Tesla and China: What the Electric Car Maker Can Learn from Porsche

2014-tesla-model-s-in-china_100464978_hIn autos, as in nearly every other industry, China is now the largest market in the world. At the same time, China is also one of the most difficult markets to crack, as one Western company after another has found over the past 30 years. Being a neighbor in Asia has also not helped. Japanese and Korean companies, like their Western counterparts, can attest to the challenges they have faced trying to penetrate the China market.

In this context, Tesla’s experience in China has actually been quite good. The company began taking orders for the Model S in August 2013, and by the end of the year, pre-orders from China exceeded 5,000. Deliveries of the Model S began to arrive in the spring of 2014, and by the end of that year, the company had shipped 4,700 cars to the country. Due to a number of operating and sales issues, which are par for the course for newcomers to China, though, only about 2,500 of the cars were actually sold and registered to drivers. Under new management, Tesla’s operations and sales in China stabilized in 2015 and the company sold 3,700 cars.

Tesla’s turnaround in China came in 2016, just three years after first entering the market. Sales tripled to an estimated 10,400 vehicles, and the company reported that its China sales had crossed the $1.0 billion mark, accounting for about 15 percent of the company’s total revenues of $7.0 billion.  Moreover, the momentum achieved last year has carried over into 2017. In the first quarter, Tesla sold 4,799 units in China, an increase of 250 percent compared with the same period last year.

On the heels of its recent success in the country, Tesla announced in June that the company is working with the city of Shanghai to “explore the possibility” of opening a factory in the area. According to a company spokesman, Tesla has been considering producing vehicles in Asia for a while. “While we expect most of our production to remain in the U.S., we do need to establish local factories to ensure affordability for the markets they serve.”

Tesla is right to consider manufacturing its vehicles in China, the world’s largest auto market and the global leader in electric vehicles. Last year, China produced 28.0 million vehicles, nearly 30 percent of all the vehicles produced around the world, and this number is expected to grow to 40 million vehicles by 2025. Given its commitment to electrification, an increasing number of the vehicles produced in China will be electric.

In order to truly penetrate the China market, the international assemblers have found it necessary to establish vehicle production in the country. In nearly all cases, the international companies have been rewarded with record sales and profits. In Tesla’s case, the opportunity to eliminate the 25 percent import tariff and to benefit from subsidies and other favorable policies that the Chinese government extends to electric vehicle makers seems compelling. Nonetheless, the case for manufacturing Teslas in China may not be that clear cut.

Need To Share Profits: While Tesla will avoid the 25 percent import duty on its cars, profits in China will need to be shared with a Chinese partner. This, in combination with a possible loss in battery sales (see below), may offset the savings in import tariffs.

Ever since Beijing Jeep Corporation, the first Sino-foreign automotive joint venture, was established in 1984 between American Motors Corporation and Beijing Auto, the government’s policy has been that foreign companies cannot produce passenger cars, buses, or trucks in China, except in a joint venture with a local partner where the foreign partner’s ownership is limited to 50 percent. Every major auto company—General Motors, Ford, Daimler, Volkswagen, Toyota—has succumbed to the 50 percent ownership limitation, and the policy has survived China’s entry into the World Trade Organization (WTO) in 2002. Under WTO rules, China was required to allow foreigners to own majority stakes in some industries. However, the production of vehicles has remained in the restricted category, unlike the production of automobile components, where China has permitted foreigners to own majority stakes since 1993.

The only exception to the 50 percent ownership policy was made in 2003 when Honda requested and was granted permission to own 65 percent of an export-only auto factory in Guangzhou. However, vehicles produced in Honda’s factory can only be exported and cannot be sold in China.

Loss Of Control In Key Decisions: In a joint venture, Tesla will not totally control decision making. While the Chinese and foreign partners in a 50/50 joint auto venture in China presumably have an equal say in management, the reality is that the Chinese partner typically has an unequal vote in certain decisions, most notably in purchasing.

Among other compromises that come with a joint venture, foreign partners face pressure in China to localize components supply and to buy from suppliers with operations in the country, whether or not these are traditional suppliers in the foreign partner’s home market. In many cases, the favored suppliers have a close relationship with the Chinese partner. Any number of auto suppliers from the United States, Europe, and Japan will attest to the difficulties they have faced breaking into the China supply chains of their traditional customers.

There are several reasons why this has been the case. First, components produced in China are likely to be cheaper than components shipped into China from outside the country. (In the early days, the foreign companies were notorious for making money on parts sales by marking up the cost of imported parts to the joint venture, a lesson that was not lost on their Chinese partners.) Second, the Chinese partner typically has its own network of relationships and suppliers in China that it prefers to utilize.

Impact On Tesla’s Gigafactory: Massive battery supply is coming on stream in China. There are now over 140 companies making batteries for electric vehicles in the country, and increased competition will exert downward pressure on prices and stimulate innovation in the industry. In this context, importing batteries from the United States may be problematic for the joint venture.

In June 2014, Tesla broke ground on its Nevada Gigafactory in partnership with Panasonic. According to Tesla, its Gigafactory will have annual battery production capacity of 35-gigawatt hours (“GWh”) and will produce batteries for significantly less cost by using economies of scale, innovative manufacturing, reduction of waste, and the simple optimization of locating most manufacturing process under one roof. Tesla and its partners will collectively invest about $5 billion into the factory by 2020, with Tesla directly putting in about $2 billion of that amount.

While Tesla’s Gigafactory was considered to be an ambitious commitment to battery capacity when it was first announced, its impact has been superseded by recent events. In its comprehensive and authoritative report on the coming “Electric Revolution,” Bernstein, a highly regarded Wall Street research firm, predicts that global battery capacity will total 228 GWh by 2020, with 170 GWh, or 75 percent, of that capacity coming out of China. With so much battery capacity available in China, the benefits of importing batteries from the Gigafactory may be lost. To the extent that the Gigafactory does not supply batteries for cars sold in China, the underlying economies of scale anticipated for the factory may not be realized.

While the case for Tesla producing in China is strong, the alternative of continuing to export cars should not be discounted, with Porsche being a case in point. In 2016, Porsche sold over 237,000 cars worldwide. China, along with Europe and the United States, were Porsche’s largest markets, and the company registered sales increases in each of the three regions. In China, sales increased by 12 percent to over 65,000 vehicles last year.

Porsche is one of the most profitable car companies in the world. In 2016, the company had sales of $25.4 billion, and Profit After Tax of $3.0 billion. Rather than establishing factories in the United States and China, Porsche has obviously found it preferable to serve these large markets by exporting cars from its factories in Germany. In so doing, Porsche offers a good example of a company that has done very well in the difficult China market, without a manufacturing presence in the country.

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