Can Tesla Learn High-Volume Manufacturing From The Chinese?

Summary

• Tesla is notorious for missing its production goals.
• Tesla just announced its intention to set up a manufacturing plant in China.
• Pretty much every Chinese auto company produces more electric cars than Tesla.
• We think that Tesla could learn a lot from the Chinese, particularly with respect to high-volume manufacturing.

Last week, Tesla (NASDAQ: NASDAQ:TSLA) announced its intention to set up a manufacturing plant in Shanghai, China. In typical Chinese fashion, Tesla would be required to form a joint venture with a domestic company in order to enter the market. Chinese companies are notorious for absorbing the know-how of its foreign partners and then forcing them out of the partnership. In Tesla’s case, we think that for once, a Western company could gain more from the joint venture in terms of know-how than the Chinese partner.

Somewhere in China: all those white cars are electric vehicles, available for rent; and yes, there’s an app for that, but you won’t need it since you can just use WeChat or Alipay. Source: Bearingtonpartners.com

Tesla’s Approach: Manufacturing By The Drip

Tesla is notorious for failing to meet its production goals. Since inception, Tesla has missed virtually every single production target with respect to both volumes and timeline. This applies not only to cars, but also to its much vaunted gigafactory. While some of this has to do with marketing, as scarcity creates a false impression of pent-up demand, and, therefore, value (reflected in Tesla’s outlandish market cap), in practice, Tesla simply seems to lack the know-how to manufacture cars in large quantities.

The upcoming Tesla Model 3 will be a litmus test for Tesla with respect to manufacturing techniques. For the moment, in the world of automobiles, Tesla could be best described as producing ‘samples’ rather than final products, or in other words, manufacturing cars by the drip.

The Chinese Market

China is the world’s largest manufacturer and buyer of cars. It is also the largest manufacturer of electric cars and electric vehicles, the latter (including buses, cars and electric bikes) by orders of magnitude.

According to Reuters, more electric cars are sold in China than in the rest of the world combined.

In addition, China has a stated goal of 5 million electric vehicles on the road by 2020.

Several brands, both Chinese and foreign, compete for the Chinese consumer with Chinese names dominating the market. Local brands of electric vehicles include BYD (OTCPK:BYDDY, OTCPK:BYDDF), BAIC, Chery, Dongfeng Automotive and Geely among others.

As is the case in the U.S., electric cars in China are heavily subsidized. Furthermore, with license plates for conventional cars being in limited supply, particularly in the larger cities (i.e. Beijing, Shanghai), purchasing an electric car is an easy way to obtain a license.

The Chinese market is also saturated by luxury brands, with virtually every single Western brand from Aston Martin to Zonda having a presence in the Chinese market.

Finally, China is a very large manufacturer of batteries. In fact, Boyd Motor, a company in which Berkshire Hathaway (BRK.A) (BRK.B) has a small interest, has its own gigafactory in operation with 10GWh of capacity as of the last report (2015) and growth plans of about 6GWh per year.

You can take this model home for about $20,000 USD after subsidies. Pictured (from Reuters): the BYD QIN electric.

What Chinese Companies Have To Gain From A Tesla Partnership

Chinese auto companies have very little to learn from Tesla, at least in terms of technology or know-how, as they have been installing batteries to vehicles probably well before Elon Musk graduated from using diapers. From a design and performance perspective, a lot of prestige brands are already at least partially owned by Chinese firms, including Lotus, which provided the initial body for Tesla’s cars.

From a technology perspective, the only innovation from Tesla comes from its self-driving technology, which we doubt would be shared with the joint venture partner.

The real strength of Tesla resides on its marketing skills and its ability to secure subsidies. We don't think the marketing approach can be replicated in China, as we don’t see any evidence of a Church of Elon gaining a foothold in the country. As for the subsidies, there is no expert like the Chinese in making the State pay for money-losing ventures.

The only possible gain for a Chinese partner from this venture comes from earning a share of Tesla’s revenues in the country without having to invest too much effort.

What Tesla Gains From A Chinese Partnership

Tesla could potentially gain a lot from the right partnership. In addition to avoiding a 25% import fee and gaining access to the Chinese market, Tesla could learn about manufacturing techniques from a well-established partner.

