The Car Company of Tomorrow
An in-depth look at Tesla Motors
“We are witnessing the most disruptive intersection of manufacturing, innovation, and capital experienced by the auto industry in more than a century. Tesla may be in position to disrupt industries well beyond the realm of traditional auto manufacturing. It’s not just cars.”
Once a figment of the imagination, the electric car has recently become a viable idea which many believe will drive our modern economy beyond its reliance on non-renewable carbon-based energy sources to a more sustainable future.
At the forefront of this shift is Tesla Motors. Founded in 2003, the Palo Alto based company is now led by the exuberant Elon Musk, famous for his part in nurturing PayPal in its early days before its eventual sale to eBay (Davis). The company’s plan for taking over the automotive industry is fairly simple, though incredibly ambitious. According to Musk, the company’s strategy is to “enter at the high end of the market, where customers are prepared to pay a premium, and then drive down market as fast as possible to higher unit volume and lower prices with each successive model” (Musk). For its part, the company has already executed on entering at the high end, originally with the performance-focused Roadster and, more recently, with the Model S, its hugely successful luxury sedan. In February of 2014 the company announced its plans to develop a $5 billion battery “gigafactory” in hopes of making its dream of a mass-market electric vehicle a reality (Cardwell and Trop).
Tesla has been called the Apple of the auto industry, the future of “Made in America”, and its Model S has been called one of the best vehicles available today. But the praise doesn’t end there. Morgan Stanley analyst Adam Jonas recently wrote “we believe we are witnessing the most disruptive intersection of manufacturing, innovation and capital experienced by the auto industry in more than a century. Tesla may be in position to disrupt industries well beyond the realm of traditional auto manufacturing. It’s not just cars” (Davis). However, does the company really deserve all the acclaim it attracts?
The Model S (2013). Image Credit: Motor Trend
Business Strategy & Business Model
To understand whether or not Tesla really is the car company of tomorrow, we’ll start by taking a look at its business strategy and business model. The two phrases are often used interchangeably though for our purposes, a distinction between the two is made.
Tesla’s Business Strategy
Tesla’s strategy is clear: by leveraging the company’s assets and extensive expertise in design, development, and manufacturing of luxury electric vehicles, the company will bring to market a high-quality, mass-market electric vehicle within the next five years. It’s scope is international and though it regularly states that it would like to manufacture mass-market friendly vehicles, it currently positions itself as a premium brand which appeals to customers who are willing to pay for a premium experience. The company’s internal competitive advantage relates to the technologies and processes it has developed alongside its internalization of all aspects of the value chain: from the manufacturing to the sale of its vehicles, which is very uncommon in the industry. Having made this decision, the company is able to control almost every aspect of the customer experience; similar to Apple and the ecosystem it has created for its line of products. This helps support its external competitive advantage, the value proposition it offers to customers: high quality, environmentally friendly, premium vehicles that perform well and are safe.
Tesla’s Business Model
Much of Tesla’s success can be attributed to its innovative business model. The company develops strong relationships with customers by controlling most or all of the factors of the customer experience through its high quality in-store experience and online communities. The in-store experience focuses on educating consumers and making them feel comfortable in a low-pressure environment. This is all done in service of the company’s value proposition, detailed above. Tesla also offers forums allowing customers to discuss their vehicles, Tesla news and issues, and so on.
The company is able to deliver on this value proposition via its key activities of research, design, sourcing, manufacturing and testing, marketing, sales and delivery, and service. A positive customer experience is at the centre of the way in which these key activities were designed and are executed upon as Tesla goes lengths in providing the most convenience possible (e.g. relative ease of purchase, a high quality final product that is built-to-order, valet service when car is in need of maintenance, etc.). Since Tesla has eschewed the traditional dealership network in selling its vehicles, all customers pay the same price and thus, can be comfortable knowing they were treated fairly.
These key activities are possible through Tesla’s leveraging of its key resources or key partners. The company’s major key resources are its human capital (its engineers and designers) and physical assets (such as its Fremont, California factory). Without its human capital the company would not be able to design and develop innovative new automotive technologies and without its physical capital it would not be able to deliver these technologies to market.
Tesla’s business model is also supported via a variety of key partners ranging from suppliers who provide components, to strategic partners who commission Tesla to develop technologies for them, to governments and regulatory authorities who establish rules and regulations within which Tesla must operate, and financial services providers, which provide convenience to customers by supporting the purchasing process.
