If a company wants to earn better than average profits it has two choices:
- Provide the industry’s most valuable product at a high price (a differentiation strategy).
- Ship a good product at the industry’s lowest price (low cost producer strategy).
Selling your product at the industry average price — stuck in the middle strategy — is a recipe for average profitability.
Tesla’s middle-of-the-road approach will struggle to convince increasingly cash-strapped customers to buy its excess inventory. The result: Tesla’s first-quarter profit plunged, causing its stock to drop 8% in pre-market April 20 trading.
Tesla CEO Elon Musk’s tendentious explanation is that lower margins now will lead to higher ones later as autonomous vehicles become the norm. Realizing that goal is a big stretch.
Tesla Has Exhausted Buyers Who Are Willing To Overpay For Its Vehicles
With inventories growing, Tesla is cutting prices to get vehicles off its books — sending its profit margin down. According to the Wall Street Journal, In the first quarter Tesla produced nearly 18,000 more vehicles than it delivered to customers while its days of supply soared five-fold from the year before to 15.
This prompted significant price cuts — leading Tesla to roughly match the industry average. The automaker’s average price in the first quarter fell 13% to $46,000, the Journal reported.
Due to “underutilization of new factories,” Tesla could be stuck in the middle for a long time. As Bernstein Research analyst Toni Sacconaghi noted, Tesla cut the price of its popular long-range Model Y crossover by $5,000 in April to $49,990 — nearly matching March’s $48,000 average U.S. new car price, according to Kelley Blue Book.
My conversations with some 80 students a few weeks ago suggests the love affair with Tesla and EVs more generally could be fading. While teaching a case study I co-authored, Apple’s Electric Vehicle, I asked students to comment on whether they or their friends or family had considered purchasing a Tesla.
Surprisingly, none had done so. They see EVs as dangerous — citing fires; the risks of running out of battery charge in a location far from a charging station; and overhyped environmental benefits — due to the social costs of mining cobalt for batteries and the coal used to power the charging stations. Many of the students prefer hybrid vehicles.
One of my students described Tesla as a powerful brand that needs to do more to realize its promise. As Alyssa Keith, a student in my Babson College Strategic Problem Solving course told me, “Tesla’s cars have become a token of status on college campuses that has clouded the conversation around improvements to EVs.”
She sees hurdles in the way of the greater dream of a clean environment and autonomous vehicles. These include: “recalls, the price of maintenance, and privacy issues in autonomous vehicles.”
While Keith appreciates that Tesla is cutting prices to try to make its vehicles more affordable, she would rather see the automaker “improve the lifetime expense of owning an EV by focusing on unit-production of their components.”
I don’t think Tesla’s price cuts will solve these problems, and meanwhile they are hurting the company’s bottom line. Tesla’s operating margin dropped from 19.2% to 11.4% in the first quarter. To be fair, that lower margin is above those of its rivals. FactSet notes Ford and GM reported 2022 operating margins of 4% and 6.6%, respectively.
Tesla’s lower operating margin fell 0.8 percentage points short of what analysts were expecting. Price cuts were not the only reason for the disappointment. Since Tesla’s deliveries rose 36% while their costs increased 39%, Tesla was also paying a higher price for its bill of materials, the Journal suggested.
To be fair, the declining price of lithium and increased capacity at new Tesla factories in Berlin and Austin, Texas could ease bill of materials inflation.
Nevertheless, Musk seemingly cares less about profits than growth. “We’ve taken a view that pushing for higher volumes and a larger fleet is the right choice here versus a lower volume and higher margin,” he told investors on April 19.
Autonomous Vehicles Will Not Be On The Roads For Years
Musk’s mouth has written checks Tesla can’t cash. Without getting into all of them, the Journal noted that “Musk once again claimed that ‘full autonomy’ might be achievable” in 2023.
That is not the first time that Tesla has fallen short of its autonomy ambitions. In 2016, Musk said Tesla would “conduct a hands-free trip across the U.S. by late 2017, a mission that has yet to be completed,” according to CNBC.
This contributes to my skepticism of his April 19 claim that “autonomy, supercharging, connectivity and service” will enable Tesla to recover its lost operating margin. Tesla has not shown a convincing technical lead in autonomous driving compared to its peers. Therefore, even if consumers were willing to pay for it, rivals would compete away the value, the Journal reported.
Meanwhile, autonomous vehicles on U.S. highways could be widely available — but not for decades. The National Highway Traffic Safety Administration says no self-driving cars exist and state laws enabling such vehicles vary widely, according to MotorTrend.
Where Tesla Is Headed Next
Tesla expects crimped consumer demand due to higher interest rates even as it continues to invest heavily to achieve its growth ambitions. The automaker sees economic storm clouds ahead. As Musk told investors, higher interest rates have the effect of increasing what consumers pay for a car and produce uncertainty that makes consumers more likely to delay “big new capital purchases like a new car.”
Meanwhile, Tesla has big investment plans. CFO
CFO
Zach Kirkhorn dismissed margin concerns and said they are not likely to slow down what could be $150 billion worth of capital spending in the coming years.
Tesla plans to build a new manufacturing plant near Monterrey, Mexico and a new battery factory in Shanghai. Musk said Tesla will deliver its Cybertruck pickup in the third quarter of 2023.
What Investors Should Do
Analysts do not seem to be persuaded by Musk’s bullish view of an autonomous-driving-led profit recovery.
Morgan Stanley’s
MS
Adam Jonas reduced his Tesla stock price target by 9% to 200; RBC Capital analyst Tom Narayan cut the firm’s price target on Tesla to 212; and Citigroup
C
slashed its price target 9% to $175 citing Tesla’s margin miss, reported Investors Business Daily.
Don’t catch this falling knife.
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