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Tesla (NASDAQ:TSLA) posted a sequential decline in delivery volumes during the second quarter as expected from the three-week COVID-induced lockdown at its critical Shanghai manufacturing plant earlier in the period. The electric vehicle (“EV”) market leader produced 258,580 vehicles (+25% y/y; -15% q/q) in the second quarter and delivered 254,695 vehicles (+27% y/y; -18% q/q). The results “snapped a two-year streak of quarter-on-quarter gains”, while also falling short of consensus estimates on deliveries of about 261,000 vehicles (+30% y/y; -16% q/q), which had already been previously adjusted downwards from 279,000 vehicles (+39% y/y; -10% q/q).
Although the results drew focus on the extent of impact endured by Tesla during the three-week production halt in April at its Shanghai plant, it also brought to light again the EV titan’s ability in ramping up productions at unprecedented speeds, which CEO Elon Musk had repeatedly chimed:
Our growth rates are faster than any large manufacturer production in the history of the earth…We’re faster than the Model T.
However, paired with increasing investors’ angst over a looming recession, Tesla shares fell deeper in after-hours trading following the release of second quarter delivery results. The stock has now dipped to levels close to its 52-week low, closing off the second quarter in the mid-$600 range as the broader market suffers from the worst first half performance in decades.
In a previous coverage, we had anticipated better entry opportunities in the near term for Tesla due to volatility induced by ongoing supply chain snarls and souring economic sentiment. Our view remains unchanged, despite positive prospects for longer-term upside opportunities still, buoyed by Tesla’s sustained competitive advantages that include robust cash generation and long-term supply agreements, as well as temporary valuation boosters like its potential three-for-one stock split coming August.
Investors’ angst has been gradually increasing amidst growing signs of earnings erosion observed across Tesla’s consumer sector peers, as well as looming recession risks ahead of another round of aggressive central bank rate hikes later this month. Volatility is expected to remain a prominent near-term theme for the EV stock, causing it to potentially trend lower especially over coming weeks as market participants await the release of Tesla’s progress on gross margins. Meanwhile, second half production and delivery performance will be a critical determinant for the stock’s eventual turnaround. Here are five factors to consider in the near term before buying the dip on Tesla:
1. Macroeconomic Headwinds
Tesla’s margin performance will be a key focus area for investors at its upcoming earnings release. Market participants are now bracing for another wave of selloffs spurred by eroding growth and earnings through the remainder of the year, as input costs remain elevated while consumer sentiment begins to dwindle.
The latest economic data showed American consumer spending declined for the first time this year in May, an implication that rising input costs are finally catching up to what the Fed had previously alluded to as still a “strong economy” to cushion impacts of aggressive monetary policy tightening. Household sentiment is also “trending at record lows, with recession fears growing as the labour market shows early signs of softening”.
Purchases in May decreased by 0.4% from the preceding month. However, there are also signs that inflationary pressures may be peaking, with the May personal consumption expenditure (“PCE”) index posting a smaller-than-expected increase of 0.6% from April and 6.3% from the prior year. Core PCE, which strips the impact of highly volatile food and energy prices, increased by 4.7% in May from the prior year, the smallest incremental gain since November.
While consumer price increases are showing signs of deceleration, and demand is slowing as the Federal Reserve had hoped for, inflation is still far from the central bank’s 2% target, meaning more aggressive policy tightening in the near-term – even if it means a recession. Paired with early signs of margin erosion reported in the first quarter by retail giants Target (TGT) and Walmart (WMT), which appears to be worsening across the consumer sector per the latest earnings shortfalls reported by home furnishing retailers RH (RH) and Bed Bath & Beyond (BBBY), the metric alongside top line growth will be a key focus area this quarter across the broader consumer sector, which includes Tesla.
2. Shanghai Ramping Back Up to Pace
While earlier lockdowns in Shanghai had cost Tesla lost productions estimated at approximately 40,000 vehicles during the second quarter, actual delivery results released over the weekend indicate tremendous production improvement since the phased reopening of its facility in late April. The EV maker’s Shanghai facility had been “producing vehicles at a rate of 17,000 units a week since the middle part of June”, which corroborates its statement that “June 2022 was the highest vehicle production month in Tesla’s history”.
Looking ahead, Tesla aims to ramp up its Shanghai facility’s output to 22,000 vehicles per week by August following the completion of the scheduled upgrades that will occur over phases through July. This would mark a strategic catch-up on plans to produce “8,000 Model 3s and 14,000 Model Ys per week” in Shanghai, which were originally intended for mid-May if it were not for COVID-related disruptions. At this production run-rate through the end of the year, Tesla’s Shanghai manufacturing plant is once again on track to accounting for half or more of its global deliveries this year.
