Tesla – No Individual Company Matters That Much, But Here We Go

No Individual Company Matters That Much—But Here We Go

As part of our overall mission for transparency, every year we present a detailed analysis of at least one of the year’s major investments. And every year I also make the following disclaimer:

It is extremely important not to pay too much attention to any one company. In fact, getting emotional about any single investment can be a distraction, a trap, and a roadblock to sound thinking. And remember, we can be in a company today and out tomorrow based on some new fact or analysis.

What is important is to see how we evaluate companies, and we hope that by reading the following analysis you will gain further confidence in our ability to pick companies wisely. If you choose to read this full write-up on Tesla, do so with an interest in learning more about our thought processes, not with an attitude that any single investment makes or breaks our portfolio. It most certainly does not.

And if you choose not to go through all this analysis, all we can say is… we don’t blame you! This is a lot to read! More importantly though, there is enough macro-level data and overall performance information elsewhere in this report, and in previous reports, to make our case without your deep- diving into the minutiae of each company. Don’t feel bad about skipping the analysis part.

For our part, though, if we are going to present this analysis, there is only one way to do it: fully and completely. That is the nature of understanding and analyzing companies—it has to be done from every angle. We are top-down, bottom-up, and inside out. All the catchphrases apply: “We need to look into every nook and cranny.” “The devil is in the details.” Those details, or fundamental premise points, are what can steer a smart investor away from a phantom “opportunity” or help him or her hone in on a hugely successful idea that can pay multitudes of profits.

We will certainly not get our premises right every single time, but if we can outperform our peers by just a few percentage points, on average, per year, that will make a dramatic difference in your net worth over time. We have done that, and a good deal more, since our inception.

Now, let’s have some fun and dig in!

Tesla is one of the 25 companies that meet our investing requirements in spades (but remember, we only need a handful). Tesla is complex. But that’s why it serves as a beautiful case study. We love complex. The more complicated the scenario, the more mispriced the asset can be. And the more mispriced assets we hold, the better the long-term potential.

TSLA – Tesla Motors Inc

A great stock is like an orchestra; when all the pieces are playing together in tune, it makes beautiful music. And right now, that’s exactly what Tesla is doing. Any way you look at it, the risk/reward formula is off the charts—if you know how to evaluate it properly.

How Long Have We Been Looking at Tesla?

All great investments start with a seed, or an idea or thought. That seed starts to grow, then it is tested and retested, monitored and reviewed, and re-reviewed, to make sure all your premises are covered. In the case of Tesla, this was a company I had been watching for a while.

As you may recall, we noted Tesla’s potential in 2013 and wrote about it in our 2014 annual letter:

“…One example of a bottom-up read is Tesla, where it’s the company’s position in one of the oldest industries in the world, its infrastructure, its vision, and the product itself that grabbed us more than anything else. We read the reviews, saw the car, and actually drove it. We got in at its relative infancy date and its early market cap of $4.5 billion. It is now valued at $21 billion and still, we believe, a bargain over the long run.” (Today it’s around $30 billion.)

And we actually found it and started monitoring it quite a bit earlier than that. We were talking about it extensively a full seven years ago, when I commented on it in my letter to Buffett, under “Future Investment Ideas”:

Despite having spotted the opportunity in 2008, I didn’t actually make my investment until January, 2013. Remember, a big part of Prime’s success stems from not only finding the right investments, but also getting in and out at the right time.

Look at when we entered and at what price!

We got in about two years after Tesla went public, and at about a $4 billion market cap—way before anyone saw this company as a rising star. What’s really amazing is that we got in not when TSLA first went public, but right before it took off. We watched it, but didn’t invest until we could see the car for ourselves, and, more importantly, drive it. We always maintain a healthy skepticism, but we also know that outsized returns depend on seeing an opportunity early and taking advantage of it. To do this, you must get in before the crowd does, get out at the right time, and modify your positions based on value already achieved.

We got into Tesla after the Model S was rolled out. Since that time—even through the rollout of the Model X— Tesla has remained, in many ways, the same car company as it was three years ago. It has introduced only one new product since we bought it—and that was fairly recently. Most of the stock appreciation we’ve enjoyed has been a factor of seeing the obvious back in 2013. In retrospect, the decision to buy looks like a foregone conclusion—just as it does with many, if not most, of the investments we make. Our analysis of Tesla, however, was highly controversial at the time. Many people were naysayers. Their arguments all seemed to boil down to, “How could you invest in a company that is losing money with each car it produces?”

So it has always gone with Tesla. If I’m being honest, the reason I have not gone into deep detail about Tesla until now is that there was so much emotion against this company that I thought it might be fruitless to try to explain our enthusiasm for it. Sometimes, the best proof is the one that comes with time. And why call attention to a third rail, especially when it represents only one of about fifty (25 long/25 short) investments we are making?

There was also a lot of fogginess around Tesla and electric cars in general, but now that fog has begun to lift a little, and I think the platform exists for much more open, objective dialogue. The most compelling reason for discussing Tesla at this point in time, though, is that the future for this stock still looks so promising.

Many of the points we will be making in this section have been thought and rethought about, and at the end of the day we will have to wait and see if we are right. We have tried to articulate many of the popular counter-arguments, too, as we have done in past reports.

We have a high degree of confidence that Tesla will go as we predict, based on the evidence we will present below. Even if we are not right about all our points, we think there is such a large margin of error between Tesla’s current market cap and what we think this stock is truly worth that this is essentially a no-brainer once all the facts are compiled. But—with the Gigafactory and Model 3 yet to come—only time will tell, and we will remain open to any new facts and arguments that may arise in the future.

Listening to the Analysts: Just One Part of the Puzzle

One indication of the negative sentiment that existed around Tesla when we bought in was that it received “sell” recommendations from many prominent analysts. You have to understand, this was at a time when you rarely saw a “sell” rating. The percentage of “sell” recommendations was extremely small—less than 1% of the 28,000 stock ratings provided by First Call/Thomson Financial as of May 2000. By contrast, approximately 74% of stock ratings were “buy” or “strong buy.”

Even now, Tesla short sellers are at a record high—about 25% of Tesla shares are being shorted, according to Markit. A surprisingly low 48% of analysts have given the stock a buy rating, while 26% have recommended hold and another 26% have recommended sell, according to Bloomberg.

So what are we to make of this? Should we pay attention to the analysts or not? Well, we all know that the analysts are not always right, to put it mildly. In fact, there has been a great deal of academic research to prove that analysts do no better, on average, than dart throwers.

Since 2008, for example, analyst data supplied by Thomson Reuters and stock performance data from FactSet show that if you had invested your money each year in the ten S&P 500 stocks most recommended on Wall Street, you now would be sitting on a 61% gain. By contrast, if you had simply followed the general S&P 500, you would be up 67%. But here’s the really shocking part: if you’d invested your money each year in the ten stocks with the worst analyst recommendations, you’d be up 180%—about three times as much.

This is not to say that you should automatically go against analysts’ picks, or that we automatically do so. Analysts’ opinions, in fact, comprise one piece of the puzzle we do look at. The point is that we do our own homework, and if a decision makes sense to us—regardless of what others think— we go with our own view of reality.

And remember this: opposition is good. In fact, if I don’t see a strong opposing position to my stock choices, then the upside potential I seek would probably not be there. Why? Because if everyone liked the stock, its price would be a lot higher. So opposition is not something I’m scared of. I welcome it and have seen it with almost all of the investments I have made. Incorrect popular opinion is what creates the outsized opportunities. The beauty of the market is that the truth will eventually prevail.

But there’s also another reason I welcome opposing opinions. They help me to better crystallize my own understandings. In short, we at Prime like to analyze everything, “positive” and “negative,” and when we know we are on solid ground, we move forward.

In order for us to get excited about a company, we need to like the product it makes, its management, its industry, and its growth opportunities within its industry. We’ll talk about the macro perspective in a moment. For now, let’s just look at the product. Tesla, the car.

I’m a skeptic at heart. I doubt everything. I test every premise I hear. That’s why I generally prefer stock investing to venture capital investing. Everything under the sun can go wrong with start-ups, from the validity of the initial idea to the reality of the end product. The premises, in short, have yet to be proven.

But when I see a product that is already out in the marketplace, it is a “proven” concept for better or worse. I can test it, buy it, research it, talk to people who own it. Then I can connect the dots going forward and take advantage of the opportunity. Or not.

That’s what I did with Tesla. Before I bought the stock I actually drove the car. My brother bought a Tesla and I gathered opinions of others who did. I took note of the fact that just about everyone else who owns one consistently raved about how amazing it was. I read the press, I looked at the surveys. My personal experience, combined with the opinions of many, many other consumers and automotive experts, helped me establish one of my fundamental premises: the Tesla is special.

And it’s not just the fact that this is an electric car. If you remember, Fisker Automotive came out with an electric car that I think many would argue looked even nicer than Tesla’s. But Car and Driver and Consumer Reports gave it awful reviews.

When you combine the electric car concept with Tesla’s bold design ambitions and an incredible CEO like Elon Musk—and then you see the car for yourself, drive it, test it, and personally validate the enthusiasm—you know you have the elements needed for takeoff. And takeoff in a huge industry with plenty of upside.

The Cold Hard Facts: The Car Itself

The Tesla Model S was introduced in June 2012 and has been competing head-to-head with established car companies, all of which have well over 50 years of experience behind them.

Even in its first iteration, the Model S…

• won major awards including the 2013 Motor Trend Car of the Year—it was the first COTY winner in the award’s 64-year history not powered by an internal combustion engine—and the 2013 World Green Car of the Year
• was named Automobile magazine’s 2013 Car of the Year
• rated as Consumer Reports’ top-scoring car ever
• earned the Car of the Century distinction from Car and Driver
• scored a perfect 0 NHTSA automobile safety rating—the highest safety rating ever from the National Highway Traffic Safety Administration

That was all before 2016, when Tesla completely updated the design of the Model S. The latest edition of the Model S received a score of 103 from Consumer Reports, which was a problem only in that Consumer Reports ratings are scored on a scale of 1 to 100. Yes, Tesla broke the scoring system. (The magazine had to revise its scale in response to the record-breaking result.)

Perhaps the most important of all of its achievements is owner satisfaction. Some 98% of owners in the Consumer Reports survey said they would buy a Model S again—more than for Mercedes, BMW, Porsche, or any other vehicle.

Consumer Reports’ annual owner-satisfaction survey covered 350,000 vehicles from one to three years old. Across all vehicles, the average satisfaction rate was about 70%. Participants were asked whether they would buy the same car again, and to consider “attributes such as styling, comfort, features, cargo space, fuel economy, maintenance and repair costs, overall value, and driving dynamics.”

The Tesla Model S scored well in all these categories, with 98% of owners giving a “definitely yes” answer as to whether they would purchase it again.

Keep in mind, all of the above occurred before some of the latest features were added to the car, such as the truly mind-boggling driverless Autopilot coupled with all the other over-the-air updates, which we’ll discuss in a moment, and before the number of Tesla charging stations was increased.

In Britain, the reaction has been similar, according to AutoExpress:

• In AutoExpress’s 2016 Drive Power customer satisfaction survey Tesla topped seven out of ten categories and achieved an overall record-high score of 97.46%.
• Model S owners raved about its 17” inch display, Autopilot features, and “Ludicrous” mode.
• Categories topped by Model S include: best for running costs, best for performance, best for road handling, best ride quality, easiest to drive, best for practicality, and best for in-car tech.

What really makes this car unique in automotive history is its ability to be upgraded over time without the need to buy a new car. This is accomplished through software patches and updates. Says Elon Musk in a L.A. Times article, “We really designed the Model S to be a very sophisticated computer on wheels. Tesla is a software company as much as it is a hardware company. A huge part of what Tesla is, is a Silicon Valley software company. We view this the same as updating your phone or your laptop.”

Topping all of this off is real-world experience and word of mouth. Tesla is not slowing down. People are just beginning to truly understand the value of this revolutionary automobile—and remember, the car and company have only really been around for six-plus years, as compared to the well over fifty- year average for most American and worldwide car companies. Tesla, with its very first iteration of its very first model, is already starting to eat everyone else’s lunch, as the following figures show.

