Tesla's Shanghai Factory Could Knock Nearly 200,000 Yuan Off the Price of Its Cars — But It May Have Come Too Late

Amid endless uncertainty, Tesla has launched its China factory.

On October 17, Tesla announced it had paid 1 billion yuan for 865,000 square meters of industrial land in Shanghai's Lingang district, formally starting its plan to build cars in China.

Both sides had been working toward this for years. In an interview at a China event in 2014, Elon Musk said Tesla would "make a huge investment in this important market." And this July, Shanghai's Municipal Commission of Economy and Information Technology went to Silicon Valley specifically to talk cooperation with Tesla.

But no foreign carmaker had ever been allowed to own a factory in China outright. As late as this March, Musk was still on Twitter urging Trump to pay attention to China's protection of its auto industry: foreign companies could not set up wholly-owned carmakers in China and could only enter through joint ventures, in which the Chinese partner had to hold at least 50% and name the chairman.

The opening came on April 17 this year, when China's National Development and Reform Commission scrapped the industry protection rules written 24 years earlier. Foreign ownership caps across the auto industry will be lifted entirely after a five-year transition — and the new-energy-vehicle sector, where Tesla sits, will open sooner than that.

That same day, Tesla founder Elon Musk retweeted the news and called it an important decision. Over the following months he came to Shanghai, ate jianbing on the street — a Chinese savory crepe — and showed off a photo taken at Zhongnanhai. Tesla's wholly-owned Shanghai company was approved on May 10.

Under the contract Tesla signed with the Shanghai Lingang Administrative Committee, its Gigafactory in Lingang will start production in 2020. Total investment in the project will be at least 14.07 billion yuan, and the eventual target is 500,000 battery-electric cars a year.

The news comes at Tesla's hardest moment.

The Lingang plant may build both batteries and complete cars, bringing Tesla's most important model, the Model 3, to China

According to what Musk said at Tesla's shareholder meeting this June, the new overseas plant will make batteries and complete cars at the same time. He named this kind of automated factory the Dreadnought. He had said in an earlier interview that inside Tesla the automated factory is called the Alien Dreadnought — the alien mother ship of science-fiction films.

The size of the Lingang site, plus what Tesla and its core supplier Panasonic have said about "making things in China," is enough to make a rough guess at what the plant is for.

Tesla now has two car factories and one battery factory. The assembly plant in Tilburg, the Netherlands, is small, serves mainly the European market, and covers a tenth of Lingang's area.

The two big ones are the factory in Fremont, California, and the Gigafactory battery plant in Nevada.

The first has 930,000 square meters of factory floor on a 1.5-million-square-meter site, with two large assembly lines, one outdoor line, and some battery production. It currently turns out about 6,800 cars a month, roughly 4,800 of them Model 3s. The second sits on a site about 260,000 square meters smaller than Lingang and is still being built.

At the 2017 TED conference, Musk said Tesla would build four more Gigafactory battery plants around the world. Asked whether China was among them, he did not deny it.

At CES this January, Panasonic president Kazuhiro Tsuga said in an interview that his company was considering making batteries for Tesla in China, because Tesla was going to build complete cars there.

Put together, Tesla's existing setup suggests the Shanghai Lingang plant will mainly build complete cars, with batteries as a sideline.

In a teardown report, the investment bank UBS found that Tesla's powertrain is tightly integrated. Apart from Panasonic's batteries, every powertrain part can be made inside a Tesla factory.

In mass production, raising the transport or production efficiency of any single step usually either raises output or cuts cost. That holds for Tesla too. It already makes most of its own battery components; putting battery and body assembly under one roof at the Gigafactory would lift its efficiency again.

Tesla sells four models, and only the mid-range Model 3 is worth this much space and money.

The old problem with electric cars was range. The Model 3 was the first at a relatively low price that could go 350 kilometers on a charge, so drivers no longer had to worry that running the heat or the air conditioning in winter would leave the car useless for daily city driving.

Its body looks like a shrunken version of the Model S sports car, at less than half the price. Dropping the front grille makes the nose look more of a piece. The Model 3 is also the cheapest car with full self-driving capability. Its cockpit was tuned for autonomous driving and the instrument panel is gone, which cuts cost and makes the car feel more advanced at the same time.

In Beijing, Shanghai, Guangzhou and other cities that ration license plates, the Model 3, as an electric car, also gets a new-energy plate, sparing the buyer the money and the wait of bidding for an ordinary one.

