In Tesla's (NASDAQ:TSLA) update on quarterly deliveries Wednesday, it was clear that the Model 3 continues to win over consumers. Deliveries of the vehicle hit a new quarterly record of 79,600 and accounted for 82% of total deliveries. Compared to the year-ago period, Model 3 deliveries were up 42%.

Even more notable, the company said in its third-quarter update on deliveries that nearly all of its Model 3 orders during the quarter were from customers without previous reservations, "solidifying the transition to generating strong organic demand."

The narrative for Tesla's flagship Model S and Model X vehicles, however, is quite different. Sales of the high-priced vehicles have fallen sharply in recent quarters.

The Model X and Model S

Tesla's Model X and Model S. Image source: Author.

Declining deliveries

In Tesla's third quarter, reported Model S and Model X deliveries fell to 17,400, from 17,722 in Q2. To be fair, Wednesday's update on deliveries doesn't represent official numbers for the period. Moreover, the company says investors should consider the estimates to be conservative, as it takes some time to verify whether all paperwork associated with deliveries during the quarter was correct. This means deliveries could have actually held steady compared to Q2.

But there's no good excuse for the sharp year-over-year decline in combined Model S and Model X deliveries: They were down 37% compared to the year-ago quarter. Furthermore, combined deliveries of these two vehicles were down in each of the last four quarters, with trailing-12-month Model S and Model X deliveries down 25% year over year.

It's safe to say that Tesla's Model 3, which was launched in 2017 but didn't see meaningful production volumes until the second half of 2018, is cannibalizing some Model S and Model X deliveries.

This isn't entirely surprising. The Model 3 has a starting price of about half of the Model S and Model X. And while the Model S and Model X are larger vehicles with bigger batteries and feature more impressive specs, the Model 3 is built with Tesla's latest touchscreen design and represents the company's latest vision for electric cars. Since the Model 3 is its newest vehicle, many customers may be convinced that it features Tesla's latest innovations and offers a more compelling value proposition than the Model S and Model X.

Why it matters

Lower Model S and Model X deliveries are weighing on Tesla's business.

When combined Model S and Model X deliveries declined 45% between the fourth quarter of 2018 and the first quarter of 2019, the company's total gross profit margin fell from 24.3% in Q4 to 20.2% in Q1. While part of this was due to a slight decline in the Model 3's gross margin over the same time frame, much of this contraction was the result of reduced Model S and Model X delivery volume. This is no surprise: As Tesla's priciest models, Model S and Model X produce higher gross profit margin than the Model 3.

Perhaps Tesla has some surprises in store to reignite sales volume for its Model S and Model X in the coming quarters. But if it doesn't, it will have to rely primarily on improved economies of scale from higher Model 3 volumes in order to improve its automotive gross profit margin.