As the I/O fund looks to position itself for the remainder of 2023. Fundamentally, we’re avoiding ‘Crocodile Jaw’ situations where the stock price is going up but fundamentals are decelerating. This is one of the reasons we greatly reduced our Tesla position for a ~60% gain.
Tesla stock has rallied through most of 2023 during a time when consensus was estimating sales to grow +23% y/y but earnings to decline 15%. The main driver behind the decline in earnings estimates is that Tesla has decided to lower prices to increase volumes at the expense of margins.
Starting in Q322 through Q223, operating margins have declined from 17.2% to 9.6%. Initially, Tesla cited making sure certain models qualified for the EV tax credit and later higher interest rates as the primary reasons for lowering prices.
Higher interest rates are effectively a price hike that increases monthly payments for those who finance their purchases. Tesla recently announced 84 month financing to lower monthly payments. Reducing the sales prices also helps lower monthly payments. Meanwhile, increasing EV inventory at dealerships and discounting at an industry level are likely another contributing factor.
However, the challenge of higher interest rates is not unique to Tesla. All OEMs face the same obstacles. Below are reported operating margins for the major global OEMs from Q322 through Q223. Either they were relatively stable for the Germans and Koreans or bottomed in Q123 and have improved in the case of the Japanese.
Despite this, Tesla is the one OEM whose operating margins have continued to decline.
Source: Y-Charts
It’s Not Just Macro
This highlights that there are other forces at work beyond the macro. We believe it points to Tesla implementing a pricing strategy to gain market share. Taking into consideration the competitive factors at work will help in trying to decipher Tesla’s pricing strategy and how that will impact operating margins for the remainder of 2023. It is through this competitive analysis framework that we will try to parameterize how low Tesla operating margins can go.
For this analysis, we chose to focus on reported group operating margins. Although this metric includes non-EV businesses, we believe it’s the most objective and public measure to provide an apples-to-apples comparison across the auto landscape globally.
At the end of Q422, Tesla's operating margin was 16%. To provide some context, at the time this was greater than the German OEMs. Tesla had firmly positioned itself in the premium segment.
The Germans have been dealing with their own challenges integrating EV offerings, and have been trying to catch-up with Tesla. Perhaps sensing its competitive moat within the premium market was fortified, this gave Tesla an impetus to lower prices further to attack the mass market segment. In Q223, Tesla’s operating margins declined to 9.6% after enacting a series of price cuts.
Currently, this is how Tesla’s operating margins compare to its main competitors. As can be seen below, Tesla’s Q223 reported operating margins are below those of most of the major US, German, Japanese and Korean OEMs.
Source: Y-Charts
How Low Can Operating Margins Go?
Strategically, Tesla will likely continue to lower prices to increase its leading EV market share to stave off competition which will intensify over the next few years. Tesla’s electric market share peaked at 78% in 2018 and stood at 62% in 2022. By 2026, Merrill Lynch estimates it will decline to 18%
Source: Merrill Lynch
In the most recent Q2 call, both Elon Musk and Zachary Kirkhorn, former CFO, signaled Tesla‘s focus will continue to be on volumes.
Musk
“So, I think it’s sort of, it would be -- I think it -- it does make sense to sacrifice margins in favor of making more vehicles because we think in the not too distant future, they will have a dramatic valuation increase.”
Kirkhorn
“We continue to work towards our goals of maximizing volumes on our vehicle business … in a way that generates the capital to continue our pace of R&D and capital investments.”
Through this competitive analysis framework, we believe Tesla’s Q3 operating margins can decline to a level between Honda and VW. Taking the midpoint, operating margins may go to 7.8% compared to most recent 9.6%. If operating margins were to reach a level closer to -- or below GM perhaps --- that could be sign they’re close to the bottom. This highlights the broader concern for investors in that Tesla has not provided any parameters nor guidance to assess how low margins may go. It is why we significantly reduced our position.