The company’s profit model is supported by two core streams of revenue: automotive sales, and development services. As the company increases production and the amount of different products it manufactures, it will benefit from both economies of scale (lower per-unit costs as production increases) and economies of scope (the ability to leverage its already established processes, technologies, factory, and distribution network in the design, development, and manufacture of future products).
Tesla’s Business Model as a System
In extending our understanding of Tesla’s business model we come to Ramon Casadesus-Masanell and Joan E. Ricart, who assert that smart companies’ business models are systems made up of choices and consequences which, at their best, come together to create virtuous cycles. Consequences can be flexible in that they respond quickly to changes in the underlying choices, or rigid in that they do not respond so quickly. (Casadesus-Masanell and Ricart)
Tesla’s virtuous cycle begins with the core value proposition it chooses to offers customers: high quality electric vehicles. In delivering this value proposition the company creates for itself a reputation for high quality and innovation, a rigid consequence. This reputation ultimately leads to a growth in sales, a flexible consequence. Growth in sales ultimately lead to high profits. Much of the revenue derived from this growth in sales is reinvested in research and development, which helps Tesla in delivering even higher quality electric vehicles. Investment in R&D will also allow the company to derive economies of scale and scope as it optimizes its operations and leverages its factory and distribution network to launch future products, both flexible consequences which lead to high profits. Furthermore, investment in R&D could glean new business opportunities for Tesla, also a flexible consequence, which leads to high profit.
A second virtuous cycle is present and begins with the growth in sales, which motivates Tesla to expand its network of galleries in order to satisfy demand for its vehicles. Since Tesla’s distribution network is wholly owned by the company (meaning there are no third-party Tesla dealerships), the company can control the customer buying experience very tightly and ensure that it is positive. This positive customer experience is supported by the company’s decision to only offer built-to-order vehicles (vehicles are produced to the exact specifications of customers). This allows Tesla to minimize waste, thus leading to higher profits, while ensuring customers are fully satisfied with their purchase.
The Model X. Originally planned for 2013, Tesla’s oft-delayed crossover is now slated to launch in 2015. Image credit: Tesla Motors.
Tesla as a Volume Operations Business
In trying to better make sense of a company’s business model, it can be useful to refer to established patterns to see how said company compares. Though the individual components of Tesla’s business model are fairly unique, at a fundamental level its model follows the same volume operations pattern well worn by other automobile manufacturers. Volume operations, as defined by author and organizational theorist Geoffrey Moore in his 2012 address at the PARC Forum, are distinguished by several centers of excellence: product design, user experience, price point, brand image, ease of support, and viral appeal.
From when you first set your eyes upon a Model S, it is clear that high quality product design and user experience are fundamental to Tesla’s approach to design, development, and manufacturing. Brennan Boblett, User Interface Manager at Tesla, describes the company’s approach to user experience as ensuring that “the car and the software work harmoniously together to create a unique experience that can be felt even before you sit down in the car” (Tengler). This dedication to user experience extends to Tesla’s galleries, which are reminiscent of Apple’s retail establishments and staffed with non-commissioned product specialists who are evaluated based on their ability in having patrons enjoy their experience (Musk, The Tesla Approach to Distributing and Servicing Cars, 2012).
Price point tends to be a very important factor for volume operations. In order to achieve the volume necessary for profitability, the price point of the offering must hit a sweet spot where it is within reach of the broader market while still allowing the company to make a sufficient profit. Though Tesla has been unable to bring to market a vehicle priced to appeal to the broader market, it has consistently stated its intent to do so.
A strong brand image is a key weapon in being able to reach the hearts and minds of the broader market and this is an area in which Tesla has made significant strides in the recent past. The decidedly premium-leaning brand was able to break into the listing of top 5 car brands based on a survey conducted by Consumer Reports which asked respondents to rank carmakers according to attributes including quality, safety, value, design and technology (Ohnsman). Tesla ranked behind only Toyota, Honda, Ford, and Chevrolet, all of which are better established brands backed by significantly larger marketing budgets.
Tesla’s commitment to ease of support is apparent in its aggressive campaign to expand its network of service centres, which now outnumber Tesla galleries. In post-service surveys, Tesla’s service quality was rated 9/10 or higher by 90% of respondents in 2013 (Tesla Motors). Further, the company has continued to push out software and hardware improvements in direct response to consumer complaints. In early 2014 Tesla announced that it would be outfitting all new vehicles with triple underbody shield and that older vehicles would be retrofitted with the shields, free of charge, addressing concerns of Model S fires which were the result of damage to the battery at the base of the car (pictured above) (Musk, Tesla Adds Titanium Underbody Shield and Aluminum Deflector Plates to Model S).
