Margins return for AI leader

Tesla is arguably one of the most advanced AI companies in the world, but its stock is dictated by margins. Over the past three years, Tesla’s average gross profit per vehicle down 60%, falling from more than $14,400 in Q3 2021 to less than $6,000 in Q2 2024, underscoring the difficulties Tesla has faced in a high interest rate environment.

Higher interest rates have forced Tesla to place more emphasis on affordability, either via price cuts or promotional financing rates, pushing average sales prices lower and impacting margins. Q3’s report showed that margins may have bottomed out, despite weak auto sales prices, due to this focus on affordability.

Perhaps the long-term story is recurring software revenue from robotaxis and humanoid robotics, but margins drive the stock price for now.

Below, I look at the puts and takes of an AI frontrunner battling financial headwinds.

Deliveries recover, but revenue does not

In the third quarter, Tesla reported sequential growth for both production and deliveries after a weak Q1, where deliveries fell below 400,000 for the first time since the end of 2022. Tesla reported deliveries of 462,890 electric cars in the third quarter, up 6.4% from last year and up 4.3% from the second quarter.

For the third quarter, Tesla reported auto revenue of $18.83 billion, up just 1.3% YoY and 1.6% QoQ and short of the consensus estimate of $19.50 billion. As a result, Tesla’s total revenue fell short of estimates, with Tesla reporting $25.18 billion in revenue, nearly half a billion below the $25.67 billion consensus.

A quick look at the growth rates shows that auto industry revenue growth lagged delivery growth by just over 5 percentage points at 1.3% versus 6.4%. This tells investors that auto sales prices fell again, and by a lot – Q3’s ASP fell below $42,000, down ~(1.7%) from Q2 and down (5.6%) from nearly $44,500 last year.

There is a particular risk of ASPs falling lower in Q4 as Tesla continues to cut some prices, with the Cybertruck seeing up to 20% cuts on various model variants in October. Musk mentioned that Tesla would aim for year-over-year growth, and with only Q4 remaining, that means Tesla will deliver more than 515,000 vehicles, which is a record high. This would also imply an acceleration to 11% QoQ growth, leaving the door open for more aggressive price cuts to stimulate demand, something management hinted at in the earnings call.

Tesla is aiming high for 2025, with Musk saying the automaker is shooting for “20% to 30% vehicle growth next year,” or about at least 2.1 million vehicles, assuming Tesla ends 2024 at about 1.75 million. Taneja added that Tesla’s “focus remains on growing unit volume while avoiding inventory build-up. To support this strategy, we continue to offer extremely compelling financing options for vehicles in all markets.”

The Fed has forced Tesla to focus on financing and affordability, which in turn has been a major cause of margin problems. I noted in July 2023 that “the comment about interest rates is the most important comment from the call, as high interest rates mean Tesla will have to cut prices” and that Tesla was “one of many tech stocks whose revenue growth and profitability are on borrowed time until the Fed instills a more dovish policy.”

Tesla’s profitability improved on cost optimizations

Despite ASPs falling again sequentially, profitability improved and auto margins recovered as Tesla captured some tailwinds from “lower raw material costs, freight and duties” and brought vehicle production costs to record lows.

Tesla went into Q3’s report facing a tough test as average sales prices were flat and vehicle manufacturing costs rose. From Q4 2023 to Q2 2024, ASPs were relatively flat while production costs rose 3.7%, lowering both automotive margins and impacting profitability. This had hampered Tesla’s ability to revitalize auto gross margins—as a result of these two changes, auto gross margins took a pretty big hit, falling from 17.2% to 14.6% in that two-quarter span.

Q3 saw a sharp improvement in automotive gross margin, expanding ~240bp QoQ and ~72bp YoY as Tesla drove manufacturing costs to a record low of ~$35,106, down ~(4.6%) from $36,802 last quarter.

Due to the large improvements in production costs, the average gross profit per vehicle back, up ~16.3% QoQ to reach ~$6,886, up from $5,921 last quarter. Essentially, Tesla produced and sold 14,000 more vehicles this quarter for ~$220 million less than last quarter.

Operating margin also increased significantly, growing to 10.8% in Q3, up from 6.3% in Q2 and 5.5% in Q1. This newfound operating margin growth adds more credence to the story of margin recovery, which has been paramount for investors as share price declines have correlated fairly closely with operating margin declines.

