Update by Michael Khouw – March 3, 2019
The Good
Elon Musk is one of the most courageous entrepreneurs in history. Courageous because, already successful from his earlier ventures Zip2, X.com and PayPal, he embarked on several new, highly capital intensive and risky enterprises including SpaceX, Solar City, The Boring Company and of course Tesla. Hindsight bias is the tendency to perceive that events were quite predictable or even likely after they have occurred, when in fact those events were viewed as unpredictable or unlikely before they took place. While battery electric vehicles are widely accepted as attractive, or even superior, alternatives to conventional internal combustion vehicles now, and most expect they will increase their market share significantly, at the time Elon Musk made his initial investment into Tesla this was an enormously speculative venture on two fronts. Automobile manufacturing is an intensely capital intensive and competitive business. Many have tried, and most of those who have subsequently failed. Even among those that were successful in the United States, only one so far, other than Tesla, hasn’t failed; Ford Motor Company, which came close. Tesla started a new company, and using electric drivetrains, a technology most consumers suspected was better suited to golf carts, proceeded to build some of the most impressive cars ever built.
Naturally, the timing coincided with significant improvements in battery technologies. Traditionally battery electric vehicles used lead-acid or NiCd batteries, which have low specific energy. Consequently, electric vehicle batteries were not only heavy but provided an extremely limited range. Combined with long charging times, BEVs were impractical substitutes for ICVs (Internal Combustion Vehicles). Lithium-ion batteries have much higher specific energy, so the common drawbacks were significantly improved, making everything from modern smartphones to Teslas possible. While the specific energy and energy density of newer batteries has improved, it is still far less than diesel fuel and gasoline. Consequently, a sufficiently large battery causes the total drivetrain to weigh considerably more than that of a gasoline or diesel vehicle, including fuel.
However, electric motors are superior to diesel and gas engines for vehicles in almost every respect. Electric motors are much smaller, lighter, and considerably less complex than their internal combustion counterparts. They are also far more efficient, transforming as much as 90% of the electrochemical energy in the battery to kinetic energy (motion). 40% is typical for the most efficient internal combustion engines, where most of the chemical energy contained in a gallon of diesel or gas is lost to heat (and sound). Electric motors are also generators, so kinetic energy can be recaptured when the motor (generator) is used for regenerative braking. The performance characteristics are also vastly superior for conventional driving because electric motors generate their peak torque at any rpm and the motor responds nearly instantly whereas many gasoline and diesel cars, particularly turbocharged cars, have noticeable throttle lag. The benefits of electric propulsion are able to offset virtually all of the specific energy and density shortcomings of batteries.
The net effect of all this? The Model S P100D, Tesla’s highest-end model weighs 4,960lbs, has a range of 335 miles and accelerates from 0-60 in 2.3 seconds. A BMW M5 has similar dimensions, weighs 4,370lbs and has a range of 341 miles and accelerates from 0-60 in 2.8 seconds. Although a buyer of an electric Tesla might not cross-shop against one of BMW’s thirstier models, it’s interesting to note that a Tesla would leave the BMW in its dust in a stoplight drag race. Of course, it isn’t just the comparable range that matters. Charging the 100 kWh battery, even at California’s relatively high electricity costs of $.19/kWh would cost 75% less than filling the BMW’s 20-gallon fuel tank at $4/gallon for premium. Not that it matters to buyers who pay over $100k for their cars, but assuming 12k miles/year on average, the Tesla driver would save $175/month. I would argue a startup building a clean-slate, world-beating car that received Consumer Reports highest-ever rating may be the most impressive achievement since the advent of the automobile, but Elon Musk aimed his sights higher than that. Elon wants nothing less than to transform transportation. Properly equipped a Model S is capable of semi-autonomous driving. Given their demonstrable progress in this area, it seems reasonable to believe that Tesla will be among the first manufacturers to offer fully autonomous cars even if we are inclined to discount Musk’s ambitious claim that Tesla will be the first, and will offer this functionality by the end of this year.
Cars powered by gasoline and diesel fuels are subsidized heavily by externalities. Externalities are those economic costs that are not borne by the buyer or user of a product. Carbon-based fuels indisputably damage the planet and sicken the people living on it. Even if you don’t happen to believe in global warming, or you do but don’t believe carbon-based fuels contribute to it, I’ll venture that you’re familiar with smog, oil spills, and cancer.
The Bad
Sometimes there can be a fine line between courage and stupidity, genius and insanity. Elon Musk has taken entrepreneurial risks and succeeded several times. His success thus far isn’t just luck. Entrepreneurial success on this scale doesn’t come from a single lucky guess or idea, but taking ideas and executing or overcoming a multitude of challenges large and small while avoiding catastrophic failures. Elon Musk and Tesla have demonstrated that they can build exceptional high-performance luxury cars that people want. When they announced this past week that they would finally be releasing the Model 3 with a selling price of $35,000, Elon Musk was fulfilling his promise of manufacturing a mass-market electric car that most car buyers can afford. How did the street reward this accomplishment? By slamming the stock which fell nearly 8% in one day, here’s why.
To make a profit selling a luxury product, a manufacturer must create a product so desirable, that well-heeled consumers who can afford whatever they want, will buy it. It is easier to charge a premium to those who determine what they buy based on what they want, rather than what they can afford. This is the reason that profit margins in percentage terms are often substantially higher for high-priced products than for lower priced ones, and orders of magnitude larger in absolute terms. The major automakers often discuss their “product mix” when reporting their financial results. Even when overall sales rise in terms of units or even gross revenues, an unfavorable product mix can hurt profitability. A Chevrolet Spark MSRP starts at $13,220, whereas a Cadillac Escalade starts at $75,195. While the selling price of an SUV may be more than 5 1/2 times that of the smaller car, the cost to manufacture it may be only 4 times greater. Consequently, GM might need to sell 15 Chevrolet Sparks to realize a gross profit of $15,000, which they would achieve with the sale of a single Cadillac Escalade. Observers might argue that a $35,000 Model 3 isn’t comparable to a Chevy Spark, but it may be a more fitting example than some may realize, and the reason for this is batteries.
