On March 30, SpaceX (Private:SPACE) made history. The 15-year-old company launched a previously flown Falcon 9 rocket, delivered a communications satellite into orbit, and returned the rocket's first stage (or booster) to Earth by landing it on a drone ship in the Atlantic Ocean. The same rocket first launched and landed in April 2016. This is the first time in the history of spaceflight that a rocket has ever been launched into orbit twice. It's a milestone on the path to full rocket reusability, which could bring the cost of launches down by more than one hundred times in the long term. The logic is simple: destroying rockets after one use is a lot more expensive than reusing them again and again. Reusability is the key to a new era of affordable spaceflight.
This historic achievement builds on SpaceX's previous world firsts. In May 2012, SpaceX became the first private entity to return a spacecraft to Earth when it recovered its Dragon capsule from the Pacific Ocean following a mission to the International Space Station. The only other entities to ever do so are NASA, the Russian Federal Space Agency, and the Chinese National Space Administration. In December 2015, SpaceX again made history by successfully landing a rocket after a return from orbit. This is a feat no company or government space agency has replicated. None even appear to have a viable program in place.
Let me stress this point. SpaceX has just done something NASA couldn't do and that long-established spaceflight companies like Boeing (NYSE:BA) and Lockheed Martin (NYSE:LMT) in their United Launch Alliance joint venture couldn't do. That should give us pause. What has the rest of the world been doing wrong? What is SpaceX doing right? How did this little upstart company come into the arena and show up the giants of the space industry? Fifteen years ago, if anyone had predicted this would happen, it would have sounded too farfetched to believe. SpaceX's achievements should not have been possible. So now there must be a reckoning. It's time to rethink our assumptions and intuitions about what is possible.
SpaceX launches a previously flown Falcon 9 rocket. Photo credit: SpaceX.
What makes Musk's companies different
When pressed to explain what he does differently, SpaceX's CEO and CTO Elon Musk responded that he operates on first principles reasoning rather than reasoning by analogy:
Well, I do think there's a good framework for thinking. It is physics. You know, the sort of first principles reasoning. Generally I think there are - what I mean by that is, boil things down to their fundamental truths and reason up from there, as opposed to reasoning by analogy. Through most of our life, we get through life by reasoning by analogy, which essentially means copying what other people do with slight variations. And you have to do that. Otherwise, mentally, you wouldn't be able to get through the day. But when you want to do something new, you have to apply the physics approach. Physics is really figuring out how to discover new things that are counterintuitive, like quantum mechanics. It's really counterintuitive.
Musk has two university degrees: one in economics and one in physics, both from the University of Pennsylvania. (He also began a PhD in physics at Stanford University, but dropped out after just two days to start his first company, Zip2, which sold for $307 million four years later.) Musk's educational background makes him mentally well-trained to think about building companies from the laws of physics upward.
Systematic first principles reasoning in the hands of someone who is intellectually gifted but in whom the temptation toward hubris is tempered by failure, close calls and an eagerness for negative feedback, as is the case for Musk, can result in radically counterintuitive ideas that we would not think are possible but are. Musk doesn't just have a profound intelligence and the right intellectual approach to building companies. He also has the right balance of self-efficacy belief. He has enough hubris to think everyone else in the world, including NASA, might be doing it wrong, but enough humility to accept that he might be wrong and to listen seriously to criticism. The cultures of Musk's companies reflect his way of thinking. One added benefit is that Musk's sci-fi vision of the future and his reverence for physics creates an exciting, alluring ethos that helps attract top engineering talent to his companies.
What works for SpaceX will work for Tesla
As an investor in Musk's other company, Tesla (NASDAQ:NASDAQ:TSLA), one of the fundamental precepts in my investment thesis is that Musk's approach to building companies with radically counterintuitive results is generalizable from the space industry to the car industry. What has worked for SpaceX will work for Tesla. This is why I take seriously Musk's heady vision for Tesla's factories.
In Tesla's Q3 2016 earnings call, Musk said, "the long-term aspiration is … limit-of-physics manufacturing." Tesla is applying "creative, first principles thinking" and most of its engineering talent to its factories in order to achieve an unprecedented level of automation and productivity, ultimately eliminating humans from the production line. I believe this is really possible. The evidence is in what SpaceX has accomplished despite ample prima facie reason for incredulity, and to a certain extent in what Tesla has already accomplished. Tesla has the right leadership in Musk, the right intellectual approach, fresh pain from the hubris of Model X design and production, and with its acquisition of Grohmann Engineering, a team with over half a century of world-class expertise.
