Neither hype, irrational exuberance nor a temporary short squeeze would appear to explain sufficiently the reception to a recent fundraiser that was reportedly over-subscribed by institutional longs at what was then a 52-week high, achieving $1.08 billion for pure electric automaker Tesla Motors Inc. (NASDAQ:TSLA). On closer examination, Tesla has many remarkable features that set it apart from comparison with other businesses, and mark it out for success in a way that provides a very real and rational underpinning for both its current price and for an expectation of future gains.
Tesla Motors Inc.
At the very outset, to assess the probability of success versus the probability of failure for Tesla, one needs to go right back to the beginning and look at its core motive, one that is not normal for any business because it is not the profit motive, at least not for its own sake. It was, and it remains the electrification of transport as a life's-calling for young and already very wealthy man seeking for meaning in an "is that all there is moment" following creation of PayPal and its sale to eBay (NASDAQ:EBAY). For Elon Musk, the success of Tesla in catalyzing a transport revolution is an urgent imperative for human progress and whatever the objective truth of that may be, for Elon Musk it is a must happen and in the absence of it happening already it fell to him to make certain that it does. The strength of that conviction since his initial $6.3 million seed investment in Tesla in 2004 has been tested and has been proven to out-weigh two marriages, and at one point the expenditure of all of his money including the last of the proceeds of the sale of PayPal and latterly in a personal guarantee to Wells Fargo and US Bank that holds the threat of ultimate humiliation in the case of the failure of Tesla to succeed in the form of a liability to recycle his remaining net worth including holdings in SpaceX and Solar City to personally buy back as many as possible of three years of the company's vehicle production as a prelude to personal bankruptcy if it fails.
As a result, Tesla is not a company with an ordinary limited liability risk profile, it is a company personally guaranteed to succeed by its Chairman, Product Architect, CEO and largest shareholder Elon Musk. Mr. Musk is personally invested alongside the company's remaining shareholders in the amount of $170 Million including a recent top-up of $100 Million to prevent the dilution of his control during a recent $1 Billion financing round. Mr. Musk's salary from Tesla as at 2012 was California minimum wage of which he accepted only $1.00 Annually, a conspicuous difference in take-home pay while all other named executives received salaries well into 6 figures. For this reason, amongst others, Tesla is a company that despite its normal voting structure and considerable resource of expertise available amongst its executives and board members has every appearance of being led by a singular visionary carrying unsurpassed moral authority. In summary, unlike a business operated by consensus on measures aimed at achieving a purely profit-motivated outcome, Mr. Musk's status affords him support for unfettered control of the direction of Tesla that need not countenance any obstruction in setting about achieving very bold visionary aims.
As a special footnote applicable to this business: The CEO is philosophically long humanity and for that reason can be expected to have a special malevolence for shorts.
Looking at the upside, Mr. Musk is contracted to the board of Tesla Motors Inc. to achieve the following milestones set against a total of 5,274,901 $31.17 share options of TSLA common stock, each to be accompanied by a $4 billion uplift in market capitalization commencing at $3.2 billion in 2012 and achieving a total of $43.2 billion before 8/13/2022. At the time of writing, this represents a target of 429% uplift in market capitalization within the same time period or less.
Successful completion of the Model X Engineering Prototype (Alpha);
Successful completion of the Model X Vehicle Prototype (Beta);
Completion of the first Model X Production Vehicle;
Successful completion of the Gen III Engineering Prototype (Alpha);
Successful completion of the Gen III Vehicle Prototype (Beta);
Completion of the first Gen III Production Vehicle;
Gross margin of 30% or more for four consecutive quarters;
Aggregate vehicle production of 100,000 vehicles;
Aggregate vehicle production of 200,000 vehicles; and
Aggregate vehicle production of 300,000 vehicles.
If an investor is satisfied that these milestones are in all probability achievable, then subject to individual due diligence, a simplistic long theory of investing in Tesla alongside Elon Musk would appear to be sufficient rationale to do so.
It is equally relevant to state that the departure of Mr. Musk from Tesla by any means would require a dramatic reassessment of both risk and upside potential. Note that Elon Musk's personal victory condition for Tesla is significantly greater than the production of 300,000 vehicles. It is to participate in a combination of producing and triggering collaboration and competition to achieve a total of 50% of all new car production as electric vehicles in a timeframe of around 13 years. Naturally ambition of that scale brings the potential of both risk and reward, and it should not go without saying that the ambition aims to interfere with vested interests on a scale that at times has been the subject matter of armed conflict abroad and will likely lead to very well-funded and considerable opposition at home if approached with insufficient consensus. In the view of this author it would however appear reasonably hopeful that such a consensus could be found in the timescale indicated, and indeed that Mr. Musk may well prove to be the catalyst and the leader suited to the task.
The following relates to factors that affect the ability or probability of Tesla achieving the first set of contracted milestones.
The Tesla Model S.
For all of the reasons often cited in awards, accolades and commentary, Model S is a remarkable vehicle, scoring highly in terms of performance, handling, safety, seating capacity, interior space, elegance, quietness, aerodynamics, economy, and sophistication of infotainment systems, being web-enabled for over-the air software and firmware enhancements.
