UPDATE: Tesla (TSLA) raised to investment grade at S&P

(Updated - October 6, 2022 1:02 PM EDT)

Tesla (NASDAQ: TSLA) raised to investment grade at S&P, to BBB from BB+

• Tesla Inc.'s reported production and deliveries for the nine months ended Sept. 30, 2022, were higher than our expectations and the ramp-up in its global capacity appears on track to meet the strong demand for its products into 2023.
• We now view Tesla's credit profile more favorably because it continues to demonstrate market leadership in electric vehicles (EVs), with solid manufacturing efficiency that supports strong EBITDA margins and sustained positive free operating cash flow (FOCF), above our previously established upside triggers.
• We raised our ratings on Tesla, including our issuer credit rating and issue-level ratings, to 'BBB' from 'BB+'.
• The stable outlook reflects our expectation that Tesla will maintain low debt levels as it sustains its solid market share, profitability, and strong liquidity amid a weakening economy and an increasingly competitive environment for EVs.

Rating Action Rationale

Tesla's year-to-date (ended Sept. 30, 2022) production and deliveries indicate solid execution on capacity expansion to support strong demand for its products amid ongoing supply disruptions. In the third quarter, Tesla produced more than 365,000 vehicles, taking its year-to-date levels to nearly 930,000 vehicles, up nearly 50% year-over-year, on track with its average annual growth target over a multiyear horizon. This happened despite production suspension in China during the second quarter, component shortages, parts inflation, and disruption to logistics. As a result, we now expect Tesla to sell 2 million units in 2023 (above our prior upgrade trigger of 1.5 million units; see our research update published Oct. 22, 2021). This will help sustain its solid market share within EVs amid intensifying competition and aggressive launches by automakers globally, particularly in China and Europe. Both the pace of production growth and the level of manufacturing efficiency in its Austin and Berlin facilities (with no material cost overruns) have been better than our prior expectations. This positions Tesla well for the production ramp-up of its future products, including its Cybertruck, which is currently planned for Austin production after the Model Y ramp is complete. The battery electric vehicle (BEV) market still remains a sliver of total U.S. auto sales at under 7% of total light vehicle sales for the first nine months of 2022. Tesla's market share within the electric and plug-in electric vehicles segment in the U.S. was about 51% in the first nine months of 2022 with lower shares in Europe and China. Its global market share for BEVs in the same period was around 18%, according to EV-volumes.com and we expect it to remain in the 15-20% range over the next two years.

Our improved view of Tesla's business supports its prospects for solid and sustainable free cash flow over the next few years. In 2022 and 2023, we expect Tesla to sustain FOCF to sales of over 10%, compared with our prior upside trigger of 2%, backed by industry-leading EBITDA margins of roughly 20%, compared with our upside trigger of 18% and well above our 10% threshold for above average margins for automakers. This is despite high expenses related to the ramp up of its Berlin and Austin manufacturing facilities, ongoing supply chain disruptions, and rising commodity costs. So far, Tesla has partially offset the effects of the disruption with higher average selling prices, sale of regulatory credits (which accounted for roughly 13% of Tesla's EBITDA in the first half of 2022), and lower manufacturing costs compared with our prior expectations. For instance, advancements in its manufacturing processes, including large castings, enabled Tesla to reduce body-welding robot count by 70% per unit of capacity in its new factories compared to its first iteration of the Model 3 body shop. Beyond 2022, key drivers for sustaining its high EBITDA margins include further innovations to reduce the cost of manufacturing and operations, securing long-term battery component supply (especially lithium), and the acceleration of software-related profits.

Solid technological capabilities and an expanded range of affordable products will be critical as the global economy weakens and EV competition intensifies. Tesla's scale, scope, and diversity of products is still limited (around 1.5% market share) relative to the global light vehicle market, which is estimated roughly at 80 million units for 2022. To sustain recent strong growth, hold its first-mover advantage, and improve market share, Tesla will need to make the total cost of EV ownership more affordable, including insurance and service costs. The timing for its goals to improve the affordability of its vehicles will be an important consideration for our market share assumptions and for potential improvements in its competitive advantage beyond 2024. We expect a positive impact on its sales once the Inflation Reduction Act (IRA) takes effect in January 2023, as its vehicles could requalify for tax credits to EV buyers (up to $7,500 per vehicle). The IRA could also benefit Tesla through some subsidies specific to producers of cells and battery modules and packs in the U.S.

To enhance its competitive position, Tesla will need to expand its range of products to contend with a substantially higher number of models from established global automakers and start-ups by the end of 2025. For instance, according to S&P Global Mobility, the BEV model count in North America will exceed 100 by 2026, over four times higher compared to 2022 levels. This includes nearly all large global mass-market and luxury automakers, as well as start-ups. Over the next 3-5 years, a few of these could become formidable competitors for Tesla. This is because many have the capacity and the vertical integration capabilities to bridge the cost gap over time and leverage their existing customer base and brand to command pricing power. For Tesla, its autopilot and full self-driving (FSD) technologies could sustain and improve its competitive advantages as it continues to make progress developing its FSD capabilities and remotely updatable artificial intelligence software.

Tesla's strong liquidity and our expectation for a conservative financial policy add cushion to the 'BBB' rating With over $18.3 billion in cash and cash equivalents at June 30, 2022, and our expectation of solid cash flow at least through 2023, we believe Tesla will maintain its strong liquidity. These levels are well above our established threshold (auto cash balances of roughly 15% of sales) for Ford Motor Co. and General Motors Co., two peers that contend with industry cyclicality. With more cash on its balance sheet than total debt, Tesla appears easily able to fund its global expansion while navigating industry supply chain and logistics-related bottlenecks that will persist into 2023.

Once Tesla's growth rate slows with the advent of more competition, we believe its financial policy and balance sheet flexibility will eventually face the harsh test of industry cyclicality pressures inherent in the auto industry. Specifically, we will monitor Tesla's plans for shareholder distributions, potential growth of it captive finance operations or other business segments, and tuck-in acquisitions. These may represent a larger cash outlay over the next few years than what we incorporate in our base case. We risk-adjust our assessment to incorporate these significant future uncertainties, in addition to a slower than expected rate of EV adoption and the coming fierce contest with several very capable global auto manufacturers.

Outlook

The stable outlook reflects our expectation that Tesla will maintain low debt levels as it sustains its solid market share, profitability, and strong liquidity amid an increasingly competitive environment for EVs.

Downside scenario

We could lower our ratings if:

• Tesla adopts a more aggressive financial policy with respect to shareholder distributions, growth of its captive finance operations or other business segments, and acquisitions, such that financial cushion reduces materially; or
• It cannot sustain solid FOCF due to slowing growth or higher-than-expected spending.

Upside scenario

We could raise our ratings if:

• Tesla sustains its first-mover advantage as EV demand expands and competition intensifies such that its global light vehicle market share appears likely to exceed 5%;
• It appears likely to sustain its recent track record of free cash flow beyond 2024; and
• It remains committed to a prudent financial policy in line with a higher rating.

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