The news we got with regard to Tesla's (NASDAQ:TSLA) full-year results is that it managed to hit its low-end of the 2015 delivery target of 50-52,000 units with 50,580 units sold. We should keep in mind however that we are not to treat these numbers the same way as we do with any other car maker. Tesla's sales system, based on pre-orders, which it piles up to give it a few months worth of orders, means that we really do not know the true level of demand. If the pre-order portfolio has grown in the past year, it means that demand for Tesla cars is actually higher than 50,000/year. If the pre-orders portfolio shrunk in 2015, it means that actual demand was less than 50,000/year.
Starting in March of this year, Tesla also will start taking orders for its model 3 car, which is in fact the model on which the current market cap of the company hinges on. Tesla currently trades at roughly 5x revenue, even after its stock price went under $200. Profitability is by no means the thing that makes this stock so attractive to investors. In its last quarter, it took a significant loss, just as it did in previous quarters.
Tesla investors are betting on it being a growth stock with potential to become not only a major car producer in the next decade, with hopes of sales reaching over a million cars per year, but the only 100% electric car producer, which will make it a growth stock for decades to come. There are plenty of people who are convinced that electric cars are the wave of the future and that Tesla will be the undisputed leader with most car manufacturers either struggling to keep pace or struggling to compete with the perceived to be obsolete ICE against the electric motor. The stock is already more or less trading as if the first stage of this decades-long bull run has been achieved. It is reflecting a company value which should be selling about a million cars in the not-too-distant future and doing so at a profit.
In the past year or so however, we woke up to a new reality when it comes to one of the most important factors affecting the global car market, but especially the US market, namely the price of oil. There are few forecasts out there presently which promise a return to the $100/barrel plateau. There are plenty of forecasts out there however which are currently forecasting oil prices in the current range or just a bit higher. My own view on the subject is that prices will be volatile in the coming decade. I think we will see oil prices testing the 2008 record within a few years. But I also believe that we will see prices return to current levels soon after the price spike. Any price spike will be sharp and short-lived, with long periods of low prices in-between.
The price of oil does have a significant impact on consumer preference when it comes to purchasing a car. The headlines in this regard tend to be dominated by the switch from smaller cars to trucks and SUVs, especially in the US. Little attention has been paid however to the fact that US EV sales declined by 6% in 2015 compared with the previous year. It is a decline which comes within the context of total US car sales rising by almost 6%, hitting a new record of 17.47 million cars.
US EV sales were in fact quite awful if we are to factor out Tesla sales, which increased by 50% compared with 2014. When looking at US sales minus Tesla, 2015 sales were down by a much steeper 16.5%. On one hand, this is making Tesla's current lineup of cars look impervious to oil price declines. On the other hand, the entire market for relatively affordable EVs which average new car buyers could potentially touch looks to be very vulnerable.
Data source: Inside EVs
That brings us to the Tesla Model 3, with a base price of $35,000, which was designed keeping in mind the desire to open up Tesla to the wider market. It is the same wider market, which as we can see, it's very vulnerable to oil price changes, with lower prices taking a significant toll on EV demand.
Any argument that this will not be the case with the Tesla Model 3 because it is from the company simply will not stand if we take a step back and think about it. Yes, the Model S and Model X are immune to the oil price decline. But that is because these models cater to the consumer category which do not count their nickels and dimes. We are talking about people who in most likelihood belong to the 1% in terms of not only income but wealth.
Households which just make it into the six figure yearly income bracket and all who are under that level do tend to count their nickels and dimes to some extent, therefore when considering the purchase of a mid-size sedan, which is a product that declines in popularity together with the price of oil, they will look at the cost of buying and owning one. When the price of oil was high, arguing in favor of purchasing an electric car was relatively easy. Yes, the price may be slightly higher, but in addition to the environmental consideration, there also is the longer term fuel cost savings to think about.
