Tesla: we’re going to miss you when you’re gone

(Tesla (TSLA) filed their 2Q earnings report last night, and while I really should wait until they file their 10-Q to make this more complete, I really just can’t help myself.)

In late January, TSLA reported an optically-impressive Q4’18 result (91k deliveries, 24% automotive gross margins, $140mm in net profits), and on the post-Q conference call, Elon Musk confidently predicted a move towards the sunny uplands of sustained profitability and free cash flow…but at the end of his prepared remarks, the incumbent CFO and longtime lieutenant, Deepak Ahuja, announced he was leaving the company.

When it came time to report Q1, however, all we got was another massive loss ($700mm net), cash burn (-$900mm), and a big decline in automotive gross margins (to 20%). Not to worry, said Musk – 1Q was affected by ‘seasonality in the auto industry’, and ‘logistics hell’ (as the company started shipments of the Model 3 worldwide – 2Q would see a return to delivery growth, positive free cash flow, and perhaps modest profits. Musk doubled down on this prediction barely a month ago, when – in a leaked employee memo – he suggested ‘a record quarter on every level.’ This subsequently goosed the stock (which had been in semi-freefall) into a stunning rebound, pushing it from the $190-ish level at the time to $260+ before this most recent release.

Surprise surprise, TSLA’s latest report arrived with a dud. Despite record deliveries, they lost more money ($400mm net, $200mm operating); automotive gross margins fell further (to 19%), and they only generated some free cash by liquidating inventory ($400mm+ in the Q) and cutting capex to less than 50% below depreciation (something you never see from ‘growth’ companies). And in case you weren’t paying attention – it wasn’t mentioned in any press release, of course – the CTO, JT Straubel (and a 16yr veteran of the company), is quitting as well.

Of course, you needn’t worry – Musk once again proclaimed TSLA would make a profit in 3Q, and be sustainably FCF generating going forward…just like he said in the last three quarters 😉


Wider Implications

Snark aside, this quarter was quite important for bulls and bears alike, simply in that it demonstrated TSLA remains structurally unprofitable even at its current rate of record deliveries (around 100k a quarter). It’s quite easy to see why: as fast as COGS per unit are falling, ASPs are falling faster. Here is ASPs vs COGS, over the last 6qs:

Screenshot 2019-07-25 11.46.19

Per the above, blended ASP was 70k per car in 4Q but just 56k in this past quarter – hence, the improvement in COGS/unit (53k -> 46k) was more than undone by lower prices. This is a function of changing mix (more lower-priced Model 3s vs less Model Xs and Model Ss) but also something I have written about before – the ASP-destructive price cuts that TSLA has needed to drive volume. Since the company has further cut prices by another 4-5% at least early in 3Q, it is very difficult to see how this changes in the future (once you cut prices for a consumer product to drive volume it is nigh impossible to start raising prices again).

If gross profits – which, by the way, include all ZEV and non-ZEV credits, so I am giving TSLA for benefit for this non-operating high-margin revenue being viewed as sustainable – even remain flat, though, it is impossible to see how TSLA ever generates operating earnings. Because as per the below, despite significant and widely-publicized cost-cutting (‘efficiencies’ to the bulls, perhaps under-investment to the bears) in recent quarters, TSLA is clearly bumping up against the limits of its opex/unit leverage – even when it is delivering record volumes:

Screenshot 2019-07-25 11.52.51

Per the above – opex per unit troughed at just over $11k in 4Q, and is essentially there today, despite all the machinations (closing stores, cutting toilet paper budgets, firing staff, not paying worker bonuses, etc) the company has rolled out this year. And yet back in 4Q, they generated $17k of gross profit per car (hence the profit), versus the $10k today (hence the loss). Since ASPs are still going down (and volumes seem likely to moderate lower as well, despite the price cuts), it is therefore unfathomable to me how TSLA ever makes any money. Yet in today’s day and age, this entity is deemed worth $55bn by the capital markets…

Of course, bulls would posit that this is just the status quo, and that TSLA will continue to grow volumes beyond the current rate. Since, given the evidence, volume growth cannot be accomplished without cutting prices (another pretty obvious conclusion derived from the above and my last blog post), most if not all incremental volume would appear to have come from new models (such as the Model Y), or from China Model 3 demand. But in the former of these cases, unit economics would be highly dilutory from the current situation (since a new model incurs all manner of ramp costs, which the Model 3 launch ramp amply demonstrated), and in any case will not meaningfully affect the PnL until 2021. Meanwhile the China Model 3 volume ramp thesis appears founded much more in fantasy than reality, given that Elon is talking about selling 150k cars a year from the China factory into a market where demand for the car today is barely 40k units a year; where competition is already far higher than any other market they operate in (and is increasing); where government subsidies were massively cut mid this yr (and will tick lower again next year); and where pricing of the local model will not, supposedly, be much lower than it is already (in reality I think they will cut prices massively again if or when the China factory is up and running). Color me skeptical on the China bull thesis, then.