In particular, Tesla could learn a thing or two about manufacturing cars in large quantities, in time and according to budget, which the Chinese have developed an expertise after so many years of being the factory to the world.

In addition, Tesla would gain access to a lower-cost supply chain.

Finally, Tesla could gain some insight into battery manufacturing to complement its own gigafactory efforts.

Investment Implications

According to Bloomberg,

Tesla has signed a preliminary agreement with the city of Shanghai to produce vehicles in China for the first time, Bloomberg News reported earlier. The agreement would allow Tesla to build facilities in Shanghai’s Lingang development zone, according to people familiar with the negotiations. Under existing rules, Tesla will also need to set up a joint venture with at least one Chinese company to obtain the necessary manufacturing permits.

The details of the agreement have not been made public, so neither the capital commitment nor the Chinese partner have been disclosed. However, in similar deals with other automakers, the Chinese partner has frequently contributed the land while the Western partner contributes the initial capital to build the manufacturing plant.

Roughly a year ago, Bloomberg floated another story about a potential China-Tesla partnership. In that report, Bloomberg mentioned the signature of a non-binding memorandum of understanding with a Shanghai government owned company. The main points of the memo are the following:

• The signature of a non-binding memorandum of understanding with Jinqiao Group (a company owned by the Shanghai government) to build production facilities in Shanghai.
• A total investment of about $9bn.
• Tesla contributing $4.5bn to the partnership.
• Jinqiao Group also contributing $4.5bn with land accounting for most of the contribution.

We think the Chinese partner may change even if still related to the Shanghai government. Nevertheless, $9bn ($4.5bn + $4.5bn) seems to be a reasonable estimate of what the total investment could be.

The specifics of the proposed joint venture have not been made public, so potential plant size or capacity and joint venture partner are unknown. It is also unknown if Tesla would manufacture vehicles and batteries at the site.

So with this in mind, how much could $4.5bn-$9bn in China buy in terms of production volumes?

Ford Motor Co. (NYSE:F) got 250,000 units of initial capacity out of a $760mm investment in a brand-new plant that opened in 2015 in Hangzhou, China (about an hour by train from Shanghai). This was also a joint venture.

In Tesla’s case, production volumes will depend on whether it teams up with an equally inexperienced partner (low production volumes, frequent delays) or a well-established one. It will also depend on how much of that investment, if any, is focused on battery manufacturing.

The Chinese market offers a lot of potential partners, many with ample electric vehicle experience. Here is how the Chinese market for electric vehicles looks at the moment, with almost no contribution from Tesla.

Source: China Association of Automobile Manufactures via Bloomberg.

Regardless of the choice, the investment should at least suffice to meet Tesla 3 expected volumes even if the North America manufacturing experiment fails and the cars are delivered 1-2 years later. None of this, of course, justifies Tesla’s current valuation, as Tesla loses money on every car it manufactures and produces a minimal number of vehicles compared to the rest of the automakers.

Some Potential Scenarios + What Would Be The Impact Of A JV On Volumes?

First, we need to take a look of how a deal may be financed. No actual details have been released to date, so we base our numbers on last year’s Bloomberg report of a $9bn agreement with an equal contribution of $4.5bn from each of the joint venture partners.

For a deal of this size ($4.5bn), we believe Tesla will be forced to raise both debt and equity. Tesla’s net leverage already stands at 18.07x on a trailing basis, making financing the venture solely with debt potentially challenging. We assume a mix of 50% debt and 50% equity, with additional shares either being sold to the general market or issued to the Chinese partner in exchange for cash.

The best scenario for Tesla would be for the Chinese partner to buy the additional shares as it would reduce the market impact of the additional issuance and would leave the partner with ‘skin in the game’. At current market prices, the JV partner would get a 4.0-4.5% stake in Tesla in exchange for a $2.25bn cash contribution to the joint venture.

This may or may not be possible depending on the final partner. Regardless, we think Tesla will be forced to finance at least half of the venture with an additional share issuance.

