Margins are particularly important to the TSLA investment case given they’re at the front line of the investment debate: Is Tesla a car company or a tech company?

As a point of perspective, operating margins for traditional carmakers averaged 8% in the first half of this year, compared to Tesla at 14%. While that 14% number is favorable compared to other car companies, it still lags behind the gold standard of hardware-software margins (that being Apple’s 38% operating margin). Long term, I believe Tesla will expand operating margins to 25% or greater, while I expect traditional carmakers’ margins to compress over the next 10 years as they feel the financial impact of the transition to EVs.

The most important metric on Tesla’s earnings is auto gross margins ex credits. Over the last three quarters, this metric has been declining, going from 24.3% in Dec-22 to 18.1% in Jun-23. The reason has been mostly related to price cuts in the first half of the year. We estimate the average reduction was 11.5% (factoring in vehicle mix). In other words, an 11.5% reduction in price resulted in about a 26% decline in gross profit.

Now the central question is: When do margins stabilize, and, separately, when will they begin to expand?

As for gross margins ex credits for the September quarter, the Street is currently looking for 18.2%. I believe they’ll report between 17.5-17.8%. My sense is the initial stock reaction will be negative on the report but turn positive on the call because of December gross margin commentary (see section below).

Here’s how I got to the September margin targets. During the quarter, there were two headwinds to margins that analysts have likely not factored into the numbers. The biggest factor was that efficiencies declined at Giga Shanghai due to retooling for the upcoming Model 3 Highland launch. As a result, production numbers in the quarter were down 10% compared to the previous June quarter. Second factor was a below-the-fold discount on US cars in inventory that I estimate averaged 4%. This discount was used on likely less than 10k vehicles so the impact to margins was only slightly negative.

While I expect a disappointment in gross margins in the September quarter, I believe earnings call commentary from the company will suggest a slight improvement in margins for December, which will be in line with current analyst expectations of 18.4%.

Here’s how I get to the case that margins will expand in December. There’s one tailwind to margins in December and one notable neutral factor.

Tailwind: I believe Tesla will hit their 1.8M production number for 2023 by producing 475k vehicles in the December quarter, up from 430k in the September, which is up 10% q/q. The increase in demand is primarily related to Model 3 Highland along with a handful of Cybertrucks (less than 5k). This means Gigafactory efficiencies will improve quarter on quarter, which will inch margins up.

Neutral effect:  Last week Tesla lowered their prices in the US by an average of 3.4% across four vehicles (including Model 3 RWD, Model 3 Long Range, Model 3 Performance, and Model Y Performance). Weighting the change by vehicle mix yields an average reduction of 2%. Weighting the change by geography (US is about 50% of revenue) yields an average reduction of 1%. Lower prices pressure margins. That said there is an offset in the December quarter related to Tesla ending its US discounts for cars in inventory, which we estimate averaged about 4%.

The biggest wildcard on Tesla deliveries over the next two years is Cybertruck production rates. It’s been rumored the waiting list for the Cybertruck is close to two million, of which I estimate one million are real buyers over the next three years. This implies about 330k trucks a year, which compares to the best-selling light truck in the US, Ford F-150, which sold just over 600k globally in 2022 (most of which are in the US). Long term I expect Cybertruck to account for about 20-25% of all Tesla deliveries. History would caution us to expect the ramp of Cybertruck to be slower than expected. Current expectations call for initial deliveries this year. I expect that number to be less than 5k in 2023, increasing to 15k in Q1 of 2024.

Another topic to consider is upcoming changes to EV tax credits. Rob Maurer from Tesla Daily flagged upcoming changes that included a tax credit headwind and tailwind. As for the headwind, he expects the credit to be reduced by about half (going from $7,500 to $3,750) early in 2024. This will have the effect of increasing the car by an average of 6%. As for the tailwind, it’s looking like the IRS will allow the tax credit to be realized immediately and applied to the purchase price. Today, EV buyers have to wait about a year before they get their tax credit, and only buyers that have a tax liability are eligible for the tax credit. This will have the effect of making the tax credit easier to use.

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