Again, none of this is really revolutionary or even that insightful, and I purposefully avoided getting into the weeds of TSLA’s dodgy accounting in this post, to avoid muddying the main issue, which is this – it is increasingly clear that TSLA is a structurally unprofitable operation, condemned to perpetually chasing volume growth in order to limit the losses it self-imposes by cutting prices to below cost to keep up the illusion of growth.

At this point, there is very little mystery in the fundamentals, or in the mechanics of this operation. The real mystery is why investors continue to support and fund this delusional, dangerous (to conusmers), wasteful (of capital), and ultimately pointless exercise. We live in a time of free money, credulity and fantasy – when the present value of a bullish pipedream drawn from many years hence has never been higher. Figuring out when the market actually cares about the underlying reality – that the dream is over, or more accurately that there was never a true hope of profitability – is the real trick to this investment, and the quest to solve that mystery goes on.

Disclosure: short TSLA













The never-ending story: Netflix and the ever-escalating cost of content

Regular readers will recall I have been following Netflix (NFLX) for many years (I wrote up some initial thoughts on this blog a few years ago), but as the service has grown from ‘challenger’ to ‘near-ubiquitous’, I find myself returning more often to the company, its growth philosophy, and the underlying existential question for any business: will it every be sustainably cash-generative?

This post was sparked by a recent discussion I had with a friend on the topic. More bullishly-inclined, he made the (reasonable) argument that NFLX was smart to swap profits/cashflows for more subscribers today, because once ‘at scale’ the company could trim its content (and marketing) spend and still provide a compelling service – so compelling, he thought, that NFLX could also raise prices substantially. My bearish counter was based upon two points: 1) the benefits of scale from this point have diminishing returns, because a huge amount of incremental content spend is not universal in demand (the incremental subscriber is not invariably a high-paying English-speaker and so needs unique local-language content that in most cases cannot be amortized globally); and 2) even if we granted them point 1) was theoretically possible, the recent history of the company – as it has grown from 50mm subscribers to 135mm in the last 5yrs – has actually demonstrated the opposite property: more incremental spend on content for less incremental benefit, not the other way around.

This second point in particular got me thinking – can we demonstrate, numerically, exactly how much more expensive it has been for NFLX to grow in recent years as the business has expanded beyond its home market (the US and English-speaking markets)? This is something I’ll explore in this post.

How much is a new subscriber worth? The ‘traditional’ method

Let’s start with some basics. For most subscription-based businesses, Silicon Valley types try to measure the value of the proposition by comparing the cost to acquire a new subscriber (‘customer acquisition cost’, or CAC) with the ‘lifetime value’ (LTV) of that acquired customer. CAC is quite easily defined: it is simply marketing expenses dividend by net new customers acquired in the period. This is how it looks for NFLX since 2014 (using TTM numbers to smooth quarterly fluctuations in marketing spend):

Screenshot 2019-07-08 15.55.44

So CAC has increased from <$50 to ~$75/paid member in the last 5yrs – not great, perhaps, but understandable in the context of a largely-penetrated home market that is subject to increasing competition (the US); and more aggressive international marketing in countries where NFLX was less well-known or where OTT TV was less understood (the rest of the world).

Of course, to provide meaning to the CAC, we need to compare it to LTV, since if LTV is similarly increasing, paying a higher CAC wouldn’t really be a problem. LTV, however, is slightly more complex to calculate than CAC, because we need to make an assumption regarding how many subscribers NFLX loses on an annual basis (‘churn’) – a number NFLX conveniently has declined to disclose since 2010. We also need to make an assumption regarding the future earnings power of each subscriber (measured in terms of gross profit per subscriber in a given period).

