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Morningstar | Tesla's 3Q Cash Flow Surges on Spike in Model 3 Deliveries

Tesla reported a seminal quarter in its history with not only record deliveries but meaningful free cash flow of $881 million. That figure is a $1.6 billion improvement from the second quarter of 2018 and a $2.2 billion improvement year over year. We have been skeptical of Tesla's ability to execute but we did expect positive earnings surprises in the back half of 2018 as Model 3 volume ramped up. However, we did not think the free cash flow movement would be this large this fast. We expect the Model 3's momentum to continue into 2019 so we plan to raise our fair value estimate by about 20% to account for about 7.5 million vehicles (of all models) delivered through 2027 instead of about 6.7 million previously. We also are giving Tesla more scale in research costs.

Tesla delivered 56,065 Model 3s in the quarter, up from 18,449 in the second quarter. Total company deliveries were 83,775, more than triple the prior-year's quarter and a 105% rise from the second quarter of 2018. Tesla also reported adjusted diluted EPS, which excludes stock-based compensation expense, of $2.90, crushing consensus of a loss of $0.19. GAAP diluted EPS came in at $1.75. CEO Elon Musk reiterated second-quarter call comments by saying he expects the company to be self-funded going forward, retire rather than refinance upcoming debt maturities, and be free cash flow-positive other than for large debt payoffs. The Model 3's demand looks excellent with Tesla reporting order cancellations from the August 2017 reservation count of 455,000 of under 20%. Anticipation should continue to build for the company after it unveils the Model Y crossover next year, though it's not expected to be available until 2020. Most interesting to us is Tesla saying that over 50% of vehicles traded in for a Model 3 were vehicles priced below $35,000 when they were new. This suggests many consumers are paying more than normal to buy a Tesla Model 3, which is a good sign for brand equity and future demand.

We remain concerned about Tesla's debt levels, recourse debt totaled about $7.3 billion at quarter-end, but cash at Sept. 30 of just below $3 billion and good fourth-quarter prospects makes us less worried about Tesla's ability to pay off the $920 million convertible bond maturing in March 2019. We do wonder how much longer the demand momentum will last. Phenomenon such as Tesla owners working delivery centers at quarter-end to speed up deliveries to new customers is amazing to hear, but we don't think that it's sustainable over the long term if Tesla is delivering millions of vehicles a year. Also, Tesla fans are eager to buy now but they may be less inclined to splurge on an expensive vehicle if a recession hits. The company will mitigate some of this cyclical risk over the next few years as it expands Model 3 availability to Europe and Asia in 2019.

Musk refused to answer a question on the call as to what attributes he would like to see in the new chairman of the board, insisting the call focus only on operational questions. Musk must step down as chairman in a few weeks per his settlement with the SEC on civil securities fraud charges. Current director James Murdoch is a possibility. We'd be neutral on him becoming chairman because to us it would likely mean Tesla remains the Elon Musk show. If the board wants to be bold it can hire a no-nonsense individual such as former GM CEO Dan Akerson, but such an appointment would probably create too much hostility with Musk, which ultimately would hurt Tesla's performance if the CEO is too distracted.