This is perhaps the main reason why my outlook on Tesla is so different from the views of many other analysts and commentators. Some of the same arguments currently leveled against Tesla could have been made against SpaceX, and they would have turned out to be wrong. For instance, Doron Levin, writing in MIT Technology Review, argues that Tesla is unlikely to build fully automated car factories because Toyota (NYSE:TM) and General Motors (NYSE:GM) have long aspired to do so but never have. The same could have been said about SpaceX's reusable rocket program. Why on Earth would we believe that a little upstart company in Los Angeles could do what NASA hasn't been able to do and give century-old industrial giants like Boeing and Lockheed Martin a run for their money? Well, here we are. Time to readjust what we find believable.
SpaceX's competitive position is incredible. As the world's only organization launching reusable rockets into orbit and landing them, SpaceX is like a normal airline competing against airlines that destroy their planes after every flight. Unless other companies or government space agencies can learn to reuse their rockets, no one can compete with SpaceX. The entire global launch industry will belong to the little upstart from Los Angeles.
Something similar could very well happen for Tesla. If Tesla can produce cars without humans on the production line while the rest of the world is limited to human speed and cost, the result will be a rupture in the car industry like Henry Ford's introduction of the moving assembly line in the 1910s. Elon Musk has already proven himself once. Why doubt that he can do it again?
Tesla's ambition: fully automated car manufacturing
The Model 3 - the internal name for designing the machine makes the machine is the - we call it the alien dreadnought. At the point at which the factory looks like an alien dreadnought, then you know you've won. It's like, what the hell is that? So we've got alien dreadnought version 0.5 will be Model 3. It will take us another year get to version 1 and probably a major version every two years thereafter. By version 3, it won't look like anything else. It might look like a giant chip pick-and-place machine or a super high-speed bottling or canning plant, and you really can't have people in the production line itself. Otherwise you'll automatically drop to people speed. There's still a lot of people at the factory, but what they're doing is maintaining the machines, upgrading them, dealing with anomalies. But in the production process itself there essentially would be no people. ... With version 1, not version 0.5
On the next earnings call, Musk said that version 1 could arrive in the summer of 2018. Even if it were to be arrive much later, creating an assembly line that is free of direct human labor would be an enormous technological achievement that would confer a radically disruptive competitive advantage upon Tesla. In terms of both speed and cost of production, Tesla would be far ahead of every other car company in the world. Not unlike how SpaceX is far of ahead of every other launch provider in the world.
ARK, a technology-focused investment firm, estimates that if Tesla achieves its ambition of fully automated manufacturing, the productivity of its assembly line will be about three times higher than its most productive competitors. Unless other car companies can follow suit and attain a similar level of productivity, Tesla could become the world's largest car company within a decade.
That's the production side of the equation. Tesla also has a plan to create practically unlimited demand for its cars. It's currently on track to be the first company in the world to commercially release fully self-driving cars.
Robots assemble cars in Tesla's factory in Fremont, California. Photo credit: Steve Jurvetson.
Tesla is the global leader in self-driving development
Tesla is pushing self-driving faster and harder than anyone else by actively collecting more training data every week than its next closest competitor, the Alphabet (GOOG) (GOOGL) subsidiary Waymo, has collected in its entire history. The faster data is collected, the faster self-driving capability can be developed. Tesla has not yet announced when its Full Self-Driving Capability will launch. However, Musk has previously indicated that its cars will be fully self-driving in 2018 and more recently tweeted that the first features of the Full Self-Driving Capability software would begin to roll out to customers by the end of July.
Tesla also has announced plans to launch a self-driving mobility service - an on-demand ride hailing app like Uber (Private:UBER) - called the Tesla Network. Customers will be able to send their cars off to pick up rides autonomously and generate revenue to recoup some or all of the cost of purchase. Tesla also may operate its own fleets. Morgan Stanley analyst Adam Jonas predicts that the Tesla Network could launch in 2018.
Tesla is likely to be the first company in the world to sell fully self-driving cars, and no other company seems poised to sell them anytime soon. If Tesla is the only company offering self-driving vehicles, this will create practically unlimited demand for its cars, including the high-end and high-margin Model S and Model X. Depending how slow competitors are in delivering their own self-driving vehicles, Tesla could enjoy stratospheric demand for years.
