As Tesla Shares Plunge, Speculation Swirls Over Why Electric Carmaker Failed To Join S&P 500 Index

After much speculation and anticipation, electric vehicle manufacturer Tesla (TSLA) failed to enter the prestigious S&P 500 stock index.

On Friday, S&P Dow Jones Indices, which oversees the 500 index, announced that, effective Sept. 21, Etsy Inc. (ETSY), Teradyne Inc. (TER), and Catalent Inc. (CTLT) will all move to the S&P 500 index, replacing H&R Block Inc. (HRB) Coty Inc. (COTY) and Kohl's Corp. (KSS).

Etsy is an e-commerce website focused on handmade or vintage items; Teradyne is a semiconductor equipment manufacturer; Catalent is a medical technology firm.

However, Tesla is one of the biggest corporations on the planet, with a market cap of $322 billion. It has also delivered four straight quarters of profits – which would qualify it for inclusion in the index. Tesla shares have skyrocketed more than 400% so far this year.

David I. Kass, clinical professor of finance at University of Maryland, told International Business Times that the reason Tesla was not added to the S&P 500 “could be the result of concerns over the quality of its earnings and the volatility of its shares.”

Kass noted that Tesla’s profits include the sale of regulatory credits to other automobile manufacturers. (Tesla earned $594 million, $419 million and $360 million in 2019, 2018 and 2017, respectively, just from selling regulatory credits)

Mike Taylor, president of Emission Advisors, an environmental credit brokerage and consulting firm based in Houston, told CNBC that Tesla makes money by selling regulatory credits to other automakers that wish to avoid paying big fines. As Tesla itself only sells zero emission vehicles, it can sell these regulatory credits before they expire to other companies.

In its July earnings report, Tesla’s total revenue of $6.04 billion included $428 million from sales of these credits – a figure larger than the company’s free cash flow.

During the July analyst’ conference call, Tesla Chief Financial Officer Zachary Kirkhorn stated: “We don’t manage the business with the assumption that regulatory credits will contribute significantly to the future. [But] I do expect for our credit revenue to double in 2020 relative to 2019. And it’ll continue for some period of time. Eventually this will reduce.”

While the sale of regulatory credits are perfectly legal, S&P may be concerned about how they pad Tesla’s bottom line.

Stephanie Hill, head of index, business and strategy at Mellon Investments. told Barron’s: “Unlike the other benchmarks that have already included Tesla in their indexes, inclusion in the S&P indexes isn’t purely rules-driven and systematic; rather inclusion is determined by a committee at S&P’s discretion. S&P 500 index selection criteria contains both quantitative and qualitative aspects.”

Dan Ives, an analyst at Wedbush Securities analyst, also suspected the sale of regulatory credits by Tesla may have influenced S&P’s decision.

“[The S&P committee members] want to see no red ink trend from a [generally accepted accounting principles] perspective to get [Tesla] over the finish line,” Ives said, according to Barron’s.

Barron’s noted that S&P looks at GAAP profit rather than adjusted earnings. Tesla has turned in profits on a GAAP basis for several quarters, but the sold regulatory credits contributed a higher portion to earnings than in prior quarters.

When a stock joins the S&P 500 index, it is automatically included in numerous index funds and exchange-traded funds, thereby expanding its investor base.

Meanwhile, Tesla shares have recently plunged – last week the stock plummeted (likely as part of an overall correction in the equity markets) more than 16%.

As of Tuesday, Tesla shares were down another 16.7% as of 1:15 p.m. EDT.

"On the one hand, the slide in the share price is due to its non-inclusion in the S&P 500, but on the other hand the slide is also a normalization of the company's valuation," said Frank Schwope, an analyst at NORD/LB, according to Reuters.

David Trainer, CEO of New Constructs, an investment research firm based in Nashville, told IB Times that S&P did not add Tesla because they know the addition of Tesla “would bow to the reckless investment environment of our day.”

“The potential downside in Tesla is so large that [it] brings huge downside risk to the S&P and could cause it to be the worst performing index over the next few years or until it is removed,” he added.