Tesla: The Ball Is In Its Court
Contributor since 2013 / 2580 Followers
Summary:
- There might not be a widespread market for electric vehicles at current MSRPs.
- Tesla, Inc. could possibly have to recalibrate its short-term production targets.
- For now, it is utilizing price cuts to solve the demand problem.
- We are Reiterating our Buy Rating and $802/share Price Target for Tesla stock.
Xiaolu Chu
The Environmental Protection Agency’s (EPA) recent directive proposing pollution control guidelines that would lead to rapid electrification of the automobile industry would clear Tesla, Inc.’s (NASDAQ:TSLA) path towards eventually becoming the world’s largest car company. The EPA guidelines would reflect in EVs capturing between 54% to 60% of the automobile market by 2030 and between 64% and 67% by 2032. The legislation is highly supportive of TSLA’s plans to ramp production to 20 million cars/year by 2030. It is important to note that General Motors Company (GM) delivered 2.27 million cars in 2022, Toyota Motor Corporation (TM) 2.11 million, and Ford Motor Company (F) 1.84 million.
Last Wednesday, Tesla reported mixed 1Q23 financial results. Although on a year-over-year basis, revenues expanded 24% and deliveries by 36%, the surplus was not reflected in gross margins, operating margins, and net income, which declined by 977 bps, 779 bps, and 24%. The shortfalls were driven primarily by the price cuts on TSLA’s EVs that unfolded during the period, but acerbated by underutilization of production capacities at the Texas and Berlin plants, and still relatively high prices associated with car components and logistics. The key takeaways from the quarter were that TSLA views lower prices as a solution for flagging demand due to weakening economies and high interest rates, and expects to maintain its stated production targets, irrespective of challenging market conditions.
Maybe customer demand for EVs at current MSRP’s is inconsistent with TSLA’s near-term production projections. They might have to recalibrate manufacturing capacity. For now, the company appears to be taking an alternate route. Their strategy likely is to lower EV prices rapidly to achieve price parity with Internal Combustible Engine (ICE) cars. That approach appears savvy on multiple levels. Given that ICE vehicles which still account for 94% of the automobile market are TSLA’s predominant competition, it makes sense to lower prices of Tesla’s to render them competitive with ICE cars. In addition, the policy to deep discount cars deals a blow to challengers as their EV profit margins remain poor. Ultimately, losing a sale of a Tesla due to affordability is more damaging to the company than losing a fraction of profit margin. Therefore, we support TSLA’s approach towards price cuts.
Over upcoming quarters, considering the ongoing price cuts strategy, we expect TSLA to experience market leading sales growth on a year-over-year basis. However, investors should calibrate sales growth expectations, as based on Federal Reserve Economic Data (FRED), automobile sales growth declined during February and March on a year-over-year basis. Nevertheless, compared to our more muted expectations for sales growth, we anticipate margin improvement on a quarter-over-quarter basis, driven by capacity expansion at the Texas and Berlin Gigafactories, lower commodity costs as disinflationary trends associated with key components begin to reflect at company levels, and decrease in SG&A and R&D spending, as the firm attempts to offset the deleveraging effect of softer revenue growth, on the bottom line. Overall, contrary to Wall Street expectations, of a decline in earnings, we anticipate growth in profits and free cash flows, on still significant sales growth and margin expansion.
Over the long term, with the secular demand side dynamics cleared by the EPA, the ball is in Tesla’s court. The runway is clear. TSLA simply has to deliver on its implied promise of becoming the world’s largest automobile company. Based on factors described below, we believe they will come through.
Price Cuts. Contrary to its history, TSLA has enacted several price cuts, since last October, beginning with deep discounting in China. The strategy is Marketing 101. Leading companies typically utilize price cuts when new entrants flood the industry with their products. Ford, in its hey days deployed a combination of production efficiency and cost containment to drive down the price of its Model T to $290 in 1924 from $850 in 1908. TSLA is utilizing vertical integration, design innovation, elimination of the use of expensive rare earths, and lower labor efforts/car to reduce costs and cut prices. Given its significant margins, TSLA is likely to further discount its cars, whenever the company believes its demand waitlist is shrinking.
