Tesla: Is Building A Great Car Enough?

Jul.24.12 | About: Tesla Motors (TSLA)

After a few years of loosely following Tesla (NASDAQ:TSLA), and a year or so of following the company closely, it was great to finally see in person what everyone has been talking about for nearly that amount of time; the Model S. I finally saw one at my local Tesla store and the reviews are true, even critics of the company have to admit that it is a fantastic car.

In terms of the quality and even value presented, there have been numerous reviews since the launch that confirm that the Model S is indeed a home run. It looks just as good or better than any of the luxury sedans it competes with. Even the door handles slide in and out of recesses in the door as a driver approaches. Simply put, strong arguments could be made that the Model S is the highest quality-- and maybe even highest value-- car in its price range on the market today. Frankly, if the CEO of the company Elon Musk is literally doing rocket science with his other company Space X, it should come as no surprise that he is building some top-notch cars (with some top-notch help of course).

But Space X and Tesla comparisons end quickly when the business models of the two companies are compared. Space X does not really operate in the real world of business (not to diminish the company, it might be a better investment candidate than TSLA) considering that its main customer is the government. Tesla on the other hand, is much more in the hands of supply and demand, much like the 800 pound gorillas of the industry like Ford (NYSE:F), GM (NYSE:GM), or Toyota (NYSE:T).

So even though TSLA may have hit it out of the park with the Model S, investors still need to be asking themselves if it is enough just to build a great car? It may be, but it would be a lot easier for investors to fall back on that argument if TSLA had more time. But financially, TSLA does not have a large margin of error when considering worst-case scenarios. As of last quarter, Tesla had about 350M in cash and cash equivalents, including about 100M in government loans and reservation payments for the Model S and X. Currently the company is in the process of growing production volume, and costs are going to rise. Meanwhile revenues may stagnate or diminish as Roadster sales taper off, and partnership deals with Toyota and Daimler are of nominal scale. As of last notice from Tesla, the company expects to reach a much-awaited breakeven point at around 8,000 Model S, which will be quite a milestone for the company. If production is indeed on schedule, this point should be reached early in Q1 of 2013.

Tesla has stated as of Q1 2012 that it has over 10,000 reservations for the S, and enthusiasts speculate that number is currently at around 14,000. Even with no growth in reservations and with a 20% margin for cancellations, it should be able to come close to that magic breakeven. But the question still remains of whether building a great car is really enough to spark sustained demand in the niche EV market, and even take market share from the less niche luxury car market.

As referenced in a previous article, statistically speaking, Tesla needs only a fraction of a percent of the U.S. households that can easily afford to buy a Model S to get it through the next year. That completely ignores international markets and domestic consumers, who will finance or stretch to purchase one. Moreover, if we look strictly at luxury car sales, there will be about 1M luxury cars purchased in the U.S. this year. Tesla needs a little less than 1% of that market to breakeven, and around 3% to have a healthy 2013. The statistics sound pretty good, but what they fail to address is the willingness of consumers to really dive into the new technology. We already know that there are about 10,000 early adopters. But beyond that, the trend is poorly defined.

The Toyota Prius is not very analogous as a car to the Model S, however its early adoption rate may shed some light on what to expect. In Prius's first year (it debuted in July of 2000 in the U.S.) Toyota sold about 5,800 and 16,000 in 2001. In 2002 and 2003 T sold about 20,000 and 25,000 Prius, respectively. With those numbers, it is easy to see Tesla thriving, and soon. But the Prius was aimed at a different market, the small and midsized segments (at that time overall U.S. auto production was about 17M per year, it is now about 12M). This market tends to attract a much different kind of buyer than the luxury market.

We can probably assume that the early adoption rate in the Prius circumstance was higher as a percentage of the market than what the Model S will be, simply due to the lower cost of the Prius and the size of the respective markets. However, if we ignore that assumption and try to stick to numbers, it gets interesting. If we are generous and we take those numbers as a percentage of the of the current domestic small car market (it is generous because A. we are looking at only the small car market and B. because the market is smaller now than it was in the early 2000s, and C. we'll use the 2003 number), we end up with about 1% (25,000/2.5M). Tesla seems to like that 1%. Given the aforementioned, that percentage is very gratuitous to the actual early adoption rates. Even so, if we apply that to the current luxury car market (about 1M this year), we arrive at about 10,000 cars. On the one hand, Tesla has already taken more than that amount of reservations, but on the other, that percentage could point to over-confident expectations for 2013 sales at 20,000.

Hopefully for Tesla, the Toyota Prius comparison is just too broad to apply to the Model S, even when using generous (to Tesla) projections. Toyota probably has a virtual warehouse of data that could help, but even Toyota might not have enough data to put together a reliable forecast on the sustained adoption rate. Q2 earnings will be presented on Wednesday July 25, and investors should listen for an update on reservation numbers and any other data that could shed light on demand. Wunderlich Securities recently announced a downgrade on suspicions of lowered production volume. However, a slow down in production at this point should not be seen as a major hurdle, it is likely just a slight speed bump.

However the demand/cash relationship could be a very real hurdle if the reservation numbers fail to gain traction. If need be, Musk has the resources and the nerve to personally indemnify Tesla for some time if the company has trouble "crossing the chasm". But it could take several years to reach significantly profitable volumes if it sticks to its plan of one model per year (the Model X is planned for late 2013 and lands in the luxury SUV market, which is even smaller than the luxury car market). Investors should remember that TSLA has a very high price to book value ratio.

Tesla stock presents a unique opportunity, but it is not cheap. If sales take off, that ratio will likely appear a lot less inflated as revenues and IP values rise, but if sales stagnate, investors also need to remember that TSLA has around 50% short interest, and its stock price which has been hovering in the low $30s of late, is on the volatile side. At the end of the day, companies like Tesla still need to operate in the world of demand and supply, and the bigger their war chest, the better. Building a great car is not the only thing Tesla needs, but it is certainly a great start.

Disclosure: I am long TSLA.