Tesla Fires A Shot Across The Bow

ARS Technica reported Friday that Tesla (NASDAQ:TSLA) has removed the $35,000 version of Model 3 from its orders page. Though the company claims the lower-priced, short-range version of Model 3 will be available eventually, some Model 3 reservation holders are sure to be disappointed. On the other hand, focusing on more heavily optioned, higher-margin Model 3 cars should cheer the company’s shareholders. Tesla “shorts” would do well to look carefully to this development because it suggests an aggressive and potentially winning strategy.

Tesla Model 3

Background

Tesla has this month sold its 200,000th electric car in the US, beginning the 18-month wind-down of the federal income tax credit for US Tesla buyers. Elon Musk announced on July 1 that the 5,000 per week Model 3 production goal had been achieved (more or less). Both of these events conform to a Tesla strategy described last April for maximizing the gross amount of federal incentives for its customers.

For Tesla, a key factor in a credits maximizing strategy is that initial high-rate Model 3 production can be skewed toward higher-end configurations because early US customers will enjoy the full $7,500 tax credit (in addition to any state and/or local incentives), making these higher-priced cars affordable for a wider range of buyers. We see exactly this in Tesla’s producing long-range, AWD and performance configurations of Model 3, while delaying the lower-priced, short-range versions. Higher-end Model 3 configurations, particularly those carrying Autopilot and Full Self-Driving software options, will give Tesla higher margins. These fancier models are also likely to appeal to BMW’s (OTCPK:BMWYY) 3 Series and Mercedes’s (OTCPK:DDAIF) C Class higher-end customers.

Let us remember briefly what happened in the high-end luxury sedan segment when Tesla brought Model S to the party. The fun part happened in 2014 and 2015. In an essentially static market, Model S sales took off, while all the other players lost ground.

Luxury segment change in sales 2014-15

And Tesla’s Model S ended up king of the hill.

2015 US Luxury car sales

Images from Author’s February 18, 2016 article here.

Will it happen again?

Could Model 3 grab market share in the much larger entry-luxury car segment like Model S did in the high-end luxury car market? Because, if Tesla were to carve the heart out of the BMW 3 Series, Mercedes C Class, and similar models from Audi (OTCPK:AUDVF), Lexus (NYSE:TM), Cadillac (NYSE:GM), Acura (NYSE:HMC) and others, these carmakers will feel a lot of pain. And Tesla might just make a go of its Model 3.

The first thing to understand about the market for entry-luxury cars is that buyers don’t have to buy these cars. Anyone purchasing or leasing even a base model BMW 320i ($34,900 base price) can buy or lease a Toyota, Hyundai (OTCPK:HYMLF) or Chevy that will take them to where they need to go and bring them back for a lot less money. Entry-luxury cars offer something “special” beyond basic, efficient transportation that buyers are willing to pay extra to have. The “special” something may be quicker acceleration or cushier seats, or fancy wheels, or special headlights, or any of a bunch of other nice, cool or trick features, gizmos and tasteful brand badges that set one of these cars apart from those driven by the hoi polloi motoring public. And at least some buyers in the entry-luxury market are willing to pay a lot more to drive a “special” car. Many entry-luxury cars are offered with an array of optional configurations and optional features that allow a customer to spend much more than the base car price. A Mercedes C Class sedan (base price $40,250) in the AMG C63 S configuration can be optioned-up past six figures by just checking the boxes (and it’s still not as quick as the AWD Performance Model 3.)

Tesla Model 3 doesn’t have to be cheaper than the competition to win in the entry-luxury market. It just needs to be price competitive and have better “special stuff”. And Model 3 has special stuff – smooth, quick acceleration; clean, futuristic interior; Full Self-Driving; batteries; SuperCharging; a Tesla badge – that other cars in in this market do not have. (Let’s not get into an argument about Tesla’s Full Self-Driving being “real”. The company offers the feature. Its cars have the hardware. You can’t tick the box for this for any non-Tesla car.)

This leaves the question of Tesla’s pricing compared to the ICE competition. Let’s take a look at how three different Tesla Model 3s compare to three roughly similar BMW 3 Series cars. Using Tesla’s Model 3 website and BMW’s US website, I configured three Tesla Model 3 cars and three roughly comparable BMW 3 Series sedans: base models, AWD models and performance models. The following table gives an idea of how these cars compare on performance and pricing. For simplicity, the 0-60 time is used as the performance metric and only to show that chosen car configurations are of generally similar performance. Pricing shown is the manufacturers’ US list before any tax credit, incentives, discounts, etc.

