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TESLA MOTORS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and the related notes that appear elsewhere in this Form 10-Q. Overview and Quarter Highlights We design, develop, manufacture and sell high-performance fully electric vehicles and advanced electric vehicle powertrain components. We are currently producing and selling our second vehicle, the Model S sedan. Model S is a four door, five-passenger premium sedan that offers exceptional performance, functionality and attractive styling. The Model S inherited many of the electric powertrain innovations we introduced with our first vehicle, the Tesla Roadster. We commenced deliveries of Model S in June 2012 and have delivered approximately 47,000 vehicles through September 30, 2014. We recently announced the availability of our Dual Motor Model S and intend to start delivering these vehicles to customers, starting with a performance-optimized version, in December 2014. We are continuing to develop our Model X crossover vehicle and currently intend to commence customer deliveries in the third quarter of 2015. After the Model X, our goal is to introduce the Model 3, a lower priced sedan designed for the mass market, in 2017. We sell our vehicles through our own sales and service network which we are continuing to grow globally. We are also continuing to build a network of Superchargers in the United States, Europe and Asia to allow Model S owners to have the ability to travel long distances without a limitation on range by charging their cars at a very fast rate for free. During the three months ended September 30, 2014, we recognized total revenues of $851.8 million, an increase of $420.5 million over total revenues of $431.3 million for the three months ended September 30, 2013. This growth in revenues was primarily driven by growth of Model S deliveries worldwide, including in Europe and China, an increase in regulatory credit sales, and an increase in powertrain sales to Daimler AG (Daimler) for the Mercedes-Benz B-Class Electric Drive. Gross margin for the three months ended September 30, 2014 was 29.6%, an increase from 24.5% for the three months ended September 30, 2013. Higher regulatory credit sales, higher vehicle production volume, supply chain efficiencies and component cost reductions, partially offset by one-time manufacturing inefficiencies associated with transitioning to our new final assembly line, contributed to the year-over-year increase in gross margin. Research and development (R&D) expenses for the three months ended September 30, 2014 were $135.9 million, an increase from $56.4 million for the three months ended September 30, 2013. R&D expenses in the third quarter of 2013 included activities to develop the right hand drive version of Model S as well as to homologate Model S for markets outside of North America. Higher R&D expenses in the third quarter of 2014 reflected our accelerated engineering work on Model X as well as development work on our dual motor powertrain and on other programs. During 2013, we significantly increased our sales and service footprint both in North America and Europe, as well as accelerated the roll-out of our Supercharging network. With the continued global expansion of our customer support infrastructure and the business in general in 2014, selling, general and administrative (SG&A) expenses were $155.1 million for the three months ended September 30, 2014, compared to $77.1 million for the three months ended September 30, 2013. We ended the quarter with $2.39 billion in cash and cash equivalents and current restricted cash and short-term marketable securities, which was a significant increase from cash of $848.9 million held at the end of 2013. This increase was primarily driven by our issuance of an aggregate of $2.30 billion of convertible senior notes in 2014. In connection with the issuance of these notes, we entered into convertible note hedge and warrant transactions. For more information on the notes, 22 -------------------------------------------------------------------------------- Table of Contents convertible note hedge and warrant transactions, see Note 6 to our Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q under Item 1. Financial Information. We expect that our current sources of liquidity together with our current projections of cash flow from operating activities will provide us adequate liquidity based on our current plans. However, if market conditions are favorable, we may evaluate alternatives to opportunistically pursue liquidity options. Management Opportunities, Challenges and Risks In October 2014, we revealed our dual motor all-wheel drive version of Model S and our Autopilot system. These announcements have significantly increased our weekly Model S order rate. Based on net orders since that announcement, excluding the extraordinary initial demand peak, we are confident of a 50% increase in both net orders and deliveries for Model S alone in 2015. Moreover, we expect that demand for Model S will continue to increase worldwide as we grow our customer support infrastructure and continue to broaden the appeal of our products, and as consumer awareness improves. In order to meet this anticipated demand, and to prepare for Model X anticipated demand, we are executing a plan to increase our combined Model S and Model X production capacity to over 2,000 units per week by the end of 2015. In August 2014, we began our production ramp by transitioning to our new final assembly line and upgrading our body center. We are planning further investments in production capacity during 2015, including upgrading our paint shop and building a new body shop for Model X. We expect our annual production will increase by over 50% each year for the next several years. Our recent production capacity expansion contributed to a production week of over 1,000 vehicles near the end of the third quarter of 2014. However, the ramp to our target production rate took longer than expected due to system integration challenges, reducing our production by almost 2,000 vehicles during the third quarter. Despite entering the fourth quarter with this production deficit, we still expect to produce about 35,000 cars for 2014. However, the loss of these cars in the third quarter means fewer available to deliver in the fourth quarter and our ability to ramp up production in the fourth quarter is constrained by the complexity of launches related to dual motor and autopilot hardware. Consequently, we expect to be able to deliver only about 33,000 vehicles in 2014, which is 50% above 2013 deliveries but 5 - 7% lower than our prior estimates for 2014. Any unexpected issues with the continued ramp of our production line or the launch of Dual Motor Model S could affect our ability to achieve these revised delivery targets. One of the significant actions we intend to take in order to reduce manufacturing complexity is simplify our product offering by reducing options and powertrain combinations. We believe this will enhance our ability to scale production in 2015. Through the first half of 2013, we had delivered Model S vehicles solely to customers in North America. In August 2013, we started