The feedback loop of production and demand
Fully automated manufacturing and full self-driving, then, can be seen as forming a feedback loop between production and demand. Full self-driving will generate practically unlimited demand which will create a surge in revenue for Tesla by boosting Model S and X sales and allow the company to raise billions more in capital if desired. This cash can, in turn, be invested into advancing its manufacturing process to reach higher levels of productivity, into expansions to the Tesla factory in Fremont, California and Gigafactory 1 in Nevada, and into building Gigafactory 3, 4, and 5.
This increased productivity and expanded production capacity will allow the company to fulfill more orders and therefore generate more revenue. Increased productivity also will increase Tesla's gross automotive margins and lower prices for customers, leading to more investable gross profit and more demand for its cars. The production end of the loop feeds back both into itself and into the demand end of the loop.
A Tesla Model S and Model X at a Supercharger station. Photo credit: Steve Jurvetson.
Competition will likely be slow to arrive
In theory, competition could rush in at any time and start selling self-driving cars. I actually hope this will happen, even at the expense of my investment in Tesla. Years ago, I lost two friends in a car accident. For the sake of all the parents, children, siblings, partners and friends who will lose loved ones in car accidents over the next few years, I hope that the major automakers will suddenly wake up and start pursuing self driving as vigorously as Tesla. We need this to happen for a higher purpose than profit.
However, established manufacturers have a shocking and frustrating level of complacency around self-driving, as well as around electric cars - which we also need for a higher purpose. It is incredible to me how slow-moving and tepid the incumbent car companies are when it comes to implementing new technologies. Tesla's Autopilot launched in 2014 and still no other car company has caught up. For example, the Model S and Model X are currently the only cars that can automatically change lanes. Since 2012, Tesla has been delivering over-the-air software updates to its cars and so far in 2017 remains the only car company to do so. Even the infotainment systems in new cars feel like computers from the last decade.
If self-driving follows this trend, Tesla will launch Full Self-Driving Capability, maybe in 2018, and 3-5 years later the incumbent automakers will still have not implemented it. Meanwhile, Tesla will be producing millions of self-driving cars per year and taking customers on billions of rides with the Tesla Network. Forward-looking tech companies like Waymo can't produce cars, so they can only move as fast on self-driving as the manufacturers are willing and able to go.
In fact, Toyota, Volkswagen (OTCPK:VLKAY, OTCPK:VLKAF, OTCPK:VLKPY), Nissan (OTCPK:NSANY), Honda (NYSE:HMC), and PSA Group (OTCPK:PEUGF, OTCPK:PUGOY, OTC:PUGOF) are all targeting 2020 for the release of their first fully self-driving cars. Ford has given a range of 2020-2021, while BMW (OTCPK:BMWYY) and Volvo (OTCPK:VLVLY, OTCPK:VOLVF) are targeting 2021, the same year that Fiat Chrysler (NYSE:FCAU) has indicated. Hyundai is an outlier with plans to develop full self-driving by 2030. This list comprises the top dozen vehicle manufacturers, excluding Suzuki (OTCPK:SZKMF, OTCPK:SZKMY), which has not announced any plans for self-driving, and General Motors, which is pursuing self-driving but has not given a timeline.
Most manufacturers will be 2-3 years behind Tesla if it launches its Full Self-Driving Capability software in 2018. Actually, since full self-driving will likely require billions of miles of training data, these companies may take another year after their cars are delivered to customers to release their self-driving software, putting them 3-4 years behind. Tesla released its self-driving ready cars in October 2016, but it seems like it will take about two years to train and validate the software.
General Motors plans to start testing thousands of self-driving cars in 2018. This is a smart move and a cool experiment, but unless GM will be testing tens of thousands or hundreds of thousands of cars, it's fundamentally in the same predicament as every other car company. It will likely need billions of miles of driving data before its self-driving software is truly ready, and so if all it has planned for 2018 is to test a few thousand cars, it's on track for 2019 at the earliest, and possibly 2020 or later.
