Tesla's Margins and Elon's Conundrum

I hope you had a wonderful week!

The market keeps bumping along with some modest gains this week. Starting Tuesday, earnings season really picks up and the next three weeks will be a deluge of data from companies, so expect a bit more volatility.

In Case You Missed It

Here’s some of the content I put out this week. Enjoy!

• Virgin Galactic Live AMA: I got together with Steve Symington to discuss Virgin Galactic after attending Friday’s flight in New Mexico. You can see the full conversation here (it starts about 5 minutes in).

• Plug Power’s Freefall: The writing is on the wall and Plug Power is likely headed for bankruptcy.

• How Warren Buffett Invests $164 Billion For Free: Buffett uses a unique insurance rule to lever up returns on his massive stock portfolio.

Why Tesla’s Growth Let to Lower Profits

Tesla reported earnings this week and once again we saw falling margins and slowing growth for the automaker. The stock didn’t react positively, falling 13.6% last week, and investors seem to be realizing Tesla won’t be both a high-growth and a high-margin company.

It has to pick one. This is Elon Musk’s current conundrum.

The simple reason is that Tesla is a manufacturing company, not a software company. 🫢 

For long-time readers, you know I’ve focused again and again on two concepts called “Internet Economics” and the “Smiling Curve” in many of the companies I’ve covered here on Asymmetric Investing. And I’ve done that because companies who benefit from both have unusual characteristics of getting more profitable as they get bigger. This upside is — asymmetric.

On the internet, the marginal customer (the next new customer you attract) has effectively zero cost because the infrastructure to serve them is already in place. The cost of a few electrons is almost nothing. Facebook having 1 billion users has essentially the same cost as having 1 billion + 1 users. This is why software and internet companies often have gross margins of 70% to 90%.

What the smiling curve tells us is that scale makes the products companies sell more valuable. Facebook is more valuable to users and advertisers because it has 2 billion users than Snapchat with 400 million users. Netflix is more valuable to users than Peacock because it can buy better content with much higher revenue from the larger user base and can charge more because it has better content. There’s a massive customer surplus (benefit) from scale.

In short, on the internet, scale leads to better margins and the ability to charge higher prices.

Manufacturing lives by different rules.

Tesla’s Margin Problem

I’m going to use Tesla as a stand-in here, but this applies to all EV, charging, solar, and manufacturing companies in general.

Tesla has seen margins drop over the past two years despite becoming bigger and more efficient as a manufacturer. Why?

Because Tesla lives by the same laws of supply and demand as every manufacturing company. Unlike on the internet, the marginal customer doesn’t find Tesla’s cars more valuable as scale increases. The opposite might be true because customers want something unique from their neighbors.

Meanwhile, costs don’t decline to zero as you scale in manufacturing. So, companies have to find a sweet spot where they make enough products not to oversaturate the market while still charging a high enough price to make a profit.

I show this dynamic in the graphic below. This demonstrates revenue and profits at the equilibrium of supply and demand. If a company chose to increase supply it could sell more products but each incremental sale would be less profitable (margins decline). They could also cut production and increase margins per sale (margins rise).

Manufacturing Economics Hits Different

The reason manufacturing is so difficult is because the upside margin and volume are limited (unlike internet economics) and there are ongoing costs just to stay in business.

Below is a very simple example of a manufacturing plant that has the following characteristics.

• $10 in fixed costs no matter how much product is produced

  • Includes electricity, labor, property taxes, insurance, etc.

• $5 in variable cost per unit produced

  • Raw materials, labor, etc.

• The chart shows unit cost (red) for production of 0 units to 4 units)

Produce nothing and you burn $10 with no revenue.

Produce one unit and it costs $15. Bump that up to four units and they cost just $7.50 apiece.

Makes sense to produce as much as possible, right?

Now, what if demand looks like this:

• Customers will pay $20 if 1 unit is available

• Customers will pay $15 if 2 units are available

• Customers will pay $5 for 3 or more units

What do you do?

Maximum profits occur at 2 units where you can generate $30 in revenue for $20 in total cost. Increasing production to 3 or more units and the manufacturer loses money on every sale.

This is the conundrum every manufacturer faces.

Unless demand is infinite — which it isn’t — eventually you have to limit your supply.

What’s A Company To Do?

Different companies take different strategies for this manufacturing dynamic. Ferarri limits supply and that drives high margins, as you would expect. But it also limits revenue growth.

GM, Ford, Stellantis, Toyota, and others try to strike a balance between supply and demand to maximize profits (see the graphic above) at a higher level of scale to reach the mass market. But none are growing production significantly because the downside of increasing supply too much is…bankruptcy.

Tesla thought it could increase supply and maintain high margins. And it did…until it ran into the laws of supply and demand.

As a manufacturer, Tesla will continue to face this challenge. It needs to balance supply with demand or it will have to continue cutting prices, which eats into margins.

This is why increased competition is a problem for Tesla.

It’s why slow EV adoption outside of California is a problem for Telsa.

Demand is growing, but it’s not infinite.

This is either a high-margin EV manufacturer OR a high-growth EV manufacturer.

Tesla can’t be both. It has manufacturing economics, not internet economics.

Disclaimer: Asymmetric Investing provides analysis and research but DOES NOT provide individual financial advice. Travis Hoium may have a position in some of the stocks mentioned. All content is for informational purposes only. Asymmetric Investing is not a registered investment, legal, or tax advisor or a broker/dealer. Trading any asset involves risk and could result in significant capital losses. Please, do your own research before acquiring stocks.