VWAPY - Tesla: Expect Margins To Shrink Again In 2024

2023-12-26 12:45:36 ET

Summary

• Tesla's profitability has declined over the past year, with gross margin, EBIT margin, net margin, and free cash flow all decreasing.
• I expect the decline to continue, mainly because the company is having to spend more money to get sales, due to weak demand.
• Despite these challenges, Tesla has advantages in its charging network and full self-driving beta test that differentiate it from competitors and may contribute to future growth.
• Given the even mix of strengths and weaknesses TSLA stock has, I consider it a hold.

Tesla, Inc. ( TSLA ) has suffered a major decline in profitability over the last 12 months. In that period, it delivered $19 billion in gross profit on $96 billion in revenue. In 2022, it did $20.8 billion in gross profit on $81.4 billion in revenue , meaning that gross margin declined from 25% to 19.7%. The same trend was observed with the company's EBIT and net margins, as well as free cash flow.

There are reasons to think that this decline in margins will continue. If you look at Tesla's decline in EBIT from 2022 to the TTM period, you will see that the majority of it was a 27% increase in cost of goods sold. This suggests that the company is having to spend more to get sales, which is not an easy cost to reverse.

The above does not mean that Tesla's profits will crater again in 2024. On the contrary, I think that Tesla will likely experience a smaller decline in earnings next year, compared to 2023. There's even an outside chance that profits will grow next year.

Even when margins decline, profit can rise if the top-line growth rate is fast enough. Tesla, to its credit, has pretty high growth. In the trailing 12-month period, it grew its top line by 28% . Granted, the most recent quarter's growth was only 9% - it was an extreme outlier. Unless a statistical " regime change " occurs, it should revert to the mean (i.e., rise) eventually. Additionally, Tesla's Q3 revenue growth was better than that of many of its peer companies in the same period. In Q3, tech companies like Apple ( AAPL ) and car companies like General Motors ( GM ) grew their revenue significantly less than Tesla did.

So, Tesla's decelerating growth on its own is not a reason for investors to panic. It's more like a reason to tread cautiously. A big part of why Tesla's revenue decelerated is because it spent much of 2023 slashing prices. CEO Elon Musk said the cuts were to unload a glut of inventory that built up at the company. Seeking Alpha Quant's historical Tesla balance sheet does show a massive spike in inventory in 2022, when the account surged 123% from $5.75 billion to $12.83 billion . The inventory-to-sales ratio also surged from .106 to .157, consistent with excessive inventory buildup.

It would appear that cutting costs to get rid of unwanted inventory was a wise move: excess inventory gives you storage and maintenance costs. On the other hand, there is the question of why the inventory levels built up so much in the first place. It seems to imply that Tesla was missing internal sales targets, and building more inventory than it needed in anticipation of orders that didn't come.

There are some scenarios in which price cuts help companies. If a company develops a reputation for having the lowest prices of all of its competitors, then that reputation is worth having to operate at thin margins. Some companies have done well at this: Walmart ( WMT ), Costco ( COST ), and Amazon ( AMZN ) come to mind. However, those are all e-commerce companies, and Tesla is a car company. The history of price competition in the car industry is a history of everybody's margins shrinking , not a history of one company dominating all the others through cost leadership.

For Tesla's margin compression to not be an issue, it would need a differentiator to prove that it's not like the car companies of yesteryear that lost market share and revenue right along with their margins. That's not an easy thing to prove but, as I'll show in the ensuing paragraphs, there are at least two things happening at Tesla that differentiate it from other EV companies. It's for this reason that, although I expect TSLA's margin compression to continue, I see the stock as a hold rather than a full-on sell.

Why Tesla's Margins Are Shrinking

I already touched on one reason for why Tesla's margins are shrinking in the introduction, namely Musk's own explanation, "unloading excess inventory." Additionally, Tesla's Q3 Press Release says the shrinking margins are due to the need to maintain cost leadership. Finally, people outside the company say that the decline is due to pressure from competitors . Who's right here?

Truthfully, all of these perspectives have some merit to them. Elon's point about the need to unload inventory is undeniably true: the company saw a large increase in the inventory-to-sales ratio in 2022, as mentioned previously.