All of the above car companies are losing shares. Meanwhile, Tesla is gaining what they are losing (and this is before Tesla has even started mass-media marketing, as we will discuss).

Autopilot: A True Revolution

On a sleepy Thursday morning in mid-October, 2015, automotive history was made in classic Elon Musk style. Model S owners woke up with a radically new car in their garage. Thanks to a version 7 software upgrade, their cars now possessed a driverless feature. Yes, this incredible leap in automotive technology was accomplished via software. This was a surprise to everyone, and, as a business move, was pure genius. This revolutionary upgrade, “beamed” to 60,000 cars overnight, was accomplished without fanfare, and, perhaps more significantly, without regulatory red tape.

Before anyone knew what was going on, bam, the cars were on the street and driving themselves.

Autopilot is the company’s suite of semiautonomous tech that integrates software with cameras, radar, and ultrasonic sensors, to grant cars limited self-driving capabilities. According to USA Today, “About 60,000 of the 90,000 Model S’s on the road to date have the requisite sensors pre-installed for Autopilot.”

The enthusiasm for the upgrade was off the chart amongst consumers, publications, clean energy proponents—almost everyone. Now that the genie was out of the bottle, how were the regulators going to push back against it? Who was going to step out in front of all that enthusiasm and play the Grinch who tried to shut Tesla down? After all, elected officials need to get re-elected. This was a calculated and brilliant—albeit very risky—move by Elon Musk. Because if anything went wrong, it was his company on the line.

While everyone was caught up in the excitement, what were we doing at Prime? Keeping our eyes glued to the internet. On a daily basis. Why? Because our investment was on the line too.

We were looking for, and perhaps expecting, hundreds of auto accidents to be reported the next day—cars flying off cliffs, head-on collisions… But that was not what we saw. Yes, there were a few relatively minor mishaps, but there was also compelling evidence that the technology was actually preventing accidents. Even in its first iteration. We saw YouTube videos in which the car spotted a pedestrian coming—before the driver saw it—and in which the car sensed a swerving vehicle ahead of it in the driving rain and applied the brakes before the driver knew what was going on.

Again, yes, there have been some issues and complaints since Autopilot was released, but shockingly few considering the magnitude of what was being pioneered here. And the advantages have clearly trumped the disadvantages by a mile.

After a few days of watching this amazing development, we knew we were witnessing a revolution. Looking to the near future, we could easily imagine scenarios such as: having your car drive your kids to school while you monitor from home with a camera, or embarking on a car trip in Los Angeles and waking up the next day in Phoenix, fully rested and ready for your meetings.

Not only could driverless technology virtually eliminate impaired driving, but—as cars begin to communicate intelligently with one another—it could increase driving speeds while greatly reducing traffic jams and accidents.

That’s just the tip of the iceberg. The fact that 60,000 self-driven Teslas have already driven over a hundred million miles is ten times more impressive than these “futuristic” scenarios. Musk says that in three years Tesla will have a car fully capable of taking you to work while you are still asleep. As if that weren’t enough, “The system learns over time. The more people enable Autopilot, the more information is uploaded onto the network.” (Note: This bodes well for T-Mobile and other phone companies because almost all cars in the future will need to be Internet connected—see our 2014 T- Mobile discussion.)

On January 9, 2016, Tesla rolled out another over-the-air update, adding a new “summon” feature that allows cars to self-park without the driver in the car. “Version 7.1 of our software [allows] our cars to put themselves to bed,” says Musk.

In summation, Tesla Autopilot’s current and future capabilities render it a genuinely revolutionary technology. Perhaps the biggest single advance since the invention of the car.

With Tesla, it’s all about constant improvement. It’s not only about what you see today. Tesla has demonstrated an unbelievable ability to take the first step, but what’s really exciting is what it is poised to do in the future.

As Musk said in a Fortune piece (December 21, 2015), “I think we have all the pieces, and it’s just about refining those pieces, putting them in place, and making sure they work across a huge number of environments … It’s a much easier problem than people think it is.”

The point is that all the pieces are in place and now it’s only a process of refinement and improvement—in safety, speed, efficiency, etc. There will be problems, and things will go wrong. Elon may change vendors, systems, cameras, software, but with each step the product will get better. It’s a long road to perfection, but the road has been laid, and we are well on our way down it. What Musk has already done is amazing. We have great reason to believe that what he will do in short order will be world-changing.

The Timing Couldn’t Be Better for the Enhanced Safety of Driverless Technology

With traffic fatalities jumping unexpectedly in 2015—up by the highest percentage in the past 50 years—driverless technology has suddenly become all that much more critical and relevant.

Why the sudden increase in auto accidents? Lower gas prices and increased driven mileage may be one reason. But the use of smartphones to talk, text, or even watch videos while on the road, is likely another contributor, according to Warren Buffett, whose Berkshire Hathaway owns Geico, one of the largest auto insurers. One in four car crashes involves cell-phone use, according to NSC estimates,

even though most states have laws banning text messaging and hand-held cell-phone use while driving. At any given time, approximately 660,000 drivers are attempting to use their phones while behind the wheel of an automobile.

“If cars are better—and they clearly are—drivers must be worse (adjusted for mileage),” Mr. Buffett said in an email, as quoted by a WSJ article (September 15, 2015). The article also points out that “The upsurge in auto accidents after years of decline was an unexpected development for two of the three largest car insurers, Geico and Allstate.” And remember: distracted driving can only be expected to increase as mobile bandwidth improves and handheld technology becomes even more prevalent, making more and more online content and functionality available.

Driverless technology, even in its current state, goes a long way toward solving the problem of distracted driving. And since the technology is smart, it will only improve by leaps and bounds as it “learns” from its own collective experience and is continually refined by engineers.

While we don’t have a wealth of statistics yet, what we are seeing so far is that even the first version of Tesla’s driverless technology is not increasing accidents at all—and that’s an amazing base to work from to reach full autonomous driving. Worldwide, there is a fatality for every 60 million miles driven. The first fatality in a Tesla Autopilot car did not occur until over 130 million miles had been logged.

According to The Economist, “A study by the Eno Centre for Transportation, a non-profit group, estimates that if 90% of cars on American roads were autonomous, the number of accidents would fall from 5.5m a year to 1.3m, and road deaths from 32,400 to 11,300.”

Driverless technology is arriving on the scene at a perfect time to counter the dangers of smartphone use behind the wheel. In fact, Warren Buffett, while troubled by the recent upsurge in accidents, is equally concerned about the future of the car insurance industry in the face of this new technology. After all, with the improved safety of driverless cars, vastly less car insurance will be needed.

The Instrument Panel

Here’s a look at the production dashboard of a Tesla. This is probably not even close to as good as it will look in a few years, as the entire design of the car may change due to driverless technology (think bed, TV, even some excercise contraption possibly). This technology, even for Tesla, is changing with lightning speed, and it’s usually Tesla that’s outdoing Tesla.

As you can see, there’s a main dashboard digital display (left) and a central 17-inch touchscreen control panel (right).

As many other car companies struggle with basic automation and good dashboard design (as we’ll discuss later), the instrument panel on the Tesla is straight out of a sci-fi movie.

Its 12.3-inch LCD electronic instrument cluster (on the left) indicates speed, power usage, charge level, estimated range, and active gear, as well as Nav directions (powered by Garmin).

The Touchscreen (on the right) is a 17-inch panel divided into four areas. A top line displays status icons and provides shortcuts to Charging, HomeLink, Driver Profiles, vehicle information, and Bluetooth. The second line provides access to several apps including Media, Nav (driven by Google Maps), Energy, Web, Camera, and Phone. The central main viewing area displays the two active apps, subdivided into upper and lower areas. At the bottom is access to various secondary controls and settings such as door locks and lights, as well as temperature controls and a secondary volume control (above condensed and adapted from Wikipedia’s “Tesla Model S” article).

Again, it’s as much a sophisticated computer system as it is a car.

Convenient Service and Maintenance

Make no mistake, Teslas are far from perfect, and owners have reported a range of problems from leaky sunroofs to rattling noises to issues with the drive train, touchscreen panel, and power equipment. But that’s where Tesla’s superior repair service kicks in. According to an article in

Fortune…

In a regular car, if your water pump went out, the company wouldn’t give you a new motor… [Tesla] has an Apple Store approach to service. They’ll change the whole unit, give the customer a new one and then take back the problematic one, rebuild it, analyze what went wrong, learn from it, and put it into somebody else’s car that needs that part.

The company is known for replacing an entire electric motor within 24 hours instead of tinkering with one troublesome part on the unit for days…

It’s a smarter approach and it results in a lot less downtime for the owner…

And while replacing an entire electric motor might seem likely a costly approach, Tesla has managed to reduce its annualized cash costs of warranty… This number has dropped from

$2,033 per car in the second quarter of 2013 to $947 per unit in the second quarter of 2015—a sign that the company continues to make improvements.

While some parts in the Model S are expensive to replace, many are cheaper than ones related to a combustion engine…

Consumer Reports recently rated Tesla’s repair facilities as better than both dealerships and independent operators. “According to [CR’s] annual survey of subscribers, independent repair shops were rated higher in customer satisfaction than most franchised dealerships, with luxury automakers like Audi and Lexus rated higher than more plebeian brands. The one exception to that was Tesla’s official repair shops, which outranked even independent shops for on-time repairs, costs, quality, and overall satisfaction.” (Gas2, February 5, 2015)

Not that EV drivers spend a lot of time in repair shops. Electric technology has fewer inherent problems than internal combustion technology. For starters, electric motors produce less heat, because they have fewer moving parts, and don’t rely on controlled explosions (combustion) to make things move.

Electric cars don’t need multi-gear transmissions. This makes for greater efficiency and less wear, because transmissions act as a drag on the drivetrain. The lack of a transmission, exhaust, extensive lubrication system, and other complications integral to internal-combustion engines also makes electric powertrains simpler. There are fewer things that can break and fewer items that need regular servicing.

“The Tesla Model S actually requires little to no maintenance compared to gasoline-powered vehicles,” according to Clean Technica (Sept. 27, 2013), “due to the fact that it has very few mechanical parts that can malfunction. The only parts that require regular replacement are windshield wipers and tires. Brake pads will require replacement as well, but not nearly as often as those in gasoline-powered vehicles, since they are used much less thanks to regenerative braking.”

Gasoline propulsion systems, by contrast, contain a much longer list of components that can need replacing and that can fail…

Components that can need replacing include, but are not limited to:

• Electronic actuators to adjust various valves
• Ignition system
• Throttle controls
• Turbochargers (some models)
• Engine control unit
• Transmission control unit
• Oxygen sensor
• Coolant pump
• Fuel pump
• Oil pump
• Engine fan
• Transmission oil cooler pump (some models)

Components that can fail include, but are not limited to:

• Transmission
• Valves
• Spark plugs
• Crankshaft
• Connecting Rod
• Cylinders
• Camshaft
• Exhaust gas recirculation (EGR) system
• Belt and pulley systems for driving the alternator, engine fan, and other parts

Source: Clean Technica

An article in Business Insider sums it up best: “A Tesla powertrain (i.e. battery, motor, power electronics, charger) has 18 moving parts… An ICE powertrain (i.e. engine, transmission, drivetrain) has hundreds, maybe thousands.”

The battery for a base model Tesla is guaranteed for eight years or 125,000 miles (unlimited miles for its higher-end battery).

Side note: Auto parts retailers may be in trouble in the future. Not only do they have to worry about Tesla and the dramatically reduced number of parts its cars require, but they also have to worry about 3D printing, which can create auto parts, and Amazon, which can deliver parts more efficiently. A trifecta of trouble. Some parts retailers have additional problems. O’Reilly, for example, is a relatively large company ($26 billion) in a mature, saturated market that cannot grow much further and has almost a 30 PE! I’m not saying I’m going to short ORLY today, but just as Tesla was on my radar as a long position way before I stepped into it in 2013, ORLY is on my radar screen as a potential short down the road. Stay tuned!

The Performance

The Model S accelerates from 0-60 is less than four seconds, making it the most responsive car on the market, according to Consumer Reports. A Toyota Prius, by comparison, takes nearly 10 seconds to reach that same speed.

