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02 JUNE 2018
Can Tesla avoid a breakdown?

Elon Musk. Photo: Wikipedia, Brian Solis www.briansolis.com
Elon Musk has long been known for his swagger. But even by his own usual standard of CEO propriety, the Tesla chief was flippant and evasive in a call with analysts in early May, and his behaviour became the story.

To an analyst asking about gross margin targets on the Model 3, Musk said: "Don’t make a federal case out of it."

When the same analyst inquired about capital requirements, the CEO waved him away. "Excuse me. Next. Next," Musk said. "Boring, bonehead questions are not cool. Next?"

"These questions are so dry," Musk complained at one point. "They’re killing me."

If the questions were dry, the answers, or lack of them, left investors shaken. The day after the call, Tesla’s stock dropped about 6%, and though it has since recovered, it is still down about 25% from its 52-week high.

The exchange comes at a critical moment for the company. Tesla raised considerable excitement with its mass-market Model 3 electric vehicle but has kept customers waiting with a backlog. Will fans stick with the company?

"I don’t know how much people’s minds were seriously affected by [Musk’s comments]," says Wharton management professor John Paul MacDuffie. "It probably annoyed some analysts, and analysts have some influence on investors. But Musk has been fairly Teflon-coated. He has attracted a lot of loyal followers and I think it will take more than that to dissuade them." The comments might have confirmed the views of skeptics, MacDuffie adds, "but I doubt it will turn out to be a big turning point unless similar behaviour follows."

Still, at the very least, Musk’s performance on that recent call did nothing to resolve the question of whether Tesla can make the jump from being a niche novelty to mass-market car company. Investors have become concerned that Tesla is burning through a lot of capital. Rather than telegraphing how the company would solve its production troubles and become profitable, the call with Tesla’s CEO further highlighted some red flags.

"The idea that mastering high-volume mass production of a mass-market vehicle is the next big test for Tesla is widely held. Musk encouraged this by saying it was the company’s goal from the start. And this is something they seem to be failing at the moment," says MacDuffie, who is also director of the Programme on Vehicle and Mobility Innovation (PVMI) at Wharton’s Mack Institute for Innovation Management. "It’s not a one-time test. You can try again. But every week there is more data on whether they’re managing to catch up with the bold promises of higher weekly production levels, enough to become profitable, so every week people can see that it’s not happening."

Tesla is considered to be ahead of its competition in many regards - and, for better or worse, none of its competition has at the helm a charismatic innovator who is sometimes thought of as a present-day Thomas Edison. But being out front doesn’t always mean getting to the finish line first, or even at all.

"Will Tesla win? The history of innovation is full of pioneering companies that enjoyed leadership positions in their market and then were overtaken," says Christian Terwiesch, Wharton professor of operations, information and decisions and co-director of Wharton’s Mack Institute. "From an academic position, the often mentioned first-mover advantage is a myth."

Good reason to be worried

"This company is in so much turmoil, and it finally seems to have taken Elon Musk and spun him to the point where he acted, I can only say, bizarrely during that recent call," said Paul A. Eisenstein, publisher of TheDetroitBureau.com, on a recent segment of the Knowledge@Wharton radio show.

Musk has reason to be worried, Eisenstein added. "This was the worst loss they ever had, albeit slightly less bad than the consensus Wall Street forecasts. They’ve got an investigation going on into the safety of their autopilot system. They’re being sued by all sorts of people," he noted. "The [National Labour Relations Board] is going after them for mass firing of what appears to have been people who supported the union at their Fremont plant. And I’ll just put [an ellipsis] there, because I can continue for another five minutes about all the problems that Tesla has."

But many of Tesla’s woes go back to the Model 3, which has captivated car geeks and others with its sleek aesthetic, many voice-activated controls, autopilot driver-assistance technology, and moderate base price.

"With its Zen minimalism, it doesn’t look or feel like any other car I’ve been in," wrote New York Times columnist James B. Stewart in April after a taking a Model 3 for a spin. "The synthetic-leather seats are comfortable, and there’s ample room for someone my size (6-foot-3). This all comes at a cost: $57,500 for this luxurious long-range version, far from the $35,000 base price that has excited many potential Tesla buyers."

Popular Mechanics named it 2018 Car of the Year, and it has excited, in fact, more than 400,000 hopefuls who would become buyers — if only they could get their hands on one.

Tesla has produced about 26,000 Model 3s, according to Bloomberg’s Tesla Model 3 Tracker, a running tool that relies upon Vehicle Identification Numbers (VIN). The company has consistently missed production targets. It had hoped to be turning out 20,000 vehicles per month by the end of 2017, but the Bloomberg tracker estimates the number has reached only about 2,600 per week. Tesla, founded in 2003, has never scored a profitable year. In the first quarter of 2018, the company reported a loss of $785 million on revenue of $3.5 billion. Model 3 has been seen by the company as a way to pay down debt and fund future R&D.

