Seeking Alpha • Sep 23
Arrival: It Is Just Getting Darker
Summary
Positive news in the early summer gave false hope in Arrival’s performance. It was dashed by reality during Q2 earnings call.
Manufacturing issues prevailed and made Arrival restructure its business. However, announced “cost-cutting” plans do not decrease losses.
I believe that the timing of the anticipated equity raise shows that the management is not confident in launching the first vehicles this year.
I confirm my earlier view that investors should stay away from the stock. Otherwise, their pockets may get burned.
Many of us wanted to believe in Arrival (ARVL). Its microfactory-based innovative concept was so good that we wanted it to become true. Unfortunately, despite some positive news in 1H 2022, recent company announcements dashed hopes for its revival. The company initiated business reorganisation. But my analysis shows that restructuring efforts do not decrease losses. Additionally, I don't believe that the management is confident in the vehicle's launch this year despite recent promises. In this article I will show why you should steer clear of Arrival until its first vehicles arrive.
The Phantom Menace
Despite all the bad news about Arrival, in the early summer there was an impression that the management had firmly gripped the business wheel and started turning the company in the right direction. Just before the Q1 earnings call, Arrival Bus achieved EU certification and received European Whole Vehicle Type Approval. Even some postponement of bus licensing to Q2 from Q1 did not seem critical. At the Q1 earnings call, the company announced that over 70% of certification tests had been completed and Arrival's production roll-out was on track. It achieved progress with the skateboard platform and managed to assemble the cabin and hoop structure. Moreover, the management promised a successful completion of the licensing test within a quarter. The phantom menace of a vehicle launch seemed to be on the horizon, and the market cheered the positive news. From May 9th to May 13th, stock price increased by 24%. The next month, further positive news came in: the company had started delivering on its promises. On June 21st, Arrival announced the completion of the required functional and safety testing and confirmed its plans to start van production in Q3.
In spite of my skepticism and thoughts in the previous article - Avoid Arrival - Management Needs To Show Some Execution - even I got a new hope for some positive production ramp-up in Q3 and Q4 2022. When I went on a stroll with my dog, my mind was obsessed with last fall's craziness around Lucid when its first vehicle roll-out was announced. I wondered if history would rhyme and something similar might happen at the market when Arrival starts production. I was aware that the market environment has changed since then; last fall, for example, the inflation was still "transitional." But the successful production launch remains the successful production launch…
Occasionally, my optimistic hopes were ruined by the reality of Arrival's performance. On July 12th, the management announced a reorganization of its business, explaining it as a decision to focus on production ramp-up in Q3 2022. To save money, Arrival planned to cut spending and employees by 30%. It was also rumored by Financial Times that Arrival would put a pause on its bus and car roll-out to focus exclusively on van production.
I considered the news positive for two reasons. Based on the analysis in my previous article, it was clear that Arrival would need cash in late 2022. Otherwise, it will lack funds in early 2023. Promised cost savings would have allowed Arrival to launch van production in Q3 in the UK (Bicester) and then in the US (Charlotte in Q4), sit out the negative market sentiment with sufficient cash, and raise equity when the proper time comes. I was even thinking of writing an article sharing my ideas to start a speculative long position. Yes, I still hoped for Lucid-like opportunistic craziness.
The second reason was that Proterra (PTRA), my portfolio company, would win a lot from postponed Arrival plans. Proterra specializes in bus production in the USA, and the alleviation of competitive pressure would be a strong opportunity for it. Besides, we should remember that Proterra's strongest competitor in the bus sector, Chinese Company BYD (OTCPK:BYDDF), is excluded from state subsidies due to geopolitical tensions between the US and China. It would have been a very strong catalyst for Proterra. You can read more about it in the article Buy Proterra on Arrival's Downs.
Revenge of the production issues
The Q2 earnings call overwhelmed me. The Financial Times was right in saying that Arrival was planning to postpone its bus and car production plans. But Arrival went further, joining the dark side by worsening its outlook. It was announced on the August 11th earnings call that management cut van roll-out to 20 vehicles. The new forecast abandoned Arrival's July promise of starting production in the third quarter. Moreover, despite production cuts, the EBITDA loss remained incredibly high.
