Tesla’s Q1 Gross Margins Got An Unexpected And Undisclosed Boost

By now we all know Tesla's (NASDAQ:TSLA) first-quarter results weren't good. However, Tesla's reported gross margins were surprisingly good in the face of price cuts and the introduction of lower-priced trims. In Q4, Model 3 non-GAAP margins were reported as being greater than 20%. In Q1, they were reported as ~20%.

Model 3 margins are critical because they signal whether or not Tesla will have a chance to be profitable as the company ships more lower-priced trims. Naturally, Tesla maintaining ~20% margins piqued my interest.

When the 10-Q was released I realized these margins were due to large regulatory credit sales not disclosed in the earnings press release, and probably not sustainable.

Tesla's regulatory credit sales

Tesla's non-GAAP margins, as disclosed in their quarterly earnings press releases (linked above), exclude some regulatory credits (chiefly zero emission vehicle (ZEV) credits). However, there are other regulatory credits which aren't excluded. From their latest 10-K:

Tesla Regulatory CreditsIn connection with the production, delivery, placement into service and ongoing operation of our zero emission vehicles, charging infrastructure and solar systems in global markets, we have earned and will continue to earn various tradable regulatory credits. We have sold these credits, and will continue to sell future credits, to automotive companies and other regulated entities who can use the credits to comply with emission standards and other regulatory requirements. For example, under California’s Zero Emission Vehicle Regulation and those of states that have adopted California’s standard, vehicle manufacturers are required to earn or purchase credits, referred to as ZEV credits, for compliance with their annual regulatory requirements. These laws provide that automakers may bank or sell to other regulated parties their excess credits if they earn more credits than the minimum quantity required by those laws. Tesla also earns other types of salable regulatory credits in the United States and abroad, including greenhouse gas, fuel economy and clean fuels credits.

Later in that 10-K, Tesla talks about how much more predictable non-ZEV credit sales usually are. In my opinion, this is why only ZEV credits are excluded from non-GAAP margins and disclosed separately from other credits:

Our revenue from non-ZEV regulatory credits generally follows our production and delivery trends as we have long-term contracts with existing customers for the sale of these credits. However, as we do not have long-term contracts for ZEV credit sales, revenue from sale of ZEV credits fluctuate by quarter depending on when a contract is executed with a buyer.

Until this last quarter, most Tesla followers have observed non-ZEV credits scaling predictably with deliveries. Some believe these are mostly greenhouse gas credits, and so are roughly proportional with U.S. deliveries. Regardless of whether or not one compares them to global or domestic (sourced from InsideEVs) sales, the number of non-ZEV credits sold in Q1 is a clear outlier:

This begs the question: What caused this increase? Is it sustainable? Why wasn't it disclosed? I'll give my guess below:

Was this the Fiat-Chrysler fleet pooling deal?

From the last 10-Q:

Automotive Regulatory Credits

We recognize revenue on the sale of regulatory credits at the time control of the regulatory credits is transferred to the purchasing party as automotive revenue in the consolidated statement of operations. Deferred revenue related to sales of automotive regulatory credits was $140.0 million and $0 as of March 31, 2019 and December 31, 2018, respectively. We expect to recognize the deferred revenue as of March 31, 2019 over the next 2 to 3 years.

Most people assume this deferred revenue was disclosing the European fleet pooling deal with Fiat-Chrysler (NYSE:FCAU). While this isn't exactly the same thing as regulatory credit sales, it's pretty close.

The Fiat deal was said to have been for "hundreds of millions," and this deferred revenue was only $140 million. What happens if we assume the deal was really for $280 million, which Tesla was able to realize half of immediately? The above graph becomes a lot more normal:

Why wasn't this disclosed? A confidentiality agreement. From the Q1 earnings call:

Philippe Jean Houchois, Jefferies LLC, Research Division - Equity Analyst

I was just wondering if you could comment on the agreement you seem to have reached with FCA on the possibility of selling your CO2 credits to them in Europe and what that means to your potential cash inflow. When that might start occurring? And if there is any chance any of those things already in the Q1 cash position?

Elon R. Musk, Tesla, Inc. - Co-Founder, CEO, Director & Product Architect

I think it's a confidential deal with FCA so we -- and we agreed with FCA not to comment on it publicly. So we must abide by that.

In summary, if I'm right Tesla got in the neighborhood of $280 million in cash, they got to realize half of this immediately, padding their margins during a terrible earnings release. Moreover, the confidentiality agreement gives them a plausible reason not to disclose these padded margins, which they surely don't want to do.

I could be wrong, and this increase in non-ZEV credits will be sustainable going forward. However, if this was the case, I would have expected Tesla to disclose them in some manner.

The effect on gross margins

As-reported automotive revenue was $3,723,861, COGS was $2,973,301, and gross margins were 20.2%. If we remove $140 million from automotive revenue it becomes $3,583,861, dropping gross margins to 17.0%.

A note on comments

Though I have been successfully trading Tesla for some time now, I've yet to write an article on them due to the "flavor" of the commentary. I'll try to respond to anyone presenting facts and evidence, but everyone else will be ignored.

Disclosure: I am/we are short TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.