Tesla's Highly Scalable Model

| About: Tesla Motors (TSLA)

Summary

Tesla's NUMMI factory located in Fremont has a high level of vertical integration, allowing for a faster and more efficient production process.

Tesla's battery and drive train are highly adaptable to many different car models and benefit from economics of scale, allowing for an incredibly efficient production process.

Tesla's headquarters/factory are located in and around Silicon Valley, and therefore can take advantage of human resources. Big names include Elon Musk, Franz Holzhausen, JB Straubel, and Gilbert Passin.

Tesla already has industry-leading gross margins, which will increase as it scales up the Model S/X and builds the Gigafactory.

Scalability Of The Production Process

A production process that is vertically integrated and automated to the fullest extent is one way that Tesla Motors (NASDAQ:TSLA) has accommodated for rapid growth in the future. WIRED has two videos (1,2) with interviews of seasoned automotive executive Gilbert Passin talking about Tesla's production process. "From the manufacturing standpoint, we assemble this car, the way we put it together, all of this is essentially very different from any other car," claims Gilbert Passin, who is the vice president of Manufacturing at Tesla. Passin has 23 years of experience working with high-profile companies like Toyota (NYSE:TM), Volvo (OTCPK:VOLVY), and Mack. The Tesla Model S production process starts with raw materials in the factory. For example, all the aluminum pieces that make up the body start as coils, which are uncoiled and stamped before being transported to the body-in-white line. At Tesla's factory, 95% of the stamping is done in-house, most of the machining is done in-house, coating and painting is done in-house, and the center display is done in-house. Moreover, all of Tesla's design engineers are stationed on site, rather than in a separate office. In this respect, Tesla is truly taking advantage of vertical integration to a greater extent than most competitors.

The factory also has 185 custom robots (160 robots plus 25 that were added during the $100 million assembly line upgrade in July) on the assembly line that it purchased from Kuka Robotics. These robots are very versatile, as they are able to switch tools up to 5 times and do up to 5-10 different tasks, whereas traditional automotive assembly lines have one robot per task (Source). Tesla also has robots that it calls "Smart Carts," which transport the car around the factory following magnetic strips. One example of the efficiency of these Smart Carts is that they reduce chances of damage and limit waste by carrying the car doors next to the car, rather than the traditional method of hanging the doors above the assembly line. "We are utilizing automation to the fullest," says Gilbert Passin.

Passin also describes how the vertical integration and automation speed up the production process and has "a lot of intrinsic value in terms of innovation, adaptability, [and] flexibility". This production process allows for huge potential for future growth.

Battery and Drive Train Scalability

Tesla's battery and drive train are highly scalable due to their simplicity and full utilization of economies of scale. The battery is the most expensive part of the car, and contains 7,104 cells in 16 modules (Battery tear-down). This article describes how Tesla assembles its battery pack: it buys 18650 battery cells from Panasonic (OTCPK:PCRFY) without the individual casing and thermal management, and assembles the battery pack with thermal management in each of the 16 modules independently. The rest of the car and drive train are engineered from the ground-up around the battery. This is in stark contrast with other auto manufacturers' electric vehicles, which have battery packs completely engineered in by battery suppliers, and are inserted into a modular standard platform or a chassis from another model (Porsche will do its EV with a modular standard platform). Third-party battery pack integration can take more than 9 months worth of engineering time and resources. This gives Tesla the engineering edge, and shows its true commitment to scaling up its electric vehicles, while other manufacturers produce subpar models from an engineering standpoint.