Tesla, on the other hand, is rapidly improving on even its current acceleration rates. The top-end Model S P85 D already had an “insane” mode capable of 0-60 in 3.1 seconds. Last year the system got an upgrade to “ludicrous” mode, which does 0-60 in a truly incomprehensible 2.8 seconds.

Only a few other production cars in the world can boast such acceleration, and all of them are either tiny, bare-bones models that hold only two people, or hugely expensive models that cost tens or hundreds of thousands of dollars more than the Tesla.

Tesla has “instant torque.” While other cars need time for their full power to kick in, the “ludicrous” Tesla Model S has all its power right there off the line. This makes the Tesla Model S the quickest production car in the world, in fact the quickest in history.

The importance of this kind of performance cannot be overstated. It is a huge selling point with consumers, especially those who test-drive the car. The Tesla obliterates the old myth that electric cars are sluggish, unsexy, and unresponsive. This is a performance vehicle that easily beats Porsches, Maseratis, and Jaguars off the starting line. It’s a car you want to drive, not just one your conscience compels you to drive.

Tesla’s Space and Comfort vs. Traditional Cars

Creating space in a Tesla has been a lot easier than it has been for gas-powered cars, thanks to Tesla’s trademark electric vehicle architecture. The lithium batteries are concealed within a remarkably thin floor-pan structure. Unlike traditional cars that have large engines taking up all the space in front of the car, Tesla’s hardware and engine are nicely tucked away, allowing the design team free play in creating space that other car makers can only envy.

That is why even the new Model 3 is going to have room for five adults “comfortably,” opening up floor space and leg-room for front passengers. All Tesla models have the design space to allow for exceptional safety, comfort, and baggage room.

My Own Case Study

This all sounds great, but sometimes a real-world perspective can bring it all home better than any theoretical or technical explanation can. With that in mind, I’d like to share a “case study.” Mine.

I recently bought a Tesla (Model X) for my wife, and we were invited to a friend’s 40th birthday celebration in Solvang, California. That’s a town in wine country north of Santa Barbara (if you’ve seen the film Sideways, much of it was shot there).

Strictly for the relevance of this story, I will divulge that I drive a higher-end car than a Tesla. But I wanted to take the Tesla on the trip because of all the cool features I knew it had, such as its ability to play almost any song in the world on vocal command and its amazing doors that open outwards and prompt my six-year-old to ask, “Daddy is the car going to fly?”

But the real reason I wanted to drive the Tesla was that I like to do personal research. I like to gain an intimate understanding of the companies I invest in.

As we pulled out onto the Pacific Coast Highway, I excitedly phoned Tesla customer service and asked them how the driverless technology worked. As the courteous employee—and I have to say, every Tesla employee I have come across has been exceptional—walked me through the steps, I soon realized how simple the technology was to use. It also had robust features that were quite handy, such as placing all the speed controls and settings on one easy-to-use control knob.

During the next ten minutes or so I began testing all the features and getting used to them— speeding up, slowing down, setting target speeds, changing lanes by using the turn signal, etc. There were about five times I found myself taking over control over the car. But each time, it was as a result of my panicking and failing to trust the system. When I realized the car was consistently doing the right thing, I knew I just had to get used to it and not panic so fast.

Autopilot handled the highway amazingly well, which quickly built my confidence. I was now going for prolonged stretches of time without touching the steering wheel, gas pedal, or brake pedal. The car, by the way, “notices” your passivity. When you don’t touch the steering wheel for a few minutes, the instrument panel will beep slightly while muting the music, and the screen will say something like, “Please put your hand on the steering wheel to maintain autopilot mode.” Another reassuring sign of the car’s practical “intelligence.”

I was giving the Tesla a workout, and it was passing with flying colors. You have to see this thing to believe it—the control panel, the screen showing other vehicles’ locations relative to yours, the almost perfect reading of the lane, the smooth centering. The whole integrated experience. Soon I did not even want to hold the steering wheel anymore. I remember thinking at one point, “Wow, I can’t believe other people are actually driving their cars. How inconvenient. How inefficient.” Amazing. I was already making the shift, in my mind, to a new era of personal transportation.

Now for the real test. Autopilot on winding roads. If you’ve been to Solvang, you know that after you leave the PCH, the road turns windy and leads up a mountainous region. Now, I don’t suggest anyone try this, because I don’t think autopilot is meant to be fully used on winding roads yet, but for the sake of research, I wanted to try it.

So I embarked on the winding passage, and the car handled the turns amazingly well. There was one time when it tried to take an exit I did not want to take, but this was an easy problem to correct by just tapping the steering wheel in the other direction. In fact, the experience was such a pleasure, I thought to myself, “I’d be happy to drive anywhere within a 5-to-6-hour range.” Most of us don’t realize how much stress driving causes, because we’re so used to it. The bulk of that stress comes from having to focus so intently. It’s much easier, I learned, to “oversee” a drive, as I was doing with the Tesla, than to execute every action and decision in detail. And for most long-duration trips, the bulk of the driving is on freeways, which the Tesla handled with ease.

There are so many bells and whistles on this car, it is hard to capture them all. And they’re not just for show; when you use the features, you realize how practical they are. For example, the car can be programmed to automatically elevate itself, via its suspension control, when it approaches the driveway of your house. The driver’s-side door senses what is around you and automatically opens when you approach the car and closes when you depress the gas. Once you try these features, you never want anything else. And the pace of Tesla’s advances is increasing.

All in all, the car exceeded my high expectations by a country mile. This is why personal experience can be so essential. It can tell you things no brochure or video or financial report can capture. I now knew that when people experienced this car it would be a turning point for them. I knew it in my bones. Would anyone really want to drive another car once they’ve tried one that can drive them to their destination refreshed, relaxed, and safer to boot?

From a Macro Perspective

A great product is only part of the picture, though. A smart investor looks at the industry as a whole and how the company fits into it.

If you look at the car industry, Toyota Motors has a $200 billion market cap, and it’s trading at about eight and a quarter times earnings. That means it’s making over $24 billion dollars a year in net income. That is a huge number. When well-managed car companies hit economies of scale and get past the initial investment phase, they can print money because the barriers to entry are so high. If you look at the top companies in the (internal combustion) car industry you have over a trillion dollars of value—all based around the same PE.

Then you have Tesla, all by itself, still at only a $30 billion market cap. That’s a recipe for great upside.

When vetting companies to invest in, Prime always looks for a “moat,” or a set of separators, that makes competition from other players difficult and can allow huge profits to be sustained and to grow. Just by virtue of being a viable player in the car industry, Tesla has already achieved a moat, and a large one at that.

First of all, the car industry is a very capital-intensive business. To start a car company takes several billion dollars, and even if you had your hands on that kind of money, you’d better get the product right the first time—which is damn near impossible in and of itself. (Tesla, amazingly, has done so.)

Distribution is another challenge; retail space for autos is extremely limited. Increased bargaining power of auto parts suppliers is another challenge, as are the economies of scale enjoyed by established competitors. These reasons, among others, are exactly why you rarely see major new entrants in the car industry. In fact, in America, the most prosperous, entrepreneurial nation in the world, no entrepreneur had successfully established a car company of any kind since Walter Chrysler did it in 1925.

To compare this to another major industry, let’s look briefly at the cell phone industry. In the past, substantial capital was required in order to enter this arena, but the cell phone industry is no longer capital-intensive. These days, “anyone” can start a phone company. This is happening all over India and China—and the rest of the world as well. Xiaomi, the largest phone seller in China, wasn’t even around seven years ago. A small group of people got together and decided to start making phones with a lower profit margin of only around $10 per phone. Nowadays, as soon as a phone comes out, you can dissect it, source all the components, use the Google Android operating system for free, and build the phone. And it’s not just Xiaomi; there is Lenovo, TCL Communications, ZTE, Micromax, Huawei, and more, all following the same game plan.

The point is, giant capital moats are getting harder and harder to find—unless they are in a dying business. The car industry, by contrast, has enormous barriers to entry. The type of competition you see in the phone industry simply does not, and cannot, exist in the auto industry.

Back to the point at hand. Tesla has already passed the point where it has overcome initial inertia— a huge hurdle—and has actually broken into the car market. The car exists. We have seen it and tested it. Tesla has built out factories and has managed to become an operating business without going under due to insolvency. This alone is a major feat. And most importantly, Tesla has built a better car than anyone else on its first try.

The point I am leading to is that if (1) you are in an industry with high barriers to entry, and (2) you are able to build a better product than all your competitors, and (3) they are all building one kind of product while you are building one that is fundamentally different (electric vs. gas), then you can eventually transfer much of the industry’s existing profits from other companies to yours. And all that net income, at very low PEs, translates to vast earnings.

And that income can now come at an accelerated pace. Why? Well, the average car is held for six years, but that is with the old technology that most cars have been using for decades. But with this exciting new technology—especially the radical new driverless feature—you can expect to see a dramatic uptick in the turnover rate at which people move away from older cars. Even if I’m fractionally correct, or even if drivers wait their full six years before switching technologies, this thing should be gangbusters. We’re talking trillion dollars of market cap and well over $100 billion in net income that’s out there and gettable for an extraordinary product that people really want.

Most important, for me at least, is that Tesla’s success is sustainable. We’ve already seen that it’s exceedingly hard, in general, for a new car company to enter the fray. But also, in the specific case of Tesla, existing companies don’t stand much of a chance against this company and its management. Typically, today’s car companies are run by CEOs sitting in luxury offices, far removed from their manufacturing plants. These appointed officers aren’t even the ones who brought their respective companies to where they are today, so they haven’t proven they possess the entrepreneurial know-how to take the company forward.

Elon Musk, by contrast, literally sits on the plant floor. With his exceptional work ethic, proven track record, and ingenuity—plus, now, the money behind him to do what he needs to do—I don’t see anyone in the industry, or on the horizon, who can catch up to him. We’ll talk about Musk a little more later.

But for now, to use an automotive metaphor, let’s shift gears.

China

According to a recent CNBC article, “China has already become the largest market in the world for EV sales, with 320,000 electric vehicles, including commercial ones, sold last year.”

James Chao, who tracks the Asian auto industry for the consulting firm HIS Automotive, predicts that number will continue to increase because of subsidies the Chinese government offers to encourage the sale of EVs. These start at $8500 and can often go higher.

The Chinese car market itself is huge and only getting bigger. Most American and European car companies are deriving an ever-larger portion of their profits from China. Just as we are seeing with many other industries, China is on a path to becoming the world’s back yard in terms of consumer spending. In case you didn’t realize how big the Chinese car market has become (and it’s still shocking to me), consider this: With a population more than four times that of the United States, China became the world’s No. 1 auto market in 2015, selling 24.6 million units as compared to 17.2 million vehicles sold in the U.S.

The problem is how to tap in to such a large and growing market. We wrote extensively in last year’s annual report about an idea we call “China-proofing.” That doesn’t mean ignoring or avoiding China; it means investing in companies that are strategically positioned to either take advantage of the growing Chinese market, or at least avoid getting hammered by it. China is the “elephant in the room” in the 21st century, and any company not factoring China into its competitive positioning is missing the boat in a huge way.

As investors, we look at China-proofing in a couple of different ways. One is the way we discussed in last year’s report. That means to be in companies that will not get eaten up by China’s advantages— for example, its vast labor force of 1.3 billion educated, hard-working people willing to work for a fraction of the costs of other countries. We don’t want to be in companies where China can re-create their product a little more cheaply, thereby eating up a larger and larger market share over time.

The competitive advantage other countries used to have is that they would import from China and sell into their local markets. Now, with China’s vast growth and wealth, not only does it have the ability to reach outside markets on its own, but it also has a massive domestic consumer base as well. So we like to be in companies that have a wide moat against this new reality.

But we also like to be in companies—this is our second way of looking at China-proofing—that can actually GROW into China. (One example of this is Activision, as China has recently opened up its domestic market to game consoles, and the Chinese are very active gamers.) This is not necessarily an easy thing to do. Most countries prefer local producers, and China is certainly no exception. It doesn’t really want American companies to succeed within its borders, especially if it believes them to be taking away potential business from local companies. We have seen, time and again, how China uses its clout to give advantage to its own companies.

