Elon musk told us where he expects model 3 margins to come from – tesla, inc. (nasdaq tsla) seeking alpha gas examples matter

####

Now, logically, we know that the Model 3 without these two differences is, as per Elon Musk’s words, unprofitable. Given those words, if we are generous, we could say that such a $35,000 Model 3 would at best show a breakeven (0%) gross margin (at such a gross margin it would still be unprofitable for Tesla, given other costs it would spread throughout the structure – selling costs, need for higher capacity throughout the organization, etc).

This immediately implies that all of the current base Model 3 margin will be contained within those two differences. There will then be additional margin on other options, like better wheels, different paint or AutoPilot, which some customers will chose and others won’t.

For one of those differences, the difference in battery capacity, the changes are straightforward. The battery is nearly the same except the larger one will have more/larger battery modules, nearly all of whose cost is in the additional battery cells contained within. We can thus ballpark the additional margin here with good accuracy. For instance, if we think Tesla gets the battery cells at $120/kWh, then the additional 25kWh will carry an additional $3,000 in cost, and yield an additional $6,000 in gross margin. The truth won’t be far from this. 10%-20% above or below at most (on cost), so $5,400-$6,600 in additional gross margin, if we want to use a range.

For the other difference, the premium upgrade package, it’s harder to evaluate just how much it will cost for Tesla to provide it. It’s comprised of a lot of small things. Typical margins on options are much higher than the margins on the base car itself. If we ballpark the margins on the premium upgrade package at 50%, this would yield another $2,500 in gross margin. Here our uncertainty is higher, so we could say that we could be wrong by as much as 50% of cost. This would make the additional gross margin be somewhere between $1,250-$3,750.

Remember, this would be on the base $49,000 Model 3. Of course, not all Model 3s sold are the base model. The ASP (Average Selling Price) is higher than $49,000, due to the uptake of additional options (paint, wheels, EAP, etc). As a result, the average gross margin on the Model 3 including the options uptake will be higher than the base estimate above. In my view, this highly validates the central estimate above (17.3%). Of course, we’re also starting from a breakeven gross margin on the $35,000 Model 3 and the actual truth – consistent with Elon Musk’s words – could easily be worse than that (negative gross margins).

Still, it would seem that Tesla’s internal calculations won’t be very far from those made above. Tesla knows all its money is being made on the two mandatory options (the long-range battery and the premium upgrade package). Of these, the largest contribution by far comes from the long-range battery (more than two-thirds of the gross margin). Here’s what I would expect as a consequence of this:

• The margins on the options and the long-range battery should be easy to attain. Hence, if and when Tesla attains its 5,000/week production capacity, and as long as it can build the rest of the car at breakeven, then the road to near-20% gross margins seems attainable.

On the other hand, while margins on the premium upgrade package and the battery should be easy to attain, they should also be hard to improve upon (in the short term). Hence, going from near-20% to the ultimate 25% should be harder than reaching the 20% objective. Also, the 20% objective will imply that only versions including the largest margin contributor (the long range battery) will be made available for a long time. That means the effective bottom base price Tesla is likely to set for the Model 3 will remain above $44,000 for the foreseeable future.

Here, something subjective intervenes. The question will no longer be whether Tesla can sell 400,000 Model 3s starting at $35,000. Instead, it will be whether Tesla is able to sell 400,000, or even the 250,000 implied by a 5,000/week production capacity, with the Model 3 effectively starting at $44,000. And worse still, whether it will be able to do so once the $7,500 EV tax credit goes away. Conclusion

It turns out that the place implied by Elon Musk is actually realistic – a central estimate on the differences between the base $35,000 Model 3 and the base $49,000 Model 3 which actually exists points to a margin of ~17.3%. Adding a bit more for other options’ intake could certainly take this number closer to 20%.

Finally, while this logic presents a path toward 20% gross margins on the $49,000 and up Model 3, it also eliminates the path toward any Model 3 priced below $44,000. This in turn raises doubts about the expected sales volume – especially if and when the EV tax credit fades away.

On a side note, Elon Musk seems increasingly unhinged. He just spent nearly an entire day railing against media on Twitter. The pressure to set things right quickly seems to be getting to him. The financial realities also must be getting to him.