Tesla Motors (Nasdaq: TSLA) the American start-up, electric car company that had its IPO in June 2010, has been getting a lot of attention amid the volatile oil market. The appeal of all-electric vehicles has never been greater because of rising oil prices, consumers' acute awareness of violent political oppression across the oil-producing Middle East, and new developments in EV technology.
As people in the United States in particular search for cheaper alternatives to fuel their cars, Tesla's industry-leading technology and anticipated launch of the Model S sedan in mid-2012 promise to be part of the solution. Its stylish and high-performing sports car, the Roadster, has already captured the imagination of investors and consumers around the world, including strategic partners such as Daimler, Toyota, and Panasonic.
However, auto industry characteristics aren't favorable to start-up companies, and the electric vehicle market remains untested in the United States. More importantly, Tesla's financial risks and debt situation put a big question mark over the company's future, and we think it's unlikely that the company will be successful if it operates alone.
Even with the inherent risks in Tesla's strategy, we also believe that its intellectual property, powerful brand image, and industry-leading products will make it a very attractive and likely acquisition for a well-established car manufacturer. This article will walk through an analysis of Tesla's risks and prospects and explain why Tesla could be a prime acquisition target in the future.
The risks
Tesla's doing more than reinventing the wheel.
With the Roadster, Tesla has delivered a serious setback to the skeptics of EV performance capabilities, and it hopes to do the same with the Model S. But reinventing automobiles isn't enough for Tesla -- it's also trying to reinvent the business model of the automobile industry from the ground up, including distribution and service networks.
After hiring George Blankenship, Tesla signaled its commitment to a retail strategy of online sales and select showrooms across the world that relies on JIT delivery. This strategy enables Tesla to capture nearly all the value in the supply chain without ceding power to third-party dealers. It also allows Tesla's dealerships to be smaller than the typical, larger dealership lots, which will save money. For a company that has only sold about 1700 cars, this business model works since they strive to be a low-volume company.
However, there are a few problems with this strategy if the Model S lives up to management's expectations. First, it remains to be seen if the 50 dealerships that Tesla plans to open will adequately support the 20,000 Model S cars Tesla expects to sell each year. Second, even if the dealerships are sufficient, the individual store traffic will be problematic. Because of the radical nature of Tesla's product, it's easy to imagine an exceptional amount of curious customers exploring the small dealerships.
Tesla also runs into a problem with its online sales. Some states, like Kansas, don't allow direct-factory sales of automobiles but require a brick-and-mortar dealership within the state. That means Tesla might lack a sales presence in many states.
The main risk is how consumers receive this new business model. By hiring Blankenship, Tesla is hoping to replicate "the feel of an Apple store" and bring that positive experience to the auto industry. However, buying a car and buying personal electronics is very different. One downside for online sales is that customers can't feel or test the product before purchasing it. A $50,000 purchase only magnifies this downside.
Tesla has made a conscious effort to keep their dealerships small and in high-traffic areas. On the other hand, the industry norm is sprawling car lots with huge inventories. Consumers are used to walking around a lot, looking at endless combinations of packages and colors. For such a revolutionary product, it's hard to imagine that consumers will be satisfied with just a couple of displays, especially if more models are offered in the future.
Best Buy has the Geek Squad, but can the Tesla Rangers also provide reliable service?
Just as Tesla is trying to replicate Apple's retail model, it's also trying to copy Best Buy's Geek Squad service model. With their limited amount of dealerships, Tesla has found a mobile solution to servicing their customers' cars. Instead of customers coming to them, Tesla sends its Tesla Rangers to the customers' home or workplace. The Rangers drive a bus with an attached trailer that carries most equipment needed to service their product on the go.
Even though Tesla maintains that its cars need minimal maintenance and many repairs can be done electronically, problems are bound to arise. Similar to their distribution network, it's unclear if Tesla Rangers will be able to deal with the anticipated Model S traffic. Currently, the system works efficiently and caters to the low volume Roadster, but if people adopt the Model S faster than anticipated, Tesla could find itself with unhappy customers. For example, if Tesla doesn't hire enough Rangers for a certain area, customers might run into problems when an emergency arises if all of the Rangers are booked.
