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The Illusion of Tesla’s (TSLA) Strong Gross Margins

April 16, 2018 / Stefan Larsen

The illusion of Tesla’s (TSLA) strong gross margins

One of the more frequently cited metrics regarding the superiority of Tesla as opposed to other carmakers, is their higher gross margins, attributed to their “unique business model” and “innovative manufacturing and technology”. They stand at about 20% as of the end of 2017 against competitors, whose gross margins average at around 15%, and are one of the stock’s big selling points according to Wall Street analysts and Tesla’s 10-K. It is used as a promise of Tesla’s currently unproven profitability, and is the basis for the only unachieved operational objective in Elon Musk’s current compensation plan, requiring consecutive quarters of gross margins at least of 30%. The question is whether Tesla’s gross margin actually deserves any praise.

Thanks to an openly published research document by Unit Economics and independent Rhode Island-based research firm, Tesla’s gross margins have been scrutinized, revealing something that should be troubling for Tesla investors. Using the principles laid out in the Unit Economics paper, the focus will be specifically on the gross margins related to Tesla’s core automotive business and the automotive businesses of its competitors, making two important adjustments for the sake of comparability.

The first one cites an important and differentiating aspect of Tesla’s business model: they don’t sell their car through dealerships. At first this could seem like an excellent idea. Dealerships have quite a lot of bargaining power with automakers, usually demanding a 10% discount from the retail price when they make their wholesale purchases. However, Tesla has conspicuously high SG&A expenses, about three times that of Ford or GM as a percentage of revenues, most likely from supporting the part of the business that would be left to dealerships by other automakers. To increase the comparability of Tesla’s automotive gross margins, Tesla’s net automotive sales should be reduced by 10% to reflect the discount that other automotive companies give to the dealerships. This first accounting normalization already reduces Tesla’s automotive gross margins to 11.2%, lower than GM which has an automotive gross margin of 13.9%.

Their margins are certainly nothing to brag about given this adjustment, but there is a second adjustment that also needs to be made to Tesla’s margins. Under GAAP, if you do development work for a current model, those costs have to be expensed as Cost Of Goods Sold (COGS). As most other automakers, GM does this; one could verify by looking at the notes in the 10-K financial statements, where it is clearly stated that expensed R&D falls under automotive COGS.

Looking at the composition of COGS in the notes of Tesla’s 10-K, one could observe that they don’t do this, instead placing the expensed R&D on a separate line, not adding it to the automotive COGS. This means that Tesla’s automotive COGS could be as high as $8,102.553 million, while its net automotive sales (including the 10% discount) is $7,681.277 million. This leaves Tesla with an automotive gross margin as low as -4.9%.

One draws the following conclusion using the latest data from the SEC for Tesla and GM’s 2017 10-K’s before the advent of Tesla’s cheaper Model 3: if their automotive gross margins were already significantly negative in a period where they were producing high-end EV’s, it will likely get even worse when they start selling their bargain car. If these adjustments are accurate and to be trusted, Tesla may be headed towards disaster as the Model 3 volumes start to climb.