“It has long been an axiom of mine that the little things are infinitely the most important.” -Sir Arthur Conan Doyle, The Adventures of Sherlock Holmes
Earlier this year, electric car manufacturer Tesla (NASDAQ:TSLA) made what might seem like a minor change to its first quarter report. Many shareholders may not have noticed that an obscure sentence vanished from the notes to the consolidated financial statements, but it may interest them to know that billions of dollars could be riding on that single sentence, for Tesla chief executive Elon Musk, personally, and for the company.
There’s one principle you should always remember when examining a company in depth:
There are no haphazard changes to company reports.
During the preparation of these reports, all changes are mooted, reviewed, and approved by multiple professionals, especially when they relate to a vital aspect of the company’s business. Though it may not always be obvious, there is an explanation beyond whim for every change that is made. In many cases, the nature of the change is straightforward or inconsequential for investors, but it’s important to identify and understand any changes that are consequential and opaque.
Identifying Tesla’s profit engine (it’s not selling cars!)
You may be surprised to learn that part of Tesla’s automotive revenue doesn’t come from selling automobiles at all. Here’s how that works:
By virtue of selling electric vehicles, Tesla receives automotive regulatory credits. Because it’s an all-electric auto manufacturer, Tesla receives a surplus of such credits relative to the minimum required to meet government emissions standards and other regulatory requirements. Tesla sells those surplus credits to traditional automakers, whose limited electric vehicle production means they wouldn’t otherwise achieve compliance with regulatory standards.
Regulatory credit sales don’t get the attention they deserve, perhaps because they represent a small percentage of Tesla’s total revenue. However, credit sales contribute an outsized proportion Tesla’s profits (on those occasions when Tesla is profitable) because every dollar in regulatory credit revenue contributes a dollar in gross profit, compared to just $0.20 in gross profit for every other dollar of automotive revenue.
Bottom line (if you’ll forgive the pun): Regulatory credit revenue is pure profit.
Over the trailing 12 months to June 30, Tesla has booked over $1 billion in regulatory credit revenue. While that number accounts for less than 5% of Tesla’s total revenue over that period, it contributed a whopping 85% of operating profits.
Revving up the regulatory credit engine
In the first quarter, regulatory credit revenue ramped up faster than a Chinese Gigafactory (see graph below). In fact, regulatory credits were responsible for a tidy 125% of Tesla’s operating profits in the March quarter, what with the auto manufacturing business continuing to lose money.
In plain terms: Regulatory credit sales are the only thing lifting Tesla’s head above water, in terms of profitability. So having established that regulatory credit revenues are vital to Tesla’s financial results, how did the financial reporting change?
The vanishing sentence that could be worth billions
In its first quarter report , Tesla removed the language relating to how it recognizes revenue on regulatory credit sales. The language, such as it appears in Teslas earlier 2019 annual report and the report for the third quarter of 2019, reads: “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 statements of operations.”
This is the first time since it became a public company that Tesla has failed to include in a quarterly or annual report language describing its revenue recognition policy for regulatory credit sales, either specifically, or under the banner of automotive revenues (barring the reports spanning the first three quarters of 2017, where the company invoked an update in accounting standards for the treatment of customer contracts that it was in the process of evaluating).
Then, as quickly as it had vanished, the language reappeared in the latest report for the…