The proposed Gigafactory 3 of Tesla (NASDAQ:TSLA) in Shanghai will be the single biggest factor in the long-term success of Tesla. It's integral to the success of the company. It's needed for both macro political reasons and on a micro company level. As Elon Musk stated last week, the factory is "fundamental to the future of Tesla." Tesla skeptics seem to have misunderstood the extent of Chinese backing for this project. China sees Tesla as an integral part of its future new energy picture.
The Big Picture
Tesla has been caught between a rock and a hard place for geopolitical reasons. The Trump Administration's hostile approach to trade with China and to Chinese companies has hit them, and many others, hard. U.S. manufacturers' import costs have been increased unnecessarily by tariffs. U.S. exporters have seen their prices increased unnecessarily by tariffs.
Tesla shares this fate similarly with many others, especially Apple (NASDAQ:AAPL). Other companies reporting recently from very different industries have had the same problem. Examples include Nvidia (NASDAQ:NVDA) and Caterpillar (NYSE:CAT). So the Trump Administration's policies make it essential that such companies manufacture more products in Asia.
On a micro basis, China is the world's largest EV market and its pole position will only increase in coming years. Apart from manufacturing EVs, the Chinese plant in Shanghai will open up tremendous opportunities for Tesla in the rapidly-growing energy storage market and in battery development. I detailed these opportunities in a recent article. China is the dominant battery manufacturer in the world.
The Shanghai Factory
Tesla cynics launched a huge PR campaign to say the factory would never be built. Once again they were 100% wrong. The illustration below shows the workers in the rain in January:
It's thought that they will be working through Chinese New Year, such is the urgency to get the facility built.
The illustration below shows the huge scale of the 864,885 square meter site:
Drone coverage of the ongoing preparations can be seen here.
Those who thought that the Chinese premier would meet up with Elon Musk to discuss the project and then not allow it to go ahead really do not understand how China works. Musk recently met the Chinese premier in Beijing. Then the premier referred to Tesla as being a "promoter of the stability of China-U.S. relations."
Shanghai's powerful mayor, Ying Yong, has put his personal credibility on the line by strongly backing the project. When Tesla bid for the land, there were no other bidders. Last year the company was allowed to be the sole owner of the project, something not offered to other manufactures then. The main contractor for the project is state-owned China Construction. The land is on a 50-year lease from the government.
The financing of the project will be interesting. Chinese giant Tencent (OTCPK:OTCPK:TCEHY) has a 5% stake in Tesla. They could well be the source of more input in the near future. However as my article here detailed, they have stakes in a whole host of EV related companies. Just in the last few days they have announced new investments in two auto plays, GAC Group and Mogu Zhixing.
Their previous investments include what many see as Tesla's main rival in the China market, Nio (NASDAQ:NIO). Tencent is a leading player in AI for auto autonomy, which would tie in with Tesla's strength in autonomous driving systems. Tencent themselves have an autonomous concept car on the roads and an operating system to match it. They plan to monetize this through their WeChat platform with its over 1 billion users. Autonomous cars will become widespread much more quickly in China than elsewhere, as I detailed here. It's uncertain how the Tencent and Tesla relationship will develop from here.
It's reported that banks in Shanghai have offered special low interest rate loans for up to 30% of the project's cost. Furthermore, other Chinese banks from outside Shanghai and foreign banks are reported to have been keen to participate. Further reports from Chinese news source Caixin (subscription required) indicate that a consortium of Chinese banks has been formed for this purpose. On the Q4 earnings call, Musk emphasized the very competitive financing being offered.
The Chinese government authorities have fast tracked the usual procedure for loan approval for the project. When fully completed it's estimated that the cost could be as much as US$5 billion. However to get the factory up and running in the first instance, Tesla have stated a figure of US$500 million. The company's finances improved in Q4. Free cash flow was up to US$910 million. In the second half of the year the cash position improved by US$1.45 billion. The convertible bond due in March 2019 will be met from the cash reserves of US$3.7 billion.
So, it appears that Tesla have the cash themselves but also the possibility of low interest rate financing from a number of sources.
