Is The Direct Sales Model Critical For Tesla Motors?

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Tesla Motors (NYSE:TSLA)  is fighting a legal battle in Indiana against a legislation which prohibits direct sales to consumers. The company has faced similar hurdles to implement its direct sales models in several states in the U.S., as auto dealers are opposed to this model.  While traditional automakers depend on their dealerships to stock inventory, provide after sales service and promote their financing schemes, Tesla’s focus on high-end, trail-blazing electric vehicles makes a direct sales model more desirable in cultivating sales and customer relationships.  Since electric vehicles do not need as much regular service and the company does not offer financing schemes, a dealership model would put pressure on its margins.  This is because it would need to ensure that franchises earn higher revenues from car sales.  Electric and hybrid vehicles are projected to dominate the car market in future and a study by Google in 2013 suggests that they would account for nearly 90% of cars sold in 2030. Several traditional automakers including General Motors, Ford, Honda and Toyota Motors are increasing their focus on electric vehicles to capture this trend, thus questioning the unfair advantage to Tesla due to its unique selling model.  Tesla currently operates in a niche space of luxury electric vehicles where new car sales are the primary source of profitability. Thus the direct selling model is key for the company to generate higher margins.

Dealership Model Might Not Be Viable

At a recent event in Washington D.C., Tesla explained that its profit model, which is based entirely on new car sales, does not allow franchises to make money by selling its cars. The company does not advertise its cars, nor does it stock inventory locally.   Its cars are custom built for each customer once they are ordered, making available inventory nearly zero.  Moreover, the sales cycles are longer since they involve the exchange of detailed information about the cars, range and charging information. All of this makes it less attractive for franchises. Tesla also believes that it’s mission to popularize electric vehicles as viable, even preferable, alternatives to gasoline-powered cars.  Moreover, because they are a low volume, high priced luxury purchase, they are best sold in a store-front based environment by a high-touch sales staff. The conventional auto dealership is clearly at odds with this selling model.

As per our estimates, Tesla’s gross profit margin for Model S would be around 27.5% in 2016 and increase steadily to around 30% by the end of our forecast period.

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If these margins decline steadily over our forecast period and reach 25% by its end, there can be a 15% downside to our price estimate. A dealership model will put pressure on these margins by way of an increase in overhead costs and the need for the company to incentivize franchises for each sale, given profits by way of financing schemes and after sale service will be limited.

We believe that the direct selling model is essential for Tesla’s success in the near term as the EV market is at a nascent stage and the company is yet to prove itself in the mass market to enjoy economies of scale. However, with an increasing number of traditional automakers entering the EV market in future, it remains to be seen  whether Tesla will be able to sustain a direct selling model at the higher volumes it envisions down the road.

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