That’s not to say American companies cannot do well in China. They can. But it’s the quantity or extent of penetration that is critical. That’s because the market opportunity is so vast, especially now that China is opening up and modernizing so rapidly. Every edge you can get matters, right now, and can make the difference between being moderately successful and ridiculously successful.

What advantage does Tesla have in China? Well, it’s a matter of life or death. Literally.

Air Pollution in China

An extensive study concluded in 2013 showed the link between air pollution and life expectancy in China. According to an article in the New York Times about the study, “Outdoor air pollution contributes to the deaths of an estimated 1.6 million people in China every year, or about 4,400 people a day.” Airborne pollution in China may have shortened the lives of 500 million Chinese by a collective 2.5 billion years.

To put it in even starker terms, air pollution causes people in northern China to live an average of 5.5 years less than even their southern Chinese counterparts; forget about comparing them to the rest of the world. And the consequences and severity of this problem have only gotten worse since 2013, due to continued industrialization and modernization in China.

Just to show you the urgency of the situation: The air pollution scale for all countries stops at 250 (micrograms per cubic meter). Beijing has seen readings of 500 or above. Shanghai had a 600+ “airpocalypse” this past winter. No one in North America or Europe has experienced anything comparable, except in the middle of a forest fire or a volcanic eruption.

Here’s a chart comparing the ten most-polluted Chinese cities with the ten in America.

As you can see, even the worst American cities would be in tip-top shape compared to Chinese cities. All of the above Chinese cities have over ten times the level of PM2.5 the WHO (World Health Organization) considers safe.

This is not just a Chinese problem. Financial Times (September 8, 2016) states that in 2013, an estimated 5.5 million lives were lost globally due to air-pollution-related causes. About 90 percent of these deaths occurred in developing/low-income countries where children under 5 are sixty times more likely to fall victim to air pollution than they are in wealthier countries. Such deaths are costing the global economy about $5.1 trillion per year. And remember, exposure to bad air increases the likelihood of developing a wide range of other medical issues.

The upshot of all this is that when it comes to Tesla cars, China and Hong Kong are a wide open market. And their governments support this. As a necessity. The Chinese people are literally dying for clean air.

None of this has been lost on Elon Musk. He recognizes both the long-term need for China to drastically reduce its overall pollution and the shorter-term need of Chinese individuals to reduce their level of smog intake immediately…

Tesla Offers an Immediate Solution

That’s why the air filtration system on the Model S, and now the Model X, is able to reduce the level of contamination in the car’s internal air from “extremely dangerous” to “undetectable” in less than two minutes. Yes, wow. Tesla says its filter is 100 times more effective than those on other cars and will remove 99.97% of particulate exhaust pollution, as well as allergens and bacteria. Tesla designed its filtration system to meet the tough HEPA standards of filtration systems used in hospitals and spacecraft. Says Tesla, “We wanted to ensure that it captured fine particulate matter and gaseous pollutants, as well as bacteria, viruses, pollen and mold spores.”

This filter is so good, Tesla says that it can withstand a military grade bioweapon attack. In fact, Tesla recently conducted a test of its Bioweapon Defense Mode, and the results were pretty impressive.

“To begin the test, they threw a Model X into a large bubble and pumped it full of PM2.5 contaminants (particles smaller than 2.5 microns), which are widely considered to be the most dangerous class because they lodge themselves so deeply into our lungs. They filled the bubble to levels roughly 18 times the ‘unhealthy’ index, or roughly four times the ‘hazardous’ index. Within two minutes of activating the Bioweapon Defense Mode, the air levels inside the cabin were safe to breathe. Within four minutes, PM2.5 levels were so low that they dropped under the threshold of detection. And here’s the kicker: the air outside the vehicle was being scrubbed too, with contamination levels dropping 40% during Tesla’s 12 minute test.” (Snapmunk, May 17, 2016)

Tesla management has the foresight to give the people not just what they want, but what they need.

Elon Musk sees the huge market potential in China and other emerging car markets. He also sees the dire situations in those places and wants to address it. According to a Forbes article (April 2, 2016), Musk recently described Hong Kong, the gateway to China, as a “beacon city for

electric vehicles,” and said that the city will have “the highest percentage of electric vehicles of any city in the world.”

The latest Tesla car currently available in Hong Kong is the Model S, and it’s already one of the most popular cars in the city since it started to arrive there in July 2014. In the above-mentioned Forbes article, Locky Law, the Tesla owner representative for an organization called Charged Hong Kong estimates that when the Model 3 arrives, 50 to 70% of new car sales in Hong Kong will be EVs, and almost all of them will be Teslas.

The Chinese government is putting forth a short-term, a mid-term, and a long-term plan for EV adoption. “The Hong Kong Government has shown a strong support of electric vehicle adoption by its initiatives to install charging stations throughout the city, and enact policies that favor purchasers of electric cars, including a registration tax waiver” (Teslarati, January 5, 2016).

Exemptions from registration taxes save Model S owners about HK$382,500 ($49,300). By contrast, the levy on a BMW 320i carries an added cost of HK$206,300, or about 38% of the sticker price.

Elon Musk said he thinks Asia will be the “biggest area of expansion” for Tesla in the next several years. His company plans a massive increase in Supercharger stations to accommodate that expected expansion. (He has also pointed out that most of China’s people live along the coast.

Therefore, the giant inland space could be used to install solar panels. “You can easily power all of China with solar [energy],” he has said. Musk, as you may know, is also chairman of SolarCity, a solar energy company.)

Restrictions and Regulations

Worldwide, governments are offering incentives for buying EVs and putting harsher restrictions on gas-powered vehicles. We see this in the U.S. as well. Internal combustion engines now face increasingly challenging state and federal regulations for emissions and fuel efficiency, and owners and manufacturers face stiffer penalties for failing to abide by these regulations. In addition to the federal and state subsidies already being offered, the Obama administration has proposed $4 billion in spending to support driverless technology over the next decade.

Carmakers face deadlines for reducing nitrogen oxide emissions (NOx) in the US and for increasing fuel efficiency and decreasing carbon dioxide (CO2) in the EU. This makes big changes unavoidable for the traditional car industry. Regulators and environmentalists, and others, have been trying to make gas cars cleaner for decades, but with the advent of electric cars, regulators are stepping up their efforts. According to ft.com, “By the end of the decade, the US, the EU and China will have brought in rules that it will be impossible for car manufacturers to comply with unless they embrace these new technologies.”

As a result, carmakers have even more ground to make up to hit the next round of targets.

All of this change will make gas-based car costs skyrocket, bringing more consumers and money into Tesla, and making Tesla cars more cost effective vs. their petroleum-based brethren. Now with diesel taking a hit from the Volkswagen scandal that saw 11 million cars being tweaked to cheat their emissions control, the pressure is on even more… and it all benefits Tesla.

Automakers are looking to move away from diesel altogether, due to increased regulations.

A Henry Ford-Like Vision: The Model 3

The whole idea behind Elon Musk’s Tesla was to start with a high-end car and then work down. The ultimate goal has always been to make a mass-produced car that’s affordable to all, thereby fulfilling Musk’s ultimate goal of transforming the world landscape for electric cars. Once you understand his grand vision, you can build your premises about Tesla’s future more accurately.

One of our big premises has always been that if Musk can build a high-end performance vehicle, then he can pretty easily build a lighter-end version of that car. After all, if you can do calculus, you can probably do simple multiplication too. And in our view, if Musk can indeed build an amazing, industry-defying, low-end electric car, the world will absolutely be Tesla’s oyster. The significance of this is impossible to overstate.

The big question was could he do it? Specifically: Could Elon Musk actually build a good low-end car for $35,000? If so, the sky was the limit.

Tesla recently unveiled the $35,000 Model 3. And it looks better than expected and is packed with more features than promised. The potential ripple effects from this development are staggering.

What Tesla basically did was to take all the componentry, along with the electronic backbone, of the Model S, which starts at around $70,000 for the base model, and give it to the Model 3. The Model 3 has the same engine concept, as well as all the same internal technology that goes into the Model S. It even has driverless technology. Think about it: The proprietary development of the componentry and software is already a sunk cost, it’s been proven to actually work, and it’s the heart of the new car. Hence, Musk rolled out the Model 3 with almost all the bells and whistles of the Model S. He even went so far as to thank all those who had previously bought a Model S for making this possible.

Here are some of the features and benefits you’ll get in the Model 3:

• A charge range of at least 215 miles
• Industry-topping safety ratings
• Access to Tesla’s “Supercharger” network of fast-recharging stations
• A zero-to-60 time of “under six seconds”
• Ability to seat five large adults comfortably
• The all-important Autopilot technology

To sum up, Model 3 will be a better car than many that are much more costly. Says Elon Musk, “You will not be able to buy a better car, any better car, for less than that.” And don’t worry, any temporary issues with the car’s features will be easily fixed—remember, this is the same technology as the Model S, and most of those bugs have had time to work themselves out.

Think about the pricing implications. Tesla sells the Model S for about $100,000, on average. The Model 3 will sticker for $35,000, before tax credits. This precipitous difference in price will have massive ramifications that we believe have not been vetted out properly either from a profit- potential perspective or a social change perspective.

Now, let’s talk about the potential ripple effects of this car and why I have had my eye on this prize since the day I first got into Tesla three and a half years ago. It starts with simple, back-of-the- envelope calculations that jump off the page.

Not only will Model 3 be the best car for the price—and, in my opinion, way beyond—but there is an additional factor that can have exponential effects.

Sit down for this one.

A Tesla for Less Than the Cost of Mobile Phone Service?!

At a $35K price tag, the gas savings on this car in many parts of the world will be more than the lease payments —essentially giving you the car for free, or at least for an extremely affordable price! Many owners, when factoring their current costs, will actually be paid to drive the best car on the road.

Let me explain. First let’s have a look at a lease offer from the BMW 3-series. As a piece in Jalopnik (January 14, 2015) points out, you can drive a BMW for as little at $309/month for 39 months. If we look a little closer, we see that this payment is based on an MSRP of $35,300.00. A lease payment is determined mostly by the purchase price over the residual value. So, what if the purchase price on a $35,000 Tesla Model 3 were further reduced by $7500 in EV tax credits? Now we have a Model 3 with a purchase price of $27,500. Let’s also say the Tesla can maintain the same 60% residual value as the BMW.

I actually think it can do better than that, what with its driverless technology, its greatly reduced number of moving parts, etc., but let’s just say it matches the BMW. So just taking it proportionately (at its $27,500 purchase price), you would get payments of approximately $240 per month.

The second step in figuring the cost of ownership is to deduct the gas payments on a car, which averaged about $140.13 per month last year in the U.S., even taking into account the tremendously low price of oil right now. That brings the cost down to $101 per month for the Tesla.

Now let’s add back $40 for electricity used per month, a pretty conservative estimate, and you end up with a net monthly payment of $141! In Europe, where gas costs are generally 2.6 times more than in the United States, all things being equal, your $141 goes down to $-64.20 per month—you are essentially getting paid to drive a Tesla. In China, where gas costs are about 71% higher than in

the U.S., your cost is approximately $20 a month! (We’re using simple calculations to estimate payment savings. Some analysts suggest the payments would be even lower; some say higher.)

Now, just to keep things in perspective: Even with no gas-payment savings, I think the car, with all its features (pollution reduction, safety, technology features, speed, range, driverless tech), will be heads-and-tails better than any $35,000 car out there and will win huge market share on that basis alone. But with payments, in the United States, amounting to $141 per month, factoring in gas savings, it’s a no-brainer.

But let’s continue with the analysis.

You can see that the United States has about the lowest gas prices in the world. And the higher the price of gas, the greater the savings with a Tesla. So globally, consumers will save even more.

The numbers, when you look around the globe, are mind-boggling. Tesla simply takes the money you would have been paying for gas and converts it into your lease payment.

Now let’s look at the electricity-cost side of the equation. We used $40 as our example for the United States. The U.S. is actually in the middle of the pack in terms of electricity costs; many countries are much lower.

