Tesla. The company name evokes very different yet equally strong responses from critics and fans. Critics argue Tesla loses money on each car sold. Indeed, with losses of $290 million in 2014 and $888 million in 2015, it’s unclear when the company will eventually hit profitability. Critics also point to the fact that cofounder and visionary CEO Elon Musk often oversells what the company can do in the short run. The company has missed stated goals and new vehicle launch deadlines. Moreover, the company has sometimes struggled with its innovations, like getting the Model X doors to work just right. On the other hand, proponents ignore the short term losses and point out that Tesla produces highly desirable electric vehicles—cars that go faster, go further (than other electric vehicles) and are safer than internal combustion engine (ICE) vehicles. They point out the astonishing fact that Tesla reeled in nearly 400,000 reservations for its Model 3 in a single week – pre-orders that will rack up over $16 billion of vehicle sales. A single tweet from Musk teasing a product announcement sent Tesla shares surging yesterday. Investors continue to back Tesla with a lofty market cap of over $30 billion, which translates into a significant innovation premium.
It’s this innovation premium that helped Tesla race to the top of our Forbes Most Innovative companies list in 2015 – and stay there. It maintains its #1 position for the 2016 ranking. Tesla’s next challenge is whether or not it can become profitable and deliver on its huge market value. And will Tesla ultimately be the catalyst behind transforming the auto industry from ICE vehicles to electric vehicles? Our analysis signals it can and likely will.
Taking Tesla’s Lofty Market Cap Into The Future
Tesla deserves its high market cap only if it can reach profitability – preferably in the next four years. Musk has long stated that the path to success was to start at the high end of the market with cars like the Model S and X and then move down market, producing more affordable cars like the Model 3. But if Tesla can’t make money on expensive vehicles as some analysts suggest, the obvious question is: can they make money selling cars at half the price?
The answer? Absolutely. Our analysis (with professor David Kryscynski of Brigham Young University) of Tesla’s improvement in cost per vehicle shows Tesla is making money on the Model S and will likely make solid profits on the Model 3. Let us explain. One of the tools of any strategist is a scale (or experience) curve. A scale curve calculates how rapidly the cost per unit (in this case, vehicle) decreases with every doubling of unit volume.[1] This analysis is useful for projecting how Tesla’s costs per unit will change going forward based upon its history.
A scale curve analysis on quarterly cost and production data from 2012-2014[2] shows Tesla’s cost of production per Model S at the end of 2014 was around $50,000 per vehicle (See Figure 1). This is actually quite good for a Model S with an average selling price of about $85,000. It means Tesla’s losses are a result of significant investments in sales and R&D to launch Models S, X and 3, and to build the battery Gigafactory. It also shows Tesla’s cost per unit has been dropping roughly 20% with each doubling of unit volume.
This scale curve analysis allows us to project with some confidence what Tesla’s future costs per vehicle will be when Tesla ramps up production on the Model 3. If we assume the Model 3 will follow roughly the same scale curve as the Model S (cost per unit drops 20% with every doubling in volume) and that it will cost 10% less to produce (and this is a very conservative assumption), we can provide rough estimates of the unit volumes Tesla will need to hit profitability. First, if Tesla can sell 160,000 units of the model 3 in a year, its cost per unit should be roughly $35,000—the base price for the vehicle (the average selling price is projected to be around $42,500). If Tesla can sell 275,000 units of the Model 3, its cost per unit will drop to roughly $27,500. With an average selling price of $42,500 and cost per unit of $27,500, Tesla would make roughly $15,000 per unit to apply to cover its costs for R&D, sales and marketing, G&A, and the Gigi-factory. Based on those projected costs, we believe Tesla will roughly breakeven at around 275,000 units and start generating company profits above that volume.
The bottom line is that sustaining Tesla’s lofty stock price depends on Model 3 volume. Musk was right when arguing that Model S and X were key to launching Model 3—the car that can drive the firm to profitability. If Model 3 generates 400,000 orders per year (the number of current reservations), the lofty stock price makes sense. If not, that’s obviously a very different ending to the story.
Financials aside, two of Tesla’s greatest assets driving its high innovation premium are something that can’t be so neatly calculated: innovation and leadership. To attain its goal of industry transformation, Tesla must first do something it’s never done before: produce cars in seriously large quantities.
