When a business is small, it is possible to overlook a lack of profits based on the belief that you will believe to raise prices later once the product becomes entrenched or the business is able to lower its input costs as the volume sizes give way to the traditional economies of scale advantages.
What has caught my attention when I analyze Tesla and Amazon is that both businesses have become quite large on the revenue front without earning consistent profits that are expected based on the size of the revenue base. Specifically, Tesla is set for losses of around $500 million in 2016 compared to revenues of $7 billion, and Amazon is earning $2.5 billion in profits compared to $134 billion in revenues.
This means that economies of scale (lower input costs) are not contemplated as part of the business model. For Tesla and Amazon to earn profits consistent with their revenue base, and attempt to justify the stock price, it is necessary for both businesses to increase the costs of their goods and services even more.
Today, Tesla announced on its website in a blog post titled “An Update to Our Supercharging Program”:
“For Teslas ordered after January 1, 2017, 400 kWh of free Supercharging credits (roughly 1,000 miles) will be included annually so that all owners can continue to enjoy free Supercharging during travel. Beyond that, there will be a small fee to Supercharge which will be charged incrementally and cost less than the price of filling up a comparable gas car. All cars will continue to come standard with the onboard hardware required for Supercharging.
We will release the details of the program later this year, and while prices may fluctuate over time and vary regionally based on the cost of electricity, our Supercharger Network will never be a profit center.
These changes will not impact current owners or any new Teslas ordered before January 1, 2017, as long as delivery is taken before April 1, 2017.”
While the specifics of this announcement may come as a surprise, this general trend should be very predictable for those of you who study the balance sheets of firms like Tesla and Amazon. When you’re that big but don’t have profits to show for it, you are going to have to experiment with large price hikes.
The obvious areas are for Tesla to charge more per vehicle, and for Amazon to charge more for shipping and Amazon prime memberships.
The difficulty is that Tesla cars are already cost tens of thousands, and in some cases, hundreds of thousands of dollars. And in the case of Amazon, it will probably need to get the cost of Amazon Prime up to $400-$500 for the service to generate profits that make sense in light of the historical experience of industry peers.
The catch is that, if this were easy to do, Tesla and Amazon would already be doing this. If Tesla needs to charge $60,000 instead of $35,000 for a Model 3, it is telling that it has elected not to do so. If Amazon Prime needs to charge $399 instead of $99 for Amazon prime, what’s it waiting for? It already has 63 million customers. The answer is that it fears losing a significant number of Amazon Prime subscribers if it raises the prices to a point at which the business model becomes palatable.
For these reasons, I put businesses like Tesla and Amazon in my too hard pile. When you are a small business, I am willing to grant a presumption that price increases and economies of scale will come in due time. But once you are a corporation generating billions of dollars in annual revenue, my presumption in your favor is not going to be so kind. You’ve already shown a failure to benefit from economies of scale, and management has already shown some doubt about the sustainability of the big, sweeping price hikes that will make the business model work.
The good news is that the process of building wealth does not require that you figure out the answers to the investing problems that require guesswork. You can instead do things like put your funds in business like Hershey (HSY). For the past forty years, Hershey has reported net profit margins of between 9% and 13%. The earnings increased tenfold between 1970 and 2000, and then increased from $1.20 per share in 2000 to $4.25 per share in 2016. You get high single digit growth and a decent dividend that grows every year. When you evaluate this in light of the certainty you get from the firm’s high earnings quality model, these growth statistics are even more impressive.
When your “default” settings as a mature business do not yield acceptable profits, it is going to create a problem for future investor returns. This is especially true when the stock valuations of Tesla and Amazon are trading at valuations as if the necessary profits are already there. My view is that you are going to see many new costs passed onto the consumers of Tesla and Amazon in the coming years, and the revenue growth will slow in response to this move which will ultimately bring down the stock price to more reasonable levels.