Source: Beast Finance Author: Beast Finance
Summary:
(1) Tesla's (TSLA) Q2 earnings beat expectations, but margins continued to decline and free cash flow was weak, leading investors to think it might be wise to sell Tesla stock to lock in gains.
(2) Tesla's gross margin fell from 25% to 18% in the second quarter despite record deliveries again and revenue growth.
(3) Although Tesla's energy business has performed well, and its energy storage business has grown by 200% year-on-year, this is still not enough to offset the unfavorable factors brought about by the decline in the gross profit margin of its automotive business.
On Wednesday afternoon, Tesla announced its second-quarter earnings. While the company beat expectations in terms of earnings and deliveries, margins continued to shrink and free cash flow was pretty weak. Since its valuation is still very high, we think it is wise to sell Tesla shares to lock in gains.
What happened?
On Wednesday afternoon, Tesla released its second-quarter earnings report. The earnings report showed that Tesla’s earnings and deliveries exceeded expectations. From a quarter-to-quarter perspective, Tesla’s revenue increased by about 7%. Although this is a very meaningful number, it is an annualized increase of about 30%, which means that Tesla will experience slower growth compared to last year. Or to look at it another way, Tesla's growth is slowing (albeit still much faster than traditional automakers).
Margins continue to decline, free cash flow is weak
When we look beyond the headline numbers, there are a few things in Tesla's earnings that don't look good at all. For example, profit margins, Tesla's profit margins have been declining. Tesla bulls have argued in the past that the company has a huge competitive advantage due to Tesla's high profit margins, which has driven its valuation higher than other auto companies. Others who are bullish on Tesla also believe that Tesla's high profit margins are the result of a combination of excellent operating structure and highly advanced production technology. But now these positive factors have either disappeared or have long since ceased to exist. Therefore, Beast Finance believes that Tesla is currently only benefiting from excess demand in the field of electric vehicles.
Over the past few quarters, Tesla's profit margins have only moved in one direction -- down.
We can see from the graph that Tesla's gross profit margin has dropped from 25% to 18% in the second quarter, which means that Tesla's profit margin has suffered a heavy hit of 700 basis points. While the absolute decline in Tesla's operating margin has been relatively small, down just 500 basis points from last year, the decline in relative operating margin has been significant (Tesla's operating margin has fallen 34%). That means Tesla now has to generate 52% more revenue than it did a year ago to generate the same amount of operating profit. This, in turn, explains why Tesla's revenue and deliveries both increased substantially last year, while operating profit declined year-over-year,
While the year-over-year decline in the second quarter was modest, we may see a larger profit decline for Tesla in the second half of the year. Better profits in the second half of 2022 compared to the first half of 2022, which means that for Tesla in the second quarter of 2023, the comparison will become more difficult. Although it is difficult to compare, because Tesla has already seen a profit decline in the second quarter, we believe that there is a very high probability that Tesla's profits will decline in the third quarter or the fourth quarter.
Operating income was also down from the first quarter despite an increase in deliveries. This suggests that Tesla's strategy of lowering car prices in order to sell more cars isn't creating any value for shareholders - while this strategy leads to higher deliveries, it doesn't really help anyone (at least not investors, who should care about profits) when profits are falling.
Although Tesla's balance sheet is very clean, its cash flow situation is not optimistic. Despite much higher profits, the company's free cash flow was just $1 billion in the second quarter and about $1.4 billion in the first half -- an annualized rate of just under $3 billion, which isn't appealing considering Tesla's valuation is well above $900 billion. If the second half of the year is comparable to the first half of this year, then Tesla's free cash flow multiple is 300 times, which we think is very expensive. In other words, investors get a third of a cent in free cash flow for every dollar they put into Tesla stock. Considering that $1 of short-term U.S. Treasury bonds can generate about $0.05 of interest per month, the cash flow yield of Tesla stock is very low.
Of course, there were some positives in Tesla's earnings report. While the solar business is very weak (down 40% year-over-year), another, more important part of Tesla's energy business is doing well. The company deployed 3.7 GWh of storage in the second quarter, an increase of more than 200% year-over-year, which is undoubtedly a very strong growth rate. While revenue growth in the energy business was lower at 74%, it was still very strong in absolute terms. The energy business was profitable on a total cost basis before considering operating expenses, as the segment posted a gross margin of 18% in the second quarter. That's an improvement from the previous quarter, when Tesla Energy's gross margin was 11%.
Unfortunately, the improvement in gross margins in the energy business was not enough to offset the headwinds from the decline in automotive gross margins, which is why Tesla's gross margins have continued to decline, as mentioned earlier. If Tesla can ramp up its energy business at a convincing pace over the next few quarters while improving gross margins over time, that should have a positive impact on Tesla's overall company financial performance.
While the energy business is small right now (about 7% of Tesla's auto revenue), it's a fast-growing business with long-term potential, and there's some uncertainty -- because we don't yet know how big the market will end up being, or which company will win.
Will the new model justify Tesla's valuation?
Tesla has gotten a lot of attention lately due to speculation that a $25,000 model could be built in Mexico, and Tesla produced its first Cybertruck this summer. Although the influence of this model is still open to debate. But it's clear there's a huge addressable market for the $25,000 model, as not many people can (or want) to pay more for an EV, especially in emerging markets.
On the other hand, some emerging markets don't have much charging infrastructure, and $25,000 may still be too high for many consumers around the world. Plus, a $25,000 car likely won't help Tesla's profit margins -- higher-end cars typically have higher margins than lower-end cars. This explains why some of Tesla's competitors, such as Mercedes-Benz, are getting rid of some low-end models to focus on high-end models, as this is how these companies generate higher profits. Mercedes has higher gross margins than Tesla, but it has been moving in the opposite direction of Tesla in focusing on profits rather than sales.
Tesla will probably sell a ton of cars for $25,000 each. However, this does not guarantee that Tesla's profits will improve - after all, we have seen before that sales growth does not translate into profit growth, and may even be accompanied by profit decline (see Tesla's second quarter data).
If the Cybertruck is sold at a higher price, it should generate higher profits. But we still don't know how profitable the car will be for Tesla, because its manufacturing process is very different from Tesla's other models, and there are many consumers who don't like the Cybertruck's exterior design.
Judging by Wall Street forecasts, Tesla's earnings outlook is not optimistic either.
Last quarter, Tesla’s earnings per share were barely revised up, and many analysts cut their estimates due to margin pressure on Tesla. Even the company's revenue forecasts aren't headed in the right direction (EPS is expected to fall by double digits this year), and while Tesla's profits are expected to improve in 2024 and beyond, even if we look at analysts' profit forecasts for Tesla for the next few years, Tesla's stock is still expensive. Tesla, for example, currently trades at 46 times projected 2026 earnings per share -- which is three years away and still yields only 2%.
Conclusion
Although Tesla's second-quarter financial results have exceeded market expectations, the underlying profit margin situation is not optimistic. Free cash flow is also pretty weak, especially compared to its very high market cap.
While Tesla's stock price has seen several big gains this year (congratulations to those who bought the lows), we still don't think Tesla is a good investment at current prices.
And a 300x free cash flow multiple is simply too expensive for an auto company with declining margins and profits, which is why we sold Tesla stock.