Price, looks and plate policy all feed directly into sales. The Model 3 is Tesla's chance to stop being a niche luxury brand and become a mass manufacturer on the scale of BMW. It is also why Tesla, which builds 100,000 cars a year, is worth more on the market than Ford, which builds 6.3 million.

The trouble is that Tesla cannot deliver at the price it promised.

UBS took a Model 3 apart. Its report says that even though Tesla has the lowest battery cost per unit — the most efficient battery manufacturing anywhere — the base Model 3 at $35,000 still makes no money. Tesla loses $6,000 on every entry-level car it sells.

In May, Tesla dropped its plan to deliver the base model. The cheapest Model 3 on sale is now the $45,000 version released last Thursday.

Production is short as well. According to figures Musk disclosed earlier, Model 3 orders peaked at 518,000, with 63,000 cancellations, leaving 455,000 net. Yet by the end of this September the car's cumulative deliveries stood at 94,269. Output that slow cannot even meet demand in the United States, so Chinese buyers are not expected to take delivery until 2019.

China passed the United States in 2010 to become the world's largest market for making and selling cars. Government subsidies and favorable plate policies have made electric cars the fastest-growing category in that market in recent years.

JPMorgan Chase's Global Auto Industry Research Report projects that by 2020 China's new-energy-vehicle market will be growing at a compound annual rate of 46%, with output of 2.5 million cars.

During the years Tesla spent fighting for its factory, established foreign carmakers had already begun putting money into building electric cars in China.

In 2017, Ford signed with Zotye to set up a joint venture devoted to developing and selling electric cars. Volkswagen had announced a new joint venture with JAC to develop and build them, and BMW planned to make an electric Mini with Great Wall Motor. The Chinese joint ventures of Toyota and Honda each showed their newest plug-in hybrids at this year's Beijing auto show.

Beyond the competition, coming to China also means catching the last of the electric-car subsidies, which may not last much longer.

Built in China, the Model 3 could fall to 290,000 yuan

Once the Model 3 is made in China, its cost and price should come down. To begin with, that removes the taxes on imported cars and the cost of shipping them across an ocean.

On May 22 this year, the State Council's Customs Tariff Commission announced that the tariff on imported complete cars would fall from 25% to 15%. Less than a month later, trade friction led China to raise the tariff on complete cars from the United States to 40%. Tesla cut its prices, then raised them again.

If Tesla simply imported the cheapest $45,000 Model 3, the car would carry a 40% tariff plus 17% value-added tax, for a total of 489,600 yuan — the level of a China-built BMW 5 Series, where Tesla would have no chance at all.

If US-China trade relations have still not eased by the time a China-built Model 3 comes off the line, Tesla's current pricing formula, which takes the US price as its base, would still make that car at least 40% cheaper.

A Model 3 that sells for $45,000 in the United States would come down to 365,000 yuan — a little above a mid-trim BMW 3 Series.

Beyond tariffs, cars run on a global supply chain, so it is fair to assume most of Tesla's current suppliers already have customers in China and that raw materials will not be a problem. Even US suppliers facing tariff trouble can apply to their own government for export subsidies, so if Tesla keeps its existing suppliers in China its costs should not rise much.

Among tier-one suppliers, the core parts — body materials, battery components and the like — will probably not be localized quickly. That is how high-end joint ventures work today. But Tesla could do what Mercedes-Benz does: an all-aluminum body for imported models and a steel-aluminum mix for the China-built ones, to save money.

Interior parts — the surfaces of the center console, the door panels, the seats — are another place Tesla could cut, and the biggest suppliers in that field worldwide are all Chinese.

Whether production costs come down is harder to say. The UBS teardown puts the production line and labor together at 47% of the Model 3's total cost. Chinese labor is indeed cheaper: a Wuhan University report found that in 2017 Chinese workers' actual pay, year-end bonus included, averaged 4,216 yuan a month ($635), against $3,099 a month for American workers. But the Model 3 line is heavily automated, and whatever is saved on labor may be swallowed by higher bills for electricity, gas and water.

Cao Dewang, founder of Fuyao Glass, began investing in the United States in 1995 and decided to build a plant there in 2014. He has done the arithmetic on the two countries: "Energy in the US is cheaper than in China — natural gas is a fifth of the price, electricity 40% of the price, gasoline only half — and transport and logistics cost less too."

