Tesla Beat Q2 Earnings Estimates, But Margins Keep Shrinking

Summary:

• Tesla, Inc. Q2 results beat earnings and revenue expectations with growth rates of 47% in revenue, 20% in earnings, and 62% in free cash flow, but net profit margin declined to 12.6%.
• The company’s shrinking margins are likely due to increased competition from traditional automakers entering the EV market, such as Ford and Volkswagen.
• Tesla’s future growth may depend on its full self-driving software and charging network differentiating it from competitors, but without these, Tesla may lose market share and see further margin compression.

Tesla, Inc. (NASDAQ:TSLA) just released its Q2 results. The release beat on earnings and revenue. The growth rates were 47% in revenue, 20% in earnings and 62% in free cash flow. With net income of $3.14 billion on revenue of $24.9 billion, the net profit margin was 12.6%. The net margin was down from 15.4% in the year-ago quarter. On the whole, the release was well ahead of analyst expectations, but nevertheless showed the recent trend of declining margins continuing.

Tesla had been dealing with shrinking margins for several quarters prior to today’s release. In the first quarter, it did just $441 million in free cash flow, when it had $1.4 billion in the quarter before that, and $3.3 billion in 2022’s third quarter.

The culprit behind the shrinking margins was most likely competition. Most of the major U.S. traditional automakers are getting into electric vehicles (“EVs”). China’s BYD Company (OTCPK:BYDDF) is now #1 in China by a wide margin. Volkswagen (OTCPK:VWAGY) is growing deliveries rapidly, Ford Motor Company (F) is growing them even faster. Put simply, the competition has come for Tesla.

Can Tesla keep growing with all this new competition in the picture?

Potentially, but it will take a lot of differentiation. The problem with increased competition is that it can leave you with lower margins on a higher amount of revenue. In economics, companies in perfect competition earn $0 in long-run economic profit. Companies in real world markets earn varying amounts of profit, where the number and strength of competitors reduces the profit margin. This can be seen in Tesla’s just-released earnings, in which the net margin tanked on 47% higher revenue.

With that being said, Tesla has some tricks up its sleeve for getting its margins up. It has a network of charging stations that enables it to make money off non-Tesla vehicles. It has its full self-driving (“FSD”) software (still in beta testing), which provides some differentiation compared to non-Tesla EVs. FSD has been criticized for requiring driver input, but it is unique in being adaptable to new environments. The “driverless taxis” that it has been compared negatively to only work in specific environments that they were trained in.

If Tesla can get FSD to the point where it can function reliably in any city on Earth without a driver, that will be a game changer. Absent that condition, then Tesla will likely lose share to other EV companies, which in turn will cause its margins to shrink further. This is what Elon Musk was referring to when he said Tesla is worth “basically Zero” unless it solves self-driving. Without that differentiator, it will inevitably lose share to competitors.

In this article, I explain why I consider TSLA stock a hold after its second quarter earnings release. I’ll start by reviewing the earnings release. Then I will take a look at the company’s competitive position and progress with FSD. Finally, I’ll look at some key value, growth and profit metrics. Finally, I’ll conclude by reviewing the overall picture and why, on balance, it supports a hold rating for TSLA.

Earnings Summary

Tesla’s most recent earnings release broadly beat analyst expectations, boasting the following metrics:

• 479,000 cars produced.

• 466,000 deliveries.

• $24.9 billion in revenue, up 47%

• $4.5 billion in gross profit, up 7%

• $2.4 billion in operating income, down 3%

• $3.14 billion in net income, up 20%

• $0.91 in EPS, up 20%

• $1 billion in free cash flow (“FCF”), up 62%

• A 18.2% gross margin, down from 25.2%.

• A 9.6% operating margin, down from 14.6%.

Overall, the release was not too far from what was expected, which is to say that the earnings growth decelerated despite an appreciable gain in revenue. The standout metric from the release was free cash flow, which grew year-over-year as well as sequentially. On the other hand, operating income shrank. Overall, a fairly mixed release, in an absolute sense, but ahead of analyst expectations.

What Can Tesla Do About The Shrinking Margins?

