••• (as long as you forget about CO2 credits, •• • cannibalization, EV regulations, price elasticity, EV class demand, income tax credits, ZEV credits, government subsidies, competitive responses, battery advancements, NHTSA and EPA rules ... which you can't) © �019 Reven�e �l'ilal}'!ics, Inc. 02 TABLE OF CONTENTS PRICING THE ELECTRIC FUTURE: HOW TO PRICE A TESLA 3 WHAT SHOULD TESLA DO? 3 Model 3 Price Cuts: At First Glance, a Bad Idea 4 Government CO2 and EV Regulations Muddy the Picture 4 Higher Margins Make Price Cuts More Attractive 5 Sales Cannibalization Makes Price Cuts Less Attractive 5 Price Cuts Today Yield Future Benefits 7 Closing Thoughts: The Only Certainty is a Need for Careful Analysis 8 © 2019 Revenue Analytics, Inc. Pricing the Electric Future: 03 How to Price a Tesla ™ Tesla’s pricing seems to be constantly in the news. It makes one wonder: what does it take to make a sustainable profit from electric vehicles? Maintaining prices high makes it hard to grow sales but cutting prices dilutes margins. WHAT SHOULD TESLA DO? DISCLAIMER: We're not best buddies with Elon (yet), and Tesla is not a client of ours (yet!). We would never advise a client without leveraging proprietary data including forecasts of costs, sales and margins. Without that data, the answer is pure guesswork...but well-researched and thoughtful guesswork can be fun and informative, so let's give it a go, shall we? DEMAND INTELLIGENCE After harmonizing the aforementioned data, one thing Tesla should do (if they haven’t already), is build and apply an analytics capability to understand the total impact of price changes on profit. Elon Musk hasn’t made this data publicly available, of course - but look at what this might involve using what we do know to run an analysis. Since the entry level Model 3 is Tesla’s top seller, we’ll focus on that vehicle. Tesla recently announced a $35,000 “standard range” Model 3, but that variant hasn’t sold yet so we’ll focus on the variants sold in 2018. • The Tesla Model 3 base price was $44,0001 • After options, the average Tesla Model 3 rose to $59,3002 • In Q4 2018, Tesla sold 63,150 of these cars.3 The Model 3’s profit margin is highly confidential. But Tesla did reveal that its gross margin is above 20%, with a target of 25% in 2019.4 Let’s split the difference and use 22.5% as our initial estimate. This translates to around $13,350 per car. This margin will be impacted by Tesla’s recent price cuts of $3,100 (first a cut by $2,000 at the start of 2019, and then another $1,100 price cut5 in February). Were these price cuts a good move? It depends. 1Electrek, “Where is Tesla’s $35,000 Model 3”, https://electrek.co/2019/01/24/tesla-model-3-base-35000/, January 24, 2019. 2CleanTechnica, “Tesla Model 3 Average Selling Price (ASP) = $59,300, Surveys Find”, https://cleantechnica.com/2018/08/23/tesla-model-3-average-selling- price-asp-59300-surveys-find/, August 23, 2018. 3Tesla Inc. press release, “Tesla Q4 2018 Vehicle Production & Deliveries, Also Announcing $2,000 Price Reduction in US”, https://globenewswire.com/news- release/2019/01/02/1679576/0/en/Tesla-Q4-2018-Vehicle-Production-Deliveries-Also-Announcing-2-000-Price-Reduction-in-US.html, January 2, 2019. 4Tesla Inc., “Tesla Fourth Quarter & Full Year 2018 Update”, http://ir.tesla.com/static-files/0b913415-467d-4c0d-be4c-9225c2cb0ae0, January 30, 2019. 5Autoweek, “Tesla Model 3 price slashed by a further $1,100”, https://autoweek.com/article/green-cars/tesla-model-3-price-slashed-1100#ixzz5glWvTe4b”, February 6, 2019. © 2019 Revenue Analytics, Inc. 04 Model 3 Price Cuts: At First Glance, A Bad Idea TM Everything starts with the customer, so how will a typical Tesla customer react? ™ One study found that for every $5,000 increase in the base price of an electric 6 E vehicle, demand dropped by 40%. So, a $5,000 price increase – 11.4% – would drive a 40% reduction in demand, a 3.5-to-1 ratio. This value, called the Model 3’s price elasticity, is fairly typical of automobiles. Applying this price elasticity to $3,100 of price cuts, 5.2%, increases demand by 18.2% (i.e. 3.5 multiplied by 5.2%). At its initial margin and volume, the Model 3 brought in about $838 million in gross profit in Q4 2018. With the price decrease, its 18.2% higher sales volume wouldn’t offset the $3,100 lower margin, reducing gross profit to $760 million. We’re just considering gross profit, not net profit, since R&D, capital expenses, etc. are already sunk. So at first glance, the price cut appears to be a bad idea. Government CO2 And Ev Regulations