Will Regulatory Credits Continue To Bolster Tesla’s Profits?
Regulatory credits have been a controversial topic for Tesla investors in the past. (see our updates below) These credit sales, which are almost pure profit, have been a key driver of Tesla’s margins over the years and the company largely relied on these credits to post operating profits in multiple quarters in 2019 and 2020. While credit sales have been quite volatile, there have been quarters where credit sales alone have topped $500 million, and have bolstered Tesla’s gross margins by as much as 6%. That said, with Tesla’s vehicle deliveries ramping up nicely and economies of scale kicking in, Tesla now appears to be solidly profitable even without credit sales. For perspective, for the first three quarters of 2021, we estimate that pre-tax profits would have stood at over $2.5 billion, excluding tax credits. This compares to 2020 when Tesla would have posted a pre-tax loss of over $400 million, excluding credits. See our analysis on How Do Regulatory Credits Impact Tesla’s Gross Margins? for a detailed look into Tesla’s regulatory credit sales and how they impact Tesla’s margins and profitability.
So are regulatory credits likely to remain a driver of Tesla’s profitability going forward? Governments are doubling down on regulation to decarbonize the automotive industry, given the urgent need to address climate change. This could drive Tesla’s credit sales in the next few years, given that the company remains one of the leading EV players by volume. However, mainstream automakers are also doubling down on their own EV programs, meaning that they could become less reliant on Tesla for credits. For example, Europe’s Stellantis, once Tesla’s largest customer for emissions credits, intends to sell more of its own zero-emission vehicles, noting that it was likely to meet its CO2 emission targets in Europe for 2021 on its own. Considering this, it’s likely that Tesla will have to rely more on cost improvements, higher deliveries from its new factories, and software sales to drive its profit margins in the longer run.
[7/23/2020] Soaring Emission Credit Sales Drive Tesla’s Q2 Beat
Tesla published Q2 2020 results on Wednesday, posting a net income of $104 million – well ahead of consensus estimates that projected a small loss. So how did Tesla manage to beat expectations by such a wide margin? Soaring regulatory credit sales were the primary reason.
The sale of regulatory credits rose to around $428 million in Q2, up from about $354 million in Q1 and just $111 million in Q2 2019. As these credits are almost pure profit (Tesla probably incurs no direct expenses to earn them), the company would very likely have reported a loss on a GAAP basis, if it didn’t recognize these revenues. Moreover, we estimate that Tesla’s Automotive Gross Margins would have been lower by over 600 basis points (6%) in Q2 2020, if not for these sales.
So why are Tesla’s emission credits sales soaring, when its automotive deliveries grew by just 3% sequentially and are down by about 5% year-over-year? Firstly, revenue recognition for these credits is quite lumpy and Tesla could sell vehicles in a quarter and recognize revenue from related credits in future quarters. Secondly, stronger demand for credits might also be driving up the price. The European Union introduced more stringent emission norms this year, requiring average Carbon Dioxide emissions per kilometer to drop to 95 grams from an average of over 120 grams in 2018 for passenger cars. Considering this, automakers need to buy credits from clean vehicle manufacturers such as Tesla in order to avoid large fines for breaking these new emissions rules. Fiat Chrysler is a large customer for Tesla’s credits – agreeing to buy credits worth roughly $2 billion over 2020 and 2021. 
To be sure, this cash cow won’t last for too long. In the medium- to long-term, mainstream automotive companies will scale up their zero-emission vehicle sales, reducing the need to buy credits from Tesla. However, Tesla should continue to improve its margins and profits via higher software sales and battery improvements (related: A Detailed Look At How Tesla’s Battery Costs Impact Its Gross Margins). Tesla’s self-driving software upgrades, which cost about $8,000 per vehicle currently, are highly lucrative and we estimate that they contributed about 400 basis points (4%) to Tesla’s Automotive Gross Margins of 21% in 2019. (See our analysis: How Do Tesla’s Software Upgrades Impact Its Margins?)
[5/1/2020] How Emission Credit Sales Helped Tesla’s Q1 2020 Results
Tesla posted a stronger than expected set of Q1 2020 results, despite the coronavirus pandemic, with revenues growing by ~32% year-over-year and adjusted profits coming in at $227 million, versus a loss of about $494 million a year ago. While the company benefited from strong deliveries of the Model 3 and a production ramp at its Shanghai factory, much of the improved profitability came from higher sales of emission credits which soared to about $354 million from an average of about $150 million over the last four quarters. If not for the spike in regulatory credit sales, Tesla would likely have barely broken even. Below, we take a look at how sales of regulatory credits have helped Tesla and why we believe the near-term outlook for the company looks quite challenging.
For more details on the outlook for Tesla’s revenues, view our dashboard analysis Tesla Revenues: How Does TSLA Make Money?
What Are Regulatory Credits And How Do They Help Tesla?
Several U.S. states and countries have Zero Emissions Vehicle regulations that require that clean vehicles account for a certain mix of auto manufacturers’ sales each year. If automotive companies, which still largely sell internal combustion engine-based vehicles, don’t meet these standards, they can buy credits from the likes of Tesla that earn credits, as they only sell electric vehicles. Although the revenues from these credits are quite volatile they are very lucrative for Tesla, as it likely incurs no direct costs to earn them. The bump in these regulatory credit sales is likely to be partly responsible for the company’s automotive gross margins expanding 300 bps sequentially to 25.5%. While it’s possible that such credits could become more valuable in the medium term, as new emissions regulations come into play in Europe and states in the U.S. look to enforce stricter norms, the current collapse in global auto sales could hurt revenues from ZEV credits in the near-term for Tesla.
Outlook Remains Tough For Tesla In The Near-term
Tesla is likely to face significant near-term revenue pressure and the company has put its 2020 guidance on hold, due to uncertainty surrounding the coronavirus pandemic and the broader economic recovery. There is little reason for people to buy expensive cars right now and Tesla’s production at its Fremont facility, which accounts for about three-quarters of its annual capacity, remains suspended and there’s no clarity as to when it could resume.
However, despite significant near-term headwinds, the company’s stock has continued to rally, almost doubling year-to-date. The company trades at a P/S multiple of about 6x, compared to GM which trades at about 0.3x, based on trailing revenues. This means that the stock has significant valuation risk, making it react more strongly to negative news compared to its peers.
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