While I’ve been bullish on Tesla (TSLA -4.79%) stock for a while, some items in its latest earnings report concern me. One or two reports shouldn’t sway investors’ confidence, but there may be a reason to worry when it’s a consistent trend.
So what’s going on with Tesla? And should investors be concerned? Let’s find out.
Falling gross margins aren’t a great sign
As one of the leaders in the electric vehicle (EV) revolution, Tesla attracts a lot of attention. That attention can be both good and bad, but the latest attention it has received isn’t of the good variety. In Q3, Tesla produced more than 430,000 vehicles, up an impressive 18% year over year. However, that is the low mark over the past 12 months, which is concerning.
Furthermore, the amount of money it’s making per vehicle is also slipping. Thanks to various price cuts across Tesla models, its gross margin has steadily fallen over the past few quarters.
Tesla’s superior gross margins had set it apart from traditional automakers. With gross margins now in the high-teens range, however, its in the same territory as legacy automakers like Toyota (20% gross margin in Q2) and Ford (17% gross margin in Q2). As a result, some of the reasons Tesla’s stock has a premium valuation are now gone.
This is a problem, because Tesla is valued at a pricey 57 times forward earnings. Tesla’s stock price would have to decline by more than 90% to match Ford’s forward price-to-earnings ratio of 5.1.
That’s an extremely bearish view. But why is Tesla’s gross margin declining?
The declines may be temporary
Tesla’s vision to be the top EV manufacturer requires it to solidify its place even as the legacy automakers launch their EV lines. By dropping its prices, Tesla can make its EVs more attractive than the competition. After it establishes its foothold as the go-to EV company, gross margins will likely tick up as price cuts aren’t required to drive sales.
There’s also the consideration of interest rates. In Tesla’s Q3 conference call, Chief Financial Officer Vaibhav Taneja stated:
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. We’ve tried to offset such adjustments by our focus on reducing costs. However, there is an inherent lag in cost reductions, which in turn impacts margins.
These price cuts also appear to be temporary to keep monthly payments for consumers down. This is all to capture the sizable U.S. EV market, which is a goal long-term investors should be cheering on.
As a result, investors shouldn’t panic until interest rates start to fall. If Tesla has to keep prices low even after that, then the lower-margin vehicles may be permanent. If that’s the case, don’t be surprised if Tesla’s stock gets whacked because it has become more like a traditional automaker.
But with technologies like artificial intelligence (AI), Robo Taxis, and full self-driving capabilities, Tesla is still working to avoid being seen as a pure automaker. While the outcomes of those long-term goals remain to be seen, they will likely provide higher margins than physical products like cars.
While the recent trends of narrowing gross margins concern me as an investor, I’m not selling my shares just yet. With no timetable on when interest rate cuts may occur, it’s a guessing game when Tesla’s margins might improve. Furthermore, with the U.S. not due to completely switch over to a full EV fleet until well after 2030, there’s a long battle ahead for EV supremacy.
I still like Tesla’s odds in that race, so I’ll remain a shareholder — for now.