That argument will not fly anymore because the top selling mid-size sedans in the US will all come in significantly cheaper to buy and own. For a comparison, I chose a five-year timeframe, which is the assumption that it takes to pay for a car if financed. The top selling midsize sedans in the US are the Nissan Altima, with a fuel efficiency of 38 mpg, Chevy Malibu, with a fuel efficiency of 36 mpg, and the Mazda6, with a 40 mpg. For the Chevy Malibu, I chose the more expensive 2.5 liter engine version for this comparison. I assume that most miles will be driven in the city, so I will assume that they all get an average mpg of about 32, 34, and 30, respectively. The starting costs of these cars is $22,000, $26,000, and $21,000, respectively. The final cost, after options are included, should come in at around $4,000 higher for these cars.
For the Tesla Model 3, we can assume an average selling price of about $45,000, making it $16,000 more expensive than the Malibu before the costs of owning the car are factored in. I do not have the information in regards to the Model 3 mileage per kilowatt hour, but the Model S does three miles/kilowatt hour, so, I will assume that Tesla 3 will get five miles/kilowatt hour. I decided to set up the comparison in Nebraska, where I live. I'm assuming an average price of gasoline per gallon in the next five years of $2.50, given that it is about $1.65 right now. The cost of electricity is $0.09/kilowatt hour. I am assuming that all cars will drive 50,000 miles for the five years after purchase. And the following is the difference in costs:
It goes without saying that the cost of owning a Model 3 versus the most popular midsize brands is not competitive when it comes to anyone who has to keep such costs in mind. One could argue that Tesla will have a much higher re-sale value after five years, but it may not be the case, given that second-hand buyers need to keep in mind the fact that they will have to deal with the costs of the battery replacement. I do not have an exact cost estimate for the Tesla Model 3 battery replacement, but it will most likely be in the $8,000-$10,000 range, given that the Model S cost is estimated at $12,000. In conclusion, the Model 3 will not appeal to the cost-conscious consumer segment.
With the above facts in mind, I think it is safe to assume that even the Tesla Model 3 will have a hard time reaching the bulk of the car market. The Model 3 will most likely reach that relatively thin potential market, wedged between the ones who can afford to buy the luxury Model S or X, which are in the over $100,000 price range when including the options and the bulk of the market, mainly made up of people who do take costs into consideration, especially cost/utility considerations. So, the typical buyer of a Model 3 will be households earning well over $100,000/year, but less than the threshold that makes people comfortable purchasing a car in the $100,000 or over range. Assuming that most households that will buy a Tesla Model 3 will be in the $150,000-$250,000 household income range, it is only about 7% of all households. Some individuals without family or mortgage burdens who still earn a significantly above average wage will also be part of the Model 3 potential market in the US, even if they are earning bellow $100,000/year. Still, the potential market is relatively limited. It is a market that the Model 3 will have to compete in with all conventional car makers as well as their increasingly diverse EV model lineups.
China and Europe
I don't believe that oil prices will have as much of an impact on EV sales in Europe and in China. In Europe, gasoline taxes are so high that the price at the pump is never low. It's either expensive or very expensive to fill up. An electric car makes more sense within that context. And EV sales have been rising throughout 2015 despite the low oil price. That is not to say however that it will be easy for Tesla to market its Model 3 in Europe. There are a few factors which I think we have to be mindful of.
One of the main factors is product nationalism, which is strong in Europe. It takes someone living there for a while to understand this concept. The European reality of today is that when one walks into a grocery store, the domestic products tend to be labeled with the national flag on the package and on store product signs. Whether we are talking about a sack of potatoes or a car, consumers tend to take pride in supporting the domestic economy by choosing domestic. It is therefore no coincidence that Renault accounts for half of all EV sales in France.
Source: Ev sales blogspot.
Germany's market shows a similar trend, albeit not as obvious at first glimpse.
Tesla has a better chance of doing well in other markets in the EU where a local car manufacturer may not be in place as a consumer favorite. Even so, I foresee consumer nationalism will continue to be a significant barrier to Tesla's success in Europe.
Competition, purely on price and quality, should also not be under-estimated. The Renault Zoe is in my view a perfect example of a product which is already on the European market and has the quality and price mix to pose a challenge to the Model 3. It only has a range of 140 miles, compared with the claimed 200-mile range for the Model 3. Renault Zoe is also significantly cheaper at a price of about $27,000 in the UK given the current exchange rate.