The batteries used in electric vehicles are expensive. So expensive in fact, that the cost of an electric drivetrain, rather than the vehicle’s performance in terms of power and range, maybe the largest consideration for cost-conscious buyers. To understand this we need to examine two very similar vehicles. One with the currently more conventional internal-combustion engine, and the other with an all-electric drivetrain. Fortunately, one of the world’s most successful car companies, that itself transformed the auto industry over half a century ago can provide this side-by-side comparison, currently the world’s largest automaker by sales, a title it has held for the last three years, Volkswagen.
Volkswagen sells some of the least expensive passenger cars currently available, such as a Skoda Citigo for just over $11,000, and most expensive, the Bugatti Chiron which costs $3,000,000. Conveniently, one of their most popular models globally, the Volkswagen Golf, is available with a wide variety of drivetrains, including an all-electric version, which helps us better understand the associated economics. We’ll compare three popular VW Golf models to a $35,000 version of the Tesla Model 3
A couple of things become immediately clear. Comparing like-with-like among the 3 Golf models we see that an electric drivetrain adds considerably to the cost of the car. In this case, Volkswagen opted to compromise, sacrificing significant performance in terms of both range and acceleration to keep the price of a comparably equipped electric version of the Golf within eyeshot of its gasoline-powered stablemates. They accomplished this largely by using a smaller, and consequently much less expensive, 35.8 kWh battery. To make an e-Golf competitive with a Tesla Model 3, or even the gasoline-powered Golfs in terms of performance would require a 60 kWh battery. At the current $120/kWh manufacturing cost x (60kWh – 35.8kWh) that would add nearly $3,000 to the cost of the VW. Put differently, for an e-Golf to offer competitive performance, it would need to cost nearly $35,000; just like the Tesla Model 3.
This is where things get bad. Ignoring the fact that tax-credit phaseouts will make the e-Golf’s net price much lower than the Model 3, it seems that Volkswagen doesn’t make much of a profit selling them. If Volkswagen cannot turn much profit on an electric version of one of their most popular models, where they have optimized manufacturing with significant automation, what chance is there that Tesla is able to produce the Model 3 profitably? In fact, the economics of the e-Golf is such that Volkswagen has announced that they intend to focus instead on a 48-volt hybrid version of the Golf for the upcoming Mark 8 series of the model. In other words, to believe that Tesla can profitably produce a $35,000 mass-market electric vehicle you must also believe that they are able to manufacture the car for less than the world’s largest automaker can. That, it seems to me, is quite a stretch.
In fairness to Tesla, there are a couple of areas where they may have an edge. For one Tesla may actually be able to produce better batteries for less than other makers. They publicly stated that they have managed to produce higher-energy-density batteries at lower cost by developing technology that permits increased use of Manganese and less of Cobalt in the battery cathode while preserving safe levels of thermal stability, the primary compromise that’s made in this type of shift in the formulation. The cathode is one of the most expensive among the component costs of manufacturing batteries and Cobalt is considerably more expensive than Manganese. Another way they have an edge over conventional automobile manufacturers is their direct-sales model. Manufacturers do not sell their cars at the retail price, the spread between the retail price, and the price dealers pay for the cars cover the cost of selling them. Tesla, by contrast, is selling the cars at the full retail price. Assuming their costs of sales and distribution are lower than the franchise-dealer model, they keep more of the sales price than other manufacturers do, all else equal. However the company’s ability to scale its operations to accommodate the distribution of 50,000 cars per month (assuming Elon’s hypothetical 500k Model 3s per year plus another 100k total between the Model S, X and Roadster models) is a big challenge, and unproven.
The Ugly
Inevitably, when we talk about stocks we must think about valuation, and how that valuation stacks up relative to a company’s competitors. Since we’ve been using Volkswagen for comparison already, we might as well continue to here. Volkswagen, in addition to knowing how to produce, distribute and sell mass-market cars globally, is among the most recognized and successful luxury car manufacturers as well. They own Audi, Porsche, Bentley, Lamborghini, and Bugatti which represent highly-competitive and tremendously successful luxury brands. What’s worse for Tesla is that Audi and Porsche are releasing electric vehicles intended to take on Tesla directly, and early reports suggest they will be very competitive indeed. They’re not alone either. Jaguar has already released an acclaimed electric car, the iPace. BMW (whose existing electric models the i3 and i8 are largely niche products) and Mercedes are also developing new electric cars. Expect them to be good.
Volkswagen does have a higher enterprise value than Tesla, by about 25%, however, although the valuation is slightly higher, it blows Tesla’s Falcon Wing Doors off in every other respect as the following table reveals.
Pay close attention to the cash available, free cash flow, and capital expenditures. Volkswagen has large amounts of cash on hand and is generating significant free cash flow despite massive capital expenditures. When you consider the future of a company reflects on their CapEx. That is the investment the company is making in the future, and VW is vastly outspending Tesla. Not only is Tesla 10x as expensive as Volkswagen, but they are also investing less than 1/8th as much in CapEx. In the short run the stock market is a voting machine, but in the long run, it is a weighing machine, and Tesla bears a heavy load indeed.