European deliveries of Model S and in April 2014, we commenced deliveries into Asia, starting in China. Based on our current projections, we expect our long-term sales outside of North America will increase to almost half of our worldwide automotive sales. We will continue to price Model S in markets outside of the United States the same as the price for Model S in the United States, with the addition of only unavoidable taxes, customs duties and transportation costs. We plan to expand in China as quickly as possible because we believe that the country could be one of our largest markets within a few years. In addition to increased deliveries into China, we have recently commenced deliveries in Japan and Hong Kong. As compared to markets in the United States and Europe, we have relatively limited experience in Asian markets; thus, we may face difficulties meeting our future delivery plans in Asia. 23-------------------------------------------------------------------------------- Table of Contents In April 2013, we began offering a resale value guarantee to all customers who purchased a Model S in the United States and financed their vehicle through one of our specified commercial banking partners. We introduced this program in Canada in October 2013 and into certain European markets in October 2014. Under the program, Model S customers have the option of selling their vehicle back to us during the period of 36 to 39 months after delivery for a pre-determined resale value. In certain markets, we also offer buy back guarantees to financial institutions which obligate us to repurchase, and the institution to sell us, the vehicles for a pre-determined price. We account for these transactions as operating leases and accordingly, we defer and amortize to automotive sales revenue the initial purchase consideration less guaranteed repurchase amount on a straight-line basis, over the contractual term of the guarantee program. Similarly, we capitalize and depreciate the cost of the respective operating lease vehicles less expected salvage value to cost of automotive sales over the same period. If a customer decides not to sell their vehicle back to us by the end of the resale value guarantee term, the amount of the resale value guarantee and operating lease vehicle net book value are then recognized in automotive sales and cost of automotive sales, respectively. The resale value guarantee amount represents management's best estimate as to the resale value of the Model S vehicle and related vehicle options during the 36 to 39 month period after delivery. We are depreciating our operating lease vehicles to expected salvage value of our operating lease vehicles at the end of their economic useful life (i.e., the end of their expected operating lease term), and we will adjust our depreciation estimates as needed if the expected salvage value decreases in future periods. As we accumulate more actual data related to the resale experience of Model S, we may be required to make significant changes to our estimates. During the third quarter of 2013, we provided the resale value guarantee to 1,877 Model S deliveries in North America and to 1,190 Model S deliveries during the third quarter of 2014. To date, we have provided the resale value guarantee to approximately 8,800 customers in North America. Model S deliveries with the resale value guarantee currently do not impact our cash flows and liquidity, since we receive the full amount of cash for the vehicle sales price at delivery. However, this program has adversely impacted our near-term revenues and operating results by requiring the deferral of revenues and costs into future periods under lease accounting. Although lease accounting will continue to adversely impact our revenues and operating results as this and similar programs initially ramp up, as time passes, the amortization of existing deferred revenues and costs will begin to partially offset this adverse impact. Furthermore, while we do not assume any credit risk related to the customer, we are exposed to the risk that the vehicles' resale value may be lower than our estimates and the volume of vehicles returned to us may be higher than our estimates which could adversely impact our gross margin. In April 2014, we launched Tesla Finance in the United States to offer leasing to small and medium-sized businesses. We expanded this program to consumers in the United States in October 2014. Leasing through Tesla Finance is now available in 37 states, the District of Columbia and in 4 provinces of Canada. We leased 347 vehicles during the third quarter of 2014 and expect to increase our leasing activities significantly during the rest of 2014. Our U.S. leases are offered directly from Tesla as well as through a bank partner. In both cases, leasing exposes us to residual value risk and will adversely impact our near-term revenues and operating results by requiring the deferral of revenues and costs into future periods under lease accounting. In addition, for leases offered directly from Tesla Finance (but not for those offered through our bank partner), we will not receive the full amount of the cash for the vehicle price at delivery and will assume customer credit risk. We continue to evaluate a number of other customer financing products, either directly through Tesla Finance or indirectly through third party financial institutions, as a way to better serve our growing customer base. If customer interest in these financing options is significant, we may be directly or indirectly subject to resale value risk for the Model S. 24-------------------------------------------------------------------------------- Table of Contents In addition to sales of Model S, we recognize automotive sales from our supply of powertrain systems to OEMs. During the second quarter of 2014, we began production deliveries to Daimler for the Mercedes-Benz B Class Electric Drive and continued these deliveries in the third quarter of 2014. Additionally, we substantially completed our production and sales activities for the Toyota RAV4EV during the third quarter of 2014. Significant cost improvements for Model S were achieved in 2013 and have continued in 2014, including part cost reductions as well as manufacturing efficiencies. We expect some of these trends to continue as we execute on our roadmap of achieving further component cost reductions and benefit from economies of scale. In the third quarter of 2014, one-time manufacturing inefficiencies related to the transition to our new final assembly line increased the cost of all vehicles produced during the quarter and negatively impacted our gross margin for the quarter. Moreover, as we expect to deliver about half of these vehicles within the fourth quarter, we expect a similar negative impact on our fourth quarter margins. We expect our automotive gross margin (excluding zero emission vehicle (ZEV) credit sales) to increase from third quarter 2014 levels to greater than 28% by the end of the fourth quarter of 2014, as manufacturing efficiencies and part costs continue to improve. Factors weighing on the automotive gross margin for the full quarter include delivery of vehicles built in Q3 with lower manufacturing