Getting to gross margin: Tesla’s year ahead

When GigaOM asked its readers last June to read the tea leaves on Tesla’s (s tsla) future, 61 percent said that Tesla would be break-even by this coming June and would be able to start making money by selling more mainstream cars. Tesla reported its Q4 numbers last week and our readers appear prescient. Founder Elon Musk told investors that the company would turn its first profit in the first quarter of 2013 after having been cash flow positive this past December.

Tesla is still a few years away from being able to sell EVs to the mass market but the company continues to plug away toward the goal. Wall Street did not like Tesla’s Q4 results, causing the share price to shed about 7 percent. The quarterly loss was worse than analysts had expected despite revenue coming in at $306 million, $7 million north of the $299 million consensus estimate.

Getting to gross margin

The earnings and revenue numbers highlight a core theme for 2013 and Tesla, which will revolve around getting to the 25 percent gross margin that Musk has promised, a milestone he reiterated on the investor conference call last Wednesday. For the fourth quarter, the gross margin was just 8 percent, owing to the high expense of ramping production and reaching economies of scale for a factory that’s geared to produce just 5,000 cars a quarter.

The small volume production of the Model S makes improving margins challenging. During Q4, Tesla flew in tires from a supplier in the Czech Republic in order to meet production goals. Air freight costs about ten times shipping freight for an automotive part, and Musk noted that the costs made him want “to punch myself in the face for that one.”

Musk told the anecdote about the Czech tires to highlight that he believes a lot of excesses like overtime and supplier costs can be dealt with over time to expand margins. When Tesla reaches certain volume levels on its orders for batteries, for example, Panasonic cuts back its pricing.

Surprises: Foreign demand and leasing

And just as Tesla has some work to meet expectations in terms of gross margin, there are also potential surprises in the company in terms of demand. The European and Asian markets open up later this year as Tesla’s head of retail George Blankenship said he’s looking forward to stores in Hong Kong and Beijing.

Additionally, the Model S cannot currently be leased, which likely is a barrier for some customers who aren’t sitting on the cash to buy the luxury car. I’d expect that to change by the end of the year, though Musk was clear that he wants compelling interest rates before rolling out a program, something I suspect could be challenging. No one really knows what a Model S will be worth in 4 to 5 years when a lease would be up. It’s such a new product for an luxury EV market about which future vehicle values are mostly a mystery.

So it gets hard for any financial institution that would underwrite a leasing program to take on risk by offering lower interest rates.  But we’ll see. I wouldn’t be shocked if Tesla is willing to offer a bit of a higher interest rate for leasing, knowing that in a recovering economy we’re going to start to see more widespread demand for luxury cars.

The Future

Finally, buried at the end of the conference call was a reference to the Model X, Tesla’s crossover SUV. Musk was reticent to give out numbers on early reservations for the all electric SUV, but he estimated that buying interest would be around 70 percent of that for the Model S. Delivering the Model X in 2014 is another incremental step for Tesla but it’s an important one and given how hard it was for the company to ramp production on the Model S, producing an SUV at good margins could be very difficult. Not to mention that significant R&D and selling expenses will be incurred to launch the Model X.

Tesla remains a production supply constrained company as it lacks the facilities to meet demand. The average wait time for a Model S is 5 months. And while Blankenship and Musk talked up potential future growth in Europe and Asia, it’s irrelevant in the short term because there are limits right now on how much Tesla can scale given that it can only output 20,000 cars a year. But all in all, these are good problems to have.