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Virginia Car Dealers Incorrectly Think They Can Sell Teslas Profitably

By Evan Niu, CFA - Apr 26, 2016 at 7:00PM

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Where's that profit going to come from?

Tesla showroom. Image source: Tesla.

Traditional franchised auto dealers have been battling with Tesla Motors (TSLA -6.42%) for years over the direct sales model. Consumers have demonstrated strong demand for Tesla vehicles, and dealers want in on the action. But Tesla's long-standing refusal to work with independent dealers has always been predicated on the simple economic truth that the dealer model would not work for Tesla.

The most recent skirmish has been taking place in Virginia, where the Virginia Automobile Dealers Association (VADA) recently filed suit against Tesla over its attempt to open a second retail location in the state. At an administrative hearing, VADA dealers argued that they can sell Teslas profitably, according to the Richmond Times-Dispatch. They're wrong.

Stuck in the middle with you
Anytime you insert a middleman into a purchase transaction, that margin has to come from somewhere. Most of the time, these middlemen earn that cut by providing important distribution functions when a manufacturer needs or wants that scale. But in the case of auto dealers, Tesla doesn't need or want that scale yet since the company is still a relatively low-volume player in the U.S. market. It can handle its current distribution needs by itself.

In order for a dealer to get a cut, Tesla would have to either a) allow the dealer to introduce a retail markup in order for the dealer to make money, or b) accept a lower wholesale price to maintain the existing retail price. Simply put, the dealer's margin has to either come out of the customer's pocket, or Tesla's. This is why dealers' primary defense of the dealer model has always been fundamentally flawed, because no markup is always better than a small markup (that you spend hours haggling over).

It goes without saying that consumers prefer lower prices, and Tesla needs all the cash it can get in order to grow.

Why it wouldn't work
Dealers make all of their money on service, but EVs require very little service relative to an internal combustion engine (ICE) car. Moreover, Tesla strategically chooses not to profit on service, with its services business posting a mere 2% gross margin last year. Compare that to AutoNation's 44% gross margin on service. The nation's largest auto retailer posted a gross margin on new vehicles of just 6%. The Virginia dealers are small local businesses, but AutoNation is a publicly traded comparable that investors can look to for context. AutoNation enjoys greater scale though, and most local car dealers' new vehicle net margins are just 1% to 2%.

Considering the capital intensity of operating a car dealer (inventory investments, real estate acquisition, showrooms, employee salaries), it's completely unreasonable for a dealer to think they can actually be profitable on a 1% to 2% net margin alone, assuming Tesla even worked with them in the first place. From a dealer's perspective, we'd be talking about low unit volumes, low net margins, and negligible service profitability. If you introduce another dealer cash cow, used cars, into the equation, then you introduce all the conflict of interests around a dealer selling both gas cars and EVs.

To be fair, at least one of the Virginia dealers is a Tesla supporter and investor, which is partially why he wants to sell Tesla vehicles so badly. But how would he feel once his hypothetical Tesla dealership started hemorrhaging cash? Under the direct sales model, Tesla can absorb retail costs and operating losses generated from individual retail locations at the corporate level, so long as the overall global business brings in enough cash flow. An independent franchised dealer cannot.

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