Tesla's (TSLA -1.11%) declining profit margins have become a cause of concern for investors. Profit margins are arguably the most important financial metrics to follow because when they fall, it's often a signal that a company's competitive position is declining. They also have a massive impact on the long-term financial models that investors use to price growth stocks like Tesla. That said, there's reason to believe the electric vehicle (EV) maker's margins will recover.
Tesla's profit margin
The chart below shows the market's concern. Following three years of excellent gross profit margin and operating profit margin expansion, Tesla's margins are down sharply year to date. The trend appears even worse if you look at the sequential progression in quarterly operating profit margin, which has gone from 11.4% in the first quarter to 9.6% in the second quarter and just 7.6% in the third quarter.
It doesn't take much to imagine the negative impact falling margins can have on Tesla's long-term valuation, especially if you pencil in the third quarter's operating margin of 7.6%, and contrast that with the 16.8% margin for all of 2022.
Data source: Tesla presentations.
What happened in 2023 to Tesla's margins?
Tesla's falling margins reflect increasing competition, waning demand for electric vehicles, and the natural outcome of a flood of new EVs in production as other companies play catch-up with Tesla. According to Cox Automotive's latest Electric Vehicle Sales Report, Tesla's share of the EV market fell from 65% in 2022 to 50% in the third quarter of 2023.
Moreover, major automakers have cut back on their EV manufacturing plans in response to weaker-than-expected conditions. For example, Ford recently announced it had scaled back its plans for the new EV battery plant it's building in Michigan. In addition, General Motors and Honda have canceled their plans to jointly develop EVs that would sell for less than $30,000. Even Tesla is being more cautious on its expansion plans. "We want to just get a sense for the global economy like before we go full tilt on the Mexico factory," said CEO Elon Musk about a planned gigafactory.
It's easy to conclude that investors need to start lowering their margin expectations for Tesla. However, I think that would be a mistake.
The automotive market has changed
The case for why Tesla's margins will improve comes down to two factors. The first relates to how its end market has changed, and the second relates to how it has stayed the same.
First, it's impossible to separate trading conditions in 2023 from the overall interest rate environment. The reality is that the automotive market, whether for traditional internal combustion engine (ICE) vehicles or EVs, is highly sensitive to interest rates. Rising rates increase monthly payments and act as a brake on consumer spending. Faced with these conditions, automakers can shade toward trying to sustain prices and margins, or cut prices in a bid to grow unit sales.
Tesla chose the latter route. On the company's recent earnings call, CFO Vaibhav Taneja said, "As interest costs in the U.S. have risen substantially, it has required us to adjust the price of our vehicles to keep the monthly cost in parity." Those price cuts have pressured its margins in 2023.
Image source: Getty Images.
The automotive market hasn't changed
It's a strategy based on understanding the second factor: The automotive market's fundamentals haven't changed. In other words, the growth area of the market is in EVs, not ICE vehicles. Tesla wants to retain its leadership of that market, and that will require it to scale up production and generate cost improvements as it does so.
Indeed, Tesla shut down some factories in the third quarter to implement factory improvements.
Furthermore, Tesla is generating substantive improvements in cost per unit vehicle, and that's an ongoing trend. For example, between 2018 and 2022, the cost to manufacture the Model 3 (Tesla's second best-selling vehicle after the Model Y, and responsible for 17% of total industry EV sales in the U.S. in the third quarter) fell by 30%. Meanwhile, Tesla's overall average vehicle cost has dropped from slightly over $39,500 in Q4 2022 to $37,500 at present.
Why Tesla's margins will improve
The company's strategy makes sense. The interest rate cycle will eventually turn, and Tesla will be able to raise prices again when it does. In addition, despite the doom and gloom about growth trends, overall EV sales in the U.S. were up nearly 50% year over year in the third quarter.
It's still a high-growth market. Tesla's leadership and ability to invest and generate cost-per-vehicle improvements mean it's highly likely to grow its margins when the interest rate environment improves. But it will only be able to keep its leadership if it grows volumes and continues to steal marches on its rivals by improving productivity and developing affordable cars while its rivals are shelving plans to do the same.