efficiency and slightly lower average selling prices from weaker European currencies. Model S gross margin itself is generally higher than automotive gross margin, which is moderately suppressed due to the significantly lower gross margin on powertrain sales. If we are not able to achieve the planned cost reductions from our various cost savings and process improvement initiatives, our ability to reach our gross margin goals would be negatively affected. We recognized $129.8 million in ZEV credit sales in 2013 which contributed to our gross margin. Although ZEV credit revenue was strong in 2013, over 90% of ZEV credit sales were recognized during the first half of 2013 with only $10.4 million recognized during the three months ended September 30, 2013. During the three months ended September 30, 2014, we recognized $76.1 million in ZEV credit sales as a result of one-time contracts with various OEMs. Since we do not expect this level of activity in future quarters, we expect the contribution of ZEV credit revenue to be lower in the future. While we will pursue opportunities to monetize ZEV credits we earn from the sale of our vehicles, we do not plan to rely on these sales to be a contributor to gross margin and our business model and financial plan are not predicated on such ZEV credits. Other regulatory credit sales recognized during the three months ended September 30, 2014 were $16.7 million, compared to $14.8 million for the three months ended September 30, 2013. In February 2012, we revealed an early prototype of the Model X crossover as the first vehicle we intend to develop by leveraging the Model S platform. We continue to test the Alpha prototypes and are in the process of building the first Beta prototypes. We recently decided to build in significantly more validation testing time to achieve the best Model X possible. We also expect this will enable a more rapid production ramp as compared to the production ramp for Model S in 2012. In anticipation of this effort, we now expect Model X deliveries to start in the third quarter of 2015. Our ability to launch the Model X program on time and cost efficiently is dependent upon a variety of factors, including supplier readiness, engineering completion and the successful completion of our validation testing. We plan to continue to expand our stores and service infrastructure in order to expand our geographical presence and to provide better service in areas with a high concentration of Model S customers. We also complement our store strategy with sales capability within service centers to more rapidly and efficiently expand our retail footprint. We 25-------------------------------------------------------------------------------- Table of Contents continue to build service infrastructure in advance of demand to ensure that after-sale services are available when and where needed. For the remainder of 2014, the rate of location openings will be fastest in Asia, followed by Europe, and then North America. At the end of May 2013, we announced the significant expansion of our Supercharger network as well as plans to reduce charging time at our Superchargers. Since the time of our announcement, we have been installing Superchargers at an accelerating pace. We are continuing to expand our network in North America and have increased our rate of deployment in Europe and Asia. If we experience difficulties in finding suitable sites, negotiating leases or obtaining required permits for such locations, our planned expansion of such Superchargers could be delayed. We are developing the Tesla Gigafactory, a facility where we intend to work together with our suppliers to integrate battery precursor material, cell, module and battery pack production in one location. In June 2014, we broke ground on the Gigafactory outside of Reno, Nevada. Construction continued during the third quarter of 2014 at an accelerated pace with first cells expected to be produced in 2016 for use in Model S and Model X. We plan to use the battery packs manufactured at the Gigafactory for our vehicles, initially for Model S and Model X, and later for our Model 3 vehicle, and stationary storage applications. The Gigafactory is currently expected to attain full production capacity in 2020, which is anticipated to be sufficient for the production of approximately 500,000 vehicles annually as well as stationary storage applications. By the time the Gigafactory reaches full, annualized production in 2020, we expect battery pack production capacity to reach 50 GWh. Of this, we expect to build 35 GWh of cell production capacity at the Gigafactory and purchase 15 GWh of cells from other manufacturers, potentially including Panasonic. We believe that the Gigafactory will allow us to achieve a major reduction in the cost of our battery packs of greater than 30% on a per kWh basis by the end of the first year of volume production of Model 3. The total capital expenditures associated with the Gigafactory through 2020 are expected to be $4-5 billion, of which approximately $2 billion is expected to come from Tesla. A modular build strategy is enabling us to scale construction, capital requirements and capacity commensurate with growing demand. While our plan is to produce lithium-ion cells and finished battery packs at the Gigafactory, our plans for such production are at a very early stage. We have no experience in the production of lithium-ion cells, and accordingly we intend to engage partners with significant experience in cell production. We recently formalized our agreement with Panasonic to partner on the Gigafactory. Panasonic will invest in production equipment that it will use to manufacture and supply us with battery cells. We will prepare and provide the land, buildings and utilities for the Gigafactory, invest in production equipment for battery module and pack production and be responsible for the overall management of the Gigafactory. Additional Gigafactory partners will be finalized shortly to create a fully integrated industrial complex. Although planning discussions with production and supply chain partners continue to progress well, to date we have not formalized any agreements with any other partners. In addition, the cost of building and operating the Gigafactory could exceed our current expectations and the Gigafactory may take longer to bring online than we anticipate. Operating expenses and capital expenditures have significantly increased in 2014 and will continue to do so as we continue to invest in the long-term growth of the company. For the rest of 2014, we will continue to significantly expand production capacity for Model S and Model X, continue the construction of the Gigafactory, invest in our customer support infrastructure, continue the development of Model X and start early design work on Model 3. Our R&D expenses in particular are continuing to increase as design and engineering work accelerates on Model X and overall product development but is expected to decrease as a percentage of revenue over time. R&D expenses for the fourth quarter of 2014 are expected 26 -------------------------------------------------------------------------------- Table of Contents to grow sequentially by approximately 10% as