Tesla is killing its potential profit margins with the Model 3 (TSLA)

Tesla reported Q3 deliveries that at 97,000 vehicles were lower than what Wall Street expected .
The company is selling far more lower-margin Tesla Model 3 sedans that higher-margin Model S and Model X vehicles.
Starving the higher-profit vehicles is a bad move that limits Tesla's ability to survive a sales downturn.
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It should be alarmingly obviously to anyone who has followed Tesla for the past few years that the Model 3, the car maker's lower-priced sedan, is eating the company.

On Wednesday, Tesla reported weaker-than-expected deliveries for the third quarter, but still a record at 97,000. Of those, the vast majority of vehicles sold were Model 3s. Just 17,400 Model S and Model X vehicles went to customers, and 15% of those were leased rather than sold.

My theory for the years immediately following the Model 3's rather uneven launch was that Tesla would attempt to manage a starkly bifurcated business: sell Model 3 for around $40,000 while still marketing $100,000-and-up trim levels for its luxury four-door and SUV.

It hasn't worked out that way, mainly because Tesla has been selling more expensive versions of the Model 3. Nonetheless, even the relatively cheap entry level sedans are priced far below the significantly more upscale Model S and Model X. This pattern could continue with the Model Y, a compact crossover SUV that's slated to join Model 3 in the lineup.

Mass-market car makers post lower profits than luxury brands

In the auto industry, mass-market car makers post profit margins of less than 10%; luxury marques do much better, and on an individual-vehicle basis can really rake in the cash. Tesla's gambit here has been to argue that the Model 3 would be a lot less costly to manufacture than, say, a Toyota Corolla, but it's clear that hasn't come to pass. Tesla's attempt to build an automated Model 3 assembly line failed so catastrophically that the company had to quickly throw up an old-school line under a tent in the parking lot of its Fremont factory.

Tesla has adopted what I'd term a backward strategy for Model 3 because CEO Elon Musk's vaunted "Master Plan" always called for making expensive vehicles to fund cheaper ones, with the ultimate goal of getting more electric vehicles on the road. Tesla has achieved that objective, but at the cost of undermining its marquee products.

The Model S was introduced in 2012 and hasn't seen a major redesign since; the Model X arrived in 2015 and is also an aging platform. Those vehicles used to the be the only real game in town for electrified luxury transportation, but they're now facing meaningful competition from the likes of Audi, Porsche, and Jaguar.

I don't think Tesla can allow its high-margin business to collapse, especially given that its cash needs over the next five years could be intense, as it launches the Model Y and commences production at a new factory in China. Of course, "high-margin" is itself speculative; Tesla hasn't posted an annual profit in 15 years of existence. It's margins are commonly expressed as "gross," not "net" (because there is no net), which is asking investors to suspend disbelieve and defer that crucial aspect of their payout to the future.

By contrast, established automakers that serve the mass market General Motors and Ford, for example have been consistently profitable for years.

In fact, Tesla is setting an unprecedented precedent: It controls most of the EV market in the US (which is still tiny), but it can't seem to use that market control to generate an easy profit. The mismatch isn't hard to explain: It costs Tesla more money to operate its business than it takes in, and the company is also awkwardly yoked to periodic debt payouts that consume cash (the debt is convertible to equity, but the stock hasn't risen to a level that would allow investors to swap their bonds for stock).

A conundrum, right?

Teslas strategy could be a problem in a sales downturn

Sort of. Tesla actually builds some extremely impressive cars. Customer support is off the charts, and the brand is so compelling that it spends pretty much zero on advertising.

But the business is being run in a borderline incompetent manner, by a CEO who surfs from crisis to crisis and a management team that when not in constant flux can't seem to effectively manufacture automobiles in an industry that's been bolting on bumpers and wheels since the 1910s. Investors have been writing checks via Tesla's equity raises, but of late, the company has been forced to bring more debt into the picture.

Debt is what kills car companies. It doesn't always kill them fast. But if profits don't materialize and money can't be socked away in the bank, the cyclical nature of the industry eventually takes away the margins and lowers the revenue, a devastating hit to the top and bottom lines that Tesla has never suffered.

Tesla used to have a lifeboat in this dire scenario: the Model S and Model X luxury portfolio. It could radically downgrade the Model 3 and its successors and rely on the pricier vehicles to see it through a rough patch. But that lifeboat won't float if Tesla doesn't invest in S and X, and it's unclear that the theoretical margins on Model 3 would be enough to see the company through a downturn.

Can Tesla fix this? I'm not sure. Investment in Model S and X would seem to be mission critical, but the expansion of Model 3 production overseas, the presumably expensive Model Y launch, and the much-discussed advent of a pickup truck along with the development of a new Roadster sports car and a semi truck are a large collective distraction.

Here's the thing: automakers can't trundle along in this mode for a long time but when a market in retreat takes away the cash, those automakers can find themselves losing eye-watering amounts of money, and they can go broke in a hurry.

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