Tesla’s Bold Price Cuts Put Lofty Valuation to Test

A central pillar of Tesla Inc.’s pricey valuation is about to face a reckoning.

(Bloomberg) — A central pillar of Tesla Inc.’s pricey valuation is about to face a reckoning.

Results from the electric-vehicle maker after markets close on Wednesday are set to show what impact a series of aggressive price cuts have had on the hefty profit margins that have long been such an attraction to investors.

Analysts expect it to be a significant one. The average estimate for automotive gross margin in the first quarter has fallen by about a fifth since late-December. Yet that hasn’t prevented the stock from staging a sharp rally this year, leaving scope for disappointment.

“Going into the earnings people are going to be saying is it worth the big move or has the market gotten ahead of itself?,” said Catherine Faddis, senior portfolio manager at Fernwood Investment Management. “Margins are going to be very consequential with the market trying to decide does this stock keep running or does it have a little pull back.”

Shares of the company tumbled as much as 3.6% to $177.65 by 9:32 a.m. New York time on Wednesday, after it announced yet another round of price cuts ahead of its earnings report.

High profitability, coupled with the promise of rapid future growth, have long been key drivers of Tesla’s vast premium over other car manufacturers. After a 50% gain this year through Tuesday’s close, the stock trades at around 46 times forward earnings, compared with single-digit multiples for both General Motors Co. and Ford Motor Co. The S&P 500 Index’s average sits at around 19 times.

While the shares have been driven by a broader resurgence in investor appetite for growth assets, as well as the boost to the EV industry from Biden administration’s Inflation Reduction Act, profit projections have been falling. That largely reflects the impact of price cuts Tesla has made to fuel sales, the latest of which came on the eve of the earnings announcement.

Automotive gross margin is seen declining to 23% in the first quarter, from 25.9% in the previous three months, according to estimates compiled by Bloomberg. Profit predictions have fallen 28% since late December to 86 cents a share.

Investors are divided on whether the company can maintain its January guidance for the automotive gross margin to stay above 20%, according to Barclays Plc analyst Dan Levy. While Chief Executive Officer Elon Musk has expressed willingness to sacrifice margins in order to drive sales, first-quarter “earnings will be the first real test of whether this is taking place to a major extent,” Levy wrote in a note Monday.

In cutting prices, Tesla is testing Musk’s theory that small changes in price have a big effect on demand.

“The desire for people to own a Tesla is extremely high,” the CEO said at a March 1 investor day in Austin, Texas. “The limiting factor is their ability to pay for a Tesla.”

Stubbornly high inflation, steep borrowing costs and the fear of a recession have altered the landscape for EV demand this year. And Tesla’s discounts have triggered a chain reaction throughout the auto industry as other automakers follow suit.

“Price cuts underscore the highly competitive nature of the auto market, where sustained high margins and high volume is unprecedented, and which we believe is necessary to justify Tesla’s premium valuation,” Bernstein analyst Toni Sacconaghi wrote in a note last week.

Bulls remain optimistic that the company can maintain a strong advantage over rivals in terms of profitability. On average, analysts estimate Tesla’s 2023 overall gross margin at around 22%, compared with GM’s 17% and Ford’s 15%, data compiled by Bloomberg show.

“Tesla represents a better risk-adjusted investment opportunity compared to most other EV-related names,” Morgan Stanley analyst Adam Jonas wrote in a note Monday. “We believe the company’s cost and engineering leadership will, over time, provide greater growth potential and adjacent revenue opportunity vis-à-vis the competition.”

Tech Chart of the Day

The year-to-date advance in major technology and internet stocks has meant a decline in volatility associated with the Nasdaq 100. The CBOE NDX Volatility Index has dropped for five straight sessions, ending Tuesday at its lowest since January 2022. The close of 21.41 compares with an October peak of nearly 40, as well as a five-year average of 26. The Nasdaq 100 fell as much as 0.8% Wednesday at open.