Why Tesla's decision to close hundreds of stores is risky

New York(CNN Business) Tesla thinks the future of auto sales is online. That may be true, but the company is taking a big risk by closing its stores.

Last week Tesla announced it would begin to close most of its stores in a cost-cutting move designed to help lower the price of its best-selling vehicle, the Model 3, to as little as $35,000.

Tesla said people will have to buy Tesla vehicles online or by phone, rather than in one of its hundreds of stores. It said selling cars on the internet would reduce the cost of the selling a vehicle by as much as 6%.

Shoppers can order just about anything online, but auto sales have been slow to change to online-only purchases. That's partly because all major automakers have used dealerships to sell their cars. Dealerships are independently owned businesses.

Tesla is the one significant automaker that sells cars directly to customers, so it's best positioned to close its stores and move sales online.

In an email to Tesla employees, CEO Elon Musk said that last year 78% of all orders for its Model 3 were placed online, rather than in a store, and 82% of customers bought their Model 3 without ever having taken a test drive. In a conference call announcing the change, he suggested this is a natural step, and that it's how people want to buy cars.

"It's 2019, people just want to buy things online," he said.

No test drives

But those who bought a Model 3 last year were big fans of Tesla already. They had to put down a $1,000 deposit months or even years before the car was available and were eager to get one as soon as possible.

It's not clear if Tesla will be able to sell the cars to the broader public without offering a traditional test drive.

"Our studies show consumers want to do more of the car-buying process online," said Michelle Krebs, analyst with Cox Automotive. But she cautioned that doesn't mean they're ready to complete such a major purchase completely online. "Not only do people want to test drive the vehicle, they want to sit in the car and learn the technology. Who's going to show them that?"

Tesla said its liberal return policy allows customers to essentially get an extended test drive and then return the car for a full refund if they aren't happy. But not all customers are willing to complete a purchase for the right to test drive a Tesla — and then wait for a refund if they're not happy.

Stock target cut

Because of last week's announcement, Barclays cut its price target on Tesla. It already had an "underweight" or sell rating on the stock, but dropped it again.

The lower priced Model 3 will work to squeeze the company's margins, predicted Barclays analyst Brian Johnson. He doesn't believe Tesla will gain a competitive advantage over automakers that still use brick-and-mortar dealerships to sell cars.

"Upon close analysis, we believe it's unlikely that savings are anywhere close to 6% of revenue," Johnson writes in his downgrade note. He said Tesla could still owe rent on stores it closes, even if it layoffs off sales staff.

If Musk and Tesla had gone with the traditional model of selling cars through a network of dealerships, it wouldn't necessarily be facing a need to close stores as a cost-cutting move. That's because the cost of operating the dealerships would have fallen on those independent business owners, not Tesla. The cash-strapped company would have been able to collect a franchise fee from the dealerships as a way of raising cash.

It also could have expanded its distribution channel much faster and more affordably than it did. Tesla has lease obligations of $1.6 billion, mostly for its stores and service centers.

Revenue strategy

But if it had set up a dealership network, Tesla would have needed to sell the cars at a wholesale price to dealers to allow them to make profit on the sales. By selling direct to consumers, Tesla can keep the full retail sales price of each car. That's particularly important to Tesla, which needs all the cash it can muster to produce its mass-market cars.

Tesla currently has 378 stores and service centers worldwide. It would not say how many are in the United States, or precisely how many will close.

Many of the stores will remain open as service centers. That is crucial for Tesla, which has struggled to provide timely service to its customers.

Even Musk has said improving service will be among the top priorities for the company this year. He suggested the closing of stores is a way of diverting more resources into improving the service.

And he also said Tesla is working to do more work at customers' homes and offices, rather than having them bring cars into the service centers.