Tesla Is Choosing Volume Over Margin

For several years now, Tesla (TSLA -2.02%) has been telling investors it wants to grow vehicle production and deliveries at an average annualized rate of 50%. It’s been doing just that.

But as of late, there’s a catch. The company appears to need to lower vehicle prices in order to keep up its staggering growth rate.

To this end, Tesla revealed in its first-quarter update that deliveries grew rapidly year over year but its profit margin was hit hard as the electric-car company used price cuts to help drive sales growth. Even more, Tesla seems to be communicating to investors that it will continue to prioritize production and delivery volume over profit margin.

Price reductions are hurting profits

Price cuts have been a central theme for Tesla recently, with the company rolling out significant price reductions for its vehicles several times this year. The price cuts have likely left some investors wondering if demand is suffering to the point that the automaker would lower its guidance for full-year vehicle production. Fortunately, Tesla said in its first-quarter update on Wednesday that it still expects to build 1.8 million vehicles this year.

This guidance represents 31% growth over Tesla’s production in 2022. Management’s decision to reaffirm its outlook for such strong growth, despite the current macroeconomic environment, suggests orders for its vehicles remain robust.

But volume growth isn’t translating to a proportionate increase in profits. On the contrary, profit is declining. Tesla’s gross profit margin declined from 29.1% in the year-ago quarter to 19.3%.

Over the same period, its operating margin took a much bigger hit. It declined from 19.2% in the year-ago quarter to 11.4%. Price cuts, therefore, are hurting Tesla’s profitability. Despite 36% year-over-year growth in vehicle deliveries, first-quarter net income declined 24%.

Looking ahead, investors should brace for more of the same. Citing “the current macroeconomic environment,” Tesla said in its first-quarter update that this year presents an opportunity for the company to “leverage [its] position as a cost leader.” In other words, Tesla wants to take advantage of the fact that its scale relative to competition puts it in a good position to lower prices and increase sales, while many other automotive companies’ electric-vehicle programs aren’t yet profitable.

Tesla CEO Elon Musk confirmed the company’s intention to choose volume growth over profit growth in its first-quarter earnings call. “We’ve taken a view that pushing for higher volumes and a larger fleet is the right choice here versus a lower volume and higher margin,” he explained. 

Price cuts may be the best move

While price cuts may hurt profits in the near term, they are likely the right move for Tesla shareholders over the long term. To this end, the company said in its first-quarter update that its “near-term pricing strategy considers a long-term view on per vehicle profitability given the potential lifetime value of a Tesla vehicle through autonomy, supercharging, connectivity and service.” This means that Tesla believes that growing its installed base of vehicles today, even if it has to lower prices to accelerate this growth, will lead to higher profits over the long term.

In addition, Tesla’s explanation for the long-term merit of its current pricing strategy leaves out a few other important benefits. Namely, every incremental sale helps create fans of both Tesla’s brand and electric vehicles, in general.

Some of this evangelism will inevitably lead to incremental future purchases. Historically, demand for Tesla’s vehicles has grown in proportion to the number of vehicles delivered in a given market. Given how different electric vehicles are from gas-powered vehicles and how nascent the market is, every delivery ultimately represents an important touchpoint with consumers — both for the buyer and the passengers who ride in the car during the Tesla vehicle’s lifetime.

To be clear, the near-term sacrifice for a potentially greater long-term outcome is significant and raises some concerns about the stock’s premium valuation. Tesla isn’t forgoing profit growth to increase deliveries. Its profits declined in order for its delivery volume to increase. Tesla management, however, seems confident that near-term sacrifices will pay off over the long haul in greater profits.

Daniel Sparks has no position in any of the stocks mentioned. His clients may own shares of the companies mentioned. The Motley Fool has positions in and recommends Tesla. The Motley Fool has a disclosure policy.