By Dean Goh
Tesla is a hot, hot stock - its share price has surged by more than 700% from the 20th of December 2019 to the 18th of December 2020. The excitement over Tesla can be said to be fuelled by the cult Elon Musk has built for himself as a successful entrepreneur and the potential mass adoption of electric vehicles (EVs) in the future to combat climate change. However, as asset managers/investors looking to invest in fundamentally strong businesses, touting one’s admiration for Musk cannot cut it as a rationale for investing in Tesla.
We should look much deeper into Tesla’s business model, risks, financials and competitive advantages before reaching a more informed decision about the investment potential of the company. Is Tesla’s popularity as a stock driven by hype or by solid business fundamentals? That’s exactly what we are going to find out in this article.
Firstly, what does Tesla’s business model look like?
Tesla reports two main business segments in its 10-k:
1) the design, manufacture and sale of its EVs like the Tesla Model 3, Model S, Model X and Model Y;
2) the sale of its solar generation storages.
As the sale of Tesla’s EVs comprise the bulk of Tesla’s revenue, we will only assess Tesla’s electric vehicle business in this article.
Tesla’s EV business model is a straightforward one. Tesla operates the plants which manufacture its EVs and the Gigafactories which manufacture the battery packs that power its EVs. The manufactured EVs are then sold to consumers directly via Tesla’s online and physical stores (we will discuss this further later). Thus, Tesla’s business model can be seen as a vertically integrated one.
Fig. 1: Tesla’s business model
I am excited for the future of EVs especially since they run on renewable energy. So I’m happy to see the rather consistent increase in sales of Tesla’s EV from quarter to quarter since at least 4Q 2017 onwards.
Financials wise, there has been lots of gripe about how Tesla has struggled to turn a profit, which I felt was only natural for a company still in its nascent phase of growth. However recently, Tesla has started showing signs of profitability by recording positive net income in all quarters starting from 3Q 2019 onwards. It also recorded positive operating and free cash flow in 6 of the 8 past quarters since 4Q 2018.
Fig. 2: A snapshot of Tesla’s quarterly financial metrics
Source: Tesla’s 3Q 2020 financial report
Although EVs are synonymous with Tesla today, the question really is whether Tesla is able to continue dominating the EV market 10-20 years from now. This very much depends on whether Tesla is able to build economic moats around its business to fend off present or potential competitors.
Lack of competitive advantages
Low barriers to entry
The EV market that Tesla operates in has low barriers to entry as EVs are not very complex to make. While a car with a combustion engine needs about 30,000 components, an EV needs just 11,000 parts. The relative ease of making an EV has allowed dozens of startups to enter the EV market over the past few years, from Lucid Motors in the US, to BYD and NIO in China. Legacy automakers like Mercedes, Ford, BMW, Volkswagen are already in or planning to enter the EV market in the next fews years. Tesla has also acknowledged the “highly competitive” market it operates in its 10-k (see image below).
Fig. 3: Tesla’s risk factors
Source: Tesla’s 2019 10-K
Low Switching Costs
One way businesses retain their customers is to make the costs of switching to using its competitor’s products/services high for their existing customers. This deters their existing customers from switching to using its competitors’ products/services.
So then, what are the costs incurred if one switches from driving a Tesla to another car? Tesla is a luxury EV. With the arguably slight product differentiation between a luxury EV like Tesla and a luxury gas-fuelled car (e.g. Mercedes S300), switching costs from a Tesla to another luxury yet gas-fuelled car is low. (Being visceral in nature, this is quite subjective.)
To illustrate what high switching costs look like, consider Microsoft. One source of Microsoft’s high switching costs comes from the fact that its Windows Server forms the IT backbone of many of the world’s largest companies today. As it is extremely costly (in terms of monetary, psychological, effort-based, and time-based costs) for any company to replace any part of an enterprise’s IT environment, we can expect many companies to continue using the Windows Server. This is how Microsoft’s high switching costs lock companies to continue using the Windows Server.
In comparison to Microsoft, Tesla’s switching costs are miniscule.