China EV Market
My article on Tencent detailed some of the numbers. China is the world's biggest auto market for ICE vehicles and for EVs. Official government policy is that all vehicles will be EVs by 2050. Sales by 2025 of EVs are targeted to number 7 million. EV sales in China are growing rapidly. Their growth compared to the US is illustrated below:
Ideally Tesla would have been up and running in China already. Production starting by the end of the year should mean they are not too late to the party. However it has produced some problems.
There have been differing reports on how badly Tesla sales in China have been hit by the trade war with the U.S. No doubt it has been harmful to Tesla's sales. From 2015 to 2016 sales had tripled to more than US$1 billion. Then they more than doubled in 2017 to more than US$2 billion. In 2017 Tesla sold 17,670 vehicles in China. According to reports, in the first nine months of 2018 they had sold over 14,0000 vehicles. Then the trade war hit.
This month has seen Tesla offer a new lower-priced variant of the Model 3 to the Chinese market. It is clear that the company has an imperative to establish the Model 3 in China as quickly as possible. Their brand name in the country already is very strong.
The new variant is the mid-range Model 3 rear wheel drive. It's being priced at 433,0000 yuan (US$64,0000). This compares to the long-range version at 499,0000 yuan (US$74,0000). One should bear in mind the Model S has been selling well in China despite the price of the S100D of 849,0000 yuan (US$126,0000).
Tesla also just introduced Model 3 with new "power sports" wheels for better performance as per the picture below:
These new model developments for China, allied to the rapid pace of activity at the Shanghai site, indicate that Tesla are at last putting in the management focus and financial investment that the China market requires.
The charging infrastructure and retail network has been built out. Tesla has more than 1,300 superchargers and over 2,000 destination charging posts in over 170 cities. There had been some complaints by Tesla owners that the Tesla superchargers have not been allowed in the most convenient locations on highways. Drivers may have been encouraged to use state-owned chargers at more convenient locations. These are interchangeable generally with Tesla, but more expensive to use. This is the kind of negative likely to be erased as Tesla builds up its relationship with the Chinese authorities. There's one charger for every six EVs on the road in the country, a high figure.
Exporting autos manufactured in the US to China always was going to be only a short-term expedient. Recent moves by Chinese authorities to switch from a direct EV subsidy regime to a credit regime will benefit Tesla. These rule changes are an attempt to reduce the number of EV manufacturers in the country. Many of these manufacturers are under-financed and producing low-quality vehicles. The authorities want a restricted number of well-financed and quality producers. Tesla is earmarked to be one of these.
Initially the Shanghai plant will focus on the Model 3 with the upcoming lower-cost Model Y to follow. The company is finally rolling out the marketing and trial rides for the Model 3 around the region. Recent road-shows include China, Hong Kong, Japan, Australia and New Zealand.
China has the largest number of EVs on the road of any country. Japan has the third largest at 205,0000 autos. Asia will be a big market for Tesla's autos in general, not just China. Japan is the fourth largest auto market in the world, India the sixth largest. As I pointed out in a previous article, India has an official government target that only EVs should be on sale by 2030. This is highly unlikely to happen, but the fact that there's a target in place is important. Japan may be a difficult market due to the preference for the hydrogen fuel cell option.
As I detailed in an article in 2017, Tesla's opportunities in Asian countries are substantial. They do however depend on management focus and capital to roll out the infrastructure. Both these now seem to have been met.
South Korea, with a government target of 90,000 EVs on the road by 2020, and Taiwan are leading promising markets. Tesla's success in Hong Kong is an example of how EV sales can flourish even in dense high rise Asian cities. The company is thought to have about 70% of the EV market there.
Australia is thought to have more than 7,000 Model 3 reservations waiting to be supplied. That country though has seen a slow take-up of EVs. Figures are not out for 2018, but in 2017 there were sales of only 2,284 EVs. A Senate Committee is currently working on ways to encourage the use of EVs. It seems likely there will be strong incentives put in place soon.
In New Zealand, this small country is going full steam ahead in a drive for EVs. There are currently 11,748 on the road. The government has a target for 64,000 by 2021.
The fast-growing European market also may be supplied from China rather than the US. Worldwide it has been estimated that the EV market will have a CAGR of 22.3% between 2018 and 2025. Europe will be the next fastest-growing market after China. Just as an example, in Norway already over half the cars sold are EVs. Parliament there has mandated that by 2025 all vehicles sold there must be EVs. Currently 6.5% of cars on the road in the country are EVs. Most of the other top 10 percentage countries are in Europe.