Model S is also the embodiment of the correct answer to a simple question that had previously evaded manufacturers of electric vehicles:
How to ensure the commercial success of a production vehicle that takes full advantage of the performance and lifestyle benefits offered by an elegant but relatively expensive electric propulsion system?
The answer: To install the elegant but expensive electric drive train in a commensurately valuable type of vehicle, a high performance sedan.
The Tesla Model S is also remarkable for a number of less commented-upon but highly non-trivial reasons:
The Tesla Model S. Car 2.0 - and very far beyond.
When looking at the Tesla Model S 85 Performance, it is normally described factually as a vehicle with a range of 265 miles EPA.
From a business perspective, with an eye to investment, it is much more useful to decompose it into two entirely separate items (The Model S Performance and the "85") that differ greatly from one another in risk and reward profile, noting that both the low risk and the high reward component rests with Tesla:
1. The Model S car (the proprietary design of Tesla Motors Inc.).
2. The 85 kWh of battery cells contained in the Model S Battery mounted beneath the car (the cells being the proprietary design of Panasonic Corporation).
The Model S is an award-winning fully mature production electric vehicle with elegant lines, a rustproof aluminum body shell and chassis for the most part and the lowest drag coefficient (0.24) of any current production car. A car with superior handling and power delivered by a highly energy-efficient electric motor that is capable of outputting an ample 416 hp at 5-8600 rpm and 443 lb-ft at 0-5100 rpm when supplied with electricity. An extremely capable and exceptionally future-proof design.
The source of electricity at the cell level, however, is by no means fixed. Currently, the Model S uses a Panasonic "NCA" nickel cobalt aluminum (LiNiCoAlO2) cell designed for 3000 cycles with minimal degradation in capacity and characterized by superior energy and power densities when compared with common commercially available alternatives. It is a truly excellent choice of cell when deployed within the Tesla Model S Battery pack and battery-management systems. A simplistic calculation of 3000 charge cycles x 265 miles EPA gives an indicative lifetime of 795,000 miles EPA or 53 years of service life at 15,000 miles per year. Even to take a conservative view at 500,000 miles to allow some margin for calendar life limits and various factors for degradation in actual service, this is an enormous figure. Note also that the battery management system present in the Model S has in some respects been designed to favor cycle life when compared with the deep-cycle laboratory bench test conditions. It is anticipated by this author that this cell-type is intentionally selected to out-last the customer requirement in the Model S vehicle for good reason discussed later in this article.
Footnote: While the current cell type is certainly fit for purpose in a 265-mile EPA range circa $100,000 vehicle package, there are two clear paths of obsolescence for this particular Panasonic NCA cell that would demand its replacement in future Tesla batteries:
1. The development of a cell with significantly increased energy density that permitted a large improvement in the range of the vehicle per unit battery size and weight.
2. A dramatic decrease in cost per kWh - to increase the profitability and/or reduce the total cost of the vehicle with battery pack installed, or to increase the range capability of the vehicle at the same or reduced price point.
Unlike the battery cell, there is no foreseeable path to the obsolescence of the Model S Car. The separation of the concept of car and battery cell, while basic in nature, fundamentally alters the risk and reward profile of vehicle production when compared with established industry norms.
As a result, the Model S vehicle is future-proof in its present form irrespective of any future risk or opportunity in the price or performance of energy storage, be it advances in battery technology, super capacitors or even far-future sources of on-board power storage (or power generation) not yet commercialized or even imagined. Irrespective of such developments, the Model S Car is ready to take advantage of them for renewed competitiveness and relevance to the market for decades to come without alteration of any sort besides renewing the contents of the battery tray underneath the vehicle.
An investment in Tesla is therefore an investment in an Auto company with patents covering future-proof electric cars. The comparative risk of obsolescence to companies with heavy investment in ICE vehicle production would appear to be substantially greater.
All of the risk factors typically discussed surrounding Tesla and electric cars generally revolve narrowly around the properties of the cells used as they relate to range and cost in particular. In the case of Tesla, that risk is borne by its cell supplier, Panasonic.
Model S, A profound innovation in upgradeable vehicles.
Beyond frequently commented upon ability of the Model S to be upgraded over the air in terms of software and firmware features.
The Model S is the world's cheapest and simplest car for its manufacturer to upgrade significantly, for example from a 265 mile EPA range to a 500 mile EPA range or greater. This dramatic upgrade will require exactly one component change in manufacturing (a new 18650 cell). A new cell can be incorporated in the design of the battery pack without any change of process flow or new investment in production equipment.
Note that the new cell could theoretically come from any source, and Tesla's first-mover advantage would in most cases dictate that Tesla would be offered any breakthrough in battery design as the most attractive EV battery customer. However, if it were the case that a new and attractive cell technology could not be developed by, purchased by, licensed or replicated by Panasonic, Panasonic while remaining a Tesla shareholder, risks the loss of Tesla as its customer, while Tesla remains secure in its ability to offer the advantages of the new technology to its customers simply by purchasing cells from a new supplier.
