Tesla & Disruptive Innovation

A week ago, ARK Invest – the investment firm headed by longtime Tesla enthusiast Cathie Wood – published its revised share price target for the company for 2025. It expects Tesla shares to hit $3000 by 2025, raising its previous target of $1400 a share by 2024. That is almost four times the current share price. For a stock that was up 740% in 2020. Insane.

Tesla is, of course, ARK’s biggest holding across its funds, worth over $3.2 billion on paper. It is at the heart of ARK’s investment philosophy – disruptive innovation causes rapid cost declines, cuts across sectors, and breeds further innovation.

I won’t debate the merits of this price target or the assumptions of ARK’s model. Instead, I want to look at the idea of disruptive innovation, and try to understand where Tesla fits into this framework.

Understanding disruptive innovation

Clayton M. Christensen was the first to outline a strategic model on disruptive innovation in his book, The Innovator’s Dilemma. According to Christensen, most technological advances can be considered sustaining innovations, because they improve the performance of established products. Because the leading companies in a sector are so in tune with their customers’ needs, even the most radically difficult sustaining technologies have very rarely lead to the failure of market leaders.

Less often, however, disruptive technologies emerge and change the landscape. The resulting products generally have worse product performance initially and are seen as cheap substitutes or serve low-end customers that existing players do not. Eventually, however, as these technologies improve, these disruptors move upmarket and compete for the higher-end customers, while the current market leaders frantically try to catch up. More often than not though, it is too late and the incumbents firms lose their leadership role or fail entirely.

The whole idea rests on the notion that because successful organizations are extremely good at allocating capital to projects most likely to result in significant revenue growth and margin improvement, they often miss opportunities to enter nascent markets. Their existing customers may not need the new product and the addressable market may be difficult to define, so capital is allocated elsewhere.

So where does Tesla fit into this framework?

Elon Musk explains Tesla’s strategy best in a 2006 blog post:

The overarching purpose of Tesla Motors (and the reason I am funding the company) is to help expedite the move from a mine-and-burn hydrocarbon economy towards a solar electric economy… Critical to making that happen is an electric car without compromises, which is why the Tesla Roadster is designed to beat a gasoline sports car like a Porsche or Ferrari in a head to head showdown… The strategy of Tesla is to enter at the high end of the market, where customers are prepared to pay a premium, and then drive down market as fast as possible to higher unit volume and lower prices with each successive model.

By first displaying that electric vehicles could compete directly with traditional internal combustion engines at the highest levels of performance, Tesla and Musk entirely changed the narrative on electric vehicles and significantly sped up their adoption. In a sense, Tesla fits pretty well into Christensen’s framework. The company determined that a significant enough market existed for an electric sports car and succeeded in creating a cheaper alternative to a Ferrari and establishing itself in this segment.

The problem, however, is that by successfully targeting the high-end performance segment of the market, the Tesla brand has become synonymous with cool. Why is that a problem? Because it makes it more difficult to execute the rest of their plan to continue to move further down market and produce higher volumes.

Like with other consumer products, especially in the luxury segment, the Tesla brand has significant value. It symbolizes performance, technological prowess, environmental consciousness, and affluence. Even if you own the newest and cheapest Tesla Model 3, you are still part of a rather exclusive club and probably get looks as you drive down the road. What happens in a few years if Tesla succeeds at mass-producing its vehicles and selling a lot of them? Suddenly Tesla ownership becomes a lot less special.

At the same time, other automakers like Jaguar and Porsche have already come out with competing products in the luxury segment and more competition is coming. These companies are bringing exceptional production quality and established brand names to the table. Tesla may still have a clear head start in terms of battery technology, but the difference is narrowing rapidly and there is an upper limit to its improvement that makes a difference to consumers.

Ignoring the competitive landscape, the company still has other concerns to address. In order for the company to achieve profitability (its current profit figures are boosted by the sale of carbon credits, they sell their cars at a loss), they need to effectively scale production to bring down unit costs. At the same time, they need to maintain a level of production quality that justifies the price tag. Taken together, this represents significant execution risk.

Which is why it is more likely that Tesla will be disrupted from below. The most popular EV sold in Europe last year was the Renault Clio, a significantly cheaper alternative that caters to European demand for more compact cars. In China, the most popular EV is an order of magnitude cheaper than a Tesla and is essentially a glorified golf cart.

Admittedly, this is a very narrow way to look at Tesla. Proponents argue that the real disruption will come from self-driving technology, which will help the company achieve exit velocity.

I wouldn’t hold my breath.

Tesla has demonstrated that electric vehicles are a viable alternative. The company will likely survive and possibly even thrive. But it will never justify its current valuation, let alone a $3,000 share price in 2025.

Most people will never drive a Tesla, they will settle for something that is just good enough.