Is A Paint Shop Stopping Tesla Producing 500,000 Cars A Year?

This is not investment advice. The author has no position in any of the stocks mentioned. WCCF TECH INC has a disclosure and ethics policy.

Tesla has been having an interesting run of late. A surge in Q3 deliveries and production numbers have driven stock price gains in recent days as investors see the company as making good on Elon Musk's promise to deliver half a million cars in 2018. One quarter of increased deliveries is apparently worth over $1bn these days, however since Elon has said more money will be needed, they need to have some good results.

All may not be as it seems though. Certainly the high level picture seems reasonable. Demand is high, Tesla (NASDAQ:TSLA) is ramping up production to meet both client and investor demand, the trouble is, Tesla is a tech company trying to make it in an old economy industry. Disruption is of course the nature of the tech game and we've seen it time and again, but there's a reason that Google is not a bank, despite how lucrative it can be. Old economy stalwarts typically operate in a more rigid regulatory regime than tech companies and Tesla may be about to find out that its options are limited by the old world.

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Tesla is certainly a threat to the car industry. A threat which is being taken increasingly seriously. Major car manufacturers the world over have hybrid and electric vehicles in the market and more coming, the question is whether Tesla can ramp up quickly enough to become a dominant player on the world stage. Large manufacturers already have a lot of factories in global locations, retooling is in many ways easier than building a new facility of course. Tesla has a first mover advantage in a lot of ways, but is it possible that Musk didn't think through all the angles in his bid to take on the major global manufacturers?

Mercedes CEO Dieter Zetsche has made a bold claim that they will be the number one premium electric vehicle maker by 2025 with 10 electric models on sale. Is this overconfidence? Or a sign of the ramp up capability of a global player with big manufacturing capabilities? Time will tell.

Paint Shop Woes?

A few months back, Elon Musk announced his very ambitious plan of producing half a million electric vehicles by 2018. According to a very thorough report by DailyKanban, the company is facing a big legal hurdle which will stop it from achieving that particular milestone. And what is it that stands in the way of Elon Musk’s master plan? A paint shop.

The company’s primary factory is located in California, specifically the San Francisco Bay Area, which happens to be a very densely populated region with extremely strict environmental regulations. This means that any plans of expansion will have to cater to not only the physical and financial challenges of expansion but those of a regulatory nature as well. This is also probably why the Toyota and GM based JV handed over the factory to Tesla, considering it would have been very difficult to expand it without facing the aforementioned challenges.

Interestingly, the biggest challenge the company currently faces stems from its paint shop. Most of the manufacturing process isn’t so hard on emissions but automobile surfacing creates a very high number of emissions in the form of Precursor Organic Compounds (POC) or Volatile Organic Compounds (VOC) which are created as byproducts of the painting process. These pollutants are usually limited (at a federal level) to 6lbs per gallon or most of the places in the US but California has extra state level regulations which actually impose a much stricter limit: at just 3.5 lbs per gallon. For a company that plans to make 500,000 cars in a year, this isn’t very good news.

Regulatory Headaches Inbound

The impact of these regulations means that Tesla is limited to producing a maximum of 25 vehicles per hour for its first year. By simple math, this means that even if the paint shop runs 24/7 you are only looking at an annual production of 219,000 cars. And according to the research conducted by Daily Kanban there is no way to bypass the red tape involved here. With the strict regulations in place, Tesla will not be able to produce 500,000 cars a year anytime in the near future. Unless of course, they start outsourcing the painting aspects of it to a third party. Apart from that, you are looking at a (much more realistic) figure of 200,000 cars produced per year – which is still about 4 times greater than the current 50,000 (although given Q3 deliveries of about 25,000, this does seem to be improving).

One thing is for sure though, if Elon Musk’s Tesla Model 3 is going to be the mainstream success that he envisions it to be then this is something that will have to be taken care of eventually. According to the same source, the company has not filed for any excess permits that might allow it to be slightly flexible with the regulation. Of course, there is also the possibility that the company will simply head into the murky waters of non-compliance if the fine is small enough and monetary in nature, but that seems unlikely at best.

The Future?

The only two real options that Elon Musk has is to either open up a new plant somewhere outside of the punishing regulations that the EPA has imposed, or, outsource the bottleneck to a third party. Considering it is something as inconsequential as a paintjob and does not contain any significant core competency elements to it, I don’t see any reason why this could not happen if Tesla wanted to, however it would likely take a hit on margin if it were to do this. For that to be true however, we will have to assume that this is the only bottleneck at play here and if this report is anything to go by, it is far too early to make that claim.

As for the stock, certainly it feels jumpy. Volatility is a bit on the high side compared to the established auto makers, but on the low side for a tech startup which in many ways is what they are. Musk isn't a huge fan of Wall Street despite the fact that some of his biggest fans hail from there. I wouldn't put it past him to have a trick or two up his sleeve but on current thinking, the stock feels high, particularly if there is no easy way to get around the environmental reg limitations facing the company.

Source: Daily Kanban Investigation.