When compared with the manufacturing design costs and complexities required of traditional automakers to refresh the line with new models even for relatively insignificant differentiation, a near doubling of the range of a Model S with the swap of a single component begins to illustrate a powerful advantage inherent in the Tesla business model in the area of vehicle design.
Model S, an innovation in after-sales market potential.
With each advent of innovation in battery performance, Tesla will be able to offer its entire customer base the option to exchange the Model S battery for a pack that transforms the range of the vehicle or includes additional technologies for power generation that are presently only theoretical. Sales of this nature can accrue to Tesla's balance sheet for the life of the vehicle, which considering its primarily aluminum construction and limited number of wear components with no exposure to IC engine vibration, the absence of exhaust, fuel and oil systems can be very considerable, perhaps in the order of 30 years.
When considering the after-sales value potential of each Model S sold, the prospect for a very long service life, during which time some very significant advances in energy storage are inevitable, along with the essentially detachable nature of the under floor battery tray design, it would seem reasonable to extrapolate the sale of new battery systems more than once for each Model S and Model X vehicle sold, and for such sales to continue to be a source of revenue for Tesla deep into the second and subsequent user market for its vehicles.
Battery recycling with the benefit of turning night into day.
A brief note on Solar City (NASDAQ:SCTY): The Solar City business with initial seed-funding provided by its Chairman Elon Musk and run by Musk's cousins Lyndon and Peter Rive, is a fascinating business model in its roll-out of what can be described as a distributed solar energy utility company. Photovoltaic panels are provided on credit to customers in return for roof-space to install the panels and a contract to sell the electricity to the home or business at a reduced rate than previously available from conventional sources. Solar City retains the right to sell the electricity to the customer with any surplus sold to the grid, continuing long after the cost of the panel is amortized. Solar City partners with Tesla on the installation of Tesla Superchargers and provides an option for Tesla customers to obtain a solar panel system to offset the electricity consumed by the Model S when charging. Solar power, like wind power has one key limitation: Power output is dependent on the intermittent presence and strength of insolation (sunshine) and wind force respectively, that is unless it is combined with a device that is able to store electricity and provide it evenly or upon demand as the application demands. With regards to supply of power to the grid, a predictable and smooth supply is a valuable high quality power source. For vehicle charging, a very high power high voltage DC supply is particularly well suited.
Tesla's close cooperation with Solar City via its common Chairman provides an ideal outlet for former vehicle batteries for use in distributed grid storage, power-smoothing and vehicle charging, thereby recouping a premium value or even profits from former-vehicle packs. This built-in path to redeem value from used batteries has the effect of enabling Tesla in due course to announce the offer of a low-cost exchange program for its customers to upgrade to new battery technologies as they become available. Solar City also provides a route for eliminating battery-recycling liability (and waste) for Tesla. As noted above, the cell technology incorporated in the current Model S battery packs is particularly well suited to extended life beyond likely need in the vehicle. With the advent of upgraded vehicle packs as options for the entire Model S and subsequent Model X fleets, Tesla can dramatically reduce the cost of upgrading its customer fleet with ready access to a market for used batteries designed seemingly with the anticipation of an extended second life in distributed grid storage.
Model X Car 2.0.1, a model in shared-platform efficiencies.
Tesla Model X is a car that is fractionally different from the Model S in terms of core R&D, sharing as it does the entire Model S platform and infotainment systems. The Model X is conceived to answer a market requirement for a large family vehicle in the format of an SUV or Minivan. A feature of note is the option of an All Wheel Drive configuration that could mark the vehicle not only for very high performance on-road with enhanced practicality for handling snow and ice but also to reward the Model X with a market as a very advanced off-road vehicle where electronically-managed traction control (torque vectoring) combined with inherent advantages in low center of gravity, low-speed torque and smooth gear-change-free transmission provide a tremendous natural advantage over IC vehicles with respect to hill climb angle and handling of sand, wet and lose surfaces. The electric drive train offers extraordinary possibilities in the absence of engine air intake, hot engine and exhaust systems for handling mixed land and water tasks. Sealed and toughened variants of the Model X may prove as truly remarkable off road as the Model S has proven to be on-road.
The conclusion of AWD development for the Model X translates directly to a simple-to-implement ultra-sport Model S AWD variant with torque vectoring to deliver added appeal as a sports car and additional practicality in cold winter climates. Just as the transfer of technology from the S to the X requires minimal additional R&D expense, so does the transfer of technology from the X to the S.
The Tesla product strategy is a perfect example of the efficiencies of cross-compatibility and re-use of valuable R&D to enter additional market segments.
A brief note on the Tesla Drive Train and Development business.
