Few next-big-thing growth trends offer as much long-term promise as electric vehicles (EVs). Based on a recently released report from Fortune Business Insights, the global EV industry is expected to reach $1.58 trillion in annual sales by 2030, representing a compound annual growth rate of nearly 18% between 2022 and the turn of the decade. 

Investors don't have to look far to see clear evidence of the euphoria surrounding the EV space. The $778 billion market cap Tesla (TSLA 1.50%) possesses is higher than virtually all legacy automakers, combined! Since the EV replacement cycle could last for decades, investors appear quite optimistic that Tesla's first-mover advantages will help it build a moat in the automotive industry.

An all-electric Tesla Model 3 sedan driving down a multilane road during wintry conditions.

The Model 3 is Tesla's flagship sedan. Image source: Tesla.

Tesla has driven its first-mover advantages to outsized gains

There's no question that Tesla has advantages or tools at its disposal that new, and even legacy, automakers lack. For example, Tesla is the only pure-play EV manufacturer that's profitable on a predictable basis, as determined by generally accepted accounting principles (GAAP). Tesla has a chance to deliver its fourth consecutive year of GAAP profits in 2023. While most legacy automakers are profitable, their EV divisions are decisively losing money and burning cash.

Speaking of cash, Tesla closed out the June-ended quarter with a heaping $23.08 billion in cash, cash equivalents, and marketable securities in its coffers. hough most legacy automakers have deep pockets, they're also typically buried by burdensome debt. That isn't the case with Tesla, which is generating billions of dollars in net cash each quarter from its operating activities. 

Tesla also has the production in place to outpace its competition. The ramp-up in output in the Berlin, Germany, and Austin, Texas, gigafactories, which opened last year, should allow Tesla to make a run at topping 2 million EVs produced annually by 2024. While 2 million units aren't tops globally for aggregate vehicle production, including internal combustion engines, no other company is relatively close in terms of battery-electric vehicle production.

Lastly, new and legacy automakers don't have CEO Elon Musk. To Tesla's supporters and investors, Musk is a visionary tasked with turning a stodgy industry on its head. During his tenure, Tesla has successfully built itself from the ground up to mass production, and its share price has gained more than 15,000% since its 2010 initial public offering. Not too shabby!

Tesla's operating margin is nosediving

However, the performance of Tesla's stock and operations tell two very different stories. Whereas Tesla's shares have practically doubled on a year-to-date basis, the company's operating margin has been on a dizzying decline since the end of September 2022. Over the past three reported quarters (ended June 30, 2023), the world's largest automaker has seen its operating margin plummet from 17.2% to 9.6%. 

It begs the question: Could Tesla's operating margin be headed to 0%?

While a complete absence of income from the company's operations seems unlikely, I also wouldn't say there's no chance of it happening. A combination of aggressive price-cutting on its lineup, higher costs associated with production expansion, and rapidly growing competition, all spell serious trouble for Tesla's operating margin in the coming quarters.

Let's be clear: the biggest red flag for Tesla's operating margin is the across-the-board price cuts it's enacted on all four of its production models (3, X, Y, and S). During Tesla's first-quarter conference call, Elon Musk plainly stated that his company's pricing strategy depends on demand. If sales prices are falling, it's likely because inventory levels are rising.

Last week, the company slashed the starting price on its high-end Model X SUV and Model S sedan. Since the beginning of 2023, the starting price of the Model S and Model X have fallen from $104,990 and $120,990, respectively, to $74,990 and $79,990. Though this exorbitant price cut qualifies the Model X for a $7,500 tax credit under the Inflation Reduction Act, it's also a drag on the company's automotive gross margin. Keep in mind, the Model S and X accounted for just 4% of the company's deliveries in the June-ended quarter. 

While the price cuts for the flagship Model 3 sedan and Model Y SUV haven't been as extreme, they're still notable. The standard Model Y, which set buyers back nearly $65,000 during the fourth quarter of 2022, can be purchased for less than $48,000 today. 

Meanwhile, the Model 3 has been slashed from $44,490, during the fourth quarter of last year, to just above $37,000 in some markets. While this latest reduction on the Model 3 could have something to do with clearing out older inventory to make way for the updated version of the Model 3 that was unveiled in China, the message is clear: inventory levels are up and demand is down.

Were this not enough, Tesla also cut the upfront cost of full self-driving (FSD) from $15,000 to $12,000. FSD is the advanced driver assistance system that allows for partial driving autonomy. As one of Tesla's presumed highest-margin products, a 20% reduction in FSD pricing is going to sting.

Something else to keep in mind is that we won't see how these cuts have fully affected Tesla's operating performance until the fourth quarter (i.e., when the company reports its results in the first quarter of 2024). Nevertheless, Tesla's operating margin looks virtually certain to head lower, based on the company's aggressive price-cutting strategy.

A blue street sign that reads, Risk Ahead.

Image source: Getty Images.

Declining operating margin isn't Tesla's only issue

Unfortunately, a plunging operating margin is far from its only problem.

For instance, Tesla lacks the history and branding power of the legacy auto players, as well as the trust they can evoke. Although Tesla has been able to capitalize on consumers' desire to go green, adjusting its prices so dramatically has cratered the value of its EVs in the used-car market, as well as made a number of recent buyers angry. That's not a formula for growing the company's brand value or building trust with existing owners.

Tesla's ambitions to become more than a car company have also struggled to get off the ground. Although the company's supercharger network has become a popular choice for U.S. EV producers, this is a relatively low-margin service. Meanwhile, energy generation and storage revenue actually declined in the second quarter from the sequential first quarter, while solar installation has been a money-losing segment since Tesla acquired SolarCity. Long story short, the company isn't getting much, if any, help in the margin department from its ancillary operations.

There's also Elon Musk, who I've opined may be more of a liability to Tesla than a benefit. Musk is constantly distracted by his multiple side projects, including X, the social media platform previously known as Twitter, and has occasionally drawn the ire of securities regulators. Worst of all, Musk regularly overpromises and underdelivers when it comes to the rollout and capability of new innovations.

I'll also mention that multiple economic indicators and predictive tools suggest the U.S. economy could dip into a recession during the fourth quarter of this year, or perhaps during the first half of 2024. Since the auto industry is very cyclical, the expectation would be for new vehicle sales, including EVs, to slow.

Wrap all of these headwinds up in a nice bow and you have an auto stock trading at 71 times Wall Street's estimated earnings in 2023 with an operating margin that's been nearly halved in nine months. For context, auto stocks typically have price-to-earnings ratios in the high single digits.

Is Tesla's operating margin headed to 0%? Probably not. But a significant reduction that pushes its operating margin into the low-single-digits seems likely.