Tesla: 2nd And 3rd Order Effects Of Production Growth – Seeking Alpha

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Thesis and background

Investing is all about going beyond 1st order thinking. As explained insightfully by Howard Marks in his book entitled The Most Important Thing:

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex and convoluted.

Especially with nonlinear stocks like Tesla (TSLA), 1st order thinking is not only limiting. It can be misleading. As a good case in point, its stock price soared more than 13% on Monday after reporting its Q4 deliveries topped expectations. 13% is indeed a lot on the surface, but it largely only considered the 1st order effects of its production and delivery growth. This article explores the higher-order effects of Tesla’s production and delivery growth. And you will see that the potential benefits of its production and delivery growth are more than, much more, what is on the surface.

1st order effects

First-level thinking is linear and is all similar. And everyone more or less reaches the same conclusions. In Tesla’s case, everyone knows that as it ramps up its production and delivery, its sales will grow proportionally.

Tesla’s total vehicle volume was just over 100k in 2017. And it has more than 473k electric cars in the first 8 months of 2021 as seen in the next chart. More than any other electric vehicle manufacturer worldwide. On Monday, it just reported that it tallied 308K deliveries in Q4 of 2021 amid supply chain pressures. As a result, it delivered a total of 781k vehicles in 2021. In terms of vehicle delivery, its growth since 2017 has been a spectacular 67% CAGR per year.

And correspondingly, its sales growth rate is projected to follow in tandem as shown below in the second chart.

Source: BackLinko

Source: Seeking Alpha data

2nd order effects

What the above 1st order calculation misses is that as production grows, the unit cost will decrease and the profit margin will expand. As a result, even if sales grow in proportion to volume, the profit would grow faster in a nonlinear fashion. And note that it is an assumption that sales grow in proportion to volume. As we will see in the next section, there are even higher-order effects that can make sales grow faster than volume.

Here in this section, we will just focus on the 2nd order effects on earnings. Such 2nd order benefits can already been observed by the actual financials in recent years as shown in the next three charts.

As shown below in the first chart, Tesla has been clearly benefiting from a cost advantage when electric vehicles production and deliveries grow. It has clearly passed the pivot point of critical scale since 2017. When its vehicle volume was just over 100k in 2017, the company’s average cost of goods sold (“COGS”) per vehicle was more than $92,000. This number has fallen by more than 50%, to about $42,000 on average per vehicle, in 2021. And at the same time, the gross profit margins have expanded substantially from 23% to almost under 27%, a 400 basis points surge.

Source: author based on Seeking Alpha data

The second chart below shows the number vehicles delivery (in thousands, the green line), the total revenues (in billions, the orange line), and the cash from operations (“CFO”) (also in billions, the blue line) since 2017. Note that you should read the number of vehicles on the left axis, and the revenues and CFO from the right axis. As you can already visually see, the profit as measured in CFO has been rising much more quickly than the total revenues, demonstrating the above second order effects. To be more precise, the vehicle delivery has been growing at 47% CAGR since 2017, and sales has been growing at 30% CAGR. However, in contrast, the profit as measured in CFO has been growing at a rate of 68%, higher than both the vehicle production and sales.

Source: author based on Seeking Alpha data

An equivalent, but probably much more insightful, way of seeing the above financials are shown in the chart below. This chart plots the average CFO per vehicle and also the average sales per vehicle since 2017. And this time, you can see very clearly that Tesla was able to make an improving profits per vehicle while the sales per vehicle (i.e., the price tag on each vehicle) have actually been DECLINING – a clear indicator of passing the pivot point of critical scale and starting enjoying the 2nd order benefits of production growth.

Source: author based on Seeking Alpha data

3rd order effects

Higher-order effects are even harder to see, and more important, for nonlinear stocks like TSLA. Even “obvious” assumptions should be carefully examined. As aforementioned, most of us would naturally assume that sales grow in proportion to volume. However, as you will see in this section, there are even higher-order effects that can make sales grow faster than volume in a nonlinear fashion.

