Why Tesla Investors Should Be Worried

| About: Tesla, Inc. (TSLA)
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EVs: The "Tablet PC" of the Consumer Auto Market?

Excitement and anticipation over the wide scale deployment of electric vehicles (EVs) seems to be at an all time high. News here in the US reads like a textbook example of a new market about to take off. For example, California-based Tesla (NASDAQ:TSLA) is nearing production of its flagship, the Model S, and, with the fanfare resembling an Apple (NASDAQ:AAPL) release event, they recently unveiled the Model X. Ahead of production, the company has publicly announced that they are planning to sell 15,000 Model S vehicles by the end of 2013. Meanwhile in Tennessee, Nissan (OTCPK:NSANY) is doubling its Leaf production workforce to meet strong demand. At nearly 10,000 units sold in 2011, the Leaf has been the top selling consumer EV. In addition, Nissan recently expanded Leaf availability nationwide effective this month. Further, with gas prices on the rise, charging an EV looks like a much cheaper alternative to filling a gas tank. Yes, EVs seem well on their way to being the next vehicle of choice for US consumers.

With this plethora of upbeat, high profile news, investor speculation has surged in recent months. These investors are hoping EVs will be the silver bullet for an unmet need; a tablet PC to the consumer auto market, so to speak.

However, the EV market is not without its fits and starts; manufacturers have experienced set-backs recently. Fisker's DOE loan has all but dried up after the company has had trouble meeting strict DOE milestones (likely related to Solyndra's collapse). And GM's (NYSE:GM) Volt assembly plant in Detroit-Hamtramck, MI will be idled for five weeks due to lower than expected demand for the vehicle. Regardless, this news seems to have done little to dampen continued hopes (and speculation) of mass EV adoption.

Given the high profile nature of EVs lately, it's fascinating that one of the major barriers to EV adoption has escaped main-stream discussion so far. This barrier, which remains largely unaccounted for by consumers and investors alike, may be the "Achilles' heel" that marginalizes pure EV makers like Tesla and Fisker if not addressed.

The Achilles' Heel: "Permanent" EV Batteries and Their Effect on Resale Values

The Achilles' heel is this; a vehicle with a "permanent" battery. EV batteries (typically Lithium Ion) don't last forever. Admittedly, I'm not the first person to point this out, but let me take this a step further. I believe these Lithium culprits could be the Achilles' heel for EVs by quickly reducing their resale values to near zero.

Here's why: Lithium Ion battery lifespan is primarily affected by two factors, calendar life and usage. The older a battery gets the more capacity it loses. Lithium-ion batteries will naturally degrade about 1% each year, even without any use. In addition, typical driving of the vehicle (commuting, soccer games, etc.) will degrade the battery's capacity as well. Each trip to the grocery store, the office and each associated recharge take a toll. The effect of each trip is small, but it adds up over time.

When you compound these two factors, an EV battery may need to be replaced in as few as 5 years (with heavy use). Or sooner, as demonstrated by the recent Tesla Roadster "bricking" fiasco. Aside from the typical warranty language of "8 years or 100,000 miles, whichever comes first" (for the 40 kWh version of the Model S), Tesla has been mum on the details of its battery warranty for the upcoming Model S. If it's anything like the Nissan Leaf battery warranty, it will explicitly exclude "gradual capacity loss."

The major problem arises out of the fact that the battery can account for as much as half the cost of the vehicle, or $20,000 to $50,000. This begs the question: "How much is an 8 year old electric vehicle worth if it needs $20,000 - $50,000 to replace the battery?" Buyers of used EVs aren't likely to pay much, if anything, for a vehicle that needs such an expensive repair. Fiscally minded EV owners may be shocked when they attempt to sell their vehicle in 8 years and find that the resale value is near zero.

It's been argued that by the time EV batteries need to be replaced, costs will have plummeted dramatically. While scaling up production and additional R&D for Lithium Ion batteries may yield some reductions in cost, these batteries are already widely deployed have been through decades of R&D. Dramatic cost reductions are only likely to come from entirely new battery chemistries which historically take decades to move from research to mass production. In other words finding a battery in 7-10 years that costs a third of what Lithium Ion does today is very unlikely. In fact, if demand for Lithium continues to increase, prices of Lithium Ion batteries are likely to follow suit.

Additional Revenue Opportunity or Showstopping Barrier?
So, the next question is whether the battery replacement issue should be viewed as an opportunity for additional revenue, or as a showstopping cost for consumers. Tesla has attempted to get ahead of this by offering prepayment plans for replacement batteries at the cost of $12,000 (for the Roadster). The plan requires seven years to elapse before the battery is eligible for replacement. The only trouble with this plan is that Tesla is likely taking a loss on the sale of the future battery. The current installed cost for a new Roadster battery is around $750/kWh ($40,000 for a 53 kWh Roadster battery), but Tesla's prepayment price pencils out to $225/kWh. While this might help Tesla's current cash flow position, at less than one third the current battery cost the numbers don't appear to favor profitability.

Batteries as a Service
The next logical idea would be to offer the EV battery as a service, so as to spread out the costs over time. Today, most consumers think about the cost of operating an EV strictly by how much it costs to recharge the battery (and ignoring the cost of replacing the battery). From this narrow perspective it appears very attractive since recharging a battery can cost equivalently 80% less than refueling a gas tank (when compared on a mileage per tank vs. per charge basis). However, recharging the battery is but a small component of the total operating cost of the vehicle. The cost of maintaining and replacing the battery is a much more expensive factor in the EV's lifecycle cost equation. Replacing this permanent battery requires taking a big hit to the pocket book all at once.

Perhaps this is what inspired the startup company Better Place, who supports and promotes vehicles with "switchable batteries" to solve the battery cost issue. The venture backed American-Israeli company seeks to offer batteries as a service, which can be switched in and out of cars in less than two minutes. The idea can be likened to a cordless drill with removable batteries. One battery can be charged externally while you use a different one. When you're done, you simply swap them. In this case, Better Place would own, maintain and charge those batteries (and associated "stations" and infrastructure). In addition, the depreciation and capacity loss of the battery would be paid for with each use, rather than at the beginning of its life. With consumer familiarity with monthly and recurring payments, the idea of batteries as a service seems like the most attractive path to mass EV adoption. If EV manufacturers, like Tesla, can capture this, they could become much more attractive to investors because of the recurring revenue opportunity. But for now, they seem stuck on the idea of a permanent, non-switchable battery.

If Tesla does not offer "batteries as a service" or some type of "switchable" battery, the company could quickly become marginalized by companies like Better Place and Nissan, who have teamed up to offer this service in other countries.

This brings us to a final consideration: Once consumers understand the true lifecycle costs of the battery system, will they think EVs are too expensive? This question can only be answered with time, and I believe we'll watch it unfold over the next 8 years or 100,000 miles, whichever comes first.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.