This One Trend Could Cost Tesla Stock Its Premium Valuation

With the market still absorbing the key takeaways from its latest financial results, Tesla (NASDAQ:TSLA) continues to trend lower. Granted, these more recent moves with TSLA stock have been relatively mild.

At least, compared to the stock’s double-digit drop immediately after the electric vehicle maker’s quarterly earnings release on April 19.

Still, while perhaps not capitulating, TSLA is likely to stay on its current downward trajectory. Why? Mainly, because the market is becoming more concerned, not less concerned, about a key headwind: thinning profit margins.

CEO Elon Musk attempted to soothe worries among investors about future profitability, but this time they are not buying what he is selling.

There may be another way for Musk to truly shift sentiment on this issue. However, I wouldn’t count on it happening.

With this, let’s dive in and see what may lie ahead for this popular vehicle electrification play.

The De-Rating Continues

It’s possible that many investors bought Tesla right after earnings hoping a “buy the dip” wager would be rewarded.

Of course, such a scenario has yet to play out. Since last week’s earnings report, the de-rating of TSLA stock has continued. Besides TSLA’s continued slide, the company’s latest numbers have led two sell-side analysts to downgrade the stock.

First, on April 20, Tudor Pickering’s Matt Portillo downgraded Tesla from “hold” to “sell.”

Second, on April 21, Truist’s William Stein lowered his rating, from “buy” to “hold,” reducing his price target from $245 to $154 per share. In both downgrades, the analysts cited thinning margins as the key rationale behind their respective rating changes.

Why are thinning margins bad for the stock? As Portillo put it explicitly in his latest analyst rating, falling margins call into question TSLA’s valuation premium to other automakers.

If this EV powerhouse’s margins continue to drop closer to that of incumbent automakers, so too could the stock’s forward multiple.

A ‘Show Me’ Situation

Lower vehicle prices, plus rising operating expenses, are to blame for both Tesla’s falling profit margins, and for its year-over-year profitability drop during the quarter ending March 31, 2023.

In my last article on TSLA stock, I argued that it remains to be seen whether the company’s price cut gambit pays off.

Elon Musk believes that the ends justify the means, and has provided investors with a substantive argument.

In Musk’s view, Tesla can more than make up for lower margins today, through the sale of add-on features like full self-driving capabilities tomorrow.

In time, Musk could be right. The skeptics, victorious right now, may just well end up eating humble pie once again. Yet while such a rosy scenario is possible, for now, analysts and investors are taking a “show me” approach instead.

This wouldn’t be an issue, if Musk’s gambit was poised to begin paying off in a matter of quarters.

However, this long-term strategy will most likely lead to more disappointment and lower prices for TSLA in the near-term. Over the next few quarters, profit margins could keep falling, with shares pulling back further.

Bottom Line

Admittedly, there may be a way for Tesla to avoid severe multiple compression. Much like how big tech firms have won back investors by scaling back ambitious growth initiatives, and focusing more on aggressive cost cutting, the company could win back a lot of investors, if it were to tweak Musk’s overarching strategy.

For instance, instead of trying to sell as many vehicles as possible, Tesla could instead target the sweet spot of both vehicle sales growth and high profitability.

That said, such a gambit may not be easy to pull off. This explains the current “maximize sales today, worry about maximizing margins tomorrow” strategy.

However, barring such swift action to mitigate/reverse the thinning margins trend, TSLA stock remains at risk of pulling back to a valuation more akin to an “old school” automaker, so tread carefully.

TSLA stock earns a C rating in Portfolio Grader.

On the date of publication, neither Louis Navellier nor the InvestorPlace Research Staff member primarily responsible for this article held (either directly or indirectly) any positions in the securities mentioned in this article.