Will Tesla’s China Gigafactory Give Porsche-Like Margins?

Recently, Tesla (TSLA) unveiled its first made-in-China Model 3 sedan from its Shanghai Gigafactory. It’s also now providing media test-drives. During Tesla’s third-quarter results, CEO Elon Musk stated that the company had already started doing production trial runs for the Model 3 at its China Gigafactory.

Impressive progress at Tesla’s China Gigafactory

The development of construction at the company’s China Gigafactory has been quite remarkable. In January 2019, it broke ground on the facility. After nearly ten months, it’s started assembling vehicles on the site. This feat has silenced critics who doubted the factory’s ability to become operational and the potential it holds for Tesla.

A two-pronged benefit to Tesla

This facility should benefit Tesla in at least two ways. Firstly, the trade war and tariff-related uncertainty have negatively affected it and other automakers. With the start of this facility, Tesla will no longer need to import the Model 3 from the US to sell in China. The Model 3 is also Tesla’s highest-selling vehicle in the country, so the company will avoid costly tariffs and related uncertainty. It had to increase its car prices in China in August due to currency-related fluctuation owing to the trade war.

Secondly, Tesla’s production costs are expected to be lower in China than in the US, at least when it ramps up fully. Lower production costs and lower logistics costs should enable the company to pass some benefits on to consumers and increase its margins at the same time.

Morgan Stanley: Tesla could earn Porsche-like margins on Shanghai Gigafactory

Some analysts also seem to be coming around to the idea of higher margins for Tesla from its China Gigafactory. On November 13, CNBC reported Morgan Stanley (MS) analyst Adam Jonas as saying that Tesla’s Shanghai Gigafactory could bolster its margins to the low- to mid-30% range. This, MS pointed out, was comparable to luxury auto manufacturer Porsche’s margins.

CNBC also quoted MS analysts as saying, “While most investors we speak with expect China to be a success for Tesla from a demand point of view, we have found that the part of the story that is still, in our opinion, widely underappreciated is just how profitable Tesla cars in China could be in a localized, mass scale, lower cost structure environment.”

Reduced labor, logistics, and supply costs in China compared to the US

One factor Morgan Stanley thinks could help Tesla achieve higher margins from the China Gigafactory is lower labor costs. They expect Tesla to reduce labor costs to one-tenth of the amount incurred at its California factory.

Tesla expects its costs to differ significantly in China compared to the US. In a press release in October 2018, Tesla noted that it was “operating at a 55% to 60% cost disadvantage compared to the exact same car locally produced in China.” This price differential was owing to ocean transport costs and import tariffs. Tesla should be able to avoid most of these costs after the factory becomes operational.

Apart from labor costs, as pointed out by MS, other factors will reduce Tesla’s costs in China. In the US, Tesla assembles its vehicles at the Fremont factory, while Nevada Gigafactory produces drive units and batteries. At the China Gigafactory, however, the company will assemble vehicles, produce batteries, and drive units at the same facility. This integrated approach should lead to cost optimizations.

Morgan Stanley: Tesla won’t be able to grab a large share of China’s EV market

Morgan Stanley isn’t sure Tesla will be able to secure a large part of the Chinese EV (electric vehicle) market. It is, however, optimistic that the company will still achieve profitability due to lower production costs. China’s EV market has become overcrowded due to the government’s initially liberal policies and subsidies.

In May, the South China Morning Post reported that in March, China had over 486 EV manufacturers. China has now been phasing out subsidies, which is negatively affecting domestic EV makers. China’s EV sales decline has accelerated since the government decided to reduce the subsidies in June. Local EV manufacturers, including BYD (BYDDF) and NIO (NIO), have blamed these rollbacks for their dismal profitability and weak demand. We discussed this in detail in Electric Vehicle Stocks Reeling on China’s Auto Sales.

Stock boost from Gigafactory

Tesla stock got a significant boost from its third-quarter results, which showed surprise profits for the company. This news, along with its positive outlook, led its stock to erase its year-to-date losses. As of November 13, TSLA was up 5.6%. The stock has gained a whopping 38% since it released its third-quarter results on October 23. Compared to TSLA’s gains, Ford (F) and General Motors (GM) are up 16.1% and 12.3%, respectively, this year.

Tesla’s gains have squeezed the shorts, who were betting big on its stock decline given its profitability concerns and overambitious targets. With the start of Tesla’s China Gigafactory, its stock price should get another boost.

According to Yahoo Finance, Adam Jonas expects Tesla’s Chinese sales to add about $4 to its 2022 EPS. Assuming a multiple of 15x, he expects this to result in a stock appreciation of about $60.