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March 15, 2015

How Volkswagen Thinks It Will Undercut Tesla On Battery Cost

THIS IS NOT AN OFFICIAL COMPANY NEWS RELEASE
- FOR THE INFORMATION OF SHAREHOLDERS AND INTERESTED PARTIES ONLY -

Summary
•Volkswagen believes it has reached parity with Tesla in terms of battery cost, and should do even better going forward.
•The company’s battery modules can contain cells from any battery cell maker, including LG, Samsung and Panasonic.
•These modules can also contain either flat/square cells, or cylindrical cells just like Tesla.
•The Tesla investment case seems to rest heavily on the belief that Tesla will have a battery cost advantage going forward.
Volkswagen is investing $107 billion in developing new models over the next five years, and the company says that electrification is its #1 technology priority.

Ever since Tesla’s (NASDAQ:TSLA) Model S successfully entered production in 2012, one of the central issues in the company’s investment story has been whether it can sustain a battery advantage over the competition. Volkswagen (OTCQX:VLKAY) invited me to a set of meetings to hear its side of the story, as told by the overall R&D boss, Heinz-Jakob Neusser, and Audi’s (OTCPK:AUDVF) R&D boss, Ulrich Hackenberg.

First of all, what do I mean by Tesla having had a battery advantage over the competition? It’s not in dispute in the industry that Tesla so far has productized an electric car with the highest amount of battery capacity per unit of weight, volume and dollar.

If Tesla can maintain this battery advantage as it moves to a lower-priced car 2017-2018 and beyond, ranging from $35,000 to $60,000, such an advantage could potentially overcome the company’s lack of scale in producing the rest of the car, and could therefore make Tesla into a far more relevant automaker than it is today.

In my conversations with Volkswagen’s management, I was struck by how much it seems to agree with Tesla and its CEO Elon Musk about the future of the electric car. For example:

•Volkswagen believes a shift to electric cars is the biggest paradigm shift in the automobile business over the next decade .

This is interesting, because it also acknowledges that in the near term, demand remains quite low. Volkswagen has not released total plug-in electric car sales numbers, but it’s not difficult to figure them out by using public records and the company’s own isolated statements.

Volkswagen’s production of one model alone, the eGolf, is now approximately 30,000 per year annualized. In addition to the eGolf, Volkswagen also offers the eUp and Golf GTE in some markets. Audi has the A3 eTron, and Porsche (OTCPK:POAHF) offers three models. Later this year, the VW Passat GTE and the Audi Q7 eTron enter production. Volkswagen is the middle of launching 40 plug-in electric models for the near term.

To support this massive investment program, the company is allocating a portion of its $107 billion investment budget over the next five years to various forms of electric cars. Coincidentally with the $107 billion of investments, Volkswagen operates 107 plants around the world, including 18 in China alone, where it sold 3.7 million cars in 2014.

•In terms of the battery technology debate, Volkswagen agrees with Tesla that the shape of the battery cells essentially doesn’t matter. The differentiation will be in other technology choices, such as chemistry, packaging, thermal management, software and so forth.

So far, from what I can gather from shareholders, the bull view of Tesla’s prospects seems to have rested on two broad assumptions about the relative battery choices:

•Tesla’s choice of purchasing cylindrical battery cells from Panasonic (OTCPK:PCRFY) is somehow, in and of itself, giving Tesla an advantage in terms of yielding more capacity per unit of weight, volume and dollar - even for the long term.
•Tesla’s competitors are somehow religiously opposed to cylindrical batteries, instead preferring flat/square battery cell formats.
Volkswagen denied that either of these two assumptions are true: The company agrees with Tesla that the format choice is essentially a wash, and it has been preparing to use cylindrical batteries side by side with flat/square batteries.

The other factor that Tesla’s bull case rests upon is the economics of scale from Tesla’s big building under construction in Nevada. In this building, it will cooperate with its anchor tenant, Panasonic, to further reduce the cost of producing batteries. How will Volkswagen meet the challenge of such a large industrial effort?

Volkswagen’s strategy to undercut Tesla on battery cost is this: It has standardized on a module size - think, a shoe box - into which battery vendors such as Panasonic, LG (OTC:LGEAF) and Samsung (OTC:SSNLF) can fit either flat/square battery cells or cylindrical ones such as the ones Tesla has been using.

This interchangeability, therefore, gives Volkswagen the ability to simply play out the battery vendors against each other without having to redesign the car’s hardware. On any given day, Samsung, LG and Panasonic will be willing to sell any of two standardized battery sizes (cylindrical and flat/square) for a different price. At this point, Volkswagen can effectively conduct a “reverse auction” among the suppliers, in order to secure the lowest price.

