cars first to determine actual demand.

It’s reasonable to expect strong demand in Europe, similar to what we see in other markets. Our primary aim is to produce electric vehicles that everyone can afford. If we could make the $35,000 model today, we would. We anticipate being ready for that within about six months.

Let’s move on to the next question.

Hi, thank you. Congratulations on a significant turning point for Tesla. As you scale, how do you plan to balance profits versus reinvestments? You are targeting sustainable GAAP profitability and cash flow. Is there a target margin or cash flow you would like to maintain to then fund new growth or accelerate opportunities?

The answer is no, we aren’t starving new vehicle development to achieve profitability. We have made significant progress on Model Y, having approved the prototype for production recently. We're looking at 2020 for volume production. We are also progressing with the Semi and the new Tesla Roadster. I’m particularly excited about the Tesla pickup truck, which I believe will reach the next level. Additionally, we plan to begin volume production of the solar tile roof next year.

Great. When thinking long-term about Tesla having a ride-sharing fleet or enabling customers to loan out their cars like on Airbnb, do you think the future involves building a platform for applications that allow car utilization? What would the business model be? Should we think of it like a revenue-sharing model similar to how Apple handles iPhone apps?

Not quite turning cars into applications, but maximizing usefulness is key. Tesla will operate its own ride-hailing service to compete directly with Uber and Lyft, while customers will have the ability to share their cars on a whim. It's a mix of Uber, Lyft, and Airbnb, and we might charge 30% to add cars to our fleet.

Let's move on to the next question, please.

Thanks, everyone. Regarding governance, as the company seeks a new chairman, what qualities and experiences do you think are essential for that person?

I’d like to keep this question within operational topics. Do you have another question?

No problem. Could you share what kind of trade-ins you're receiving for Model 3? What are the top brands customers are switching from, and how many are new to the brand?

Yes, I can provide that information. The majority of trade-ins we see come from non-premium brands. Over half of the trade-ins were originally priced under $35,000. Aside from that, we have observed no strong patterns indicating anything significant.

This is a substantial upgrade for many people as it is the most expensive car they have purchased.

Again, the main reason for many customers to refer friends to Tesla is safety.

If I could add one more question, do you view Q3 as a turning point where Tesla could sustain operations without needing support from outside capital?

Yes, that is our goal. We do not intend to raise equity or debt at this stage. However, our current operating plan aims to pay off our debts rather than refinancing them, thus reducing overall leverage.

I would like to add a point regarding logistics that can influence operations. I recently examined our inventory and was surprised by the time and cost required to get cars to customers. In August, it took an average of 30 days to deliver a car, which we reduced to 20 days by the end of the quarter. Our goal for Q4 is to bring this average down to less than 10 days, which greatly enhances our capital efficiency since we are producing around $75 million worth of cars daily. Every additional day in delivery costs us around $750 million in capital requirements.

This aspect—that alone—could over time significantly outperform all competitors. It’s a crucial advantage.

Improving these efficiencies and reducing our inventory in Q3 contributed positively. Although we faced a rise in accounts receivable due to quarter-end, we anticipate continued improvements in Q4 and onwards.

Ultimately, if this were our only focus, it would provide a competitive edge against all automakers over time. We’re committed to that improvement.

Thank you. We'll proceed to the final question now.

Thank you. Elon, as the federal tax credit begins to phase out with your sales exceeding the threshold, what impacts have you modeled that may slow sales?

We don’t anticipate a significant production decline as customer options increase. While the tax incentive will reduce in half by the end of this quarter, additional low-cost options will help in sustaining demand within the U.S.

Are you concerned that it may depress demand within the U.S.?

As we introduce more affordable models, I believe that's what will sustain U.S. demand.

Fantastic, that concludes our call today.

I'd like to add a closing comment. I personally wish to thank all Tesla employees for their incredible hard work during this quarter and prior quarters, as the company’s results reflect the dedication and passion our team has shown despite numerous challenges. A heartfelt thank you to all our customers and investors for believing in us and supporting our vision of advancing global transition to sustainable energy.

No, I am good.

Anyone have additional comments? Thanks everyone, look forward to the next call.

Thank you. Goodbye.