compared to the third quarter of 2014. Our SG&A expenses will continue to grow in absolute terms as we expand our customer and corporate infrastructure globally. SG&A expenses for the fourth quarter of 2014 are also expected to grow sequentially by approximately10% as compared to the third quarter of 2014. We plan to spend about $350 million in capital expenditures in the fourth quarter of 2014 as we continue to invest in additional production capacity, accelerate the pace of Gigafactory construction, and continue vehicle development and our global expansion. During the third quarter of 2014, certain conditions with respect to the closing prices of our common stock in accordance with the terms of our 2018 convertible senior notes (2018 Notes) were met and accordingly, 2018 Notes are convertible at the holders' option during the fourth quarter of 2014. Upon conversion of 2018 Notes, we will be obligated to pay cash for the principal amount of the converted notes and we may also have to deliver shares of our common stock in respect of such converted notes. Any conversion of the notes prior to their maturity or acceleration of the repayment of the notes could have a material adverse effect on our cash flows, business, results of operations and financial condition. Should such closing price conditions continue to be met in the fourth quarter of 2014 or a future quarter, 2018 Notes will be convertible by their holders during the immediately following quarter. Similarly, if certain conditions are met with respect to our 2019 Notes or 2021 Notes in the fourth quarter of 2014 or a future quarter, the 2019 Notes or 2021 Notes will be convertible by their holders during the immediately following quarter. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. We base our estimates on historical experience, as appropriate, and on various other assumptions that we believe to be reasonable under the circumstances. Changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. We evaluate our estimates and assumptions on an ongoing basis. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. For a description of our critical accounting policies and estimates, please refer to the "Critical Accounting Policies and Estimates" section of our Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2013, as filed with the Securities and Exchange Commission (SEC). In addition, please refer to Note 2, "Summary of Significant Accounting Policies," to our Condensed Consolidated Financial Statements included under Part I, Item 1 of this Quarterly Report on Form 10-Q. 27-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth our condensed consolidated statements of operations data for the periods presented (in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Revenues Automotive sales $ 849,009 $ 430,196 $ 2,236,062 $ 1,386,934 Development services 2,795 1,150 5,633 11,343 Total revenues 851,804 431,346 2,241,695 1,398,277 Cost of revenues Automotive sales 598,472 324,883 1,615,047 1,090,300 Development services 1,481 3,595 6,674 8,304 Total cost of revenues 599,953 328,478 1,621,721 1,098,604 Gross profit 251,851 102,868 619,974 299,673 Operating expenses Research and development 135,873 56,351 325,135 163,523Selling, general and administrative 155,107 77,071 406,690 184,080 Total operating expenses 290,980 133,422 731,825 347,603 Loss from operations (39,129 ) (30,554 ) (111,851 ) (47,930 ) Interest income 300 68 907 97 Interest expense (29,062 ) (6,492 ) (72,183 ) (26,705 ) Other income (expense), net (3,090 ) (740 ) 2,401 18,018 Loss before income taxes (70,981 ) (37,718 ) (180,726 ) (56,520 ) Provision for income taxes 3,727 778 5,685 1,230 Net loss $ (74,708 ) $ (38,496 ) $ (186,411 ) $ (57,750 ) Revenues Automotive Sales Automotive sales, which include vehicle, options and related sales, and powertrain component and related sales, consisted of the following for the periods presented (in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013Vehicle, options and related sales $ 818,119 $ 422,004 $ 2,164,491 $ 1,351,056 Powertrain component and related sales 30,890 8,192 71,570 35,878 Total automotive sales $ 849,009 $ 430,196 $ 2,236,062 $ 1,386,934 Automotive sales during the three and nine months ended September 30, 2014 were $849.0 million and $2.24 billion, an increase from $430.2 million and $1.39 billion during the three and nine months ended September 30, 2013, respectively. Vehicle, options and related sales represent revenues related to deliveries of Model S, including vehicle options, accessories and destination charges, vehicle service and sales of regulatory credits to other automotive manufacturers. Powertrain component and related sales represent the sales of electric vehicle powertrain components and systems, such as battery packs and drive units, to other manufacturers. Vehicle, options and related sales during the three and nine months ended September 30, 2014 were $818.1 million and $2.16 billion, an increase from $422.0 million and $1.35 billion during the three and nine months ended September 30, 2013, respectively. The increase in vehicle, options and related sales was primarily driven by Model S deliveries in Europe and China which commenced in August 2013 and April 2014, respectively. During the three and nine months ended September 30, 2014, we delivered 7,785 and 21,821 Model S vehicles, respectively. During the three and nine months ended June 30, 2013, we delivered 5,516 and 15,585 Model S vehicles, respectively. In April 2013, we began offering a resale value guarantee to all customers who purchased a Model S in the United States and financed their vehicle through one of our specified commercial banking partners. We also offer this program in certain countries outside of the United States. Under the 28-------------------------------------------------------------------------------- Table of Contents program, Model S customers have the option of selling their vehicle back to us during the period of 36 to 39 months for a pre-determined resale value. We account for transactions under the resale value guarantee program as operating leases and accordingly, we defer and amortize to revenues the initial purchase consideration less resale value guarantee amount on a straight-line basis, over the contractual term of the guarantee program. If a customer decides not to sell their vehicle back to us by the end of the resale value guarantee term, the amount of the resale value guarantee is then recognized in automotive sales. During the three and nine months ended September 30, 2014, we delivered 1,190 and 3,578 Model S vehicles under the resale value guarantee program, respectively. During the three and nine months ended September 30, 2013, we delivered 1,877 and 3,512 Model S vehicles under the resale value guarantee program. As of September 30, 2014 and December 31, 2013, we had $333.6 million and $230.9 million in related deferred revenues and $397.7 million and $236.3 million in resale value guarantees, respectively. During the three and nine months ended September 30, 2014, we recognized revenue of $32.7 million and $84.3 million in automotive sales related to this program, respectively. During the three and nine months ended September 