The Model 3 could be the worst thing that ever happened to Tesla

Small cars are in crisis in the US. Automakers struggle to make money on them, and increasingly consumers want big pickups and SUVs — vehicles that generate fat profits.

The smaller vehicles that customers are clamoring for are compact crossover SUVs. Automakers don’t want to give up on small cars because they remember what happened the last time gas prices spiked and large vehicles fell from favour. But Trump-era politics are making it difficult to shift small-car production to cheaper labour markets.

Into this challenging small-car situation will soon arrive Tesla’s $US35,000 Model 3 mass-market sedan. The avidly anticipated Model 3 is scheduled to launch in late 2017, and Tesla has said that it expects to be building 10,000 per week at some point in 2018, as it strives to hit 500,000 in annual deliveries next year.

With nearly 400,000 pre-orders for the Model 3 in the books, this all sounds like a great deal for Tesla.

Except that CEO Elon Musk’s company, which has defined itself as a purveyor of high-tech luxury EVs for an elite buyership, is about to collide head-on with the cruel reality of small-car manufacturing and sales.

That hefty batch of pre-orders isn’t the problem; such an unprecedented level of demand, for a car that isn’t even being bolted together yet, proves that Tesla has abundant, untapped growth potential. The difficulty will come after the initial surge in Model 3 production, as Tesla moves away from lucrative sales of its Model S sedan and Model X SUV and is exposed to the harsh economic dynamics of smaller, cheaper vehicles.

Heading in the wrong direction?

I’d said this many times, but it bears repeating: the Model 3 represents a move for Tesla in the opposite direction of where the money is in the car business. A $US35,000 compact sedan brings in a lot less than a $US100,000-plus mid-size SUV.

For Tesla, the Model 3 is a far greater risk than the Model S or X were. The earlier vehicles validated Tesla’s identity as a real car company, as opposed to a sexy Silicon Valley dream — that’s what Tesla was when it was selling only its original Roadster sports car. The automaker has reliably lost money most quarters, but the gross margins on the S and X are enviable, around 20%.

You could argue that the Model 3 isn’t truly a mass-market vehicle. Rather, it’s more of a BMW 3-Series-type car, a play by Tesla to go after the lower end of the luxury market rather than the mass-market proper. However, the Model 3 is setting up to be Tesla’s flagship vehicle, its Model T, its VW Beetle — the car that changes everything, gets electric-cars to a critical tipping point, and begins the process of fulfilling Musk’s overarching vision of a rapid human exit from the fossil-fuel age.

We already know, based on Tesla’s projections for its cash burn in 2017, that the company will spend most of its cash-on-hand, about $US3.5 billion, to launch the Model 3 this year. And that’s just the launch — getting the Model 3 to full-scale production in 2018 could be wildly expensive. Tesla built only about 80,000 vehicles last year. The carmaker’s costliest days are definitely ahead of it, and we haven’t even started to pay for additional battery factories, an expanded Supercharger network, and the price of integrating SolarCity after a 2016 merger.

Why bother?

This all raises an obvious question: Why even do the Model 3 in the first place?

An answer, beyond the straightforward one that Musk wants to save the world, is that Tesla has a bit of segmentation problem. It sells essentially only two vehicles. Even boutique carmakers such as Ferrari do better than that. And while Tesla’s cars are undeniably cool, they aren’t particularly exotic: the Model S is a very nice four-door sedan, and the Model X is a pretty cool SUV. If that’s what you want or need, Tesla has a car to sell you. But if you want something else, Tesla doesn’t provide much in the way of choice.

But the nightmare scenario with all this is that we already know Tesla isn’t terribly good at making cars, even if it can charge a premium for the cars it does make. The company is a decade old and can’t even build 100,000 vehicles in a 12-month period. By the standards of the modern auto industry, that should be fatal.

It clearly isn’t — just look at Tesla market cap, which until a recent pullback was within a few billion of Ford’s $US50 billion. That’s a strong vote of confidence in Tesla’s future.

A turning point

But just because the production of the S and X hasn’t hurt Tesla, that doesn’t mean the Model 3 won’t. Musk has offered some innovative thinking about how Tesla can revolutionise manufacturing with the Model 3, centering on automation (Tesla’s also bought Grohmann Engineering, a German firm specializing in automation, last year). But in the short term, the Model 3 will be assembled using the current state of the art for the auto industry.

Tesla hasn’t mastered that art. The Model 3 will be the first major test of whether it can.

And even if it does, Tesla will still have to reconcile the cost of building the Model 3 with the profits it will have to give up to introduce a cheaper, higher volume car.

There’s no question that the Model 3 will be a hit. The unprecedented number pre-orders guarantees that. It’s what comes later, when being a mass-market automaker becomes the relentless grind it is for every other mass-market automaker on earth. We’re all incredibly excited about the Model 3. We’ll be even more excited when it arrives.

And then we’ll have to sort out whether or not it was really a good idea to begin with.

NOW WATCH: Elon Musk came up with an ingenious solution to a Tesla owner’s Twitter complaint in just 6 days

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.