2023 has not been the best year for serial entrepreneur Elon Musk. Just months after acquiring social media platform Twitter for $44 billion, Musk recently admitted that the company is worth less than half of what he paid for it.
On top of that, his electric vehicle (EV) company, Tesla (TSLA -1.11%), has instituted a number of price reductions in an effort to entice buyers. While demand for its vehicles is generally high, consumers are scaling back discretionary spend as fears of recession rise and high inflation lingers.
The company just reported earnings for the first quarter of 2023. The stock has sold off by 12%, but investors may not have seen the worst.
Is now a chance to lower your cost basis? Or should you sit on the sidelines and watch the stock potentially keep dropping? Let's dig in.
Q1 at a glance
For the quarter ended March 31, Tesla's total revenue was $23.3 billion, up 24% year over year. The company's automotive revenue was $19.9 billion, which represented a 19% annual increase.
At first glance, these growth rates look pretty good considering the current macroeconomic environment. However, looking at the income statement on a deeper level is important. Tesla's gross margin under generally accepted accounting principles (GAAP) was 19%. This is a decline of nearly 10 percentage points from Q1 2022. To make matters worse, the company's gross margin has been declining steadily for the last couple of quarters now.
After accounting for operating expenses, Tesla's operating margin came in at 11.4% in Q1. This is nearly an 8% decline year over year, and almost 5% decline from the fourth quarter of 2022.
Given the contraction in margins, investors should not be surprised to learn that Tesla's free cash flow is shrinking dramatically. For Q1 2023, the company reported $441 million in free cash flow, down 80% year over year.
Image source: Getty Images.
What should investors be thinking about?
Following the earnings report, Tesla stock was bombarded with a number of stock price reductions from Wall Street banks. Goldman Sachs reduced its target from $210 per share to $185 per share, but still maintains a buy rating. J.P. Morgan slapped a price target of $115 per share, but believes the stock is undervalued. Perhaps the most concerning sentiment came from Truist Financial, which lowered its price target from $245 per share to $154 per share and downgraded the stock to a hold position.
Within the company's Q1 investor deck, Tesla wrote: "Although we implemented price reductions on many vehicle models across regions in the first quarter, our operating margins reduced at a manageable rate. We expect ongoing cost reduction of our vehicles, including improved production efficiency at our newest factories and lower logistics costs, and remain focused on operating leverage as we scale."
The biggest question mark here is when all of the price reductions will be baked into Tesla's financials. Until investors can see how the cost cutting initiatives are translating into a concrete financial picture, it is very difficult to discern what Tesla's profile will look like.
Has this been seen before?
The strategy behind cutting the prices of goods and services is pretty simple. The idea is that the company will make up for the lower sales per unit by generating a higher volume from enticing more people to buy.
For example, back in the 1970s, Domino's Pizza was struggling to keep up with its competition. However, the company eventually developed a game-changing promotion in the same vein as price cuts: 30 minute delivery or your pizza is free. This type of promotion was unheard of at the time and resulted in an avalanche of new customers for the pizza chain.
In more recent history, this Fool contributor keenly pointed out that Apple engaged in price cuts during the early days of iPhone. Again, the thesis was that Apple would make up for the potential drop in revenue from the price reductions by selling more iPhone devices.
One thing to keep in mind with Apple and Domino's is that each of these companies has the luxury of acquiring repeat business from these types of promotions. In the case of Apple, iPhone users tend to upgrade their devices and thereby spend money on new phones every few years. Moreover, Apple has mastered locking users into its ecosystem, generating sales from both additional hardware and services purchases. In the case of Tesla, however, people typically don't buy a new car every Friday night, like they may a pizza.
Although the stock is dropping, it is hard to know with a high degree of confidence if this is an opportunity to buy the dip. Only time will tell if Musk's strategy will work. As of now, despite the decline in margin, the company is still profitable on a per-vehicle basis. However, investors need to be aware of the fact that Tesla's margins could keep contracting in the short term. More importantly, should this be the case, it is paramount to question what this could do to Tesla's roadmap.
Tightening margins will limit Tesla's ability to invest in new products and services. So, being able to visualize and quantify how much the decline in cash flow is impacting the long-term growth prospects of the business will be supremely important in the coming quarters in particular.