30, 2013, we recognized revenue of $9.4 million and $11.3 million, respectively, in automotive sales related to this program. In April 2014, we began offering a direct leasing program to small and medium-sized businesses in the United States for Model S. We expanded this program to consumers in the United States in October 2014. Qualifying customers are permitted to lease a Model S for 36 months, after which time they have the option of either returning the vehicle to us or purchasing it for a pre-determined residual value. We account for these leasing transactions as operating leases and accordingly, we recognize leasing revenues over the contractual term of the individual leases. Lease revenues are recorded in automotive sales and for the three and nine months ended September 30, 2014, we recognized $1.1 million and $1.3 million, respectively. Powertrain component and related sales for the periods presented were related to powertrain component sales to Daimler under the Mercedes-Benz B-Class Electric Drive program which commenced in April 2014 and to Toyota under the RAV4 EV program. Powertrain component and related sales for the three and nine months ended September 30, 2014 was $30.9 million and $71.6 million, respectively, an increase from $8.2 million and $35.9 million during the three and nine months ended September 30, 2013, respectively. During the third quarter of 2014, we completed the RAV4 EV program. Development Services Development services represent arrangements where we develop electric vehicle powertrain components and systems for other automobile manufacturers, including the design and development of battery packs, drive units and chargers to meet customers' specifications. During the fourth quarter of 2012, we entered into a development agreement with Daimler to assist with the development of a full electric powertrain for a Mercedes-Benz B-Class EV. Development services revenue for the three and nine months ended September 30, 2014 relates primarily to completion of the final development milestone and the delivery of prototype samples to Daimler under this program while development services revenue for the three and nine months ended September 30, 2013 includes revenues for the achievement of various milestones and from the delivery of prototype samples to Daimler under this program. During the three and nine months ended September 30, 2014, we recognized development services revenue of $2.8 million and $5.6 million, respectively. During the three and nine months ended September 30, 2013, we recognized development services revenue of $1.2 million and $11.3 million, respectively. As of September 30, 2014, we have completed our development services under this program. 29-------------------------------------------------------------------------------- Table of Contents Cost of Revenues and Gross Profit Cost of revenues includes cost of automotive sales and costs related to our development services. Cost of automotive sales during the three and nine months ended September 30, 2014 was $598.5 million and $1.62 billion, an increase from $324.9 million and $1.09 billion for the three and nine months ended September 30, 2013, respectively. Cost of automotive sales includes direct parts, material and labor costs, manufacturing overhead, including amortized tooling costs, royalty fees, shipping and logistic costs and reserves for estimated warranty expenses. Cost of automotive sales also includes adjustments to warranty expense and charges to write down the carrying value of our inventory when it exceeds its estimated net realizable value and to provide for obsolete and on-hand inventory in excess of forecasted demand. In April 2013, we began offering a resale value guarantee to all customers who purchased a Model S in the United States and financed their vehicle and vehicle options through one of our specified commercial banking partners. We also offer this program in certain countries outside of the United States. Under the program, we capitalize the cost of Model S into operating lease vehicles and depreciate the respective operating lease vehicles less expected salvage value to cost of automotive sales on a straight-line basis, over the contractual term of the guarantee program. If a customer decides not to sell their vehicle back to us by the end of the resale value guarantee term, the remaining operating lease vehicle net book value is then recognized in automotive sales. As of September 30, 2014 and December 31, 2013, we recorded $578.7 million and $377.0 million in operating lease vehicles, net, related to Model S deliveries with the resale value guarantee. During the three and nine months ended September 30, 2014, we recognized $18.9 million and $50.3 million in cost of automotive sales, respectively, related to operating lease vehicle depreciation under this program. During the three and nine months ended September 30, 2013, we recognized $5.9 million and $7.3 million, respectively, in cost of automotive sales related to operating lease vehicle depreciation under this program. Our warranty reserves do not include projected warranty costs associated with our resale value guarantee vehicles as such actual warranty costs are expensed as incurred. For the three and nine months ended September 30, 2014, warranty costs incurred for our resale value guarantee vehicles were $2.1 million and $5.1 million, respectively. For the three and nine months ended September 30, 2013, warranty costs incurred for our resale value guarantee vehicles was $0.7 million and $1.1 million, respectively. In April 2014, we began offering a direct leasing program for Model S to small and medium-sized businesses in the United States. We expanded this program to consumers in the United States in October 2014. Qualifying customers are permitted to lease Model S for 36 months, after which time they have the option of either returning the vehicle to us or purchasing it for a pre-determined residual value. We account for these leasing transactions as operating leases and depreciate the respective operating lease vehicles less expected salvage value on a straight-line basis over the contractual term of the individual leases. As of September 30, 2014, we recorded $35.0 million in operating lease vehicles, net, related to Model S deliveries under this program. During the three and nine months ended September 30, 2014, we recognized $0.6 million and $0.7 million, respectively, in cost of automotive sales related to operating lease vehicle depreciation under this program. Gross profit during the three and nine months ended September 30, 2014 was $251.9 million and $620.0 million, an increase from $102.9 million and $299.7 million during the three and nine months ended September 30, 2013, respectively. The increase in gross profit was primarily due to higher regulatory credit sales and manufacturing and supply chain efficiencies as well as component cost reductions, partially offset by one-time manufacturing inefficiencies associated with transitioning to our new final assembly line. 30-------------------------------------------------------------------------------- Table of Contents Research and Development Expenses Research and development (R&D) expenses