Editor’s note: This article was written and planned separately from Maarten’s series on “Tesla Bankwuptcy Explained,” but it slots in excellently and complements Maarten’s articles well, so I’m adding it to the series archives.
By Peter Forman
In the ongoing tug-of-war between Tesla bulls and bears, one of the most controversial subjects these days is the gross margin that Model 3 can generate at a 5,000 cars per week production rate as well as the rate when production lines have fully matured. Bears had previously focused on whether Tesla could successfully ramp up Model 3 production quickly enough so as to hit the 5,000 per week production number before Tesla’s cash position becomes compromised, but with the company now consistently turning out thousands of Model 3s per week and evidence of additional gains, the emphasis has shifted to the profitability of those cars produced, and this is where the concept of gross margin becomes key.
A simplified definition of gross margin is the revenue brought in from selling a product, minus the cost of producing that product, expressed as a percentage of the revenue. For example, if a Model S sells for $100,000, and costs $75,000 to produce, $25,000 is left over and the gross margin is 25%. Typically, Tesla has reported gross margins exceeding 25% for Models S and X, but bears see Tesla’s estimate of eventually reaching a 25% gross margin for Model 3 as being unrealistic. Is it? I’ll delve into that question, but first, let’s consider how important Model 3’s gross margin is in the attainment of companywide profits at TSLA.
Coming up with average revenue per Model 3 sold is pretty easy to figure for the current 2nd quarter and beginning of the 3rd. All Model 3s currently produced by Tesla are the long-range version with the premium package. With $1000 shipping tacked on, the price tag is $50,000. A majority of Model 3 owners, just like Model S and X owners, will order the $5,000 Enhanced Autopilot option, about a quarter will opt for the $1,500 19” sport wheels, and most buyers will spend an extra $800 to get a color other than black. The net result is that the average Model 3 currently is a $55,000 vehicle.
When Tesla begins building dual-motor Model 3s in Q3, the average sales price will increase further. By the time the basic Model 3 is introduced, efficiencies of production should allow it, too, to be profitably produced. Once Tesla reaches a production rate of 5,000 Model 3s/week, you’re looking at about 60,000 Model 3s produced every quarter (12 weeks × 5,000 Model 3s per week).
Thus, $55,000 per Model 3 × 60,000 produced each quarter results in Model 3 revenue of $3.3 billion. The full 25% gross margin will not be realized within the next couple of months, however. That’s because the current Model 3 assembly line is expected to eventually hit 6,000 or 7,000 Model 3s/week and because various efficiencies are not present during the current Model 3 ramp-up. The parts conveyor system has been removed, and a couple of functions in general assembly that were to be done by machines are now being done by people. Let’s instead use a gross margin amount of 20% (a number given as likely achievable by the 4th quarter of 2018). Take 20% of $3.3 billion and you arrive at a contribution of $660 million to Tesla’s profits each quarter. That’s massively helpful for reaching profitability.
Looking at the Q1 2018 earnings report, though, TSLA reported losses of over $700 million for the quarter. How would an improvement of $660 million bring Tesla to profitability in the 3rd quarter? If you look closely, Tesla reported a negative gross margin on Model 3 in the 1st quarter. Eliminate those negative results and replace them with a $660 million positive contribution to the company’s bottom line and Tesla could indeed do what Elon Musk says: achieve profitability in the 3rd and 4th quarters of 2018.
Why such a poor performance in Model 3 gross margin during the first quarter, though? Perhaps the easiest way to understand these negative numbers is to consider the impact of fixed costs (and depreciation, specifically). Tesla produced a little over 800 Model 3s/week in the 1st quarter of 2018, only about one-sixth the number of Model 3s it plans to produce two months from now. Tesla’s CFO Deepak Ahuja when questioned about Tesla’s depreciation costs said in that conference call that “at a steady run rate of 5,000 or so cars per week, we are in my mind well below most of our competitors – well below $2,000 per unit depreciation cost.”
If you realize that the depreciation cost per car was split between only one-sixth the number of cars in Q1, though, the cost of depreciation per car in the most recent quarter was nearly six times $2,000, or a figure somewhere in the vicinity of $12,000 and nearly $10,000 more per car than what can be expected once Tesla is turning out Model 3s at a 5,000 per week production rate. That is one of the realities of gross margin: when output is low, such as in the 1st quarter, fixed costs prevent the car from being profitably produced. Once the car reached a 5,000 per week production rate, though, the fixed costs are being divided up sufficiently that they become rather small. [Editor’s note: This is why some major automakers talk about the thousands of dollars per car that are lost producing EV models. These figures are based on low production. If production were at a large scale, they could eventually make money on EVs. The arguments as to what holds higher sales vary — lack of interest from automakers, a long-term financial threat to their bottom lines, perceived lack of consumer demand, lack of competitiveness in a new era of the auto industry, lack of battery supplies, etc.]
Thus, you see the equation of number of vehicles sold × average sales price × gross margin equals the contribution that vehicle will make to improving Tesla’s profitability. We also know that as the number of vehicles sold increases, the gross margin increases, because each vehicle carries a smaller percentage of the company’s fixed costs.
There’s another reason why increasing the number of vehicles built improves gross margin: human productivity. If you have a factory worker overseeing a machine that builds 800 vehicles per week, that human will be many times more efficient when overseeing the same machine building 5,000 vehicles per week. It’s one of the advantages that Tesla can leverage because of its highly automated production process.
