I. Introduction: In Which I Scratch My Head
I spent several weeks puzzled by this mystery: Why did Tesla (NASDAQ:TSLA) reveal the Model 3 so far in advance of when it will be able to deliver it?
Sure, I understood what the upside might be: a huge infusion of interest-free debt and a higher share price to juice an impending capital raise.
Source: Montana Skeptic
The interest-free debt has arrived, contributed by a large and unsophisticated class of unsecured creditors. Tesla's Model 3 deposits are now "approaching" $400 million, which surely is sweet for a firm that ended 2015 with negative working capital.
Besides raking cash into the till, Tesla also benefits from the frenzy of fawning media. The non-stop hype helps sustain the stock price and sets the stage for a possible multi-billion dollar stock offering.
Is the upside really all that big ...
So, yeah, the Model 3 reveal had some advantages for Tesla. But when you think about it, the advantages are relatively modest.
The almost $400 million in Model 3 deposits sounds like a big number, but it's less than one quarter's cash burn, and that's before refund requests start rolling in.
And while the retail excitement creates positive investor sentiment, the excitement alone is not sufficient to create the conditions needed for a badly needed equity raise.
The timing of the equity raise ultimately depends on when Tesla's investment bank underwriters feel comfortable enough to launch it. Right now, they're jumpy. Since calling on their valued clients last August to buy more TSLA shares, they have seen two catastrophic earnings reports, a recent miss on deliveries, and continuing Model X headaches.
The Q1 financial results are going to be bad: I've forecast even worse losses than the analysts are estimating, and I worry I may have underestimated the red ink. The underwriters almost surely will want to see the Q1 earnings report before they start peddling TSLA shares again.
... because the downside sure is immense.
Having tallied up the extra cash and higher share price as benefits, let's examine the early reveal's obvious and huge downside: the famous "Osborne Effect" in which potential customers, anticipating something new and better in the foreseeable future, decide to postpone purchases of what they otherwise would have bought in the meantime.
Look what Tesla just did to collect only one measly quarter's worth of cash burn. It converted hundreds of thousands of potential Model S customers into people who now are convinced that if they wait only 18 months more, they can have a gorgeous Tesla sedan costing less than half as much as a Model S.
Had Tesla not revealed the Model 3 so soon, some of these Model 3 hopefuls would have stretched to afford a new Model S. With Model S demand on the life support of incentives, discounts and a nose-job refresh, Tesla certainly could use more Model S customers.
And the loss of new Model S sales is not the worst of it. The worst of it is how the promise of a 2017 Model 3 will inhibit sales of used Model S cars.
While relatively few of the Model 3 deposit-makers would have been new Model S buyers, many more of them would have stretched to buy a used Model S.
The macro factors are already bad for the Model S.
The costs of the early reveal in lost Model S sales come into sharper focus when you consider what's going on in the overall automobile market. After several years of record new car sales, industry experts now forecast new car sales will begin to decline in 2018, just as the Model 3 begins volume production.
The forecast for the used car market is even bleaker. Millions of cars that were leased when the auto boom began in 2013 will begin entering the used car market this year. Manheim Consulting, recognized as the leading expert on the U.S. car market, estimates used-vehicle supply will hit records during each of 2016, 2017 and 2018.
Sure, there is a sizeable cadre of committed Tesla loyalists who will consider only a pure electric vehicle. And among them, many will consider only a Tesla. But the fact remains: Tesla will be trying to grow its market share in an environment where new auto sales are peaking and used car inventory is at a record high.
And an environment, one might add, where gas prices are likely to remain low for years to come, depriving Tesla of one of the advantages it enjoyed when it took a small fortune to fuel an SUV.
II. In Which I Slap My Forehead, And Say, "Of Course!"
So, back to the puzzle that had me scratching my head at the start of this article: Why did Tesla take the huge risk of dampening its Model S sales and inflating its RVG liabilities with an early Model 3 launch?
The answer is Panasonic (OTCPK:PCRFY). Tesla already has two big Panasonic problems, and it hopes the flood of Model 3 deposits will help solve both of them.
The 2013 contract problem: Tesla must buy more cells than it can use.
Tesla's first Panasonic problem is its contractual obligation to buy a minimum number of 18650 cylindrical cells between 2014 and 2017. The contract (actually, a 2013 amendment to the 2011 Supply Agreement) was announced with great fanfare. Tesla would buy "nearly 2 billion cells" equating to annual car sales of 150,000 or so in 2017.
Tesla exaggerated a bit. The real number is 1.836 billion cells, which we can glean from an attachment to the contract. It defines Panasonic's capital investments in Japanese factory capacity as the "Investment Cost," and allows Panasonic to "recover the Investment Cost from Tesla [redacted] for at least 1.836 billion Items (cells) [redacted]; provided, however, that [redacted]."