consist primarily of personnel costs for our teams in engineering and research, supply chain, quality, manufacturing engineering and manufacturing test organizations, prototyping expense, contract and professional services and amortized equipment expense. Also included in R&D expenses are development services costs that we incur, if any, prior to the finalization of agreements with our development services customers as reaching a final agreement and revenue recognition is not assured. Development services costs incurred after the finalization of an agreement are recorded in cost of revenues. R&D expenses during the three months ended September 30, 2014 were $135.9 million, an increase from $56.4 million during the three months ended September 30, 2013. Higher R&D expenses in the third quarter of 2014 reflected our accelerated engineering work on Model X as well as development work on our dual motor powertrain and other development programs. The $79.5 million increase in R&D expenses consisted primarily of a $25.3 million increase in expensed materials primarily to support Model X development, a $24.5 million increase in employee compensation expenses, a $21.1 million increase in costs related to accelerated engineering work on Model X as well as dual motor powertrain and other development programs, and a $5.7 million increase in stock-based compensation expense related to a larger number of outstanding equity awards due to additional headcount and generally an increasing common stock valuation associated with newer grants. R&D expenses during the nine months ended September 30, 2014 were $325.1 million, an increase from $163.5 million during the nine months ended September 30, 2013. The $161.6 million increase in R&D expenses consisted primarily of a $53.0 million increase in employee compensation expenses, a $43.5 million increase in costs related to Model X, dual motor powertrain and right-hand drive Model S engineering, design and testing activities, an $41.6 million increase in expensed materials primarily to support our Model X, dual motor powertrain and right-hand drive Model S development, a $18.9 million increase in stock-based compensation expense related to a larger number of outstanding equity awards due to additional headcount and generally an increasing common stock valuation associated with newer grants and $3.7 million information technology and facilities-related costs to support the growth of our business. Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses consist primarily of personnel and facilities costs related to our Tesla stores, service centers and Superchargers, marketing, sales, executive, finance, human resources, information technology and legal organizations, as well as litigation settlements and fees for professional and contract services. SG&A expenses during the three months ended September 30, 2014 were $155.1 million, an increase from $77.1 million during the three months ended September 30, 2013. SG&A expenses increased primarily from higher headcount and costs to support an expanded retail, service and Supercharger footprint as well as the general growth of the business. The $78.0 million increase in our SG&A expenses consisted primarily of a $34.5 million increase in office, information technology and facilities-related costs to support the growth of our business as well as sales and marketing activities to handle our expanding market presence, a $33.9 million increase in employee compensation expenses related to higher sales and marketing headcount to support sales activities worldwide and higher general and administrative headcount to support the expansion of the business, a $2.2 million increase in stock-based compensation expense related to a larger number of outstanding equity awards due to additional headcount and generally an increasing common stock valuation associated with newer grants and a $1.4 million increase in professional and outside services costs. 31-------------------------------------------------------------------------------- Table of Contents SG&A expenses during the nine months ended September 30, 2014 were $406.7 million, an increase from $184.1 million during the nine months ended September 30, 2013. The $222.6 million increase in our SG&A expenses consisted primarily of a $100.7 million increase in employee compensation expenses related to higher sales and marketing headcount to support sales activities worldwide and higher general and administrative headcount to support the expansion of the business, a $94.3 million increase in office, information technology and facilities-related costs to support the growth of our business as well as sales and marketing activities to handle our expanding market presence, a $27.7 million increase in stock-based compensation expense related to a larger number of outstanding equity awards due to additional headcount and generally an increasing common stock valuation associated with newer grants and a $4.4 million increase in professional and outside services costs. Interest Expense Interest expense during the three and nine months ended September 30, 2014 was $29.1 million and $72.2 million, an increase from $6.5 million and $26.7 million during the three and nine months ended September 30, 2013. We incurred interest expense during three and nine months ended September 30, 2014 primarily from our 2018 Notes, 2019 Notes and 2021 Notes and capitalized interest to assets under construction related to significant asset construction. During the three and nine months ended September 30, 2014, we capitalized $3.7 million and $6.9 million of interest expense to construction in progress, respectively. Interest expense during the three and nine months ended September 30, 2013 was related primarily to the early repayment fee, interest and the amortization of the remaining loan origination costs associated with the repayment and extinguishment of our then outstanding Department of Energy (DOE) loan principal of $439.6 million as well as our 2018 Notes. During the three and nine months ended September 30, 2013, we capitalized $0.4 million and $2.3 million of interest expense to construction in progress, respectively. In March 2014, we issued $800.0 million aggregate principal amount of 2019 Notes and $1.20 billion aggregate principal amount of 2021 Notes in a public offering. In April 2014, we issued an additional $120.0 million aggregate principal amount of the 2019 Notes and $180.0 million aggregate principal amount of the 2021 Notes, pursuant to the exercise in full of the overallotment options of the underwriters of our March 2014 public offering. We incurred approximately $35.6 million of debt issuance costs in connection with these notes, which we initially recorded in other assets and are amortizing to interest expense using the effective interest method over the contractual terms of the notes. The interest rates are fixed at 0.25% and 1.25% per annum for the 2019 Notes and 2021 Notes, respectively, and are payable semi-annually in arrears on March 1 and September 1 of each year, commencing on September 1, 2014. During the three and nine months ended September 30, 2014, we recognized $1.0 million and $2.2 million of interest expense, respectively, related to the amortization of debt issuance costs and $4.9 million and $11.2 million of accrued coupon interest expense, respectively. In accordance with accounting guidance on embedded conversion features, we valued and bifurcated the conversion option associated with these notes from the respective host debt instrument and initially recorded the conversion option of $188.1 million for the 2019 Notes and $369.4 million for the 2021 Notes in stockholders' equity. The resulting debt discounts on the 2019 Notes and 2021 Notes are being amortized to interest expense at an effective interest rate of 4.89% and 5.96%, respectively, over the contractual terms of these notes. During the three and nine months ended September 30, 2014, we recognized $19.6 million and $44.1 million of interest expense, respectively, related to the amortization of the debt discount. 