Tesla, Inc.’s (NASDAQ:TSLA) weak performance in Q3 indicates that the company is no longer a no-brainer investment in the current environment, which is full of macroeconomic and geopolitical risks that have already begun to negatively affect the company’s business in different markets. Even though Tesla’s CEO Elon Musk tried to soften the blow by stating that they’re on track to reach the delivery target for FY23, it’s still safe to say that it will become significantly harder for the company to please the market given all the challenges that it faces.
Not only could the contraction of Tesla’s margins continue due to the rise of competition and the ongoing electric vehicle (“EV”) price war, but the company could also become one of the biggest casualties of a potential Sino-American confrontation, which would limit its upside in the long run. As such, it seems that CEO Elon Musk has an unsolvable problem on his hands at the moment, and there are reasons to believe that the geopolitical factors would only make the situation worse in the following years.
Tesla’s Margins Are Under A Threat Of Further Contraction
Earlier this month Tesla reported its Q3 earnings results. Even though its revenues during the period increased by 8.9% Y/Y to $23.35 billion, they were still below the street estimates by $790 million. At the same time, Tesla’s non-GAAP EPS stood at $0.66, below the estimates by $0.07.
Going forward, it would become harder for Tesla to aggressively scale its business and improve its bottom line performance at the same time. Even though Elon Musk stated during the latest conference call that the company is still on track to deliver 1.8 million vehicles this year – even though the deliveries declined Q/Q in Q3 – there’s still a risk that its margins will continue to deteriorate in the foreseeable future.
This is due to the ongoing price war in the EV industry, which already negatively affected dozens if not hundreds of automakers such as Mercedes and NIO (NIO). Tesla’s business has also been affected by this price war, as its operating margin in Q3 came in at 7.6%, down from 9.6% in Q2, and down from 17.2% a year ago. Its GAAP gross margin of 17.9% in Q3 was also down from 25.1% a year ago and down from 18.2% last quarter.
What’s more, is that the contraction of margins came at precisely the wrong time, as Tesla is currently in the middle of starting the deliveries of Cybertruck in late November. The issue here is that the scaling of the production of Tesla’s latest pickup truck will take time and much-needed resources until it starts to generate a positive cash flow. Elon Musk noted during a recent call that it could take 12 to 18 months until Cybertruck starts to generate returns.
Considering this, it’s safe to say that the contraction of margins is likely to continue in the following quarters and would certainly prompt investors to lower their bottom-line performance estimates, especially if the ongoing DOJ investigation results in a material adverse impact on Tesla’s business.
Additional Risks To Consider
In addition to the potential further margin contraction in the future, there are also additional major risks that could limit Tesla’s upside in the foreseeable future. One of those risks is a potential further hike of interest rates by the Federal Reserve. In a recent conference call, Elon Musk spent some time explaining how the rising rates that could stay higher for longer would have a major negative impact on the ability of consumers to purchase new vehicles. Considering that inflation has been on the rise in the last couple of months while the U.S. GDP growth rate exceeded expectations in Q3, there’s a possibility that the Federal Reserve will decide to stick with its hawkish monetary policy for a while. If that’s the case, then Tesla would certainly be negatively affected by this.
What’s more, is that the rising geopolitical risks could also disrupt Tesla’s operations in the foreseeable future. Let’s not forget that the Sino-American trade war which started back in 2018 is not over yet and the worsening of relations between Beijing and Washington won’t help Tesla, which relies on undisrupted globalization, to significantly improve its state of affairs anytime soon. Add to all of this the fact that the European Union is on the brink of starting a trade war with China due to the flood of Chinese-made EVs, which include Tesla‘s Shanghai-made cars, into the European market, and it becomes obvious that the company’s business model is under a threat of further disruption.
While Tesla has been trying to diversify its supply chains to minimize the global risks, it might fail to do so in the end after Elon Musk stated during the latest conference call that they haven’t gone full tilt on the Mexico factory due to the current macroeconomic challenges.
On top of all of that, the increased geopolitical risks could also undermine Tesla’s advanced projects. Let’s not forget that the company’s chips for its Optimus robot and Dojo supercomputer are manufactured by Taiwan Semiconductor (TSM) mostly in Taiwan, while Nvidia’s (NVDA) H100 GPUs that Tesla uses for its AI projects are produced there as well. Elon Musk even began the latest conference call by stating that Tesla recently completed a 10,000 GPU cluster of H100s. Considering that the Biden administration recently tightened the export restrictions of advanced chips into China, there’s a risk that Tesla won’t be able to properly realize its AI and full self-driving ambitions in one of the most important consumer markets in the foreseeable future.
Considering all of those risks that are already limiting or are about to limit Tesla’s upside, it would become much harder for the company’s stock to trade at the current valuation. Let’s not forget that the company’s latest earnings results have already disappointed the market and prompted a massive depreciation of its shares which are now down ~15% in the last couple of weeks. At the same time, Tesla still trades at over 60 times its forward earnings and over 6 times its forward sales. For comparison, the overall sector trades at median forward P/E and forward P/S multiples of 13x and 0.75x, respectively.
Given all the internal, macroeconomic, and geopolitical challenges that Tesla faces, it’s hard to see how it will be able to thrive in the current environment. Even if it continues to scale its production in the following years, it would still be hard to justify its premium valuation in this new environment.
The Bottom Line
While Tesla has been one of the biggest beneficiaries of the zero-interest rate environment and wasn’t affected much by the geopolitical risks in the recent decade, it’s safe to say that it faces an entirely different situation now. Not only do the rising rates make it more costly to access capital, but they also emphasize the importance of the bottom line performance that was mostly ignored during the ZIRP period.
As such, a potential further margin contraction due to the rise of competition and the ongoing price war is certainly going to have a greater negative effect on the performance of Tesla’s business and its shares in the future. The latest depreciation of Tesla’s stock certainly indicates that that’s indeed going to be the case going forward. On top of that, the rise of geopolitical risks in such an environment is likely going to limit Tesla’s upside as well and make investors question its current premium valuation even more in this new reality.
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