Tesla's Model 3 Sales Now Face Uphill Battle As U.S. Backlog Appears Exhausted And Tax Credit Is Expiring

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About: Tesla, Inc. (TSLA)
by: Kurt B. Feierabend
Summary

Model 3 estimated delivery time of under sixteen days shows that Tesla has completely worked through its months-long U.S. backlog of reservations.

The pending phase out of the electric vehicle income tax credit pulled demand forward, but Model 3 delivery times still indicate demand is much less than capacity.

Other cases of reductions in EV incentives have resulted in severe declines in EV sales.

"$7,500 tax credit expires December 31" currently appears prominently at the top of the Tesla website with a button below the notice beckoning, "Order now for 2018 delivery." On January 1st, the $7,500 electric vehicle federal income tax credit will be cut to $3,750 for all Tesla vehicles, but if you custom order a Model 3 today, Tesla (TSLA) expects to build and deliver your vehicle within these last sixteen days of 2018. While that tax credit reduction notice is important, equally important is to note that any new customer won't need to wait very long for delivery. With the low wait time, it appears that there is no longer any U.S. backlog for firm Model 3 orders. It would be very unlikely that Tesla is giving new customers preference over those who put down deposits for the Model 3 up to two and a half years ago.

In its SEC filing early this year, Tesla stated that Model 3 reservations "continued to exceed 450,000" while through the end of the third quarter, Tesla has only built 94,000 Model 3s in total. At some point after the end of the quarter, with Tesla manufacturing a few thousand Model 3s per week, the wait time disappeared. At least in the U.S., all of the willing buyers have already ordered their Model 3s and are no longer in the backlog. The rest of those people in the U.S. who put down their $1,000 deposit simply took a pass when their turn came up and decided against ordering their Model 3. Otherwise, those purchases would be occurring, and the wait time for a new customer would still be substantial. Even the extra $3,750 federal income tax credit a buyer would receive for a Model 3 delivered before December 31st wasn't enough to convince those remaining reservation holders to pull the trigger. A customer not willing to buy a product at the price the seller is willing to sell is not a customer at all even if a deposit was put down.

That gives rise to the question, "What is the steady state demand for the Model 3 given that U.S. backlog depleted so rapidly and, additionally, what will Model 3 demand be once the federal income tax credit also drops by $3,750 for Tesla?"

That's not to scoff at current Model 3 sales. By almost any measure, Tesla's Model 3 sales have been extraordinary. InsideEV estimates 18,650 Model 3s were delivered in November. If InsideEV's number is accurate, Model 3 sales were roughly in the same ballpark as the 23,367 Honda Accords sold in the U.S. in November. Model 3 is an electric vehicle which is also about twice the price of the popular Accord. That's not a trivial accomplishment for Tesla.

However, the current high level of Tesla's Model 3 sales is likely temporary. Sales were certainly pushed higher as Tesla worked through the pent-up demand of higher-margin buyers, and sales also benefited from the pull forward of demand as buyers rushed to beat the reduction of the $7,500 income tax credit which drops to $3,750 on January 1st. With the end of both of those stimuli and with the actual reduction in the income tax credit in just over two weeks, the demand for the Model 3 is likely to drop sharply in Q1. How much the demand drops off remains to be seen.

There are a few precedents for seeing how a reduction in electric vehicle incentives reduces EV sales, and those may be a good proxy for how the income tax credit reduction in the U.S. for Tesla might affect sales of Tesla's vehicles. In an extreme case, Hong Kong cut strong EV incentives which previously had halved the price of Tesla vehicles. With the incentives subsequently cut, sales of Tesla vehicles in Hong Kong went from around 2,000 in the period between April 2016 and December 2016 to just 32 during the same period in 2017. Another possible precedent, which is closer in size to the federal income tax reduction is Georgia's 2015 decision to remove their $5,000 electric vehicle state income tax credit. Sales of electric vehicles in Georgia dropped from 1,426 electric vehicles in a month to just 242 electric vehicles in the month after the credit was removed - an 83% reduction. The drop in EV sales after removal of an EV incentive has generally been extreme.

The obverse also appears to be true in that financial incentives drive EV sales. California, for example, has a generous EV rebate program of $2,500 per battery-electric car which can increase to $4,500 depending on income. Currently, California is leading the EV charge with 95,000 electric vehicles being sold in 2017, which was fully half of all electric vehicles sold in the U.S. in 2017. It's hard to point to any factor which made California first in the nation in EV adoption other than the financial incentives. It's unlikely that California residents are so unique that they simply favor electric vehicles more than people in other states, so cost is clearly a strong consideration in the consumer electric vehicle purchase decision. If the $2,500 to $4,500 rebate is what propelled California to be number one in EV sales, it's not hard to see that the federal tax credit reduction of $3,750 might move the needle by a similar magnitude in the other direction for EV sales, not only in California but also across the U.S.

In addition to sales, Tesla's margins will also be reduced with the federal income tax credit reduction going into effect for all Tesla vehicles. The effect of the reduction on Tesla's margins can be derived by looking at financial incentives from a consumer demand perspective. The reality is that the $7,500 federal income tax credit doesn't really benefit the consumer at all! Other than perceptions, the actual effect is that the income tax credit pushes up the entire demand curve by $7,500 as the customer is then willing and able to pay $7,500 more for a vehicle, to which the manufacturer responds by adjusting the selling price upward to hit a new, higher point on the curve to maximize its profit. That works both ways in that the $3,750 reduction will now force Tesla to soon reduce the average selling price of all its vehicles sold in the U.S. to fit a demand curve which has moved downward by $3,750. All else being equal, that $3,750 per vehicle reduction falls straight down through Tesla's income statement to directly reduce net income.

Conclusion

Overall, electric vehicle adoption has been on an upward trend which is certainly positive for all EV manufacturers, including Tesla. However, it would be a mistake to assume Tesla's vanishing backlog is a non-event or to simply dismiss any effect that the federal income tax credit reduction may have on Tesla's sales and margins. Tesla finds itself in a much different situation without those catalysts. It's not a question of whether the double whammy of losing those catalysts is negative - it's a question of how negative.

Tesla's shares are currently at $366, which is near its all-time highs in the wake of Tesla's blowout third quarter earnings report and amid several recent analyst upgrades. Tesla's recent share performance may indicate that investors and analysts now believe there's little risk in Tesla returning to net losses. However, Tesla isn't out of the woods, and it remains to be seen if Tesla will ever be able to sustain a profit after Model 3 demand adjusts downward. Yes, it's still stormy in Shortville, but keep a close eye on the weather in Longville as Model 3 sales estimates and anecdotes start bubbling to the surface, maybe within the next month or so.

Disclosure: I am/we are short TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.