The Tesla Drive Train business beyond Tesla banded vehicles is set to become highly significant from late 2013 with the introduction of the 2014 Mercedes Model B Electric Drive. This is an attractive and credible 135hp 115-mile range city car that features a 28 kWh version of the Tesla-style under-floor battery pack, though notably Lithium Ion type as used in the Tesla Roadster and not NCA as used in the Model S, and a small but Tesla inspired high-resolution touch-screen, network connectivity and smartphone app with remote access to pre-entry climate control. While Daimler is at present unique in its preparations for disruptive stress emanating from Tesla (despite reported indicators of deep inroads made by Model S into the Mercedes S-Class market segment in the USA), the Mercedes B Class Electric Drive sets an example of what is possible for Tesla to do in trade for disruptive stress placed on the US Auto Industry without near-term cannibalizing of Tesla's top-down product introduction strategy.
To summarize regarding vehicles prior to Gen III, following the long phase of R&D from 2004 onwards including testing and factory build-out phases, Tesla has achieved its objective of producing not just the best electric car, but the best car of any kind as exemplified by a sample of its awards: 2013 World Green Car of the Year, 2013 Motor Trend Car of the Year, Automobile Magazine's 2013 Car of the Year, Time Magazine Best 25 Inventions of the Year 2012 award, and Consumer Reports' top-scoring car ever.
In the process, Tesla has accumulated considerable experience with the Roadster and built a substantial and valuable patent portfolio covering everything from impressive battery safety innovations (that amply match the task of protecting customers as well as protecting the company and its investors from bad news), an in-house induction motor design that Nikola Tesla himself would have approved of that avoids the requirement for expensive rare-earth magnets, to patents protecting software and sunroof mechanisms. Tesla has also made some game-changing decisions in the way existing core R&D capital is leveraged to new models and variants and to produce exceptionally future-proof cars containing the core innovation of a discrete and replaceable battery tray that will remain a revenue stream for the company deep into the second and subsequent user markets.
The Tesla business: If anything, a financial model that is arguably more impressively engineered than the Model S.
A virtual monopoly on answering the call of climate change anxiety (in a way the markets can get behind).
The beauty of the Tesla story is that it does not begin with Tesla Motors Inc. at all. Tesla, as exemplified by the Model S, is the first credible caller in reply to a $ Multi-Trillion environmental awareness campaign that has been gathering momentum in the media, in schools, offices and government policies the world over for the past thirty years or more. Tesla is a credible caller and not just any caller because it is the first to read the fine print: The world demands an answer to climate change and global warming accompanied by improvements in standards of living, not a return to the dark ages. The Model S is such an answer.
While opinions still vary (and I should hate to lose a readers' attention on the subject of a business case because of it), this author happens to agree. The recent news of the Keeling Curve that tracks the concentration of atmospheric CO2 hitting 400ppm, a figure which if allowed to persist for long enough (let alone rise rapidly as it is doing) seems likely to correspond to sea levels of 3 million years past that would inundate every one of the world's coastal cities. Looking at the inexorable rate of climb in CO2 levels corresponding directly to the era of oil consumption over the past two hundred years or less, it seems more than likely this is not something natural that we are helpless to prevent. Like anything of our own doing, we have the power to not only undo it, but to do much better for ourselves in the process. The imperative therefore is for solutions that capture the power of the markets, making climate change and global warming something that is profitable to solve. That is the grand significance of Tesla Motors.
Every award-winning Model S sold or contemplated for purchase on its features and benefits comes with a great customer incentive (and it's not interest-free credit or a fancy key-ring). The Model S comes with a huge chunk of value and meaning carved out from a multi $Trillion externality to the Tesla business: A powerful vision of genuine hope for humanity and the world we all live in and a solid answer to the guilt (or rage) that we will leave a profoundly dangerous mess for school children to clear up after the reckless irresponsibility of grown adults.
I will refer to this later as the $Trillion climate change externality of the Tesla Business or simply the $Trillion externality.
Tesla Motors Inc. What it is and what it is not.
Tesla has no mandate to be a small luxury automaker. While Tesla with its broad appeal and current market leadership in electric vehicles has out-sold vehicles in the luxury category, Tesla is in fact the early stage expression of a $43 billion mainstream US automaker, accompanied by a drive train supply business that links it to partnerships with global automakers Daimler (Mercedes) and Toyota.
In addition, Tesla is proceeding on a war path to offer the Auto industry in the US and worldwide a menu of choices, all of which are not only acceptable but a cause for celebration for Tesla shareholders: Disruption, willing cooperation, cooperation mandated by disruption and genuine competition that contributes to developing the market overall and to provide a united consensus against the oil lobby in the transportation sector.
The Auto Industry is not the enemy
As a matter of fact, a vehicle that is more expensive because it carries a long-range battery that customers can charge cheaply or for free using a PV system just adds to the value proposition an automaker is able to provide to its customers at a profit. These are automaker profits that are traditionally given away by automakers to the oil industry when shipping a vehicle with an empty fuel tank for the oil industry to fill. Additionally, electric vehicles are far less engineering-intensive to build and with the correct economies of scale, EVs are destined to be more profitable overall. The following marks this author's only point of contention with the philosophies of Elon Musk: I believe that promoting the profit motive for automakers to add value to their customers with pure electric vehicles is a sufficiently powerful argument to achieve a disconnect from oil (and hence CO2 production) making a CO2 Tax unnecessary. I also believe that a very large lobby of EV owners, particularly once that figure approaches a majority, will not tolerate the mockery of charging zero emission vehicles from oil, gas or coal sources, and this alone is likely to be enough to bring the markets and public policy into alignment with the objective of directing large amounts of capital into the construction of a clean grid. This path seems more powerful than a CO2 tax and does not require a reduction in living standards to achieve its aims.
