Tesla: Significant Margin Growth Via Raw Materials Integration

Summary

• Two key battery metals, lithium and nickel, are experiencing extraordinary pricing pressure at the moment and, with upcoming supply shortages, there’s little sign of reprieve any time soon.
• Tesla looks to be interested in the production and refining of both metals, in order to secure its future supply and significantly reduce its cost of production.
• By partnering with, or buying, juniors near production, Tesla could improve its automotive margin by another 1.2% and, more importantly, ensure it is able to sustain maximum production capacity.
• Looking for a portfolio of ideas like this one? Members of The EV Supply Chain get exclusive access to our model portfolio. Learn More »

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I don't think there's a person on this website who hasn't heard of Tesla (NASDAQ:TSLA). Though what readers might be a little less aware of is a growing issue regarding the company's supply of critical battery metals. Recent comments from members of Tesla's executive team, including CEO Elon Musk, indicate that the company is planning on entering the mining space to relieve some of these supply chain pressures. This article will aim to demonstrate the existing supply issue, and how Tesla could benefit significantly from supply integration.

The Material Problem

As raw materials prices have continued to skyrocket, Tesla has been forced to raise the price of its vehicles across the board. As Zachary Kirkhorn, Tesla's CFO, explained "it's quite an unprecedented situation of raw material movement." Currently, according to Allkem (OTCPK:OROCF), lithium is selling for around $35,000 per tonne. Spot prices, which comprise the vast minority of transactions in the lithium market, have surpassed $100,000 per tonne according to Benchmark Mineral Intelligence. In the beginning of 2021, lithium spot prices were around $9,000 per tonne. Now, there's no question that this extreme market cannot last.

However, it will take time to subside and, when it does, I expect a settling price of around $18,000 per tonne. While a significant reduction from today's insane market, this is still about a 50% premium from what lithium prices settled at a few years ago when supply and demand were more closely balanced. I'll touch on this a bit more later, though with lithium not even in a shortage yet, it's possible that significantly elevated prices could persist for a few years. This trend continues to nickel, one of the other critical elements Tesla seems to be targeting at the moment.

Much like lithium, nickel is currently in the midst of an extreme run that has pushed prices up quite significantly. This is largely due to the fact that Russia is the leading producer of high-grade nickel products, which some expect could create a supply shortage in the battery market. While there was a supply deficit last year, this was originally expected to reverse to a surplus this year. Now, with Russia's invasion of Ukraine, it's unclear how supply will be impacted. Currently, nickel costs around $34,000 per tonne, though I expect prices to correct down to $20,000 per tonne. Although a significant correction from current levels, similar to lithium, this is still far above previous averages.

Because of this raw materials problem, battery production costs rose for the first time ever. From $132/kWh in 2021, battery costs rose to $135/kWh in 2022 following more expensive raw material prices. Now, a 2.27% rise in battery manufacturing costs may not seem like that much, but this came even before the massive spikes this year. Additionally, extrapolating the rate of battery price reductions, this 2.27% price hike is effectively a 6.06% jump given what battery prices should have been this year.

Bloomberg NEF

Rising prices aren't the only issue that Tesla is trying to combat with its upcoming purchases of mining operations. Rather, these rising prices are symptomatic of a larger issue within the supply chain of both nickel and lithium. Because new mines typically take more than 10 years to bring into production after initial discovery, future supply estimates, at least through the end of the decade, can be made with rather high degrees of confidence. With those estimates, even conservative growth estimates for EV adoption seem to indicate that a supply deficit is unavoidable. While nickel supply is only just exiting a deficit, it's expected to return to a shortage beginning in 2026. Lithium, on the other hand, could enter a supply shortage as early as next year. An article on The EV Supply Chain examines the nickel market a bit more in depth.

Tesla's Opportunity

As a producer, Tesla could procure its lithium for around $3,500 per tonne. Assuming that there's an average of 11.35 kg of lithium in every Tesla vehicle, and annualizing Q1 vehicle production to an annual output of 1.24 million, bringing lithium production in-house would save the company $204 million per year. With growth to around 2 million EVs per year already in the pipeline, given the company's European and Austin Gigafactories, this rises to $329 million per year. The opportunity here should now be pretty clear.

At production costs of around $5,800 per tonne, depending on the source, nickel too provides a significant opportunity for Tesla to reduce its operating expenses. Now, only about half of Tesla's cars last year included nickel in the cells, as the other half was LFP, but those that do contain nickel likely contain about 56 kg. Using the same production estimate of 1.24 million, assuming half are LFP, bringing nickel production fully in-house would save the company about $493 million. With an annual output of 2 million vehicles per year, this rises to $795 million per year. Annualizing Q1 automotive revenue, bringing nickel and lithium production in-house would add about 1.2% to the company's gross margin. These are also long-term estimates, the savings using current prices would be even more significant.

Though, while the savings are certainly a benefit, the security that in-house raw material production creates is perhaps even more significant. As critical battery metals shift towards supply deficits, companies like Tesla may be forced to cut production. Companies, such as the CATL, are already starting development on alternative battery technologies.

