Tesla's Perplexing Pricing

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About: Tesla, Inc. (TSLA)
by: Numbers Nerd
Summary

Tesla reduced the prices of their cars $1,100.

It was the second price drop in the past 45 days.

Timing points to a demand issue.

Let me get one thing out in the open from the start, I am long Tesla (TSLA) both financially and in their mission. I freely admit that I look for the positive spin on news, but I am also a realist. I often get frustrated when Tesla bears come up with contrived theories about news that typically has a simple explanation (although a pro-Tesla explanation), so I try to avoid doing that myself. With that in mind, I believe the recent price drop on the Model 3 signals to a demand issue in the US.

The Facts

  • On January 1st, the federal tax credit for Tesla vehicles dropped by $3,750
  • In response, Tesla reduced the price of its vehicles across the board by $2,000
  • Tesla announced the ending of their referral program, citing the high cost that it added to the Model 3
  • On February 5th, Tesla reduced the price of Model 3s in the US by another $1,100, claiming the difference was the savings from ending the referral program

The Numbers

Around October 19th, Tesla opened up all Model 3 variants to the referral bonuses. Given that many of the orders for cars delivered after October 19th had already been made, I think it is fair to assume 2/3rds of the 63,150 Q4 Model 3 sales were open for referral bonuses. That gives us a ballpark Q4 estimate of the referral impact of 63,150 * 2/3 * $1,100 = $46.3 million.

In another Seeking Alpha article, WY Capital examines the GAAP profit after removing regulatory credit sales and non-recurring items and noted that Q3 had a profit of 122.6 million, while Q4 (with higher sales) had a lower profit of $98.0 million. If we include the $46.3 million in the Q4 number, then the profits look more in line with their respective revenue amounts, as the Q4 value increased to $144.3, a 17% increase in profit.

The Margin

In both Q3 and Q4, Tesla reported M3 gross margins right at 20%. This would indicate that the M3 process became more efficient (which is evident in the higher production numbers) roughly to the tune of $1,100 per car. Following that logic, we can estimate what the effect on M3 gross margin will be (assumptions are ballpark and just meant to illustrate margin impact)

Q4 ASP $57,000

Q4 COGS $57,000 * .8 (20% margin) = $45,600

Eliminate the referral program and the new COGS drops from $45,600 to $44,500

Reduce prices by $1,100 and the ASP drops from $57,000 to $55,900

That puts the gross margin at 1 - (45,600/59,900) = 20.4%. Essentially, Tesla is keeping the margin the same as before.

The Problem

Up until this point, everything is still neutral for me. There should be no impact to the gross margins, there isn't any hidden boogeymen in the Q4 profit numbers, and the cars are more affordable and can reach a slightly larger market now. So what is my problem? The timing of the price drop doesn't make sense to me on two fronts.

First, in the 3rd quarter update, Tesla stated:

We continue to target a 25% gross margin ex-ZEV credits on Model 3.

They are currently short of that target. With that being the case, why not allow the $1,100 to push your gross margin up to 21.9%? I can understand passing efficiencies off to your customers once you hit your goal, but believe it is important to first stabilize your business.

Second, there is a known price increase in the near future. On July 1st, Tesla customers lose another $1,875 worth of federal tax credits (and another $1,875 on January 1st, 2020). For a vast percentage of Tesla buyers, this is effectively a $1,875 price increase. Why wouldn't Tesla wait until July 1st to announce this price reduction to offset a majority of that price increase?

The Potential Reasons

The one rosy reason that I could come up with for the timing of the price reduction is the US delivery gap. InsideEV's monthly sales scorecard had 6,500 Model 3s being sold in the US in January. During the 4Q earnings call, Elon Musk stated that all M3 production was for EU and China, leaving nothing for the US market. The 6,500 sales would represent the remaining M3s in transit and the rest of the available US M3 inventory as of year-end 2018. Additionally, reports from Twitter and Reddit have shown that customers currently ordering a Model 3 in the US are being told deliveries would happen in March.

This is in line with Tesla's methodology of producing EU/China cars in the first two months, and saving US production for the back half of the quarter. This allows Tesla to deliver the maximum number of cars per quarter with as little inventory and in transit as possible.

All this points to a 1 to 1.5-month gap between customers who bought 2018 produced inventory Model 3 in January, and 2019 produced Model 3 sales later in March. Having this gap could be seen by Tesla as a good time to implement a price change strategy, as it will leave fewer buyers upset than waiting a few days would have resulted in a $1,100 savings. Instead, those buyers who got the more expensive M3s are getting their cars months in advance.

Having written all of that, I don't believe it is motivation enough to counteract the two timing issues I highlighted above. Without being able to think of another viable alternative, I have to fall back on the theory that Tesla is trying to increase demand in the US. As Tesla further ramps up their production capabilities, they will need to make sure demand doesn't flag in their largest market. Price reductions is one demand lever that they can pull.

The news isn't all bad though, as signs still point to strong demand in the EU. Tesla has yet to open up RWD and MR orders for the EU, indicating that demand for the higher cost models is still enough to support production. I expect Tesla to open up those configurations once they are about 2 months out from fulfilling the current demand.

But for Tesla's shipping strategy to work, there still needs to be a level of local US demand to absorb 1/3rd or more of their production capabilities each quarter. I sincerely hope that I am wrong on this front, but in the absence of perfect information, I have to believe the simplest logic to explain the action.

Disclosure: I am/we are long TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.