In theory Tesla could also shrink the battery, the way other joint-venture brands detune engines to create cheaper versions.

But Tesla has no room for that. It already loses $6,000 on every base Model 3 with a 50 kWh battery. A version with a smaller pack would only lose more. That is why Tesla chose to build the long-range Model 3 first.

For a rough estimate of what a China-built Tesla would cost, look at the gap other carmakers show between the joint-venture and imported versions of the same model. As a rule, a domestically built gasoline car runs about 10% to 20% cheaper than the imported one.

At a 10% discount, the Model 3 would come to 328,300 yuan; at 20%, 291,800 yuan — nearly 200,000 yuan below today's imported price.

That is not exactly cheap, roughly the base trim of an Audi A4 or a BMW 3 Series, but an electric car is still easier to register. Among electric cars in the same bracket, a China-built Model 3 would offer more for the money. It would undercut a Chevrolet Bolt carrying import duty, and it beats the BYD E6 on both looks and range.

Tesla's biggest problem: is the factory already late?

From wanting to invest in a plant to actually putting one on the ground, Tesla spent four years — four years it passed alongside China's growing electric-car market.

With government price subsidies and preferential new-energy plates, electric cars priced a little over 100,000 yuan have already taken a large share of that market. And traditional carmakers, cutting costs through joint ventures with cars like the Prius, the Nissan Leaf and the BMW i3, have been steadily picking off would-be Model 3 buyers.

By the time Tesla's Shanghai plant starts production in 2020, subsidies for short-range electric cars in China will have been phased out across the board. According to a draft of China's 2018 new-energy-vehicle subsidy policy obtained by Economic Observer, the subsidies end in 2020. That makes the case for an electric car over a gasoline one worse still. When Hong Kong's government scrapped its tax break for electric vehicles, Tesla's sales there fell from 1,200 a month to an average of four.

Tesla also has a ramp-up problem. Raising output at the Gigafactory has always been hard. The Model 3 took half as long as the Model S to reach 100,000 deliveries, but Bloomberg's tracking of the California plant's weekly delivery curve shows that in the first year of Model 3 production, Tesla did not hit a single one of the delivery targets it had set for itself.

Tesla has been making electric cars since 2008 and delivered only 100,000 in all of 2017. Judging by its record of keeping its own promises, the Shanghai plant's target of 500,000 cars a year does not look promising either.

At the same time, Tesla is short of cash.

Tesla's free cash flow — operating cash flow minus capital spending — has been negative for five straight quarters. In the three years since 2015, the only quarter in which it was positive was the third of 2016, at $424 million. In every other period cash flowed out, at worst by nearly $1.5 billion. (Free cash flow turned positive again in the third quarter of 2018.)

Negative cash flow means what Tesla earns selling cars falls far short of what it spends building them, and everything else. To save money, Tesla has promised to cut spending this year, from $3.4 billion last year to under $3 billion. In June, Musk also announced layoffs, cutting 9% of the staff in non-production departments.

Bonds issued at the top of the stock market to buy an affiliated company are another bill coming due. Tesla's filings show a $230 million convertible bond maturing next month with a conversion price of $560.64 a share; the stock now trades around $260. Converting would mean a huge loss for the holders, so almost nobody will. Having Tesla pay in cash is the realistic outcome.

Another Tesla bond, $920 million maturing next March, has the same problem. Tesla also has $1.2 billion of debt falling due in 2019.

The Shanghai plant can raise money in China to cover its own needs, but a factory that will not reach volume production until 2020 does nothing for the pressure Tesla faces at home in the United States.

Musk had earlier proposed taking Tesla private to escape the swings of the share price, and said he had already reached an agreement with Saudi Arabia. As for where that stands now: Musk paid a fine and gave up the chairmanship for breaking Securities and Exchange Commission rules and misleading investors. Meanwhile Wall Street and Silicon Valley have been backing away from Saudi Arabia over the death of a Saudi journalist. Getting Saudi money now, without angering its own customers, has become close to impossible for Tesla.

The wider picture is no clearer. Tariffs on parts and finished cars between China and the United States could still move, and since the start of this year the US Congress has been debating measures to restrict the flow of technology abroad.

Amid endless uncertainty, Tesla has launched its China factory.

Chart: Feng Xiuxia

Cover image source: Tesla