The Tesla, the rolling roll-out
Tesla's own answer to the latent demand posed by the Multi $Trillion climate change externality is profound on many levels: With the stated aim of making high-priced vehicles and following through with increasingly affordable electric cars.
The progression follows an assumption of falling battery price per unit performance over time (with the assistance of price-breaks on increasing volume)
The progression follows the requirement to accrue and protect R&D in advance of inspiring competition.
The progression anticipates an increasing requirement for capital expenditure for production funded by previous iterative steps.
The progression (from Model S onwards) anticipated a halo effect from higher to lower priced models that is impossible to achieve in reverse.
To achieve these aims, the method Tesla employs conforms precisely to a well-publicized Technology Adoption Curve theorem detailed in a Silicon Valley favorite business book by Geoffrey Moore entitled Crossing The Chasm. This feature of the Tesla business lends a degree of predictability to fundamentals underpinning the stock price.
To test the validity of the paragraph above (namely is Tesla using the Technology Adoption Curve): By all appearances the answer is yes. However for further proof, CEO Elon Musk has alluded to it in an interview by referring to the rate of accumulated customer adoption in an "S" pattern annotated with Crossing The Chasm keywords: innovators, early adopters, early mainstream, late mainstream and so on (an "S" shape is also my favorite way of picturing the rate-change of a bell-shaped curve). Lastly, Elon Musk took advantage of the Geoffrey Moore formula to great effect in launching PayPal, using it to justify what would have been an otherwise unimaginable risk. With PayPal, Musk took the business from a functioning pilot program to a critical mass of users with a public payout totaling $60 Million in pre-loaded PayPal accounts containing from $20 per account and tapering until the system was self-sustaining with around 1 Million users. It was $70 Million of Elon Musk's $180 Million winnings from the $1.5 Billion sale of PayPal to eBay that along with sales of the Roadster and input from Daimler and the DOE ultimately got Tesla through its IPO.
Approaching three years from its 2010 IPO with the DOE loan paid in full, this is now Tesla's turn to follow the Technology Adoption Curve.
There are three vital features of this conclusion that are worth noting in order to evaluate this stock:
1. No matter what the contents of the news flow, Tesla Output in terms of car sales is highly likely to follow the rising first leg of a bell-shaped curve, a shape that starts off relatively flat and becomes progressively steeper. If one were to consider the Roadster customers as innovators, the wait list customers for the Model S as Early Adopters, the Consumer Reports Review filling the chasm, Model S sales are now on the first slope of the Early Mainstream. It is a geometric increase that had already started just prior to the end of Q1 2013.
2. The second feature is that analysts (and human nature) rarely count on the high probability of a geometric increase in business performance.
3. The third feature is that Elon Musk knows both of these things (that Tesla business fundamentals are designed to increase geometrically and that both longs and shorts rationally expect linear improvements in quarterly results as a best-case scenario for the longs).
The Tesla Q1 earnings call beats.
From one of my own Seeking Alpha comments made before the May 8th Q1 Earnings call:
"There is a functioning line doing apparently 500 cars per week. (There is a reasonable speculation that this figure might have been pushed still harder after a much faster than anyone would expect cost rationalization / gross profit yielding and systems-optimization procedure - I would do it if I could because that's the blind spot for the earnings call beat - and Musk can and probably will do that in my opinion)."
I will demonstrate the underlying sources of geometric growth a little further below. In the mean time, I would like to point out that early-stages of geometric progression provides the explanation for the earnings call beats of both guidance and analysts expectations in Q1 2013, and suggest that one be aware that in accordance with the Technology Adoption Curve, this will continue to be a pattern in subsequent earnings calls for no other reason than there is nothing to stop it being that way.
Looking towards Q2, it is clear that it is possible for Tesla to process its backlog of orders to keep pace with a geometric progression extending from the Q1 results. To put the fact that it is possible, together with the knowledge that the business is being managed to conform to a geometric Technology Adoption Curve, will allow any reader at this point to sensibly predict the real Q2 production numbers and to extrapolate earnings. (These numbers will be very different from guidance). There is no such thing as fiduciary duty to shorts to prevent an outrageous beat. Naturally, if we can be clear that the production figures for Q2 will be closer to 6,750 - 10,000 units than the 4,500 on guidance, then it is reasonable to expect that with 38% of the float shorted on last count, the stock stands to be squeezed to somewhere in the region of $150 to $200 around next earnings. Supporting this process is also a good reason why reservation numbers are now masked.