The cost of maintaining this service network also could pose a problem. Tesla plans to charge $1 per roundtrip mile, which seems inadequate to cover the costs of reaching customers nowhere near a service center. The system would become very inefficient and costly for a loosely concentrated customer base. High costs would also arise if a customer's car was severely damaged and needed transportation to a distant shop.
The worst-case scenario for Tesla would be a recall because of its limited amount of service centers. With the new technology, a recall certainly isn't out of the question, and customers would have to wait for days to weeks for the Rangers to make their rounds.
Production challenges?
DoubleClick, YouTube, Zappos.com. All great businesses, all acquired for different reasons. Even with a great business model, not every business can make it alone. In the automobile industry, it's difficult to imagine that Tesla can weather the risks on its own.
One glaring risk is Tesla's production capabilities. After entering into its partnership with Toyota, NUMMI became Tesla's sole factory for the Model S. While most established car companies have multiple factories, Tesla remains at risk with any disruption to NUMMI or its supply chain. Tesla must also bear higher-than-average costs to ship its cars worldwide from California.
Another downside to Tesla's business is its gamble on EVs. Alternative energy and propulsion systems are gaining more attention as gasoline prices continue to their steady upward trend, and there's no guarantee that consumers will adopt EVs as the alternative. While large companies have the luxury of waiting for the market to pick its propulsion system, Tesla won't be able to adapt well as a result of its small size and limited financial resources.
No money, too many problems
Tesla's financial risk is the greatest threat to the company's future. Historically, Tesla's cash inflows have come primarily from financing, leaving it with dangerously high levels of debt. Its current stock price is predominately based on investors' expectations for future earnings. If those sentiments change in the near future, the Tesla's story could end badly.
Even if investor sentiment doesn't change, Tesla will have a mountain of debt to service. The United States Department of Energy (DOE) loaned Tesla $465 million at the beginning of the year. This loan has several restrictions that are structured around the progress of the Model S and several financial ratios. Tesla stands to lose revenue if the Model S delays, since the DOE loan pays in installments as the Model S reaches various development and production benchmarks. Management even said that if it can't access the DOE loan in its entirety for any reason, then it'll have to issue more equity or debt, diluting the stock price and increasing company risk.
The auto industry is notoriously difficult for start-ups. By going alone, Tesla is severely disadvantaged in scale, established distribution channels, production expertise, and financial resources. Even with their solid product and performance so far, it's tough to envision that Tesla will reach critical mass and profitability anytime soon.
The prospects
Nobody can hold a light to Tesla's tech.
It's not fast enough. It doesn't go far enough. It's too small. These are all common reasons for why hybrids still comprise only 3%-4% of the American car market, and why many Americans don't believe electric cars are a viable transportation option in the future. But that's one of the fascinating things about Tesla's planned Model S sedan (~$50,000 base): If it works as the company says, then the Model S will actually be bigger and faster than comparably priced, gas-powered cars. Not to mention, the base range of 160 miles (300 miles with the most expensive battery pack) will satisfy most Americans' monthly driving needs. The Roadster currently goes about 200 miles per charge.
It's no wonder, then, that auto manufacturing giants Toyota and Daimler have recognized Tesla's remarkable advances in battery and electric powertrain technology, and made significant financial investments through formal partnerships. They're attracted to Tesla's culture of innovation that has propelled it to technologically lead the pack of companies hoping to launch their own EVs. In addition, Tesla spokesperson Khobi Brooklyn commented in an email that the recent $30 million investment by Panasonic will allow Tesla to benefit from Panasonic's "fundamental chemistry knowledge and experience as the world's leading battery cell manufacturer." Ms. Brooklyn also noted that Panasonic "is designing an automotive grade cell specifically optimized for power, safety and cost" and is a "preferred supplier" for Tesla.
