The market’s primary focus going into Tesla’s Q1 23 earnings report were signs of stabilization and improvement in automotive gross margins that management guided for in the Q422 earnings call. Although the normalized $0.85 eps was in-line with consensus, Tesla did not meet their margin targets. In doing so, Tesla indicated that they have changed their 2023 strategy to increasing volumes at the expense of margins.
As a result, visibility into margins for the foreseeable future have been reduced and management credibility has been dented.
We are going to review the key points we outlined in our preview note.
Pricing + Margins
An important part of our previous analysis was based on Tesla’s Q4 comments on ASP and automotive gross margins, excluding leases and rent credits, after significant January price reductions. This is what Tesla said after those reductions.
Zachary Kirkhorn, CFO
So there is certainly a lot of uncertainty about how the year will unfold, but I'll share what's in our current forecast for a moment. So based upon these metrics here, we believe that we'll be above both of the metrics that are stated in the question, so 20% automotive gross margin, excluding leases and rent credits and then $47,000 ASP across all models.above both of the metrics that are stated in the question, so 20% automotive gross margin, excluding leases and rent credits and then $47,000 ASP across all models.
In Q123, Tesla automotive gross margin less credits was 19% vs consensus of 20.7%.
Meanwhile, reported automotive gross margin, which include regulatory credits and leasing, was 21.1% and operating margin was 11.4% compared to 25.9% and 16.0% in Q422, respectively.
The main drivers were lower prices and factory related ramp up costs. Higher expenses related to warranty adjustments on older Model S and X were also a factor but were described as one-off.
Critically, the market would likely have given Tesla a pass if they gave indications that its margin targets were still intact. Rather than that, Tesla stated that the margin declines were reflection of Tesla’s change in business strategy to lower prices to increase volumes at the expense of margins.
This is how Elon Musk described the business focus for 2023.
“I want to reiterate the philosophy by which we're operating the business this year. Our approach is to grow volumes as quickly as possible in both our vehicle and energy businesses.”
“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. However, we expect our vehicles, over time, will be able to generate significant profit through autonomy.
So we do believe we're like laying the groundwork here, and then it's better to ship a large number of cars at a lower margin, and subsequently, harvest that margin in the future as we perfect autonomy. This is an extremely important point.”
Tesla’s rationale is that once a car is purchased, this allows them to collect higher margin revenue in the future such as software. It’s somewhat akin to if Apple cut prices on their latest iPhones to get new users and says they’ll make much over the course of the phone’s lifetime via apps and services.
This strategy shift raised questions on pricing and future margins. In contrast to Q422, they would not provide any specifics.
Question: What is the process to make auto pricing adjustments? What variables do you consider? How frequently do you review pricing?
Elon Musk
Yeah, I think this is not something that we can really talk about. It's just — we do our best to evaluate the production output, macroeconomic conditions, and we make a decision. But it's — and unless there's something you'd like to add, Zach.
Zachary Kirkhorn
I think that's right. I mean, as a team, we review where we stand globally on a weekly basis and certainly, I can't get into the details of the reasons why certain decisions are made. But it is something that's very actively managed by a subset of the leadership team.
Question: what do you anticipate 2023 automotive gross margins ex-credits will be at the company's current pricing levels?
Zachary Kirkhorn
Yes, I can start off on this one. This is a difficult environment to make a projection like this. There's a lot of macro uncertainty. There's also headwinds and tailwinds. And this is basically a question I think that's asking about viewpoint and where costs will go. And within costs, there's a set of costs in which we do control the set of costs in which we're kind of subject to what's going on in the macro world.
Question: Back on the automotive gross margins. So, I think, I guess, a few months ago, even after major price cuts, you felt pretty strongly that 20% automotive gross margin was still probably a reasonable floor. Obviously, the macro has gone worse and additional price cuts have happened. Is there anything else that has changed in terms of the outlook? Is it just the macro deteriorating? Is it the competitive landscape? Anything else that's sort of like makes you think differently around the full year? And is there a way, therefore, to frame a floor?
Zachary Kirkhorn
“Yeah. About half of the miss against that previous conversation last quarter is attributed to adjustments we made in pricing in the second half of the quarter. I mean, I guess you could argue that that lowers the floor in a sense. We've also made pricing adjustments so far this quarter. So that brings it down further.
About the other half of the miss in Q1 was attributed to things that are nonrecurring. So I mentioned these in my opening remarks. It's a warranty adjustment for cars that were previously produced but not part of the pedigree of cars we're building now and some autopilot-related deferrals as we make some technology changes here that this deferral should get recognized once some of the software catches up. So those two things are not repeating. So hopefully, that helps answer your question.”
Elon Musk
“Yeah. I mean there's really two macro factors that are tricky. The biggest being the interest rate. So if there's a very high Fed rate or interest rates are very high, that is — every time the Fed raise the interest rates that's equivalent to increasing the price of a car. It makes the cars less affordable because people are able to buy cars as a function of what they can afford on a monthly basis. So that's — so it's just almost directly equivalent to a price increase, is there any kind of interest rate increase.
