Big news hit the automotive industry when leading electric vehicle (EV) manufacturer Tesla (TSLA 10.91%) decided to cut the prices of its cars by as much as 20% around the world. These cuts, which affect all of Tesla's product lines, have reverberated across the industry, and shares of competitors like Ford have fallen 5% on the news.
Wall Street is likely speculating that price cuts indicate weakening consumer demand for EVs in 2023. Traditional automotive manufacturers have spent billions of dollars to bring new EV products to market in the last couple of years, so this could be poor timing for the industry as a whole.
Some investors might argue that by lowering prices, Tesla will bettto position itself in comparison with competitors betteritives the company gets from lowering costs will be heavily outweighed by the negative impact the strategy will have on its financials over the next few years. Here's why.
Where Tesla's profits came from
Over the last couple of years, multiple factors have been working in Tesla's favor to help it deliver outsized -- and, I might argue, unsustainable -- profit margins.
First, it ramped up its production capacity at the perfect time, with minimal competition from large automotive competitors. In the fourth quarter of 2021, Tesla produced 306,000 EVs, almost 3 times the number it produced in Q4 2019. This was during the heart of the COVID-19 pandemic when people around the world stopped spending money on travel and in-person events while simultaneously getting stimulus checks from the government. Many of these people decided to use that money to buy an EV, and who did they turn to? Tesla. With this growing scale, the company was able to achieve operating leverage and expand margins.
Second, Tesla was able to keep its major input costs down because the prices of commodities were largely stable or falling across the globe.
Third, the company was able to raise prices due to supply constraints in the automotive industry. With rising customer demand and minimal supply across both EVs and traditional cars, Tesla was able to significantly raise the average selling price of its products with little impact on orders.
Add up all these factors, and we can see why Tesla's operating margin has gone from around 0% at the start of 2020 to 16.7% over the last 12 months. That's more than twice the operating margin Toyota, the second-largest automaker (by revenue) in the world, is able to generate.
Data by YCharts.
Why the price cuts are bad
While everything seemed to work in Tesla's favor from 2019 to 2022, everything is starting to move in the wrong direction.
- Car supply is increasing worldwide, especially EVs because dozens of competitors are finally bringing products to market.
- Input costs for commodities have risen substantially in 2022, which will finally start to flow through to Tesla's expenses in 2023 and 2024.
- Average labor costs in the United States are steadily rising, undoubtedly impacting Tesla's thousands of employees.
This leads us to the aforementioned price cuts. Sure, dropping prices should boost orders this year, but at what cost? With many of Tesla's input expenses rising at the same time that it is cutting prices, its profit margins will get compressed next year. Unless Tesla can spur so much demand from the lower selling prices that orders go through the roof in 2023, these cuts are bad news for the business, at least for the next few years.
Is the Tesla thesis broken?
Even with the stock down more than 50% in recent months, Tesla is still one of the largest companies in the world by market cap at a value of $386.5 billion. Over the last 12 months, the company has generated $11.2 billion in net income, giving it a trailing price-to-earnings ratio (P/E) of 34.5, well above the market average of 21. This wasn't a big deal when profits were growing rapidly each year. When that stops, it will make the stock much more expensive and less appealing to growth investors.
If Tesla's operating margins get cut in half -- a plausible scenario when expenses are rising and selling prices are falling -- the company's net income could fall significantly over the next few years. Falling earnings coupled with an above-average trailing P/E is not a recipe for success, and this makes me think the worst is yet to come for Tesla shareholders.