The final aspect of Moore’s description of volume operations is viral appeal. In considering Tesla’s business model viral appeal is tough to assess considering the fact that the company’s products are still out of reach for most consumers. Further, due to their nature as large purchases, vehicles simply do not lend themselves very well to virality the way in which social networking services, apps, and content do. However, the considerable brand equity the company has been able to develop in such a short period of time may be a sign of Tesla’s viral appeal.
Moore contrasts volume operations to complex systems, which have differing centres of excellence: systems architecture, end-to-end integration, proprietary technology, domain expertise, project management, and ecosystem relationships. Tesla also follows the complex systems pattern to a certain extent. This is seen primarily within its development services business where it derives revenue by completing powertrain development work for other manufacturers such as Daimler and Toyota. Though development services accounted for 27% of Tesla’s overall revenues in 2011, the company has recently moved away from this source of revenue as it expands its own manufacturing operations. As of 2013, development services account for less than 1% of the company’s revenue. Though it means that Tesla now has fewer sources of revenue upon which it can rely, according to Moore, this may not be such a bad thing. He believes that in order to achieve “escape velocity”, a company must figure out which business model it wants to rely upon and in this case, it is fairly clear which business model is more important to Tesla.
The design of Tesla’s galleries is inspired by Apple and Starbucks’ retail establishments. Unlike typical car dealerships, Tesla’s galleries are located in high foot traffic areas such as malls and shopping streets. Image credit: LA Times.
Financial Performance
Past Financial Performance
Though Tesla’s business model is fairly innovative, finding ongoing success as a corporation is not as simple as riding the coattails of innovation. We’ll now take a look at the company’s recent financial performance in order to get an understanding of whether it has been able to leverage its innovative apporach to the automotive business to deliver value to investors and customers.
Tesla has experienced a significant amount of overall revenue growth over the last several years, with 387% growth in 2013, driven primarily by growth in automotive sales.
At the same time, the company’s revenue mix has changed fairly considerably as well. Whereas the company earn a considerable portion of its revenue through development services for other manufacturers prior to 2012, the company has begun to rely less on this source of revenue; it accounts for only 1% of its 2013 revenues. Much of the change in revenue composition can be attributed to the growth in sales of its current flagship product, the Model S, the vast majority of which were sold in North America (though the product was also launched in Europe) and the completion of contracts for development services with various manufacturers.
A company’s return on invested capital (ROIC) is a measure of whether or not it is able to create value for investors. The observation gleaned in determining Tesla’s ROIC, is that it is far below its weighted average cost of capital and therefore, based solely on this measure, value is not being captured for investors.
In evaluating Tesla’s ability to capture value, understanding the context surrounding its fruition and continued operation is key. Tesla is only about 10 years old and went public in 2010. It is unique in that it is a very young company that is attempting to disrupt an industry with many entrenched players whom all have significantly more experience and resources. Tesla’s business model is incredibly innovative relative to its competitors in that it owns and operates its distribution network (stores, galleries, service centres, etc.). Further, the company has thus far only released two vehicles, one of which, the Roadster, was in extremely limited quantities.
However, the company faces many risks. Considering the length to which the economy currently relies upon combustion-engines and hydrocarbons in general, any significant change is a while off. Tesla’s vision for a future of sustainable transport is likely not in the best interest of entrenched parties in the automotive industry. As such, the potential for a competitor with more experience in the industry, greater resources, and a well-established brand to introduce a product that directly competes with Tesla is very worrying. Further, it is possible that Tesla will not be able to execute on its trickle-down strategy and thus, be unable to deliver truly compelling electric vehicles at a price point appealing to the mass-market. Also, Tesla’s recent move away from the development services revenue stream increase the riskiness of the business as the company is effectively putting all its eggs in one basket. If the company’s core business of automotive sales were to experience setbacks, Tesla may not have the ability to continue operations. These, among other risks, are serious considerations for investors to take into account.
That said, not all signs are negative. It is clear that though the company is not currently capturing value for investors, it certainly has ability to do so in the future. This can be seen in the trend of significant revenue growth alongside improving margins and ROIC. Note that the company’s ROIC has increased significantly over the past four years and it is well on its way to delivering a positive return that will likely beat its WACC in the near future. Furthermore, at this early stage in the life of Tesla, capturing value is likely not an expectation for most of its investors. As is the case with most new technologies, the cost initially starts off very high, only to come down over time.