32 -------------------------------------------------------------------------------- Table of Contents In May 2013, we issued $660.0 million aggregate principal amount of 2018 Notes in a public offering. We incurred $12.0 million of debt issuance costs in connection with the issuance of 2018 Notes which we recorded in other assets and are amortizing to interest expense using the effective interest method over the contractual term of 2018 Notes. Under the terms of 2018 Notes, 1.50% coupon interest per annum on the principal amount of the notes is payable semi-annually in arrears on June 1 and December 1 of each year, commencing on December 1, 2013. During the three and nine months ended September 30, 2014, we recognized $3.0 million and $8.8 million of interest expense, respectively, related to the amortization of debt issuance costs and accrued coupon interest. During the three and nine months ended September 30, 2013, we recognized $3.0 million and $4.3 million of interest expense, respectively, related to the amortization of debt issuance costs and accrued coupon interest. Similar to the 2019 and 2021 Notes, we valued and bifurcated the conversion option associated with 2018 Notes from the host debt instrument and initially recorded the conversion option of $82.8 million in stockholders' equity. The resulting debt discount on 2018 Notes is being amortized to interest expense at an effective interest rate of 4.29% over the contractual term of 2018 Notes. During the three and nine months ended September 30, 2014, we recognized $3.9 million and $11.5 million of interest expense, respectively, related to the amortization of the debt discount. During the three and nine months ended September 30, 2013, we recognized $3.8 million and $5.4 million of interest expense, respectively, related to the amortization of the debt discount. Other Income (Expense), Net Other income (expense), net, consists primarily of the change in the fair value of our DOE common stock warrant liability and foreign exchange gains and losses related to our foreign currency-denominated assets and liabilities. We expect our foreign exchange gains and losses will vary depending upon movements in the underlying exchange rates. Prior to the expiration of the DOE warrant in May 2013, the DOE warrant had been carried at its estimated fair value with changes in its fair value reflected in other income (expense), net. Other expense, net, during the three months ended September 30, 2014 was $3.1 million, an increase from $0.7 million during the three months ended September 30, 2013. The $2.4 million increase in our other expense, net, is primarily attributable to unfavorable foreign currency exchange impact from our foreign currency-denominated assets. Other income, net, during the nine months ended September 30, 2014 was $2.4 million, a decrease from $18.0 million during the nine months ended September 30, 2013. In March 2013, we entered into a fourth amendment to the DOE Loan Facility which, among other things, accelerated the maturity date of our DOE loans to December 15, 2017; therefore, the DOE warrant was no longer expected to vest. We recorded the reduction in fair value of our DOE common stock warrant liability of $10.7 million in other income, net, during the three months ended March 31, 2013. Other income, net, during the nine months ended September 30, 2014 and 2013 was also attributable to the favorable foreign currency exchange impact from our foreign currency-denominated assets and liabilities. Provision for Income Taxes Our provision for income taxes during the three and nine months ended September 30, 2014 was $3.7 million and $5.7 million, compared to $0.1 million and $1.2 million during the three and nine months ended September 30, 2013, respectively. The increase during the three and nine months ended September 30, 2014 was due primarily to the increase in taxable income in our international jurisdictions, following the commencement of European Model S deliveries in August 2013 and Model S deliveries in China in April 2014. 33-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources As of September 30, 2014, we had $2.37 billion in principal sources of liquidity available from our cash and cash equivalents, including $1.69 billion of money market funds. Other sources of cash include cash from our deliveries of Model S, customer deposits for Model S and Model X, sales of regulatory credits, cash from the provision of development services, and sales of powertrain components and systems. We expect that our current sources of liquidity, including cash and cash equivalents, together with our current projections of cash flow from operating activities, will continue to provide us with adequate liquidity based on our current plans. These capital sources will enable us to fund our ongoing operations, continue research and development projects, including those for our planned Model X crossover and certain future products, such as Model 3, establish and expand our stores, service centers and Supercharger network and to make the investments in tooling and manufacturing capital required to introduce Model X and to continue to ramp up production of Model S as well as make investments in the Tesla Gigafactory. We may seek additional capital resources to partially fund certain long-term growth initiatives. As of October 31, 2014, we had 235 Supercharger stations open in North America, Europe and Asia. We expect to continue making investments in the Supercharger network. If market conditions are favorable, we may evaluate alternatives to opportunistically pursue liquidity options. Also, should prevailing economic conditions and/or financial, business or other factors adversely affect the estimates of our future cash requirements, we could be required to fund our cash requirements through additional or alternative sources of financing. We cannot be certain that additional funds will be available to us on favorable terms when required, or at all. 0.25% and 1.25% Convertible Senior Notes and Bond Hedge and Warrant Transactions In March 2014, we issued $800.0 million aggregate principal amount of 0.25% convertible senior notes due 2019 (2019 Notes) and $1.20 billion aggregate principal amount of 1.25% convertible senior notes due 2021 (2021 Notes) in a public offering. The net proceeds from the offering, after