Twelve of Europe’s biggest utilities companies had to reduce the value of their assets by over 30 billion Euros in 2015. Worldwide, energy and electricity prices are getting cheaper and cheaper, for a variety of reasons.

But, all in all, even if electricity costs come in at a fair amount more than $40 a month, it doesn’t move the equation much. And with solar panels, wind, and battery storage technologies being rolled out by none other than Elon Musk—along with other sustainable technologies—I would expect electricity prices to stay where they are, or, more likely, go down.

Another consideration: With much cheaper energy costs for the Tesla, people will drive more than they currently do—further increasing the savings. Many family plane trips, for example, will be out the window due to the reduced costs of driving and to the fact that roads trips will be a much more appealing option when the car drives itself. High-mileage users like cab and Uber drivers, heavy business travelers, delivery people, and others will have an even higher impetus to buy the cars.

And we haven’t even mentioned the potential reduction in insurance costs. Tesla already has the highest safety ranking of any car ever tested, and Autopilot is only in its infancy. When features such as auto warnings, auto stop, and smart re-routing become even more refined, there will certainly be a continued reduction in accidents for Teslas, which will bring the cost of insurance down.

But not to lose the forest for the trees, even when looked at from a worst-case perspective—zero gas savings—the Model 3, and all the other Tesla cars, will be dominant vehicles due to their coolness, reliability, speed, technology, and overall performance.

Throw in the gas savings and there should be smoke coming out of your ears.

Presales Going Wild

Now you can see why Tesla Model 3—even before all the features of the car have been revealed (Elon likes to under-promise and surprise)—is getting so many pre-orders, at $1000 each. Tesla has taken in about 400,000 orders and counting, to the tune of $400 million.

And I think Tesla and Elon Musk are still underestimating the potential. The staggering pre-sales of the Tesla Model 3 electric car seem to have caught everyone by surprise, including Musk himself.

This leads us to the topic of growth, and that is what really turns into profit. It’s one thing to have a great new concept or product—but when that concept or product is in an industry that has a huge market (understatement), then all this enthusiasm is warranted.

Growth Potential

We’ve talked about all the benefits of electric cars, and Teslas in particular. The question then becomes, “How big is the car market and how much of it can turn electric?”

First, some perspective on size. There are over one billion cars on the road today, and last year about 72 million cars were sold worldwide. In the United States alone last year, the value of new cars sold was greater than the value of all housing sold. This is an industry with trillions of dollars in annual revenue that employs over 240,000 workers in the U.S. alone.

In terms of how big the electric car market, as a percentage, can get, let’s look at some countries’ penetration rates. Norway currently has the highest, with 18.5% of all new car registrations during the second quarter of last year being EVs, according to data from research firm IHS. Hong Kong’s penetration was 5.6% for that period, according to Charged Hong Kong’s data, putting that city in a tie for second-highest with the Netherlands.

As the case of Norway shows, penetration can change quickly. The above shows just q2 of 2015. By December, the rate had reached 22.4%, way up from 13.8% in 2014. The highest-ever monthly market share for EVs occurred in the March 2016 period—with a whopping with one in three passenger cars registered in Norway being a plug-in electric car (33.5%). As you can see, this is an incredibly fast-growing market as governments get behind EVs and the cars improve. It’s also a market whose growth will accelerate rapidly as the number of charging stations multiplies, mileage ranges increase, and people see their neighbors and family members going electric.

Tesla is the number one seller of electric cars in Norway. In fact, as of December, 2015, Tesla was the best-selling car overall in Norway. And that is with a $100,000 vehicle. A $100,000 car is much different from a $35,000 car (not to mention the addition of the high-end Model X now as well).

And the market is growing tremendously fast, right now. Not just in Norway, but all around the world.

All of this growth has been occurring without the availability, affordability, or deep consumer knowledge of the Tesla automobile—it’s a new car, priced very high in its current version, and on back order around the world. And again, all of this growth is before the $35,000 Tesla Model 3 has even been introduced to the market. Imagine how the market will grow with the right car at the right price, more charging stations, government backing, etc.

How much of the car market is Tesla eventually going after? After Model 3, Tesla is already planning on making an even more affordable car. Elon Musk: “I’m super excited about being able to produce a car that most people can afford. And there will be future cars that are even more affordable down the road. But with something like the Model 3, it’s designed such that roughly half of people will be able to afford the car. Then, with fourth generation and smaller cars and whatnot, we’ll ultimately be in the position where everyone will be able to afford the car” (source: WealthDaily, April 27, 2016).

Tesla doesn’t need to accomplish this goal in order to be wildly successful, but if it does, that’s all the more gravy.

What’s important to realize is that Musk is going for the whole kit and kaboodle. And I, for one, don’t question his ability to achieve it.

In January, he announced plans for “at least a few million [cars] a year” by 2025. But I think he underestimates the demand. Analysts predicted approximately 20,000 to 100,000 Model 3s to be ordered in the first year. But even with a $1,000 down payment just to order the car, and one-year expected wait times, Tesla surpassed that number in 24 hours. Even Musk seems to be shocked. He openly admitted that the blockbuster reservation numbers will require a change of plans: “Definitely going to need to rethink production planning.”

With 72 million cars being bought per year worldwide, I wouldn’t be surprised if the number of Tesla pre-orders hits well above 1 million even before the car is released. And remember, most of the world’s population is not even aware of this car yet. This is not a situation where demand will wane. In fact, my bet is that the car’s momentum will continue to build well after the initial excitement wears off. This is a pretty safe bet, given all the premises I’ve been outlining.

My “home research” bears out my optimism, at least anecdotally. On a test basis, I have spoken to four people about the Model 3 and all of them have either put in an order or say they will. (One was an Uber driver, one was a friend, one was a valet parking guy, and one was a guy who came to upgrade the gas meter at my house.) When people learn about the car, they want it.

Here’s one more point: In 2015, Jefferies conducted a survey of Model S owners and discovered that nearly 70% had previously owned a car that cost less than $60,000 (Business Insider). Tesla is not only moving people up, it’s moving them up by leaps and bounds. So if lower end consumers are willing to make the leap to the $80,000 range just to get a Model S, imagine what their enthusiasm will be for getting a Tesla for the same price as mid-range cars. Ludicrous.

In 2012, Musk agreed to what seemed to be almost impossible milestones… for others. Although he was given until 2022 to meet the goals, he’s hit half of them in only three years. His top goal is $43.2 billion in market cap. That makes him highly optimistic. But I would be even more so if I were him, now that I have studied the whole situation.

And Now, Let’s Hear from the Other Side

As you know, at Prime we’re all about finding the widest moat that will not only give us tremendous upside, but will also help limit our downside. That’s the essence of true value investing. It’s not a question of whether a company will be successful over the next year or so; it’s question of whether it has a substantial enough moat to outperform over the next five to ten-plus years, and in a big way.

So let’s take our analysis further to see what else sets Tesla apart from existing and future competitors. To do that we need to look, respectfully, at the concerns and opinions of our peers who might prefer to short Tesla. We want to know what everybody is thinking, because the more points of view we consider, the higher our chances of nailing the right valuation for the company—which leads to exceptional returns as well as the ability to get in at the right time, get out at the right time, and modify the position properly; a formula that has consistently set Prime apart.

This is usually one of the most interesting parts of any analysis—weighing the other points of view and dissecting them for contradictions or missed premises. As we have noted in past annual reports, reality will prevail in the end. And whoever gets the analysis more correct will make the most money. It’s that simple. Nothing emotional about it.

So… What is standing in Tesla’s way? What are people worried about? What do the naysayers say?

Let’s start by going back to the beginning, when we were receiving a lot of resistance to our pro- Tesla stance. We’ll look at some of the major concerns we were hearing when we first bought in, then we’ll look at some of the concerns we’re hearing today.

What They Were Saying Back Then

Here are some of the main arguments we heard against Tesla a few years ago…

“States are opposing the sale of Teslas.”

There was a lot of talk about how Tesla had an uphill battle because many states were considering banning their sales. And several states, including Colorado, Virginia, Arizona, Texas, and New Jersey, did in fact jump on that bandwagon. Most of the opposition to Tesla came from traditional car dealerships. These folks liked their cushy, protected business model and didn’t welcome the fact that Tesla was selling its cars through Tesla-owned dealerships and directly to the consumer.

Our View: Almost nothing can stop “an idea whose time has come,” and Tesla’s success is not dependent on any one state.

A. Politicians are politicians, and they want to be on the winning side with consumers. Elected officials may miss the boat for a short period of time, failing to understand the power of a movement, but they quickly learn the truth and change their positions. That is exactly what happened to the few legislators who got swayed by the lobbyists and tried to oppose Tesla sales. They got a mouthful, an earful, and an eyeful from their constituents. And they just as quickly changed their stance.

B. It didn’t really matter if states did oppose. Tesla was, and is, oversubscribed. No single state can stop its progress. If anything, the opposition only makes the car seem more enticing to many. Consumers in the states that initially tried banning the car could easily have a Tesla shipped directly to them, or buy one out of state and drive it home. When it comes to making a purchase of this magnitude, people are willing to be inconvenienced.

“Tesla has underbody problems.”

Starting in the second half of 2013, there were a few well-publicized fires in Tesla vehicles. These occurred when the cars struck a hard piece of debris on the road, which pierced the underbody and caused the battery to ignite.

Our View: If Tesla could build the best, most technologically advanced car, it could surely fix the underbody issue, which was relatively simple. Teslas are still safer than gas cars. And the underbody issue has, in fact, been resolved.

A. Most people don’t know this, but Tesla’s underbody problem was a result of a conflict between Tesla and Toyota engineers. The conflict originated when the two companies still had a partnership, before Toyota decided to sell out of its shares and pursue hydrogen fuel cell cars instead (a whimsical idea, for many reasons, including the fact that there are only twelve hydrogen fuel stations in the United States… but I digress). The Toyota engineers, when they were working with Tesla, argued that the underbody of the car needed no protection layer and that to install one would just add extra weight. The Tesla engineers, and Elon Musk, argued that the underbody should have protection, and strong protection. So they had to compromise. They added a plate, but it was thin. Well, guess what? Thin didn’t work. Tesla was right.Even with the underbody problem, Teslas were safer than gas cars. As Elon Musk correctly pointed out on Tesla’s website, “The odds of fire in a Model S, at roughly 1 in 8,000 vehicles, are five times lower than those of an average gasoline car and, when a fire does occur, the actual combustion potential is comparatively small.”

B. Tesla quickly fixed the problem. Tesla provided an over-the-air software update that increased the vehicle’s ground clearance at highway speeds. It then added a titanium plate and aluminum shields to its new models and promised to retrofit old models for free. There are now videos online of solid concrete blocks being crushed beneath Teslas. Problem solved. Better still, the world saw the willingness and ability of Tesla to make the world’s safest car even safer. (As a side note, I did sell off more than half of my Tesla shares after the third fire or so—because I could. Even though I knew Tesla would fix the issue, I thought another fire could easily happen over the next month or two and there might be some panic- selling on Wall Street. So I got out for a short while, then got back in again. As a result, we didn’t miss the upside—December was a great month for Tesla—but we protected our investors in the event that the problem took a little longer to fix.)

“There isn’t enough demand.”

There was a perception that, although most people thought electric cars were a good idea, the public wasn’t ready to adopt them on a wide-scale basis yet, due to performance issues and lack of “sex appeal.” Driving an electric car seemed like a sacrifice, kind of like installing a waterless toilet.

Our View: Demand is brisk and growing fast. If you can get a high-performing vehicle with tons of extremely cool extras, including Autopilot and a space-age dashboard, who in the world would not want an electric car? Especially when that price point comes down dramatically, as it will with the Model 3. ‘Nough said.

“There aren’t enough charging stations.”

Naysayers claimed the charging infrastructure wasn’t in place yet for electric cars to really take off as a viable alternative to gas engines.

Our View: Not a problem for most consumers, and the number of charging stations is rapidly increasing.