Still, we can take a shot at it. In the below, I have assumed annual churn is 25% (so just over 6% per quarter); this is actually lower than cable TV churn (around 7% a quarter), despite the fact that NFLX is cancellable any time without penalty, so I would argue this is not aggressive. I have also simply aggregated gross profits (again on a TTM basis to smooth quarterly fluctuations), and as a result LTV (over a similar period) looks something like this:

Screenshot 2019-07-08 16.04.01

You can see that despite the fall-off in LTV in recent quarters, the absolute number (around $180) is still well in excess of CAC ($75-80) – meaning when we plot the all-important LTV/CAC ratio chart, we see that despite the decline of late, growing subscribers still appears to be value additive to the enterprise (even if the pace of recent decline should be of some concern):

Screenshot 2019-07-08 16.07.54

So when measured in the ‘traditional’ way, NFLX’s astounding subscriber growth still appears to be generating net positive lifetime value per customer to the company (uncertainty around churn not withstanding), validating the bull thesis, right? Not so fast…

The increasing cost of content bogey and the need to adjust LTV accordingly

The main problem with the above approach is a conceptual one: once the customer has been acquired (through marketing spend), the assumption is made that – for those customers that don’t churn out – you don’t need to ‘re-acquire’ them – whatever you spent in marketing dollars to get them in the door, that is the total cost to you to keep them on board. But what about the cost of maintaining them as a subscriber? In many software/SaaS businesses (where this methodology originated), that may truly be a very small incremental cost. But NFLX makes no secret of the need to spend exponential amounts of money on new content that – purportedly – drives more eyeballs – but (and this is the key) in reality exists to maintain existing subscribers. I think it’s fair to consider incremental content spend by NFLX as an added cost to maintaining its subscriber base for three simple reasons: 1) not many people watch the same content twice (meaning once consumed, content needs to be replaced); 2) increasing engagement – something NFLX is ironically proud of – increases the velocity of needed content replacement, effectively driving up the maintenance flywheel against the company; and 3) alluding to my earlier point, a lot of the new content being created in recent years has a much smaller intended audience than earlier content (given increasing localization, etc).

In other words, the traditional metric associated with measuring the value of a customer needs to be modified, to account for the excess $$ being dedicated to growing the content pool which – even if amortized over an increasing number of paid users – should nevertheless be thought of as the cost to ‘re-acquire’ the customer, continually, to stop them quitting and going to another service (of which there are now many, and growing).

Here’s how I’m thinking about it. In the traditional LTV calculation, we look at gross profit per subscriber to estimate what the potential value that customer could bring in over its lifetime could be (before he/she churns out). ‘Gross profit’ is essentially average revenue per user (that is, average monthly subscription cost) less the total cost to deliver the content to the customer (the overwhelming majority of which is content amortization, in other words, content production costs spread over a 10yr assume content ‘life’).

But the strict income statement entry – ‘cost of revenue’ – is, as we have discussed, not the only run-rate cost of content to the company: NFLX has been spending more and more on content, in escalating fashion in recent years, and this is reflected in the difference between the content amortization cost in the income state (‘Cost of Revenues’ in the PnL) and the net incremental cash out spent on content costs (in the Cash flow statement).

Pulling it all together from NFLX’s financials, here is the incremental content spend (again TTM for smoothing) over the last five years:

Screenshot 2019-07-08 16.27.51

It’s worth dwelling on the significance of the above. Five years ago, NFLX was spending ~$500mm a year on content than it was currently amortizing; today that number is almost 10x greater ($4.5bn) and they are still guiding to spend more!

Of course, this escalating content spend has come along with massive subscriber growth so we need to relate the increased spend to the enlarged subscriber base. Below, I show the incremental content spend beyond the PnL, on a monthly basis (using the average TTM paying subscriber base as the denominator) – you can see that even on an equalized basis, NFLX is spending >3x the amount on incremental content beyond the PnL, per subscriber, than it was in 2014…

Screenshot 2019-07-08 16.34.02

Coming up with a modified LTV/CAC calculation

Considering the above, I think it’s fairly obvious that we need to modify the ‘traditional’ LTV/CAC metric to account for this increasing cash cost of content (even if it hasn’t made its way into the PnL yet). We can do this simply, by subtracting the incremental content spend, from the gross profits, per paying subscriber (we don’t need to change any of the CAC calcuation, since marketing costs don’t need adjustment). We do this, and voila, all of a sudden (what I would argue) the true LTV/CAC doesn’t look so rosy (including the ‘traditional’ LTV/CAC for comparative purposes):

Screenshot 2019-07-08 16.42.08

I consider the above chart fairly damning evidence against the NFLX bull narrative, as it demonstrates a) the business has essentially been adding negative value subscribers since late 2016 (when content spend really kicked into high octane); and b) the increasingly negative value nature of the proposition has been accelerating in recent quarters.

