Can Tesla Motors Build Cars As Well As Detroit and Still Make Money?

A prototype of Tesla's upcoming Model X SUV. Tesla is encountering setbacks as it gears up to manufacture the Model X. Source: Tesla Motors

Tesla Motors has achieved something difficult: It has entered the auto business, credibly, with a great car, the Model S sedan.

That's a hard thing, and Tesla deserves enormous credit. But manufacturing its car has been another story. Tesla has kept its quality high, but boosts in manufacturing speed have been slow to come despite what the company says is a consistent backlog of orders. And it has encountered delay after delay as it works to add the Model X SUV to its production line.

CEO Elon Musk, citing manufacturing challenges around the Model X, lowered production expectations again this past week.

Tesla is often hailed as a technological leader -- but on this front, at least, it's still well behind the big global automakers. But the investment case for Tesla hangs on the assumption that it will become a profitable mass-market automaker in a few years. Can it catch up to the big automakers' manufacturing expertise in time to build its upcoming mass-market Model 3 -- at a profit?

Manufacturing efficiency is the auto industry's real "moat" Designing a great car is hard. Creating an assembly line to build it is also hard. But optimizing that assembly line to build those great cars profitably in the face of fierce, well-funded competition is really hard.

In fact, I argue that manufacturing -- profitable manufacturing -- is the auto industry's real "moat", the thing that fends off new entrants.

First of all, it's expensive. For a mass-market model, the established automakers might spend $250 million or more just on factory tooling, all of the special dies and equipment needed to manufacture the new model in big quantities for several years.

The high cost of the tooling required to build a car means that the auto business -- at least in the mass-market -- is a low-profit-margin affair. Modern auto factories are highly optimized to keep costs as low as possible, while delivering the highest possible quality.

Both are critical. Without high quality, an automaker's products will suffer in the marketplace. But if an automaker's factory is less efficient than rivals', it's at a big disadvantage: It either has to price its car higher, which will hurt sales, or take a smaller profit.

A smaller profit is something a company can ride out for a while. But eventually, in the auto business, it becomes a big problem: With less money to spend on the development of its next models, the automaker starts to fall behind rivals in terms of quality and features as well.

This is how Toyota bridged Detroit's moatToyota was able to bridge the established automakers' moat and become a global giant because it was (and is) exceptionally good at efficient manufacturing. More than anything else, that's the secret of Toyota's success.

It's also the "secret" (one of them, at least) behind the near-death of the Detroit automakers. Toyota and the other Japanese automakers outdid them on quality and manufacturing efficiency, and that nearly put them out of business. (What saved them? They caught up -- but only after years and years of effort, and billions of dollars spent.)

If Tesla wants to compete in the mass market, if it wants to build and sell a million or more cars a year, it's going to have to compete -- not on quality, or range, or zero-to-sixty times -- but on manufacturing efficiency with the likes of Toyota -- and now, Detroit.

Right now, Tesla is far behind the incumbentsTesla didn't have a billion dollars to spend on its Model S, and (at least at first) it didn't expect the sales necessary to support a full-blown production effort that would max out its huge California factory. Instead, thecompany has been bootstrapping its assembly line, adding tooling gradually to support rising production volumes.

CEO Elon Musk said this past week that the factory would have the ability to build about 1,000 units of the Model S and 1,000 of the Model X per week once Model X production is fully ramped up. In other words, Tesla probably has the necessary tooling to build about 100,000 vehicles a year now.

But it has never come close to that number. It's not close to producing 100,000 cars a year right now. It built just over 30,000 last year, and Musk said this week that it would produce between 50,000 and 55,000 cars in 2015.

Given that Musk consistently says that Tesla has lots and lots of orders for its cars, manufacturing would appear to be what's holding the company back.

Manufacturing challenges put the investment case for Tesla at riskThe case for Tesla as an investment doesn't rest on the Model X. More than anything else, it rests on the model that will follow: the long-awaited Model 3.

Tesla hopes that the Model 3 will compete head to head with mass-market gasoline cars, at a price around $35,000 -- and that it will boost Tesla's total sales to around 500,000 cars a year by 2020.

Tesla has access to a whole lot of expertise, and it should be able to ramp up production to around 500,000 cars a year -- if not by 2020, then by soon after. But the big incumbents will have caught up with Tesla's battery-electric technology by then. Can Tesla catch up with their huge advantage in manufacturing efficiency?

Or put another way, will Tesla be able to compete on price with the big guys and still make money? For Tesla investors, that's the question. One way or another, the answer will be found on Tesla's factory floor.

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John Rosevear has no position in any stocks mentioned. The Motley Fool recommends Tesla Motors. The Motley Fool owns shares of Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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