The battery cells that Tesla uses are unique to Tesla's vehicles, and can achieve the full benefits of economies of scale. Tesla uses 18650 battery cells from Panasonic, which have been commoditized and scaled to serve the laptop industry, which means Tesla can achieve cost per kilowatt hour of less than $300 on the pack level. This can be compared with other electric vehicle manufacturers, who have tried to lower costs by using large format pouch battery cells. These cells have been used since the early 2000s in hopes of eventually having lower price per kWh than lithium-ion batteries, and indeed have been slowly decreasing costs. However, this battery format is part of the reason that other auto manufacturers have costs above $500 per kilowatt hour for their battery packs currently. The other problem with these cells is that they essentially make up a whole module in a battery pack, while Tesla's battery packs contain 444 cells per module. This means that Tesla can achieve higher economies of scale than competitors for the same battery capacity. Furthermore, Tesla will reduce cost of individual cells and the battery pack by matching the battery production capacity of the world in 2013 in 2020 with its $5 billion Gigafactory. So not only is Tesla currently leading in battery costs, but its battery cost reductions are accelerating as they scale up. Part of the reason that other auto manufacturers haven't scaled up is the sheer cost of electric vehicle batteries, and Tesla has solved this problem. High economies of scale means high pressure to scale up.

Finally, Tesla's drive train is highly adaptable to different models and is extremely simple, which contributes to its scalability. Here is a comparison between Tesla Model S drive train, the Nissan (OTCPK:NSANY) Leaf drive train, and the BMW M5 drive train:

(Sources: Model S, Leaf, M5)

A simple drive train means a more streamlined production process, and decreases R&D spent on little bells and whistles, while increasing R&D funds available for improving the larger, more important parts of the system and production process. In Tesla's 2011 corporate presentation, it shows how the drive train is also highly adaptable to different models, which means rapid adaptation to many markets:

(Source)

Resources

The other factor that contributes to Tesla's ability to ramp up is the human resources. Elon Musk, JB Straubel, Franz Von Holzhausen, and Gilbert Passin have all contributed some innovation to the scalable production process, and this trajectory of innovation will continue as long as these executives remain in place. A testament to the great leadership at Tesla, the Model S, went from concept to reality in about 2 years, with a cost to market of only about $650 million (Source). The Model S is one of the most praised cars on the market, and it outsold all of its Internal Combustion Engine (ICE) equivalents in 2013, including the Mercedes Benz S-Class. This shows that Tesla's leadership has led the company to create a high-quality and innovative product quickly. Other automakers have more conservative executives who tend to try to manage risk more than they manage opportunities, as evidenced by the low-volume compliance electric vehicles that other automotive manufacturers have introduced. The willingness of Tesla's management team to take on risk by reinvesting virtually all revenues into R&D and SG&A means that Tesla will be able to continue to innovate and scale up quickly relative to competitors.

Future Gross Margins

The reason that Tesla's highly scalable model is relevant is because it not only translates into faster mass-volume production, but also into higher gross margins. Elon Musk, Tesla's CEO, has the intention of approaching Porsche margins of 40% in the long term. In 2013, Tesla achieved 25% gross margin in the 4th quarter, and Tesla is on track to achieve 28% gross margin by the end of 2014. These numbers are already industry-leading, despite low volumes of 22,477 vehicles in 2013 and projected 35,000 vehicles in 2014. The addition of the Model X onto the same line in 2015 will increase this gross margin even further, due to economies of scale. Also, the Gigafactory, which comes on-line in 2017, will reduce battery costs by at least 30%, which translates into even higher gross margins. This will allow Tesla to maintain a 20%-25% gross margin even after it enters the mass market, because the Model S/X will offset the lower-margin mass market car called the Model 3.

Conclusion

Full use of vertical integration and automation, the simple, adaptable drive train and unique battery format, as well as the risk-taking management are all characteristics of Tesla's business model that will allow it to scale up faster than competitors. However, a highly scalable production process is useless unless there is underlying demand. In this article, I outline that even a bearish case for Tesla's Model S/X/3 results in 220,000 car sales, and the bullish estimate is 670,000 cars, based on comparable cars in the industry. The reason that Tesla's stock has such a high valuation and yet has room to grow is that Tesla has plenty of fans that could translate into sales as Tesla enters the mass market and scales up. This makes Tesla a once-in-a-lifetime growth and disruption story.

Disclosure: The author is long TSLA.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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