Let's assume the average Tesla vehicle (Models S & X) sold during the four-year contract period has an 85kWh battery. At 7,104 cells per battery, that works out to 258,000 cars.
Tesla sold 31,655 cars in 2014 and 50,557 in 2015. So, assuming all cells are used for cars, Tesla would need to sell 176,000 or so cars in 2016 and 2017 to meet its contractual obligations.
Can Tesla do that? It has guided for between 80,000 and 90,000 deliveries in 2016. It's unlikely Tesla will meet even the low-end guidance; my forecast for 2016 is 66,000 deliveries.
2017 looks no better. Model S sales are flat at about 12,500 per quarter, and Tesla will have burnt through its backlog of Model X orders (which it built over a four-year span) by the end of Q3 2016. New Model X orders have slowed to a trickle.
So, there's a good chance Tesla has committed to buy more cells than it can use in cars. The stationary storage business might be a solution to this problem, but only if Tesla can sell Powerwalls and Powerpacks in sufficient volume to soak up the extra cells (and break-even doing so).
Tesla's promises of massive stationary storage volume and high margins, however, keep on slipping into the future. The past few weeks have seen the quiet disappearance of the 10kWh Powerwall, and uncharacteristic Tesla silence about any new utility-scale Powerpack contracts.
To consume the number of cells in one 85kWh car battery, Tesla needs to sell 11 Powerwalls or one Powerpack.
What happens if Tesla fails to meet its purchase commitment to Panasonic? Tesla will surely owe Panasonic some material amount, but the contract redactions make it impossible to say how much. Only Tesla's auditors know for sure if, indeed, even they know.
The 2014 agreement problem: Panasonic expenditures depend on Tesla demand.
Tesla's second (and much larger) Panasonic problem is, of course, the Gigafactory. In earlier articles, I have meticulously detailed how Tesla is far behind in both its hiring and construction spending promises.
Here, from Tesla's Incentive Agreement with the State of Nevada, is Tesla's forecast for total Gigafactory capital spending:
Source: October 17, 2014 Incentive Agreement, Exhibit A
Under its agreement with Panasonic, Tesla is responsible for the Gigafactory structure. Therefore, the first two line items (the building and its systems, totaling $1.4 billion) presumably are Tesla's responsibility.
The remaining $3.6 billion of costs are for equipment to manufacture cells and batteries. Those costs fall primarily on the shoulders of Panasonic and its sub-suppliers. (Panasonic has famously said it will install "up to" $1.6 billion of equipment; curiously, no one has ever asked Tesla who will install the other $2 billion worth.)
According to the latest report filed by Tesla with the State of Nevada, Panasonic had spent only $64 million on Gigafactory equipment as of year-end 2015. In other words, Panasonic had spent less than 2% of the total cell and battery equipment costs forecast by Tesla. Tesla looks bad, having spent only 22% of the total construction cost, but Panasonic looks 10 times worse.
So, with Tesla already struggling simply to meet its obligations under its 2013 Panasonic contract, and with Nevada state officials becoming restless, how does Tesla go about prodding Panasonic to increase its Gigafactory spending under the 2014 agreement?
The answer is sitting right there in the 2014 agreement, in Section 1.1(a) of the General Terms and Conditions. Panasonic's obligation to install Gigafactory equipment depends on Tesla's "rolling monthly forecast of its anticipated requirements for Goods [defined elsewhere as cylindrical lithium-ion battery cells]."
There's nothing quite like 400,000 reservations for a Model 3 car to justify an enormous rolling monthly forecast for required lithium-ion cells.
But wait, you say. That's a phony number. The Model X had more than 31,000 pre-orders, and with much larger deposit requirements, yet we're seeing less than a 25% yield rate on those pre-orders.
That's true. It's a totally phony number. Indeed, the yield on Model 3 pre-orders will almost certainly be much lower than the anemic Model X yield:
- With a far smaller deposit requirement, Model 3 reservations are likely to be less durable.
- Some pre-orders will drop away as other EV competitors arrive before the Model 3.
- Others will be cancelled when the Model 3 is delayed past 2017.
- Many will fall off when Model 3 pricing is announced (and it becomes clear the base model will cost far more than $35,000).
- And more will disappear when some reservation holders realize they have no chance of qualifying for the $7,500 federal income tax credit.
Phony though it may be, the Model 3 pre-order number is the best Tesla has to use against Panasonic.
I've already detailed why I believe Panasonic may be looking for an escape from its Gigafactory obligations, and pointed to the contract provisions that Panasonic might rely on. (See the section entitled,"There must be some way out of here," said the joker to the thief . . . in this article.
The Tesla discussions going on in the Panasonic boardroom these days are, no doubt, highly interesting.
