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Tesla Is Getting More Desperate to Sell Pricey Model 3 Sedans

Adam Levine-Weinberg, The Motley Fool

A little over a week ago, Tesla (NASDAQ: TSLA) tried to pump up Model 3 sales by telling potential customers in the U.S. that they would be eligible for the full $7,500 federal electric-vehicle tax credit if they placed an order by Oct. 15. The tax credit for Teslas will drop to $3,750 for deliveries after Jan. 1, 2019.

This tactic doesn't appear to have been very successful, judging by the fact that Model 3 lead times haven't budged. As a result, Tesla shifted course last week, replacing the cheapest Model 3 variant it had been selling with a new "mid-range" model at a slightly lower price point. The sudden decision to introduce a new Model 3 variant suggests that Tesla is struggling to find a workable balance between stimulating sales and protecting its profit margin.

Tesla's dilemma

After announcing the Model 3 in early 2016, Tesla quickly accumulated hundreds of thousands of reservations. The advertised starting price of $35,000 before government incentives -- and significantly less after tax credits -- for a vehicle with at least 215 miles of range clearly tapped into a deep well of pent-up demand for high-quality electric vehicles.

However, when the Model 3 went into production in mid-2017, Tesla began with just the rear-wheel-drive, long-range-battery version, equipped with a premium interior package. This put the starting price (before tax credits) at $49,000, with other options potentially pushing the price significantly higher.

When Tesla branched out earlier this year, it did so by adding even pricier dual-motor models to the mix. The goal was clearly to boost the Model 3's gross margin. For the moment, at least, Tesla cannot build a $35,000 version of the Model 3 profitably.

A silver Tesla Model 3 parked on a road, with a green field in the background

The $35,000 base version of the Model 3 still won't be available for months. Image source: Tesla.

Indeed, even with a super-premium production mix and rising output, Tesla expects Model 3 gross margin to come in around 20% in the fourth quarter, below its target of 25%.

The problem for Tesla is that there is limited demand for the Model 3 at the price points offered thus far. The backlog of confirmed orders appears to be shrinking, as many U.S. reservation holders are waiting for the cheaper $35,000 model to become available.

Trying to stir up sales

It seems pretty clear that Tesla would have no shortage of orders if it made the $35,000 Model 3 available now. But with its current cost structure, such a move would lead to big losses. Tesla doesn't have the financial resources to absorb that kind of hit to its bottom line. It needs more orders at the Model 3's higher price points.

Tesla probably hoped that advertising Oct. 15 as the last day to order for guaranteed delivery by year-end would trigger a big influx of orders from customers deciding to pay extra for options they didn't need rather than risk losing the tax credit.

This week, it tried a different approach. On Thursday, CEO Elon Musk tweeted that Tesla had just made a new mid-range Model 3 variant available at a lower price point. The mid-range Model 3 offers 260 miles of range, compared to 310 miles for the long-range models and an estimate of at least 215 miles for the "standard-range" version that hasn't entered production yet. The starting price is $45,000 before tax credits.

As of Thursday evening, the lead time for orders of the mid-range Model 3 was six to 10 weeks, which implies that buyers would receive their vehicles by year-end. Tesla is advertising that the starting price would be $35,000 in California after federal and state tax credits.

This looks like another ploy

There's no way to be sure what Tesla's intentions are, but it certainly seems like the company is trying every tactic at its disposal to fill up its Model 3 order book for the rest of 2018 without having to make the margin-killing $35,000 version available.

Many U.S. customers who wait for the $35,000 Model 3 may not receive their vehicles until the second half of 2019. By then, the federal tax credit will be just $1,875 -- $5,625 less than the tax credit available today.

The potential loss of $5,625 in tax credits wasn't enough to get many reservation holders to order a $49,000 long-range model last week. Tesla probably thinks that making a $45,000 mid-range model available will change that calculus. After accounting for the potential difference in the tax credits available, the mid-range model may cost just $4,375 more than the $35,000 base version of the Model 3 right now.

At the same time as it introduced the new $45,000 model, Tesla removed the rear-wheel-drive, long-range-battery option from its Model 3 order page. (Musk says that it can still be special-ordered for another week or so.) That means the cheapest variant with 310 miles of range is now a pricier dual-motor option with a $54,000 starting price. That means higher profit from long-range models could offset much of the margin headwind from introducing the lower-cost $45,000 mid-range Model 3 this quarter.

Tesla will get some breathing room in early 2019 as it begins Model 3 deliveries outside of North America. It will be able to start with the priciest, highest-margin versions first. But before long, it will need to make the $35,000 version available -- or else dramatically reduce its sales targets. Unless Tesla can make massive improvements to its cost structure by then, the Model 3 alone won't be enough to make the company sustainably profitable.

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Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Tesla. The Motley Fool has a disclosure policy.