In a crowded field of EVs, Tesla has managed to retain its crown as no. 1 EV maker by market share. Its share of the EV market has even increased by 4.4 percentage points from 2018 to 2019. So I figured Tesla might have some strengths worth exploring.
Fig. 4: EV market share by brand
Before looking at how Tesla benefits from direct dealerships, let’s understand dealership laws in the US. Due to franchise laws in many US states, direct auto manufacturers can only sell their new cars via independent dealers. The idea behind the franchise system is that third-party businesses can service customers better by fostering competition.
However, Tesla is quite special - it sells its cars directly to consumers via its retail stores and online channels. This has two benefits for Tesla:
Tesla sells its EVs at retail prices (which are higher) rather than at wholesale prices to dealerships. So Tesla earns more selling its EVs directly to consumers.
A counter-argument can be made that in the long-term, legacy automakers can also be an EV-only company. However, some analysts point out that legacy automakers have “legacy cost structures” around their gas-fuelled vehicles that take a long time to eliminate. These programs cannot be stopped just to manufacture EVs as this would cause losses for the legacy automaker.
Tesla believes that direct sales creates a better customer buying experience.
At Tesla’s retail stores, customers deal only with Tesla-employed sales and service staff. Customers can also buy and customise Tesla EVs directly online on Tesla’s online sites. Further, Tesla has combined many sales centers with service centers (i.e. Service Plus centers), where customers can charge/ service their vehicles at.
On the point of customer experience, Tesla has initiated other ways for its services to stand out. Tesla employs “Tesla Rangers”, mobile technicians who can service vehicles from the Tesla owner’s house. In certain cases, technicians can fix problems with the Tesla remotely as the Tesla Model S can wirelessly upload data for technicians to view and fix the problems.
Cheaper battery costs = Cheaper EVs
The high cost of batteries is the main reason why EVs are so expensive - battery costs account for about 30% of the total cost to consumers. This is due to the high cost of Cobalt, which is by far the most expensive element in a lithium-ion battery which powers EVs. If Tesla is able to find a much cheaper alternative to lithium-ion batteries, this would make its EVs much more affordable to the mass market.
When Tesla held its “Battery Day” in September 2020, Musk unveiled Tesla’s plans to cut battery costs of its EVs by half within 3 years. Most were incremental techniques that would lead to cumulatively large improvements in the technology used to produce batteries.
For example, Musk shared that Tesla is working on a high-nickel cathode that eliminates cobalt, with cost savings of around 15%. Tesla is also making new anode and cathode designs, which is expected to cut costs by 5%.
Tesla is also moving backwards in the supply chain, re-engineering cathode and anode production processes to remove any redundant intermediate steps. As Tesla has secured mining rights to a 10,000-acre lithium deposit in the US, Tesla is now able to establish cathode manufacturing using domestic lithium and nickel supplies.
Material improvements in the battery production process and the streamlining of the supply chain are expected to decrease Tesla’s battery costs.
Fig. 5: Improvements in Tesla’s EVs to save costs
Source: Tesla’s 2020 Battery Day presentation slides
As first movers in building factories for the production of batteries, Tesla has a cost advantage that legacy automakers might take years to match. Legacy auto makers might be deterred by the huge capital outlay required to build the factories required to produce batteries for EVs. As for automotive companies like BYD that already produce mainly EVs, they need Tesla’s financial muscle to invest heavily in the production of cheaper batteries if they were to pose any market threat to Tesla.
As mentioned earlier, EVs are quite simple to make, but making affordable EVs is quite the opposite.
Vertically integrated model
In 2016, Tesla blamed “unsatisfactory supplier capability” for the delayed ramp up of the Tesla Model X production. Since then, Tesla did what other legacy automakers have not done - that is to do almost everything themselves.
Most automakers today are assembly and branding companies. After assembling parts from their supply chain, they hand the finished product to the dealerships. However, Tesla has taken its manufacturing in-house, from the manufacture of its windows to seats to batteries. Tesla essentially takes full control of the important pieces of the Tesla experience. This affords Tesla the agility to conduct requirement gathering, iterative development and functionality validation of its vehicles, innovating its products efficiently.