However if you were a bull, and even if you were willing to acknowledge my methodology had merit, you might push back in some or all of the following ways:

  1. this methodology doesn’t take into account future price increases;
  2. NFLX won’t have to spend current levels on content in the future;
  3. NFLX can increase revenues in other ways (advertising, etc).

Of these, I think 2) is fairly easy to dismiss, since NFLX has avowed publically they will continue to outspend all the competition on content, for the medium-term – and since competition is only increasing (Disney+, Hulu, Amazon Prime video, HBO go, CBS, Apple, etc etc), and since some of these competitors view OTT almost as a loss-leader (Amazon, etc), I don’t think it’s really credible to envisage a world in which NFLX voluntarily cuts content spend (as opposed to one in which the market forces them to slow down spending ). Similarly, 3) is fairly anathema to what NFLX is purportedly trying to create – ad-free high quality on-demand content – and I would expect churn would sky-rocket if they introduced ads onto the platform. And once again, given the competitive landscape, this seems unlikely unless most/all competitors move in a similar direction.

This leaves price hikes. I think the point is a reasonable one, and has been pursued by NFLX historically – the question is really one of scale. Certainly there is scope to hike prices somewhat, especially in developed markets; but NFLX is increasingly an international story (essentially all sub growth comes from outside the US now) where the legacy of high cable bills (and level of GDP wealth) is simply smaller. Today, over half the subscriber pie is international, and with the US mature, this ratio will only grow – limiting, I think, the upper bound of price for the increasing majority of subscribers

Moreover, we still need to question the scale of any price hikes in relation to the escalating content bill. The chart below shows the percentage of ARPU that is currently consumed by incremental content spend beyond the PnL: this number was 10% in 2014 but is nearly 30% today:

Screenshot 2019-07-08 16.57.14.png

That is to say – NFLX could manage to raise prices 30% across the board, unilaterally – and it would still only bring ARPU into line with the escalating cost of content (assuming it stopped where it is, which it won’t). That kind of price increase may be stomachable in the West (even at the cost of a big jump in churn, perhaps temporarily), but it would necessarily price out large portions of the emerging world (that NFLX needs for its growth story).

Where does that leave us?

This has been a long exploration, but I’m fairly confident reiterating my early prognostication: NFLX is an amazing service, but I really can’t see how it will ever generate sustainable free cash flow, let alone an adequate return on capital – let alone a return adequate to justify the current $180bn valuation (!). That doesn’t make it a short (and I’m not), but unless you expect an uber-benign future where NFLX is free to raise prices with impunity whilst reining in the excessive content spend it and its competitors have been enacting exponentially, it certainly doesn’t make it a long either.

Disclosure: no position in NFLX











Tesla’s unit growth, and the art of spurious comparisons

There’s a fairly fundamental concept in most retail industries: the concept of same-store sales (‘like-for-like sales’, ‘equivalent-store sales’, ‘existing-store sales’, etc). This is a pretty intuitive concept, but to recapitulate by example, let’s say I’m a McDonald’s franchisor, and last year I had 100 stores that did $100mm in revenues ($1mm/store), and sold 250k Big Macs at $4 a pop (this is a very minimalist hypothetical McDonald’s :)). That’s great but I want to grow, so let’s say I open another 100 stores. Unfortunately though I over-estimated demand for Big Macs, such that the new stores underperform and draw traffic from my existing footprint (there are lots of other burger joints out there, of course), and I am forced to cut prices on my burgers to $3.5 each to maintain growth in my burger volume (necessary to keep all those grills in the new and old stores busy). At the end of the year I report 350k burgers sold and $122.5mm in revenues – both new ‘records’ for my franchise operation – but clearly a large decline in same-store-sales, and, as a result, profits (I doubled the store count and a huge component of fixed costs but only increased revenues 22%). It’s quite easy in this example to see how revenue growth for its own sake actually destroys value.

Which brings me to Tesla (TSLA), which just reported ‘record’ quarterly deliveries of 95k vehicles, versus the Q4’18 performance of 91k deliveries. Bulls are busy trumpeting this as proof that demand is strong and sustainable; but I think if you break down this theoretical record by analyzing the geographic footprint of where the sales are coming from actually suggests the opposite. Once you realize that unit volume is being driven by a combination of new market entries and price-cutting, it’s pretty clear that TSLA’s unit growth is only so many empty calories.

