On February 28th, Tesla (TSLA) announced a laundry list of major and minor changes to various aspects of its business. Analyzing these changes in detail would take a book and not necessarily be productive. This article is intended to shine light on just one aspect of the changes.
One of the fundamental problems of Tesla is a “vertical” business model that does not scale well. This model, driven by CEO Elon Musk’s exceptionally poor business judgment, and seen as a differentiator by unaware fans, has been one of the many drags on Tesla business. Consider the Company’s vertical sales model.
Traditional car sales model depends on franchise dealerships. The benefit of dealerships is that sales and service function are carried out, not by the manufacturer, but by independent third-party dealers. To start selling a car in a new geographic area, a car manufacturer selects a dealer in that area who will advance his balance sheet to do the sales and service infrastructure buildout for the prospect of getting a return on investment over time. Similarly, when new models are launched by car manufacturers, dealers extend their balance sheets to test the waters on demand.
These third-party dealers typically are lean mom-and-pop operations or small local/regional players. These entities do not have the overhead of a public company, are closely tied to their local communities, and are responsive to the needs of their region. They also use cost-effective business models that are appropriate for the customer base they serve.
Tesla’s vertical model has none of these benefits. For Tesla to grow, it must make all the infrastructure investments. Operationally, Tesla has proven itself to be an inept and inefficient player even in the areas that are supposed to be its spheres of competence (consider the Fremont plant which is among the least efficient and lowest quality car plants in the industry). It is hard to imagine Tesla achieving competence in managing a worldwide retail chain. So, not only is the model balance sheet inefficient but also gives Tesla subpar results.
Elon Musk is starting to realize the inefficiency of this retail operation. Unfortunately, the solution he has come up with is yet another vertical model. He is choosing to go with an online model a la Netflix, Amazon, or Dell. Note that Tesla has not had much senior sales management since Jon McNeil left. This decision about online retail is likely being made by junior executives and Musk without deep understanding of the sales process. Bloomberg reporting suggests that this new online strategy is coming from Sanjay Shah – an ex-Amazon executive who is currently the VP of Sales for Tesla Solar business.
However, the reality of the car business is that car sales and service is a high touch operation and the online model is extremely limited for selling and servicing cars. Order taking and processing can move online but most fundamental aspects of sales and service still need to be satisfied with physical infrastructure.
Will Online Model Save 5% In Costs?
Musk, in a conference call, had this to say about the cost savings he expects to achieve from the online model:
We're also reducing the Model S and Model X prices and transitioning to online only. It effectively reduces our costs by about 5% maybe 6% and so we've applied that to S&X as well as to Model 3.
For the sake of discussion, let’s assume that Tesla is planning for a 5% cost reduction for the online model. Is this likely?
Killing physical retail will certainly eliminate outside salesmen but does not save much in costs beyond that. Note that just about the only function migrating into the cloud is the order taking function. Yes, there will be savings in showroom leases, electricity, maintenance, etc. However, there are functions that get done in physical retail that still need to be done – like trade-ins, test drives, preparing cars for delivery, physical delivery, servicing cars post-delivery, etc.
Tesla may choose not to do some aspects, like the trade-ins, but that will come at the cost of reduced sales as some customers will not be inclined to do two separate transactions and like the convenience and pampering of dropping off one car and picking up another.
Traditional retail tells us that trained salespeople are valuable in selling luxury products. They can pamper customers, make them feel special, nudge them to decide, upsell, follow up, and do various subtle things that create incremental value to a Veblen good purchaser. Tesla may be underestimating the value of a sales force subtly training customers, upselling customers, and closing the sale.
One of the more interesting comments made by Tesla was regarding test drives. According to Tesla:
Last year, 78% of all Model 3 orders were placed online, rather than in a store, and 82% of customers bought their Model 3 without ever having taken a test drive.
This justification shows that Tesla is likely making a grave mistake by using statistics from current clients. To date, Tesla customers have mostly been enthusiasts and have typically owned several Tesla cars. Although Model 3 has drawn customers who were not past Tesla owners, by and large, the current customer set is unique.
For many customers in the mass market, a car is the largest or second largest purchase they will ever make behind buying a residence. These customers will be unlike the current batch of Tesla customers who are typically wealthy and have purchased several Tesla cars in the past.
As word spreads about Tesla’s poor quality, online approach to selling becomes even more difficult. Prepaying for a car would be a problem for many until Tesla has a stable and credible MO. Without the traditional car buying experience, Tesla will not be able to access much of the mainstream market it desperately needs to access.
Costs are likely to be high during the transition from physical retail to online retail. During the transition to the new business model, the company will suffer through the double whammy of higher retail overhead and lower ASPs - with a disastrous impact to the P&L and the balance sheet. These challenges are in addition to soft issues like customer and sales force confusion and lost business.
It is difficult to quantity the impacts of the move to online retail because there are no easy parallels that are available as a reference. However, given the challenges, the likely result, after an expensive and challenging transition to the new model, is certain to be subpar. The hoped-for cost savings will not materialize, or will come at the expense of reduced sales, and reduced ASPs. The net result will be that Tesla will lose even more money.
The Test Drive Dilemma
Not having test drive may work to a high degree among enthusiasts but the main stream market, which Tesla needs to tap into, will be a lot less willing to buy a car without a test drive and sight unseen. Tesla seems to have a keen appreciation of this challenge of the online sales model. To overcome that, Tesla is making a very bold move. According to Tesla:
We are also making it much easier to try out and return a Tesla without a test drive. You can now return a car within 7 days or 1,000 miles for a full refund. Customers are becoming increasingly comfortable making purchases online, and that is especially true for Tesla — which is a testament to the products we make.
Firstly, it should be noted that Tesla has been notoriously late in refunding deposits to customers. Some customers have waited for months to get even small refunds to the tune of $1,000. As word spreads, it will be hard for Tesla to convince many of its potential mainstream customers that they must put forth a $40,000+ payment before they can try out the vehicle.
Secondly, even if there are no trust issues, it is doubtful if many customers will go to the extent of pre-paying and buying a car just to test drive.
It is also likely that the 7-day, 1000-mile return policy will be abused. Adventurous customers will find ways to exploit the system if Tesla does end up expediently refunding customer money. A car that gets used for 1000 miles will easily lose about 10% of value, or about $4,000. Tesla cannot afford to have a lot of such returns. However, given Tesla quality, the odds are high that these returns will be significant.
Regardless of Tesla’s intent and strategy, the most likely outcome here is that this test drive strategy will dramatically reduce the sales funnel, will be expensive for Tesla, and will make it difficult for Tesla to drive sales.
The Question Tesla Has Not Answered
As can be seen, there are many limitations of the online model from a customer view point. What is is it that customers gain with this model? A smoother ordering process? Anything else?
A fundamental problem with Tesla’s proposal is that its online model offers very little benefit (outside of speed of transaction) and expects a huge change in consumer behavior. That is unlikely.
Tesla’s retail channel never made any sense. Owning and operating dealerships around the world was always a foolhardy endeavor.
Unfortunately, the model that the Company is moving to, online, is unlikely to work well for Tesla given Tesla’s current circumstances. A high percent of early adopters and fans who have waited years for Model 3 may have bought online without retail store help but that is not the demographic that needs to buy for Tesla to dramatically increase sales.
Furthermore, going online does not solve the fundamental underlying logistical issues of the car business. Consequently, we are about to witness a massive destruction of capital as the Company’s physical business model unwinds. This destruction of value is unlikely to be made up by incremental online sales.
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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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Any positions disclosed by the Author are part of a diversified portfolio. Author considers lack of diversification to be one of the most grave errors made by many investors.
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