Tesla Inc. (TSLA, Financial) has always been big on talking about the future. That is unsurprising, given its staggering share price ($335.35 at the close on Jan. 9) and market capitalization of close to $60 billion.
Promises of rapid and profitable future growth is what justifies Tesla’s share price. A cornerstone of that growth narrative is the Model 3 sedan, which is meant to become Tesla’s first truly mass-market product. The tribulations of the Model 3 production ramp were watched closely by the financial media and Wall Street analysts throughout 2018. It proved to be quite a show, which CEO Elon Musk referred to as “production hell” on more than one occasion.
Yet, all the sturm und drang surrounding the Model 3 rollout has served to draw attention away from other aspects of Tesla’s business. Most importantly, it has distracted from what appears to be declining interest in the company’s flagship premium vehicles, the Model S sedan and Model X crossover. These two models carry loftier price-tags than the Model 3 and so contribute significantly more (on a per-vehicle basis) to Tesla’s bottom line. Thus, it is a real problem for the automaker that demand is softening for these vehicles. Let’s discuss.
Tesla claims production constraints
Combined Model S and Model X production was supposed to come in at 100,000 units in 2018. This has become the evident steady-state run-rate for their production lines. Early last year, during the fourth-quarter 2017 earnings call, Musk repeated a claim that Tesla had made a number of times before, namely that Model S and Model X demand far exceeded the 100,000-per-year production. On that call, an analyst asked why Tesla was not investing in expanded production, if indeed these high-margin models were production-constrained. Musk’s answer was telling:
“There have to be investments in new lines or it's going to require overtime, which negatively affects gross margin. Kind of design the manufacturing machines are to create, and then you'd have to redesign the machine or go redline. And so I think we feel pretty good about the 100,000 a year for S and X, and we want to focus on just improving the efficiency of production and gross margin.”
In other words, it would be a hassle to expand production, even though there was plenty of demand to absorb it were Tesla to choose that path. This answer helped to support the narrative that demand was undiminished for Tesla’s two flagship products. Yet, in the year since that call, it has become quite clear that the real problem is softening demand.
Wintertime shows dwindling demand
Despite Musk & Co.’s early 2018 assertion that demand for the Model S and Model X were as strong as ever, the delivery numbers posted throughout the year painted a different picture altogether. Indeed, when Tesla last week reported its fourth-quarter 2018 production and delivery numbers, it showed a significant year-over-year decline hitting its two luxury vehicles. Tesla delivered 27,550 Model S and Model X vehicles during the quarter, thus missing its year-end target by roughly 600 vehicles. Worse still, deliveries in the quarter were down by roughly 900 vehicles compared to the same period in 2017.
The international market proved especially cold toward Tesla this winter. Based on the U.S. delivery estimate published by InsideEVs, which has proven quite accurate in past quarters, deliveries collapsed in Europe. Other independent estimates and channel checks reinforce this negative picture, showing deliveries falling across the continent. The one bright spot in Europe was the Netherlands, with deliveries up by more than 2,000 units compared to fourth-quarter 2017. But this was due to the imminent expiration of a tax credit, which pulled forward Dutch demand. The boost in sales in this country failed to mitigate the global drop in demand.
In the fourth quarter of 2018, things looked especially bleak in Norway. While the Scandinavian nation may not seem like it would be a major market for Tesla, government incentives have made it something of a Mecca for electric vehicles. Tesla enjoyed several years as the sole seller of high-end luxury electric cars, turning Norway into one of the company’s most important international markets. Yet, last quarter Norway showed a drop in demand. The absolute deliveries figure was buoyed slightly by a last-minute fleet sale of 280 vehicles. However, that move is indicative of increasing desperation to move metal, since fleet sales invariably come in at lower margins.
Veering further off course
While admittedly only a week into 2019, the signs of weakening demand for the Model S and Model X have continued to pile up. In Norway, where vehicle delivery data is published daily, we can already see deliveries lagging compared to the start of 2018.
The introduction of competition in the high-end electric vehicle segment late last year has not helped Tesla’s cause. The Jaguar i-Pace, which began deliveries in the fourth quarter of 2018, has received rave reviews and blowout sales, especially in Norway. With the phaseout of the Dutch tax credit, Tesla looks poised for an even harder year in Europe for its two high-value models.
Meanwhile, another crucial international market, China, has also shown signs of severe demand weakness. In the third quarter of 2018, Tesla reported $408 million in revenue from China, down sharply from the $564 million raked in during the third quarter of 2017. That decline occurred before the escalation of the trade war between the U.S. and China. Tesla demand reportedly cratered in the wake of Chinese tariff hikes on imported vehicles. According to one report, sales in China by as much as 70% in October. Tesla has disputed this figure, but has not provided an alternative delivery number. Given the already flagging demand in the third quarter, it is abundantly clear that demand took a bigger hit in the wake of tariffs jacking up prices for would-be buyers.
In the U.S. and globally, Tesla is having trouble selling the Model S and Model X units it continues to build.
Nowhere else but down
Tesla’s oft-repeated claim that the Model S and Model X were production constrained has now been proven definitively false. It is yet another demonstration of Tesla’s tendency for exaggeration and overconfidence. More importantly, the softer demand will impact the automaker’s bottom line. Fleet sales and rental car agreements can move metal, but they will also harm margins. That is something Tesla can hardly afford, given its relatively perilous finances.
Tesla managed to post a blowout profit in the third quarter of 2018, thanks in large part by resorting to a number of unsustainable and unrepeatable tactics. Moves such as stretching payables, slashing capex to the bone, and prioritizing buyers of the highest-margin Model 3 configurations helped pad out the quarter and post a big surprise to the upside, but it may well be as good as it ever gets for Tesla. With the introduction of a cheaper mid-range Model 3 in the fourth quarter of 2018, there was inevitably going to be some margin compression. Higher-margin Model S and Model X sales were critical to Tesla’s profit, so their falling margins will further exacerbate things.
After the third-quarter triumph, Tesla claimed to have turned the corner, promising to deliver sustainable and growing profits from that point on. Given what we know about fourth-quarter deliveries, that promise may have already been broken. Yet, even if Tesla manages to eke out another profit, it will be down sequentially thanks to falling margins and limited growth in total delivery numbers. Then things will likely only get worse in the first quarter of 2019.
Verdict
Overall, the outlook for Tesla is increasingly bleak. Thus far, the market has retained confidence in Musk and his upstart company. A poor (or simply lackluster) financial showing in the fourth quarter will likely shock many of his backers out of their complacency. An even worse first quarter 2019 could precipitate a rout.
At this stage, Tesla is priced for perfection. Yet the real-world data pouring in so far indicates that things are going anything but perfectly. Even if investors do not believe Tesla is on the verge of a severe downward price correction, they would be prudent to be out of this stock. The chance of a fourth-quarter surprise to the upside is perilously small, while the chance for disappointment is palpable.
If you do not have the conviction to go short, that is perfectly understandable. Tesla’s stock has defied gravity for so long, it is hard for many people to fathom the prospect of it finally falling back to earth. This is no easy short. But being long this stock at this stage looks increasingly like dangerous folly.
Disclosure: Short Tesla via long dated put options.
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