Today, the 60 kWh Model S can be purchased for $71,070 before any federal tax credit, and after a $7,500 tax credit, the car can be purchased for $63,570. Since the valuation of Tesla Motors (NASDAQ:TSLA) is highly sensitive to its future demand, short sellers claim that the market for a $63,570 sedan is simply too little to justify its near $15 billion market cap. However, if after the federal tax credit, the price of the Model S was reduced from $63,570 to $39,570 without Tesla losing one penny of profitability, would short sellers still claim the market is too small to justify a $15 billion market cap? I think not! A $39,570 Model S would be priced 6.2% below the 2013 Audi A6 that sells for $42,200. In 2012, Audi produced approximately 284,888 A6 models worldwide. With the extra recognition and more advanced technology, the Model S would likely sell far more than its Audi competitor. Here is a list of recognitions that the Model S has received.
Consumer Reports rated the Model S with a score of 99 out of 100, becoming the magazine's best car ever tested. The score would have been higher but for the fact that the all-electric car does need to stop and recharge during extremely long-distance drives. "If it could recharge in any gas station in three minutes, this car would score about 110," said Jake Fisher, head of auto testing for Consumer Reports. Fisher called the car's performance in the magazine's performance tests "off the charts." It is worth noting that the Consumer Reports review predates the battery swap demo that can replace the battery in the Model S in 90 seconds.
So, how is it that Tesla could magically reduce the price of its Model S by $24,000 (or 38.80%)? The trick is to not sell the battery to the car owner, but instead recoup the cost of the battery by charging customers each time they do a battery swap. Tesla demonstrated its battery swap technology on June 21, 2013 that showed two Model S sedans having their battery swapped without the driver getting out of the vehicle and in half the time as the fastest gas pump in Los Angeles, CA. Elon Musk has stated that the cost of building battery swap stations to cover the entire United States would be about $100 million. This is a relatively small amount compared to the $760 million in cash Tesla had as of their June 4, 2013 shareholders meeting.
The important question to answer is what would Tesla have to charge per battery swap in order to recoup the cost of the batteries over their lifetime? The answer is approximately $70 per swap under reasonable assumptions, which is right in line with Mr. Musk's statement that the battery swaps would cost between $60 - $80. The assumptions to arrive at a cost of $70 are listed below.
- The electricity used to recharge the batteries is $0.11 per Kwh in 2013, which is the national average.
- Electricity costs increase at a rate of 2.9% per year.
- The typical Model S owner drives 15,000 miles a year.
- Tesla discounts its future cash flow from battery swaps at 10% per year.
- Battery swaps increase in price by 2.9% per year.
- The battery has no residual value after 8 years and 120,000 miles.
- Assume a $24,000 60 kWh battery cost (battery cost estimates are all over the place, but Tesla said it will replace a Model S 60 kWh battery for $8,000 after eight years).
Below, Table 1 shows how profit from battery swapping would look over the 8-year life of the battery. The swapping cost was estimated by taking the 15,000 miles of driving divided by 200 miles of range on a full charge, which comes out to be 75 swaps per year. Then multiply the cost of a kWh times by the 60 kWh battery to get 60 kWh * $0.11 (national average) = $6.60. Then multiply $6.60 (cost per swap) * 75 (number of swaps per year) to get $495. I then add in $5 for the storage and installation costs, which brings the cost up to $500. I then increase this cost at 2.9% per year to account for inflation.
Most believe the battery will last far more than 8 years, and that its residual value will not be $0 after 8 years. In fact, Tesla even warranties its batteries up to 8 years and 125,000 miles, so the estimated present value of the cash flows is conservative. In addition, the present value of the cash flows is greater than the $24,000 estimated cost of the battery, which means Tesla would earn the same amount in revenue per car and increase profitability, but it would take 8 years to recover the cost of the battery. It is important that if Tesla implements such a system, owners are charged per mile they put on the battery they are swapping and not on how full the charge is. This way owners that charge at home will not avoid paying for the battery over the 8 year time frame. Also, Tesla has stated that the 60 kWh battery could be replaced after 8 years for $8,000, which means the cost of battery swapping will decrease significantly as batteries become cheaper to build.
