Yesterday, Tesla (TSLA +0.91%) announced it will make a $25,000 electric vehicle sometime in the near future, and it had me feeling some deja vu from the last decade following the solar industry. Ten years ago, I was extremely high on solar energy because costs were coming down, technology was getting better, and it only made sense that adoption would increase rapidly as solar power plants became more cost-competitive with fossil fuel power plants, and solar stocks would soar as a result.
Most of the thesis was spot on. Solar energy production has exploded, solar panel efficiency is better than ever, and costs are now lower than fossil fuels in most locations. The problem? Very few solar stocks made any money. That experience has me nervous about Tesla stock's future, now that it's moving even further downmarket. And the risk translates to pure EV companies like Nikola (NKLA +0.00%), NIO (NIO +7.08%), and Workhorse (WKHS +0.00%), who are far less developed than Tesla is today.
Image source: Tesla.
The battle between growth and margins
Over the last few years, Tesla has gone from manufacturing vehicles that regularly sell for over $100,000 to promising to sell vehicles for $25,000. If we take those numbers as an example, Tesla would need to sell four times as many vehicles to generate the same revenue.
But on the profit side, the picture typically gets worse as prices come down. If a $100,000 vehicle generates a 25% gross margin, as Tesla once aimed for, and a $25,000 vehicle generates a 15% gross margin, for example, you would have to sell 6.7 times more vehicles to make the same gross margin. And that trend is not only possible, but it's also likely for Tesla, and we saw it happen in the solar industry.
Let's take First Solar (FSLR +3.09%) as an example. The company produced 1.4 gigawatts (GW) of solar panels in 2010 and increased that to 5.7 GW in 2019. But what did profits and margins do?
FSLR Gross Profit Margin (Quarterly) data by YCharts
As you may have guessed, both gross margin and net income were down over the past decade at First Solar. Costs were lower and production increased, but the increase in volume couldn't overcome the drop in margins, and profits have actually dropped as First Solar has grown.
We can see margins trend lower in the auto industry as sale prices get lower as well. Take Ferrari (RACE 0.09%) compared to Ford (F 0.90%) and General Motors (GM 0.46%) as an example. In 2019, Ford sold 5.4 million vehicles worldwide and GM sold 7.7 million vehicles. On a scale basis they crush the 10,131 vehicles Ferrari sold, but right now Ferrari is more profitable than Ford over the last 12 months, and not far behind GM because its gross margin is nearly 50%, compared to single digits for Ford and GM. Long term, earnings are volatile, but it would be easy to argue that Ferrari is the auto stock that's generating the most shareholder value long term.
RACE Net Income (TTM) data by YCharts
Now, let's tie what we learn from the solar industry over the last decade with what we see in the auto industry. As Tesla grows production, moves downmarket, and reduces average sale prices, we would expect revenue growth to stall despite production increasing. And gross margins should come down as Tesla competes with lower-cost vehicles.
The first already seems to be happening for Tesla. You can see below that revenue growth has stalled, despite production growing, in large part due to sales shifting from the higher-cost Model S/X to the lower-cost Model 3/Y.
TSLA Revenue (TTM) data by YCharts
The decline in margins will take longer but you can see above that gross margin continues to be below the 25% benchmark that Elon Musk set for Tesla and is trending lower. And remember that electric vehicle (EV) competitors have been slow to ramp production, which could bring further pricing pressure, unless Tesla's brand allows it to command a premium for its EVs. Based on new product announcements, investors should expect competition to really heat up in the EV market in the next two to three years, which ironically coincides with Tesla going even further downmarket with a $25,000 vehicle.
To be clear, I'm not arguing that Tesla is wrong in moving downmarket or increasing production. But I think it's worth understanding that profitability will not necessarily increase with production if the company's sales mix changes. Solar companies tried to grow volume enough to offset margin losses but couldn't in most cases. Tesla is trying to do the same in a business where companies who make lower-cost vehicles traditionally have trouble making consistent long-term profits. If we see margin pressure in the EV industry that looks anything like what we saw it in the solar industry, then Tesla may vastly underperform what investors appear to be predicting based on a $400 billion market cap.
Solar stocks don't set a good precedent
Understanding this history is important because investors who are bullish on EV growth can learn a lot from what happened to company finances as solar manufacturers lived through the growth phase of the industry. Despite the growth in solar deployment, solar stocks have struggled. You can see below that the biggest names in the industry today are lagging behind the market by a wide margin, and First Solar and SunPower (SPWR +0.00%) have lost investors' money since the start of 2010. Only Canadian Solar (CSIQ +2.36%) has squeaked out a gain, and it's a modest one at that. And these are the companies that survived. Massive manufacturers like Yingli Green Energy, Suntech Power, and SolarWorld filed for bankruptcy even as the industry grew.
The simple reason stocks haven't done well is because increased solar manufacturing and deployments haven't led to an increase in earnings, as you can see below.
FSLR Revenue (TTM) data by YCharts
A thin margin of error
The reason solar stocks didn't do well over the past decade isn't that solar wasn't successful in disrupting fossil fuels, or because the amount of solar deployed each year didn't grow like crazy. It did and that was part of the problem. Costs had to come down to grow the market, and as the cost of solar panels came down so did margins. Manufacturers then had to compete more on price than technological differentiation. Margins came down eventually, earnings dropped, and stocks fell. For companies that layered on too much debt to expand, the only remedy was bankruptcy.
EV manufacturing isn't exactly the same as solar, but there are lessons we can learn. I think it's clear that margins will come down as EVs become more affordable and Tesla, Ford, GM, and many others increase production. That'll force more price competition, which is ultimately why major automakers don't make much money on low-price vehicles today. These trends could lead to a sharp increase in EVs on the roads, but a big reduction in profits from each vehicle sold.
With a market cap that's hovering around $400 billion, investors are eventually expecting Tesla to demonstrate it can make a consistent profit. But moving downmarket might not be the way to do it, and the solar industry provides some cautionary tales for investors.