It's not just in the lower price category that Tesla is set to be challenged in Europe. The Audi Q6 e-tron SUV will have a 310 mile range and will be available in 2018. The Q8 e-tron model will have a range of about 370 miles, compared to the 260 mile range of the model X 90D. It is worth mentioning that such performance will command a high price of over $130,000, but that is the same price as the model X 90D. In order to get the cheaper X 70D, which is priced at a starting point of $80,000, one has to scale down expectations, including when it comes to range. Bottom line is that the myth of the Tesla range advantage is just that, a myth. Other producers can match it for a relatively similar price. I therefore see no reason to expect Tesla to become dominant on the European market.
One final consideration with regard to the European market has to be the overall political and economic situation which is moving in a negative direction. We need to keep in mind the fact that EV sales are heavily reliant on subsidies in EU countries. Germany is rumored to invest an extra two billion Euros to promote EV sales in the next few years. The problem is however that when talking about the EU, we are increasingly facing a situation where we have to admit that there is a growing probability that within a few years there will be no EU, which will come with tragic economic consequences. As I pointed out in a recent article, there is in my view more than a 50/50 chance of an EU-triggered global crisis this year. One of the most important political and economic EU institutions, namely the Shengen borderless area agreement, is already in collapse. Within such a scenario, I see EV subsidies disappearing all over Europe very fast, perhaps right around the time when the Model 3 will hit the market.
It was not long ago that Elon Musk was proclaiming that China will likely become an important market for Tesla. Perhaps the most important one. China is indeed emerging as a very important EV market. Problem for companies like Tesla is that it is mainly emerging as an important market for local EV producers, with outsiders largely shut out by China's incentive regime, which is geared toward giving the local guys a big advantage. As a result, Chinese EV sales soared to 188,000 in 2015, but few foreign producers made much of an inroad.
Source: EV sales blogspot.
Firms like BYD may end up not only dominating the Chinese EV market, which is growing very fast, but may end up challenging others in Europe and elsewhere as its EV sales continue to grow. As far as the Chinese market for Tesla goes, if the Model S experience is any indication, the Model 3 will most likely go on sale in China at a hefty $60,000 starting price, which in my opinion makes it a non-starter. Tesla would have to start producing it in China in order to make it in China, just as Elon Musk has suggested Tesla will do in the future. For that to happen, it will have to make some compromises which could prove to be costly to the company in the longer run.
Even after making such compromises there is nothing to suggest that firms like BYD will not still benefit from the home turf advantage, with the Chinese government finding ways to promote domestic firms. There is also another possibility, namely that China will do away with the massive EV subsidies it currently grants to domestic EV producers. The economic performance of the former engine of global growth has been less than stellar judging by official data, and perhaps even disastrous if we are to assume that the actual situation is a lot worse than the official data would indicate. Personally, I find it hard to believe that if in coming years China will be faced with public discontent, it will continue to pour billions of dollars per year in EV subsidies.
While subsidies in China and Europe are threatened by the increasingly difficult economic and political environments, in the United States Tesla risks losing the $7,500 federal subsidy due to its relative success in sales. According to the phase-out clause in the subsidy law, once a manufacturer reaches sales of 200,000 EVs in the US market, the subsidy is phased out. Tesla seems to be three years away from reaching that point, which in many ways will make it worse than the potential loss of subsidies across the board, which I foresee to most likely happen in Europe and China within a few years. It is worse, because Tesla will reach that point many years before many of its competitors will, which means that others will receive those subsidies long after Tesla will not, giving Tesla a significant competitive disadvantage.
Having listed all the likely and potential difficulties faced by Tesla in the future, I should point out that it's still a growth company and will continue to be for a long time to come. It's just that we need to reign in expectations significantly. I believe it is starting to happen already, as its stock is now far from its $282 peak and not looking like it will challenge that peak any time soon. Tesla stock still has a long way to go in order to get down to reality. But, as is the case with most investments, it will get there, especially now that it is starting to sink in for investors that even Tesla cannot defy reality.
Disclosure: I/we 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.