By recouping the cost of the battery over its lifetime, Tesla would be able to sell its sedans at a lower price than the Audi A6, which would likely push annual demand past 300,000 units for the Model S alone. Assuming the average selling price of the Model S is $80,000 before deducting the savings from not purchasing the battery, Tesla would earn $960 million with a conservative 4% net income margin. At a $15 billion market cap, Tesla would have a 15.63 P/E ratio on Model S sales alone. Next year, Tesla will be rolling out its Model X and in the next 3-4 years the Gen III, which will significantly add value to the company.
There are even more benefits to Tesla implementing a program where buyers do not actually purchase the batteries. First, the owner does not have to worry about the deterioration of the battery over time because as long as they use battery swaps, they will be getting a newly charged battery each time they stop for a 90 sec swap. This will help customers reduce the risk of low resale value, because all non-battery components of an electric vehicle have long life cycles. For example, there are reports of electric power trains that are still running in top shape after being in an electric van for over 30 years. If 30-year old electric power trains are still running in top shape then Tesla, which produces the world's most advanced power trains, is likely to produce power trains that last even longer. Second, customers will have much lower insurance premiums because the cost to replace a damaged Tesla will be much less. Finally, Tesla owners will also be able to rapidly update their batteries to the newest available battery technology, but it will cost a premium.
If Tesla could easily implement a pricing scheme where they recouped the cost of the battery over its lifetime via battery swaps, and could reduce its price to a point that demand is likely to exceed 300,000 units a year, then why haven't they? Two main reasons stand out. First, Tesla would not be recouping the cost of the batteries immediately, which means lower current cash flow to finance capital expenditures. Right now, Tesla needs all the cash it can get its hands on, so that it can ramp up production of the Model S, increase the number of service centers, stores, and galleries worldwide, and R&D for the Model X and Gen III. If early adopters of the Model S are willing to pay the full price of the car, it makes sense for Tesla to use the proceeds to expand more rapidly. As of the annual shareholders meeting, Elon Musk was confident annual demand for 2013 would exceed 40,000 units worldwide. Because production is still constrained to 21,500 for this year, it would be a mistake for Tesla to grow too quickly. It would likely end badly if they suddenly received 300,000 orders for the Model S and could only collect 61% of the revenue immediately as the cars were sold. The second major drawback is that consumers could end up paying more for the battery swap service than they would pay to drive a comparable internal combustion engine, or ICE vehicle. For example, a Tesla owner that drives 15,000 miles a year would pay $5,250 in 2013 for the battery swap service, but if he or she had instead bought an ICE vehicle that got 25 mpg at an average price of $3.60 per gallon, they would only spend $2,160. However, the average price for a gallon of gas in the EU is approximately $7.50, which brings the fuel cost of the ICE vehicle up to $4,500. After considering the lower cost of maintenance for an electric vehicle and the lower depreciation rates, it is about a wash for those living in the EU.
Tesla is a wonderfully innovative company, and once it has established its production and battery swap stations I believe they will implement some sort of pricing system that spreads out the cost of the battery in the way I have described above. This will give Tesla considerable market power, and improve demand for the Model S by at least a factor of 10. I expect Tesla to implement this system sometime after the Model X begins deliveries and management is confident in their ability to produce cars efficiently with the highest standards in quality. The huge influx of demand that would come from a $40K price point would greatly increase the value of Tesla's stock, but it will be difficult to manage producing that many cars. The number one mistake fast growing businesses make is growing too quickly, which makes companies financially fragile. I expect Tesla to implement this pricing scheme only if demand becomes constrained or they feel like they can handle it from a cash standpoint. I do not expect either to happen in the next 6 months, but after that it is likely. If you have a long-term investment horizon, Tesla is a great buy and hold. However, be prepared to hold it for a decade and ride the short-term volatility.