Tesla's Aggressive Financing: Revolutionary Or Shortsighted?

| About: Tesla Motors (TSLA)

Electric vehicle maker Tesla (NASDAQ:TSLA) stole headlines over the past several days. The firm announced that it will be profitable on both a GAAP and non-GAAP basis as its first quarter sales exceeded expectations (4,750 units versus 4,500 units estimate). Tesla also cancelled its 40 kWh battery version, which is positive, in our view, because it will raise the firm's average selling price, likely boosting margins. We were a bit surprised to see the company have software limit the driving range to 40kWh rather than force consumers to upgrade to 60kWh batteries, but we think the decision could positively impact brand perception.

More importantly, Tesla revealed what it's calling a "revolutionary" financing plan. Tesla has partnered with US Bank (NYSE:USB) and Wells Fargo (NYSE:WFC) to offer 63 month financing at an APR of 2.95% and 10% down. This doesn't make the car cheap - a mere $1,097 a month payment for the 60kWh model doesn't scream bargain - but it does give the firm exposure to lower (but not low) income buyers; not only the wealthy. This is far from revolutionary, but Tesla's guarantee to effectively allow buyers to walk away from their Model S after three years could be. Tesla will allow buyers to sell the car back to Tesla with the same residual value as an S-class Mercedes (approximately 43%). This is guaranteed not only Tesla, but also founder and CEO Elon Musk.

Ultimately it will be out of Tesla's hands what the real residual value of the Model S. Tesla's taking on a large amount of risk because market rates will ultimately prevail. The three-year residual value percentage of a Model S could be 43%...or 55%...or 30%. The market for luxury resale is fairly robust, but if Tesla's vehicles are just the flavor of the week, the company (and Musk) could be on the hook for potentially large losses. The company may have created a floor above the natural depreciation rate, and it could be forced to sell the cars a second time for a loss.

Of course, it could work out phenomenally well for Tesla. Sales could swell because the car will be available to a much larger population, giving the company cash to invest in its business via new models, retail outlets, improved technology, or production facilities. The Model S could also retain a higher resale value because there will be limited supply, allowing the company to make money on its repurchase option. It seems unlikely that Tesla could retain a higher residual value than a Mercedes S class, but it is possible, in our view.

We think taking on this risk was a necessary step towards growing the business. Yet, we've seen some evidence that sales may have slowed towards the end of the quarter. An executive emailed potential customers, asking them to turn in their paperwork before the end of the quarter so the company could post a profit. This, coupled with Tesla's aggressive "true cost of ownership" campaign could suggest some weakness. The firm jumped through hoops and made rather outrageous claims to suggest the "true" cost of purchasing a Model S is $471 per month. This "true" cost nets out monthly gas consumption (assuming 15k miles driven/annually), deducts $40 a month for the residual guarantee, a $222/month "business tax" deduction, time at the gas station opportunity cost savings of $100/hour at the gas station, and $100/hour in commute time savings from riding in the carpool lane.

While all of these things may be true, how would investors feel if Apple (NASDAQ:AAPL) started selling users on the true cost of iPhone ownership based on relatively nebulous and hard to quantify metrics like forgoing the cost of buying a PC? What if Panera (NASDAQ:PNRA) started advertising prices for its salads based on the potential medical savings compared to a double cheeseburger? We think investors would be highly skeptical of demand.

Ultimately, we think Tesla's financing step was necessary to grow the business, and it could boost the business in a positive direction. However, the decision is not risk free, and the company's effective put option could put its survival in jeopardy if demand falls. Further, Tesla's aggressive price calculations could turn off customers, and it could show that sales velocity could be declining. Musk is a fantastic entrepreneur, and we see the potential for massive upside, but we simply aren't thrilled by the current risk/reward opportunity, so we won't be adding shares to the portfolio of our Best Ideas Newsletter at this time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.