January 31, 2018 / 3:56 PM / 20 days ago

Breakingviews - Hadas: Tesla’s $60 billion mistake on pay

LONDON (Reuters Breakingviews) - Sometimes companies need chief executives who are visionary geniuses. Sometimes more mundane skills are required. Tesla’s plan to hand Elon Musk as much as $60 billion in stock over 10 years shows the electric-car maker is confused about what sort of boss is appropriate.

Investors do not seem unduly worried about the prospect of giving 10 percent of the company to “Elon” - as the latest letter to stockholders calls Tesla’s founding genius and chairman - if he meets new “stretch goals”.  The shares are down just 2 percent since the Jan. 23 announcement.

Shareholders presumably enjoy dreaming that Musk can lead Tesla to big-time prosperity. That would be a big change. In the first nine months of 2017, the company generated an operating loss equivalent to 11.5 percent of revenue. Nor is running the company in the red bringing tremendous growth. Revenue in the third quarter was a relatively modest 8 percent higher than in the same three months of the previous year. 

There are good reasons for the weak results. The sales stall reflects the pains of bringing Tesla’s new Model 3 into full production, while the losses reflect the normal absence of economies of scale at a startup manufacturer.

However, for Musk to reach his lucrative milestones Tesla has to become the opposite of a startup. To collect the incentive scheme’s last 1 percent of the shares, the company must reach about the same size and achieve roughly the same level of profitability as General Motors, currently the most successful U.S. car company. That’s a real stretch.

Getting there will require Musk’s magic touch on technical innovation. Brilliant ideas are not enough, though. Grand schemes and sudden strokes of genius do not power automotive assembly lines. 

Manufacturing requires endless attention to every little detail. As American carmakers learned the hard way, failure is guaranteed without an ample supply of mundane engineering competence, not to mention motivated workers, cooperative suppliers, friendly regulators and tremendous quality control.

Tesla faces higher barriers than any experienced incumbent. It cannot merely catch up. To woo millions of new customers, it has to be better than its rivals.

That is not impossible, especially as Tesla has a head start in electric vehicles. But battery-powered cars are still cars. To make them price-competitive and safe, the challenger will have to add a great deal of traditional bureaucratic reliability to its current imagination-centred corporate skill-set.

The hero-worship implied in Musk’s gargantuan potential bonuses suggests the company has not yet grasped this reality. The founder’s approach is literally to aim for Mars. That is not the mindset that encourages the care and caution needed in a competitive, capital-intensive industry in which cost reductions are generally incremental. 

The stakes are high. Since even small missteps can cost lives and destroy corporate reputations, excessive haste could lay waste to the company. On the other hand, a too-slow learning curve would give Tesla’s profitable and experienced rivals more time to develop comparable products.

Musk, who has never run a profitable mass production company, seems like the wrong person to strike the right balance. True, he might recognise that the best way to earn his billions is to put more experienced executives in charge of operations. The remuneration plan, however, does not suggest he has acquired much in the way of modesty.

The Tesla board and Musk could be suffering from a Silicon Valley confusion. They may think of Tesla as a new sort of software enterprise, similar to Google-parent Alphabet, Facebook or Microsoft.

Tesla shareholders would certainly welcome that trio’s profitability. Their average operating profit margin in the most recent fiscal year was a stunning 32 percent. But that is an idle dream for the ultra-competitive automotive industry, in which a 10 percent operating margin is exceptionally high.

Or perhaps Musk is aiming to make his company the next Apple, which reported a 27 percent operating profit margin last year. Again, emulation is futile. Thanks to extensive outsourcing, the phone-maker’s annual revenue is almost 7 times the value of the physical assets on its balance sheet. For most car companies, that ratio is about 4-5.

It’s true that electric cars have a higher ratio of software to metal than petrol-powered vehicles. Still, all automobiles need far more precision engineering than search engines, social networks or even smartphones. And the rapid, sometimes careless innovation of Silicon Valley is ill-suited to the car industry, which requires ultra-high durability and has an ultra-low tolerance for error. 

Tesla cynics – there are quite a few – say success requires a miraculous transformation. Current shareholders presumably think the dilution involved in the new Musk bonus plan is a reasonable price to pay for that. However, stock-market dreams eventually yield to product-market reality. Instead of promising to give up more ownership to Musk, Tesla’s outside investors would do better to take more control. 

Breakingviews

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