By Michael Grinshpun
- High finished goods inventory does not imply that Tesla has an inventory because there is a pipeline full of cars being shipped at the end of the quarter.
- Regional monthly fluctuations in registration are caused by allocation of deliveries and do not represent fluctuations of demand like some Tesla bears suggest.
- Short wait times are not representative of low demand because there is going to be a large increase in deliveries in this quarter, resulting in shorter wait times.
- Tesla’s actions as a company show very clearly that they are production constrained and will not be demand constrained for a while.
- The Model SD and autopilot will increase demand as it gets on the streets. Some investors may not realize how crucial the Model SD will be to increasing demand further.
- There are plenty of other ways that Tesla can increase demand, and the fact that they are not taking advantage of this is a testament to the production constraint.
Are the “demand constrained” arguments substantiated?
It is likely that in following Tesla (TSLA), one might encounter theories that Tesla is not production constrained as they claim. These arguments come in many different forms, ranging from finished goods inventories being high, to regional monthly drops in registration, and shrinking wait times. It is important to examine these claims because they directly contradict what Tesla’s management has been repeating in conference calls and shareholder letters. In essence, to claim that they are demand constrained is to claim that the management at Tesla is committing massive fraud. This is one reason to be skeptical of these claims.
These are the most common arguments:
- High finished goods inventory means that Tesla has an inventory and therefore doesn’t have enough demand.
- Regional monthly fluctuations show that demand is unstable or falling in some regions.
- Decreasing wait times means that there is less demand.
The High Finished Goods Argument
Recently, John Lovallo of Bank of America Merrill Lynch estimated that Tesla has 3000 vehicles stocked in inventory or in transit based on the fact that Tesla had $226 million in “finished goods” inventory in the most recent quarter, which called into question Musk’s statement on the quarterly call:
“Essentially in the third quarter we sold every car, that was including cars from, like, showrooms and everything we basically had. There was just nothing left to sell.”
Musk could very well be right despite the fact that Tesla has so many finished goods. Production only totaled 7200 cars in Q3 according to Deepak Ahuja (Tesla CFO), and that means that about 585 cars were taken out of the pipeline and/or stores to get to the 7785 delivered number. This is also consistent with the fact that finished goods were actually down quarter over quarter from $250 million to $226 million. Musk probably did exaggerate this statement as the company obviously didn’t wipe clean every single store because that would render them no longer functional. This argument also does not prove that Tesla is demand constrained because we know that every quarter, Tesla has been adding to the pipeline of cars in transit. This is clearly the reason that there are 3000 cars in finished goods inventory, some of which are service center and store cars.
The Regional Registrations Argument
Another “proof” that Tesla has decreasing demand is regional monthly drops in registrations. Many authors like to show monthly data for different regions to show that demand has plateaued. This is what Elon Musk had to say to that:
“Part of the reason why we don’t release the monthly deliveries number is just because it varies quite a lot by region and then the media tends to read all sorts of nonsense into deliveries. We’ll have like 1000 cars reach a country one month and none the next month and then people — or like 100 the next month trickle in or something because those were the numbers that were registered in one month versus the next and people say Tesla sales dropped by a factor of 10.”
A company whose demand exceeds their supply would have to allocate deliveries in order to keep wait times at a minimum, and this is what Tesla has been doing, which results in monthly fluctuations in regions. These fluctuations are inconsistent because of the delay between delivery and registration. Also, deliveries are not indicative of demand when looking at a production constrained company. Therefore, no conclusions about demand can be made based on the deliveries until it is a proven fact, not a conjecture, that Tesla is demand constrained.
The Short Wait Times Argument
The other argument for decreasing or stagnating demand is the wait times for the Model S. Just a few weeks ago, Tesla’s website showed that new orders in the US would be delivered in late December for the 60, 85, and P85D versions while the 85D would be delivered in February. Meanwhile, people who were receiving their cars last week ordered their car about 3 months prior. Up until last week, new orders were getting wait times of just under 2 months. This decrease in wait times is used to prove that Tesla’s demand is decreasing.