Tesla's long-term prospects for growth
ARK predicts that the global self-driving mobility-as-a-service industry will reach $10 trillion in annual revenue in the early 2030s. McKinsey has a much more conservative forecast, projecting $1.5 trillion in annual revenue in 2030 split between self-driving mobility-as-a-service and in-car digital services such as entertainment for all former drivers who have now become idle passengers. McKinsey also projects a $1.25 trillion increase in annual revenue for vehicle sales and a $480 billion increase in revenue from aftermarket services.
As a personal observation, the gross margin on self-driving mobility-as-a-service should be high at least initially, since it will likely be possible to charge only somewhat less for rides than human-powered mobility-as-a-service companies like Uber and Lyft (Private:LYFT). The variable costs of providing mobility-as-a-service are the same as the per mile cost of car ownership. With electric cars, the "fuel" costs and maintenance costs will be significantly less than most car owners are used to today.
Given Tesla's 2-4 year lead over major auto manufacturers, it is well-positioned to emerge as a leader in the self-driving mobility-as-a-service industry and capture a significant share of the revenue from this new market. The greatest challenge for Tesla in the self-driving mobility-as-a-service space will likely be ramping production to millions of vehicles per year so that it can compete with the rest of the auto industry.
This is what makes Tesla's road map for fully automated manufacturing so crucial. The faster Tesla can ramp production, the more it can capitalize on its lead in self-driving. Producing only 100,000 or even 500,000 cars per year will squander its advantage. Even its target of 1 million cars per year in 2020 is too small. As competitors roll out vehicles with hardware for full self driving in 2020 and 2021, Tesla needs to reach a multi-million production volume in 2021 in order to retain its data advantage (or at a bare minimum not fall significantly behind) and to position itself to capture market share in the self-driving mobility-as-a-service industry.
Don't panic about Tesla's cash burn
The most frequently cited challenge for Tesla is its cash burn. While some commentators believe Tesla is on an unsustainable trajectory, I see this challenge as manageable. First, there seems to be enough investor interest in Tesla for it to continue to raise capital until it becomes cash flow positive. Tencent's (OTCPK:TCEHY) recent $1.8 billion investment in Tesla reinforces this view.
Second, Tesla is on track to become cash flow positive next year, according to analysts at Deutsche Bank. This estimate is contingent on Tesla selling 250,000 Model 3s in 2018, significantly short of the company's own target of 400,000. Morgan Stanley expects Tesla to become cash flow positive toward the end of 2018 on a much more conservative forecast of only 80,000 Model 3 sales that year. Furthermore, Morgan Stanley expects Tesla to become profitable in 2019 and to post a profit of $881 million in 2020.
Third, even if Tesla runs into serious trouble and the capital markets dry up, Musk won't let the company die if he can possibly prevent it. SpaceX is a profitable company, it is currently launching at a record rate, and it is beginning to benefit from the cost savings of reusable rockets. Musk's stake in SpaceX is believed to be worth $8.1 billion based on a $15 billion valuation as of June 2016, which may have since climbed higher thanks to its recent advances in reusability and accelerated launch cadence. At a $15 billion valuation, Musk could sell 3% of SpaceX's outstanding stock for $450 million and still retain ownership of 51% of outstanding stock. Since SpaceX's stock structure appears to be split between voting and non-voting shares, it's possible that he could sell more and still retain control of the company.
Both a rising valuation for SpaceX and the sale of non-voting shares would increase the amount of cash Musk could raise without giving up control. In a truly dire scenario, Musk could sell some of his voting shares to a trusted friend like Larry Page, whose company Alphabet already has a major stake in SpaceX. There is a precedent for this. In 2013, Musk and Page had a deal to sell Tesla to Google when Tesla was in rough financial waters. By selling some of his voting shares of SpaceX to someone like Page, Musk could raise potentially billions in cash to bail out Tesla.
Alphabet CEO Larry Page is interviewed by Charlie Rose at TED. Photo credit: Steve Jurvetson.
What we should learn about Tesla from SpaceX
Those who doubt that Tesla is capable of fully automated manufacturing and full self-driving should look at Musk's track record. With SpaceX, he has already pushed the edge of technology forward. SpaceX's achievements in rocket reusability have earned it a place in history and an enviable position in the space launch industry.
With SpaceX, Musk has already transformed one industry that was previously ruled by sleepy incumbents. With Tesla, Musk is on the path to transforming another. The automotive industry should wake up from its complacency now. Watch out. Disruption is coming.
Disclaimer: This article is not investment advice.
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Disclosure: I am/we are long TSLA. 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.