Model 0-60 Base Optioned

Tesla Model 3 – Base Model

5.6 35,000 35,000

BMW 320i – Base Model

7.1 34,950 34,950

Tesla Model 3 – Long Range, AWD

Blue Paint; 19″ Wheels; Auto Pilot; Self-Driving;

Delivery

4.5 53,000 64,500

BMW 340ix – AWD

Premium Pkg; Executive Pkg; Blue Paint; 19″ Wheels

Drive Asst; Park Ctrl; Blind Spot; Active Cruise;

Heated Rear Seats; Heated Steering Wheel;

Charging + WiFi; Apple Play; Destination

4.6 50,950 63,535

Tesla Model 3 – Long Range, AWD, Performance

Blue Paint; 19″ Sport Wheels; Auto Pilot; Self-Driving;

Delivery

3.5 64,000 74,000

BMW M3 – RWD Performance

Blue Paint; 19″ Wheels; Drive Asst; Executive Pkg;

Automatic Trans; Stainless Pedals; Blind Spot;

Charging + WiFi; Apple Play; Destination

3.9 66,500 78,320

This comparison shows that in order to match the performance and features of a Tesla Model 3, one is looking at a BMW 3 Series that costs about the same. While many investors think of Tesla cars as being “expensive” compared to the touted $35,000 base price, quite the same thing can be said of BMW cars – and, presumably, those of its competitors as well. Tesla’s “effective” pricing is lower by the amount of federal tax credit, any state and local incentives, and any purported fuel cost savings over the ownership period. BMW’s prices are also lower by the amount of any dealer discounts, promotional incentives, trade-in allowances and the like.

The big price differential between Tesla and BMW (and most legacy players) comes in the guise of Tesla making higher-end configurations, while (for now) avoiding lower-cost versions of the Model 3. It isn’t that Tesla cars are more expensive, the company just makes more expensive [versions of its] cars…

Shot Across The Bow

This is where Tesla’s strategy and the outlook for the entry-luxury car market starts to look interesting. What the company has done in reaching 5,000 per week Model 3 production, delivering its 200,000th US car at the beginning of Q3 and delaying the Model 3 short-range configuration is to tell the car market this: Tesla will make a quarter million high-end BMW 3 Series comparable cars a year, sell these (primarily in the US for Q3 and Q4) and not bother with entry-level product (yet). Or, to put it more bluntly, the company just told BMW, Mercedes, Audi, Lexus, Cadillac and the other entry-luxury segment carmakers that it will eat their lunch. Because if Tesla sells a half million highly optioned entry-luxury cars into the market, the other companies will be left mostly with the entry-level end of the market. Ouch!

Tesla is aiming to repeat what it did with Model S, but this time on a much, much larger scale. And we are not talking about someday. The company’s plan is up, running and in play right now, today.

The competition has nothing ready to put in Tesla’s way. The GM Bolt electric car is not an entry-luxury product, and no versions are offered that effectively compete with higher-end Model 3 configurations. Jaguar’s (NYSE:TTM) iPace is coming to the market, but it is aimed at the costlier Tesla Model X, and no robust cross-country Supercharger-like network exists to support the iPace at this time.

How It Will Go

Entry-luxury carmakers offer cars from low-end entry models through AWD and performance cars. Unit sales are largely at the low end, but a disproportionate amount of carmakers’ profit is earned from higher-margin, highly optioned cars. In a market of competing, mature technology ICE cars, and with a need to sustain dealer networks and maintain market share, legacy carmakers must deliver a full range of product. Build only high-end cars and most of their customer base will defect and market share and dealer networks collapse. Build only entry-level cars and most of the profit goes away.

In 2016, BMW sold 545,116 3/4 Series (sedan/coupe) cars. To achieve this sales volume, the company offered entry-level as well as higher-end configurations of its 3/4 Series cars. Arguably, to steal half a million sales from BMW’s 3/4 Series for the Model 3, Tesla would need (at least) to deliver both high-end and entry-level Model 3 cars, because that covers the price range of cars that BMW 3/4 Series customers buy. But such does not appear to be the company’s plan.

Tesla aims to take market share from the high end of the entry-luxury car segment mix. It has put off making the short-range, $35,000 version of Model 3, so buyers with $35,000 to spend can’t buy a Model 3, at least for now. This means Tesla has no chance, for now, of stealing half a million BMW 3/4 Series customers for Model 3 and wiping the BMW 3/4 Series cars from the face of the earth. But Tesla doesn’t need every BMW 3/4 customer. There are plenty of Acura, Alfa Romeo (NYSE:FCAU), Audi, Cadillac, Infiniti (OTCPK:NSANY), Jaguar, Lancia, Lexus, Lincoln (NYSE:F), Mercedes and Volvo (OTCPK:VOLAF) entry-luxury customers to be had. Tesla may even bag some BMW 5 Series, Audi A6 and Mercedes E Class customers with its long-range, AWD and performance versions of the Model 3.

If Tesla pulls off this high-end, cream-skimming strategy – like it did with Model S – that will be good for the company and for shareholders. It will be disastrous for legacy competitors because profits come largely from selling high-end configuration, highly optioned vehicles, and Tesla is going after those high-margin sales. It is one thing for a company like BMW to see, say, 20% of its 3 Series customers across the board go over to Tesla and quite a different thing should the top (high end) 20% of its customers defect.

Conclusions

Tesla has embarked on a bold strategy, choosing to target Model 3 sales at the high end of the entry-luxury car market rather than offering Model 3 configurations covering the entire segment. Tesla is following a strategy that will “cream-skim” high-end, high-profit customers from the likes of BMW, Mercedes, Lexus and Cadillac. Tesla did this same thing with Model S. Its strategy is already in play. Within the next quarter or two, investors may expect to see a rout of legacy carmakers even greater than was seen in 2014-15 with Model S as Tesla takes on the entry-luxury segment in earnest with Model 3.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: These writings about the technical aspects of Tesla, electric cars, components, supply chain and the like are intended to stimulate awareness and discussion of these issues. Investors should view my work in this light and seek other competent technical advice on the subject issues before making investment decisions.

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