How Tesla’s Battery Strategy Could Drive Strong Margins On Model 3

by Trefis Team
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Tesla (NYSE:TSLA) launched its mass market Model 3 sedan in late July, delivering the first few vehicles to its employees. During the company’s second quarter earnings call conducted earlier this month, it indicated that the sedan could garner gross margins of as much as 25% at some point next year. This is impressive, considering that margins on Tesla’s luxury Model S and X stand at similar levels, with most mainstream automakers such as GM and Ford commanding margins of under 15%. So how exactly is Tesla projecting such thick margins on this product? Below we provide a few possible explanations.

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Model 3 Could Have The Lowest Battery Costs In The Industry

The price per kilowatt-hour (kWh) of lithium ion batteries has declined from an average of around $400 in 2012, when the Model S was launched to levels of under $150 currently. For instance, GM, says that it pays about $145 per kWh for batteries it sources from LG Chem for the Chevy Bolt. Battery costs on the Model 3 could be still lower, as Tesla has been working on improving its battery technology as well as the supply chain. Tesla, along with Panasonic, has designed a new variety of battery cells called the “2170” which will replace the smaller “18650” cells which have been in use for decades. The new cells provide higher energy densities (meaning that they can store more energy for a given size) and will also be manufactured using an automated process that will help to cut costs. Moreover, these cells will be manufactured at Tesla’s Gigafactory in Nevada, enabling it to cut logistics costs compared to the cells on the Model X and S, which are imported from Japan. The larger cell sizes will also mean that there will be fewer cells per module and fewer overall modules in each vehicle (only 3 modules in a Model 3 battery pack versus 16 on the Model S).

Focus On The Pricier Extended Range Model Will Help Margins

Tesla is offering the Model 3 in two versions, differentiated by the range, and this strategy could prove crucial to boosting overall margins. The standard model is priced starting at $35,000 and offers a 220-mile range, while the extended range model offers a 310-mile range and is priced at $44,000. If we assume a battery cost of about $130 per kWh, the ~ 50kwh battery on the base model would cost about $6,500. The  ~75kWh battery on the extended range model would cost about $9,750, translating into incremental costs of about $3250. As the extended range model sells for an additional $9,000, it could command a healthier dollar gross profit of about $5750 (without accounting for any other incremental non-battery costs). As the long-range model is likely to remain the more popular of the two (it’s also the only option available to early customers) it’s likely to improve margins significantly for Tesla. Tesla is also offering several other add-ons such as the premium package (additional $5,000), enhanced autopilot ($5,000) and full self-driving capacity ($3,000) – which are all likely to be high-margin offerings that could boost average selling prices and profits on the Model 3.

Tesla Is Working On Building Scale, Reducing Complexity 

The company has set an aggressive target of producing as many as 10k cars per week next year. While we remain skeptical that it will be able to meet these targets, considering its past track record, there’s no denying that the mass-market nature of the Model 3 should provide the company with significant economies of scale compared to its more niche luxury models. Tesla has also simplified the design of the Model 3 to make production easier, learning from its mistakes with the Model S and X. The company intends to initially offer the car with just 100 permutations, compared to over 1,500 permutations for the Model S in a move that should make production and inventory management easier.

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