As the Model 3 is to be made in Shanghai, it seems uncertain why one would ship more expensively produced models from the US first. This is one argument why the Shanghai factory has come later than is ideal. The announcement of the lower-priced Model 3 can be seen as one reaction to this conundrum. This also will leave open the question as to whether the U.S. plants will have sufficient demand to run at full capacity.
In 2018 the U.S. plant had an incredible ramp-up of production. The company delivered 245,240 vehicles. That is almost as many vehicles as the whole previous history of the company. It's probably the fastest ramp-up of production of any auto company in history. The Model 3 is by a long way the best-selling premium model in the US. It now has a delivery run rate of 350,000 autos per annum.
The question needs to be asked whether such supply will meet demand in 2019 and what will be produced in the U.S. factories once the Shanghai factory is up and running. The company has stated that the higher specification models will continue to emanate from the US. Tesla is aiming for a 3,000 vehicles per month production when the Shanghai factory gets up and running.
On the earnings call, Musk predicted Model 3 demand to be anywhere between 500,000 and 800,000 units per annum.
The company states that the capital spend per unit of capacity for the Model 3 at the Shanghai plant will be under one half that of the Fremont plant. By the end of this year the Shanghai plant should be up and running with its stamping, paint shop, body joining and general assembly.
The existing Model S and X, the upmarket versions of the Model 3, and the planned Semi and new roadster may not be sufficient for Fremont. Most likely, the Model 3 and Model Y will be manufactured in the US but just for the US market, and the China factory would handle the rest of world demand. On the earnings call Musk seemed to make it clear that the Model Y would be produced in the first instance in Fremont. The model is expected to have about 76% parts share with the Model 3. Capital constraints make it uncertain when the Model Y will be in production.
Tesla and the China Battery Market
Tesla and BYD Auto (OTCPK:OTCPK:BYDDF) are the two leading EV manufacturers in the world. It's no coincidence that both have adopted a strategy of vertical integration. So far BYD has done this more widely than Tesla. Other auto companies have been very tardy in this but are now trying to jump onto the vertical integration bandwagon. This is evidenced by recent initiatives from such as Volkswagen (OTCPK:OTCPK:VLKAF), Toyota (NYSE:TM) and Daimler Benz (OTC:OTCPK:DDAIF).
Much of the success of Tesla has come from the batteries and the constant evolution these are enjoying. Lithium-ion batteries have a huge range of advantages over the old lead acid batteries of ICE vehicles. Tesla's cylindrical, as opposed to prismatic, cells have proven superior over competitors. They have been able to improve successively the respective ratios of lithium, cobalt, nickel and aluminum to maximize performance and cost.
My recent article laid out the position, particularly as for Tesla's relationship with partner and investor Panasonic (OTCPK:OTCPK:PCRFY). Panasonic themselves are investing heavily in battery manufacture in China. However it would be no surprise if Tesla has made some commitments to the Chinese authorities concerning utilizing battery production from Chinese companies.
On the Q4 earnings call, the company confirmed they will continue to make the battery modules and packs. Cells will be sourced from the US, from Japan and from China. Musk stated:
"We do think we have the best costs in the world. To the best of our knowledge our costs are lower than anyone else right now and they're improving."
Chinese companies are reckoned to control more than 50% of the world lithium market. They have a strong position also in the more uncertain world of cobalt supply (Tesla have in fact been successful in progressively reducing the proportion of cobalt in their batteries). It would be no surprise at all to hear announcements this year of close cooperation between Tesla and Chinese battery manufacturers. A further advantage for Tesla in this is that new battery developments, such as solid state batteries, are likely to emanate from China, South Korea or Japan.
Forthcoming announcements on financing and partnerships for Tesla in China will be interesting. The authorities in China see Tesla as an integral part of their future new energy picture. This is an extraordinary opportunity for the company if Musk manages it right with sufficient financing and management input into the Chinese and Asian markets.
Disclosure: I am/we are long TSLA, BYDDF.AAPL TCEHY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.