Standing on Tesla's Shoulders
Elon Musk's goal for Tesla is amazingly simple yet incredibly difficult: create sustainable transportation. When combined with SpaceX, Musk is dedicating all of his time and energy to pursuits aimed to advance humanity. Even though Musk's ambitions and motivation are not up for debate, the degree to which Tesla will be able to complete Musk's goals are once again being drawn into question following Tesla's recent earnings report. As long as Tesla remains an automobile manufacturer, Apple is the best positioned company to rethink personal transportation. Instead of buying Tesla, Apple will look to stand on Tesla's shoulders.
Tesla, the Pioneer
Much to critics' disappointment, Tesla will forever be known as a pioneer in personal transportation. The company didn't just build an electric vehicle, which is not too difficult to achieve, but successfully designed and manufactured an electric car that was able to produce an emotional connection with its driver. Tesla made electric cars cool. Electric cars were once cast off as boring vehicles that were purchased as an act of charity to the environment. However, Tesla was able to show what technology and software can do when added to a legacy industry where there hadn't been any successful new U.S. entrants in 50 years.
It is this focus on product that has served as fuel for the "Apple should buy Tesla" suggestions that began to pop up a few years ago. As tech enthusiasts bought the Model S and experienced the same emotional connection with a car that they had with their iPhone, something felt wrong. These Model S owners wondered why Apple didn't create the Model S. Tesla seemingly beat Apple to the automobile punch. Accordingly, in order to fix this cognitive dissonance, the theory was that only after Apple bought Tesla would the world once again make sense with Apple selling the best smartphone and car.
Of course, that type of thinking is not just grossly misguided, but intellectually dishonest. There is no rule or law that says every great product must come from Apple just as it is incorrect to assume Apple should or needs to buy a company simply because it has a product that people love. Unfortunately, this focus on Apple & Tesla M&A has led to many ignoring two important trends: Tesla is facing a growing dilemma as an automobile manufacturer, and the auto industry is showing signs of incredible change that will question the car's definition.
Many have pointed to Tesla being not only an automobile company, but also a software start-up or energy company. While that claim contains some truth, as seen with Tesla's Gigafactory, Supercharger network, and Powerwall systems, one can not ignore the fact that at the end of the day, Tesla is building its own cars. Raw material enters Tesla's Fremont factory at one end, and Model S and Model X vehicles come out the other. Unless this dynamic changes and Tesla moves away from building its own cars, the company is an auto manufacturer and risks remaining a pioneer.
Tesla's Dilemma
For the past few years, Tesla has been able to sprint forward on the energy associated with the Model S launch. Good press and reviews led to growing consumer interest and a subsequent increase in sales. It would appear Tesla made it. As shown in Exhibit 1, Tesla has been able to ramp up production each year by healthy percentages. In 2015, the company shipped approximately 50,000 Model S and Model X vehicles, which was less than Elon Musk's 55,000 initial goal.
Exhibit 1: Tesla Vehicle Deliveries (Model S and Model X)
While all may seem strong, under the hood, things are much more concerning. Tesla appears to be operating with a very slim margin of error. With $1.2 billion of cash on the balance sheet and capital requirements totaling $400 million to $500 million per quarter, Tesla does not have much excess capital, a critical ingredient for Musk's current strategy to create sustainable transportation. On the company's most recent conference call, management considered $1 billion to be the minimum amount of cash the company can hold in order to run the business.
Tesla faces a cash dilemma, and nowhere is this more apparent than management's very own production guidance. Tesla is targeting 500,000 car deliveries by 2020. On the surface, this may seem like any other aggressive goal that a young company sets for itself, but dig a bit deeper, and this target seems problematic.
Exhibit 2: Tesla Vehicle Delivery Estimates
Note: Vehicle delivery estimates for 2016 and 2020 are from Tesla.
The company will need to find a way to increase automobile production by 10x in just five years in order to meet its delivery goal, all the while having very little excess cash. It's not that this day wasn't predicted to happen by nearly every legacy auto executive, but an increasing number of observers thought Elon Musk would find some way around it, where "it" was the inevitable. An auto manufacturer needs immense levels of capital in order to produce a profit, and Tesla's strategy for reaching that type of profitability is being drawn into question.
Tesla's game plan was to use Model S and Model X cash flows to fund production of a mass market car, the Model 3. Once this Model 3 hit the market, Tesla would be able to reach profitability by having additional scale. Producing 50,000 vehicles a year just isn't going to cut it at Tesla's current prices. However, Model X production issues, specifically with the Falcon Wing doors, have led to delays and additional questions about how effective the Model X will be in terms of funding Tesla's production expansion. Whether customers would even want a lower-priced Tesla electric vehicle with fewer bells and whistles than the Model S and Model X hasn't even entered the equation and doesn't play a role in Tesla's dilemma. It is assumed that the demand will be there, and this may end up being grossly optimistic. Instead, Tesla's issues are related to the realities of being an automaker.
