I still don't see how stimulating demand a bit by giving up gross margin a good deal for Tesla at a time when they will still be supply constrained for probably more than 18 months forward. Getting a high GM on the Model S and X is crucial for a fast ramp up in production of their higher end models as well as the Model 3.
That's a good question. For me, it's a question of how quickly we want to ramp up production in the near-term and how many vehicles do we want to sell in the long-run.
First the near-term, it looks like Tesla will enter 2015 at 50k/year run rate (1000/wk) and exit 2015 at a 100k/year run rate (2000/wk). One risk of ramping up so quickly is that capacity might outpace demand. I happen to think that is not a big risk. So why not ramp up to a 150k to 200k per year run rate by the end of 2015? Of course, there may be other constraints that kick in at this rate, but I think for many of us we might start wondering if there is sufficient demand to get to 200k/year by end of 2015. If you want to try to grow like that, it may be prudent to adjust your pricing earlier than later. If you cut prices after raising capacity above demand, it looks weak. If you smartly trim prices before you ramp up capacity on noble grounds that you want to put more EVs within reach of more car buyers, it looks bold and forward looking. There is a strategic commitment that happens when you must scale up your capacity to meet the aggressiveness of your pricing plan. So that's next year. Do we want to end 2015 at a 150k run rate or better?
Second, in the long-run, we have concerns about the ultimate demand for the Model S. I think many people see the Model S as maxing out with demand at 100k to 200k per year. In fact, I see people making the assumption within their cash flow models that unit sales for both Models S and X combined will level out once the Model 3 is introduced. Part of the thinking here seems to be that the Model 3 will be so attractive that it will take sales away from Models S/X. If this happens, I would argue that part of the fault would be a lack of affordability in the Models S and X. Think about someone how wants to spend about $75k on a Tesla. Their choice could be to buy a totally optioned out Model 3 at say $65, or a very stripped down S60. So if they go for the Model 3, then Tesla misses out on $10k in revenue. But under my pricing proposal, they could actually get an nicely optioned S60 for $75k. Whether they go for the S or the 3, the customer is given a better set of choices and will be happier either way. So if Tesla makes progress on the affordability of both the Models S and X, I think these models can stand there own when the Model 3 is introduced. Moreover, I think they could continue to grow unit sales through the end of the decade, perhaps hitting as much as 500k/year in 2020 for Models S and X combined. Does this take anything away from the Model 3? I don't think so. To the contrary, if Models X and S can reach 500k/year by 2020, this will create tremendous backing to accelerate the ramp up for Model 3 and whatever is to follow. So instead of ramping Model 3 to 300k to 400k per year by 2020, maybe we could be looking at 600k to 1000k per year by that time.
I would also point out to people working on cash flow models for Tesla that, if you assume that Model S/X unit sales max out with the introduction of the Model 3 and that the margin on the Model 3 is substantially lower than Model S/X, then you have a serious drop off in the y/y growth of gross profit as the Model is rolled out. This kind of drop in earnings growth could undermine high P/E ratios. So if Models S and X plateau too quickly this could be a real crisis for the stock price. If you want the stock price to grow past the introduction of Model 3, then you really hope Models S and X can continue to increase unit sales without compromising ASP or GM. So my hope is that Tesla will embrace the affordability challenge for the Model S when the Model X rolls out and later work on affordability of Model X as the Model 3 is rolled out. I think this is more sustainable path.
So do I think that S60 needs to get an affordability upgrade right now? No, not really. I think the announcement of the D could be a great opportunity to slip this in and be offset by the ASP and GM gains that the D will afford. The next opportunity is see is when the Model X is introduced, particularly if the focus is on high-end versions of Model X. Here again the attention will be on the high-end new thing and will offset impact on ASP and GM. Another opportunity may come when significant auto-pilot technology is released. If Tesla waits too long, waits until unit growth of the Model S has stagnated, then it could be more of an embarrassment to cut prices or add standard features. So that is why I would prefer to do this when something new and bold is introduced. Another factor is this idea of never decreasing the price of the Model S, by which I mean the ASP. If you let the ASP run up too high too fast, then you leave yourself little room to the upside. You risk having to make cuts to ASP just to keep sales volume up. So expanding affordability on the way up builds in some robustness to never having to pull back ASP. So I'd like to see ASP capped to about $100,000, wherein you enhance affordability only as much as is needed to keep ASP at about $100,000. Under my theoretical pricing plan, that would also hold GM to at least 30% and increase it as the Base.Cost comes down due to efficiency. There are many ways to enhance affordability. FWIW, I'd like to see the S60 upgraded to a 70 kWh pack once a cheaper battery pack becomes available. In fact, if an S70 plus Supercharger access were offered today at $71,000, I would personally find that pretty compelling, maybe that's just me. However, I don't think this is really in the cards until the Gigafactory is pumping out product. Until then, I think modest price reductions on the S60 is the way to enhance affordability.
I guess another issue around enhancing affordability in advance of Model 3 is that there is significant demand waiting in the wings for the Model 3. If some of that demand in waiting can be induced to buy sooner, that could be a good thing. For example, a 20% margin ($12,500) on a $62,500 S60 in 2015 may be worth more to Tesla than a 15% margin ($7,500) on a $50,000 Model 3 in 2018. And such a customer may even elect to buy a Model 3 in 2018 as a second vehicle. So if it makes sense to build out capacity to sell that Model 3 in 2018 for a $7500 margin, doesn't it make sense to build out the capacity to sell the S60 at a reduced cost to make $12,500 margin in 2015? The question should be how do we tap into demand for the Model 3 before the Model 3 is available. This is analogous to the current situation with the Model X. There are 20,000 reservations for the Model X just waiting to buy. Some fraction of those reservation holders are mostly waiting for AWD. So by introducing the Dual Motor option now on the Model S, some fraction of demand waiting for the Model X will be induced to buy a Model S with D on average a year before they would otherwise get a Model X. IMO, it's just not good enough to say to a customer in waiting, "Look, you're just going to have to wait x number of years for the product for you." No, the response should be more like, "What can we offer you today that would come closest to satisfying your needs?" So the Model S plus D is a really good step toward satisfying the needs today of future Model X buyers. Will it satisfy all Model X reservation holders? No, but it is the right thing to do. It will satisfy some demand in waiting and generate needed cash flow to propel the company forward. So I'll leave us all with this challenge in mind, what can Tesla do within the next 12 months to tap into the demand in waiting for the Model 3?
