Tesla Cuts Off An Arm To Deliver On $35k Model 3 Promise

Once again, Tesla proves the doubters wrong... at a terrible cost.

Electric Automobiles On Show Inside A Tesla Motors Inc. Store
Bloomberg—Bloomberg via Getty Images

If there is one fact that can bridge the yawning divide between Tesla bulls and Tesla bears, it's that when Elon Musk's automaker has its back up against the wall, it will go to unpredictable lengths and take immense risks to survive (tip 'o the hat to @TeslaCharts on Twitter for pointing this out). Countless times Tesla has found itself in a dire spot, hammered by bad news and leaking red ink, only to slam the door the swarming short sellers with some gambit or or surprise result. To fans these heroic comebacks are a sign of Tesla's intrinsic resilience, while to critics they are signs of intrinsic weakness and can raise the specter of fraud or deception, but everyone agrees that Tesla is nothing if not a survivor.

This week Tesla did it again, announcing the long-awaited $35,000 base-price Model 3 that many critics were starting to suspect would never come. Just three short months ago, a leaked Musk email suggested that Tesla needed to cut $3,000 per car out of the base Model 3's bill of materials and labor cost in order to achieve neutral gross margins, a staggering hurdle by auto industry standards. With demand for the higher-priced versions of the 3 faltering in the meantime, the pressure was mounting on Tesla to produce the base-model 3, for short-term business reasons as well as to deliver on Musk's promise of an "affordable" electric car priced at roughly the average price of a new car in the US. And sure enough, against all the odds, Elon delivered.

This would be unambiguously good news for Tesla if it weren't for literally everything else that was announced yesterday. Most importantly, the way Tesla itself framed its ability to deliver a $35,000 Model 3 is cause for serious concern: 

Shifting all sales online, combined with other ongoing cost efficiencies, will enable us to lower all vehicle prices by about 6% on average, allowing us to achieve the $35,000 Model 3 price point earlier than we expected. Over the next few months, we will be winding down many of our stores, with a small number of stores in high-traffic locations remaining as galleries, showcases and Tesla information centers.

As usual, this news is being hailed in some corners as a bold, Amazon-like self-disruption but evidence to support the view that this is a masterful chess move is scant. Just over a month ago, I looked at Tesla's considerable ongoing investments in sales and service centers, and though I focused primarily on the latter it was clear that most of these investments were dual sales and service centers. In mid-January, Politico reported that Tesla was "revving up its lobbying efforts in New Jersey to open new retail store locations." A month before, Tesla was bragging on Twitter about new store openings. In the words Bernstein's Toni Sacconaghi, "Given its seeming abruptness, it does not appear that yesterday's announcement was made from a position of strength."

So then why did Tesla decide to slash its retail footprint, which includes roughly 130 currently-open locations in the US, and lay off most of its sales force? The obvious conclusion is that it has thus far been unable to make meaningful cuts on bill of materials and manufacturing side of the equation, and that stores were the most palatable way to rapidly reduce fixed costs. In certain respects, it's a clever move keep analysts from discussing the persistent operational weaknesses at Tesla's Fremont factory, but it's also akin to cutting off an arm and eating it to survive. You can really only do it once, and after you've done it any future survival emergencies will have to be tackled with but one arm.

Of course, Tesla insists that all is well. In a leaked email, Musk argued that "last year, 78% of all Model 3 orders were placed online, rather than in a store, and 82% of customers bought their Model 3 without ever having taken a test drive." But, as is becoming something of a pattern for Tesla, these seemingly inarguable statistics have a serious context problem: the vast majority of Tesla sales last year were to committed fans buying higher-spec Model 3s off a two year or more waiting list. Not only is it naive to believe that the mass market will continually buy cars with as little research as someone who put down a deposit two years before a car even existed in production form, but as Sacconaghi adds "salespeople have been important in upselling Tesla customers, as well as selling Tesla solar products." (Incidentally, nobody seems to even remember that the Elon Musk explicitly said that "one of the main reasons we acquired SolarCity was to use our Tesla stores to sell not only cars, but also Powerwall and Solar").

What Tesla will do to offset the inevitable demand impact of shuttering its stores is offer customers the ability to return a new Tesla within 7 days or 1,000 miles if they have never test-driven a Tesla before (subject to other terms and conditions). But Musk has repeatedly touted similar refund policies before, and as CNBC's Lora Kolodny has reported, customer experiences are not always exactly glowing. Furthermore, experienced industry players like Jeremy Alicandri of Maryann Keller & Associates say that return policies like these "will be abused." "Tesla will need to vet customers to make sure they are real buyers," Alicandri told me on Twitter, "but as it’s promoted in the press release, there will be abuse. Years ago, I oversaw a BMW program with new 7 series, and it was a disaster."

For Elon Musk this was doubtless a situation in which he had to pick the lesser of several evils. Not selling a base-price Model 3 meant bleeding demand, refunding deposits and losing face (a particularly unacceptable price). Cutting costs on the manufacturing side is too hard and takes too much time, while the supply chain was already squeezed dry the last time Tesla had its back to the wall (less than a year ago). Compared to all these unavoidably problematic choices, slashing the retail channel merely creates a high likelihood of risk... and as Elon Musk proved at PayPal, where he handed out credit cards like candy, sometimes the only way to move forward is by tolerating huge amounts of risk. The only question is: will these risks ever actually catch up with him?