Why Tesla's Model 3 Could Fail

Tesla Motors has enjoyed huge success in the ultra-luxury car market with its Model S sedan. The company has steadily ramped up production of the pricey electric car, yet demand has always exceeded supply -- even though Tesla does no advertising and never offers discounts.

Demand has grown for Tesla's pricey Model S sedan. Image source: Tesla Motors.

That's why many investors, stock analysts, and car enthusiasts -- including my colleague Daniel Sparks -- expect Tesla to have big success in the mass market with its less-expensive Model 3 sedan.

However, while the Model 3 will be much cheaper than the Model S (and the upcoming Model X SUV), it's likely to end up confined to the luxury market, competing with the likes of the BMW 3 Series or the Mercedes C-Class. This may put Tesla's ambitious sales goals -- 500,000 cars per year by 2020 and "a few million" per year by 2025 -- out of reach.

The price -- and the real priceTesla CEO Elon Musk has said the base price of the Model 3 will be about $35,000 -- before the impact of government tax incentives. The current $7,500 federal tax credit for EVs would bring the final price down to roughly $27,500, and even less if state tax credits are available.

In theory, that should make the Model 3 quite affordable. It still might cost a little more than a Prius, but would probably offer better performance -- and, of course, it wouldn't require any gas. At this price, the Model 3 could target a cross-section of middle-class hybrid owners and tech enthusiasts.

However, the number of people who walk out paying less than $30,000 after tax credits for a Tesla Model 3 will be tiny. Instead, a typical buyer will almost certainly pay more than $40,000 -- and perhaps more than $50,000. That would still move Tesla into the broader luxury market from its current ultra-luxury niche. But it wouldn't be a mass-market car.

Why the Model 3 will still be priceyFirst, the history of the Model S offers evidence that a base model for the Model 3 might not be very appealing.

Tesla originally planned to offer a 40-kilowatt-hour Model S as a base model, starting at $52,400 after the $7,500 federal tax credit, and featuring a 160-mile range. It killed this version before the first Model S delivery to simplify production, because it only accounted for 4% of Model S orders.

More recently, Tesla killed the 60 kWh Model S, which had a range of just over 200 miles. Instead, Tesla introduced a 70 kWh version that costs about $4,000 more.More generally, the Tesla Model S sales mix has tilted heavily toward the most expensive versions with the most options -- bringing the average selling price to about $100,000.

Demand for the Model S has been heavily skewed toward the priciest versions. Image source: The Motley Fool.

For the Model 3, Tesla will probably offer a battery upgrade option. Based on the comparatively low demand for the 40 kWh and 60 kWh Model S versions, getting closer to 300 miles of range could be seen as a near-necessity, at least if you might ever take a road trip.

Furthermore, to keep the price down, many standard features of the Model S are likely to be options on the Model 3. Option packages for the Model S can easily add up to more than $10,000. This would drive actual prices for the Model 3 far beyond $35,000.

In addition, the $7,500 federal tax credit won't last long unless the U.S. government changes the rules. As it stands, the credit will phase out quickly beginning two quarters after a manufacturer reaches cumulative sales of 200,000 electric vehicles or plug-in hybrids.

If demand for Tesla's Model S and Model X vehicles stays strong, the company will be well more than halfway to the 200,000 phase-out level before the Model 3 even goes on sale. Adding the Model 3 will quickly put Tesla over 200,000 cumulative sales in the U.S., driving the federal tax credit down to zero within a year and a half.

Is there a big enough market at this price?To recap, the Model 3 won't benefit from the $7,500 federal tax credit for long. Plus, the Model S sales history suggests most consumers will demand an upgraded battery. And once the out-the-door price is around $40,000 -- and not $27,500 or less -- most buyers will want to add creature comforts that could easily push the price beyond $50,000.

This has two implications. First, Tesla might price itself out of the vast majority of the market. (In the U.S., the luxury segment represents about 11% of the total auto industry.) Even a dedicated environmentalist might be hesitant to upgrade from a Prius to a Model 3 when there's no federal tax credit to narrow the cost gap and when adding a few basic options pushes the price tag beyond $40,000.

Second, at this price point, Tesla will face much more formidable competitors than the mass-market automakers. Going up against the likes of BMW and Mercedes means facing off against brands with their own loyal followings. Tesla will have to deliver a car that is just as high-quality as the much more expensive Model S if it wants to sell hundreds of thousands annually.

Selling millions of vehicles by 2025 will be an even greater challenge. Even the mighty BMW brand has never broken the 2 million mark (though it's getting close). To reach this goal, Tesla will need to deliver a much cheaper car after the Model 3.

The article Why Tesla's Model 3 Could Fail originally appeared on Fool.com.

Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.