deducting transaction costs, were approximately $787.6 million from the 2019 Notes and $1.18 billion from the 2021 Notes, respectively. We incurred $12.4 million and $18.7 million, respectively, of debt issuance costs in connection with these notes, which we initially recorded in other assets and are amortizing to interest expense using the effective interest method over the contractual terms of these notes. The interest rates are fixed at 0.25% and 1.25% per annum for the 2019 and 2021 Notes, respectively, and are payable semi-annually in arrears on March 1 and September 1 of each year, commencing on September 1, 2014. In connection with the offering of these notes, we entered into convertible note hedge transactions whereby we have the option to purchase initially (subject to adjustment for certain specified events) a total of approximately 5.6 million shares of our common stock at a price of $359.87 per share. The total cost of the convertible note hedge transactions was $524.7 million. In addition, we sold warrants whereby the holders of the warrants have the option to purchase initially (subject to adjustment for certain specified events) a total of approximately 2.2 million shares of our common stock at a price of $512.66 for the 2019 Notes and a total of approximately 3.3 million shares of our common stock at a price of $560.64 per share for the 2021 Notes. We received $338.4 million in cash proceeds from the sale of these warrants. Taken together, the purchase of the convertible note hedges and the sale of warrants are 34-------------------------------------------------------------------------------- Table of Contents intended to offset any actual dilution from the conversion of these notes and to effectively increase the overall conversion price from $359.87 to $512.66 per share in the case of warrants relating to the 2019 Notes and from $359.87 to $560.64 in the case of warrants relating to the 2021 Notes. In April 2014, we issued an additional $120.0 million aggregate principal amount of the 2019 Notes and $180.0 million aggregate principal amount of the 2021 Notes, pursuant to the exercise in full of the overallotment options of the underwriters of our March 2014 public offering. The net proceeds from this offering, after deducting transaction costs, were approximately $118.2 million from the 2019 Notes and $177.3 million from the 2021 Notes. We incurred $1.8 million and $2.7 million, respectively, of debt issuance costs in connection with these notes, which we initially recorded in other assets and are amortizing to interest expense using the effective interest method over the contractual terms of these notes. In connection with the issuance of these additional notes, we entered into convertible note hedge transactions and paid an aggregate $78.7 million. In addition, we sold warrants to purchase (subject to adjustment for certain specified events) a total of approximately 0.3 million shares of our common stock at a strike price of $512.66 per share for the warrants relating to the 2019 Notes, and a total of approximately 0.5 million shares of our common stock at a strike price of $560.64 per share for the warrants relating to the 2021 Notes. We received aggregate proceeds of approximately $50.8 million from the sale of the warrants. During the third quarter of 2014, the closing price of our common stock did not meet or exceed 130% of the applicable conversion price of our 2019 Notes and 2021 Notes on at least 20 of the last 30 consecutive trading days of the quarter; furthermore, no other conditions allowing holders of these notes to convert have been met as of September 30, 2014. Therefore, the 2019 Notes and 2021 Notes are not convertible during the fourth quarter of 2014 and are classified as long-term debt. Should the closing price conditions be met in the fourth quarter of 2014 or a future quarter, the Notes will be convertible at their holders' option during the immediately following quarter. 1.50% Convertible Senior Notes and Bond Hedge and Warrant Transactions In May 2013, we issued $660.0 million aggregate principal amount of 1.50% convertible senior notes due 2018 (2018 Notes) in a public offering. The net proceeds from the offering, after deducting transaction costs, were approximately $648.0 million. We incurred $12.0 million of debt issuance costs in connection with the issuance of 2018 Notes which we have recorded in other assets and are amortizing to interest expense using the effective interest method over the contractual term of 2018 Notes. The interest under 2018 Notes is fixed at 1.50% per annum and is payable semi-annually in arrears on June 1 and December 1 of each year, commencing on December 1, 2013. During the third quarter of 2014, the closing price of our common stock exceeded 130% of the applicable conversion price of our 2018 Notes on at least 20 of the last 30 consecutive trading days of the quarter; therefore, holders of 2018 Notes may convert their notes during the fourth quarter of 2014. Should the closing price conditions be met in the fourth quarter of 2014 or a future quarter, 2018 Notes will be convertible at their holders' option during the immediately following quarter. Furthermore, under current market conditions, we expect that almost none of 2018 Notes will be converted in the short term. In connection with the offering of 2018 Notes, we entered into convertible note hedge transactions whereby we have the option to purchase (subject to adjustment for certain specified events) a total of approximately 5.3 million shares of our common stock at a price of approximately $124.52 per share. The cost of the convertible note hedge transactions was $177.5 million. In addition, we sold warrants whereby the holders of the warrants have the option to purchase (subject to adjustment for 35 -------------------------------------------------------------------------------- Table of Contents certain specified events) a total of approximately 5.3 million shares of our common stock at a price of $184.48 per share. We received $120.3 million in cash proceeds from the sale of these warrants. Taken together, the purchase of the convertible note hedges and the sale of warrants are intended to offset any actual dilution from the conversion of 2018 Notes and to effectively increase the overall conversion price from $124.52 to $184.48 per share. For more information on 2018 Notes, 2019 Notes and 2021 Notes, see Note 6 to our Condensed Consolidated Financial Statements included under Part 1, Item 1 of this Quarterly Report on Form 10-Q. Customer Deposits Customers are required to make an initial deposit to place an order for their vehicle. Customer deposits vary depending on the vehicle model and country of delivery. These amounts are recorded as current liabilities until the vehicle is delivered. While payment for the remaining balance of the purchase price of the vehicle is generally collected at time of delivery to the customer, in some cases partial or full payment may be collected prior to delivery. Such payments are recorded as customer deposits. Customer deposits related to Model X still represent fully refundable reservations. As of September 30, 2014, we held customer deposits of $227.1 million. |