Of course Tesla’s vertically integrated model extends to taking charge of its own sales and service networks too.
Huge Capital Expenditure (CAPEX)
Apart from battery costs, the lack of Economies of Scale (EoS) is another factor causing the relatively high prices of EVs. Hence, to achieve EoS, Tesla needs to build more assembly plants to achieve annual unit delivery volume in the millions. Tesla estimates its capital expenditures to be” at the high end of..range of $2.5 to $3.5 billion in 2020 and [to] increase to $4.5 to $6.0 billion in each of the next two fiscal years.)
Tesla’s CAPEX is huge compared to the operating cash flows of $2.92 billion and $980 million Tesla has generated in FY 2019 and FY 2018 respectively. To generate positive free cash flow in FY 2020 and the many years going forward, Tesla needs to ensure that the cash generated from its operations is greater than the amount spent on CAPEX.
Fig. 6: Tesla’s annual CAPEX
Source: The Street
As with all investments, Tesla’s huge CAPEX on its factories may not pay off. The success of Tesla is partly contingent on policymakers’ commitment to EVs as the next generation of personal transportation. Tesla also needs to be able to sell its EVs at affordable prices to the masses - which is dependent on how successful Tesla is in bringing battery costs down and increasing its vehicle range.
Key Man Risk
Muskian fanfare has kept many investors hyped about the future of Tesla. And it’s also a fact that Musk plays an extremely integral role as CEO of Tesla. So it was quite worrying to read in Tesla’s 2015 10-k that Tesla “is highly dependent on the services of Elon Musk” but that “he does not devote his full time and attention to Tesla”. Musk is also CEO of SpaceX.
Tesla’s fate is closely linked to Musk’s actions - in a similar vein Disney’s is with Bob Iger and Starbuck’s is with Howard Schultz. If Musk one day decides to leave Tesla, would Musk’s successor have his entrepreneurial nous to navigate this challenging industry?
Asset managers’ Dilemma
As Tesla officially joins the S&P 500 index in December 2020 as one of its largest constituents, a broader range of asset managers now face the dilemma of whether to own Tesla shares, and if so, how much of it?
The dilemma arises from the tremendous uncertainty of Tesla’s future. If Tesla continues its impressive rally and asset managers don’t own a sizeable weightage of Tesla in their funds, they might significantly underperform the S&P 500 index. On the other hand, they may find themselves ahead of the S&P 500 index if they choose to own little to none of Tesla’s shares and Tesla’s rally reverses course.
Before Tesla’s inclusion in the index, Tesla has been a very under-owned stock across actively managed funds as its low profitability and high debt excludes itself from stock screeners asset managers have created.
However, asset managers might be glad to know of the inclusion phenomenon. This happens when a stock joins an index and its share price correlates more strongly with the index when they joined. This is because inclusion in an index changes the structure of the company’s shareholder base. After Tesla had been added to the S&P 500 index, about 17% of its shares available for trade will be owned by passive investors, who buy and sell all 500 stocks in the S&P index as a group. Hence, the volatility of Tesla’s stock is expected to decrease.
It’s important to keep the hype over Tesla in perspective to its potentially bright, yet uncertain future. At the end of the day, Tesla’s growth prospects can only be fulfilled by the fulfilment of certain hard realities.
I hope this article has shown you that the quality of Tesla’s business is not as straightforward as coming to the conclusion as to whether Tesla is a good or bad business. Rather, Tesla has its strengths and weaknesses, that Tesla can use to dominate or get exploited respectively.
Dean is a first year Philosophy and Economics undergraduate at the London School of Economics. He started writing articles about REITs investments when he was 18. He then went on to write and publish articles on Singapore and US equities for an award-winning investment blog site before university started.
This information should not and cannot be construed as or relied on and (for all intents and purposes) does not constitute financial, investment or any other form of advice. Any investment involves the taking of substantial risks, including (but not limited to) complete loss of capital. You are advised to perform your own independent checks, research or study.