For a fuller picture of a company’s past financial performance, its ability to generate value for customers must also be assessed. One method of doing so is to create a sources of revenue statement, which concludes with how much revenue a company generated as a result of stealing share from competitors. When a company generates revenue through share gains it is attracting customers away from competitors, which would only be possible if the company was offering a more valuable product or service.
Though Tesla did not generate any revenue from share gain in 2010, a significant portion of the company’s revenue growth in 2011, 2012, and 2013 was the result of share gains, 69%, 93%, and 382% respectively. It should be noted that during 2010 the market grew significantly more than any year since, which is likely the reason for the relatively poor performance with respect to revenues from share gains. The significant share gains in the last several years can be attributed primarily to incredibly successful launch of the Model S. Tesla is not yet an established market participant with an established customer base and thus, the company can only really gain market share, which is only possible if it offers something of value to customers. As production of the Model S ramps up and Tesla introduces new models, it is likely that the trend of considerable share gains will continue.
All in all, though Tesla has yet to post an annual profit, the company’s financial performance shows incredibly positive signs. It has the potential to begin creating value for investors in the very-near future and has shown a consistent ability to create value for customers, which is likely why the company has recently been such a Wall Street darling (its stock gained 325% in 2013). If Tesla is able to improve the efficiency of its operations while continuing to deliver on its value proposition to customers, its future financial performance will likely be very positive. This notion is tested below.
Projected Financial Performance
In order to project Tesla’s future financial performance, several assumptions had to be made, as follows:
- Tesla will continue to grow at an incredibly fast pace for the next several years before growth tapers off. This growth expected due in response to the company’s plan to launch several new vehicles (the Model X crossover and its third-generation electric vehicle) and is in line with its strategy to start at the top of the market (the high end) before pushing downwards to the mass market. The company’s recently announced “gigafactory”, which is expected to have the capacity to produce enough batteries for 500,000 vehicles by 2020 (up from 22,477 vehicles manufactured in 2013, per the company’s Q4 2013 Letter to Shareholders), further supports this assumption.
- Tesla will continue to offer high quality vehicles at a premium price relative to its competitors. Thus, it is assumed that Tesla’s operating margins will be in excess of the industry average, which over the past 4 years has been 8.1% (per Capital IQ).
- With the significant growth expected of the company (see point 1, above), Tesla’s ability to generate revenues relative to its capital base (its capital turns ratio) will increase over the next several years. The industry average capital turns for the last 4 years of 3.5 (per Capital IQ) was used as a baseline.
- Tesla will achieve a terminal growth rate of 5.5% based on the growth expected of the company (see point 1, above).
Based on the assumptions above, we are left with a final valuation of $25 billion. The company’s market value as of December 31, 2013 was $19 billion (note that as of market close on April 14, 2014, Tesla had a market cap of $24 billion). The premium noted is likely as a result of differing assumptions and the release of several pieces of news since December 31, 2013, including the company’s FY2013 financial statements (which beat analyst expectations), the announcement of the company’s planned gigafactory, and so on.
Conditions for Continued Success
At this point we have taken a look at Tesla’s business strategy, its business model, how the company’s business model fits the volume operations pattern, and its past and projected financial performance. Before concluding on whether or not the company really is the car company of tomorrow, we will take a look at the conditions necessary for Tesla to continue to be a success.
In an article for the Harvard Business Review, A.G. Lafley, Roger L. Martin, Jan W. Rifkin, and Nicolaj Siggelkow, suggest that framing a problem as a choice incites action on the part of management rather than having management dwell in describing or analyzing the challenge. Having framed the problem as a choice, the alternatives are analyzed with an eye to the conditions that must exist for their success. (Lafley, Martin, Rifkin, and Siggelkow)
The major issue faced by Tesla is the fact that it currently relies very heavily on one source of revenue: vehicle sales, and that too from one model. The company has explicitly stated that it plans to introduce two new models in the near future, the Model X crossover and its third-generation electric vehicle, which it expects to offer at a lower price point and produce at higher volumes than its previous offerings. However, the company does not have a strong record of launching its products on time or at the price points originally promised as seen in the already late Model X being further delayed to 2015 from 2014 (Souppouris). If the overall economy slumps and Tesla’s premium vehicles are no longer attractive or a competitor launches a satisfactory product at a lower price sooner than Tesla, it could face significant trouble, which could threaten the company’s continued operations if it does not have any other sources of revenue on which to rely.
As a choice, this issue can be framed as follows: should Tesla Motors continue to focus its efforts exclusively on bringing the Model X and a viable mass-market electric vehicle to market or should it attempt to diversify its sources of revenue by leveraging its expertise in the research and development of sustainable technologies to offer lithium ion batteries for sale to other businesses?
