The recent earnings season has been a tumultuous one for the tech industry, with several high-profile companies, including Tesla, Alphabet, and Meta, reporting results that failed to meet Wall Street’s expectations.
This has led to a significant sell-off in the shares of these so-called “mega-cap” stocks, sparking a broader market rotation that has seen investors pivot towards smaller, more nimble companies, or “small-caps.”
The S&P 500 and the tech-heavy Nasdaq Composite both posted their worst days of the year so far last week, with the former tumbling 2.31% and the latter shedding 3.64%. Alphabet was down a little over 5% by the close, while Tesla plummeted more than 12%. This sell-off was largely driven by disappointment with the earnings results from these tech giants.
Tesla Rocks the Boat
The company reported total revenues of $25.5 billion, a modest 2% increase year-over-year, driven primarily by growth in the Energy Generation and Storage business and higher regulatory credit revenue.
Despite the revenue growth, Tesla faced some headwinds in its core automotive business. The company experienced a 5% decline in vehicle deliveries compared to the same quarter last year, with 443,956 vehicles delivered. This decline was partly offset by the introduction of the Cybertruck, which became the best-selling EV pickup in the U.S. during Q2.
Profitability metrics showed some pressure, with operating income decreasing 33% year-over-year to $1.6 billion, resulting in an operating margin of 6.3%. This decline was attributed to reduced average selling prices for S3XY vehicles, restructuring charges, and increased operating expenses related to AI projects. However, these negative factors were partially offset by higher regulatory credit revenue and growth in Energy Generation and Storage gross profit.
Tesla’s Energy business was a bright spot in the report, with record deployments of 9.4 GWh in energy storage products, leading to record revenues and gross profits for the segment. The company’s services and other revenue also grew by 21% year-over-year.
Cash flow remained strong, with Tesla generating $3.6 billion in operating cash flow and $1.3 billion in free cash flow during Q2. The company’s cash and investments increased by $3.9 billion to $30.7 billion, demonstrating solid liquidity.
In terms of technology and product development, Tesla highlighted progress in its AI initiatives, including improvements to its Full Self-Driving (FSD) capability and the deployment of AI in its manufacturing processes. The company also noted advancements in battery technology, with increased production of its 4680 cells and cost improvements.
Looking ahead, Tesla expects its vehicle volume growth rate in 2024 to be lower than in 2023 as the company focuses on launching next-generation vehicles and other products. However, the company anticipates that growth rates in energy storage deployments and revenue in its Energy Generation and Storage business will outpace the Automotive business in 2024.
Tesla also provided updates on its product roadmap, confirming that plans for new vehicles, including more affordable models, remain on track for start of production in the first half of 2025. The company is adopting a strategy that balances cost reduction with prudent growth, aiming to fully utilize its current expected maximum capacity of close to three million vehicles before investing in new manufacturing lines.
The Rise of Small-Cap Stocks
As investors sell off the mega-cap tech stocks, they appear to be pivoting towards smaller, more nimble companies, or “small-caps.”
There are several small-cap stocks, including Fabrinet, ATI, Ensign Group, SPS Commerce, and Mueller, that have been seeing gains recently. But these small-caps have room to “play catch-up” as investors believe the mega-caps have reached “unsustainable levels.”
Additionally, small-caps tend to benefit more than tech companies and big companies if interest rates do come down, as they often have more debt and their businesses are more economically sensitive.
After the recent sell-off, many of the “Magnificent Seven” mega-cap stocks have become cheaper than almost all the small-cap stocks mentioned on a price-to-earnings basis. However, the market works through this brutal rotation, the newfound cheapness of the big caps may not be enough to save them, as lower prices will be required to accomplish that.
Implications for Investors
The recent market dynamics have significant implications for investors, both in the short and long term.
In the short term, the sell-off in mega-cap tech stocks and the subsequent pivot towards small-caps presents opportunities for investors who are willing to take on the higher risk associated with smaller companies. The potential for small-caps to benefit from a potential interest rate cut, as well as their relative undervaluation compared to the big tech names, make them an attractive proposition.
However, in the long run, the fate of the mega-cap tech stocks will be crucial for the broader market. These companies have been the driving force behind the market’s performance in recent years, and their continued success or decline will have a significant impact on the overall investment landscape. Investors will need to carefully assess the long-term prospects of these companies, as well as the sustainability of the small-cap rally, to make informed decisions.