The upgrades would also contribute to Tesla’s broader plans to increase Giga Shanghai’s annual production capacity to one million vehicles at full ramp-up, up from its “original installed capacity of 450,000 vehicles”, in order to better capture burgeoning demand in China – the world’s largest EV market. While EV sales faltered in April as China grappled with its worst COVID outbreak across major cities, including core production and financial hub Shanghai, the market showed resilience in May with EV sales increasing 111.5% year-on-year to more than 421,000 units.
The China Passenger Car Association has also forecast continued retail sales growth for June at 15.5% year-on-year and 35.2% sequentially at 1.83 million units based on acceleration observed in each of the first three weeks of the month, indicating “an improving market as production is in the process of resuming” after monthslong COVID lockdowns. While a separate growth estimate has not been disclosed for EV sales in the month of June, we expect a similar trajectory of acceleration given the emerging mode of transportation has been consistently accounting for more than a fifth of monthly new car registrations in China this year, buoyed by rapid adoption amidst supportive policy support.
In addition to being better positioned for capitalizing on growth opportunities within the Chinese EV market, continued production ramp-up in Shanghai through the second half of the year is also expected to drive better unit economics, and inadvertently, improved auto sales margins for Tesla. The EV maker posted auto gross margins, excluding automotive regulatory credit sales, of 30% in the first quarter. Consensus estimates for the same metric in the second quarter are currently down to approximately 26.4%, taking into consideration additional ramp-up costs at new facilities in Austin and Berlin, which Musk had referred to as “gigantic money furnaces”, as well as rising material costs amidst protracted battery component shortages and supply chain constraints. However, continued ramp-up in Shanghai, paired with easing supply disruptions from China, which ships critical supplies to support productions at Tesla’s U.S. and Europe facilities, are expected to further auto margins (ex-credits) back to or beyond 30% again in the second half of the year and through 2023.
3. Pricing Gains
Inventory shortages across the U.S. due to ongoing production challenges and supply chain constraints have pushed the average price of new vehicles to an all-time high. The average price of a new car has surged 13% from the prior year to $47,000 as of May. Higher input and production costs for EVs, which many automakers have sought to pass onto customers via sticker price increases, have catapulted the average for the sector to $61,000, pricing out the majority of American buyers from the new-car market.
With affordability being a large overhang in the car purchasing landscape, consumer preferences are now “moving to two vehicle segments: luxury and used”. While most average income households are “buying used cars that are more than a decade old” to compensate for the combination of double-digit increase in new car sticker prices due to rising input costs, and an accelerated shift by automakers toward manufacturing higher-priced and higher-margin models, the remaining cohort of higher-earners are opting for luxury alternatives that are not that much more expensive than the industry average.
While the latest economic data shows that consumer purchases of goods are slowing as inflationary pressures continue to price buyers out of the increasingly expensive EV market, close to half (45%) of the American population still earns annual income of more than $75,000 a year and have expressed a preference for the luxury alternative that they can still afford. More than 25% of the American population stated a preference for EVs on their next vehicle purchase, while 40% of current premium vehicle owners have “reported being very likely to consider an EV for their next purposes”. And these trends continue to bode favourably for Tesla, which currently commands 75% of the American EV market. Despite having repeatedly raised its global prices this year – with the latest being a 3% to 5% bump across its line-up in the U.S. – demand has remained robust in Tesla’s core market.
Repeated price increases in China – with the latest being a 5% increase for the Model Y Long Range – also have not deterred buyers from Tesla, despite the absence of government subsidies. Although only the rear-wheel-drive Model 3, currently priced at RMB 279,990 ($41,900), is eligible for the RMB 11,088 ($1,660) EV purchase subsidy in China, which requires range capability of more than 300km per charge with a sticker price below RMB 300,000 ($44,850), Tesla has continued to sell-out in its second-largest market. The majority of units produced from its Shanghai facility has also been absorbed by local demand, with exports to Europe accounting for only a nominal volume.
The combination of persistent price increases, paired with extended lead times across all of Tesla’s major markets underscore the EV maker’s unmatched pricing power within the burgeoning industry that still benefits from robust demand despite a looming global economic slowdown. Combined with continued production ramp-up across the production facilities it has installed across all major EV markets as discussed in earlier sections, Tesla is expected to benefit from persistent pricing gains over the longer term. This is also expected to further Tesla’s trajectory for additional auto margin expansion through the remainder of the year to compensate for challenges experienced in the second quarter, and beyond 30% in the long run.
