How Tesla's risky bet on making cars in China could pay off

Hong Kong(CNN Business) After a wild 2019, Tesla is finally making cars in China. It picked a rough time to start.

The country's car industry is in a major slump, with momentum expected to slow further as a broad economic slowdown becomes more pronounced. Tesla also faces stiff competition from local carmakers and foreign rivals with more manufacturing experience in China.

But analysts say that if Tesla CEO Elon Musk pulls off his risky strategy — it built its big, new Shanghai factory to grow its business, pump out more cars and better target Chinese customers — the company could give China's car market a much-needed jolt of energy. Local, troubled brands would need to up their game or die out.

Tesla could make out well, too. It has started electric vehicle production in China ahead of some foreign rivals, and its Shanghai factory could push its production costs lower. Success means grabbing a bigger slice of the world's largest car market.

Investors, at least, are optimistic about the company's plans: After falling as much as 46% earlier this year, Tesla's (TSLA) stock hit an all-time high this week.

A 'turning point' for the car industry

After years of growth, car sales in China have now dropped for 17 consecutive months.

Sales are expected to drop 8% for all of 2019, according to a forecast published by the China Association of Automobile Manufacturers. That's worse than last year's 3% slide, the first annual decline since 1990.

Next year looks a little bit better, but sales are still expected to decline 2%.

"The car market has reached a turning point," said Wang Hexu, a car industry analyst for Shanghai-based Hwabao Securities. He said that while the "high growth period" is over, sales will pick up again after 2020.

The slowing sales stem from China's broader economic problems, which have been compounded by rising debt, the US-China trade war and a severe shortage of pork, the country's staple meat. The buying power of Chinese consumers has also taken a hit, and big ticket items like cars are among the first things people avoid when budgets are tight.

"Consumers are concerned about future income and cash flows," said Zhang Huaizhi, an analyst for Dongxing Securities, a research firm based in Beijing. "They will put off buying cars or properties when they have too much debt."

Tesla may already be keeping those spending concerns in mind. Bloomberg reported last week that the company is considering cutting the price of its China-built Model 3 sedans — its best-selling car — by 20% or more next year. The publication pointed out, though, that such a decision could hurt Tesla's initial sales there because potential buyers might wait to buy one at a discount.

The company did not respond to a request for comment about the Bloomberg report.

Tesla can cut its prices and still make good profits, said Li Wenhan, a car sector analyst at Fortune Securities, a research firm in central China. He added that Tesla has received government support in China, including subsidies and lower tax rates.

An aggressive market

Tesla is the most recognized electric vehicle brand in the world, and its CEO has a penchant for bold ideas and an unconventional management style. The company has also had an erratic year: It lost a ton of money in the first quarter as competition heated up and its cars lost a big chunk of their US tax incentives, before rebounding as Tesla got a better handle on costs.

The company will have to stay on top of its game to succeed in China.

The country's car market has grown rapidly since the early 1990s, when the economy started taking off on the back of bold market reforms. By 2009, it surpassed the United States as the world's largest car market.

The Chinese government is now aggressively pushing for the adoption of new energy vehicles, such as electric or plug-in hybrid cars, and wants such vehicles to make up a fifth of its auto sales by 2025.

That goal is attractive to many companies, including major established brands. While western carmakers have been operating with local Chinese partners for years, and some of them are now zeroing in on electric cars. Volkswagen (VLKAF), the world's biggest automaker, has set a goal of producing 22 million electric cars worldwide by 2028 — more than half of which it wants made in China.

Tesla also faces competition from premium Volkswagen brand Audi and BMW (BMWYY), both of which have plans to start manufacturing electric vehicles in China in 2020. There are also homegrown contenders in China: Shanghai-based Nio, for example, is gunning for the same type of luxury customer as Tesla.

Tesla isn't new to the Chinese market: It's been delivering cars to people there since 2014, when Musk flew to Beijing and personally handed over car keys to Tesla's first Chinese customers. Revenue from China reached $2.14 billion in the first nine months of this year, a 48% increase over the same period in 2018, according to US government filings.

But Musk has touted the new factory — which was built in just 10 months and is the company's first outside the United States — as a game changer, calling it a "template for future growth." The company has said it wants to eventually make 500,000 cars a year in Shanghai.

Survival of the fittest

Analysts pointed out that Tesla's decision to double down on China could actually help weed out poorly performing companies in an oversaturated market.

More than 480 electric car makers had registered in China by March, according to the most recent data from National Monitoring Platform for New Energy Vehicles, a group that tracks the sector. Several of them have raised billions of dollars in funding over the past few years, raising the specter of an industry bubble.

That has led the government to dramatically cut incentives for buying electric vehicles — a decision that will lead to tough competition on pricing, according to analysts from Anbound, a Beijing-based research firm.

Tesla could create a "benchmark" for local brands to live up to, according to analysts from Fortune Securities. In a research note earlier this week, they compared Tesla to a "catfish" capable of stirring things up, pointing out that the company has more "advanced technology and brand recognition."

As Tesla is able to push its costs down and sell vehicles for lower prices, that will push companies that sell cheaper cars to improve their products. The Fortune Securities analysts said that pressure could even extend to big Chinese names like BYD. That company is expected to launch a new electric car next year called the Han, which will retail for about 300,000 yuan (roughly $43,000) — about 16% less than the starting point for Tesla's similar Model 3 in China.

-- Michelle Toh contributed to this report.