From another of my own SA comments:
"There would appear to be a pattern emerging. Non-disclosure of production figures "looks" like it is disguising low numbers when in fact it is disguising high numbers. The spread permits for reliable beats of analysts' expectations. A most simple and reliable method of raising a stock price - in fact I have never seen skepticism played against itself so expertly. It is like playing poker with the opponent's cards in plain view - read the analysts figures whatever the number is, make more than that. If you can give high guidance above analysts expectations and beat that also, fantastic."
The lag in business fundamentals when compared to market capitalization is based on out-of-date quarterly earnings data exacerbated by the injection of uncertainty on production figures to draw-in short interest to levels of low liquidity. Good-news confirmation measured out in interim guidance only to be beaten again on earnings is a perfectly engineered environment for a rolling short-squeeze that provides Tesla with a legitimate and superior capitalization. It is quite brilliant, on par with the vehicle engineering.
The Tesla brand.
Problem: Climate change externality (anxiety)
Not just the best electric car but the best car of any kind.
The Tesla brand has at least three key branches
1. The celebrity status of its CEO Elon Musk, his heroic early stage private investments in Tesla, the philosophy that connects Tesla to the $Trillion Externality (that makes that investment a heroic investment in humanity), to Solar City which serves to counter any question of green credentials with a net emission-free grid input that covers the entire Tesla fleet. Finally SpaceX that gives Tesla the last word in any debate suggesting that the Tesla team cannot fundamentally out-class the engineering credentials of a traditional automotive manufacturer.
2. Tesla: The American high-tech-leading automaker, job creator, exporter of American pride, and the only US automaker to clear its debt to the US government (A restructured Chrysler lawfully walking away from $1.3 Billion does not really count).
3. The Brand value present in the Tesla Model S is where it gets fascinating. During the Q1 Earnings Call, Model S was reported to be replacing an unpredictable pattern of preceding vehicles from inexpensive to very expensive.
So far, the Model S has only been expressly promoted by objective measures. By range, efficiency, economy, sports performance, road handling, safety, low usage of brakes, few moving parts, low maintenance, fit and finish, comfort, quietness, trim, informatics, large sunroof and a variety of calculations concerning the relative cost of ownership when compared with gasoline vehicles.
Not one single lifestyle message or explicit celebrity endorsement. Yes Cameron Diaz and Ben Afleck and probably many other celebrities own a Model S without Tesla drawing attention to it. There is a great deal of un-tapped value in this area because the Tesla Model S is not confined to a socio-demographic stereotype. It is an EV, it is green, it is expensive, it is economical and low maintenance, practical, serene, connected to the Earth, Powerful, Sporty, responsible, manly, also feminine, it speaks of career progression, even celebrity, it also speaks of environmental tenderness, caring, it speaks of fun, nights on the town, beach life, it's a practical family car, a doctor on call, a limo - the list of attributes is endless, and there is no one who needs to feel uncomfortable purchasing it as would be the case with a Ford F150, a dodge Viper or a BMW 7 Series which clearly define whole swathes of society as either aligned or not aligned with the stereotypical imagery associated with those vehicles: For example, it would not be a good use of advertising budget to advertise the Viper or the 7 Series in a magazine about tasteful home decor. But you could certainly do so with the Model S just as easily as the Model S would fit alongside the Viper in Fast Car magazine or alongside the 7 Series in The Economist. It is also true that an F150 driver of mid-income could stretch to a Tesla Model S and justify the sense in that decision to his friends, family and neighbors legitimately on its low maintenance and running costs practicality and environmental credentials and enjoy much better dating success with it by comparison to stretching to buy a similarly priced BMW 7 Series that would merely be considered financially irresponsible.
Model S is a remarkable car in many more ways than its engineering when considering its market access.
As a footnote to the subject of branding:
The curious case of the Tesla Supercharger station.
Almost nothing could be as evocative as a well-branded Tesla Supercharger Station replete with obelisk, solar paneled roof and the promise of endless free electric fuel, especially if one is forced to drive past it in search of a gas station. Whether or not Tesla makes use of the potential, I would propose that the ability of a Supercharger Station to attract a stream of drivers for a mid-travel break of thirty minutes or more is the dream of the gas-station kiosk multiplied. It would be counter intuitive if highway-accessible retail and food outlets seeking a reliable source of affluent customers with time to shop and eat would not bid for the opportunity to host a supercharger station in their parking lot. This factor can lead to a far more rapid rollout of Superchargers at lowered impact to Tesla than would otherwise be envisaged.
Three sources of geometric gains embedded within the Tesla business model.
Positive feedback loop 1.
An illustration of advertising expenditure as a battle to obtain market share between Tesla and a traditional automotive manufacturer.
(Ignoring the possibility for drive train cooperation for sake of example). It is possible to make an astonishing comparison between Tesla and the traditional Detroit-based Automotive Industry practice:
Tesla cost of publicity: $0.00 (constant media attention)
Detroit cost to compete: $high and ever increasing
Value of press achieved with incremental Tesla sales: $high and increasing.
Impact of Detroit advertising with incremental Tesla sales: $diminishing returns.
