(This is post #12 in a series explaining my long-term TSLA investment philosophy. For previous posts, see
Articles/megaposts by DaveT)
In this post I’ll cover another competitive advantage of Tesla, namely vertical integration.
Vertical integration is one of Elon Musk’s favorite approaches to drive down costs. He’s done it with SpaceX, with SolarCity, and now is doing it with Tesla.
In Tesla’s Q3 2014 conference call, Elon Musk notes:
“I don't think outsourcing decreases the cost. That tends to increase the cost in our experience. It's just like the reason we outsource stuff is just because we had too many fish to fry. But it's almost always the case that when we've in-sourced something, it got cheaper. I mean the thing that would make us really efficient or for any given technology level, is to say,
how far did that molecule move? And if the molecule is taking several round trips around the world, that's expensive. If it's just moving from one station to the next, then that's obviously lower cost. And so the
vertical integration just means that the molecule doesn't move as much and it's not being put in a box and then put in a truck and then on a boat, and then, you know, going through customs and stuff like that. So I mean I think that's generally true that
vertical integration and doing things at large scale results in cost reduction.” [emphasis mine]
Vertical integration is one of the key components in order to meet the cost reduction efforts required for Tesla’s 3rd generation vehicle.
In fact, it’s my belief that Tesla is well along the path of vertical integration. They started with the key, large components first, like the battery pack and drive train. Then, they started producing other auto parts in-house (ie., they have their own plastics department and make most of their own plastics). They are expanding their in-house production of auto parts, as shown by their expansion into the Lathrop facility that is dedicated to in-house auto part production.
When asked about the Lathrop facility at the 2014 shareholder’s meeting, Elon replied:
“We are actually expanding our activities in the Stockton area. Lathrop's a city near Stockton, so in the greater Stockton/Lathrop area we are setting up a lot of manufacturing activity to supply components to the Fremont factory. So as we expand production at Fremont and plan to get to the sort of 1/2 million level we have to move a bunch of manufacturing that is done at Fremont to other factories, some of which are our own, some of which are our suppliers. We can't be at the half million mark and be as vertically integrated as we are at Fremont. So we expect to do substantial expansion in Lathrop/Stockton area to supply the Fremont factory."
It’s interesting to note that Tesla is entering the market of production of auto parts. Now, I need to probably explain this more clearly. Every auto maker that makes cars also makes some auto parts like the engine, transmission, body, etc. However, most auto makers rely on a very large supplier network to provide them with hundreds of auto parts. It can be a massive supply chain and much of the auto industry has revolved around managing and negotiating supply chain agreements, as well as keeping a check on quality control.
In Tesla’s case, they started out contracting with auto parts makers to secure hundreds of auto parts. However, over time Tesla has a vision to remove inefficiencies by increasing in-house production of parts (although they will likely always rely on a number of suppliers for certain parts). I’m considering this a new market for Tesla because typical auto makers aren’t producing most of their own auto parts. The auto parts industry is a huge industry with many companies. So, as Tesla becomes more vertically integrated they become a hybrid of sorts - an auto maker and an auto parts maker (where typically these two functions were separate companies and separate markets).
The result of Tesla’s aggressive vertical integration is mainly a reduction of costs. By producing parts in-house, Tesla is able to save on production, shipping, logistics, supply chain management, and other costs.
The Gigafactory will be a massive display of vertical integration - raw material enter at one end of the factory and finished battery packs leave at the other end. The cost savings will be tremendous.
Tesla’s aggressive approach to vertical integration (ie., in-house production of auto parts, Gigafactory, etc) will allow Tesla to release a truly compelling mass market electric vehicle at an affordable price.
And after Tesla releases their 3rd generation vehicle, Tesla’s aggressive vertical integration will allow them to continue to remove inefficiencies, improve their product and increase their competitive edge in the market.
Tesla’s vertical integration doesn’t stop at vehicle production. Rather, vertical integration continues on to Tesla owning their own service centers, owning their own retail stores, and also owning their own supercharger network. Vertical integration outside of vehicle production results not only in cost reduction but also in improved quality. For example, by owning their own service centers Tesla is able to quickly gather feedback on possible issues and implement a series of fixes to see what’s the best solution. And when they roll out their solution they’re able to do so economically because the service centers aren’t charging a large markup like independent dealers would. In the case of a recall, Tesla is able to keep costs down to a minimum and this is a huge advantage as well.
By owning their own retail stores, Tesla is vertically integrating the sales and eduction experience of the customer. Tesla is able to directly control how the potential customers is treated. With independent dealers, the temptation is to push hard for a sale to everyone who walks in the door. However, Tesla has a strong value to allow visitors to explore and learn about their vehicles without a heavy-handed sales approach. The result is that Tesla is seeding relationships for the long-term while independent dealers try to squeeze sales in for their end-of-month deadline. Over time Tesla’s approach will win over fans and will prove to be a unique and large distinguishing factor.
Lastly, by owning their own supercharger network Tesla is able to control the experience and deliver the fastest charging times in the industry. Tesla is able to continuously improve charging times by optimizing how their battery packs are charged by the superchargers. Early on Tesla realized that they needed to face range anxiety head on with a creative solution, rather than waiting for others to create a charging network. Tesla realized that charging speed was going to be crucial and they pushed for a solution that would allow them to push the limits of charging speed. This required them to own, maintain, and improve on their own charging network. Further, they made the bold decision to not charge for supercharging on each charge but rather include it in the upfront cost of the car. They were able to make that decision financially viable because they took responsibility to negotiate cheap (or no-cost) deals to lease land and they decided to make a bet that solar panels would offset charging costs in the long-run.
Overall, Tesla has been super aggressive in pursuing a vertical integration approach to vehicle production, battery production, in-house auto parts production, service centers, retail stores and superchargers. Not only will the vertical integration approach give Tesla significant cost savings but also it will win people over with the advantage of quality and customer experience.
Tesla is building a very compelling customer experience for the end-customer. Customers probably won’t be interested in the vertical integration behind-the-scenes, but that’s the beauty. To the customer it will all work like magic. Tesla’s retail stores will be cool and friendly, their cars will be awesome, their service centers convenient and not greedy, the supercharger network fast, etc. It’ll all be summed up when people say, “Tesla is awesome!”. Everything will just work and it will be compelling. The pieces are being put into place. The big launch is Gen3 (Tesla's 3rd generation vehicle). Watch out.
