Tesla's profits: look closer

Tesla shares jumped twenty-two per cent after the company reported that third-quarter automotive gross margins had widened to 17.1 per cent. Wall Street analysts hurried to say that Elon Musk’s price cuts were at last paying for themselves. The filings tell a less tidy story.

Two years of price cuts

The background is a long squeeze. From late 2022 Tesla cut prices repeatedly on its best-selling Model 3 and Model Y, in America, Europe and above all China, where local rivals led by BYD were selling cheaper electric cars in rising numbers. The cuts protected volumes but hollowed out margins that had once been the envy of the industry, and deliveries fell year on year in both of the first two quarters of this year. Investors had grown used to quarters of shrinking profit.

Earlier this month the company's robotaxi presentation, meant to shift attention to autonomy, disappointed investors looking for timelines and detail, and the shares fell sharply the next day. That left the third-quarter numbers carrying more weight than usual. A better margin was exactly what the market wanted to hear, which may explain why it asked so few questions about where it came from.

Rivals foot the bill

The margin got a big lift from $739 million of regulatory environmental credits, which cost Tesla next to nothing and were sold to older carmakers struggling to meet EV mandates. Credit sales were up seventy-three per cent on a year earlier. Strip them out and automotive margins look much weaker. In effect, rival carmakers are paying Tesla cash that helps fund its price cuts.

How the credit market works

Governments in America and Europe set emissions or zero-emission sales targets for each carmaker's fleet. A manufacturer that falls short can either pay penalties or buy credits from one that has a surplus. Because Tesla sells only electric cars, it earns credits on every vehicle without having to offset any petrol models, and it can sell them to competitors whose own electric programmes are behind schedule. The revenue drops almost straight to profit, since there is no extra car to build. Prices are negotiated privately, which means outsiders can see the total but not what each credit fetched or how long each contract runs.

That makes credits a peculiar kind of income. They are real cash, and they have been part of Tesla's business since the start. In 2020, its first profitable full year, the company collected more from selling credits than it earned in net income. What they are not is evidence of pricing power in the core business. A quarter in which credits rise sharply while car prices fall tells investors that regulation, not demand, supplied the margin improvement.

The buyers are the companies Tesla competes with. Fiat Chrysler, now part of Stellantis, paid Tesla to pool their European fleets for emissions purposes in 2019 and 2020 rather than face fines from Brussels. Every such payment is a transfer from a slower-moving rival to the market leader, which weakens the buyer's finances at the moment it is trying to fund its own electric models. Consumers pay too, indirectly, because compliance costs are built into the price of petrol cars.

Why the windfall is fragile

The market for credits depends on the gap between regulations and what other carmakers can achieve. That gap can close from either side. Legacy manufacturers are launching more electric models, which reduces their need to buy compliance from a rival. Regulators can also loosen the rules. Donald Trump has promised to roll back federal policies favouring electric cars, and a looser federal regime would shrink demand for credits in America even as Mr Musk campaigns for his election.

Europe points the other way. The European Union's fleet-wide carbon targets tighten next year, and several carmakers have warned they may struggle to meet them, which could keep demand for Tesla's credits strong there for a while. The result is a revenue line that swings with politics on two continents, which is the opposite of the dependable earnings stream that a twenty-two per cent share-price rise implies. Federal tax credits for buyers of electric cars, worth up to $7,500 under the Inflation Reduction Act, face the same political risk, and losing them would hit demand at the moment Tesla needs volume growth.

The case for the bulls

Tesla's defenders have a point. Beyond credits, the company did cut its cost per vehicle, and its cheaper production at scale is a genuine competitive advantage. Energy storage, a smaller business, grew rapidly and earns healthy margins. Management also promised volume growth next year on the back of cheaper models, which would spread fixed costs over more cars. If those come through, margins on the cars themselves could improve without help from regulators.

The difficulty is that each of those claims is a forecast, while the credit boost is in the reported numbers. Cheaper models will carry thinner margins per car. Chinese competitors are building similar cost advantages, and they face fewer barriers in markets outside America. Growth from energy storage is welcome but is too small to carry a company valued on the expectation that its cars and software will dominate the industry.

What to watch

Three numbers will tell investors whether the margin story is real. The first is automotive gross margin excluding credits, which Tesla reports and which strips out the regulatory windfall. The second is average selling price, which shows whether the price cuts have stopped. The third is credit revenue itself, which will reveal whether this quarter was a peak or a new level. Fourth-quarter deliveries, due in early January, will also show whether volume growth has resumed.

Tesla’s margin beat owed more to record credit sales than to selling cars at better prices. When the credit windfall fades, the pressure on prices across its core models will show. Expect margins excluding credits to stay under pressure through next year, and the share price to depend more on promises about autonomy than on the economics of the cars Tesla actually sells.