Much of the investor speculation about Tesla Motors (NASDAQ:TSLA) and its future centers on the ability to purchase cheaper batteries for the Generation 3 platform, due to launch in about three years time. This is one of the primary topics that separate the longs from the shorts. Success in bringing an affordable, and desirable EV to market could guarantee Tesla a place among the major car manufacturers for the foreseeable future and justify the high valuation. Failure to do so could bring about the crash that some expect and leave Tesla as an interesting footnote in the history of tech stocks.
Here in SA there have been many comments about future battery technology, and undoubtedly there will be developments beyond the current chemistries. But I want to show how Tesla may bring a much cheaper car to market without any sudden breakthroughs in battery technology although this could, and probably will, happen in the future.
However, it is usually a long road from laboratory demonstrations to full-scale production, so I have only followed the existing trends in batteries to see how Tesla may deliver a Generation 3 car at a substantially lower cost than the current Model S.
The aim point is to make a car that is about $40,000 to $45,000 before any tax credits or other incentives but still has a good performance and range. It is not as difficult for Tesla as you might think. I'll look at the cost compared with the Model S.
At each step in the costing analysis I will use values that are on the conservative side, so the final result may be considered a maximum pricing for when the Generation 3 platform enters production in mid to late 2016.
I am not a financial expert so this analysis is necessarily much simplified from the model that Tesla will be using, but I hope that it at least points the way to the cost reductions that could be expected in the next three years.
Starting Point: The Batteries
First of all I'll assume that Tesla will continue to use the best Panasonic cells and not go down the route of cheap generics. I am certain that Elon Musk will not compromise his cars by using less than the best, and I would expect that the relationship between Tesla and Panasonic will continue as long as it is beneficial to both of them: Tesla gets the best cells at a very good bulk price and Panasonic has a very healthy order book!
Another assumption, but a valid one in my opinion, is that Tesla will not produce a car with less than a 60kWh battery, a lesson learned from the very low uptake of the now cancelled 40kWh Model S.
I'll also assume that the cost of the top-end Panasonic cells used by Tesla does not change, except for the usual reductions found in high quantity repeat ordering. The reason for this assumption is that older cell chemistries will almost certainly fall in price as full production is established, but new cells are likely to keep to a similar introductory price as the previous generation until production is ramped up and some of the R&D costs are recovered. I am taking a very conservative view here as, in reality, a battery manufacturer will almost certainly want to bring a new product to market at a competitive price point while still leaving a small price advantage to the customer using the previous generation product.
It is generally accepted that battery energy density improves by 7 to 8% a year, so for this analysis I will assume the lower value to again be on the conservative side. The actual improvement could be much more than this as, with the potential for extremely high orders from EV manufacturers, the incentive for more rapid development is certainly there.
Finally I'll assume that Tesla will follow the trend of the Model S and make Standard 60kWh and 85kWh versions of the Generation 3 car with a Performance (P85) 85kWh version as the top of the range model.
Now, simply looking at the battery pack, a 7% improvement in energy density of the cells over the four years between the launch of the Model S and the Gen 3 platform gives a 31.08% overall improvement. This gives an immediate reduction in the cost of the battery pack, even if the cost for the individual cells has not fallen, as only 76.29% (1/1.3108) of the number of cells in the Model S pack will be needed for the same power. This will also allow the Gen 3 platform to be about 20% smaller than the Model S as has been mentioned by Tesla.
This improvement figure agrees very well with Panasonic's move to 4.0 Ah cells from the 3.1 Ah cells as currently used in the 85kWh Model S (a 29% improvement). The 4.0 Ah cells will certainly be available in high enough production quantities well before 2016. To put this in perspective, Tesla will probably be ordering 100 million cells every two to four months once production is well under way.
Assuming that all parts of the car scale similarly (I realize that this is a rather simple way of looking at the manufacturing process but it gives us a working number, and the battery is a large part of that cost) we have an immediate 23.71% reduction in cost.