This decrease in wait times can be explained by looking at the Q2 and Q3 10Qs in the inventory breakdown. In Q2, raw materials inventory totaled $235.279 million and the work-in-process inventory totaled $48.110 million. In Q3, raw materials inventory was $361.837 and the work-in-process inventory was $74.981 million. This represents a 53.8% increase quarter-over quarter for raw materials, and a 55.8% increase for work in process. This shows how Tesla is increasing production at a fast rate during Q3/Q4, which would explain why the wait times went down in such a short period of time. This is also seen in Tesla’s guidance: Tesla delivered 7785 cars in Q3, and guides for 11,200 cars in Q4 (33,000 for the year).
Moreover, the wait times are no longer this short. Today, Tesla’s website shows that new orders in the US for the 60, 85 and 85D versions will be delivered in March and the P85D will be delivered in December. This sudden jump from December to March for the 60 and 85 versions represents a wait time of about 3.5+ months, and shows something about Tesla’s US deliveries. Tesla puts cars on the boat to Europe and Asia during the first half of the quarter, and begins to deliver in the US in the last half of the quarter, which explains the delivery time frame jump from December to March. Tesla has been doing this kind of allocation of deliveries for a while, but it is now clearer than ever. This further demonstrates that Tesla is not demand constrained because a company that was demand constrained would not have the luxury of deciding which orders ship where and when. A demand constrained company would be forced to just ship cars when they got the orders.
Does Tesla Motors Act Like A Demand Constrained Company?
The short answer is no. Here is a list of recent developments that proves this:
In 2013, Tesla increased the base price of a Model S twice: once in January and once in August, totaling a few thousand dollars depending on the model (source). Not only that, but prices for the options went up, and some options became non-standard. This was during a time when other electric vehicles like the Nissan Leaf and Chevy Volt were cutting their base prices. Tesla has not re-lowered these prices back to their original level and has kept the current prices until the recent reorganization of options. Moreover, Tesla recently increased prices in Europe by a few thousand Euros as Elon Musk promised on the quarterly call (source). There was even a price increase on the D model: when the all wheel drive model was released, the premium over the regular 85 was less than $4000, and today the D model costs $5000 on top of the 85 kWh version. Simple supply and demand shows us that no company that has a demand constraint would raise prices and then keep them at that level.
But the evidence that Tesla is really production constrained does not stop there. Tesla reduced the amount of options by grouping things together into packages, and removed some options altogether (such as the black roof and the green and brown colors). This was supposedly done to increase production efficiency. This is a double punch to the “demand constrained” theory, as a demand constrained company would not decrease the amount of options because that would result in catering to fewer customers, and a demand constrained company certainly wouldn’t do such a thing to increase production efficiency (A.K.A. increasing production ramp up rate).
Another recent development that shows Tesla is production constrained is that Tesla idled its production line and spent $100 million to retool to upgrade the production line in order to be able to produce the Model X and increase Model S production from 800 to 1000 cars/week. Again, it is important to examine what a demand constrained company would do and compare it to what Tesla is doing. Telsa is spending money to increase production, while a demand constrained company would be better advised to spend money to fill its production capacity.
Yet another example of Tesla acting like a production constrained company is that Tesla recently switched to another assembly plant in Tilburg Netherlands that is nearly triple the size of the old 200,000 square foot building (the new one is 530,000 square feet). The assembly plant in Tilburg is where all the cars destined to European customers are assembled. For obvious reasons, a demand constrained company would not take this action because expansion of assembly capacity when the current capacity cannot be filled would be incredibly unwise.
Also, Tesla currently has 112 stores and 81 service centers, and is building 27 stores and 37 service centers. If Tesla were having struggles with demand, it would be expanding stores faster than service centers because it would be better to get your car serviced at some point in the future rather than never because the company failed due to lack of demand. This is obviously not the case as Tesla is expanding service centers at a much faster rate than stores.
There are more examples of Tesla acting like a production constrained company and not a demand constrained company: Tesla cancelled the 40 and the 60D versions of the Model S and therefore caters to fewer consumers. Also, management at Tesla has repeated that Tesla is production constrained almost every quarter. The combination of the flawed arguments that Tesla is demand constrained and the overwhelming evidence that Tesla acts like a production constrained company instead is enough to see that Tesla’s management is most likely telling the truth.
Can Tesla’s Demand Increase Further?
