Rumor Mill: Elon Musk announcing a Tesla factory in Shanghai could ignite growth in China [Video]

Teslas are becoming common sights in the megacities of China. The company sold 10,400 vehicles in China in 2016 - triple the previous year’s figure - and sales for the first three months of 2017 have put it on track to double that this year. China represented around 13% of Tesla’s global deliveries in 2016, translating to $1.1 billion in revenue. And more growth is just around the corner - reservations for Model 3 in China are second only to those in the US. This week rumors began to surface about plans for a Tesla factory in Shanghai.

Above: Tesla has been gaining traction in China (Image: Tesla Central)

Bloomberg reported that, "Tesla Inc. is close to an agreement to produce vehicles in China for the first time, giving the electric-car maker better access to the world’s largest auto market... The agreement with the city of Shanghai would allow Tesla to build facilities in its Lingang development zone and could come as soon as this week... Tesla would need to set up a joint venture with at least one local partner under existing rules and it isn’t immediately clear who that would be."

Above: Rumors surface about a Tesla factory in China (Youtube: Bloomberg TV Markets and Finance)

While Tesla has been steadily increasing its China sales, most observers agree that, to really push growth into overdrive, the company will need to establish a joint venture with a local partner, as other foreign automakers have done to establish a local factory. Importing cars from California adds a hefty layer of expenses, and China’s 25% tariff on foreign-made goods and 17% value-added tax adds another. The end price to a Chinese buyer is as much as 50% higher than in the US - Model S starts at the equivalent of $105,000, and Model X at $130,000. Teslas remain status symbols for the wealthy, and most of Tesla’s 2016 sales were concentrated in Beijing, Shanghai, and Shenzhen, China’s centers of prosperity. Model 3 will probably sell for around $50,000 in China, putting it out of the reach of middle-class buyers.

Without a local factory, Tesla won’t be able to bring prices down to a level that will make Model 3 a truly mass-market model. Whether or not this latest rumor is fact, it's likely a factory in China is coming. And knowing what we know about Tesla and Elon Musk, it’s a virtual certainty that the company will reach for the sky and establish a local factory sooner rather than later. Fortune also recently reported that several Chinese companies and cities are actively courting Tesla for a joint venture. 

In any event, Tesla appears to have turned a corner in the world’s largest auto market. As Fortune's Scott Cendrowski writes, it’s an impressive turnaround for a company that has struggled with its China strategy. For its first few years in the country, Tesla was plagued by delivery delays, customer service missteps and a lack of charging infrastructure. More recently, several factors have combined to lift Tesla’s fortunes. The arrival of Model X tapped into China’s love of SUVs; the number of charging stations reached critical mass; and the company’s direct-sales model began to catch on. Perhaps most importantly, the rising tide of the government’s support for electrification is lifting China’s electric vehicle industry to new heights. In 2016, sales of plug-in vehicles in China rose 50% to 507,000, more than three times the US figure. The government is forecasting sales of 7 million per year by 2025.

Above: Tesla Model X has become increasingly popular in China (Image: InsideEVs)

For China, electric vehicles are not only a way to deal with the country’s choking air pollution, but also to gain a seat at the top table of the global auto industry. Although plug-ins incorporate cutting-edge technology, they are in many ways simpler to build than legacy gas vehicles. And Western automakers’ stubborn resistance to bringing electrics to the mass market offers an opportunity to fill the void.

Chinese automakers may not be able to compete with brands like Mercedes or BMW on quality, but a low-cost, no-frills electric vehicle - the kind that Chinese companies specialize in - could conquer the low-end EV market that the major automakers are ignoring (meanwhile, Tesla attacks from the high end).

More than a dozen automakers with Chinese owners or backers are vying for a slice of the growing electric pie, including Faraday Future, Karma, NEVS and NextEV. The latest hopeful is Sokon, a Chinese automotive manufacturer that just opened a Silicon Valley headquarters for a new electric vehicle subsidiary, SF Motors. “The EV industry in China is studying Tesla and taking inspiration from it,” said Fu Yuwu, president of the government-backed Society of Automotive Engineers of China. “It inspired a batch of Chinese startups who studied Tesla before they started their own business.” Meanwhile, Chinese corporate giant Tencent, one of the world’s 10 largest publicly traded companies, recently invested $1.8 billion in Tesla stock.