As mentioned before, Tesla's prospects heavily rely on a successful launch of its Model S in mid-2012. Any long delays in production could spell financial demise for the company. Having said that, Tesla has done a great job of advancing its technology -- quickly, and on a shoestring budget -- to the point where EVs actually look like a feasible alternative to gas-powered cars. The release of the first operational Model S in January 2011 was an important step. Based on current and future industry competition, we expect Tesla to retain its technological competitive advantage for at least the next few years and succeed in making the Model S a fully functional and well-performing vehicle.
Who's the EV competition?
We don't want to simply provide a list of all of the possible competing EVs, since Automotive News' "Watts Up" already does a pretty good job of that. Instead, we'll explain why another one of Tesla's key assets is that the Model S will occupy a unique position in the EV market when it launches in 2012.
There are a few general parameters that we think consumers will judge electric cars on: performance, range, price, and style. (Safety, too, but there isn't yet sufficient safety data that would distinguish the EVs from each other.) Of course, different consumers are looking for different combinations of those parameters. After reviewing the competition, we think that the Model S -- if it works close to expected -- exhibits a unique and preferable combination of those decision factors that will prevent close competition. Price, range, and performance attributes suggest that "competitors" like the Chevy Volt, Nissan Leaf, or Fisker Karma appear to target different customer segments altogether.
Watch for an acquisition of Tesla in the next three to five years.
We examined the future of the EV industry, Tesla's products, and different key aspects of Tesla's business model. As stated in the first section of this article, we don't think that Tesla will operate optimally alone, even if the Model S functions well. However, we outline a number of reasons why Tesla is an attractive and likely acquisition target over the next three to five years:
1) Rising oil prices mean EV start-ups will attract the attention of traditional automakers.
The future of Tesla's EV market has never looked better because of trends in the oil market, and most established automakers understand that. Instead of trying to develop their own EV technology from scratch, many automakers are "partnering" with start-ups like Tesla that have already spent years developing a niche expertise in EV technology. A large part of EVs' economic appeal depends on rising oil prices, so why will oil prices rise over the long term?
The deep recession of the last two years temporarily ameliorated the "pain at the pump," but the climbing global demand for oil with a resurging economy has caused oil prices to threaten the fragile recovery.
On another level, unprecedented unrest and violence in the Middle East have shown American consumers exactly why the oil addiction can't be taken lightly. Even the flattening of oil prices from reduced demand in Japan won't last very long. Many experts think that the accompanying nuclear crisis and consequent backlash against nuclear power in Japan will ultimately cause the Japanese government to use more oil to produce electricity in the future as a substitute. Moreover, since the "cheapest" oil has been largely tapped out, and demand from China, India, and Brazil continues to burgeon, it's very likely oil prices will move in one direction: up. That means the cost savings from driving an electric vehicle will also increase, and cause more consumers to switch over to EVs. Less than 1% of total U.S. energy production comes from petroleum, so electricity prices will be largely insulated from volatility in the oil market.
2) Tesla's brand image and potential synergies make it attractive to luxury automakers entering the EV market.
Tesla has made a name as a top-tier trailblazer, designer, and producer of electric vehicles and technology. When the company first started in 2003, the idea of EVs hitting the mainstream market was only a dream. But that didn't stop Tesla from successfully developing the Roadster, which hit markets in 2008 with critical acclaim. Tesla's Roadster destroyed the notion that EVs inherently are less powerful and poorer performing than their gas counterparts.
A luxury automaker like Daimler would sync perfectly with this brand image. Daimler prides itself on cutting-edge technology, class, and style in its cars, very similar to Tesla. Tesla's culture of innovation would find a welcome home at Daimler, which has sufficient cash flow to fund development without taking on potentially debilitating levels of debt like Tesla currently has to do.
