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TSLA: Why Improving the Model 3’s Gross Margin Could Be Difficult

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Dec. 4 2020, Updated 10:52 a.m. ET

Tesla’s second-quarter production data

In the previous article, we learned that Tesla’s (TSLA) revenue growth will be highly linked to its Model 3 deliveries this year. While the company doesn’t expect an increase in its Model S and Model X deliveries this year, its automotive revenue is likely to be primarily dependent on its Model 3 delivery numbers. The company is expected to release its second-quarter vehicle deliveries and production data in the first week of July.

Let’s move on by looking at the recent trend in Tesla’s gross margin in its Automotive segment.

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Tesla’s Automotive gross margin

In the first quarter, Tesla reported a 19.7% gross margin in its Automotive segment on a GAAP (generally accepted accounting principles) basis, slightly better than its 18.9% gross margin in the fourth quarter of 2017 but worse than its 27.4% gross margin in the first quarter of 2017.

The company’s gross margin from its Model S and Model X remained slightly higher than 25% in the first quarter. Improvements in its Model S and Model X mix, effective cost reduction, higher pricing, and positive currency exchange helped TSLA expand its gross margin for its two premium cars.

Challenges with Model 3 margin

The company also expects to achieve a gross margin of 25% for its Model 3 after its production rate stabilizes at 5,000 units per week. However, the road to achieving a 25% gross margin for the Model 3 may not be easy for Tesla. The company is currently struggling to achieve its production goal of 5,000 units per week.

Because it’s Tesla’s lowest-priced vehicle, the Model 3’s gross margin can only be improved with the help of economies of scale going forward. Even if the company manages to achieve 5,000 units per week of Model 3 production, it’s important for this production rate to stabilize for the company to see any improvement in its gross margin.

Note that Ferrari (RACE) is well known to have highest profit margins in the auto industry (XLY). In the first quarter, RACE reported a gross margin of 53%, while automakers General Motors (GM) and Ford Motor Company (F) reported gross margins of 16.4% and 8.4%, respectively.

Now, let’s see how Tesla’s second-quarter production data could affect its valuation multiples.

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