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Why Car Dealers Should Be Terrified of Tesla's Model 3 Numbers

By Evan Niu, CFA - Apr 4, 2016 at 9:00PM

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The insane turnout for Model 3 reservations might indicate that consumers are ready for the build-to-order model.

Tesla showroom. Image source: Tesla.

I think it's safe to say that no one enjoys the current car-buying experience in the U.S. Consumers simply endure it.

This is why auto dealers have long viewed Tesla Motors (TSLA 7.33%) and its direct-sales model as an existential threat, despite the fact that Tesla's U.S. market share is effectively a rounding error in the context of record U.S. vehicle sales. But Tesla has historically been relegated to the low-volume luxury market segment, so its inherently limited customer base has a hard time being all that vocal when it comes to changing protectionist state laws.

That may have all just changed.

The mainstream is ready for change
It must have dismayed dealers when hundreds of people lined up at Tesla stores last week to put down a $1,000 deposit on a car they had never even seen before. We're talking about hundreds of thousands of reservations at this point, all voting in favor of the direct-sales model. Even though the Model 3 total tally -- which is likely approaching 300,000, if not more -- includes international reservations, a majority of those reservations are still probably right here in the U.S.

Right now, just 6% of U.S. car sales are build-to-order, according to Automotive News. While build-to-order is quite common in Europe (roughly half of new car sales), Americans typically walk into a new car dealer, pick a unit from available inventory, and drive it off the lot. American automakers have tried to implement build-to-order models before, but they were largely unsuccessful, in part because it affected nearly every aspect of operations.

Model 3 is demonstrating that the American consumer may be ready for a change.

Dealers' last defense
Earlier this year, the FTC hosted a panel on auto distribution. While dealers touted "intrabrand competition" as their primary defense for their role in the value chain, the argument is deeply flawed. For a consumer, removing a middleman market is better than reducing it.

That being said, there is one extremely important function that dealers do play in the value chain: outsourced inventory investment and risk. Dealers, most of which are small local businesses, invest millions of dollars in vehicle inventories that any consumer can purchase on the spot. Interestingly enough, this is also part of the basis for the current protectionist laws; the laws are meant to protect those local investments from potential direct competition from the manufacturer.

Here's where it really hurts: If Model 3 represents widespread consumer interest in build-to-order, then that effectively undermines the dealers' last justifiable reason to exist. At the very least, it significantly minimizes their place in the value chain.

Inventory is evil
At the FTC panel, one of the presenters was Fiona Scott Morton, the Theodore Nierenberg Professor of Economics at the Yale University School of Management. Morton notes that a wide range of industries have been changed by e-commerce and the ability to buy things on the Internet, while auto retailing stubbornly refuses to adapt. This discrepancy is becoming "more and more obvious to an ordinary consumer," particularly since a car is a particularly large purchase.

Over time, the consumer willingness to endure the dealer model is diminishing, as consumers are now seeing what kinds of innovation are possible without franchised dealers. She describes some other industry benefits of the build-to-order model, speaking from the perspective of an automaker:

Efficient manufacturing, just-in-time manufacturing. So this is the Dell model as it used to be called. I produce to demand and not to inventory. I make cars that people want. In fact, I make cars that people have already paid a deposit on. So I don't even incur the cost for the parts until I have cash in hand.

That saves carrying costs for both the manufacturer for parts and the dealer for inventory. Moreover, you're never marking down a car, because every car is already bought. So that, the estimates on the savings of that changing a system from producing to inventory to producing to demand are quite large. So then, you don't need a local dealer to hold inventory for you.

Inherently, inventory always carries risk. If it can't be sold, then it must be written down or impaired, which is universally painful. But since build-to-order inventory is already purchased, there is very little inventory risk for the manufacturer. The OEM doesn't need to make as many estimates regarding its unit mix and which trims or options will be in demand, potentially producing a vehicle that the market doesn't want.

Some inventory is always necessary, and indeed Tesla does carry new-vehicle inventory. These are mostly showroom models and service loaners. The company currently has about 260 units of inventory listed for sale in the U.S. But the vast majority of its finished-goods inventory ($476.5 million as of the end of 2015) consists of vehicles in transit to customers. There's very little risk associated with that inventory.

Maybe the incumbent OEMs should try build-to-order again.

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