Aside from the close strategic fit, there are enormous synergies that a luxury automaker like Daimler could realize if it acquired Tesla. Many more potential synergies exist; these are just a few of the tangible ones:
One synergy is access to Tesla's unparalleled assortment of intellectual property in electric powertrain technology and car design. Tesla currently has 35 patents and 280 pending patent applications. By acquiring Tesla, a traditional automaker won't have to spend a lot of time and money developing the technology itself. This IP also has the potential to produce large amounts of revenue, but only if the Model S and future models can be launched in a timely manner and through wide distribution and service channels that characterize large, established automakers.
That brings up the next synergy, which are the distribution channels. As said before, Tesla currently faces a huge problem with its inadequate distribution strategy for the Model S that likely will result in significantly lower sales than otherwise may be achieved. Since Tesla's management knows that constructing a large network of brick-and-mortar stores is beyond their financial resources, they've instead adopted a strategy of building a small number of company-owned stores and then utilizing online sales (but there are legal restrictions on online car sales in many states). An acquisition by a large automaker would give Tesla access to a worldwide network of established dealerships and service centers; the largest incremental cost only would be building "bump-ons" to the dealerships to house the separate Tesla brand. Also, customers might feel more comfortable with a company that operates a regular service network, instead of solely relying on "mobile service" that doesn't seem feasible with a planned level of car sales in the tens of thousands per year.
The last main synergy comes from established automakers' expertise and efficiency in high volume car-manufacturing. With such high fixed costs in the auto industry, sales volume is critical to achieving profitability, but Tesla doesn't have any experience with large-scale manufacturing or volume sales.
It has tried to avoid this issue by saying that it specifically structured its business model to be able to achieve profitability with relatively low sales volumes, but that's very tough to believe given industry precedents.
A manufacturing expert like Daimler or Toyota could use its extensive manufacturing experience to streamline and perfect high-volume production of the Model S, and also help Tesla secure much more favorable procurement contracts from suppliers.
3) Provisions in the Tesla-Daimler partnership suggest Tesla is already viewed as a potential target.
The agreement between Daimler and Tesla interestingly includes many "anti-takeover" provisions that would make an acquisition from a third party much more difficult. For example, Blackstar (an affiliate of Daimler) has a right of notice on any acquisition proposal that Tesla receives from any company except Daimler, and Blackstar then has a right to submit a competing acquisition proposal.
On the other side, Tesla's CEO Elon Musk, who is also Tesla's largest shareholder, agreed to not sell any shares of his stock to any auto manufacturer except for Daimler. He also agreed that he won't vote any of his shares in favor of a liquidation transaction to any automobile equipment manufacturer, other than Daimler, without affiliate Blackstar's consent.
So, it appears that there's much more to the Daimler-Tesla partnership than a simple a transfer of capital and electric powertrain products. Tesla has done a good job in its contracts with Daimler and Toyota to specifically protect its intellectual and technological property from being transferred, meaning that Tesla isn't giving away its competitive advantages. These provisions indicate that Daimler may be closely examining an acquisition of Tesla in the future, likely on the condition that Tesla can prove the Model S is fully functional and ready for production. Otherwise, it doesn't make much sense for Daimler to have established the restrictive anti-takeover provisions that essentially give it "priority" access for an acquisition. Tesla and Daimler spokespeople declined to comment about the reasons for establishing those provisions in the agreement, so the true strategic intentions are unknown at this time.
Conclusion
After researching and analyzing auto industry conditions and Tesla's financial situation, we think it's unlikely that Tesla will financially succeed on its own even if the Model S works as predicted. However, the direction of the EV market, Tesla's cutting edge technology, positive brand image, and potentially enormous synergies make it a likely acquisition for a luxury automaker seeking to enter the growing EV market.
Disclaimer: The conclusions in this article reflect the opinions of the authors only, and not those of any of the mentioned companies' management or employees.
Disclosure: The authors do not own shares of Tesla, Daimler, or Toyota, nor do they plan to purchase shares of those companies within the next month.