A. Unlike with gas cars, every house is a fueling station. The main charging of electric vehicles takes place at home. Early on, Tesla required inspection of homes’ 240-volt outlets, but soon realized there was no need for this. Homeowners proved more than eager to get their outlets upgraded on their own. For most people’s driving patterns, home charging is enough; they use an external station only occasionally, if at all.

B. Tesla has installed its own charging stations all over the United States and the rest of the world in major markets—and is planning to double the number over the next year. Charging stations, in my view—especially with other vendors coming online to sell this service—will not be a problem. Also note: AAA roadside assistance now comes with a battery charger for electric cars, giving you approximately 50 miles on half an hour of charging. Expect the speed and volume of charging services to increase rapidly over time, as consumer demand increases and technologies rapidly improve.

“Tesla won’t be able to overcome consumers’ ‘range anxiety.’”

One of the major negative perceptions about electric cars was that their range, on a single charge, was too limited.

Our View: The issue has largely been resolved.

A. The per-charge range of a Tesla, even in its early iteration (230 or 265 miles, depending on choice of battery), is more than sufficient for most drivers. Only 600,000 Americans are classified as “mega-commuters” who travel at least 50 miles to get to the office. That means 99.5% of all drivers have a commute of less than 50 miles. Even for most mega-commuters, the range of a Tesla should easily cover a back-and-forth commute (recharging at the office is also a growing option). The percentage of the population that regularly requires a longer range than Tesla now offers is so small that it won’t really reduce the market. The range anxiety problem, compared to what it was at Tesla’s inception, is almost non-existent.

B. Teslas are rapidly increasing in range. In April of 2016, the EPA announced that the new Model S 90D was capable of getting 302 miles on a charge, a new record for EVs. Factoring in the upgrade, Teslas can now go as far on a charge as many gas cars can go on a full tank. Musk recently announced that he estimates Tesla will be offering a 600-mile range by 2017, and sees a 745-mile range following not long after.

As you can see, we have come a long way from where we were three years ago. Now that these major hurdles have been overcome to most people’s satisfaction, Tesla has been established as a reputable, tier 1 competitor in the car industry with full legitimacy. This was quite a speed bump to get over. And remember, the fact that there were perceived hurdles to overcome was what allowed us to take advantage of the $4 billion market cap and enjoy its sevenfold increase to today.

What They Are Saying Now

But before we round out our argument about Tesla’s worth, let’s look at some of the arguments we’re hearing today. Tesla remains controversial. But most of today’s arguments have shifted from whether Tesla will become successful to how successful it can become. People in general are no longer worried about the viability of Tesla; the new million-dollar question is what Tesla will be worth in the future.

“Automakers entering the EV market will eat into Tesla’s market share.”

The biggest argument against Tesla has become this: Now that electric cars are proliferating, and are a proven concept, every car company is going to jump into the race and will knock down Tesla’s profit margin, replicate its technology, and eat into its market share, or at least cap its value where it is today.

Our View:

 A. We think competition is actually good for Tesla. And so does Elon Musk. In short, he wants it. “I encourage more participation by whoever it is to create electric vehicles,” Musk said in an interview earlier this year.

He has put his money where his mouth is, in grand fashion. While Apple, Samsung, and other technology companies are spending hundreds of millions of dollars on seemingly insignificant patents, Elon Musk has given Tesla’s patents away. For free. On June 13, 2014, Seeker.com reported, “Electric carmaker Tesla announced it was giving up its patents to ‘the open source movement,’ to help spur electric vehicle technology. The unusual move comes with Tesla enjoying huge success, but against a backdrop of multiplying legal squabbles among technology firms over patents.”

Musk deflected the shock and praise resulting from his action, saying, “What we are doing is a modest thing. You want to be innovating so fast that you invalidate your prior patents, in terms of what really matters. It’s the velocity of innovation that matters.”

The reason Elon gave up the patents before the rollout of the Model 3 was twofold:

• I believe he really does want to help the planet. He has said, “I don’t think people quite appreciate the gravity of what is going on [with regard to global warming] or just how much inertia the climate has.”
• To help the EV industry, and therefore his business, This is smart thinking, in my opinion. By sharing Tesla’s patents:
• More people will use electric cars, thus fully retiring the old stigma of electric cars as being slow, impractical, and dorky.
• The industry will increase the availability of recharging stations and share the cost of building them by creating a common infrastructure.
• Tesla can create appetite for, and help the growth of, its own battery-producing Gigafactory, which will sell batteries to other car manufacturers as well.

“Competitors will replicate Tesla’s technology.”

Our View: What people don’t realize is that it is MUCH more difficult for other companies to replicate what Tesla is doing than anyone imagines. It’s hard for old-school car companies, because they have an uncomfortable relationship with high technology, and it’s also hard for tech companies, because they don’t understand the auto industry very well. From the outset, Tesla has had one foot firmly planted in each industry, giving it a double moat. Tesla is both a large-scale car manufacturer and a leading tech company. It has already married these difficult-to-reconcile components.

There are a number of reasons why existing companies can’t copy Tesla, which we’ll explore one by one.

A. Car companies can’t keep up with the rate of technology Car companies are now truly tech companies, whether they recognize it or not. One of the major problems in the auto industry is the rate of speed at which technologies can change. Traditionally, an average redesign cycle for vehicles has been about three to five years, while a tech company updates its systems multiple times over the course of a single year. Now we’re now looking at a major turn cycle every two years for automobiles. If things were static, it would be easy to catch up—but the pace of innovation coming out of Tesla continues to increase at a faster and faster rate.

B. Even after decades of being in business, the differences between car companies are still huge—showing it’s not easy to catch up, or even to replicate Even without advanced computer technologies, Japanese and German manufacturers have been soundly beating American car companies in the quality game for decades. American car companies could not even figure out how to competitively build vehicles whose basic designs have been around for years. U.S. product quality was consistently—I hate to say it, but it’s an obvious fact—inferior as compared to that of Germany and Japan.

Over the past six years, annual report cards from Consumer Reports indicate that domestic automakers are sitting among the bottom of the pack in terms of reliability and satisfaction ratings. Out of a score of 100, Ford ranks the highest, with an unimpressive average score of 63.1 over that time period, with GM averaging 56.1 and Chrysler averaging an abysmal 48.

As a new entrant in the field, Tesla has the advantage of starting fresh with consumers. And its customer satisfaction ratings, as we reported earlier, are in the stratosphere for both product and service.

C. Legends in the business still have manufacturing/quality problems. In the U.S., which has traditionally had the most advanced technology, car makers are still struggling to mass-produce great cars. You can see that in the overall satisfaction scores above, as well as in the number of recalls that are still occurring today for a variety of Many of these manufacturers aren’t faring well in Consumer Reports, with the percentage of recommended vehicles from each company often dipping below 50%.

Recalls are proving to be a thorny issue and are showing that U.S. car manufacturers are having a challenge even getting their existing technology right. Automakers recalled a record

51.26 million vehicles in the U.S. in 2015. That total topped the 50.99 million vehicles recalled in 2014. And in case you thought this was only a recent blip on the radar, you can see that recalls have been increasing over the past several decades…

I don’t point this out to bash anyone—running a successful car company is exceedingly difficult—but to show that the premises analysts are using to steer investors away from Tesla are flawed.

D. Technology problems are on the increase for car companies. Other car companies can’t even get the dashboard right, forget about making cutting-edge technology that all works together seamlessly as in the Tesla—even though Tesla has had far fewer years to get it

Dashboard Woes

The dashboard is the brains of a car’s operations. New Age cars simply cannot function properly and elegantly without a solid dashboard managing all of the technology. The dashboard is vital for safety, for customer satisfaction, and for providing a gateway to futuristic features such as driverless technologies.

A dashboard would seem to be a pretty easy thing to nail

down, but that has not proven to be the case for the traditional car-makers. Car companies have been trying to get their dashboards right since before Tesla was founded, and they are still struggling mightily today—while Tesla has driven circles around them. For example, all Tesla screens can be reconfigured by touch, drag, and drop. That technology is not even available on many computers yet.

Technology problems in general continue to plague the industry…

Bad Tech Erodes Consumer Confidence

A February 24, 2016 press release from J.D. Power states, “Problems with technology continue to cause declines in owner satisfaction with long-term vehicle dependability, according to the J.D. Power 2016 U.S. Vehicle Dependability Study^SM (VDS). The study shows that problems with vehicle audio, communication, entertainment, and navigation (ACEN) systems now account for 20% of all customer-reported problems. Furthermore, ACEN is now the most problematic area on most vehicles, and is the apparent cause of a 3% year-over-year decline in customer satisfaction with vehicle dependability.

“The decline in reliability coupled with a record number of vehicle recalls and safety-related complaints affect consumer confidence,” said Renee Stephens, a J.D. Power executive.

Hence, the 400,000 pre-orders of Tesla’s Model 3 as opposed to the 20,000 first-year annual sales expected for the GM Volt. Buyers are not stupid.

Again, U.S. car companies have been scrambling for decades to remain competitive. And that is with relatively simple, stable technology. The new tech is a faster moving target than ever before because, for one reason, Tesla is constantly doing over-the-air updates to its software. Consumers go to sleep at night with one technology and literally wake up in the morning with a better one.

Connectivity Issues

Integrating consumer-end technology in cars is a continuing problem for car companies. J.D. Power’s June 2015 survey of new car buyers found the greatest complaints involved vehicle connectivity systems. Voice recognition and Bluetooth integration were top concerns.

The trailblazer in this endeavor was Alan Mulally of Ford, who bravely sought to transform the industry even before Tesla started. “When Alan Mulally unveiled the Ford Sync infotainment system nearly eight years ago,” says an article in Advertising Age (December 16, 2014), “no other automaker had anything like it. And no one had ever heard of an iPhone.

“But Mr. Mulally’s push to put Ford Motor Co. on the leading edge of in-car technology later backfired with a glitchy, confusing upgrade to Sync known as MyFord Touch, and now Ford is toning down that aspiration as it works to undo the damage.”

Consumer Reports memorably declared in 2012 that the MyFord Touch system “stinks.”

Now, in 2016, Ford is burying the MyFord Touch name and is being forced to partner with outside vendors. The end result will not be the sort of revolutionary and differentiated technology Mulally sought to make Ford stand out from the crowd.

And it’s not just Ford. Consumer Reports and J.D. Power report the majority of automakers’ systems are deterring and frustrating customers. Meanwhile, 60% of Chinese consumers report that they will buy a different car just for connectivity and tech-automation reasons.

What to do?

Car companies certainly did not want to give up control of the biggest differentiator of their brand, but now they are throwing their hands up and relying on tech companies for leadership and guidance. Their last and best hopes may be Apple’s CarPlay and Android Auto, which have only recently been installed by auto makers.

Which brings us to our next point.

“Car companies will join forces with tech companies to compete.”

If the car companies can’t compete with Tesla on their own, they will join with tech companies to do so. And in doing so they will beat Tesla.

Our View: Again, easier said than done.

A. Tech and auto companies do not partner As we saw in the case of Tesla and Toyota fighting over the underbody, trying to “share” the build-out of an electric car is inefficient and uncomfortable… to say the least. These days it is hard enough to get one company going in the right direction, but to try to do that with two or more companies, each with its own technology, biases, and approach to integration, is like trying to train a cat and a dog to be doubles partners in tennis. The issues are compounded when the companies are from two different industries.

Recently, Ford’s Executive VP of Global Marketing, Sales, and Service said of these new partnerships, “There are significant challenges that remain. And probably the most important one is the ability for the car industry to work with and partner with non-car industry software companies to really build their capabilities on the vehicle itself.”

B. Tesla’s driverless technology is miles ahead of the competition. Problems with driverless integration are similar to those with dashboard technology—but on steroids. Driverless functioning needs to be a seamlessly integrated technology that encompasses all parts of the car, from the sound system to the engine to the suspension to the braking system to the For the same reasons automakers failed with the dashboard, they will likely fail even harder with the autopilot.

Let’s see what is already happening.

Recently Car and Driver tested the world’s top four semi-autonomous cars—Nissan‘s 2015 Infiniti Q50S, Daimler‘s 2015 Mercedes-Benz S65 AMG, BMW‘s 2016 750i xDrive, and Tesla‘s 2015 Model S P85D—to see which one had the best hands-free driving.

