Over the past several years,Tesla has posted massive profit growth. The electric vehicle pioneer was unprofitable under generally accepted accounting principles and barely breaking even on an adjusted basis. In the second half of last year, the operating margin increased to nearly 15%.

There is a simple reason why the company has suddenly risen to the top of the auto industry in terms of profitability: the company is selling a lot of vehicles built on a single platform at high prices. This fact is not widely acknowledged as the source of improved fortunes. Let's take a look at what this means for the company.

Production and revenue surge

The company delivered over 936,000 vehicles in the year, up 155% from two years earlier. The Model 3 sedan and Model Y SUV accounted for almost all of the company's output last year. Due to a long production shutdown, deliveries of the Model S and Model X fell to 24,980 from a peak of over 100,000 a few years ago.

The shift away from the Model S and Model X did not hurt profitability. The average selling price held up well.

Excluding vehicles delivered under lease, the average selling price of a car by the end of the year was less than $50,000, down from $60,000 in 2019. The automotive sales rose to $44.1 billion, up from $26.4 billion in 2020 and $19.4 billion in 2019.

A recipe for fat margins

It's good for margins to sell nearly 1 million vehicles in a year at an average selling price of more than $50,000. The Model 3 and Model Y are built on the same platform and share many components. This reduces complexity and costs.

An overhead view of a red Tesla Model 3.
Image source: Tesla.

This is not specific to the company. GeneralMotors and Ford Motor Company have high-volume businesses that sell full-size trucks and SUVs at high prices. GM sells over 1 million full-size trucks and SUVs in the U.S.

The GM and Ford full-size truck/SUV franchise appear to generate operating margins in the 20% to 30% range, accounting for the bulk of both companies' profits.

In the third quarter of 2020, when the full-size truck and SUV plants were operating at maximum capacity to rebuild inventory, GM posted a 15% operating margin in North America. The rest of its business is less profitable than its margins would suggest.

What does it mean for Tesla?

It is likely that the strong momentum will continue in 2022. The company expects to grow sales at a 50% compound annual growth rate for the foreseeable future. Unless supply constraints get worse, it should be able to hit that growth rate. Demand continues to exceed supply, as shown by the long wait times for many models.

Most businesses face rising costs. It has been able to raise prices to compensate. The base price for the cheapest Model 3 on the website is now $44,990. The Model Y starts at $60,000 and goes up to $80,000 with the full self-driving package. The cheaper models have estimated delivery dates in the fourth quarter, while the more expensive ones have near-term deliveries. Further margin expansion should be supported by this.

A blue Tesla Model Y.
Image source: Tesla.

The outlook is cloudier. Supply constraints are preventing the auto industry from meeting demand and causing prices to go up. The average transaction price for U.S. auto sales has gone up recently. It would be no surprise if the company could push its average selling price back to $60,000 this year, as it would be able to grow its combined deliveries of the Model 3 and Model Y well beyond 1 million.

As supply constraints ease, auto prices will retreat. Other brands will look to break the stranglehold ofTesla on the EV market by offering reasonably capable alternatives at much lower prices. GM is promoting a Chevy Equinox EV that will be available in the fall of 2023.

The addition of a cheaper entry-level vehicle will be needed to continue growing unit sales. Offering a broader choice of models will add costs and complexity, while the price of electricity will decline due to competitive forces.

As it gains scale in the years ahead, it is poised for strong earnings growth. After its recent decline, the stock is still trading for 77 times forward earnings. It will be difficult to live up to that valuation given the margin headwind it will inevitably face as it broadens its product lineup.