Tesla’s Business Model Highlights What The Shift To Electric Means For The Auto Industry

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If Elon Musk’s goal with Tesla Motors (NYSE:TSLA) was just to make the best electric car ever, he has already achieved it with the all-wheel drive version of the Tesla Model S P85D. According to Consumer Reports, this model is so good that it literally broke their ratings system. [1] So what now? Given that Tesla has the best car, it should be easy to build a business model around that. But the task Tesla has set for itself is not so easy. Tesla’s goal is to become a dominant player in the luxury vehicle market. This market, which includes Audi, BMW, Mercedes-Benz and Lexus, generates about 5-6 million unit sales per year or $220 billion in revenue. That means that the average price of a vehicle in this segment is around $44,000 at most. In comparison, Tesla’s Model S P85D all-wheel drive retails for a price of around $128,000.

Tesla’s stated goal in the past has been to make a successful high-end car and then invest the resulting profits to make a less expensive electric car, using the proceeds to make a $35,000 third generation vehicle. This is not merely a strategy statement:  the structure of Tesla’s Fremont factory literally reflects this idea. Only 20% of the factory is currently used to make Model S vehicles, while the rest lies dark, waiting for its call to action. In order to achieve this goal, Tesla will have to make significant incremental improvements and tweaks to the traditional way in which cars are made, sold and serviced. Below, we take a look at the three broad ways in which Tesla’s business model sets it apart from all other car companies.

We have a price estimate of $170 for Tesla, which is about 30% below the current market price.

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What the Shift To Electric Means

The first and most important thing to appreciate about Tesla is that electric cars are not merely about cutting down on emissions. The shift to electric power transmission fundamentally changes the mechanical complexity of the car. The number of moving parts is reduced drastically, as the drive shaft, fuel tanks, transmission, and internal combustion engines are all removed. This reduced complexity means that the sophistication required to build and design cars changes, which in turn changes not only who can build these vehicles but how they are built. Put simply, if the value in the car industry in the last ten years lay in the engine, the shift to an electric power train means that the value now lies in the battery.  A further shift to self-driving cars might in turn change that value center, but that is a separate discussion.

It is quite possible that the manufacture of the drive train, battery, welding, stamping, interiors and the infomatic systems inside cars get modularized and outsourced in the future, just in the way the smartphone industry outsources scale to Shenzhen. On top of this, companies will be able to add their own software capabilities, branding, marketing and distribution to create additional value. However, all this is still some time away. Currently, it is Tesla alone that is pointing to that path. Yet instead of outsourcing, it does everything in house. This ranges from using the most expensive aluminum stamping machine in North America to robotically operating welding machines. Indeed, even the manufacture of the motor that is used in the drive train occurs at Tesla’s Fremont factory.

The $5 billion Giga Factory is an attempt to bring battery making in house as well. There is solid economic thinking behind this:  the supply chain involved in the manufacturing and distribution process of a battery is vast, encompassing the mining of elements in South America and their shipment to North America for initial refining and processing. Thence, these raw materials are shipped to Japan or South Korea for further refining and processing, and then back to North America where the finished battery is installed in a car that could be sold across the globe. This is a horribly inefficient process. Tesla’s big move is to bring all these different parts under the same roof. This move alone will save the company a lot of money. Besides savings in labor costs, the amount of lithium required to support Tesla’s sales targets will double the demand for lithium alone.  The increased demand will in reduce the battery’s price.  As the number of single digit percentage reductions add up, the cost of producing and selling a battery can come down by as much as 30%. Given that 25% of the cost of making a car is battery costs, this can result in improved margins and help the company get to its target of a $35,000 Tesla electric car.

There’s one other major change that the shift to electric vehicles can have to the auto industry. Currently, car companies rely on a model refresh  and new a model launch model to drive sales. Automakers introduce a model to their line up, upgrading it with new features to it every two to three years before changing the model after about eight to ten years. New model launches and model refreshments are known drivers of new car sales. However, with the reduced number of moving parts and the ability to ship updates through software, this may no longer be necessary. For example, Tesla will be shipping self-driving features to the Tesla Model S 70D cars that it has already sold this fall. Given the increased mechanical simplicity of the power train, there will be greater value according the software systems that control it.  And updates can be extesive:  a recent update on the  Model S was priced $10,000.

Direct Sales

Another way in which Tesla is going against the grain is by opting to sell vehicles directly to consumers, unlike other car manufacturers which use franchised dealerships. There are two main reasons why Tesla can do this: 1) In addition to significant expertise in the car manufacturing process, Tesla also brings a lot of software expertise. This is manifest in the ability of the Tesla Model S to wirelessly upload data so that technicians can view and fix the car online without even needing to touch the vehicle. If required, they can send technicians who can service the car at your home. Tesla calls these technicians Tesla Rangers. 2) Additionally, this is another place where the reduced mechanical complexity pays the company dividends. Fewer moving parts means fewer points of potential failure, which means that the company doesn’t need to rely on service centers to support the car after it has been sold. The way conventional dealerships are currently set up, they make most of their profits from this after-sale service process. In its absence, dealerships would most hardly make a profit, as they compete so aggressively on vehicle price.

Cutting out the middlemen, Tesla can make higher profits. It can also improve the customer buying experience. In this way, Tesla is similar to Apple, which opts to sell its products through its own stores, staffed with its own employees, instead of exposing them to the conflict of interest that emerges when you try to sell through Best Buy or RadioShack. Additionally, Tesla also makes use of Internet sales, allowing customers to customize and purchase a Tesla vehicle online. According to Tesla, this whole process costs the company $2,000 per vehicle sold. [2] So the company decided to tweak this model too. Tesla launched a program that allows a Model S owner to recommend a Tesla vehicle to someone for a $1,000 credit at service centers in the future. And the person who buys the car on the recommendation of an existing Model S owner gets a $1,000 discount on the purchase price.

Supercharger Network

Tesla is also unique in the way that it not only has to sell cars, it also needs to popularize the technology on which its cars operate in order to sell them. This requires the company to build out a network of charging stations to allow Tesla owners greater range in their travels. The current supply of Supercharging stations allows Model S owners to take free long distance road trips along specific routes. As of the Q2 earnings call, the company has 487 supercharging stations globally and is opening a new one at the pace of one every 24 hours. [3] On average, drivers in California are never more than 42 miles away from a charging station and drivers in Germany 33 miles away. [4]

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Notes:
  1. Tesla’s New Car Is So Good, It Literally Broke the Consumer Reports Scale, Bloomberg, August 2015 []
  2. Tesla’s Using Its Customers to Get Around Trouble Opening Stores, Wired, June 2015 []
  3. Tesla Letter To Shareholders Q2 FY 15 []
  4. Ref: 3 []