Tesla says price drops are long-term thinking, but it’s really about demand

Tesla has just released its Q1 2023 earnings report amidst several price drops since the beginning of the year. This left investors questioning how these drops would affect margins, and Tesla has an explanation, but it’s perhaps only a partial one.

In a nod to the question on everyone’s lips, Tesla’s earnings report starts off immediately with a couple of paragraphs intended to address the effect of these price drops on its industry-high margins.

In the current macroeconomic environment, we see this year as a unique opportunity for Tesla. As many carmakers are working through challenges with the unit economics of their EV programs, we aim to leverage our position as a cost leader. We are focused on rapidly growing production, investments in autonomy and vehicle software, and remaining on track with our growth investments.

Although we implemented price reductions on many vehicle models across regions in the first quarter, our operating margins reduced at a manageable rate. We expect ongoing cost reduction of our vehicles, including improved production efficiency at our newest factories and lower logistics costs, and remain focused on operating leverage as we scale.

Tesla is pointing out that since its EV volume is so drastically higher than every other automaker’s, it can build cars at a lower cost than the competition.

And indeed, after yesterday’s price drops and other even larger price drops earlier this year, Tesla has gone from being near the top of the EV price range to near the bottom. Last year, Tesla repeatedly hiked prices while the industry faced supply challenges and EV demand well exceeded supply.

After tax credits, the base Model Y is now under $40k, while many electric SUVs have higher starting prices. And the base Model 3 is now available for $40k before credits are taken into account, though it now only qualifies for $3,750 due to the IRS’ new battery guidelines.

Tesla points out that these cuts reduced its margins but says that this margin reduction happened at a “manageable rate.” In Q1 last year, Tesla’s operating margin was 19.2%, and this year it’s 11.4%, a drop of 779 basis points.

This is a big chunk, cutting operating margins almost in half – and note that there have been further price cuts, both in the US and elsewhere, since the end of the quarter. So we could expect average selling prices to go down further in next quarter’s earnings and perhaps another cut to margins.

That said, Tesla is still planning to grow production at a CAGR of 50%, guiding for 1.8 million deliveries next year (about 31% growth from last year’s 1.37 million production). Tesla says it would rather focus on high volume and lower margins.

And it should be noted that higher volume also displaces more gas vehicles, which is better for the environment and public health.

There are other reasons for these price drops. For one, costs have come down, particularly with a massive global drop in the costs of resources like lithium after last year’s massive global spike. Also, as Tesla CEO Elon Musk has pointed out, rising interest rates have made it more expensive to get a loan on a car, which means Tesla has had to lower prices to make purchases seem more attractive (this is a case study in how rising interest rates can lower inflation).

But Tesla claims these margin cuts are manageable, and not only that, the company is taking a long-term view:

Our near-term pricing strategy considers a long-term view on per vehicle profitability given the potential lifetime value of a Tesla vehicle through autonomy, supercharging, connectivity and service. We expect that our product pricing will continue to evolve, upwards or downwards, depending on a number of factors.

Here, Tesla says that despite the vast majority of its revenue coming from sales of cars – in Q1, $19.9b came from cars and only $3.3b came from energy, services, and other – it feels confident that any losses in automotive sales revenue will be made up for in the long term by these other revenue categories.

Tesla currently sells access to its FSD Beta software for an eye-watering $15,000. This is an enormous chunk of change, particularly for a car that sells for $40k new. Tesla CEO Elon Musk has claimed that FSD has enormous value, though most who have used it recognize that it’s definitely not ready for primetime yet. Perhaps this is why timelines for its rollout keep getting pushed back. (Is it next year yet?)

Tesla also mentions Supercharging as a potential revenue center. Right now, Tesla doesn’t make a lot of money on Supercharging, but that may change very soon, as the company has started opening up Superchargers to other brands. Tesla used this opportunity to establish the “North American Charging Standard” using its connector, claiming that, since its connector is on the majority of cars and DC chargers in North America, other automakers should follow Tesla’s lead and use its plug.

This also opens the company up to the availability of billions of federal dollars earmarked for charger installation but which can only be used on chargers that are open to multiple brands of car. Until recently, only Teslas could use Superchargers, but now that they’re open to other cars, Tesla can presumably angle for some of those billions.

Finally, Tesla says that service could be a profit center, a big change from Musk’s original philosophy on the topic. Here’s a video from Tesla’s 2013 shareholder meeting, timestamped to 1:36 when his answer on service begins:

“Our philosophy with respect to service is not to make a profit on service. I think it’s terrible to make a profit on service.”

Clearly, things have changed since then, and Tesla is much larger and has different goals and considerations now than before. But in the context of discussing auto dealerships, with which Tesla is still in a battle, one would think that this overarching “philosophy” would not have changed with transient business conditions.

Nevertheless, this is one way in which Tesla could conceivably offer reduced upfront prices, with the hopes that the continual business of servicing vehicles in the field would help to shore up margins. Most other automakers don’t have this option since they don’t own their dealerships, but Tesla does, which gives it the flexibility to capture this portion of revenue. It sounds like the company now explicitly intends to seek this revenue after originally promising not to.

Electrek’s Take

But there’s another reason that Tesla doesn’t mention in its report: demand.

I know; we’ve heard it before. For the last decade, other automakers, media, incumbent industry, oil companies, captured regulators, and so on have all said that there just isn’t enough EV demand. We’ve called them wrong every time, and they’ve been wrong every time.

But specifically, here, we’re talking about demand solely for Tesla, after the huge price hikes that the company engaged in over the course of 2021 and 2022 and amid questionable public behavior by the CEO.

At the time when Tesla was raising prices, EV demand was very high, and EV supply was very low. This gave Tesla, the company with the most EV supply, significant pricing power.

Now, we still have high global EV demand, with many other brands selling out vehicles while gas cars go unsold. But in the US, we have an ever-changing tax credit environment, with some new rules going into place yesterday. This means there’s a lot of shifting happening in the industry, and it’s hard to predict which models will have the most demand as only some qualify for the tax credit (however, you can bypass most restrictions by leasing).

And while Tesla is mostly on the good side of this – its cars are now much lower in price, and most of them qualify for credits – it also has a ton of supply, is continuing to ramp quickly, and may be alienating potential customers.

Anecdotally (and in data), CEO Musk’s recent behavior related to the Twitter “dumpster fire” he keeps burning his money in has affected the company’s reputation. Musk says that TSLA shareholders will benefit in the long term from all the irrelevant nonsense he’s very publicly getting himself into, but we are not convinced.

So between high prices, erratic behavior from the CEO, and availability of other EV models, customers have perhaps looked elsewhere over the last year. As a result, Tesla’s inventory started to grow in a way that the company hasn’t ever really dealt with before, and it had to start pulling demand levers. It first did this with incentives, but this year has focused instead on large price drops.

Those price drops will definitely be able to bring some customers back, but it remains to be seen if some customers were permanently turned off by the high-profile behavior of the CEO.

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