The above is possible because of the $Trillion externality referred to above. The public audience is primed to welcome the rise of Tesla. Last year, GM reportedly spent $4.2 Billion on advertising, Ford reportedly closed behind with $3.9 Billion. It is impossible in consideration of these kinds of numbers to compete with Tesla that is making exponential gains in awareness and brand value without the requirement to budget for any above-the-line advertising expenditure at all.
The result is essentially a battle between a Positive Feedback Loop and a Negative Feedback Loop. A head-to-head battle of this nature is a foregone conclusion in Tesla's favor. Tesla combined with the tailwind of environmental concern for its success is already potentially the most important and least compromised Automotive Brand in the USA today and gaining similar traction World-Wide via the Internet and Tesla Retail.
Positive Feedback Loops 2 & 3.
These positive feedback-loops relate to both sales and the cash flow to support geometric sales growth. They have been made possible by strict adherence to focusing on brand value first with the support of the $Trillion externality.
Tesla customer vehicles leveraged as a $1 billion (and growing) display and demonstration fleet in a mode indistinguishable from an asset of the company.
A source of geometric sales growth, the Tesla virtual sales force:
Tesla enjoys the extraordinary advantage of an evangelical customer base. At present, there are an estimated 10,000 (minimum) Model S vehicles in circulation and growing rapidly. At a nominal average value of $100,000 each, these vehicles represent a $1 Billion and growing fleet of sales demonstration assets, each complete with one if not a whole family of messianic salespersons. In many, if not most cases, Model S (and Roadster) owners are shareholders and remunerated for sales success by dramatic uplifts in the Tesla stock price. The sales story these customers can tell is more genuinely persuasive than anything that could be said in an auto dealership backed by any amount of advertising, and the sales close can be as simple and direct as providing the use of a smartphone connected to the Tesla website to place a reservation with the prospect at the peak of passion. Alternatively, a sale can be as free of pressure as a later visit to a Tesla Store for a test drive or sitting at home with the Internet. It is revolutionary and supported by the simple message, the answer to climate change anxiety: not just the best electric car but the best car of any kind.
For calculation purposes on this metric alone, this author feels that it is entirely appropriate to add at least 100% of the value of each car sold to the value of Tesla Motors Inc. as a virtual asset which over its lifetime can readily achieve a continual stream of sales.
In traditional automotive industry practice, each car sold has a relatively high percentage chance to lead to a same-brand sale at end of life or end of a period of ownership. The process of achieving a net parity customer retention across the fleet, let alone a positive percentage growth figure is fettered with the negative feedback loop of $Billions in advertising, somewhat subsidized by the profitability of maintenance. It is also true that to motivate the repeat sale, it is likely necessary to bear the cost of producing a new iteration of the model type or even designing and producing a new vehicle every few years.
The comparison is again one of a positive feedback loop vs. a negative feedback loop. In direct competition, the situation is clearly hopeless for the traditional method of obtaining incremental sales vs. Tesla.
Customer vehicles as an inexhaustible supply of cash flow positive working capital for geometric growth, indistinguishable from a fixed asset of the company leveraged for lending (except the cost of finance is externalized).
When combined with Tesla Finance and in the case of all orders where delivery time fits within the window of supplier credit terms, Tesla receives a total of 100% of the full order value, composed of the customer reservation fee and direct payment or the proceeds of the customer's bank loan plus an estimated 2% commission in the case of financing from Wells Fargo and US Bank totaling 100% or 102%.
From steady-state production onwards, all funds are received by Tesla in advance of cost of goods sold exposing profits as free cash flow.
Simply put, the cash-flow model of Model S Sale is:
Order > 100% or 102% Cash input > Parts and Materials Order > Manufacture > Delivery > Parts and materials Payment.
When considering growth, each production cycle is able to yield funds sufficient to produce the same number as the last, plus an additional amount of vehicles equal to the profits of the previous cycle.
While compounding will not be perfect, in a starting case that assumes a 25% gross margin. This presents the ability to increase production by 125% for each completed production cycle without burning cash. Any period of steady state production at each ramp level will permit the rapid accumulation of cash to fund additional production equipment and SG&A overhead.
In an interview with Bloomberg on May 22nd, following the repayment of the DOE loan, the question of Tesla's future funding requirements was answered by Tesla CEO Elon Musk as follows:
'I think we actually have enough capital at this point to not need to raise any future funding because the S is cash flow positive we have more than enough money to get the Model X done and then I think we will generate enough free cash flow to fund the roughly $1Billion necessary to create the affordable mass market 3rd generation vehicle [..] just relying on internal cash flow.'
Additionally, Tesla Financing has the effect of adding the collateral value of each vehicle produced as security for the working capital of the Company, the loan repayment and cost of finance being borne by the vehicle owner in the normal manner of vehicle finance. By this method, there exists a positive feedback loop that increases the working capital of the company by up to 102% of the value of each vehicle sold in a manner that has its direct equivalent in adding a fixed asset to the Market Capital of the company.
The Innovator's Dilemma and its solution, Daimler style.