4. Ongoing Logistic Bottlenecks
Despite expectations for improved production ramp-up in the reopened Shanghai facility, and the brand-new Austin and Berlin facilities later in the year, realization of related margin improvements will likely be delayed for at least a quarter or two given ongoing logistics and supply bottlenecks. Pricing gains on Tesla’s most recent MSRP hikes are not expected to be reflected in margins until at least the third or fourth quarter, given the backlog of orders that Tesla is working to fulfill, with current lead times going as far as July 2023 on the Tesla Model Y Long Range in the U.S.
Delivery volumes are also expected to stay behind production volumes for the rest of the year, given slow recovery of backed-up logistics arrangements from previously “idled factories and warehouses [and] slowed truck deliveries”. While “supply delivery times shortened in May relative to April, and were on par with times in March 2020” following China’s gradual emergence from its monthslong COVID lockdowns, global logistics costs remain at elevated levels. The “logistical hurdles” caused by yearslong sporadic pandemic disruptions are not expected to fully resolve until late 2023 or 2024. The pileup at ports due to pandemic-related closures, paired with continued labour shortages is expected to impede the speed of getting inventory off the lots and into customers’ hands, which is required before Tesla can recognize the sale on its books.
The logistics constraints are expected to remain an overhang on near-term production ramp-up efforts as well, though not as prominent as disruptions faced during the second quarter. As mentioned above, China, which accounts for 12% of global trade volumes, is gradually re-emerging from strict mobility restrictions, which is a development in the right direction. This is consistent with management’s identification of supply chain constraints as the “main limiting factor” that is prohibiting Tesla, and peers across all industries, from realizing its full growth potential in the near term. And related bottlenecks are expected to persist “through the rest of 2022”, partially offsetting and delaying the full margin expansion potential from pricing gains and continued production ramp-up in the second half as discussed in earlier sections:
Our own factories have been running below capacity for several quarters as supply chain became the main limiting factor, which is likely to continue through the rest of 2022…
5. Austin and Berlin Ramp-Up Costs
More recently, Musk had also alluded to logistics constraints in China being the primary challenge to ramping up productions at Austin – the required tooling for producing Model Ys fitted with the 2170 cells at the new facility got “stuck in China” due to recent pandemic restrictions. This is just one of the many anticipated headaches of ramping up productions at a new facility, underscoring another driver for near-term pressure on margin expansion that investors should expect to be reflecting in Tesla’s second quarter results.
The billions of dollars in capital spending and production expenses incurred to date on getting volumes to capacity at the new Austin and Berlin facilities indicate higher variable and fixed cost pressures, as well as disruptions to free cash flow growth for the second and third quarter as expected. However, improved cadence later in the year, supported by easing global supply chain bottlenecks, alongside a potential expansion in production rate and capacity, are expected to usher auto margins back to 30% by 2023.
Final Thoughts
Tesla’s valuation is indeed a difficult one to grasp, as it continues to trade at a higher market value than those of top legacy automakers combined. But the stock has consistently traded at elevated multiples that average about 8x forward EV/sales and 41x forward EV/EBITDA over the past three years to account for long-term market expectations for its synonymity to EV adoption, prowess in auto manufacturing ramp-up, and robust cash flow generation.
Accounting for Tesla’s actual second quarter delivery volumes, with no material changes to long-term growth and cost structure assumptions applied in our previous forecast, the EV maker is proceeding favourably towards its multi-year target of growing sales by at least 50% in the current year. And considering positive developments to getting Shanghai productions back up to speed, and production ramp-up at Austin and Berlin to cash in on better unit economics alongside continued gains on unmatched pricing power, Tesla remains on positive track towards further margin expansion, and even potentially delivering over 1.5 million vehicles by year-end as Musk had cited for his “best guess” during the first quarter earnings call. As such, we are maintaining our near-term price target of $1,100 for the stock. The PT considers key valuation assumptions consistent with Tesla’s historical average performance, supported by expectations for continued market share gains over the longer term.
But despite improvements expected for Tesla’s valuation ahead of its long-term fundamental growth prospects, we continue to caution near-term market headwinds that count macroeconomic uncertainties, as well as persistent, though alleviating, supply chain constraints and production challenges. These factors – ranging from a highly-anticipated 75 bps rate hike to increasing risks of slashed earnings from slowing consumer spending and a possible recession – are expected to further weigh on the broader market. And the Tesla stock is expected to move in tandem with it and sustain additional price swings over coming weeks until the upcoming earnings on July 20th where investors will be keeping their eyes peeled for the EV maker’s margin performance as earnings risks surge across consumer stocks.
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