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Gross Margin Of The Tesla Model 3 In Q3 2019

|About: Tesla, Inc. (TSLA)
Summary

In the second quarter of 2019 the gross margin on the model 3 was probably less than 4%, at least in the US.

In the third quarter Tesla lowered its prices again, and hence I expect gross margins to decline further.

It will be increasingly difficult to produce the model 3 because the profit margin cannot support capex for maintenance of the factory.

Below you will find a discussion of the gross margin on Tesla Model 3 cars. I will then give my opinion on the stock.

Back in 2018 Tesla (TSLA) said gross margins on its cars would be over 20%. In the first quarter of 2019 gross profit on cars was indeed 22.8%. This number includes also sales of the more expensive model S and X. These 2 cars are much more expensive than the model 3 and almost certainly have higher gross margins. So I think the gross margin on the Model 3 was at most 20% during the first quarter of 2019.

In the first quarter of 2019 the company started selling the short range version of the model 3 in the US but did not sell many of these cars. Therefore I do not think it had a big effect on the gross margin on its cars. Also in the first quarter of 2019 the company started selling the model 3 in Europe and China. Like it did in the US in the second half of 2018 it sold the versions with the highest margins first. In the second quarter of 2019 demand for these more expensive versions of the model 3 probably got saturated so instead the company introduced the short range also outside the US.

Within the US average selling prices of the model 3 declined from $57.2k in Q1 to $50.4 in Q2 2019, according to Mark Johnston. So that is a decline of 11.9%.

If previously the gross margin was a factor M_old and prices declined with a factor d what would be the new gross margin? From elementary calculus it follows:

M_new = M_old -d -M_old*d

So in this case the new gross margin would be 0.2 -0.119 -0.2*0.119 = 0.0572 = 5.7%

Another factor in this gross margin discussion is accounting for returned cars. Many people started lawsuits to return their Tesla lemon. Many of these cars were model 3s. These stories and lawsuits are not just anecdotal: CNBC has published many stories on production issues in the Tesla factories including this recent story. Tesla seems give priority to making certain minimum production numbers over quality of the produced cars.

In Norway it has been reported almost 2% of the model 3 cars was returned and then deregistered. Unfortunately I could not find the tweet in which this was reported. I suppose these cars were returned for their abdominal quality and Tesla scrapped them. The effect of these returned cars is of course a lower gross margin. From elementary calculus it follows that to get the new gross margin we just can subtract the percentage of returned cars from the gross margin percentage. So taking returned cars into account the gross margin is 3.7%.

In the current quarter Tesla already decreased prices once. Even the cheapest version of the model 3 has got  $1000 cheaper. Price decreases for luxury versions of the model 3 were even higher. I do not know the product mix but my gut feeling says on average model 3 prices have been decreased with 3% already this quarter. After applying the formula above it follows the new gross margin will be 0.59%.

Bottom line

I do not see how Tesla can make a profit on the model 3 with such a low gross margin: only 300 bucks per car! Last quarter the company spent $700 million on Selling, General and Administrative. Let's assume $500 million was related to the model 3. Then Tesla has to produce more than 1.5 million model 3 cars per quarter to offset just these costs! No way Tesla has this kind of production capacity. And then I have not even mentioned costs for paying interest and capex to maintain the factories. I estimate these costs at at least $200 million per quarter. Tesla will have to produce over 2.3 million model 3 cars per quarter to cover these costs as well.

Moreover the product mix will continue to worsen going forward and that means gross margins will further erode and probably turn negative. I also suspect Tesla underreserves for warranty, especially on the model 3. So the gross margin on the model 3 might already be negative.

Free cash flow could be a reason to continue production of model 3. Depreciation and amortization was $468 million last quarter. I estimate at least $200 million of that is needed to maintain the factories and for interest payments. Note that if the company sells 100,000 model 3 they generate a gross profit of only $30 million. Clearly, profits from the model 3 do not cover the costs for maintaining the factories. So it will be increasingly difficult to produce model 3 since Tesla will need to find other funding for the maintenance capex.

Also I suspect part of the overhead costs are in reality variable costs. Tesla hides these costs in S, G & A to support the story that the company will be profitable if it manages to sell enough cars. Maybe real gross margins have been negative already from the beginning.

For the second quarter Tesla might still report $200-300 million of free cash flow. However I do not expect this to continue in the third quarter because of lower prices and lower demand from increased competition and a damaged brand. Free cash flow will turn negative then.

I suppose Tesla will have no other choice than to stop production, in particular of model 3. If they have not done this already I guess current production is still to maintain the growth story and pump the stock. That is indeed something the company has been successful in with a stellar stock valuation as a result. But since it gets difficult to maintain the growth story I expect the stock to go down again. Therefore I recommend shorting the shares and selling the shares if you still own them.

Disclosure: I am/we are short TSLA.