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Forget Ramping Up -- Can Tesla Motors Ramp Down?

By Evan Niu, CFA – Mar 26, 2016 at 1:00PM

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Scaling back production during industry-wide downturns is an important area where the electric-auto maker has no experience.

Tesla has focused on ramping up Model S in recent years. Image source: Tesla.

With all eyes being on whether or not Tesla (TSLA) can successfully ramp up production to 500,000 vehicles per year by 2020, It might be a little premature to talk about ramping down. But it's an important consideration and potential risk factor for long-term investors to think about, even if there are no immediate implications.

Tesla's immediate goal is to significantly ramp up volumes in the years ahead. This is far easier said than done, and whether or not Tesla will be able to execute on that growth is an open debate and precisely why it's such a battleground stock. In no uncertain terms, Tesla's premium valuation depends on Model 3's success.

The downside of ramping up
Let's say that Tesla is able to execute on that growth. That would actually become a double-edged sword in some ways. The auto business is characterized not only by extreme levels of capital intensity associated with scaling production, but also very high levels of fixed costs associated with operating overhead. This is why operating breakeven levels are so important, since if units dip beneath certain volume thresholds, companies begin hemorrhaging cash -- fast.

General Motors estimates that its global breakeven point is 4.5 million wholesale vehicle sales, not including sales made through its joint ventures in China. Ford (F 1.29%) CFO Bob Shanks recently said the company could break even if U.S. auto sales dropped to 11 million. That would be a significant pullback from the 17.5 million total vehicles sold last year in the U.S. Ford could cut costs by $3 billion if needed as it adjusted production levels, of which $1 billion would come from manufacturing operations.

Model 3 could be vulnerable to macro downturns
This is an area where Tesla has no experience. Throughout its history, Tesla has been in growth mode, spending vast sums of money developing its vehicles while building up the infrastructure necessary to produce and service those vehicles. But if and when it scales its production base to its targeted levels, being able to ramp down is an extremely important skill that's critical to surviving in the auto business for the long term.

If investors fast-forward far enough to a possible future where Tesla is mature and consistently churning out hundreds of thousands of vehicles per year, it could become highly susceptible to industrywide downturns. While the 2008 downturn nearly bankrupted the company, Tesla has enjoyed robust demand for the Model S ever since 2012.

Model S is less vulnerable to macro downturns. Image source: Tesla.

However, the luxury segment that Model S is currently dominating is less vulnerable to macroeconomic fluctuations due to the relatively affluent customer base. But the mainstream Model 3, and the related production goals, will significantly raise Tesla's fixed-cost base while the mainstream customer is very much affected by macroeconomic downturns.

The first cut is the deepest
In other words, Tesla needs to show that it can exercise cost discipline if and when the auto market cools off. Tesla just hired Jason Wheeler as its new CFO, and Wheeler does seem promising when it comes to cost discipline. Here's what he said on the last call:

We're also getting to a point where we have operating leverage in the business. We'll continue to aggressively manage our growth and expenses. Finally, and I walk around and I'm on this every day. It's the relentless focus on automotive unit cost reductions. That's my mandate.

While that cost discipline is in the context of managing growth investments, at least investors know that Wheeler is on the right page. Hopefully, if and when the time comes that Tesla needs to focus on ramping down, Wheeler will be able to make the tough cuts.

Evan Niu, CFA owns shares of Tesla Motors, and has the following options: long January 2018 $180 calls on Tesla Motors. The Motley Fool owns shares of and recommends Ford and Tesla Motors. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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