Tesla Inc (NASDAQ:TSLA) stock is up nearly 60% year-to-date. The stock currently is 12% off its 52-week high, and trades at 11.2 times book value and 5.6 times sales.

This valuation means high expectations for TSLA stock to succeed. Will Tesla will be able to sustain its competitive advantages and deliver future profits?

One of Tesla’s competitive advantages comes in the form of the battery supply chain it is building with Panasonic Corporation (ADR) (OTCMKTS:PCRFY).

Most electric cars run on lithium-ion batteries, and according to Bloomberg, these account for about 40% of the vehicle’s cost (though costs are falling). A 2010 report by the Boston Consulting Group found that 75% of the cost of producing battery packs are volume-dependent, meaning that as production increases, unit costs will drop.

So whoever scales up first will enjoy a cost advantage.

TSLA stock and Panasonic have invested billions of dollars in “gigafactories” which produce lithium-ion batteries for electric cars. By 2018, the Gigafactory will produce batteries capable of storing 35 Gigawatt-Hours (GWh) of electricity every year.

Last year, Tesla claimed a cost of $190 per Kilowatt-Hour (KWh) for battery packs. In February, the company announced it had achieved a further 35% cost reduction at its Gigafactory 1.

Tesla’s battery supply chain is one of its big competitive advantages. So should Tesla worry about other manufacturers ramping up their production and reducing costs, perhaps eroding Tesla’s cost advantage?

China, Lithium-Ion Batteries and TSLA Stock

China doesn’t hide its desire to dominate several high-tech industries, including electric cars. The government encourages the use of electric vehicles (EVs) in multiple ways, and will require 8% of car sales next year to be EVs and hybrids.

China also offers subsidies to battery manufacturers, but these require a minimum 8 GWh installed production capacity in China. Only two Chinese firms, BYD COMPANY LTD ‘H’CNY1 (OTCMKTS:BYDDF) and CATL, qualify.

This quote in a Financial Times article sounded alarming:

“China’s approach has echoes of the one it took on solar power a decade ago. It dominated the solar industry by lowering costs and driving prices down by 70 per cent and could do the same for batteries, says Gordon Orr, former Asia chairman of McKinsey.”

China, after all, designated solar energy a “strategic emerging industry” in its 12th Five-Year Plan a few years ago, and subsidized domestic production. Chinese producers ramped up production, and may have sold solar panels below cost overseas, a practice known as dumping. This contributed to a drop in solar panel prices, and led to bankruptcy for many solar panel makers in the U.S. and Europe.

And articles like this, about China burying Elon Musk in batteries, sound scary. As did this quote from CATL’s marketing director in the Financial Times:

“But we think over the next 10 years, there may only be 10 lithium battery producers left, with the top three taking 60 percent of the market.”

This certainly reminds me of what happened to the solar industry a few years ago.

And again, just as with solar panels several years ago, there is now talk in China of excess capacity among battery manufacturers.

Impact on Tesla

Tesla is positioned on both ends of the battery supply chain: it is both a consumer and a producer.

A fall in battery prices would benefit Tesla by slashing the price of electric cars and making them more competitive with cars running on internal combustion engines.

TSLA stock wants the transition from gas-guzzlers to electric cars to take place sooner rather than later. Once it scales up, it will earn a profit and no longer need continuous injections of cash. And Tesla seems to have the upper hand in customer satisfaction.

The faster this transition takes place, the better. The greater risk probably lies in not ramping battery production fast enough to meet demand.

A drop in battery prices would probably impact pure-play battery producers, and Bloomberg thinks they might suffer the same fate as solar panel producers did a few years ago.

As for Tesla, its competitive advantage rests on more than just a cost advantage in battery production.

Tesla produces products that people love and are willing to pay a premium for. Tesla scores high on customer loyalty surveys, much like Apple Inc. (NASDAQ:AAPL). The venture capitalist Gene Munster drew parallels between the two in a May article.

TSLA stock bulls hope that once the transition to electric cars takes place, people will buy Teslas and enjoy them so much that they’ll never switch brands.

They do have some evidence to support this: Tesla does enjoy higher gross margins than many other automakers, although this came before the mass-market Model 3.

But, as I’ve mentioned in past articles, I have some concerns over Tesla’s valuation.

Even Elon Musk admitted the company was overvalued on May 18, and TSLA stock is up over 10% since then. Now who has better information on Tesla than Elon Musk?

Do you think Tesla’s fundamentals have changed so much since then that this valuation is warranted? Or could this be a case of the market getting a little ahead of itself and pricing things irrationally?

As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.