“Our main focus,” according to Car and Driver, “was automatic lane keeping: how well these four early semi-autonomous cars guide you safely and securely while relying on their electronic wits instead of the driver’s hands, eyes, and judgment.

“The route was a 50-mile stretch of Michigan roads including 30 miles of freeway driving, and the other 20 miles were allotted to rural and city driving. Michigan roads in particular ‘present a daunting challenge to hands-free driving because of their abysmal repair standards.’”

The Winner

“Tesla’s Model S was the stand-out winner among the four vehicles tested,” Car and Driver

reported. The magazine had plenty of praise for the vehicle’s Autopilot system: “The Tesla’s Autosteer performance can be distinguished from our other contenders …this car identifies the exact center of your lane of travel and holds that course with minimal deviation. This system rises well above parlor-trick status to beg your use in daily driving.

“Also to Tesla’s credit, this is the only car capable of hands-free lane changes. You simply use the turn signal the normal way and the Model S glides smoothly into the next lane after verifying that there’s space to do so safely.”

Bottom line, after all its testing, Car and Driver concluded that Tesla’s Model S Autopilot technology “lives in a class of one.” And the software was only four months old at the time.

C. Tesla has a distinct advantage in the driverless arena: experience and data. Every day, the fleet of Model S and X Teslas is driving more than three million miles. That means that in just one day, Tesla’s cars travel about twice the distance Google’s cars have traveled in the entire history of their self-driving car Tesla is gleaning vastly more data than its competitors in the race for the true self-driving car. Each day that data pool increases with the number of Teslas hitting the road. With the Model 3, and the continued growth of S and X, it’s hard to imagine how others (such as Apple and Google) will catch up.

This growing body of experience and data not only helps with Tesla’s internal R&D, it also gives the company a competitive advantage with regulators and governments. In order for regulators to be comfortable approving a fully autonomous car, they’re going to want to see a vast amount of data, maybe billions of miles’ worth. They’ll want to view this data in a wide range of circumstances, in many countries all around the world, with varying rules of the road, and varying types of behavior from drivers and pedestrians.

“Technical issues and delayed development/release times show Tesla is biting off more than it can chew.”

Tesla is already getting slammed in the press for technical glitches, and its Model 3 is going to take much longer than anticipated to work out the kinks and go into mass-production on a wide scale.

Our View: Yes, Tesla has had a few problems, but they are minuscule when viewed against the company’s ambitious design goals and phenomenal successes. If it takes some extra time for the company to get fully ramped up to its ambitious plans regarding the Model 3, that’s a minor speed bump relative to the company’s growth potential.

A. Tesla has shown it can solve its problems. What’s important is not that Tesla has had some problems—those are inevitable, especially when your design and technology goals are so far ahead of the curve—but that it has had fewer of them as time goes on, has solved them efficiently, and has learned from them.

The vertically lifting falcon-wing doors of the Model X are a good example of this. Tesla had to sue the German auto-parts maker, Hoerbiger, for allegedly misrepresenting its ability to design the complicated part and for failing to live up to the product specifications. But Musk has learned his lessons from previous production cycles. He is simplifying the componentry for the Model 3 and adding further vertical integration…

B. Vertical integration of parts further separates Tesla from the competition. Musk has developed the ability to manufacture most of the needed parts within his own factory. He knows that out of the thousands of parts needed to build a car, if even one or two are missing, the car cannot be completed. “It’s very important for us to have the ability to produce almost any part on the car at will because it alleviates risk with suppliers,” he says. This added capability will speed up delivery times for an aggressive ramp-up.

C. Suppliers are now scrambling to work with Tesla. At first, many manufacturers did not believe Tesla’s numbers, in terms of how many parts it said it wanted, and couldn’t meet the expectations fast enough when Tesla turned out to be Now, parts manufacturers can see that Tesla is a big, legitimate company with hundreds of thousands of cars on order. And they want to be the suppliers.

But even if, in a worst-case scenario, the Model 3 takes an extra year to build, that is no big deal in the grand scheme of things. For the record, though, I think Musk has learned so much that his cars will actually be delivered ahead of time, and at an accelerating pace going forward. He’s achieved the crazy feat of building the best luxury car in the world—in electric format, no less, and with driverless technology. Therefore, common sense says he will be able to figure out how to ramp up production of a car he’s already producing. Let’s not forget that in the last quarter of 2015, 17,400 Teslas were put into consumers’ hands. And once you build one beautifully functioning car and are able to deliver it—overcoming thousands of obstacles in the process—then ramping up becomes a relatively easy problem to solve.

“The end of electric car subsidies will cause Tesla to lose its edge.”

In the U.S. the current electric car subsidies from the government will expire six months after Tesla reaches the 200,000-car mark. In many people’s minds, this will eliminate one of the company’s main competitive advantages, especially against gas-powered vehicles.

Our View: The subsidies don’t matter as much as people think they do, and by the time they expire, Tesla’s momentum will be strong enough to easily compensate for their absence.

A. The car is so far above and beyond other cars, it doesn’t even need subsidies in order to Tesla is the best car around, by objective, third-party standards. It is already competing with the best combustion cars money can buy—and beating them hands down. Remember that this is the first non-gas-powered car to win the coveted Car of the Year award from Car and Driver, along with a trunk-load of other awards.

B. The gas savings alone on the Model 3 will be almost equivalent to the lease payments of the car, as discussed above. You are getting the car almost for free, even without the subsidies factored The subsidies are nice, but non-essential for competitive purposes.

C. California and many other states have additional subsidies. California’s is $2,500. Then there are other “zero-emission vehicle” (ZEV) credits. ZEV credits are a mandate dreamed up by the California Air Resources Board (CARB), which requires the manufacturing and sale of a certain number of “zero emission” cars per Tesla’s Model S generates four credits per unit sold. To make a long story short, this means the company can sell $20,000 in ZEV credits to other manufacturers for each Model S sold—a cost borne by purchasers of other cars.

D. Remember that gas-powered cars are currently “subsidized.” As Elon Musk has tweeted, “all gasoline cars are heavily subsidized via oil company tax credits and unpaid public health costs.” As EVs continue to become more prevalent and environmental concerns continue to grow, the momentum for combustion cars will die down and regulators will be pressured to tack even stiffer penalties onto the pollution causers than they have in the past.

E. Now, let’s look at those EV subsidies themselves. First of all, in the U.S, the current subsidy doesn’t stop until two full quarters after Tesla hits the 200,000-car By the time Elon Musk reaches 200,000 cars, his production machine will be humming—and in the following six months he can and will produce a large number of cars that will still qualify for the full subsidy. And, as he has calmly suggested in a tweet, he plans to maximize that opportunity by perhaps not selling his 200,000th car until he can ramp up to take full advantage of the six-month grace period.

Secondly, even after the first six-month period, the federal subsidy only drops by half for another six months…then by another half for the next six months, before reaching zero. All in all, it adds up to 18 months of continued subsidies after selling the 200,000th car. So, there is plenty of time for Tesla to fully milk the subsidy. And that assumes the subsidy actually will expire. Remember, Congress is known for extending popular legislation.

The wave of environmental legislation is getting stronger, especially in other countries. So if and when the U.S. subsidies run out, other countries will be there to pick up the slack. Even Germany, the kingpin of the combustion car industry (Mercedes, BMW, Volkswagen, Porsche, Audi, etc.) is talking about providing a subsidy for electric cars—to improve the air and to make sure that their stalwart combustion-carmakers get a kick in the pants to help them compete with Tesla. So, if U.S. subsidies wane, much of the world, including even Germany now, is seeing the light and will provide new ones.

In other words, I wouldn’t worry about subsidies being needed for Tesla to compete with combustion engine cars. Subsidies are great, and they helped Tesla get through its incubation phase, but in the end they’re just a small piece of a much bigger puzzle.

Management and Cash Further Separate Tesla from the Pack

Management

Tesla’s biggest differentiator, I would argue, boils down to one thing—management. This is true for all great companies. What we at Prime look for is a great product in a great and growing industry— but it absolutely must be run by great management. Most of the investments that have paid off handsomely for us in the past have hit this kind of trifecta.

The premise that other manufacturers will catch up to Tesla in swift order is flawed because it doesn’t take into consideration the quality of Tesla management. Elon Musk is one of those exceptional visionaries who also has keen real-world know-how. Although conventional wisdom might suggest that competitive edges crumble over time, history tells us that when you have truly exceptional thinkers at the helm, the schism between their companies and others can actually increase over time… as long as the luminary remains in place. Look at Larry Page of Google, Steve Jobs, Jeff Bezos, Bill Gates, Howard Schultz…

Elon Musk is a truly exceptional person with a proven history. He founded two successful Internet companies during the dotcom era (the latter of which, PayPal, sold to eBay for $1.5 billion). And now he has become one of the most successful startup founders of the past two decades. In addition to his work with Tesla, he is the chairman of SolarCity and chief executive of SpaceX.

At only 44-years old, Musk has built an astonishing business empire; the three companies he leads are worth almost $50 billion combined.

Elon was able to buck the odds and not only build a good electric car, but one of the best cars on the road. On top of that, he has built the best auto parts technology—a feat completely independent of his car-design success.

But he’s also a hands-on director. Musk gets involved in everything. In addition to serving as CEO, Musk was Tesla’s product architect. He moved the company’s design studio to Los Angeles and obsessed over small details like the Model S’s light switches and door handles, while two teams of engineers worked in shifts around the clock.

Musk’s conviction in Tesla is evidenced by the fact that he has been taking no salary as CEO (except the minimum wage for his company). He made $37,584 last year. Yes, you read that right. And that was only because he had to meet California minimum wage laws. And he has not accepted that salary for ten years. Rather, he has invested continual sweat equity in the success of the company. Show me another car CEO who has done that.

Though we are excited about the moat Musk has already built, we are even more excited about the moat he has yet to build. The evidence suggests that Elon is a guy who is just getting started and that what we have seen so far is probably just the tip of his iceberg. To have pulled off what he already has with Tesla—when everyone thought he was crazy at the start—is proof positive of the type of individual we are dealing with.

By contrast—not to put anyone down, but for analysis’ sake—look at most of his peers at the other car companies. Their accomplishments pale beside Elon’s. He built the most revolutionary car ever. And did it at such a high quality level it was named Car of the Century. He built the best driverless technology on the market, and did it in a stealthy way that shocked the industry. He rose to the top of the high-end car market immediately, and is now proceeding to demolish the middle market. And he is already planning a $20,000 electric vehicle. At about half the cost of the existing Model 3, every driver will actually get paid to drive this car, when gas savings are factored in. And again I expect it will be the best car for the money. After all, Musk thought of, and built, a state-of-the-art Gigafactory in short order. And it’s already producing product. He’s even looking toward electric airplanes next.

Management’s vision is often the most underrated aspect of any company by investors and analysts.

Cash

Emerging from the cost-cutting consciousness of its initial $3.5 billion in total market cap, Tesla now has a $32 billion market cap and can easily raise a few billion in cash—multiples of its original operating budget—without affecting current shareholder value much at all, thanks to the high valuations that Tesla shares are currently enjoying. With an influx of working capital, Elon will now be able to compete without a hand tied behind his back.

Two More Substantial “Edges”

Two additional factors that give Tesla a leg up on the competition:

Untapped Marketing Potential

We’ve looked at some of the concerns that swirled about Tesla when it was starting out and some of the concerns that surround it today. My bet is that just as the old concerns failed to hold water, so will the new ones. Not because I say so, but because of the facts I’ve been outlining.

All of these concerns, new and old, are really about one thing: Tesla’s ability to successfully compete, over the long run, in an industry dominated by giants with vastly more experience than Tesla. Here’s one final consideration that should help put what Tesla has been doing into perspective. Car manufacturers are the biggest advertisers in the world. Current global automakers are burning more than $8 billion per year in advertising.

Tesla spends only a tiny fraction of what the other automakers spend. For example, in 2014, GM spent $5.2 billion on marketing, while Tesla spent less than 1 percent of that: $48.9 million. And Tesla has not yet gotten into television advertising.