The price cuts are an excellent tool for TSLA to evaluate customer demand for its cars, at lower price points. Further, losing a couple of thousand in margin, when the firm can earn much more by selling more cars, appears prudent. Ultimately, it is absolute profit, not margins that matter. During 2023, TSLA plans on delivering ~500,000 additional cars compared to the previous year’s ~1.37 million. In addition, as the company scales production substantially every year, towards its path to 20 million cars/year by 2030, the market is going to become inundated by Teslas. As a product becomes more readily available, its price falls. That is Economics 101. Given these dynamics, we expect TSLA to continue to discount its cars as production increases.
Production. To dramatically ramp production of its cars, TSLA has indicated that it anticipates to gradually build eight additional Gigafactories. Currently, its EVs are manufactured at its plants in California, Texas, Berlin, and Shanghai, with production capacities of 550,000, >250,000, >250,000, and >750,000. In addition, at its Investor Day, the firm announced that it plans to break ground later this year on a Gigafactory, in Monterrey, Mexico, where it expects to manufacture its next generation cars.
Competition. Compared to TSLA, the peer group has significant problems. Their production capacities are relatively limited with: Ford anticipating delivering 600,000 EVs over 2023 and 2,000,000 by 2026, General Motors 1,000,000 by 2025, and Stellantis N.V. (STLA) 6,000,000 through 2030. Considering that based on the recent EPA directive, customer demand for EVs is likely to skyrocket over upcoming years, the firms might expand their production plans. However, given TSLA’s standard response to production increases at the rivals, is price cuts, the competition is likely to encounter a tight market.
In that regard, it is noteworthy that although the challengers introduced EVs with MSRPs below that of Teslas, TSLA remains the largest seller of EVs, on the planet, by a wide margin. Our argument is that TSLA is likely to discount its EVs to a point where it believes its cars represent the most reasonably priced product in the market, in terms of value for money. Net-net, the peer group is likely to find it difficult to deploy price as leverage to ignite demand. In addition, given that profit margins on the competition’s EVs are significantly below that associated with Teslas, engaging in price wars with TSLA, is likely to be counterproductive.
Overall, considering production challenges, low profit margins, and the EPA on their heels, with mandates for EVs and against ICE cars, the competition appears struggling in regards to their EV objectives, ensuring TSLA’s continued dominance of the industry.
Customer Demand. According to research conducted by TSLA, consumer demand for Teslas increases substantially, for every $1,000 reduction in price/car. Case in point, during 1Q23, Tesla deliveries increased by 4% on a quarter-over-quarter basis and by 36% on a year-over-year basis, likely driven by the deep discounting on Teslas that unfolded in the U.S., Europe, China, Australia, South Korea, and other geographies, over the period. Considering that economies across the globe are suffering with increasing inflation and advancing interest rates, TSLA’s deliveries likely would have underperformed, had the timely price cuts not been implemented. Therefore, we believe that affordability rather than desirability is a key gating factor limiting sales of Teslas.
As price cuts continue to be rolled out, a market will develop for hundreds of thousands of additional Teslas, the firm plans to produce, every year. Further, as customers digest the recent EPA guidelines, they are more likely to decide in favor of an EV rather than an ICE car as their next automobile purchase. Considering that TSLA plans on overwhelming the EV market with its reasonably priced cars, the probability that a purchaser will select a Tesla appears high. Cumulatively, a combination of factors, including superb design, excellent quality, solid performance, value for money, and EPA guidelines are likely to propel customer demand for the ever increasing Teslas slated to be rolled out as the decade progresses.
Considering our Bull Thesis described above, we are confident that TSLA will achieve the growth objectives we have indicated in our initiation report on the company. Therefore, we are reiterating our Buy Rating and Price Target of $802/share for TSLA.
Bottom Line
Tesla short sellers had hoped the competition would fix CEO Elon Musk and his company. Instead, through recent maneuvers, Tesla has fixed the competition. With ever-unfolding production delays, ever-dwindling profit margins, and ever-deteriorating market appeal associated with their EV business, the peer group appears hamstrung. What are they going to do to achieve their announced objective of usurping TSLA’s world’s largest and most profitable EV manufacturer mantle. From our vantage point, their options appear limited, as driven by government regulation, the rivals are forced to swap production of their high margin ICE cars for low margin EVs. The legend of how Tesla, Inc. came from nowhere and outplayed the largest automobile manufacturers with their deep pockets and market hegemony, to establish itself as the world’s largest car producer, once electrification of the industry is done and dusted, will be one for the history books.
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