There’s even a third advantage to Tesla’s profitability by scaling up Model 3 production that isn’t specifically addressed in financial documents. When Model 3 appears in Tesla showrooms, it greatly increases the number of visitors coming to that showroom. According to Tesla, in locations where Model 3 has appeared, Model S and Model X sales have gone up, not down. Apparently, with the current long wait times to receive a Model 3, a good many people who come in to look at Model 3 end up purchasing a Model S or X. Tesla also sells non-automotive products such as solar shingles, solar panels, and home batteries. Sales of all these products will benefit as they’re exposed to larger crowds of Tesla Store visitors when Model 3 makes its way into the showroom.
The contribution a vehicle makes to an automaker’s overall profitability is referred to as gross profit. Model S and Model X are already generating lots of gross profit, but other expenses are presently exceeding the gross profits of S and X. For the automaker to become profitable, Model 3 needs to contribute in a major way with its gross profit, too.
What exactly are these other expenses and how will they change as Model 3 production ramps up? There’s a category of substantial expenses called Research and Development (R&D) that focuses on future products such as autonomous driving and Tesla semi-truck tech, and it will not necessarily change as Model 3 ramps up. Interest is another cost that won’t necessarily increase during a Model 3 ramp.
Then there’s S, G, and A (sales, general, and administrative). Tesla has recently announced an effort to keep these expenses under careful scrutiny. Sales (think Tesla stores) will increase as Tesla expands, but not nearly at the pace of the growth in revenues. For the “general” category, think expenses such as Superchargers, but once again, these expenses won’t expand nearly as fast as revenues increase. Although some locations such as San Francisco to San Diego have high usage of Superchargers and will require additional Superchargers as Model 3s become common, much of the Supercharger network (at least in the United States) is underutilized and just won’t need additional Superchargers added for quite some time. Further, Tesla is currently paying for the Supercharger electricity for the vast majority of Model S and X recharging events, but owners of Model 3s will pick up the electricity tab in the future, greatly reducing the cost to Tesla of adding additional users to its Supercharger network. Finally, administrative expenses should not grow significantly as Model 3 ramps up.
It is the combination of rapidly growing gross profits from Tesla’s products and careful control of operating expenses such as R&D, SG&A, and interest that will allow Tesla to achieve profitability.
By now, I’m sure there are many Tesla bears reading this article who are rolling their eyes and saying, “Just because Elon says Tesla will achieve 25% gross margins in 2019 doesn’t make it true. With a base price of less than half that of Model S, how in the world do you cut half the cost of making the car?”
Part of the answer is that you don’t need to cut half the expense of manufacturing Model 3 because gross margin is based upon average sales price for a vehicle, not base price. Very few buyers will opt for the plain-Jane base Model 3 at $35,000. The Enhanced Autopilot is such a cool feature for the car that you can expect a fairly high take rate even from low-end buyers. Further, the gross margin of the Enhanced Autopilot is far closer to 100% than to 25%, since it is basically just software installed in the vehicle.
Then there’s the efficiency of the assembly line. Instead of building 1,000 vehicles/week on either the S or X line, Model 3 will soon see 5 times that output. Fixed costs are divided much further on the Model 3 line, and with such hefty production numbers on Model 3, humans working on the line will be considerably more efficient than on either the S or X lines. Need proof? Look at the interior of the Model 3. It redefines the word “spartan” and can be produced with a minimum of human intervention. This is no accident, as the Model 3 was designed for running off the assembly line at a rate of over 5,000 per week.
Look, too, at the battery technology. The 2170 cells in the Model 3 are more efficient than the S and X cells, especially when combined with improved chemistry. Instead of transporting cells all the way from Japan, Tesla’s partner Panasonic produces the 2170s for Model 3 right there in Gigafactory 1, the same building where the cells are assembled into battery packs. All in all, Model 3 is a quantum leap forward in affordability of a long-range electric vehicle.
The numbers to look for with Model 3 are achieving a 20% gross margin some time in the 4th quarter of 2018 and achieving 25% gross margin during 2019. If Tesla can meet its production targets and produce the desired gross margins, the car company will be profitable and cash-flow positive. The short thesis that Tesla will run out of cash would be utterly destroyed.
We may get a chance fairly soon to see what type of gross margins Tesla’s Model 3 can produce at a 5,000 vehicles/week production rate. Elon Musk previously said that dual-motor Model 3s would be introduced only after the vehicle ramp reached at least 5,000/week. On May 11, Musk tweeted, “Tesla will enable orders end of next week for dual motor AWD & performance. Starting production of those in July.” Such a tweet suggests confidence that a 5,000/week production rate is coming by July. Once that production rate is obtained, all eyes will be on Model 3 gross margin. If Tesla’s ability to predict gross margins for Models S and X is any indication of its ability to predict Model 3 gross margin, the actual numbers should be close to Tesla’s projections and Tesla will indeed have a bright future.
Peter Forman is a writer and innovator who began buying Tesla’s stock at $28 a share and has never looked back. This former airline pilot and college professor has a passion for applying new technologies to education. More recently, he has focused on understanding the trajectory of today’s clean energy revolution. He drives a Tesla and powers 100% of his house and vehicle’s energy needs through rooftop solar panels.