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The Long-Range Strategy Behind Tesla's "Revolutionary" Financing Product

By John Rosevear and Isaac Pino, CPA - Apr 18, 2013 at 12:00AM

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Tesla Motors (Nasdaq: TSLA) made headlines on April 2 when it announced what it called a "revolutionary new finance product" that would give Model S buyers an opportunity to enjoy some of the advantages of a traditional new-vehicle leasing program.

The company immediately put some marketing muscle behind the new program, an unorthodox auto-loan plan created by Tesla in partnership with US Bancorp and Wells Fargo (NYSE: WFC). Never a company to shy away from hyperbole, Tesla's marketing materials – including the front page of its website – made the claim that the new program would allow buyers to own a Model S sedan for "$500 a month" when all costs were considered.

That claim drew some ridicule when it turned out to be based on dubious assumptions. But given that the cheapest Model S starts at over $60,000, and can go up sharply from there, $500 a month sounded like a compelling offer at first blush.

CEO Elon Musk echoed the $500-a-month claim in conversations with reporters, and it seemed clear that the company – or at least Musk – expected their new finance product to produce a significant bump in Model S sales.

It didn't help Tesla's stock, though. Tesla's shares fell 7% the next day, as Wall Street analysts opined that the product was unlikely to do much for Tesla's sales in the near term.

Why did Tesla create this program? And does it still have value to the company even if few buyers take advantage of it?

The importance of leasing in the luxury-car market

While the Model S, an American-made, all-electric, luxury sedan with a range of up to 300 miles, is in many senses unique, it nonetheless has competitors. A buyer seriously considering a Model S is probably already driving a luxury car in the Tesla's general price range, and may well be considering the Tesla as an alternative to simply buying anotherBMW, Mercedes-Benz, Audi, or Lexus.

So in a very real sense, gas- (or diesel-) powered cars like the BMW 5-Series and Mercedes E-Class are indeed Model S competitors – as are to some extent their larger and more lavish siblings, the 7-Series and S-Class.

But many BMWs and Mercedes aren't sold outright, with payments that could easily exceed $1000 a month on a five-year loan. Instead, they're leased: At the time of Tesla's announcement, Mercedes was offering 24-month leases on new E-Class sedans beginning at $579 a month.

These kinds of lease programs allow buyers who can't (or who choose not to) afford to buy an expensive luxury car outright a chance to drive and enjoy one for a more modest monthly payment. And they are tremendously popular among luxury-car buyers: At one point last year, leases accounted for 76% of the new vehicles financed by Mercedes' U.S. financing unit.

Clearly, a company wishing to do business in this end of the new-car market would be well-advised to have a robust leasing program available. But for reasons explained below, it's likely that Tesla was unable to find a financing company willing to create a true leasing program for the Model S.

Why Tesla can't yet offer a conventional lease program

From a bank's perspective, the problem is likely this: Right now, nobody knows what a Model S will be worth in two or three years.

The starting point for creating any new-car leasing offer is an assumption of the car's "residual value", the likely value of the vehicle on the used-car market at the end of the lease. It's typically expressed as a percentage of the car's value when new.

Calculating the residual value of a new car from a major automaker is a straightforward exercise. A great deal of data on used-car sales is available; that data can be sifted and a reasonable assumption can be made about what the car will likely be worth. Even with all-new models, data from that automaker's other recent cars can be used, and a close estimate made.

That won't work for Tesla, a new company with a new car powered by an unconventional technology that may or may not catch on with consumers in time. From a bank underwriter's perspective, it may not even be reasonable to assume that Tesla the company, which is after all a recent start-up, will be in existence at the end of a three-year lease that starts today.

Long story short, it's likely that Tesla tried and failed to create a conventional leasing program, patterned on those offered by other luxury-car brands, for the Model S. That led the company, and its partner banks, to create an unconventional alternative.

The details – and long-range purpose – of Tesla's "revolutionary" financing product

Tesla's "revolutionary" financing product is essentially a 66-month car loan with a 2.95% interest rate – but with some unique features clearly intended to make it more lease-like. First, there's no down payment required: The banks will provide qualified customers with 10% of the purchase price, an amount that will be largely reimbursed by federal and state tax credits and incentives offered on electric cars.

Second, as with a lease, the buyer can (but does not have to) exit the deal after three years. Tesla has promised to buy back any Model S financed under this plan after three years, at a value pegged to the then-current residual value of the Mercedes-Benz S Class. Musk has said that he will personally guarantee that repurchase option if Tesla is unable to do so.

So what's the point of this program? Near term, it'll probably draw a few cost-conscious buyers off the fence. It's not a bad deal, even if the payments are far from the "$500 a month" that Tesla seems so intent on advertising.

(That number, by the way, comes from a "True Cost of Ownership" calculator on Tesla's website that shows how various "savings" can offset the monthly payment, which actually starts at $1,097 for the most basic Model S. Some of those savings are not unreasonable, such as the gas purchases that are unnecessary with a Model S; some are dubious, like a business tax benefit that will apply to few buyers, and a calculation of the value of the time saved by not having to drive to gas stations.)

A longer-range vision may be at work

But the program seems to have been created at least in part with a longer-range vision in mind. By offering to repurchase the car after three years at a good price, Tesla is essentially establishing a future floor for prices of used examples of the Model S. That will serve to keep the price of a used Model S strong, which will in turn preserve Tesla's ability to charge strong prices (and thus preserve what Musk has promised will be rich margins) for its new cars.

It will also put Tesla in a position to offer attractive lease deals in a few years, once banks are willing to go there, by ensuring that the residual value of the Model S is (at least) as good as that of the Mercedes S-Class. And that program, if and when it arrives, could do very good things for Tesla's quarterly sales numbers.

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