The Changing Auto
There is no denying that the Model S and Model X rethink what an electric car can be, but they don't rethink what a car can be. Auto manufacturers currently compete on three attributes: performance, style and price. For Tesla, performance is how the Model S and Model X stand out. Elon Musk may have been able to beat BMW and Mercedes Benz in terms of performance, but the Model S and Model X remain firmly entrenched in the legacy auto industry. The addition of software and autonomous features doesn't change this fact.
However, there are signs that the way consumers think of automobiles is changing. In the future, convenience and personalization will trump performance. We see the early stages of this with Uber as consumers now have an easier way of getting from point A to point B. Similar to how the iPhone altered the cellphone's trajectory, a new kind of car will do the same to the automobile, but the Model S and Model X are not the answers.
While many in tech have been quick to focus on autonomous driving and new car ownership models as the interesting things to watch in the auto space, there will be more important developments to monitor early on. As automobiles include additional cameras and sensors, the car will begin to morph into a different kind of machine capable of capturing the world around us. The car will begin to handle new roles in our lives. Beginning to think of a car as a smart room on wheels naturally leads to the importance of having a fleet of similar "rooms" on the road in order to refine software and build neural networks (deep learning technology). Tesla's Autopilot is an example of software benefiting from having a fleet of 100,000 Tesla vehicles on the road. Accordingly, the important variable in this dynamic is the quantity of cars. Having a large fleet of cars will be essential regardless of car ownership trends. The process of overseeing the mass production of rooms on wheels will be the single most important variable to monitor in the auto space.
Apple's Interest in Personal Transport
It has been a year since the first reports of Apple's electric car project, Project Titan, were published. In that time, although we have gotten additional clues as to Apple's interest in personal transportation, there still has been very little said of Apple's long-term plans for getting into the automobile industry.
Apple's motivation for entering the automobile industry will be to fundamentally rethink what it means to use a car and alter the competitive advantages reside in the auto industry. The current auto industry is not set up to handle automobile production where product cycles are measured in weeks and months, and design plays a much bigger role in the production process. Instead, Apple is best positioned to capitalize on this change as the company now has more than a decade of experience using third-party contract manufacturers to produce mass-market personal technology devices. Simply put, owning car factories and producing cars will become a liability, not a strength, in the auto industry.
Apple will not enter the auto industry if it lacks confidence that it can oversee enough car production to change the industry. Along those lines, Tesla's 50,000 to 100,000 vehicle annual production rate would simply not be significant enough for Apple. In fact, even Tesla's 500,000 vehicles per year goal would not be large enough. Apple is likely thinking how to design and build millions of vehicles per year. As shown in Exhibit 3, a hypothetical 2.5 million annual vehicle delivery rate for Apple nine years after launch would be five times more aggressive than Tesla's already lofty goal. Apple would be using a completely different sales scale to eventually have a multi-million car fleet of smart rooms on wheels.
Exhibit 3: Tesla Vehicle Delivery Goal vs. Hypothetical Apple Car Sales Target
Selling 2.5 million vehicles per year would represent approximately three percent of the global automobile market. How can Apple reach that goal? Have a lot of cash and rely on third-party contract manufacturers. There is no other company in the world with as much cash as Apple. In addition, Apple has been gathering an incredible amount of experience from working with contract manufacturers to build 230 million iPhones per year (the smaller the device, the more difficult it is to design and manufacture at scale).
Apple Doesn't Need to Own Tesla
There is no need for Apple to own an auto manufacturer in order to come up with its own electric car. This would be the equivalent of Apple owning a smartphone manufacturer in order to come up with the iPhone. Accordingly, the strategy Tesla is following in which it produces its own cars is not something that would be of interest to Apple. This isn't to take anything away from the Model S and Model X as top cars on the road, but Apple's automobile plans do not require owning car production facilities.
Even though Apple doesn't need to buy Tesla to change the auto industry, there may be a place for Apple to use Tesla as a supplier. Depending on how effective Apple is in its R&D efforts, Tesla's upcoming Gigafactory may prove to be a viable battery source for an electric Apple Car. In addition, Tesla may end up proving to be a good partner for supplying larger portions of the electric powertrain. Over time, Apple would work to limit the dependency on any one partner and control all major technologies found in the car, but relying on a high-quality supplier in the beginning would contain some validity.
For Elon Musk, having Tesla serve as a supplier to Apple is not a stretch or loss since such a reality would still align with his long term goals of reaching sustainable transportation. In addition, Musk has gone on record to welcome new companies to the electric car space. With Apple's contract manufacturing partners potentially using parts produced in a Tesla factory, there would be no need for Apple to own its own automobile assembly plants, similar to how Apple doesn't need to own key iPhone assemblers.
Apple will look to stand on Tesla's shoulders by not entering the low-margin vehicle production and assembly businesses and instead focusing on hardware and software design. Tesla laid the path for rethinking electric cars, and Apple will learn from Tesla's early decisions to rethink the car.
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