But while Tesla has challenged conventional automotive thinking in many areas, often successfully, the production issues on the Model 3 point to a serious error in thinking, say analysts for Sanford C. Bernstein & Co. Tesla has over-automated, Max Warburton notes in a recent report. Musk "recently said ‘the competitive strength of Tesla long-term is not going to be the car — it’s going to be the factory.’ He also talks of massive automation and minimizing labor," writes Warburton. "Tesla has tried to hyper-automate final assembly. We believe Tesla has been too ambitious with automation on the Model 3 line."

Very high automation in the welding and paint area is the global norm, but Tesla’s extending it to the final assembly area is contrary to now-accepted wisdom at pretty much all of the world’s automakers, says MacDuffie. Why?

"One simple way to say it is, it is the most labour-intensive aspect of a car plant. It’s also been the target of automation for a long time," says MacDuffie. "Pretty much every big company tried an aggressive campaign in the assembly area and it didn’t work. It is relatively expensive to buy the equipment, expensive to maintain it, and even though it is flexible, meaning you can programme it, it didn’t turn out to be so flexible."

MacDuffie notes that a company could fine-tune the automated final assembly equipment for one model, but would then have to change it for another, leading to breakdown and maintenance issues. "If you are losing time and money maintaining it and not getting the flexibility that is the reason for doing it in the first place, then you start to look at whether it’s wise to replace the robots with humans."

He adds that humans, as it turns out, are uniquely good at what has to be done in final assembly jobs. They are physically dexterous at moving their hands into difficult places in the interior of the vehicle to get things done. They can do many different tasks that require divergent skills — for example, turning a bolt, checking a torque, recording some data and making sure it’s the right model — "and they do that in 60 to 90 seconds over and over all day."

Humans are also good at spotting things that can be improved when it comes to quality, safety or productivity "if you set up a process to elicit those ideas, as Toyota taught the industry," MacDuffie notes. "Assembly area jobs are hard, which is why they pay well, but they are also jobs people are eager to have because they offer middle-class pay and a career."

"Robots are tricky to ramp-up," adds Terwiesch. "Human workers can improvise much better."

Part of the challenge is that in the Model 3, Tesla is funneling several big aspirations into a single venture, says Wharton management professor Jacqueline Kirtley. "At various moments in last few years, Tesla has been the poster child for how this is going to work in the private sector," she says. "It’s that cliché that game-changing technology comes from the little guy and topples the big automotive industry. But it’s such a dynamic story, partially because Tesla has put so many things into this one vehicle" — it is electric, it has driverless technology, and it was to have been manufactured largely by way of automation.

"The little guy who wants to change the world has to take big steps to change the world," says Kirtley. "They don’t have the time to take the baby steps that Ford or Mercedes could take on the way to what Tesla is trying to produce. You take big steps, but those are the places where you get the big challenges."

The challenges seem to mount on a weekly basis. Several key executives have stepped down or taken leave from the company recently, including one in charge of production and another heading safety and automation. A longer list of leaders have left over the past few years. "This exodus is definitely worrisome," said MacDuffie during a segment on the Knowledge@Wharton radio show. "I would call it the biggest worry, from my point of view."

Another active area of concern is the safety of Tesla’s autopilot system. In one recent accident, a Tesla Model X hit a highway divider and the driver was killed. In another, a Tesla Model S struck a stopped truck and the driver emerged from the accident with a broken ankle. Each of these accidents was covered in the media extensively, and Musk complained that the 40,000 automobile deaths from human-driven cars every year do not receive the same kind of scrutiny.

"If autopilot is safer than human-driven technology, we ought to support it and not criticise every single [accident]," MacDuffie said. On the other hand, the concern is legitimate. "These seem like pretty basic things that the system ought to pick up, and it’s clearly not," he added.

Musk has said that if the company can reach its goal of making 5,000 Model 3s per week, it will make a profit in the second half of the year. "I think our understanding of production is improving … exponentially," Musk told analysts. Volume is increasing, while capital spending is declining "dramatically."

Will it all happen fast enough to satisfy customers on the Model 3 waiting list?

Says Terwiesch: "Their cars are awesome. I have driven the S and the Model 3. I would trade in my BMW in a second, but I will not wait for two years for a Model 3." 