- Tesla’s all wheel drive model is catering to their high end market to a greater extent than the regular model, which means it will likely increase sales.
- The raving reviews that will come after the all wheel drive model hits the streets will result in hyped media reporting and more free advertising for Tesla.
- After a month of taking all wheel drive orders, Musk stated that the rate of demand if extrapolated to an annual rate was 70,000 cars/year. Musk says that a reasonable projection based on this rate is that it settles to 50,000 cars/year.
- The order rate might increase as the all wheel drive version is available for test drives and is in the hands of owners who will give Tesla even more free advertising by word of mouth.
- Cheaper leasing and autopilot features are bound to attract more buyers.
Tesla’s much hyped all wheel drive version of its Model S did not excite shareholders the day after the reveal, but it is likely that it has consumers excited. Tesla sells to the high end market, where performance is critically important. The new Model S all wheel drive version goes 0-60 mph in 3.2 seconds according to Tesla and 3.1 seconds according to Motor Trend. This puts it ahead of the Mercedes Benz E63 AMG S, the Audi RS7, and the Porsche Panamera Turbo S, and allows it the title of the quickest production sedan. Also, the added weight of the second motor will lower the center of gravity and will result in better handling. Moreover, dual motor all wheel drive is likely to result in tighter turning radius, which again means better handling. Obviously, Tesla is really catering to its market here, and may start to take market share from sportier coupes due to the Model S’s higher utility (more luggage space, more seats, etc).
Motor Trend wrote a raving review of the all wheel drive version, and as more reviewers test the car, it is likely to follow in the footsteps of the original Model S by garnering various awards, raving reviews, and hyped media attention. Of course, this increases consumer interest in the car. However, even before all that, Elon Musk claims a high order rate during the first month:
“If you just extrapolated the demand since the announcement, it would be like 70,000 cars a year, but that’s in terms of demand. But I think that would probably be unwise to state that as a steady state prediction. So we’re, like, more considering around 50,000.”
As with the regular Model S, orders might increase once the all wheel drive version hits the streets due to the word of the mouth effect. With an increase in consumer interest, the amount of test drives will increase. Supposedly, 25% of Tesla’s test drives end up being sales. This rate might increase because of the sheer performance of the car, which likely will feel faster than even the most iconic fast cars (like the Bugatti Veyron Super Sport) due to the instantaneous torque.
On top of this, Tesla has offered cheaper leasing due to capital savings with its banking partners and autopilot features. These new offerings combined with the all wheel drive version could create even more than 50,000 cars per year in global demand. For comparison, the Mercedes S-class is the best selling car in the class, and there were 65,128 produced in 2012 (source).
What Else Could Tesla Do To Increase Demand?
Tesla’s actions resemble those of a production constrained company, which means that Tesla has not taken the various opportunities to increase demand. For example, Tesla could introduce more options, bring back the 40 and the 60D versions, lower the price of the Model S, advertise the Model S, expand store infrastructure faster, and negotiate fleet deals by offering discounts. All of these options are on the table, yet Tesla has chosen not to use any of them, which is a testament to the production constrained notion that Tesla has been pushing all along.
Meanwhile, the electric competition for the Model S will not arrive until 2018 at the earliest with the Porsche Pajun. Competitors from Daimler and Audi are planned for 2021 (source). It is also worth mentioning that none of these car companies have plans to roll out a fast charging network or a large-scale battery project like Tesla. The Model S will probably be on its second generation by the time there is any competition, so it will be difficult to catch up for the other automakers who still have not figured out how to create an electric car with more than 100 miles range.
Not only are the constrained arguments unsubstantiated, but also there is overwhelming evidence that Tesla acts like a production constrained company and not a demand constrained company. Moreover, Tesla has a lot of potential demand already generated with the all wheel drive Model S with auto pilot and the cheaper financing, and Tesla has many different ways to increase the demand for the Model S. Investors have worried about Tesla’s demand for a long time, but those worries are not backed up by anything. The fact that many investors ignore the facts presented in this article and continue to spread the demand constrained hypothesis could mean that there are some gains to be realized in the stock as those investors are squeezed out of their position.
About the Author: Michael has a strong interest in the economics of clean technologies and studies the industry for investment purposes.