Tesla investors are looking for a margin floor. Elon Musk, the carmaker’s chief executive, is reluctant to commit to one and is intent on ramping up sales volumes at the expense of profitability. The problem? The sacrifice isn’t delivering rewards.
Cutting prices since the start of this year dragged the gross margin below a previously set threshold of 20 per cent and behind market expectations, set at 19.3 per cent during the first quarter. The former stock market darling is trying to prop up demand in a rush for scale as it faces intensifying wider economic pressures. Yet the number of vehicles sold rose by only 4 per cent on the previous quarter to just shy of 423,000.
Investors have grown wary about whether the group can deliver on its lofty growth ambitions. The shares collapsed by almost two thirds last year, but have regained some ground after Musk dangled bullish car delivery targets for this year. An enterprise value of 25 times forecast earnings before interest, taxes and other charges is racy enough, but it is a considerable discount to a five-year average multiple of 37.
Scepticism historically has been centred around its ability to increase production quickly enough to capitalise on the clamour for its electric cars. Now the focus has turned to whether Tesla will need to take more aggressive action on prices to stimulate demand for its model 3 and Y vehicles. It has stuck by an annual target of 1.8 million vehicle deliveries, 50 per cent ahead of last year, with a best case of two million. Yet demand faces several obstacles.
The broader strain on consumer finances that has accompanied a rapid rise in interest rates is an obvious problem for what is a premium product. Orders are still in excess of production, Musk has pointed out. The problem is that this is after heavy markdowns. Prices were cut yet again this week, which means that in the United States Tesla has reduced its base price for its Model Y sports utility vehicle by 20 per cent so far this year and its Model 3 saloon car by 11 per cent.
Price cuts delivered about half the hit to the gross margin, which fell from 23.8 per cent in the previous quarter and trails far behind the 29.1 per cent achieved during the first three months of last year. The rest were one-off costs, including changes to warranties for cars previously produced.
Musk seems relaxed. “Technically we could sell for zero profit for now and then yield actually tremendous economics in the future, no one else could do that,” He has told investors. Why? Robo-taxis. He is betting on a future where Tesla vehicles are fully self-driving and where its autonomous software delivers a future revenue stream. The launch could come by the end of this year, Musk reckons, but this is not the first year he has made such a claim. Several crashes in recent years, some fatal, raise more questions over the rate at which Tesla can roll out fully autonomous vehicles.
Until Tesla gains that approval and expands the self-driving fleet, when does the margin pain end? Will the electric vehicle manufacturer have to give more ground on prices to sustain demand this year? Both seem likely. Analysts at Wedbush reckon the margin will be at 19.5 per cent during the present three months, before hitting the watched-for 20 per cent in the third quarter.
The strength of demand becomes a more pressing question as rivals have emerged, including the Warren Buffett-backed BYD in China, as well as deep-pocketed, traditional automotive groups such as Toyota looking to challenge Tesla’s lead.
Attaining sales scale matters. The premium embedded into Tesla’s stock was predicated on the belief that expanding production volumes would steadily beef up margins. The relative simplicity of Tesla’s model compared with traditional carmakers — offering only four models, limited colours and direct-to-consumer distribution — enhances that size benefit.
Tesla had been following the playbook: just look at the trajectory of the carmaker’s operating margin over the past five years, a time when deliveries have risen from just under 30,000 to just over 420,000. The operating margin came in at 11.4 per cent over the first quarter of this year, versus -0.2 per cent in 2018.
What is the prognosis for margins this year? Raising production at its factories in Berlin and Austin, Texas, will ease some of the pain. Under-usage at those plants in the final quarter of last year, caused by supply chain constraints, cost the equivalent of $2,000 to $2,500 per car, according to Tesla’s estimates.
Logistics costs have come down considerably and inflation in the price of lithium, an all-important part of battery technology, is starting to abate. On commodities, which has provided the “maximum” of pain to the cost structure, the peak in cost rises was in the second half of last year, Tesla thinks, with some improvement in the first quarter and more to come during the present three-month period.
As far as liquidity goes, the group is generating enough dollars from sales of its cars to fund the building of its existing production facilities, an increase in its sales teams and the development of the Cybertruck, which is due to begin production this year.
The end of Beijing’s zero-Covid policies puts supply on a firmer footing and could prove a fillip to demand. Tesla’s ability to expand further in the Chinese market is crucial over the medium term. Competition and a shaky economic backdrop are also biting at the margin here. Price cuts have been extended to China over the past 12 months, including dropping the cost of its models 3 and Y by between 6 per cent and 13 per cent in January.
Tesla’s bet on China isn’t limited to electric vehicles. This month plans were announced to build a new battery storage factory in Shanghai, capable of producing 10,000 Megapack storage units each year. That’s in addition to its existing Megafactory in Lathrop, California.
Set the Tesla business aside, the existential challenges associated with Musk’s many extra-curricular activities have not disappeared. They include founding SpaceX, the rocket launcher where he is also chief executive, and Neuralink, the AI challenger, and of course, his controversial takeover of Twitter. The last sale of Tesla stock was a $4 billion offload in November, but Musk repeatedly has gone back on his word that there will be no more.
Tesla is also asking investors to suspend disbelief, but maintaining firm faith that price cuts will deliver knockout sales volumes would be misplaced.
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WHY Margins could continue to tumble if prices are cut even more