Skeptics say Tesla overpromises, rarely hitting ambitious timelines. In fact, in the past five years Tesla has fallen short on more than 20 projections, ranging from car-production output to financial targets.[1] On Tesla’s last earnings call in May, Musk announced a dramatically revised production schedule for Model 3. Instead of pushing it back, Tesla moved it forward – by two years. Like many of Tesla’s analysts, we think its production goal of 500,000 vehicles in 2018 is very aggressive and probably impossible. Shipping such a massive quantity of cars means revving up production of Tesla’s existing models, bringing online the world’s largest electric battery factory, and cranking out hundreds of thousands of Model 3 sedans – an entirely new vehicle. Musk has laid out a timeline for Model 3 suppliers to ensure that they have parts ready for production by July 1, 2017. But he conceded, even while giving that date, that it “is not a date that will actually be met; it is an impossible date,” but it is a date the company needs “to hold suppliers to.”[2]
Overpromising is Musk’s MO. Some frame this as a critical flaw. Yet, it could actually be what makes him a compelling leader of innovation. “Elon is pretty good at harnessing and channeling the team to do pretty amazing things that were beyond what the team even thought was possible,” says co-founder and chief technical officer JB Straubel. “If you challenge people to work hard, they achieve more than they think they can. Most leaders don’t want to do that.” Musk’s track record of promising the impossible is matched by a track record of delivering the wildly improbable. He pushes Tesla (and SpaceX) to pursue – and realize – unprecedented innovation in unconventional ways. Take a simple act like moving one of the world’s largest stamping presses from the east to west coast in the U.S. After purchasing the machine at a bargain price, Tesla asked the manufacturer how long it would take to disassemble and deliver to California. The quote was a year. Tesla’s response was, “we can’t afford to wait; we’ll figure out a way to do it in three to four months.” And they did with an internal team that was pulled together expressly to pull off the move quickly. The team hit a number of roadblocks along the way but problem-solved their way to getting the press safely transported and installed in Freemont in four months. Concerned the press was too large for tunnels and overpasses, they cut seven inches off the press bed. They even modified and raised cranes at the factory so that the press could be reassembled and programmed. To finish off the installation, Tesla employees, including VPs, volunteered personal time on the weekends to repaint the press red, white and grey – Tesla colors.
The sacrifice of personal time in pursuit of the larger goal is characteristic of Tesla employees, including Musk who has been known to move his desk (and even his sleeping bag) to the center of the action. On the Q1 2016 earning call, Musk said, “I move my desk around to wherever the most important place is for the company and then I sort of maintain a desk there over time to come and check in on things.”
From his position “in-the-trenches,” Musk pushes Tesla to figure out how to hit a high mark in terms of product and business model innovation. Whether employees can continue to push so hard over a longer time horizon without burning out or getting demotivated by seemingly impossible targets remains to be seen. So far though, Tesla’s innovation results have been impressive. The company’s most significant innovations in the past few years, beyond the vehicle itself, span several different categories.
Sales: Tesla’s revolutionary, direct-to-consumer sales model – which allows customers to purchase directly from Tesla as opposed to through third-party franchised dealerships – has upended the way people today think about buying cars (just like Uber has changed the way we think about taxis). Now you can also shop for your Tesla while you browse for suits at Nordstrom. Just this year, a Tesla “Gallery” showcasing Tesla vehicles opened inside the high-end retailer, located in the men’s department at the Grove in Los Angeles. It’s an experiment that will likely pressure traditional dealers to get more creative about sales.
Cash for cars (reservations): Earlier this year, Tesla received 325,000 reservations for the Model 3 in the first week of the unveiling, far exceeding expectations for the $35,000 compact electric car. People stood in lines overnight to reserve a car that they had never even seen! Moreover, they were reserving a vehicle that they wouldn’t actually be able to purchase for at least 18 months. A reservation requires more than a signature; to reserve their Model 3, customers handed over $1,000. With over 400,000 reservations to date, that’s over $400 million in “free” capital. The “funds through reservations” cash allows Tesla to fund research and development projects, construction of its battery factory, and an expansion of retail stores, service centers and its Supercharger network. The rush of orders also means Tesla took in more cash from the Model 3 than its June 2010 stock market float, which raised more than $226 million.