Before we go into details, let us turn to the Q2 earnings call transcript and look at how the management presented the new strategy.
So our capacity is reduced. Like instead of two factories, we do one, and we do this to save cash. [...] The second one is actually the supply chain and the -- how we're receiving the parts. [...] And the third one is we actually took a very conservative view because originally, we wanted to make, like, many shifts to push the volumes for the end of the year, but we are switching our mode to more preserving the cash, because like anything you do an extreme level, so it just costs more.
We got the note from Arrival that they were cutting down on their production to save on costs. Management assumed that the company lost money with every new vehicle before a certain production threshold was reached. The more cars were produced, the more money was burnt. Therefore, it would be better to produce 20 vehicles than 400. Such a roll-out would be sufficient enough to persuade investors in the credibility of the microfactory concept and would allow Arrival not to burn all of their cash in the "robotic furnace." I understand such logic and find it the right step. Although microfactories can produce cars on a small scale compared with established car producers, they are still built for 10,000 vehicle production per year. Therefore, a 400 car roll-out would still not be sufficient to cover fixed costs. What surprised me was that such a production cut resulted in the new 2022 forecast implying a much higher EBITDA loss than the outlook provided a couple of months ago.
Author's analysis
Earlier this year, Arrival expected an EBITDA loss of between $185 million and $225 million for the full year, but recently they projected a $175-195 million EBITDA loss in H2 2022 alone. I would like to repeat the statement because it is of utmost importance: a couple of months ago, Arrival expected to produce 400 vehicles and generate a $200 million EBITDA loss over the year. Now it plans to build 20 cars and generate over $300 million in EBITDA loss. Do we speak about cost savings? What maintains the costs so high? To answer this question, let us have a look at the cost structure.
In 1H 2022, Arrival spent $136 million on administrative expenses, which is almost 70% higher than the previous year. The company provided the following explanation:
The increase was driven by provisions for obsolete inventory (USD 14.9 million) and related purchase commitment penalties (USD 7.3 million), share based payment expenses related to new programs (USD 9.1 million), asset write-offs and other expenses related to our move from our Russia location and increased wage (USD 3.3 million), travel (USD 1.8 million) and consultative spend (USD 18.9 million) as the company readies for start of production.
$22 million were spent on inventory and other purchases that were no longer required for the manufacturing. I understood it in that way that Arrival ordered some parts that became unnecessary due to changes in the production process. Then the company spent $9 million on new programs. I expect these costs to go down in the 2nd half as the new programs were abandoned. Spending on consulting services for the production launch was the largest category explaining the increase. The key question is whether or not consulting services will be further required. Before we answer this, let me estimate which costs the production itself will incur.
Certainly, some vehicle roll-out in the 2nd half of the year would increase costs compared with the 1st half, but how much money does the production of 20 vehicles require? As Arrival uses innovative microfactory concept, it is challenging to estimate expenses precisely. But we can get an upper bound of the costs benchmarking Arrival against EV peers. For example, Rivian (RIVN) spent $243,000 COGs per vehicle in Q2-22, while its factory was utilized for 13%. If we take this figure as a conservative estimate, then COGs for production of 20 vans by Arrival would be around $4-5 million. Thus, the share of manufacturing costs will be minor in $200 million costs expected in the second year-half.
Therefore, the only explanation behind such high full-year costs is that expenses for an obsolete inventory and consulting spend will continue to be extremely high. I believe the company still needs money to adapt its manufacturing process before the first vehicles can be rolled out.
Arrival did not provide any update on the manufacturing progress in a Q2 earnings call. I guess there was just no good news to share. It seems to me that until mid-July, management still hoped to overcome the issues and therefore stuck to the expected production launch in Q3. Unfortunately, they did not solve these problems and therefore had to increase spending on calibrating the manufacturing process. Furthermore, I believe management is still not confident in the provided timeline and would like to get hedged in case of further delays. Let me explain how I've come to this conclusion.
ATM platform
At the Q2 earnings call, John Wozniak, Chief Financial Officer, stated that they established a $300 million ATM platform (ATM stands for at-the-market offering) to raise money.