The next aspect in reducing costs is in economies of scale. This is unknown but could be anywhere from 5 to 25% or more. We do know that Tesla intends to manufacture more Generation 3 vehicles per year than the current production rate of the Model S, but I'll be fairly pessimistic and say only 10% savings by economies of scale.
Including this factor now gives 76.29% x 90% = 68.66% of the cost of the equivalent Model S car.
Making a Profit
Finally we need to consider the gross profit margins. If the actual margin realized on the Model S is 25% (a subject of more debating among investors, but projected by Tesla to be reached by Q4 2013) then Elon Musk has said he would be willing to drop the margin on the Gen 3. If it is dropped to 15% (still a very healthy margin, especially if the Gen 3 platform becomes a high volume car) then the cost again falls to 115%/125% = 92% of the above calculation.
The overall reduction by all these factors is to 76.29% x 90% x 92% = 63.17% of the pricing for the Model S cars.
The current prices for the Model S from Tesla's website, not including the tax credits, are $94,900 for the Model S Performance 85kWh, $79,900 for the Model S Standard 85kWh and $69,900 for the Model S Standard 60kWh.
Scaling these figures by 63.17% gives:
$59,948 for a Performance 85kWh Gen 3, $50,473 for a Standard 85kWh Gen 3 and $44,156 for the entry-level 60kWh Gen 3.
The Bottom Line
The prices for the Performance P85 and Standard 85 cars can be reduced a little to give "customer friendly" prices of $59,900 and $49,900 although this drops the gross profit margins to 14.9% and 13.7% respectively. The 60kWh entry-level car is not quite as low as we would like, but it is already below the upper $45,000 mark. If priced at $42,900 it still realizes an 11.7% gross margin.
These figures were arrived at by assuming the lowest expected improvement in battery technology, only 10% reduction in cost because of economies of scale, and still keeping close to the 15% gross margin on the Generation 3 platform with the exception of the entry level model at almost 12%. If battery technology improves more than the minimum (very likely) or economies of scale give a better reduction in cost (high level repeat orders could realize this) then the final production costs could be quite a lot lower and the margins consequently higher.
This time Tesla is also not starting from a completely new design. The Gen 3 platform is a derivative of the Model S, and so most of the development work is already done. This means much lower R&D costs. With 60kWh and 85kWh battery packs it would even be possible to use the same motors and inverters as used in the Model S: a further saving. Only the software would need minor adjustments to account for the different size and weight of the car. Yes, Tesla will have to add more shifts and more lines to the factory for the increased production but they have already gained much experience here with the Model S.
There could even be other cost cutting exercises as the Gen 3 cars are not in the luxury sedan class of the Model S, but I'm sure that Tesla will want to keep the Gen 3 cars as high quality, if not luxury, models. Reductions in detail costing may only need to be made here for the entry-level model.
If Tesla staggers the release of the Gen 3 cars as they did with the Model S by releasing the P85 first (including a "Signature" edition), then the Standard 85 and finally the Standard 60, they could take advantage of further reductions in battery and scaling costs over time to realize a higher than 11.7% margin on the 60kWh model. But even with the reduced profits as outlined above these are still very good margins for initial production, and after that the margins should improve as production ramps up.
If the biggest selling car from Tesla in three years time is the entry-level 60kWh model, a gross profit margin of 11.7% gives about $4,500 for each car. 50,000 cars a year (and I'm sure that Tesla can manage much better than this in three years time) would realize $225 million gross. Skew the production towards the higher value cars and this number could be almost doubled. Run the plant at 100,000 Gen 3 cars a year and the gross profit margin for just the Gen 3 series would approach $1 billion.
Looking to 2016
These figures are just my speculation as I don't have an inside line to Tesla and I have no experience in costing something as complex as a high volume production car. But to add a little spice to the speculation, what about the performance of the new cars. The Gen 3 platform is smaller and lighter than the Model S platform so, with similar (or even the same) motors and inverters we could expect up to 10% improvement over the Model S.