Now that Tesla’s margin compression is an established trend, it’s time to ask:

What can be done to reverse it?

There is essentially nothing Tesla can do to prevent new companies from entering the EV industry. What it can do is differentiate itself. This is where FSD comes into play.

FSD is a bit different from competing self-driving systems in that it aims to work in novel environments. This is very different from Alphabet’s (GOOG) Waymo and General Motors’ (GM) Cruise, which are AI-powered transportation services trained rigorously on specific cities. Waymo is available in San Francisco, Phoenix and Los Angeles, while Cruise operates in San Francisco, Phoenix, and a few cities in Texas.

Then there’s the self-driving systems that other car companies are making. These are also different from FSD’s beta test in several ways:

1. Ford’s Blue Cruise is advertised as highway-only, FSD can operate in cities with occasional human intervention.

2. GM SuperCruise is also highway-only and limited to highways that were mapped out in advance.

Neither of these services is even attempting to work on novel environments the way FSD is. So, if Tesla can make FSD work, then it will be a real differentiator. The downside is that FSD still has many kinks to work out. The pre-trained alternatives are good enough to run full robotaxis in some cities. FSD still requires human intervention and, despite being for sale, is fundamentally still a beta test. It remains to be seen whether Tesla will ever deliver a truly driverless experience, but if it does, it will be a real differentiator.

Profitability, Growth and Valuation

Next we get into the core analytical aspect of my TSLA analysis: the financials, including profit, growth and valuation metrics.

Some of the growth metrics were touched on earlier in the earnings recap. Briefly, revenue increased while margins shrank. To zoom out a little, we can look at the longer term growth picture. As of July 19, Seeking Alpha Quant has the following five year CAGR growth metrics for TSLA:

• Revenue: 49%.

• EBITDA: 77%.

• EBIT: 148%.

• Book value: 77%.

Pretty steady growth all around, but then again, the most recent quarter showed significant deceleration from these levels.

Then we have profitability. As we saw in the Q2 release, Tesla’s margins are trending downward. However, even before the release came out, they were not particularly high by the standards of a tech company. As Seeking Alpha Quant reports, they were:

• 23.13% gross margin.

• 14.8% EBIT margin.

• 13.7% net margin.

• 2.85% FCF margin.

The company is certainly profitable, but not gushing with margin.

Next up, we have valuation. At the close today, Tesla stock traded at about $291. It had the following diluted EPS, adjusted diluted EPS and free cash flow per share figures (the EPS figures taken directly from Tesla’s release, the free cash flow numbers converted by the author using 3.468 billion outstanding shares):

	Q3 2022	Q4 2022	Q1 2023	Q2 2023	TTM amount
GAAP EPS	$0.95	$1.07	$0.73	$0.78	$3.53
ADJ EPS	$1.05	$1.19	$0.85	$0.91	$4
FCF	$3.3B	$1.42B	$441M	$1.005B	$6.166B
FCF PER SHARE	$0.95	$0.41	$0.127	$0.29	$1.777

Click to enlarge

From these figures at the $294 stock price, we get these multiples:

• P/E (GAAP): $82.43.

• P/E (adjusted): 72.75

• Price/free cash flow: 163.

These multiples suggest that Tesla is more expensive than the NASDAQ 100-Index (NDX), the most followed tech barometer. According to the Wall Street Journal, that index has a 32 P/E. So, Tesla is more richly valued than its peers. On the other hand, its top line growth is above-average for the peer group, but with margins decreasing, it’s hard to say that growth is strong overall.

The Bottom Line

The bottom line on Tesla is that we saw little in its second quarter release to suggest that it is worthless. The company is profitable, and does have positive free cash flow. But at the same time, there is little to suggest that the company’s fundamentals justify its current stock price. You need to believe that Tesla will keep growing rapidly well into the future in order to justify the investment today.

Potentially, Tesla could deliver all that priced-in growth. But it will need a differentiator for that to occur. If you’re buying Tesla, Inc. stock now, you’re effectively betting that FSD, or the charging network, will lock in a moat for the company that it doesn’t currently have. Personally, I’m sitting this round out.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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