Autonomous driving: Virtually all major car and tech companies are pursuing self-driving technology as the future of transportation. But Tesla and Google are the earliest innovators – and Tesla, by many accounts, is taking an early lead in the race. While Tesla vehicles are not yet fully autonomous, its Autopilot System is the most advanced on the roads today. And Tesla only continues to interate and improve the technology based on real-world data and experience as Tesla cars hit the road. But Tesla’s ambitions go well beyond just having your car’s autopilot drive you to your destination. “When true self-driving is approved by regulators, it will mean that you will be able to summon your Tesla from pretty much anywhere,” says Musk. “Once it picks you up, you will be able to sleep, read or do anything else enroute to your destination.”[3] But beyond that, Tesla is planning to create a “shared fleet” and a mobile app (like Uber) so that you can “add your car to the Tesla shared fleet just by tapping a button on the Tesla phone app and have it generate income for you while you’re at work or on vacation.” Think about it: your car could become an income generating asset. This could dramatically lower the true cost of ownership since most cars are only in use by their owner for 5% to 10% of the day.
Betting on batteries…and solar: Musk made waves with his recent announcement of Tesla’s new 100 kWH battery pack for Model S and Model X, which he claims makes the Model S the quickest production car in the world. But it’s Tesla’s Gigafactory that is perhaps the most vivid example of the scale of Musk’s ambitions. When the Nevada factory is complete, it will be – literally – the world’s largest, by footprint. It will also become the world’s largest producer of batteries. By 2020, the Gigafactory will reach full capacity and produce more lithium ion batteries annually than were produced worldwide in 2013. Eventually, the Gigafactory will produce enough batteries to supply 150 gigawatt hours of batteries per year – enough to power 1.5 million Model 3s. But arguably, for Tesla, it’s bigger than all of these things. It’s more than a battery factory; it’s the critical key to the company’s future. Without the Gigafactory, there wouldn’t be enough batteries to launch the Model 3 and Musk’s ultimate quest to save the world from climate change could fail. But in the future, Tesla doesn’t just want to power its cars with just batteries—it wants to use solar. Indeed, in his recent “Master Plan, Part Deux,” Musk wants to “create stunning solar roofs with seamlessly integrated battery storage” so your car could generate the energy it needs just by sitting out in the sun all day.
All this adds up to Tesla making the move from automotive company to a rapidly expanding energy innovation company. And Tesla’s history of solving tough, seemingly impossible problems means its goal of becoming the best manufacturer in the world might actually be possible.
Leading The Charge At Auto Industry Transformation
So is Tesla still at the front of auto industry transformation? What we know so far is that electric vehicles were essentially dead before Tesla joined the fray. Tesla has shown the world that EVs are desirable compared to ICE vehicles—they are faster, safer, require less maintenance and are greener.[3] Now Tesla has reservations for over 400,000 model 3’s and the world’s largest automaker, Volkswagen has announced that they are moving into EVs in a big way. As more incumbent (and possibly new: think “Apple”) automakers jump onto the electric bandwagon, the cost per battery cell will drop (and/or range will increase) at an even faster rate. Tesla announced its plan to expand its electric vehicle product line to address all major segments with Musk claiming that “a future compact SUV and a new kind of pickup truck” are in the works. With this momentum, barring the unforeseen, we expect the dominoes to continue to fall in the direction of EVs and wouldn’t be surprised to see them account for one-fourth of all new car sales in the U.S. in 10 years. And with ongoing innovation, the EVs of the future will outclass those of today. They may drive themselves, charge themselves, and generate income by themselves as owners place them in an autonomous Uber-like fleet. Tesla dreams big because it asks and answers the big questions. And that’s why investors have kept Musk’s Tesla #1 on our 2016 list of most innovative companies.
[1] An experience curve is similar, showing the cost per unit over time with cumulative units produced. (Pulliam, Susan; Mike Ramsey and Ianthe Jeanne Dugan. “Tesla Talks Big: Falls Short.” Wall Street Journal, Tuesday August 6, 2016.)
[2] These data come from public sources. Tesla reports the cost of automobile manufacturing as a line item in its annual and quarterly reports. Tesla does not publish production numbers but there are a number of Tesla enthusiasts and analysts who have developed estimates of sales volume by quarter. Since Tesla has a backlog for Model S vehicles and typically ships as soon as it produces, it is likely that the sales volumes match tightly the production volumes in any given quarter.
[3] There is much debate and disagreement about how much greener BEV vehicles are for the world; but at the very least with BEVs we can control where the pollution exists and keep it away from people more effectively. ICE engines pollute where people live.
Jeff Dyer is the Horace Beesley professor of strategy at the Marriott School of Management at Brigham Young University and a cofounder of the Innovator’s DNA (www.innovatorsdna.com), an organization dedicated to helping individuals and companies realize their full innovation.
