Tesla’s (TSLA) Cost Reduction Plan Should Bode Well for the Stock

Tesla (TSLA) had some interesting developments recently that helps with illuminating the cost reduction commentary that was released last month. In an earlier article, we looked at the effects of store closure, which was initiated to offset the financial impact from launching a base model at the $35,000 price point. When paired with the ZEV energy credits (set to reduce from $3,750 to $1,875 by July 1^st, 2019 and will then fully expire by the end of 2019) there’s an onslaught of orders right now, as pricing is just below the mean of the auto market.

Currently, the base Model 3 translates to an actual price point of $29,950 (not factoring sale tax). When factoring sales tax of 9%, the Model 3 absolute transaction price is approximately $32,645. This is an important price point for Tesla, as it hovers just below the average price range of vehicles purchased in the United States.

At least according to Morgan Stanley research (figures below) the average transaction price for vehicles in the month of January was $34,000 with the Luxury Car category exhibiting 12.8% year-over-year sales growth in the month of January. Because the Model 3 base model falls under the Luxury Segment and it’s also priced at the mid-point of the total U.S. auto market, execution at this specific price level is critical to the Tesla investor thesis.

Source: Morgan Stanley

While, the base-variant Model 3 was made available on February 28^th, 2019 with 6-8-week delivery quoted on the sales page (implying deliveries in the middle or late April 2019). It was initially quoted at 2-4-week delivery for the $35,000 base model, which then later got changed to a 6-8-week delivery.

In a recent report by the Verge there were zero deliveries of the $35,000 base Model 3, which is hardly surprising given the updated delivery window, and heightened prioritization of deliveries for higher-priced Tesla cars across its line-up. Manufacturers will always prioritize the production of higher priced product variants, and with initial production goals difficult to meet (given the volume of orders), it’s more likely that the base Model 3’s will roll-off the assembly lines in late April.

Some have reported dissatisfaction with delays across various enthusiast forums, but with the $2,500 non-refundable deposit, it’s unlikely that delays will result in cancellation of purchases. Furthermore, the entry-level price point is affordable enough for half of all auto purchases in the United States, so the likelihood of cancellation due to pricing is low.

Shareholders shouldn’t panic over the delays with deliveries, because historically the company’s been known to delay deliveries to meet demand, and even in cases where there’s delays customers won’t bail on their non-refundable $2,500 commitment. So, the shipment thesis likely remains intact (for the most part), but where things get a little confusing was profitability.

To address this issue, Tesla announced price increases that would result in average pricing across the line-up to increase by 3%. This pricing shift helps with offsetting the entry pricing tier, but to accomplish this Tesla also announced store closures, which I have estimated a 50-60 store reduction (tied to non-performing business locations) out of an estimated store count of 250 retail locations resulting in a total store count of 190 to 200. Delivery Centers will remain stable at 120 (but will likely grow to a figure of 140+ location by the end of year), which is in-line with the commentary that Elon Musk later delivered in a company wide note (which got leaked by CNBC).

Following Elon Musk’s updated commentary, I continue to stand by my estimate that the bottom 20% quartile of stores will close whereas Service Center openings will continue to increase throughout FY’19. Top performing stores obviously won’t close, and headcount reductions of non-performing sales staff is not surprising and is very common in the retail sector.

When retail companies look to consolidate their retail footprint, they usually target a store reduction rate of the bottom performing 10-20% of locations, and when looking at the statements from Elon Musk, it’s pretty much a summary of what’s going on in retail in general, and it is no way a reflection of the quality of management, because in any store portfolio there’s always the non-performing cohort, which have to be closed in favor of opening new locations that could deliver profitability and sales.

It’s smart management, and I don’t believe it reflects some visceral cost reduction cycle that will lead to mass layoffs, but rather a reallocation of financial resources from non-performing locations to the opening of new locations that will actually grow revenue and profits, which is a positive for Tesla shareholders.

Wall Street is pretty evenly split between the bulls and bears, with TipRanks analytics demonstrating TSLA as a Hold. Based on 23 analysts polled in the last 3 months, 9 rate a Buy on Tesla stock, 9 issue a Sell, and 5 remain sidelined with a Hold rating. The 12-month average price target among these analysts stands at $320.20, which implies nearly 12% upside from current levels. (See TSLA’s price targets and analyst ratings on TipRanks)

Disclosure: The author has no position in TSLA. The information contained herein is for informational purposes only.

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