The "cost leadership" point appears shakier. Tesla is often considered a luxury brand, with such brands, you want the company to maintain its pricing power. If Ferrari ( RACE ) or Patek Philippe were to lose their reputations for being high-end (i.e., expensive), then people would lose interest in them. Ferrari, in particular, is known for keeping its high price points even during the most severe recessions. If Tesla is a luxury brand, like its fans think , then it should also have pricing power. The company certainly isn't known for selling the most expensive cars in the world, but it does have a reputation for being cutting-edge. A spiral of desperate seeming price cuts would put that reputation in jeopardy - especially if the company had to start "cheaping out" on features to maintain its margins at the newly lower price points.

Also, companies attempting to be cost leaders in the car industry are not doing all that well with it empirically. Below you'll see a chart of three car companies considered to be cost leaders and their five-year gross profit track records. Only one of them is actually growing.

As you can see, apart from Toyota, the three companies are seeing their dollar amount of gross profit decline, along with the gross margin. This certainly does not hold true for RACE or BMW . Based on my comparison between three randomly chosen budget brands and two randomly chosen luxury brands, it appears that pricing power is more desirable than cost leadership in the car industry.

The last point about pressure from competitors is applicable here. BYD Company ( BYDDF ), NIO ( NIO ), and Volkswagen ( VWAGY ) are all big international players, and they're all growing faster than Tesla.

Tesla's Advantages

Despite the pressures it faces in its core business, Tesla has two indisputable advantages:

1. The charging network. This does $5 billion a year in revenue, no other EV company has anything similar in the United States, and it allows Tesla to capture revenue from non-Tesla manufacturers . You may have heard of companies like Ford ( F ) operating charging networks, but those largely rely on Tesla's charging stations .

2. Full self-driving. Many stories have been written about how various other AI drivers/robotaxis outperform Tesla FSD in individual cities they were rigorously trained on, but Tesla's FSD is the most ambitious of these projects in that it is training its AI in a massive beta test that aims to create an autonomous car that can operate anywhere. If Tesla can get FSD to the point where drivers can truly take their hands off the wheel anywhere, then it will be far ahead of what any of its competitors are doing in their local test projects.

Above, we have one established advantage that Tesla has now, and a unique strategy that, if it works, will make Teslas the go-to choice for those wanting self-driving capability in their EVs. Only one of these can be taken to the bank, but the ambition of the full self-driving project can't be ignored. If it can ever escape beta testing, it will be a huge differentiator for Tesla.

My Conclusion

Having reviewed the financial, competitive, and technological factors that have been moving Tesla's earnings and stock price, I'm prepared to arrive at a conclusion about what will happen with the company's margins and profitability:

The margins will continue shrinking, but the decline in dollar profits will slow down. Key to this forecast is the high likelihood that Tesla's revenue growth will accelerate from last quarter's rather tepid 9% rate. The reason the growth was so slow last quarter was because the company was dealing with such a large pile of unneeded inventory it had to cut costs to deal with it. That condition will only last so long. Once inventory levels come down, the price cuts will likely stop, and modest growth in car sales revenue will be the likely result.

Why is "modest revenue in car sales" a good thing for a company trading at 70 times earnings ? Because the company's energy (i.e., supercharger) and services businesses are still growing at a rapid pace. The energy business grew at 40% last quarter, and the services business at 32%. These businesses combined are already 20% of the total. If they together keep growing at about 35%, then their contribution to Tesla's overall growth in the same quarter next year will be 7%, then 9.45% in the 2024 quarter, then 12.75% in the 2025 quarter. Remember, this is in addition to the modest growth in car sales, which I predict to be about 9%. Grow 20% of an amount by 35%, and 80% of the same amount at 9%, and you get 14.2% overall growth.

Were this much revenue growth achieved, then starting from Q3's numbers, we'd have $26.66 billion in revenue. If direct selling costs ("COGS") increase at the Q3 rate (19%) once more, then that account grows to $22.8 billion. The end result is $3.86 billion in gross profit, a decline of 7.6%. Yes, this model has Tesla's gross profit declining again next year, but the rate of decline in the base period was 22%. So we have a decelerating decline in gross profit.

For this reason, I consider Tesla stock a hold. The company's charging business is a very valuable asset, but it will have to keep growing at Q3's pace for several years before it's moving the needle for the whole company. Unless revenue growth from car sales is unexpectedly high, there is little to suggest that Tesla can get back to growing its profits next year. On the other hand, I expect revenue growth to be a fair bit higher than what analysts are expecting (5% based on the consensus estimate ), so there is a chance of a rally on better-than-expected earnings. It's a mixed picture; I'd take some profits if I were sitting on them, but I wouldn't short TSLA stock.

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