On the first of February, I wrote this about Tesla (TSLA 2.56%):
Profit margins are much more important than production growth. If Tesla continues on this margin compression path, its earnings will be much lower in 2023 than they were in 2022.
This has materialized even faster than I thought, with Tesla facing major profit margin headwinds in the first quarter. With inflation hurting its input costs and the company being forced to decrease selling prices to get rid of inventory, 2023 is shaping up to be a tough year for the company.
The bears have been proven right about Tesla so far in 2023. Here's why its Q1 earnings report should have investors increasingly pessimistic about the leading electric vehicle manufacturer.
Q1 earnings: Major margin compression
In the first quarter, Tesla's revenue grew 24% year over year to $23.3 billion. Even with this top-line growth, its gross profit fell by 17% year over year to $4.5 billion as its gross margin declined 10 percentage points from 29% to 19%. This led to operating margin falling from 19.2% to 11.4% and operating profit shrinking by a whopping 26% year over year. Investors were not pleased with these results and decided to sell off Tesla stock by more than 10% on the day following its earnings release.
With even more price cuts implemented in April, Tesla's operating margin is likely closer to 5% than 10% right now. If the company cannot regain its 15%+ operating margins, this will have a huge effect on its ability to generate cash for shareholders in the coming years.
TSLA Revenue (TTM) data by YCharts
Why margins are so important
The problem with Tesla's valuation -- at least when it is trading at a market cap of over $500 billion -- is that it is pricing in both huge production growth and profit margins of 15%. Let's run through some numbers to show why this is the case.
Over the last 12 months, Tesla has generated $81 billion in sales. Let's say it is able to triple this five years from now due to the continued proliferation of electric vehicles. That brings annual revenue to $243 billion, or close to the size of Toyota. With 15% profit margins, that equates to $36 billion in earnings, or a forward price-to-earnings ratio (P/E) of just 14. Investors who buy today probably do fine over the next five years if the stock ends up trading at or above the S&P 500's average P/E of 22 five years from now.
But at a 5% profit margin on the same level of annual revenue, that equates to just $12 billion in earnings or a forward P/E of 42. Seeing as it will take around five years for Tesla to reach this level of revenue, shareholders are likely in for a rough time if profit margins average 5% over the next five years and if the stock trades at an earnings multiple close to the market average of 22. Under this scenario, that would equate to a 50% decline in value over five years.
Management and Elon Musk can tout production growth until they are blue in the face. But margins are going to be the key driver of stock returns for Tesla this decade.
No, autonomous vehicles are not going to save Tesla
On the Q1 conference call, Tesla CEO Elon Musk said the company would achieve full-self driving technology this year for its vehicles if things went according to plan. Tesla bulls like Ark Invest use these claims to model a future with millions of Tesla "robotaxis" on the road building a disruptive Uber-like ride-sharing network.
It's worth remembering that Musk has been saying Tesla's self-driving cars are almost ready since 2014, and (surprise!) they haven't arrived. So why should anyone believe him this time? In fact, if I was an investor in Tesla, I would be worried about any negative impacts of its autonomous driving project. The company has been selling expensive "full self-driving" packages to its customers for years, even though it is clearly misleading marketing. There are also major liability concerns from the growing instances of wrong turns, crashes, and speeding that have occurred in Tesla vehicles with this self-driving technology engaged. Regulators are starting to take notice.
And don't get me started on the battery storage and solar roof tile bull cases. Both segments are extremely low-margin and will have no impact on Tesla's profits (at least in the next five years) due to supply constraints around the globe.
No, the Tesla story is going to be based on how much money it can make from selling cars. Right now, that number is shrinking. Investors in Tesla should not take this margin compression lightly when considering whether to own the stock going forward.