The analogy to a hypothetical burger chain is not perfect (because TSLA isn’t opening new factories in all of its new locales and therefore doesn’t face the same fixed cost burden on incremental sales), but conceptually it is somewhat instructive. Lost in the bullish headlines this morning is the simple reality that in Q4’18, TSLA was only selling the Model 3 in the US (its core market); by now the Model 3 is available worldwide (with the exception of some very small right-hand drive markets) – tenuously equivalent to opening a vast number of new ‘stores’ to achieve a marginal increase in sales. Instead, if we look purely at the US market, where the Model 3 has been out for the entire year (both 2H 2018 and 1H 2019), the unit performance looks unimpressive to say the least: Model 3 deliveries fell 42% half-on-half in 1H’19 versus 2H’18 (67k vs 116k, per InsideEVs). Incidentally, this half-on-half decline is mirrored in the performance of the Model S (-52% HoH) and Model X (-46%) as well.

In other words, in Tesla’s most mature market – and despite significant price cuts and the introduction of the much lower-priced Model 3 SR+ – unit sales are falling rapidly half-on-half. It is hard to argue there is any seasonality involved, either: since 2014, the average HoH change in US SAAR is negligible (see below), so it’s not as if there is an external reason for the large decline in ‘same-market sales’ in the US:

Screenshot 2019-07-03 10.33.36

Rather, it seems fairly self-explanatory what happened: there was a large, one-time surge in demand last year in 2H, as all the pent-up demand for the Model 3 was fulfilled in 2 voracious quarters; thereafter, run-rate demand (in the US) seems to have moderated to much lower levels, even at lower prices (actually there are still one-time pull-forward effects in the US in 2Q, like the halving of the Federal Tax Credit once again, but let’s leave this aside for now). This is not readily apparent in the gross numbers, because of the aforementioned opening up of new markets. But as we lap 2H’19 comps, and as Europe/China mature in the coming quarters, it will most certainly become much clearer (and signs are already pretty bad re run-rate demand in Europe, especially, as daily registrations have rolled over much faster than was seen in the US).

Thus in recent quarters, TSLA has found itself somewhat in the situation of our hypothetical burger franchisor: wanting, needing to show growth (to defend the stock price) but with underlying unit growth receding in its existing core, having to continuously open new markets, as well as cut prices, to maintain gross unit momentum.

The effect of price cuts should be readily understood, but is something the bulls conveniently ignore. Taking the simplest measure of average selling price (total automotive revenue divided by unit deliveries), TSLA’s ASP’s have been declining fairly consistently over the last 5 quarters (ignoring 2Q for now as we haven’t seen the print yet, though I expend the trend to continue):

Screenshot 2019-07-03 11.13.53.png

While of course a good chunk of this is due to the introduction of the Model 3 progressively from 2Q last year, we also know TSLA has cut prices at least 3 times in the last six months on all its models; and has been known to push large end-of-quarter discounts to clear inventory (as happened in 1Q).  Finally, it demonstrates the futility of TSLA achieving unit growth for its own sake, at the price of ASPs. Consider that in this 2Q, ASPs only declined modestly from 1Q (and thus are around $60k blended), TSLA will have shipped 5k more units than in 4Q’18 – a quarter that was only very marginally profitable ($200mm), excluding subsidies – but at the cost of 5k x ~$10000 gross margin per vehicle, or $500mm in total and thus putting the company back squarely in loss-making territory. That doesn’t sound much like a record quarter, to me…but it is a trick Elon and co will have to repeat, ad nauseam, to satisfy a stockmarket pricing in ongoing aggressive unit growth in the coming years.

Since we all learnt in Economics 101 that demand is a function of price, this all goes to the heart of the bull/bear debate and why the bear position – one I occupy – is so intractable. Any fool can tell you that if you sell Rolexes for $500 a pop your unit growth will be incredible; you’d also be hard pressed to find someone arguing such an idea would be a smart business move. Selling something, anything, of value demonstrably below cost will undoubtedly move units – but to confuse this with creating economic value is borderline insanity. If you are marketing a consumer product that is currently unprofitable (check), that has demonstrably sold its highest ASP products ever (check check) and cannot grow units on a like-for-like basis without cutting prices (check check check), how will it be possible to ever generate sustainable profits (let alone an adequate return on capital)? The market may close its eyes and bathe in the glow of ‘record unit volume’ for a day, a month, or longer, but in the end if the business proposition is unsustainable, the stock will follow.

Disclosure: short TSLA