The conditions that must exist for either of these options to be successful are detailed below.
Is Tesla Really the Car Company of Tomorrow?
There are few companies that capture the imagination the way in which Tesla has managed to. Its vehicles are extremely well regarded, it emphasizes a customer-first experience like few corporations, and its a Wall Street darling which is likely to deliver significant value to investors in the near future. However, much of the company’s future is based on the promise of the acceptance of electric vehicles as a replacement for the oil-hungry gas guzzlers of today. But what sets Tesla apart has been its ability to deliver on its promises. When it first came about, no believed that a startup out of California would be able to deliver a high performance electric vehicle that consumers would actually want to buy. But in sticking to its vision and with a little bit of luck, Tesla has been able to silence the critics and deliver nothing less than the modern spaceship.
Update (July 16, 2014): Tesla has officially announced their “Gen 3" vehicle, a smaller EV meant to compete with the BMW 3 Series and other similar competitor offerings. It’s named the Model 3.
Bibliography:
Bullis, Kevin. “Will Musk’s Gigafactory Gamble Pay Off? | MIT Technology Review.” MIT Technology Review. Massachusetts Institute of Technology, 14 Apr. 2014. Web. 14 Apr. 2014.
Casadesus-Masanell, Ramon, and Joan E. Ricart. “How to Design a Winning Business Model.” Harvard Business Review (2011): n. pag. Print.
Davis, Joshua. “How Elon Musk Turned Tesla Into the Car Company of the Future | Magazine | WIRED.” Wired.com. Conde Nast Digital, 25 Sept. 2010. Web. 13 Apr. 2014.
Davis, Scott. “Tesla, Tesla, Tesla: Building A Power Brand From Scratch.” Forbes. Forbes Magazine, 24 Feb. 2014. Web. 11 Apr. 2014.
Lafley, A. G., Roger L. Martin, Jan W. Rifkin, and Nicolaj Siggelkow. “Bringing Science to the Art of Strategy.” Harvard Business Review (2012): n. pag. Print.
Musk, Elon. “Blog.” The Secret Tesla Motors Master Plan (just between You and Me). N.p., 02 Aug. 2006. Web. 11 Apr. 2014.
Musk, Elon. “Blog.” Tesla Adds Titanium Underbody Shield and Aluminum Deflector Plates to Model S. N.p., 28 Mar. 2014. Web. 12 Apr. 2014.
Musk, Elon. “Blog.” The Tesla Approach to Distributing and Servicing Cars. N.p., 22 Oct. 2012. Web. 12 Apr. 2014.
Ohnsman, Alan. “Tesla Breaks Into Top 5 Brands in Consumer Reports Survey.” Bloomberg.com. Bloomberg, 5 Feb. 2014. Web. 13 Apr. 2014.
Shaikh, Danial. IChallenge Part A: Tesla Motors Inc. Rep. N.p., 17 Feb. 2014. Web. 10 Apr. 2014.
Souppouris, Aaron. “Elon Musk Says It Would Be a ‘great Idea’ for Apple to Make Cars.” The Verge. Vox Media, 20 Feb. 2014. Web. 12 Apr. 2014.
Tengler, Steve. “Tesla’s Groundbreaking UX: An Interview with User Interface Manager Brennan Boblett.” UX Magazine. N.p., 4 Nov. 2013. Web. 12 Apr. 2014.
Tesla Motors Inc. Tesla Motors, Inc. — Fourth Quarter & Full Year 2013 Shareholder Letter. Palo Alto, California: Tesla Motors Inc, 19 Feb. 2014. PDF.
Tesla Motors Inc. Tesla Motors Inc Form 10-K Annual Report. N.p.: EDGAR Online, 26 Feb. 2014. PDF.
Trop, Jaclyn, and Diane Cardwell. “Tesla Plans $5 Billion Battery Factory for Mass-Market Electric Car.” The New York Times. The New York Times, 26 Feb. 2014. Web. 12 Apr. 2014.
Wohlsen, Marcus. “Why Apple Could Win Big With Tesla’s Giant New Battery Factory | Business | WIRED.” Wired.com. Conde Nast Digital, 26 Feb. 2014. Web. 12 Apr. 2014.
Additional Resources
If you’d like additional information on Tesla’s business model or financial performance, see iChallenge Part 1: Tesla Motors here.
My original spreadsheets, which include the ROIC calculation, ROIC and revenue drivers analysis, statement of revenue sources, and DCF valuation, are available here.