Above: Tencent’s purchase vaults the company to the position of Tesla’s fifth-largest shareholder and should provide Tesla with greater access to the Chinese market (Image: Bloomberg)

Tesla began taking orders for Model S in China in August 2013, and had 5,000 preorders on the books by the end of the year. At first however, in an effort to ensure a good customer experience, Tesla accepted orders only from buyers in cities that had Tesla service centers, and who had access to a parking spot and a home charger. These restrictions encouraged gray-market resellers, who bought in bulk and resold to buyers who didn’t meet Tesla’s requirements. The first China deliveries arrived in spring 2014, but customers outside of Beijing and Shanghai were told they wouldn’t get their cars until Tesla's new service centers were finished. Unlike in the US and Europe, Tesla didn’t get much coverage in the Chinese press. Most potential customers knew very little about electric vehicles - many didn’t understand that they are designed to be charged at home (of course, many consumers in the US still don’t realize this), and thought they would have to rely on public charging, which was almost non-existent at that time.

By the end of 2014, things were looking bad. Tesla had shipped some 4,700 cars to China, but sold only 2,500. The company blamed the shortfall on speculators, but, according to Fortune, several former employees say the real problem was a lack of customer support.

In January 2015, a company spokesman acknowledged that Tesla had been “a little bit too impatient in the Chinese market.” The company shook up its local leadership, making Tom Zhu head of China operations, and revamped its strategy. Elon Musk traveled to China to meet with President Xi Jinping and other leaders, and tweeted that he was “very optimistic” despite “earlier mistakes.”

Above: Tesla CEO Elon Musk meeting with China President Xi Jinping in Beijing (Twitter: China Xinhua News)

By the end of 2015, sales were still disappointing - 3,700 for the year - but the future was looking brighter. Tesla was installing Superchargers faster than anywhere else in the world (today there are about 120 Supercharger locations in China, and the company says there will be a total of 800 charging stations by the end of 2017).

Meanwhile, Chinese consumers were starting to realize the advantages of buying a Tesla. In China, most foreign luxury cars are sold at dealerships known as “4S stores,” which tack on huge extra fees. Tesla’s direct-sales model lets buyers avoid dealers, which are no more loved than they are in the US. Also, unlike other automakers, Tesla doesn’t jack up its prices for export markets - its vehicles are priced roughly the same in China as in the US. The bottom line is that, even though hefty import tariffs increase the total cost, Teslas cost less than other coveted luxury vehicles.

Chinese buyers have also learned that buying a plug-in car may be the only way to get any car at all in a reasonable time frame. To fight congestion and air pollution, local governments issue a limited number of license plates, and getting one can take years (in 2015, 6.2 million Beijing residents applied for 37,000 available licenses). In many cities, electrified vehicles are exempt from these restrictions, and from enormous registration fees. This situation has led to unintended consequences - Chinese consumers are buying plug-in hybrid SUVs as fast as they can get them, even though they may never plug them in - but that’s another story.

Above: China is gaining as a percentage of Tesla's overall business (Image: Fortune)

Another boost to Tesla’s China business was the arrival of Model X. The Chinese love SUVs as much as Americans do - in the first half of 2016, they accounted for 35% of passenger-vehicle sales. It’s no coincidence that Tesla sales started spiking when Model X arrived in the country in June 2016.

The most important factor for any foreign company doing business in China is a good relationship with the government, something that Tesla is carefully building. Like Apple, it’s putting money back into the local economy by buying Chinese-made components, especially touch screens. In 2015, Tom Zhu said Tesla would double its spending on Chinese-made parts, to $500 million.

Regardless, the big question looms... how (and with whom) will Tesla establish that 50/50 joint venture in order to establish a local factory in China? Bloomberg speculates that, "while Musk has blown into powerfully dug-in industries like autos, space and energy with little deference to precedent, in China he faces a different beast. He's going to have to play by the rules... It's hard to imagine Elon Musk jumping into bed with an old guard that Tesla was spawned to disrupt. Ditto for the 15 so-called startups with permits to make electric vehicles in China, most of which have ties to traditional automakers." 

Above: Tesla Model S in China (Image: Gas2)

That said, it's conceivable that "Musk's company could still form a partnership; it's just that the Chinese firm wouldn't have to be a carmaker. Instead, it could be a tech company like Tencent Holdings Ltd., which already has a 5 percent stake in Tesla." To that end, Tencent President Martin Lau said during a recent earnings call, “An automobile is becoming a smart device. We want to partner with the leading company in such fields.” Although plausible, forming a joint venture with Tencent would certainly be considered a disruptive move by Musk. But then again, disrupting the old way is standard practice with Tesla. This could get interesting, so stay tuned.