Muddy The Picture DEMAND INTELLIGENC But it gets more complicated. Tesla buyers are eligible for electric-vehicle income tax credits. Prior to January 2019, they received $7,500; but this dropped to $3,750 in January 2019 because Tesla’s total sales of electric vehicles passed a 200k-unit threshold.7 Of Tesla’s competitors, none are in the same position, with only GM, maker of the Bolt and Volt, losing half its tax credit starting in April.8 So in the market, Tesla’s price cut really translates into a “perceived” price increase of $650 (i.e. $3,750 less tax benefit minus $3,100 price cut versus a $3,750 “perceived” price increase if Tesla held price. Applying the same math as before to these two scenarios, we calculate that the price cut really prevented a 22% crash in demand to 49,173 units rather than a modest decline of 4%. With this view, the price cut yields a profito f $618M versus $653M. It still doesn’t appear to be a good idea, but the negative impact is less. We’re not done yet. California and several other states require automotive OEM’s to earn Zero-Emission-Vehicle (ZEV) credits in proportion to their sales in the state. Every time Tesla sells an electric vehicle in these states, it earns credits. Once you reach this credit threshold you can sell the excess to other OEMs who are in short supply and desperately need these credits. Similarly, OEMs can trade other types of non-ZEV emissions credits to comply with NHTSA and EPA rules. In the third quarter of 2018, Tesla reported $189M in sales of credits while it delivered 83,500 vehicles.9 6Green Car Reports, “Tesla sales: how much do rebates matter to buyers in Canada?”, https://www.greencarreports.com/news/1115929_tesla-sales-in-canada- how-much-do-rebates-matter-to-buyers, March 27, 2018. 7Car & Driver, “Tesla Buyers to Lose $7,500 Tax Credit at End of Year”, https://www.caranddriver.com/news/a23743195/tesla-tax-credit-deadline-date/, Decem- ber 26, 2018. 8Electrek, “GM Hits Electric Vehicle Tax Credit Threshold, Phase Out to Start in April”, https://electrek.co/2019/01/03/gm-hit-electric-vehicle-tax-credit-thresh- old-phase-out-april/, January 3, 2019. 9Seeking Alpha, “Tesla’s 10-Q Reveals Q3 May Not Have Been Profitable, After All “, https://seekingalpha.com/article/4217588-teslas-10-q-reveals-q3-may-profit- able, November 2, 2018. © 2019 Revenue Analytics, Inc. 05 Each vehicle netted over $2,250 from credits alone, increasing its effective ™ profit margin. Factoring in this higher profit margin, the net impact of the price cut is to drive a profit of $755M vs. $764M without the price cut. It’s a much closer call now, but the price cut still doesn’t appear justified. Higher Margins Make Price Cuts More Attractive As mentioned at the start of the analysis, we assumed an average gross margin of 22.5%, with Tesla targeting 25% in 2019. What if Tesla achieves its 25% gross margin target in early 2019? Its per unit margin before price cuts and credits would then be $14,750. With each incremental sale worth more, repeating our calculations yields gives us a profit of $845M with the price cut versus $837M without. DEMAND INTELLIGENCE This seems to suggest that Tesla may have finely tailored its Model 3 pricing to maximize profit. But there might be an even more solid case for the price cut. In the new age of mobility, auto OEMs don’t stop profiting once a car is sold; they profit over the entire customer life cycle. For example, with a $7,000 over-the-air software update, essentially zero-cost for Tesla, customers can activate the Model 3’s Enhanced Autopilot functionality, and an even more enhanced “full- self-driving” option is slated in the future.10 Based on take-rate surveys, about 23% of Model 3’s were purchased without either feature.11 If only 10% of owners later upgrade to the enhanced autopilot, the average incremental margin is $700/vehicle, raising the gross profit to $887M with the price cut versus $871M without. Now the price cut is even more attractive. Sales Cannibalization Makes Price Cuts Less Attractive Unfortunately, we can’t consider the Model 3 in isolation. Every time Tesla sells a Model 3, the sale has to come from somewhere, as shown in the figure on the next page (6). Either the buyer’s second choice was to not buy a car, to buy a competitor’s vehicle, or to buy another Tesla. The first two situations are great for Tesla; they either grew the market or stole a sale from a competitor. But in the last case, Tesla steals a sale from its more expensive and more profitable vehicles – Model S or Model X.