BYMOF - Tesla Q3 Earnings: Margins In Downward Trend; Avoid Stock At Current Prices

2023-10-19 10:30:00 ET

Summary

• Tesla's Q3 results were disappointing, missing estimates on both revenue and earnings.
• Volume growth is only possible with price reductions, leading to weak revenue growth and declining margins.
• The company's energy business shows potential for growth, but the dependence on the automobile business poses challenges for future profits.

Article Thesis

Tesla (TSLA) reported its most recent quarterly results on Wednesday afternoon. While deliveries were up on a year-over-year basis, we have known about this fact before the earnings release. Almost everything else looked bad, and Elon Musk's comments about the Cybertruck and Tesla's near-term future were very discouraging as well.

What Happened?

On Wednesday afternoon, Tesla, Inc. reported its most recent earnings results , for its fiscal third quarter. The headline numbers can be seen here:

This looks, in short, pretty bad. Tesla missed estimates on both lines, and it wasn't even close. Revenue growth was in the single digits only, which is not adequate for a company that is valued at around 80x forward net profits. For contrast, fast-growing NVIDIA Corporation ( NVDA ) generated 101% revenue growth during the most recent quarter, and it trades at less than 40x net profits -- which is just half of Tesla's valuation.

Tesla's free cash generation was pretty weak as well, and even worsened compared to the previous year's period. This is, again, not at all a great sign for a presumed growth company that is priced for perfection.

The market reacted negatively to this bearish surprise, sending Tesla 5% lower at the time of writing, while Tesla also dropped by almost 5% on Wednesday in regular trading hours, before the results had been released.

Tesla's Volume Growth: What Is It Good For?

During the cheap-money years, especially during the pandemic when interest rates hit record lows, many investors were interested in business growth primarily. They didn't care a lot about profits and cash flows, which is why unprofitable businesses such as EV startups have traded at extraordinarily high valuations and market capitalizations at times. But as money has become more expensive again, investors have increasingly realized that business growth alone is not what drives value for investors. Instead, business growth should go hand in hand with rising profits and cash flows, and, ideally, those profits and cash flows should be shared with investors via dividends and/or buybacks.

Tesla has a goal of growing its automobile sales by 50% per year, but volume growth is, it seems, only possible when Tesla lowers the sales prices of its vehicles. While deliveries were up 27% year over year during the third quarter -- which is around half of the long-term goal -- revenue growth was just one-third of that. With sales rising by 8.9% only, Tesla can't really be described as high-growth any longer, I would say. Note that this does include Tesla's energy division, which is growing faster than the auto business right now, thus the numbers for Tesla's auto business look even worse. Automotive revenues were up by just 5% on a year-over-year basis. While some see Tesla as a diversified tech company, I don't agree with this: Tesla has several business units, but the automobile business is the largest and most important one, which is why I'd call Tesla an automobile business -- after all, I also call Meta ( META ) a social media business, even though the company has some other business units.

When a company generates 5% revenue growth in its most important division, then that is not necessarily a disaster -- as long as the company is priced accordingly. But with Tesla still being valued at well above $700 billion, it seems highly questionable to me whether Tesla is trading at a valuation that is appropriate for an automobile company growing at a single-digit rate.

Things look even worse when we focus on profitability. As noted above, Tesla's volume growth is only possible due to the company continually lowering the prices of its vehicles. Price reductions in all major markets have occurred over the last year, and that is why revenues were up a lot less than the company's deliveries. Some Tesla bulls claim that Tesla is only lowering its sales prices due to making so much progress in bringing down expenses, but that does not seem true when we take a look at the company's margin performance over time. These are the gross margins Tesla has generated over the last five quarters:

Q3 2022: 25.1%

Q4 2022: 23.8%

Q1 2023: 19.3%

Q2 2023: 18.2%

Q3 2023: 17.9%

We see that gross margins have dropped dramatically on a year-over-year basis, and we also see that the downward trend remains in place: Gross margins continue to decline every quarter. This would not have happened if Tesla had lowered the sales price of its vehicles in line with cost reductions. Instead, Tesla has lowered its sales prices a lot faster than what its cost reduction efforts would have allowed for, which is why its margins were devastated.

