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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Can Economies Of Scale Rescue TSLA?

Can Economies Of Scale Rescue TSLA?

Few potential investments out there are as divisive as Tesla. On one side, bulls see the electric vehicle maker as a fundamentally different kind of car company and one that heralds a new future for the industry. Bears look at the lack of profit and the limited number of models being sold currently and see a vastly overvalued stock.

There is little doubt that Tesla’s current production and profits are not enough to support its stock price. But the investment case for the company really rides on what the future will bring. And if Wall Street analysts are right, that future might be brighter than many bears are allowing for. Tesla’s Gigafactory has the potential to not only shake up the grid-scale energy storage industry, as was so widely reported earlier this year when the firm announced it was getting into that business, but it also has the potential to create enormous economies of scale in the firm’s core car business. Related: Fund Managers Have Their Own ‘Black Monday’ Thanks To The Saudis

One of Tesla’s most expensive costs in each vehicle is the battery that operates the car. Those battery costs should drop precipitously as the firm ramps up production. The truth of the matter is that Tesla is a company that has been built around mass manufacturing, but right now the firm is only aiming to produce between 50,000 to 60,000 cars this year.

Thus Tesla’s fixed costs – which are ultimately intended to be spread over a much larger production base – are currently dragging down its profitability. The same thing will hold true with the firm’s battery plant – initially at least. But as the production ramps up and Tesla starts using more of its excess capacity, that will all change. Investment banks see the ramp up of the battery plant lowering per kwh costs by 50 percent. Related: Iran Deal Opponents Try A New Approach

If Tesla can achieve a 50 percent drop in its battery costs, this will enable the company to put out its long-awaited Model 3 with a base price of $35,000 – solidly in the mainstream of new car price tags. This battery cost advantage will raise margins by 1000 basis points bringing total Original Equipment Manufacturer (OEM) margin to 23 percent to 33 percent depending on the model in question.

All of these cost efficiencies might sound far-fetched, or at least speculative, except that they are already happening. At the price of batteries when Tesla first developed the Model S, the battery pack alone would have cost $90,000. Today that price is down to $36,000. A further 50 percent drop in price would add $18,000 in profit to Tesla’s bottom line. On 50,000 units sold, that $18,000 in extra profit would translate to $900 million in incremental profit.

None of this means that Tesla’s success is guaranteed though. Related: Support For OPEC Production Cut Is Increasing

Rival car makers are starting to see the writing on the wall and are looking to add new models that will rival Tesla’s. Nissan already have an EV model, as do several other firms. Yet those competitors to Tesla lack the cache that Tesla’s sleek engineering and masterful publicity efforts (or lack thereof) offer to the customer.

Recently though, Porsche and Mercedes have both announced their intention to begin competing with Tesla on the EV front, and both firms carry the kind of brand appeal that might actually be able to challenge Tesla. Mercedes says it will have a rival product out in a few years – possibly 2018. Porsche has a model that may arrive by the end of the decade. Neither company is a threat to Tesla right now. In fact, if the VW emissions testing debacle continues to pick up steam, both brands may end up focusing resources on that issue. But if those firms’ plans continue uninterrupted, then Tesla will eventually face serious competition. That is something investors need to keep an eye on going forward.

By Michael McDonald of Oilprice.com

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  • mulp on October 01 2015 said:
    New EV makers will only increase demand for cells and for battery pack manufacturing, and Tesla will be heavily invested in integrated manufacturing of both, with plans already being made to remanufacture battery packs integrated into the same facilities. The cells Tesla uses in batteries are "naked" in that they need no jackets to protect the cell for handling, because the battery pack provides the protection. That means remanufacturing batteries will remove cells that are simpler to break down for recycling.

    Nothing Tesla is doing is hard to duplicate, just costly in the labor to understand the process steps and flow and then to build the integrated capital assets and train all the workers to run it essentially from mine to battery to vehicle and back for remanufacture.

    Maybe Tesla simply becomes a battery specialist to the transport and utility sector, something the cell and battery makers long in the business failed to become because they did not build devices to use batteries and thus sold only jack-of-all-trade-master-of-none energy storage products.

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