Friday, November 16, 2018

Tesla: Innovation is often based on finding errors in conventional wisdom

(Note: Float math at the end.)

Larry Ellison is the founder and part owner of Oracle. His second biggest holding is Tesla. Ellison has said: "Innovation is often based on finding errors in conventional wisdom."

At Tesla, Elon Musk is enthusiastic about a recent insight he had and immediately started putting into practice. It is interesting because it goes against conventional wisdom. What he is doing, doesn't "make sense".

He explained his thinking during the recent Q3 conference call (excerpt below), subsequently, he has started taking action.

Let's consider some actions he undertook and whether they "make common sense".

From Twitter november 15th 2018:
Musk: "Tesla just acquired trucking capacity to ensure Model 3 can be delivered in US by Dec 31 if ordered by Nov 30"
Musk: "We bought some trucking companies & secured contracts with major haulers to avoid trucking shortage mistake of last quarter."
Musk: "Skipping rail saves over a month for East Coast deliveries. All things considered, it’s better to use trucks. Single load/unload & direct to owner location."
Q; What happened to being green? Trains save fuel!
Musk: "We have to truck to departure rail head & truck from arrival rail head, which is usually (far) from customers. Car gets moved around rail yard a lot too & trains don’t leave often."
Musk: "Will also be using dedicated roll-on, roll-off fast ships for transporting cars to Europe & Asia in Q1. Major focus on minimizing time from factory to new owner. Did not fully appreciate the working capital impact until recently."

So what is happening? Shipping by truck instead of train increases expenses. Fast ships are more expensive than slow ships.

What Musk is doing literally "doesn't make sense". Here is a good explanation of why that is the case as calculated in this Twitter thread: https://twitter.com/ad8871/status/1063183182701436934

Twitter user People's Grain: "1/ So what does Captain Planet (Musk) mean by working capital impact of shipping by rail? Let's see." 
"2/ working capital for holding inventory is covered by Tesla's ABL (Asset Based Lending) credit line. They can borrow approximately 85% of COGS (Cost of Goods Sold) per car and the rate is LIBOR (London Interbank Rate) +1% = 3.3% interest"
3/ in q3 (third quarter of 2018) unit COGS for Model 3 were about $47k so you can borrow $40k at 3.3%. Musk said shipping by truck saves a month vs rail. So 1 month of interest on a 40k loan is $110. Stated goal is reducing delivery from 29 days to 10 which is $70/car
4/ at current production that's about $6m savings per quarter but subtract the higher cost of shipping by truck from that. Small potatoes indeed, maybe even negative potatoes. How many "trucking companies" can one acquire for $6m?
5/ the answer here is that it's not about working capital efficiency. But we knew that. I suppose it's
about credit being maxed and having capital at all.

To be continued: From a Earnings per Share point of view "negative potatoes' but from a cash flow point of view;  Consider Phil Knight and Nike in "Shoedog" high profits, negative cash flow and neg. equity, Sam Walton: highest debt just before Walmart IPO.

Bezos 2004 Letter: http://media.corporate-ir.net/media_files/irol/97/97664/reports/2003_%20Shareholder_%20Letter041304.pdf

Musk during last quarter call Q3 2018:

"We do not intend to raise equity or debt. At least that's our intention right now, that may change in the future. But the current operating plan is to pay off our debts not to refinance them, but pay them off and reduce the debt load and overall leverage of the company. But I actually almost forgot one quite important thing. As - and this is quite helpful, it's always helpful to have these sort of crisis situations with logistics, for example.


As I dug into the inventory like basically finished product inventory from factory to the customer, I was quite surprised to see how long that took that took, and that it was quite expensive in a lot of cases to get cars to customers. This was something I didn't fully appreciate before. And we really have a major initiative at Tesla to get the average time from the exiting the factory to receiving the check from the customer, being in the customer's hand, if we can only get the check when we give the car to the customer. So getting a car from factory to customer to get that to as short as possible.

In August, the average time in North America to get a car from the factory to a customer was 30 days, which is embarrassingly long. By the end of the quarter, we've reduced it to around 20 days. And our goal in Q4 - this is a goal, not a promise. But our goal is to get the average time of the car from factory to customer under 10 days. This is a giant improvement in the capital efficiency of the company, because we're making on the order of $75 million worth of products per day - of cars per day. So every day, it required $75,000 - $75 million with capital, so every 10 days, it's $750 million.

And we - obviously, we have a loan from the bank that we can make use of. But the banks will only loan us 85% of the cost of the vehicle, which translates to about 70% of the price of the vehicle. So - and then we've got this loan outstanding, which effectively increases the COGS of the car. And it dilutes the company to the tune of 30% of one of the inventory - of the finished goods in transit it.

So that this is really like tightening that and getting that below 10 days in North America and then also improving dramatically the time - the transit time to Europe and Asia. It is where like having local factories is actually very important for capital efficiency of the overall system. Because, I think, over time, we want to get the time from a car going from a factory to customer under 7 days worldwide. And then, the terms that we have with from our suppliers are, on average, just over 60 days.

Now, our product inventory management also there's a lot of room for improvement there. We think we can probably cut that down to a few $100 million or so, Deepak, something like that, maybe $200 million or $300 million of COGS at the factory. So effectively, what we're going to go is reverse the working capital requirement for the company quite dramatically, so to a point where the faster we grow the more capital we have. This is incredibly important for capital efficiency of the company. It's night and day."

Deepak, is there anything you would like to…

Deepak Ahuja (Tesla CFO)

No. I think you are totally right - we are reducing the raw material inventory on one hand by keeping production stable, finding efficiencies and warehouse management and the supply chain. And at the same time, reducing the time to deliver the car and convert that car into cash. And that significantly improves working capital needs.

Elon Musk

Yeah, it's really quite dramatic. So, yeah, I think it sure profoundly changes the financial effectiveness of Tesla.

Deepak Ahuja

Yeah, we reduced our inventory in Q3, which helped. And then, although we had higher payables because - sorry, higher receivables, because the quarter end, the weekend, we won't have that in Q4, so all of this should continue to help us in Q4 and beyond, the working capital again.

Elon Musk

Yeah, I mean, it occurs to me that, even if the only thing - like even if this was the only thing that Tesla did differently was to shorten the time from factory to end customer. In any given company that would outcompete all of the companies over time. It would not be a contest.

Math: Sales Tesla $75m a day November 2018, Toyota $700m a day (automotive, not an energy company)

Today:
Payment to suppliers after 60 days, delivery in 10 days = 50 days float.
$75m x 50 days = $3 750 float - $250m COGS at factory = $3,5b float
Sales doubling:
$150m per day = $7b float
$300m per day = $14b float
$600m per day = $28b float
Current Tesla long term debt: $10b 

If growth continues Accounts Payable should keep increasing, but the company will be generating cash (as well as profits) and be less reliant on external financing.

Going forward: Question: When will they self-drive to customer's door?Musk: "Probably technically able to do so in about a year. Then up to regulators."

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