How a Chinese factory could drive demand for Tesla vehicles far higher

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    Tesla FactoryBenjamin Zhang/Business Insider

    Electric-car maker Tesla may be close to making the final arrangements with the city of Shanghai for a car factory in the Chinese market, Bloomberg reported on Tuesday.

    An agreement with the city could be official as early as this week, Bloomberg said, citing “people familiar with the matter.”

    Making vehicles in China could help Tesla significantly. Here’s why.

    Eliminating tariffs

    Tesla CEO Elon Musk has been vocal about the company’s plans to eventually launch a factory in the important market for some time now. For instance, in an October 2015 tweet, Musk said a China factory could come as soon as 2018. He has emphasized on several occasions that the China-based factory would be built for local demand.

    Building and delivering cars in China comes with a key advantage — one that Tesla will probably take full advantage of: By building vehicles locally, Tesla can forgo a 25% import tariff. However, investors shouldn’t expect this benefit to flow directly to the electric-car maker’s bottom line. Hungry for sales growth and market share, Tesla will instead probably reduce the price of its locally built vehicles in proportion to its tariff savings.

    Tesla disclosed its pricing policy for global markets in a 2014 blog post called “A Fair Price.” In the post, Tesla emphasized that it will never try to bank on higher profit margin in some markets just because it’s possible. Instead, Tesla said for any given market outside the US, it will price its vehicles the same as they’re priced in the US, “adding only unavoidable taxes, customs duties, and transportation costs.”

    Tesla’s pricing strategy for the Chinese market is unconventional. Many automakers mark up their vehicles’ prices beyond incremental fees for operating in China, raking in a higher profit per car.

    tesla chinaNg Han Guan/AP

    Assuming Tesla maintains its existing pricing strategy, a factory in China would allow the company to price its vehicles aggressively in the world’s largest auto market.

    And considering a China-based factory will probably be focused primarily on building the company’s upcoming lower-cost, higher-volume Model 3, aggressive pricing on the company’s most affordable vehicle yet could generate surprising local demand.

    Why China is key for Tesla

    A look at Tesla’s most recent annual 10-K reveals why China is such an important market for the electric-car company. Not only did Tesla’s revenue in China skyrocket during 2016, but it now also represents a sizable portion of overall revenue.

    After initial challenges in China, including an overhyped launch that didn’t fully factor in demand from scalpers, and poor communication about Tesla’s plans for a charging infrastructure in the market, Tesla sales in China more than tripled in 2016 as the company doubled down on the market and built out its Supercharger network in the country.

    Tesla’s revenue in China in 2014, 2015, and 2016 was $ 477 million, $ 319 million, and about $ 1.1 billion, respectively. Revenue from China in 2016 accounted for about 14% of Tesla’s total revenue, up from about 8% of total revenue in 2015.

    By building a local factory and reducing the price of its vehicles to reflect the elimination of import tariffs, Tesla’s sales in China could eventually rival its sales in the United States.

    If Tesla really is planning to launch a factory in China soon, it will need to do it through a joint venture to meet China’s requirements for foreign investment to represent no more than 50% interest in any local venture.

    Daniel Sparks owns shares of Tesla. The Motley Fool owns shares of and recommends Tesla. The Motley Fool has a disclosure policy.

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