That’s right; Tesla has created its brand value without TV advertising. The market for its product has been created almost entirely by word of mouth and proven value. In the rest of the industry, brand loyalty is relatively low in spite of $8 billion in annual advertising. Tesla, on the other hand, spends very little on marketing and yet has enormous aspirational value, not only in the USA, Canada, and Europe, but even in countries like Thailand, Malaysia, South Africa, and India, where Tesla has not yet sold a single car. People across the globe are salivating to own the car.

Poised to Dominate the Mid-Priced Market

Tesla has already built a high-end car. Now it is poised to attack the lower end.

This high-end market Tesla has established gives it the credibility and brand appeal to go after the lower markets. Almost all other car companies that have gone into lower markets have created a new brand so as not to diminish their high-end brand. Tesla, on the other hand, is actually using the high-end brand to drive the lower end. This creates a huge trust buy-in for the lower end Tesla Model 3 and future Tesla cars that will get rolled out.

As with everything else, the proof is in the pudding. Let’s look at what Tesla is currently doing both on the low end and the high end.

The table below shows what the Tesla Model 3, after one week of selling reservations, was poised to do to the lower-end market and its effect on the high-end market (Mercedes, Porsche, BMW, etc.).

Sources: Car and Driver and Car.com

Quite stunning. And it’s just the beginning.

What about all the other great manufacturers? The Toyota Prius has been the only really viable, high-quality, electric-type car for many years now. It has had a huge head start and great success, and is manufactured by the leading car manufacturer in terms of current value. Yet it began losing huge market share to Tesla even before the roll out of the Model 3. Prius sales were down nearly 11% last year and the car sold only 184,794 units in the U.S. in 2015. Tesla’s vastly more expensive vehicles were a main culprit. And now look at those presales of the Model 3.

Last but Not Least, the Gigafactory

Adding to Tesla’s already huge competitive advantage is a monumental initiative we have only touched upon so far. That’s the Gigafactory. While the car industry is spending $8 billion dollars a year on advertising, Musk is using the bulk of his company’s money to help build Gigafactories.

What is the Gigafactory? It is an absolutely massive manufacturing plant designed to produce enough batteries to fuel Tesla’s goal of making 500,000 electric cars per year by 2020. It is also anticipated to lower the cost of auto batteries through economies of scale. “The biggest leverage we have in making electric vehicles more affordable for everyone is reducing battery cost,” says Tesla CTO JB Straubel. Dan Dolev, an analyst with Jefferies, recently predicted that the Gigafactory’s huge production capacity will help cut the cost of Tesla’s batteries in half.

Presently, batteries make up about a third of the cost of an electric car. As battery prices drop—due not only to the natural evolution of the product, but also to the Gigafactory and to other companies getting into the battery business—this will lower the cost of electric cars.

Just to give you a little scale perspective, Gigafactory will be the world’s second-largest building by usable space, and the world’s largest building by physical area. According to Tesla, the factory will be up to 10 million square feet and will employ 6,500 people.

And if size alone were not impressive enough, Tesla, once again, is out ahead of the curve by anticipating its own future needs. Tesla may expand and potentially double the size of Gigafactory 1. In June 2015, the company announced it had exercised its option to buy 1,864 acres of land adjacent to the original 1,000-acre site.

Gigafactory 1 is already producing Powerwall products (see below) in its completed section and plans to move into auto battery production by the end of 2016. According to an article on CNET.com, by the time the plant is fully up and running, it will be producing more lithium ion batteries per year than the rest of the world combined produced in 2013.

Gigafactory will also be supplying the EV industry as a whole with batteries. This will be good for the EV revolution, while creating a whole new profit center for Tesla. The company will be making money on its competitors’ cars as well as its own. A true win/win scenario.

And in case you’re concerned about whether there will be enough raw materials to produce all these car batteries, current estimates, show that, “Through 2030, battery packs will require less than 1 percent of the known reserves of lithium, nickel, manganese, and copper. They’ll require 4 percent of the world’s cobalt. After 2030, new battery chemistries will probably shift to other source materials, making packs lighter, smaller, and cheaper” (Bloomberg, February 25, 2016).

Gigafactory gives Tesla a massive competitive advantage just for its car business alone. But the true impact of the Gigafactory can be appreciated only when you frame it against Musk’s stated vision for the whole company: “The goal has not been: Let’s make cars. The goal has been: We need to accelerate the advent of sustainable energy.”

According to Tesla CTO Straubel, that’s why Musk is pitching and manufacturing home battery packs. “If we can create huge demand for batteries,” Straubel says, it will create “this virtuous cycle of reducing prices further.” Thus Tesla has started two lines of home energy storage products called Powerpacks and Powerwalls.

“The issue with existing [home] batteries,” says Musk, “is that they suck. They’re expensive. They’re unreliable. They’re stinky. Ugly. Bad in every way.” The idea is to pair the new Tesla products with solar panels—either on the rooftops of homes or in large-scale solar farms—allowing consumers to store energy during the day, when the sun is shining, and use it at night for free, instead of drawing energy from power plants that produce greenhouse gases.

How big is the market potential for this idea?

Musk thinks Powerpacks and similar products just might be the key to solving the problem of global warming. He uses Boulder, CO as an example, and explains that if that city, with a population 103,000, “bought a mere 10,000 Powerpacks and paired them with solar panels, it could eliminate its dependence on conventional power plants entirely.”

The U.S. could do the same with only 160 million units of the product. Then Musk offers even higher figures: “900 million Powerpacks, with solar panels,” he says, “would allow us to decommission all the world’s carbon-emitting power plants; 2 billion would wean the world off gasoline, heating oil, and cooking gas as well.”

The market in Unites States alone is potentially massive, but other countries—with their frighteningly high pollution levels and inadequate electrical infrastructure—have an even higher incentive to use the battery packs.

Musk is hell bent on making the Gigafactory a huge success. And if early indications are anything to consider, Tesla is well on its way. Case in point, Gigafactory is ahead of schedule in terms of its construction timeline. And Musk describes demand for his firm’s batteries as “crazy off-the-hook.” In fact, he is already realizing that one Gigafactory will not be enough to fuel burgeoning demand. “We’re going to need probably, like, ten or twenty of these things,” he says.

To my mind, the Gigafactory is a major indicator that Musk is not only able to think way outside the box, but is able to deliver on that vision here in the real world, and to do so efficiently. The fact that he is actually building the Gigafactory, and that it is ahead of schedule, may be the most amazing thing I’ve ever seen in business. (We can take this as evidence that he will be on track for car and battery production as well.) When was the last time you heard of any new and complicated project— not to mention something so physically huge—moving along ahead of schedule?

Tesla, the Investment

So why the heck did we do all of this analysis? Well, here is where the performance of the car and the company tie back to the performance of the investment—and to the performance of the investment manager you choose.

How does Tesla stand up as an investment in the long side of a portfolio?

I don’t see how you can come to any conclusion except that the potential growth of Tesla over the next one, three, five, and ten years—and perhaps beyond—is staggering. And remember: as an investor, you have to recognize potential before it is fulfilled. Wall Street has a herd mentality and only truly believes in an opportunity once its value has already been proven. A smart investor looks at what the evidence suggests is likely to happen in the years to come and invests accordingly.

Again, Toyota motors has a market cap of $200 billion—at 8.25x earnings. It is highly profitable and is netting $24 billion per year. And that’s just one company. Without a Gigafactory. That shows you the breadth and size of this industry.

Now you have Tesla, at only a $30 billion market cap, feasting on the competition. And its presales of the Model 3 suggest it has only been on the appetizer course. With its ultra-cool technology, environmental cachet, speed, safety, comfort, cost savings, and dominance in the driverless car revolution, there seems to be nothing stopping Tesla from taking over a huge chunk of this 70- million-car-per-year industry.

And remember… the billions of the cars on the road today get turned over every twenty years. Tesla can not only gain substantial market share, but can also increase the pace of the turnover in the industry through the aspirational value of its cars. When people see and drive this thing, believe me, they are going to want to turn in their clunky gas hogs sooner rather than later.

And all this can be done with much higher profit margins than previous automakers have enjoyed. Why? Because: 1) Tesla started later and has much lower legacy costs (pensions, etc.) than those of the fifty-plus-year-old companies. 2) Tesla is building from scratch so it can set up its operation much more efficiently than its competitors—look at its 500,000-car location in Fremont. 3) Building at such scale, with only three car models to worry about, gives Tesla an additional advantage in terms of efficiency and economies of scale.

And, of course, Tesla doesn’t need much of an advertising budget.

If you look at Tesla’s most recent quarterly financial statements, you’ll see that it makes a gross profit margin of 21.64 percent (source: Ycharts). That margin is already higher than GM’s, Ford’s, and Toyota’s (source: Ycharts).

Tesla just announced that it is moving its 500,000-car per year target up from 2020 to 2018. The new target for 2020? Closer to a cool 1 million.

And people are worried about what? The car not being produced fast enough? A few months of being up or down $500K? A small issue with the functioning of a new feature? Something tells me folks are just missing the mark on this opportunity… as often happens in the stock market.

Seeing Through the Negativity and Confusion

When it comes to stocks, I am highly skeptical, and that is a good trait for evaluating investments. But there comes a time when too much skepticism can cause you to miss out on a blazing opportunity that is right under your nose. When I first heard the ambitions Elon Musk had for Tesla, I, too, thought “I’ll believe it when I see it.” But now I do. See it, that is.

The important thing, from an investment perspective, is to be critical-minded but not to be swayed by unwarranted negativity. Don’t let minor hiccups such as a production glitch or a critical press review here and there sway you. The press likes to focus on problems and blow them out of proportion. If the Tesla’s satisfaction rate goes from 99% to 98%, you can bet you’ll see headlines like, “Number of Dissatisfied Tesla Owners Doubles.” But there’s no reason to panic if you have a clear view of the big picture.

When the story came out that Consumer Reports was retracting its recommendation of the Tesla after discovering some new issues through its customer surveys, TSLA’s shares got clobbered for a week. But those who reacted negatively missed the point, in my opinion. The survey was finding problems on advanced features that other car companies weren’t even trying yet. And remember, Tesla was a new car company, and it was showing that it could get its problems fixed.

The crucial point was that customer satisfaction for the brand remained just as high as it was before the magazine’s retraction. Consumer Reports admitted, “Despite the problems, our data show that Tesla owner satisfaction is still very high: Ninety-seven percent of owners said they would definitely buy their car again.” Shares of TSLA soon took off again.

So, What Is Tesla Worth?

All right, I think we have reached the point where we have asked, and answered, almost all of the questions I have heard raised about the Tesla. My analysis is now on the table. I hope it helps you understand how we view this company, but more importantly, I hope it helps you understand the thought process we use when analyzing investments in general.

So what do I think Tesla is worth?

For the sake of our current and future investors, I won’t answer that question directly. But I will tell you that I believe we are only seeing the tip of the Elon Musk iceberg. Given all the facts I’ve shared with you—and the unbelievably wide gap between Tesla’s current value and what I believe its true value to be—I’m not sure it really matters exactly how much I think it’s worth.

But I didn’t ask you to read these 30+ pages to leave you hanging on my valuation, so I will go far as to say that, in my opinion, even at a $100 billion market cap—over three times its current market cap—Tesla would still be a strong buy.

Is that an outrageous statement? Not at all. I believe it’s backed up by the facts and figures we’ve seen. How people are coming to different conclusions is beyond my ability to grasp.

But still, let’s temper this a little bit…

• Remember, Tesla is poised to win on so many fronts that we don’t have to be right about all of our predictions. Our margin of error is so wide you can sail the QE2 through it. This is exactly the kind of investment that has allowed us to perform as well as we have over the years.
• If we are wrong, and the situation on the ground starts shaping up differently from our analysis, in any major and unexpected way, then we will revise our position accordingly, just as we have done many times in the past and most recently with Chipotle (see above). Remember, the importance of this analysis was not to look at Tesla per se, but to show you our thought process in general. We believe we’ve proven ourselves capable of synthesizing what is happening to our investments in real time and make adjustments on the fly.

And please remember, Tesla is just one of our 25 long positions that we feel strongly about.