Then the other factor is whenever there is uncertainty in the economy, people will generally postpone new — big, new capital purchases like a new car. This is a natural human reaction. So if people are reading about layoffs and whatnot in the press, they're like, well, they might be worried about — they might be laid off. So then there'll be naturally a little more hesitant than they would otherwise be to buy a new car. Now this is just the nature of the auto industry. But there is — there will be a trans amount of pent-up demand for new cars. So it goes through cycles.”
Question: I just wanted to first just follow-up on your comments in your letter about leveraging your cost position as others struggle with unit economics and also taking into account the lifetime revenue, actually in a way that most other automakers will never see just given your service network and supercharging and other attributes. Can you just maybe give us a sense of how far you'd be willing to take this? Are there brackets around the range of initial margin that you'd be comfortable with? And again, any color that you might provide on the updated range of margins that you'd expect in the auto business?
Elon Musk
I think we may have answered this question or tried to ask this question a few times. But it's difficult to say what the margin will be. It depends on what the macroeconomic environment is like. So for example, if the Fed were to lower the rates, that would be super helpful for demand. If they raise them, that just raises the interest costs that buyers have to pay for to buy a car. So it reduces affordability and therefore, reduces demand. So it's — but if — like if we look past, say, this year or like go sometime next year, middle of next year, so I think things are looking really — I think, like I said, albeit if there's some major geopolitical wildcard that turns up. But in the absence of that, I think I would be very optimistic about middle of next year, end of next year.
Zachary Kirkhorn
“Just to add to Elon's comments, just two other points. What's really important for us this year in addition to just managing the day-to-day of the business but is also investing in, as Elon mentioned, what 2024 and 2025 will look like. And so using the cash generated from the sale of products today and reinvesting that, this is very important for us. And I think that what happens to margins over the next couple of quarters that only matters in the context of what that means for our ability to reinvest into 2024 and 2025.”
“And we have a lot of space before that becomes something that we have to revisit our investment plans. And so we're planning to keep the business healthy. But I just want to caution folks about reading too much into what happens over the near-term here because we're very focused as a company on making sure that when we exit this macroeconomic situation, this company is positioned in the best possible way.”
Key takeaways from the above comments
· Kirkhorn’s last statement is important. He seems to be indicating that there could be continued margin pressure in the short-term as part of their pricing strategy
· Musk’s comments indicate the consumer is feeling the pressure from higher interest rates and weaker macro and Tesla has needed to respond by cutting prices
Raw materials
On the positive side, Tesla will begin to see the benefit of lower lithium prices in the 2nd half of the year. They also are beginning to contract lithium forward at attractive prices.
Elon Musk
Lithium has dropped a lot. It's worth mentioning that the price of lithium has dropped significantly.
Zachary Kirkhorn
Yes. And that's the piece that we expect to see more impact on in Q2. And, generally, as a company, we do expect commodity prices to come down and have a more meaningful impact in the second half of the year.
Elon Musk
Yes.
Karn Budhiraj
We are seeing, as Elon mentioned, quite a bit of softening in the lithium carbonate market. This was — six months ago, we were trading at like $85,000 a ton, and today's spot price is about 26%. So there's been a dramatic decrease in that.
Of course, we were able to take advantage of low lithium pricing earlier on with fixed price contracts. And we find that this is going to be another opportunity — opportune moment to basically extend that into the later half of the decade. But we — at the quantities we're procuring, we're not as impacted by the spot market because we have those contracts in place, and we're just going to be going and doing more of that.
Production, Inventory and Free Cash Flow
Tesla has maintained their 1.8 million unit production guidance.
Inventory days increased slightly from 13 to 15 days leading to a decline in fcf of $0.4B vs $1.4B in Q4. Tesla stated they are trying to balance their regional mix of production and deliveries that is impacting quarter-end cash free cash flow.
Conclusion
Based on Tesla’s prior comments, we entered Q123 with very clear catalysts in mind that did not materialize. We did not expect this sudden shift in their business strategy nor has Tesla provided any tangible insights into their new pricing strategy.
They did make it a point to say that their margins were still industry leading. However, at 11% group operating margins, they are now lower than the Germans and just above the US, Korean and Japanese manufacturers. Tesla suggested that margins may go lower in the future.
This strategy shift is an important change in our investment thesis for Tesla.
We expect there to be continued margin uncertainty for at least the next couple of quarters and earnings estimates to be revised down. The I/O team believes that these factors will present headwinds for Tesla stock until there is more clarity.
Recommended Reading:
Tesla: Impact of Lower ASPs & Raw Materials, Margins, IRA and More.
Tesla Q4 Earnings: Solid ER and Valuation is Low
Tesla – Q4 Results Strong, Looking for Entry
Tesla Stock: What You Need To Know About Q1 Earnings
Timeout for Tesla Stock: Where We Plan to Buy