Research is beginning to show that automated or semi-automated vehicles like those TSLA makes, when there are enough of them in operation, can lead to increased vehicle miles traveled (“VMT”). In other words, as TSLA sells more vehicles and there are more of its vehicles in operation, we are very likely to drive more. The reasons behind this are that vehicle automation, and particularly automated and connected vehicles when there are enough of them, will substantially reduce driver workload and hence encourage more driving. Key research findings from the Institute of Transportation at the University of California, as shown below, demonstrated this higher-order effect.

These results show that that with partial automation, drivers drive on average 4,888 miles per year more than comparable car owners who do not have partial automation. What makes these results of even more particular relevance to TSLA is that the results are actually from a sample of Tesla users, comparing their VMT with and without Autopilot.

Source: eScholarship

Such higher-order effects can make even sales grow faster, much faster, than volume in a highly nonlinear fashion. There are many possible strategies that Tesla can use to monetize on such 3rd order effects. Just to name a few examples:

  • Service sales. Service sales will be proportional to VMT, not only the number of vehicles. And hence service sales will grow faster than volume.
  • Insurance. Again insurance sales will be proportional to VMT, not only the number of vehicles. And hence also will grow faster than volume.
  • Other paid services such as autonomous driving functions and software. This is an area that can grow at an even higher order due to the so-called network effects. The network becomes exponentially more profitable and valuable as it becomes bigger.

Risks

There are risks involved with TSLA investment. At a grand level, it has a heavy speculative flavor and is definitely not for all investors. To detail a few of them:

  • Even though higher-order effects are more important, they are harder to see and also increasingly more speculative. The 2nd order effects are pretty well demonstrated by the financials now. But the 3rd order effects mentioned above are inherently speculative.
  • Its production growth plan may not materialize. Management’s target is ambitiously at 20 million by 2030, about 25x of 2021 volume and a growth rate of 43% CAGR per year. It is very uncertain whether such an ambitious goal can be reached or not. For example, Morning Star analysis assumes Tesla only delivers around 5.7 million vehicles by 2030, well below management’s target.
  • Its ongoing production expansion projects are facing delays. Giga Shanghai is producing cars, but only at a partial capacity that is substantially lower than its target capacity. It’s Giga Berlin and Texas are still under construction and Giga Berlin has hit numerous delays.
  • At the same time, competition is become more intense, both from traditional automakers and new EV entrants. Traditional major automakers (Toyota, Ford, et al) are investing heavily in EV development, which will result in intensified competition for market share.

These uncertainties are capsulated in the large variance in the consensus forecasts as shown below. The variance between the optimistic and pessimistic forecasts is more than a factor of 2x. In terms of annual rate, the low-end forecasts predict 18% CAGR per year between now and 2030, and the high-end estimate projects 29% CAGR.

Source: author based on Seeking Alpha data

Conclusion and final thoughts

Investing is all about going beyond 1st order thinking. Higher-order effects are harder to see, but more important, for nonlinear stocks like TSLA. Even “obvious” assumptions should be carefully examined. In particular,

  • In Tesla’s case, as it ramps up its production and delivery, its sales will grow proportionally. However, this is only the 1st order linear effect.
  • One of the key 2nd order effects is that its profit will grow faster and nonlinearly. It has clearly passed the pivot point of critical scale since 2017. The COGS per vehicle has fallen by more than 50%, from more than $92,000 in 2017 to about $42,000 on average per vehicle in 2021, as its production scales.
  • There are 3rd order effects at play that can make even sales grow faster, much faster, than volume.
  • As TSLA sells more vehicles and there are more of its vehicles in operation, we are very likely to drive more. As a result, even sales can grow nonlinearly from several strategies such as service, insurance, and autonomous driving functions and software. All these revenue sources scale not only to units of cars sold, but more importantly to total miles driven.

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Source: https://seekingalpha.com/article/4478677-tesla-2nd-and-3rd-order-effects-of-production-growth

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