The Chinese firm aims to commercialize a sodium-ion battery by 2023, which won't require nickel or lithium. Unfortunately, with an energy density of just 160 Wh/kg, it comes in far below Tesla's 260 Wh/kg high-nickel batteries. With LFP cells, the budget lithium-ion option, holding an energy density up to 210 Wh/kg, these sodium-ion cells really have no utility beyond relieving supply deficits. 160 Wh/kg just isn't suitable for most EV applications. Though, as some estimates place manufacturing costs at just $77/kWh, it's possible that they will find significant utilization in utility-scale storage applications, or perhaps in conjunction with other lithium-ion cells in EVs.

But Tesla can't exactly sell premium vehicles with sodium-ion batteries. The company could move further down market, but that begins to eat into revenues and profitability. While the company has claimed multiple times that its eventual goal is to make EVs accessible to everyone with the introduction of a $25,000 car, such a vehicle also would significantly dilute the company's brand value. And, earlier this year, it was made clear that the company is not pursuing development of such a vehicle and, if it was ever released, it would only come after full autonomy is achieved. So I wouldn't get my hopes up. Without much wiggle room within its existing product lineup to introduce sodium-ion batteries, Tesla has built a heavy reliance on lithium-ion and isn't well-suited to deal with a shortage. If it were to face a supply shortage of lithium and nickel, Tesla would not be able to meet its production capacity. The message is clear: Act now or be forced to make significant compromises in the next few years.

It's likely that Tesla will aim to partner with, or takeover, projects that are only a year or two away from commercial production and, not only are these projects limited, but they're also not exactly cheap. Currently, Tesla has $17.5 billion in cash and cash equivalents, generating $2.2 billion in free cash during its most recent quarter. Though, with about $9.2 billion in long-term liabilities, and $21.5 billion in current liabilities, not all of this cash can simply be put towards acquiring more assets.

Tesla's liquidity isn't exactly the greatest, offering just enough in current assets to cover current liabilities. The company's quick ratio, which removes inventory from the equation, is likely a better indication of the company's ability to consistently make good on its liability obligations. Though, as demonstrated by the figure below, Tesla has historically struggled with liquidity. I'd say that the company's existing leverage is already fairly significant and, at the moment, it may be wise for the company to reduce its debt position before taking any more on.

Long Term Tips

Even still, following the buyouts of Millennial Lithium ($400 million) and Neo Lithium ($737 million), I'm confident that Tesla could secure all of its necessary mining reserves for less than $1.5 billion. Both aforementioned companies are within a few years of commercial production and also project output that would cover Tesla's lithium needs, making them solid benchmarks. $1.5 billion isn't chump change but, with significant free cash generation, I do believe that Tesla could afford to integrate all of its lithium and nickel requirements.

Tesla's current 32.9% gross automotive profit margin is already outstanding, largely due to the company's ability to extract the maximum value from its vehicles given its direct-to-consumer business model and a luxury perception. All things equal, integrated resource production could bring it up to just under 35%. However, production costs have long been a struggle for the company, famously reaching a boiling point with an overreliance on automation for the Model 3. Tesla has largely moved past those days, though it now faces rising production costs at no fault of its own. However, by taking a more active role in upstream supply, Tesla may unlock yet another significant cost reduction, boosting its industry-leading margins even more.

Investor Takeaway

While I applaud this strategy, I cannot recommend the stock. Despite my rather liking the company, it's just become far too detached from its fundamentals. Driven largely by retail investor hype and a very loyal fanbase, I believe Tesla is quite overvalued. For a company in the S&P 500, 54% retail ownership is incredibly high. Even perennial consumer favorites with cult followings of their own, such as Apple (AAPL), Disney (DIS), and Amazon (AMZN), only have retail ownership of 38.6%, 31.4% and 27.8%, respectively. Just to clarify, strong retail support isn't inherently a bad thing, I just mean to say that this is what I believe the source of Tesla's inflated value to be.

However, for those of you who disagree, and I know there are plenty, I think this is something to be very excited about. Tesla's gross automotive margin is undeniably impressive and further margin growth will enable the company to grow its value without even needing to grow sales. Furthermore, because any acquisitions or partnerships would be financed through capital expenditures, it won't even count against the company's profitability on the income statement. Of course this will impact free cash flow, which is a critical measurement of a company's financial health, but investor focus tends to be on profitability.

More broadly, I believe there may be a number of automakers that follow suit and decide to move upstream. Not only would this help them save on costs, by a significant margin, but it also allows automakers to have greater oversight of their supply chain. In an environment where social responsibility is becoming more important for consumers and regulators, such oversight may enable automakers to ensure relevant standards are being met. For companies like General Motors (GM) and Ford (F), I'm interested to see their strategies moving forward because, quite frankly, their raw material procurement strategies look lackluster at the moment and I hold some doubts that either will be able to meet their aggressive electrification goals. Not due to a lack of ambition or desire, but due to a lack of raw materials. This risk is very real, and I don't believe that others are taking it as seriously as they perhaps should be.

This trend toward greater OEM involvement in the supply chain will drive funding toward juniors. With most major automakers committing tens of billions of dollars toward the development of EVs, as much as $96 billion in the case of Volkswagen, it only makes sense that a portion of these budgets should go towards securing raw materials. Greater access to funding will drive the entire junior battery metal mining sector up as the general financing risk is lowered and more projects are able to enter production in a timely manner. Additionally, with limited projects available, OEMs will likely be forced to increase their offers as less projects become available and some may even engage in bidding wars over top assets.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.