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Why Tesla's Model 3 Could Fail

By Adam Levine-Weinberg - Jul 5, 2015 at 8:04AM

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Tesla has had huge success in the ultra-luxury auto market. Moving into the mass-market segment will be more challenging.

Tesla Motors ( TSLA 4.24% ) has enjoyed huge success in the ultra-luxury car market with its Model S sedan. The company has steadily ramped up production of the pricey electric car, yet demand has always exceeded supply -- even though Tesla does no advertising and never offers discounts.

Demand has grown for Tesla's pricey Model S sedan. Image source: Tesla Motors.

That's why many investors, stock analysts, and car enthusiasts -- including my colleague Daniel Sparks -- expect Tesla to have big success in the mass market with its less-expensive Model 3 sedan.

However, while the Model 3 will be much cheaper than the Model S (and the upcoming Model X SUV), it's likely to end up confined to the luxury market, competing with the likes of the BMW 3 Series or the Mercedes C-Class. This may put Tesla's ambitious sales goals -- 500,000 cars per year by 2020 and "a few million" per year by 2025 -- out of reach.

The price -- and the real price
Tesla CEO Elon Musk has said the base price of the Model 3 will be about $35,000 -- before the impact of government tax incentives. The current $7,500 federal tax credit for EVs would bring the final price down to roughly $27,500, and even less if state tax credits are available.

In theory, that should make the Model 3 quite affordable. It still might cost a little more than a Prius, but would probably offer better performance -- and, of course, it wouldn't require any gas. At this price, the Model 3 could target a cross-section of middle-class hybrid owners and tech enthusiasts.

However, the number of people who walk out paying less than $30,000 after tax credits for a Tesla Model 3 will be tiny. Instead, a typical buyer will almost certainly pay more than $40,000 -- and perhaps more than $50,000. That would still move Tesla into the broader luxury market from its current ultra-luxury niche. But it wouldn't be a mass-market car.

Why the Model 3 will still be pricey
First, the history of the Model S offers evidence that a base model for the Model 3 might not be very appealing.

Tesla originally planned to offer a 40-kilowatt-hour Model S as a base model, starting at $52,400 after the $7,500 federal tax credit, and featuring a 160-mile range. It killed this version before the first Model S delivery to simplify production, because it only accounted for 4% of Model S orders.

More recently, Tesla killed the 60 kWh Model S, which had a range of just over 200 miles. Instead, Tesla introduced a 70 kWh version that costs about $4,000 more. More generally, the Tesla Model S sales mix has tilted heavily toward the most expensive versions with the most options -- bringing the average selling price to about $100,000.

Demand for the Model S has been heavily skewed toward the priciest versions. Image source: The Motley Fool.

For the Model 3, Tesla will probably offer a battery upgrade option. Based on the comparatively low demand for the 40 kWh and 60 kWh Model S versions, getting closer to 300 miles of range could be seen as a near-necessity, at least if you might ever take a road trip.

Furthermore, to keep the price down, many standard features of the Model S are likely to be options on the Model 3. Option packages for the Model S can easily add up to more than $10,000. This would drive actual prices for the Model 3 far beyond $35,000.

In addition, the $7,500 federal tax credit won't last long unless the U.S. government changes the rules. As it stands, the credit will phase out quickly beginning two quarters after a manufacturer reaches cumulative sales of 200,000 electric vehicles or plug-in hybrids.

If demand for Tesla's Model S and Model X vehicles stays strong, the company will be well more than halfway to the 200,000 phase-out level before the Model 3 even goes on sale. Adding the Model 3 will quickly put Tesla over 200,000 cumulative sales in the U.S., driving the federal tax credit down to zero within a year and a half.

Is there a big enough market at this price?
To recap, the Model 3 won't benefit from the $7,500 federal tax credit for long. Plus, the Model S sales history suggests most consumers will demand an upgraded battery. And once the out-the-door price is around $40,000 -- and not $27,500 or less -- most buyers will want to add creature comforts that could easily push the price beyond $50,000.

This has two implications. First, Tesla might price itself out of the vast majority of the market. (In the U.S., the luxury segment represents about 11% of the total auto industry.) Even a dedicated environmentalist might be hesitant to upgrade from a Prius to a Model 3 when there's no federal tax credit to narrow the cost gap and when adding a few basic options pushes the price tag beyond $40,000.

Second, at this price point, Tesla will face much more formidable competitors than the mass-market automakers. Going up against the likes of BMW and Mercedes means facing off against brands with their own loyal followings. Tesla will have to deliver a car that is just as high-quality as the much more expensive Model S if it wants to sell hundreds of thousands annually.

Selling millions of vehicles by 2025 will be an even greater challenge. Even the mighty BMW brand has never broken the 2 million mark (though it's getting close). To reach this goal, Tesla will need to deliver a much cheaper car after the Model 3.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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