Is Tesla, Inc. About to Build a Factory in China?

Since electric-car maker Tesla (NASDAQ: TSLA) confirmed earlier this year that it is in talks with Shanghai Municipal Government about building a factory in the region, there has been little news regarding the matter. But The Wall Street Journal chimed in (subscription required) this week on Tesla's plans for China, saying the company has made an arrangement with Shanghai to build a wholly owned factory in the city's free-trade zone.

A factory in China is particularly important for Tesla as the company ramps up production of its most affordable vehicle yet, the Model 3. Management believes the $35,000 car will help Tesla transition from a low-volume manufacturer to one that competes with mass-market players. But Tesla will need to succeed in China if it wants to meet its aggressive production and sales targets.

A Tesla factory in China

By working with local suppliers and making products close to its end customers in the region, Tesla could significantly reduce supply chain logistics costs and delivery costs. But since the factory would be wholly owned, Tesla likely wouldn't qualify for an exemption from China's 25% import tariff, according to WSJ.

A wholly owned auto factory in Shanghai would be a first for a U.S. auto manufacturer, WSJ noted. China typically requires international companies operating in its territory to form a joint venture with a local manufacturer. Such a partnership allows U.S. automakers in the market to bypass the local government's 25% tariff on auto imports, but there is, of course, a downside: U.S. automakers are only entitled to half of any profits generated from the venture. However, with a wholly owned factory in China, Tesla wouldn't need to share the fruits of its growing business with a local manufacturer. In addition, Tesla would be able exercise more control than if the factory operated as a joint venture.

Given how fast Tesla's sales are growing, and given Tesla's wildly ambitious target of increasing vehicle production from an annual run rate of just over 100,000 units today to half a million next year and a million in 2020, having greater control could help Tesla make faster decisions and grow its operations in China more quickly.

Why China is key

It's no surprise that Tesla is taking China seriously. Its sales have surged in the market recently. Between 2015 and 2016, Tesla's revenue in the market more than tripled from $319 million to $1.07 billion. Thanks to this rapid growth, Tesla's revenue in China went from 8% of total revenue in 2015 to 15% of revenue in 2016.

In addition, Tesla's strong appetite for market share -- even if it means forgoing profits today -- has led the company to adopt an unconventional pricing strategy in China. Unlike some other U.S. automakers that hike the price of their vehicles beyond incremental shipping expenses, taxes, and customs duties for their sales in the market, Tesla has committed to only increasing prices enough to cover these mandatory costs. This could help the company quickly gain an edge in the market.

But the best reasons for Tesla to build a factory in China are not company-specific. Not only is China the world's largest auto market, but the government has aggressively moved toward incentives and policy to support the adoption of electric vehicles. For growth-hungry Tesla, China is a massive opportunity.

Tesla expects to have more clarity on its China production plans by the end of the year.

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