Since Tesla's operating expenses have soared over the last year -- they rose by 43%, at a time when gross profits were down -- Tesla's operating margin performance looks even worse compared to the gross margin performance:

Q3 2022: 17.2%

Q4 2022: 16.0%

Q1 2023: 11.4%

Q2 2023: 9.6%

Q3 2023: 7.6%

The downward trend is pretty clear here, and it is even more pronounced on a relative basis: While gross margins dropped by around one-third over the last year, Tesla's operating margin was more than cut in half.

Not too long ago, Tesla bulls praised the company for its industry-leading margins, talking about how these high margins justify a premium valuation and praising Tesla's direct-to-consumer business model for the hefty margins it generates. And indeed, Tesla did generate strong margins a year ago. But that has not been the case in recent quarters, and things are getting worse and worse. A sub-8% operating margin is not at all great for an automobile company -- Mercedes ( MBGAF ), BMW ( BMWYY ) and even plain old mass-market manufacturer Toyota ( TM ) have generated operating margins in the 10%-12% range over the last quarter. In short, Tesla has now fallen behind many of its competitors margin-wise, and if the recent downward trend in margins persists, things could be even worse during the fourth quarter.

What happens when one combines weak top-line growth and hefty margin headwinds? Profits decline, and that is exactly what we see at Tesla: The company's GAAP earnings per share of $0.53 for the third quarter of 2023 were the weakest EPS number we have seen over the last two years -- which is not at all becoming for a growth company that trades at a very high valuation.

Tesla: What's The Outlook?

Let's start with something positive: Tesla's energy business is showing appealing business growth, and that should remain the case for the foreseeable future. While solar deployed dropped by almost 50% on a year-over-year basis, that's the less interesting portion of the energy business. Storage, which is the more interesting part of the energy business, saw compelling growth during the third quarter, as storage employed was up 90% on a year-over-year basis. Compared to the first half of 2023, growth wasn't very strong, as deployment levels were just 2% higher than during the first quarter, but that could be due to timing. Overall, I believe that there is a pretty good chance that this business unit will continue to experience substantial growth in the coming years.

However, due to the aforementioned fact that Tesla is very dependent on its automobile business for revenues and profits, a positive performance from the energy storage business will likely not result in strong revenue and profit growth in the near term. Instead, Tesla could be facing even weaker profits during the fourth quarter. First, Tesla cut the prices of its vehicles in early October -- these price cuts were not reflected in the company's Q3 results yet but should impact margins during Q4. Second, Tesla's Cybertruck is causing problems. Elon Musk, Tesla's CEO, phrased it even more harshly: He stated that the company "dug out [its] own grave" with the Cybertruck, as bringing the model to volume production is apparently very difficult. It thus seems logical to assume that Cybertruck will be a headwind for profits in the near term, as the company is slowly ramping up production.

Is it a disaster when an automobile company faces margin pressures and when a new model is making problems? Not necessarily -- many competitors have experienced the same. But most of those trade at earnings multiples in the 5x to 10x range, while Tesla is trading for around 80x net profits right now, which is an important difference.

While Tesla still has a strong brand in the EV space, and while its balance sheet is very clean, the company is facing considerable problems: Volume growth is well below what the company aims for and is only made possible due to price reductions, margins are crashing, profits are declining, free cash generation is weak. Add an uncertain macro picture and rising interest rates that make financing a new vehicle more costly, and I believe avoiding Tesla at current prices is a wise choice.

Sure, if Tesla were to solve self-driving in the near term and before anyone else, that would likely justify a large portion of the current market capitalization. But to me, it does not look like that is a very likely outcome. Tesla had to realize that solving self-driving tech is a lot harder than Elon Musk had assumed, and there are competitors with robo-taxis on the road already, while Tesla is, for now, stuck at Level 2. Buying Tesla based on the hope of this changing soon is too risky, I believe.

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