The formula for disruption moves inexorably to its logical conclusion once it takes root. At the outset, a small team with a new technology can be massively motivated to win early adopters representing less than 1% of the market of an incumbent technology. By way of illustration in the auto industry, 1% of the customers of a large ICE manufacturer is a very attractive win for a small newcomer. Conversely, for the large ICE manufacturer defending against the loss of that 1% of its customers by direct competition will cost far more than retaining those customers is worth. The ICE manufacturer simply cannot afford to build a great EV and declare with full force that EVs are now the way forward and ICE is old news with sufficient integrity to retain that 1%, because by doing so it risks alienating 99% of its customer base and destroying the economics of amortizing capital equipment for ICE production. Retaining 1% of its customers cannot foot the bill for the damage.
What the ICE company will tend to do instead is half-hearted harassment in the 1% space: Hybrids.
By the time the young EV company has won a meaningful quantity of customers away from the ICE manufacturer, for example 10%, the larger company is faced with losing money and market share rapidly while the small company has by then attained brand leadership in the new technology wave and is accelerating geometrically to becoming too expensive and too confident to be purchased. In a battle between a small money-making enterprise and a large money-losing enterprise, it is inevitable that market leader positions will be reversed with catastrophic consequences for the old incumbent.
There are very few valid defenses against this formula. One of which is exemplified by the actions of Daimler with respect to Tesla.
The involvement of Daimler as a minor shareholder and participant in Tesla could be lifted directly from the pages of the Innovator's Dilemma with Daimler effectively positioning itself as heir apparent of the Tesla business upon maturity. In fact, a Daimler affiliate, Blackstar, holds a right to review any serious third party bid to purchase Tesla effectively preventing the sale of the business to another party without Daimler's consent unless Daimler is literally out-bid. Jerome Guillen, formerly leader of the Business Innovation department at Daimler is a key person at Tesla in his role as Director of Model S Programs. Harald Kroeger is a Tesla board member who is responsible for the electrics and electronics of all Mercedes-Benz cars and the development of Mercedes eDrive Vehicles. Effectively the companies, Tesla and Daimler are intertwined, which provides considerable security for both parties and alleviates the urgency for Daimler to dismantle its Mercedes ICE business until such a time that the EV market is considered large enough to enter with full commitment. Once Tesla has become fully established and effectively able to lead the Daimler global operations in EV production, there appears to be a pre-arranged path for that to happen. This arrangement provides Tesla with an option for a step-change in scale and for an exit most likely via the route of merger on a 2-5 year horizon. It is worth noting that in accordance with the strictures of the Innovator's Dilemma, this option would more likely lead to a Musk, Kroeger and Guillen leadership of Daimler, were it to take place rather than the absorption of Tesla as an adjunct to the ICE business.
Tesla Motors Inc. looks to be substantially past the point of vulnerability as a business, and indeed past the tipping point of the inevitable disruption of the US Auto industry while remaining largely under the radar of provoking a hostile reaction beyond a flurry of objections from franchised dealers. With the political capital garnered through early repayment of the $452 Million DOE loan, this author is of the opinion that State Franchise Laws are now a removable obstacle for Tesla.
Tesla is the de-facto senior party in negotiating cooperation with respect to its power train business in the USA, especially. However, it may be too early to see the willingness for any new cooperation in advance of Tesla cutting meaningfully into sales of incumbent manufacturers and this may be a matter of more than twelve months and reliant upon the launch of the gen 3 vehicle, although the latter is very likely to be accelerated into production sooner than 2017 at this juncture. Elon Musk has commented specifically that he now expects Tesla to be able to fund the $1 billion estimated cost of readying the Gen III program from internally-generated cash.
The Auto industry in Europe is still less prepared defensively and the buying public better motivated than in the USA for the adoption of the Model S in terms of fuel prices, however, with Elon Musk committed to a heavy schedule already between Tesla and SpaceX, there must be some additional resource situated in Europe able to continually align Europeans to the brand message of Tesla, this factor out-weighs the mere attractiveness of the value proposition represented by the vehicle itself in leveraging mass consumer fervor.
The business of Tesla is able to scale extremely rapidly on internally generated cash flow and enjoys unprecedented support as a backstop to failure in the form of CEO guarantees rendered. Tesla also offers upside security in the form of a pre-laid path to merger or acquisition with Daimler, however, it is worth noting that this option is presented as a choice for Tesla and not necessarily the most attractive possible outcome for the company or for the stock. I have said little about Tesla Retail, however, it is fair to say that the Tesla brand is likely to survive any event in the foreseeable future including merger because of its central importance within the innovation of direct sales and service. In addition to which, the burden imposed by US dealers on the traditional Automotive industry is useful in accelerating Tesla's dominant negotiating position for change to EV production based on Tesla Drive Train IP. Naturally, prior to Q2 results, it is very difficult to establish more than one data point on a curve as the business was in a very different mode at Q4 2012, and this uncertainty stands to unseat both longs and shorts in the interim.
It is, however, fair to say with a great deal of certainty that the Q2 earnings call will lead to a spectacular new run-up on the beat of every metric currently assumed to be in evidence.
Thank you for taking your time to read this lengthy article, I hope very much that it has been of value to you. I trust you would agree that Sun Tzu would be proud.