A race against mounting competition

Tesla can’t afford to waste any time. Interest in electric cars is on the upswing. One in five Americans is interested in purchasing an EV in the future, according to a recent AAA survey, a higher percentage than in any previous survey. Environmental concerns are one major motivator, but U.S. drivers cited as other appeals lower long-term costs and advanced technology features. Worry about driving range before having to recharge also seems to be abating.

At the same time, the market has enormous potential for growth. At present, EVs account for just 1% of auto sales worldwide, and while future demand is unclear, automakers are springing into action. GM has announced the release of 20 EV models by 2023, and Toyota has plans for 10 models by early in the next decade. More than 100 new EV models are scheduled to roll into showrooms in the next few years.

As Tesla tries to catch up with demand for its Model 3, it is clear that it must also keep an eye on quality. "There have been some complaints about the fit and finish, the body panels not lining up as beautifully as you’d want," says MacDuffie. "The Model 3 has had some problems in that regard, and while it’s not an $80,000 model, it’s also not a super-cheap car — it’s still selling for $40,000 or $50,000. I don’t think people are going to tolerate that for long."

It’s not unusual for a company ramping up to encounter some of the problems Tesla is experiencing, but Tesla’s reach is ambitious, says Wharton management professor Tyler Wry. "Tesla got a lot further down the road before they hit these issues. Tesla actually built cars that they built well, and then has been trying to go from that to a mainstream producer on the scale of the Fords and GMs. This is a gigantic lift," says Wry. "I think any company would struggle with that."

One thing the company might need to do is manage expectations, he says, noting the pronouncements of big ideas and grand visions that come from Musk regarding Tesla and his other ventures. "Most of the time he has been able to pull it off, so to temper expectations might not be in the company’s DNA."

Tesla’s CEO and story are also part of the appeal, at least for some, says MacDuffie. "There are super-strong believers on both sides," he says. "The green tech press raves about Tesla and there has been a drumbeat of really critical stories for years now, on Fox, because of the government subsidies, because it’s green. It has taken on a little bit of this polarised political environment. It doesn’t completely break down that way, but there is a little bit of that, which is why you can find outrageous statements on both sides of the issue."

Wry believes that Musk should continue to be Musk. "This is going to sound contrarian, but one of the things I would recommend is not to over-correct in this instance. If you think back, there are companies like Apple that had a charismatic founder, a good initial product, and then they tried to become a normal company … all the excitement got sucked out," he says. "Then the visionary comes back, sets the tone for the product and vision, and Apple becomes what it is today. Tesla has tons of challenges, and I think they ignore them at their folly. But you don’t want to over-correct and ask for a different leader. Having Elon Musk there is a big reason people want to buy these models."

But patience may be running low for some. Adam Jonas, an analyst with Morgan Stanley and proponent of EV and all things autonomous, recently published a critical assessment of Tesla, citing production woes. Jonas downgraded its Tesla stock target price to $291 from $376. "He was one of the biggest voices pushing the super-high valuations of the past," said MacDuffie.

If Tesla can figure out how to scale up production, the upside is considerable. "The Model 3 is so dominant of a car compared to a BMW 3, an Audi 4 or Mercedes C, that they could really move up to sell big volumes," says Terwiesch. "They need to debug the Model 3 line and most likely build an additional plant. With the roadster coming out and a small SUV on the Model 3 platform, I could see Tesla selling close to one million vehicles per year…. That would be a 10x increase in volume compared to 2017. It really is all an operations game at this point."

Operations, for sure. But confidence is important, too. When Musk let loose on analysts, they didn’t respond kindly. Wedbush Securities analyst Michael Pachter spoke for many when he tweeted: "The first ‘rule’ of being a public company is that if you seek investor capital, you owe them the courtesy of answering their questions. We on the sell-side represent the owners, and it’s ‘not cool’ to be rude. If Mr. Musk wanted to run a private company, he should have done so."

Plus, whether they will have to rely on further investment is not at all clear. "Tesla says they don’t need to raise any more capital in this period. Other people are saying maybe they do," says MacDuffie. "The real issue is if they decide they need more capital and all of a sudden they can’t raise it at a price they are willing to pay, that would be a sign of trouble." That is where Tesla has benefited from the goodwill of the investor community, and if that went bad it would spill over into other parts of Tesla’s reputation, MacDuffie notes.

"If they make it through and don’t need to raise capital, fine," he adds. "If they need it and they don’t have trouble, that will suggest that this story will keep rolling, and this down period will turn out to be just one of the valleys among the peaks that have been the overall story of Tesla."
Useful resources:

Knowledge@Wharton
Knowledge@Wharton is the online research and business analysis journal of the Wharton School of the University of Pennsylvania. Visit our InfoCentre or website.

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