If Tesla's ploy succeeds, and Panasonic massively steps up its Gigafactory spending, then the benefit from the early Model 3 reveal may outweigh the detriment.
In that case, look for a well-publicized announcement by Panasonic firmly committing to increased Gigafactory spending. That would be a vindication of Tesla's decision to reveal the Model 3 so early. Almost certainly, Tesla would engineer such an announcement to leverage a large capital raise.
If, however, Panasonic resists any expansion of its Gigafactory commitment, and instead questions why the Model 3 yield will be any better than the Model X yield has been, then Tesla's decision to begin accepting Model 3 pre-orders so far in advance of production may have lots of second-guessers.
III. Two More Reasons Why The Model 3 Will Cost At Least $45,000
In addition to the reasons I detailed earlier, I see two additional factors pointing to higher-than-advertised Model 3 cost.
1. The Chevy Bolt is a great base case for the Model 3.
The short version is that planners, whether in government or the private sector, are chronically too optimistic in projecting the time and expense required for any new project.
To guard against the traps of the Planning Fallacy, Kahneman urges planners to make their forecasts by first identifying an appropriate "reference class" that is similar to the project they are examining.
So, what might serve as a reference class for a small electric sedan with a range of 200 miles? Well, obviously, the Chevrolet Bolt. We know it will be available later this year and we know it will sell for $38,000.
Ah, you say, but a Chevrolet is not a Tesla. Tesla is a more gorgeous, sexy car with more brand cachet and a worldwide Supercharger infrastructure.
I'll grant you all that. But I offer the Bolt simply to show what a highly efficient automobile company can build for $38,000 at what most believe will be a minuscule margin. To think that Tesla, which is hugely inefficient relative to GM, can build a much better car for $3,000 less is simply fantasy.
2. The Gigafactory cost savings will not materialize.
For years Tesla's narrative has been that it will achieve the cost savings necessary to make a $35,000 Model 3 possible by constructing a staggeringly large and fully integrated Gigafactory whose efficiencies, economies of scale, and breakthrough chemistry would result in 30% battery cost reductions.
And, for years Tesla has been promising that Gigafactory cell production would begin in 2016.
Well, so much for all that. Last month, Tesla quietly let slip that additional Gigafactory construction phases have been deferred and rescheduled, with final construction completion moving from October 2017 until some unspecified date in 2020.
Let's assume for a moment Tesla actually could squeeze a fully integrated battery factory into the one-seventh-size structure now existing. The problem remains: Tesla needs sub-suppliers to make that happen.
Panasonic has spoken of more than a dozen sub-suppliers who would be needed at the Gigafactory. We are now 16 months past Tesla's own schedule for signing up those sub-suppliers. Exactly zero has committed to locate at the Nevada facility.
There is simply no way that by 2017 or even 2018 the Gigafactory will be achieving the economies of scale that Tesla promised would reduce the Model 3's battery cost.
I encourage Tesla believers to go back and read the endless stream of breathless "news" articles written two years ago about the Gigafactory. Those "journalists" evidently have amnesia; in now gushing about the Model 3, they appear to have altogether forgotten about the blown schedules and broken promises of the Gigafactory.
Peter M. De Lorenzo is spot on with his brilliant dissection of the sycophantic cheerleading by so-called journalists in promoting the Model 3 narrative.
IV. Why I Don't Trust Elon Musk (Parts 26, 27 and 28)
What does it tell you that Elon Musk spent several days tweeting like an excited schoolgirl about Model 3 reservations, and yet has been utterly silent about the yield on the 32,748 Model X pre-orders. This, after excising from the most recent 10-K any information about pending Model X reservations.
What does it tell you that Musk knew about the Model X's defective third-row seats no later than March 26 (when the problem was discovered), yet neglected to mention it until after Tesla had secured the bulk of the Model 3 reservations?
And what does this tweet say about Elon Musk?
The $14 billion figure implies that 100% of the Model 3 pre-orders will convert to actual sales (at an average price of about $43K). This despite a much lower yield on Model X pre-orders, which required much higher deposits and hence were likely much "stickier." Have we already forgotten about the "crazy off the hook" Powerwall reservations?
There is a phrase that comes to mind when I think about Musk's neglecting to include information about Model S and Model X pre-order yield while touting Model 3 pre-orders: "omitting to state a material fact necessary in order to make the statements made, in light of the circumstance under which they were made, not misleading."
A Note About Other Contributors
As is my wont, I have borrowed freely from the ideas and analysis of others, including (at the Yahoo Tesla message board) n0m0renancy, temagami, and dynamicviolence, and (at Seeking Alpha) investor.gator, Bonaire, and one who calls himself SteakWaffle.
None of them is responsible for my errors, and none of them necessarily agrees with all points of my analysis.
Disclosure: I am/we are short VIA LONG-DATED PUTS.
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.
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