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Tesla's Margins Are Poised to Dominate

After reporting a sequential decline in ex-credit margin, Tesla is positioned for rapid margin expansion.
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For the second quarter, Tesla reported a GAAP profit of $104M (granting the company eligibility for inclusion in the S&P 500 index) and announced the selection of Austin, Texas for their next gigafactory. While these pieces of news have captured the headlines, there are many other fascinating details to be unearthed from Tesla's second quarter report. One area unlikely to receive much attention is Tesla’s gross margin performance in Q2.

Heading into the report, analysts were expecting Tesla to report an automotive gross margin excluding regulatory credits of 17.3%. Tesla beat these expectations handedly, posting a margin of 18.7%, a 140 basis point overperformance. However, automotive gross margin excluding credits was down sequentially from Q1’s 20.0%. Investors may not be excited by declining margins, but there are many reasons for optimism being shrouded by the unique conditions of Q2.

With production shut down at Tesla’s largest factory for more than a third of the quarter, and other factories experiencing down time, Tesla was not able to leverage the full scale of their production facilities in the second quarter. On Tesla’s earnings call, CFO Zach Kirkhorn confirmed that inefficiencies from downtime accounted for the entire sequential margin decline.

This revelation carries interesting implications.

First, Tesla dropped prices in Q2 on Model 3, Model S, and Model X in multiple regions. Kirkhorn’s statement implies that under normal circumstances, Tesla would have been able to maintain or grow margins despite these price drops. This suggests a relatively significant decline in Tesla’s marginal production costs. Tesla was not able to capture that benefit due to production downtime.

However, as more normalcy returns to the production schedule in Q3 and Q4, the equation flips. Tesla’s margins will shift from reflecting downtime headwinds to reflecting record production rate tailwinds. This sudden flip may surprise investors looking only at the surface level sequential decline.

Second, Tesla is continuing to experience margin expansion on their new products: Fremont Model Y and Shanghai Model 3. Both products have the potential to exceed Tesla’s current total automotive margin rate. As they become a bigger part of total revenue, they may provide a mix benefit. At minimum, they will improve from their current levels.

Finally, Tesla continues to expect feature expansion on their Full Self-Driving option later this year. As Tesla delivers more features, they can recognize a greater percentage of the revenue from the sale of the option. In addition to allowing recognition of historical deferred revenue, this helps the upfront margin on new sales as well.

Wrapping it up:

With headwinds flipping and joining forces with other tailwinds for the second half of the year, Tesla’s margins look poised for rapid expansion. The efficiencies discussed for gross margin are even further leveraged when considering operating margins.

Considering the other business lines, Tesla is in a similar position with energy products as they ramp Megapack and Solar Roof, and service/other margins have continued to improve sequentially.

Q3 and Q4 may be the first opportunities for Tesla to demonstrate exactly how profitable it can be.

Please share your thoughts in the comments section.


Disclosure: Rob Maurer is long TSLA stock and derivatives.