Whether or not you believe Tesla Motors‘ (NASDAQ: TSLA ) stock is the buy of the decade or the most egregiously overvalued company on the Nasdaq, you have to respect CEO Elon Musk with what he’s done to completely disrupt a stoic and stodgy auto industry over the past decade.
I for one fall into the short-sellers camp having on numerous occasions listed my reasoning as to why I believe Tesla shares have driven themselves to an astronomical premium. But, even as I sit here short shares of Tesla, I also recognize that premium valuations come to companies willing to be innovative and take chances. As Elon Musk has previously said: “Failure is an option here. If things are not failing, you are not innovating enough.”
Perhaps this was on his mind when Tesla Motors, just shy of two weeks ago, unveiled its plans to build a self-proclaimed Gigafactory that will capable of mass-producing lithium-ion batteries for its EV vehicles.
The scope of Musk’s design is absolutely massive (link opens a PDF).
Source: Tesla Motors.
It involves a one- or two-level factory, built upon 500 to 1000 total acres, encompassing up to 10 million square feet, and capable of producing 35 GWh/year in battery cell output by 2020. To put that into perspective, every LI-battery producer combined in 2013 produced fewer than 35 GWh/year in battery cell output.
Many on Wall Street have lauded Musk’s brevity with applause — and with good reason. Musk hasn’t shown Wall Street an ability to fail as of yet. And as I pointed out yesterday, there are a handful of incredible opportunities that are being opened up by the building of this Gigafactory.
However, there are also a number of under-the-radar risks that could manifest and crush Musk’s dream of diversifying Tesla’s revenue stream and drastically reducing the long-term costs of battery packs in order to make them cost-competitive with traditional gas and diesel-burning automobiles.
These five terrifying risks are, in no particular order:
1. LI-battery margins may not be meaningful
With an expected build-out cost of $4 billion-$5 billion, the Gigafactory certainly isn’t a drop in the bucket, but all things considered, it’s actually cheaper on a cost-basis to a number of other LI-battery plants. The big question, though, is whether the margins generated from making LI-batteries will be worthwhile enough to translate into any meaningful gains for Tesla.
Let’s take a look at Panasonic (NASDAQOTH: PCRFY ) , for example, which has a working partnership with Tesla through at least 2017 and produced the equivalent of about 5 GWh/year in LI-battery cell output last year, but delivered an operating margin of just 1.3% in its energy segment (which includes photovoltaic cells as well). The assumption would be that Tesla’s Gigafactory would be more efficient on a production basis than Panasonic’s factories due to its power derivation from solar and wind sources as well as internal improvements; but are the margins going to be that much more exceptional?
Tesla tends to be very secretive about its bottom-line battery costs, so there’s really no way for the average investor to gauge whether its margins would be enough to cover what would be the enormous costs of producing 35 GWh/year of LI-battery production, as well as paying approximately 6,500 employees. Tesla will also be splitting at least some of its profits with its development partners, further eroding what could wind up a very slim operating margin.
2. The need for strong Model S, X, and E sales to cover the cost of the factory
Another requirement for the Gigafactory’s success is that the Model X and E sell well enough to justify its operations. By Tesla’s own estimates that includes moving 500,000 units per year, up from estimates of just 35,000 units in 2014. This is phenomenal growth potential, but it also comes with a number of question marks.
For one, can Tesla actually stay on track? If you recall, the Model S’s debut was delayed a number of times. Also, the Model X SUV was originally planned to go on sale in 2013, but was pushed back an entire year to late 2014. I’m not questioning that Tesla hasn’t had success once it’s finally delivered on its EVs, but its ability to meet or beat production targets is about to get a lot more important. If Tesla is unable to generate significant profits from its Model X or E, or meet its production expectations, then its Gigafactory may only compound its problems. Don’t forget that Tesla raised $2 billion via a convertible bond offering just over a week ago to pay for its end of the Gigafactory. These notes become due in 2019 ($800 million) and 2021 ($1.2 billion) — essentially right as the factory should hit its stride — and could be difficult to pay if the Model X and E aren’t hitting these lofty targets.
The other factor to consider is that competing EV automakers aren’t standing still. While no automaker is anywhere near pushing the range offered by Tesla, the possibility that it could have some very direct competitors within four-to-six years is quite real.
3. Tesla has no knowledge of LI-battery manufacturing
Elon Musk is clearly a pioneer at boldly going where no one has gone before, but even Tesla has had to admit that when it comes to manufacturing LI-batteries, it doesn’t have the slightest clue. In the risks section of its 10-K annual filing (page 26 for those interested), Tesla remarked that “we have no experience in the production of lithium-ion cells, and accordingly we intend to engage partners with significant experience in cell production and to date we have not formalized such partnerships.”
While an ambitious move by Musk, it demonstrates that Tesla may not have a strong command of LI-battery cost of goods or pricing, which could adversely impact its operating margins. In addition, even with the help of a partner, or a number of partners, there’s no guarantee that Tesla’s costs or Gigafactory build-out will remain on schedule or that it can manage such a large scale-up. If the ramp-up of production doesn’t occur quickly, the Gigafactory could sustain hefty losses.
4. Potential environmental concerns
Although Tesla is doing its part to reduce its carbon footprint by passing on fossil fuels, LI-batteries have their own set of environmental concerns that may come to light.
According to a study conducted last year by Abt Associates for the U.S. Environmental Protection Agency, batteries that use cathodes with nickel and cobalt, and solvent-based electrode processing, lend to the highest health and environmental risks. The environmental risks listed include resource depletion, global warming, and ecological toxicity, while the negative health impacts can include poor respiratory, pulmonary, and neurological effects.
Keep in mind this isn’t a risk that’s unique to Tesla — all LI-battery manufacturers could draw the ire of the EPA. However, simply given the immense scope of this project, covering some 10 million square feet and producing 35 GWh/year of output, Tesla could become a bull’s-eye for the EPA.
5. Battery technology innovation
Perhaps the biggest wildcard of all is what happens if innovation leads to a more efficient/smaller/better battery than lithium-ion. There are a number of other LI-battery alternatives out there that could emerge as a competitive threat to Musk’s Gigafactory.
General Electric (NYSE: GE ) , for example, is developing a flow battery that it anticipates could have a 240-mile range and may be able to be produced for one-quarter the cost of the current lithium-ion battery pack in a standard EV.
Another possibility is sodium-sulfur batteries which haven’t been tested commercially in EV’s as of yet, but have shown promise as electricity storage for power grids. The advantage, if researchers and harness this type of battery into an EV and solve its high operating temperature issues, would be improved energy density and very high charge and discharge efficiencies.
While investors would love it if LI-batteries are the long-term solution for EVs, it’s quite plausible that we’ll see the introduction of newer battery technologies long before 2020, which could put a serious kink in the Gigafactory’s chance of long-term success.
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Sean Williams is short shares of Tesla Motors, but has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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