Tesla’s auto business has always been valued using the frameworks that investors use to value auto businesses. This is an easy and often helpful rule of thumb to use. Tesla builds factories, so does every other automaker. They have high upfront equipment expenses, so does every other automaker. They sell customers a new car every 10 or so years, so does every other automaker.
And although I broadly agree with all those points, I think it’s becoming increasingly wrong to value Tesla’s auto business like an auto business. And the reason is because of all the services Tesla sells after a new vehicle leaves the factory. Let me explain.
As soon as a Ford vehicle rolls off the production line, it’s sold at wholesale prices to a dealership. At that very moment, Ford’s job is done. They get a cheque from the dealership, and get back to building more cars. And Ford’s not unique here. Almost every automaker operates in the same way. They make all their money at once, and then they never get another penny from the customer who bought that car for another 10 years, when they’re ready for a new car.
Often, automakers don’t even know exactly who their customers are.
Tesla on the other hand is showing promising signs that they can make significant money from customers after they buy a car. This is where Tesla Services comes into play. And the foundation for making money after a purchase comes from having both a direct relationship with end consumers, and the capacity to build all the things customers need or want.
If we look at Tesla’s services business today, it’s easy to pass this off as a bad business. Gross margins have always been negative, and the overall revenue is only about $500 million per quarter. But bear with me for a second. There’s more to Tesla’s Services business than meets the eye.
To get context on what Tesla Services may one day become, let’s look at Apple’s Services business and explore some of the parallels between it and Tesla. Because Apple’s Services business is one with 64% gross margins, and is responsible for a third of Apple’s gross profits. In short, it’s a very big deal.
Apple offers iPhone trade-ins, Tesla offers Tesla trade-ins. Both have reasonable pricing power to decide how much to offer for trade-ins, and have loyal customer bases that keep coming back with old devices as they upgrade to new ones.
Apple offers Apple Care, Tesla offers Tesla Service Centers and Insurance. Both companies handle repairs, maintenance, and insurance internally, and can therefore charge a premium for the white-glove convenience. They’re both one-stop shops for any problems with your products.
Apple offers Apple Arcade, Apple Music, and Apple TV+. Tesla now offers Premium Connectivity. When you want premium entertainment on your phone, you use one of Apple’s services. When you want premium entertainment or navigation options in your car, you buy Tesla’s premium connectivity feature. Both of these services will offer fat profit margins to each company.
The comparisons mentioned above are straightforward, and most people would recognize them as similar businesses. But there are a couple more services Tesla is working on that aren’t perfect comparisons to Apple’s business lines.
Apple offers iCloud, Tesla offers Supercharging. iCloud is the easiest way to store documents. You pay a monthly fee, and Apple gives you extra storage space. Supercharging is the easiest way to charge your Tesla on the road. You pay a per charge fee, and Tesla gives you a full battery. Not a perfect comparison, but a similar business model. You’re paying for either storage space or electricity, at reasonable, but not rock-bottom prices.
And I need to address the margins here, because Tesla has already said they don’t want to turn Supercharging into a profit center. Apple probably does make a profit on iCloud, but Tesla has another angle they can use to squeeze out profits on Supercharging. That’s Licensing.
In this sense, it’s kind of similar to Apple’s CarPlay licensing. For a fee, other car makers could get access to the Tesla Supercharging network instead of an in-car operating system. Non-Tesla’s can’t charge at Superchargers today, and I don’t have reason to believe it’s coming anytime soon. But Tesla has shown that they’re open to collaborating if any automaker doesn’t feel like building their own charging network. And as the Supercharger network grows larger, this possibility of licensing grows stronger, and so does Tesla’s pricing leverage.
And there’s one more similarity between Apple and Tesla worth mentioning.
Apple offers the App Store, and Tesla is working on the Tesla Network. At first, this seems like an odd comparison, and I’ll be the first to admit it’s not perfect. But there are some similarities.
First, you can’t download apps to your iPhone from any other store than the App Store. And when the Tesla Network goes live, you won’t be able to dispatch your driverless car on any network other than the Tesla Network.
So both companies will have this captive audience. Apple has an installed base that is forced to use the App Store, and Tesla customers will all have driverless cars that can only be used on the Tesla Network.
Apple already charges 30% for in-app purchases on their platform, and Tesla is aiming to do the same for matching riders with driverless cars. While the fee for driver matching appears similar to Uber and Lyft at first, neither of those companies have the power to keep their drivers exclusively on their service. Uber can’t stop you from driving with a competitor. Tesla and Apple can.
This is the real money-making machine for Apple, and Tesla believes it will be very profitable if they can execute as well. There are no margin-draining fixed costs to deal with as a middleman. Neither company has to build physical products with expensive machinery, both services are just apps that live on the phones of every customer.
This exercise isn’t meant to imply that Tesla Services will grow exactly like Apple Services or that they’ll be exactly as profitable as Apple. All I’m saying here is that when we break down Apple’s Services bundle, a lot of the components are similar to offerings that Tesla either has, or is building.
And when we zoom out on the overall auto industry, these service offerings that Tesla is launching are all things that other automakers have lost control of.
Dealerships handle auto trade-ins, so they get the profit, not the manufacturer.
Repair shops handle service visits, so they get the profit, not the manufacturer.
Insurers handle auto insurance, so they get the profit, not the manufacturer.
Gas stations handle refuelling, so they get the profit, not the manufacturer.
And Uber and Lyft handle ride-sharing, so they get the profit, not the manufacturer.
And since Tesla is building out a vertically integrated stack of all these services, it becomes totally unreasonable to value Tesla’s auto business like an auto manufacturer. Tesla is already doing $750 per quarter in service revenue from the average car in their fleet, and with a growing Supercharger network, a premium connectivity fee, and the Tesla Network planned for 2020, Tesla Services revenue is expected to ramp up quickly.
Margins are still negative, but they are improving as Tesla’s auto business grows. Tesla Services had -36% margins in Q3 2018, and now -22% margins in Q3 2019. Scale is important for turning Tesla Services into a positive gross margin business, but if dealerships, repair shops, gas stations, and ride-sharing companies can have positive gross margins as independent businesses, why can’t Tesla Services figure out how to be profitable too? And once Tesla Services does turn the corner to profitability, look out.
10% gross margins on $750 of revenue per quarter is $300 of gross profit per year for every single vehicle in the Tesla fleet. Of course, Tesla’s fleet continues to grow at 60% per year, and service revenue per vehicle is growing too, so this trend might catch a few investors by surprise.
Let’s imagine a hypothetical for a couple years from now. Tesla has a fleet size of 2 million cars, and is doing $1000 per vehicle in services revenue each quarter. If they can achieve a 10% gross margin on those services, that’s an additional $800 million of profit per year from services. If instead that services revenue achieves a 30% margin, a little better than their auto manufacturing business, that’s $2.4 billion of profit per year.
And if the Tesla Network really blows up, that would create a massive increase in service revenue per vehicle, let’s say $3,000 per quarter as a guess. It would also imply margins that are much closer to Apple Services, let’s assume their 64% as a rough guess. That’s almost $6,000 of profit per vehicle, per year. If we assume a fleet size of 2 million vehicles, that’s over $11 billion of annual profit just from Tesla Services.
Again, I’m not suggesting this is exactly how Tesla Services will play out, I’m just illustrating how quickly this could become a meaningful business line if Tesla Services can execute.
Because in the process of stacking so many services on top of their vehicles, Tesla’s auto business is transforming from an auto manufacturing business into a hardware-services hybrid, not too different from Apple’s business (except the fact that Apple doesn’t manufacture their phones). And it’s about time investors start recognizing this shift.