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Tesla’s (TSLA -0.79%) declining profit margins have become a cause of concern for investors. Profit margins are arguably the most important financial metrics to follow because when they fall, it’s often a signal that a company’s competitive position is declining. They also have a massive impact on the long-term financial models that investors use to price growth stocks like Tesla. That said, there’s reason to believe the electric vehicle (EV) maker’s margins will recover.
The chart below shows the market’s concern. After 3 years of fair gross profit margin and operating profit margin expansion, Tesla’s margins have fallen dramatically so far this year. The trend looks even worse when you look at the sequential increase in quarterly operating margin, which fell from 11. 4% in the first quarter. to 9. 6% in the second quarter and only 7. 6% in the third quarter.
It doesn’t take much to imagine the negative impact falling margins can have on Tesla’s long-term valuation, especially if you pencil in the third quarter’s operating margin of 7.6%, and contrast that with the 16.8% margin for all of 2022.
Tesla’s declining margins reflect increased competition, declining demand for electric vehicles, and the natural result of an influx of new EVs into production as other companies try to catch up to Tesla. According to Cox Automotive’s latest EV sales report, Tesla’s share of the EV market fell from 65% in 2022 to 50% in the third quarter of 2023.
In addition, major automakers have scaled back their EV production plans in reaction to weaker-than-expected conditions. For example, Ford recently announced that it has scaled back plans for the new EV battery plant it is building in Michigan. General Motors and Honda have canceled plans to jointly expand electric cars that would sell for less than $30,000. Even Tesla is more cautious about its expansion plans. “We just need to get a feel for the global economy, as we did before we all left. “at the Mexico City factory,” CEO Elon Musk said of the gigafactory project.
It’s easy to conclude that investors want to start lowering their margin expectations for Tesla. However, I think that would be a mistake.
The reasons why Tesla’s margins will come down to two factors. The first is how your end market has changed, and the second is how it has stayed the same.
First, it’s about separating business situations in 2023 from the overall interest rate environment. The truth is that the car market, whether it’s classic internal combustion engine (ICE) cars or electric cars, is very susceptible to interest rates. Rising interest rates are increasing monthly expenses and slowing customer spending. Faced with such situations, automakers might try to maintain costs and margins, or reduce costs in an effort to increase unit sales.
Tesla chose the latter. During the company’s recent earnings conference call, Chief Financial Officer Vaibhav Taneja said, “As interest rates in the U. S. In the U. S. , the U. S. has increased significantly, forcing us to adjust the value of our cars to keep the monthly charge at parity. These price cuts have put pressure on its margins in 2023.
It is a strategy based on understanding the moment factor: the fundamentals of the car market have not changed. In other words, the expanding domain of the market is electric vehicles, not ICE vehicles. Tesla wants to strengthen its leadership in this market, which will force it to increase production and generate technological innovations in doing so.
That’s because Tesla closed some factories in the third quarter to implement improvements.
In addition, Tesla is generating really important innovations in vehicle unit loading, and this is a constant trend. For example, between 2018 and 2022, production loading of the Model 3 (Tesla’s second-best-selling vehicle after the Model Y and (for 17% of the industry’s total EV sales in the U. S. ) increased to 17% of the industry’s total EV sales. The U. S. economy in the third quarter) fell to 30%. Meanwhile, Tesla’s overall average vehicle cost has risen from just over $39,500 in the fourth quarter of 2022 to $37,500 currently.
The company’s strategy makes sense. The interest rate cycle will end up being the opposite and Tesla will have to raise costs again when it does. In addition, despite the pessimism surrounding expansion trends, overall sales of electric vehicles in the U. S. are still growing. U. S. sales sales increased approximately 50% year-over-year in the third quarter.
It’s still a high-growth market. Tesla’s leadership and ability to invest and generate cost-per-vehicle improvements mean it’s highly likely to grow its margins when the interest rate environment improves. But it will only be able to keep its leadership if it grows volumes and continues to steal marches on its rivals by improving productivity and developing affordable cars while its rivals are shelving plans to do the same.
Lee Samaha does not hold any position in any of the stocks mentioned. The Motley Fool holds positions in Tesla and recommends it. The Motley Fool recommends General Motors and recommends the following options: $25 calls in January 2025 at General Motors. The Motley Fool has a political disclosure.
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