Energy Storage was a bright spot in Q3 when, even with a sequential decline in deployments and (21%) sequential decline in revenue, gross margin increased from 24.5% to 30.5%. This helped the company’s overall gross margin expansion, with Tesla reporting a gross margin of 19.8% in Q3, up from 18.0% in Q2.

Q4 margins will be “challenging” to maintain

Q3’s profitability is a welcome sign, but CFO Vaibhav Taneja warned that “maintaining these margins in Q4 will be challenging given the current economic environment,” however, due to car affordability issues.

Investors may have to get comfortable with thinner margins going forward on the auto side. When the stock was at all-time highs in 2021 and early 2022, Tesla reported more than $14,000 in gross profit per share. vehicle or a high 20% gross margin that topped 30% once. Now the average gross profit per vehicle fell more than (52%) to $6,886 in Q3, with automotive gross margins back to 17%, although it has been below 20% since the start of 2023.

This decrease in gross profit per vehicle stems from weaker average sales prices, which have fallen quite dramatically since the start of 2023 and continue to fall. The reason margins were able to expand in Q3 was to reduce production costs, not car prices.

As long as Tesla continues to lower prices, margin gains will primarily be realized on the cost side. The path to higher margins will occur when Tesla can push production costs toward $30,000 and lower, and when the pressure on ASPs is resolved.

Musk said in Q3’s call that Tesla is “still on track to deliver more affordable models from the first half of 2025,” which would require similar cost reductions to maintain margins. Musk also hinted that thin margins may be the norm for investors, as Tesla noted that affordable model production in the first half of 2025 “will result in achieving less cost reduction than previously anticipated.”

Robotaxis still isn’t here, despite multiple timelines

While the robotaxi option is promising for Tesla, it has yet to yield tangible AI revenue. Tesla’s robotaxi unveiling event earlier this month was met with a lackluster response, sending shares down more than (8%) the day after as the production timeline for its ‘robotaxi’ was pushed back yet again, a familiar story to Tesla investors over the last few years.

At the unveiling of Tesla’s pedal and wheelless custom-built robotic axle, called the Cybercab, CEO Elon Musk said production could begin in 2026 or as late as 2027, saying he “tends to[s] to be optimistic about timeframes.” This is another year-long delay for Tesla’s most anticipated product, with Musk in 2022 having promised to unveil the robot axis in 2023 and start production in 2024. This follows an initial promise from 2019 to have a million Tesla vehicles equipped with Level-5 autonomy in 2020. Years later and Tesla still hasn’t implemented the robot axis, putting further pressure on margins.

Musk reiterated Tesla’s goal to launch production of the Cybercab in 2026, adding that Tesla is “aiming for at least 2 million units per year of the Cybercab.”

Tesla Deep Discount, Access Point Coming: I/O Fund (youtube.com)

Following the April 2024 Q1 earnings report, I joined Bloomberg China to discuss the most pressing issues for Tesla, saying that “as AI approaches, that’s the piece that Tesla has to execute on. So what we’re seeing is a moment where it’s a little too early for AI software… we’re not in that cycle right now, and that’s what Tesla really needs for its stock to rebound, where it was before as a Wall Street darling [in 2021]. And that AI software cycle, if I had to give you my best estimate, it would be more of a 2026 discussion.”

Conclusion

Despite a mixed Q3 earnings report with a loss in revenue and an EPS beat, Tesla’s report beat expectations in the one area that mattered most — margins. Automotive gross margin increased due to manufacturing cost improvements even as sales prices fell, boosting operating margins back into the double-digit range.

While the AI ​​story is one to watch, margins have been the driving force behind the scenes for stocks and remain the data point to track until a credible, tangible revenue stream from robo-axis emerges. I/O fund portfolio manager Knox Ridley wrote in August 2023, when the I/O fund cut our Tesla position for a 60% gain, that the I/O fund “avoided ‘Crocodile Jaw’ situations where the share price rises, but fundamentals are declining.”

By closely tracking Tesla’s margins and fundamentals, the I/O fund caught Tesla’s move out of the 2022 lows and exited the top in early 2023. The I/O fund continues to track Tesla, but recently shared research with premium members about two AI beneficiaries in a lesser-known semiconductor space with excellent EPS numbers. Learn more here.

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I/O Fund Equity Analyst Damien Robbins contributed to this report.