Assuming 50% of Tesla’s contribution is financed with debt, net leverage would initially increase to 23.22x on a trailing basis, although leverage should start to decrease rapidly once previous capital investments plus the joint venture start generating revenues. With the right partner, the JV could be generating revenues as early as 2019.

To analyze the potential impact of the Chinese JV, we model three different scenarios. In the first scenario, we model Tesla as it stands today (i.e. no JV). In the second, we assume the venture does happen and that the facility manufactures products designed for the U.S. market regardless of where they are sold. Most likely, this will result in the JV producing the Model 3. In the third scenario, we assume Tesla designs and manufactures a product specifically for the Chinese market (what we call the PRC model) in addition to manufacturing the Tesla 3.

In all scenarios, we assume the investment in the JV covers manufacturing of the vehicles plus the batteries.

Note that our estimate for Tesla Model 3 deliveries is closer to Goldman’s model than the 400,000 vehicles that Elon Musk thinks Tesla is capable of producing. We simply don’t think Tesla has the expertise to attain that output, nor that there is a market for 500,000 Tesla vehicles in the U.S. Already, there seems to be evidence that the Model S and Model X demand seems to have peaked and that it is beginning to drift downwards.

As for the Chinese market, we think that there is very limited demand for the more expensive models, even with the resulting discount from avoiding the 25% import fee. During 2016, Tesla seems to have sold only around 5,000 vehicles; this is the largest market for vehicles in the world. For the upper end of the market, there is simply too much competition in China and the Tesla name carries no particular significance. For the upper segment, Tesla competes in the luxury market, not in the electric vehicle market.

For the middle segment of the market, where the Model 3 lies, we also think a large portion of the JV output will have to be sold outside of China. In our scenario #2, we assume Tesla Model 3 production in China peaks at 250,000 vehicles but that at least 150,000 are exported outside of China (to the rest of Asia, Europe or the U.S.).

In scenario #3, we assume that with help from the joint venture partner, Tesla designs a model specifically for the Chinese market, which would be cheaper than the Model 3. We assume 150,000 deliveries of this model for 2020, with the peak defined by potential demand, not capacity.

At the lower end of the market, Tesla would also face intense competition from domestic manufacturers, many of which already produce many more vehicles per year than Tesla. With the right partner, however, Tesla could benefit from the perceived value of being a Western brand, which is still associated in China with higher quality.

Under the U.S. only scenario, we assume total deliveries of about 253,000 by 2020, as Tesla encounters difficulties in achieving full-scale manufacturing. Under the JV venture scenarios, we assume production exceeds 500,000 vehicles by 2020 with some of the output being absorbed within China.

Under our Tesla-only scenario, EV/Vehicle sold by 2020 is $233,812, which is astronomically higher than other vehicle manufacturers. Under the JV scenarios, the EV/Vehicle halves to about $112,092, which is still very high but at least lower.

Many authors on Seeking Alpha have provided comps on an EV/Vehicle basis. We suggest the reader to keep our EV/Vehicle estimate in mind and consult one of those articles if interested. Needless to say, Tesla’s valuation is off by orders of magnitude.

Final Thoughts

Tesla doesn’t have to partner with a car manufacturer to enter the market. Tencent (OTCPK:TCEHY), which already has an investment in Tesla, has been floated as a potential partner. A partnership with Tencent would mean that Tesla is betting on the Chinese market, as opposed to manufacturing cars in China and selling them elsewhere (including the U.S.).

In a potential JV with Tencent, however, Tencent would have the upper hand in the negotiations as it is a very strong brand within China.

Tesla could also partner with a battery manufacturer, and the largest battery manufacturer in China happens to also be the leading electric car company in China.

We think Tesla would be better served by partnering with an established car manufacturer as Tesla could learn some valuable processes that could be then exported to North America.

Conclusion

Tesla will be lost within China amongst a sea of domestic and foreign car manufacturers. China is already the world’s largest manufacturer of electric vehicles by a large margin and one of the world’s largest manufacturers of electric car batteries. It is also saturated with luxury brands.

What Tesla could gain, however, is the expertise to finally move from a niche player with a cult following in the West, to a large scale car manufacturer. Provided it can find a market for its vehicles, a successful China move could help Tesla to eventually 'grow' into its current valuation.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.