Tesla's New Battery Supply Contract - Trick Or Treat?

| About: Tesla Motors (TSLA)

On Wednesday of this week Tesla Motors (NASDAQ:TSLA) announced that it had signed a new battery supply contact that requires Panasonic (OTCPK:PCRFY) to expand production capacity in order to supply Tesla with up to 2 billion lithium-ion cells over the next four years. The 18650 cells will be used to power Tesla's award winning Model S as well as its planned Model X, a performance utility vehicle that is scheduled to go into production by the end of 2014. In connection with the new contract, Panasonic will build an additional production line for small batteries at a facility in the Osaka area and re-start another line at a separate Osaka plant to meet anticipated demand.

While most commentary on the new supply contract has focused on the 250,000 to 300,000 cars Tesla could build over four years with 2 billion cells, I found one article from Bloomberg that focused on the business benefit to Panasonic and estimated Panasonic's potential revenue at $7 billion, or roughly $3.50 per cell. Panasonic did not confirm Bloomberg's revenue estimate and its spokesman apparently declined to comment on the issue.

If Bloomberg's revenue estimate for Panasonic is accurate, Tesla's 2-billion cell battery supply treat includes a nasty hidden trick in the form of a 40% to 75% cell cost increase that will have to be passed along to customers. It probably won't make a difference to Model S and Model X buyers who seem to be willing to pay any price for eco-bling, but it could be showstopper for Tesla's plan to build a $35,000 to $50,000 Gen3 model that will need $18,000 of battery cells.

For the last few years, one of the most fun speculations in the battery industry has been Tesla's per-cell cost under its supply contract with Panasonic. While lithium-ion battery experts agree that the material and component costs for Panasonic's 18650 cells are in the $2.00 to $2.50 range and cell costs should be in the $3 to $4 range, public statements from Tesla executives suggest that their cell costs during the launch phase were significantly lower. In August, inside EVs reported:

"By most estimates, the battery for the Model S that I drove should cost between $42,500 and $55,250, or half the cost of the car. But (Tesla Tech Officer) Straubel indicated that it is already much lower. "They're way less than half, actually," he says. "Less than a quarter in most cases."

I have no reason to question the accuracy of Mr. Straubel's claim, which suggests a pack level battery cost of about $25,000 and a cell level cost of about $2. After all, outfits like Panasonic that have excess production capacity and are trying to find new markets for long-in-the-tooth legacy products will frequently offer loss leader pricing during the launch phase because they know they'll be able to catch up quickly if an embryonic market matures into a stable market.

While companies like Panasonic are frequently willing to sacrifice short-term profit to achieve long-term goals, particularly if they can do so without incurring substantial capital costs, no company can buy for a dime, sell for a nickel and make it up on volume. They never incur significant capital costs to expand capacity for a money losing product line.

If Bloomberg's estimate of Panasonic's expected revenue under the new contract is accurate, it looks like the honeymoon is over, Panasonic is done with loss leader pricing and the battery packs Tesla builds in the future will cost $8,000 to $12,000 more than they did during the launch phase.

While the Bloomberg article could be a case where a rogue reporter pulled numbers out of thin air to hype Panasonic's stock, Bloomberg is a well-respected organization that checks its facts carefully before publishing. Hopefully Mr. Musk will add some clarity on Tesla's future battery costs in next week's Q3 conference call.

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.