This kind of commoditization - not unlikely that we have a very liquid spot price for oil that’s traded - would be impossible if the parts weren’t interchangeable. Of course, you can always redesign the car based on a new battery, but that takes years and costs huge amounts of money.

Rather, Volkswagen will undercut Tesla on battery cost because it does not put everything on one card, by investing billions of dollars into its own factory whose product has to remain the most technologically competitive, as well as operate at the highest level of capacity utilization in order to be competitive. Volkswagen figures it can consistently pay a lower price per kWh by constantly playing all the battery vendors against each other: Let THEM (the battery cell vendors) make the investment in capex, while WE (Volkswagen) always get the lowest price, thanks to competition.

This is no different than Volkswagen avoiding making its own tires. It would simply not make any sense to vertically integrate this technology.

In addition to undercutting Tesla on battery CELL cost, Volkswagen will also have it own production of the entire battery PACK. Volkswagen believes it has a reasonable chance to be competitive with the cell vendors, once you go to the pack level. It has its internal battery pack factory that competes with the external cell suppliers, such as LG, Samsung and Panasonic. To see how flexible Volkswagen’s production is, let’s look at three current examples: •eGolf and eUp: Panasonic cells, but Volkswagen makes the battery pack. •Golf GTE: Panasonic makes both the cells and the entire pack. •Passat GTE: Samsung cells, but Volkswagen makes the battery pack.

In a separate interview, Audi CTO Hackenberg dropped a bomb by confirming how flexible this Volkswagen battery strategy is. He said that the all-new Audi R8 eTron, which Audi expects to have a range of 280 miles, has a battery pack that consists of 52 modules containing a total of 7,488 cells. In other words, 144 cells per module.

7,488 cells in total. You know what that means, folks. It means that Audi is using the same cylindrical cells as Tesla, even though the vendor in this instance is Samsung, not Panasonic.

It’s no wonder that the overall battery statistics of this car, the R8, are therefore similar to Tesla. The capacity of the battery pack is similar, the kind of cells used is similar, the weight per kWh is similar, and the range is similar.

The difference is that while Audi uses this Samsung cell today, it is not wedded to what it would be producing in its own battery cell factory, had it been in Tesla’s shoes. Audi can switch to LG and Panasonic, and switch from cylindrical to flat/square battery cells, if the battery cell price fluctuates in its favor. It’s harder to do that if you own your own factory for which you have paid billions and have to run at close to full capacity utilization in order to be competitive on cost.

Finally, Volkswagen emphasized that the industrial economics of producing all flavors of a car - gasoline, diesel, hybrid, plug-in hybrid and fully electric - totally integrated on the same assembly line are huge. With demand for electric car being both small, uncertain and highly fluctuating in the near term, allocating a specific car and production line to a low-volume electric car is simply a recipe for losing your shirt.

Volkswagen is engineering almost all of its cars to be made with all of these powertrain combinations going forward. There will be a plug-in hybrid and fully electric version of almost every single nameplate under the VW umbrella. Volkswagen already offers more plug-in electric models than any other automaker, and it should soon be at 40 different plug-in electric models.

The one area where Volkswagen does not want to take as a direct and active role in the electric car food chain is the charging network. While it dabbles in small initiatives here and there, it basically wants to stay out of it. It wants other entities, such as gasoline stations, parking garages or other independent service providers, to deal with electric car infrastructure.

The rationale for this is that it does not want to saddle the buyer of a plug-in electric car - who basically is charging only at home and/or at the office - with the cost of building out the infrastructure. It would add to the price of the car, and Volkswagen aims to be the low-cost leader.

While I agree that in the long run, car companies ought not be involved in charging infrastructure build-out, I disagree about the short term. To ensure the best possible customer experience in these nascent electric car days, I think it would be wise for the automaker to take a very active and direct role in funding this civil engineering project. It does not need to last for too many years. After a few years, it can be sold to an independent party - sort of like what happened to Orbitz in the airline industry. But it needs the automaker’s far more robust push in these early days.

Conclusion

Volkswagen believes it has eliminated Tesla’s battery advantage, and this will play itself out as the new models roll out in the coming years, starting with the Audi R8 eTron in 2015 and the upgraded VW eGolf shortly. By 2018, this strategy will be in full bloom. By making battery modules with interchangeable cells, Volkswagen can play Panasonic, LG, Samsung and others against each other, ensuring the lowest cost at all times. Then, producing the fully electric and plug-in hybrid cars on the existing assembly lines assures the lowest cost for these cars overall.

To read the full article please click here to visit SeekingAlpha.com
Seeking Alpha Disclosure: Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Additional disclosure:
At the time of submitting this article for publication, the author was short TSLA. However, positions can change at any time. Volkswagen paid for airfare, lodging and meals to enable this first-hand report. The author regularly test-drives cars provided by many of the major automakers, including Volkswagen.
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