At the same time we may also expect a Model S Performance P110 (an 110kWh battery pack with the new cells, and a new, higher powered motor and inverter). Allowing only the 10% reduction in cost for economies of scale for this car (the new 110kWh battery will cost the same as the original 85kWh pack) gives a price of $85,400, and this can be taken down to a more customer pleasing $84,900 if a 24.3% margin is accepted. The same 10% reduction gives a new Standard 110kWh model at $71,900 and the original Standard 85kWh model now becomes the entry-level car for the Tesla S series at $62,900 using either the older generation batteries (the ones we have today), by then much cheaper than their initial cost, or a smaller battery pack with the new cells. I expect the 60kWh version to be dropped in this new line-up.
I've not included the Model X here as details may change before it is finally launched, but pricing should be about the same as a similar specification Model S.
So here's my take on the 2016 Tesla Motors new car line-up with only a little adjusting of the margins to make the figures look more interesting to their potential customers, and as I used very conservative costing to get to these prices, they could well be lower than this (or the margins could be higher). The speed, acceleration and range ratings are my estimates from the Model S figures on the options page of Tesla's website.
Tesla Motors New Models for mid/late 2016:
Performance P110: $84,900 for 140 MPH, 3.7 sec zero to 60, 340 miles EPA rating
Standard 110: $71,900 for 130 MPH, 4.9 sec zero to 60, 340 miles EPA rating
Standard 85: $62,900 for 125 MPH, 5.4 sec zero to 60, 265 miles EPA rating
Performance P85: $59,900 for 135 MPH, 4.0 sec zero to 60, 290 miles EPA rating
Standard 85: $49,900 for 125 MPH, 5.2 sec zero to 60, 290 miles EPA rating
Standard 60: $42,900 for 120 MPH, 5.7 sec zero to 60, 220 miles EPA rating
Superchargers will be upgraded to 150kW to give a 30 minutes 250 miles top-up for the cars with the 110kWh battery pack.
8 years unlimited mileage on all batteries except Gen 3 Standard 60kWh, and this is 8 years, 125,000 miles.
Only another 7 or 8% of cost saving is needed to bring the Gen 3 Standard 60kWh model to $39,900. If the cells improve at 8% per year instead of 7% we're already halfway there. A little more from other cost savings, or even just waiting for another six months development or cost reduction in the batteries, and that price point can be met!
The 60kWh Gen 3 will be the last 60kWh car produced by Tesla.
By early 2018 the new Roadster will be built on the Generation 3 platform. It has a 100kWh battery pack and a similar motor and inverter to the P110 Model S. Top speed is 155 MPH with a 3.4 seconds zero to 60 time and an EPA rated range of 350 miles. Launch price is $74,900.
By 2020 all Tesla cars will have a minimum of 85kWh battery packs with the majority having over 100kWh. The top models will have at least 135kWh battery packs and better than 400 miles EPA rated range. All battery packs with greater than 100kWh energy will have 10 years unlimited mileage warranty.
New superchargers will be able to deliver up to 200kW for the highest capacity batteries with a 300 miles top-up taking just under 30 minutes, and prices will continue to fall.
So, will it happen? That's the fun of investing! I have tried to look at a multi-billion dollar industry over the next three years in a very simplified way, and my assumptions and speculations could be far from the actual reality encountered by Tesla.
We all take risks based on our knowledge of the company and the market. But the biggest risk taker here is Tesla itself, and any long investments in TSLA will depend on an almost flawless execution of Tesla's future plans.
There is always a high risk of failure with a limited range of products, and more of a risk with Tesla as their current range is all built on the one platform. Just one major problem could bring the whole of Tesla to a standstill.
There will certainly be other competitors in the EV market as well but Tesla has a head start, both on product and patents. Musk has stated that he will be happy to see other players in the field, especially, I am sure, if they also use Tesla drive trains!
I suggest that you look at other articles on Tesla, pro and con, and draw your own conclusions.
But we don't have long to wait until 2016.
Disclosure: I am long TSLA. 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.