Apr 27 2020 - How Strong Is China's Leverage Over Tesla?

Summary

MaxedOutMama and I explained last week why we see Tesla’s center of gravity shifting to Shanghai. The article provoked an outpouring of comments.

Happily, some Tesla bulls were appreciative, and on several key points all seemed to agree.

Naturally, we had our critics. We attempt here to address the major lines of attack.

We examine the proposed escape routes, taking a close look along the way at the U.S. and China markets while unearthing further details of the deal.

We see no easy way to liberate Tesla's Shanghai revenues to feed a starving Fremont. China may even have Tesla's brand and IP locked down.

Introduction

The article I published on Friday in collaboration with MOM (@MaxedOutMama), entitled Tesla’s Transformation Into A Chinese Company Seems Unstoppable, generated a large number of thoughtful comments.

MOM and I were especially pleased that some who identified themselves as Tesla (TSLA) investors expressed appreciation that we had called to their attention issues they had never considered.

By way of a refresher, the article detailed some essential points in the agreements under which a Tesla subsidiary, which we call Tesla Shanghai operates in China. Those agreements include a Grant Contract under which Tesla Shanghai has rights to use the 214-acre factory site, a Factory Loan Agreement under which Tesla can borrow up to RMB 9 billion (.26 billion) for construction, and a Working Capital Loan Agreement giving Tesla a one-year line of RMB 2.25 billion (5 million).

We distinguished between Tesla Shanghai and the rest of the Tesla corporate structure (which we call the Rest of Tesla). We argued that inevitably Tesla Shanghai will be competing with the Rest of Tesla for customers, that Tesla’s Fremont factory is doomed to underutilization in consequence, and – worst of all – that the Rest of Tesla will be unable to extract any revenues from Tesla Shanghai for years to come.

We detailed why we believe the Tesla Shanghai agreements line up with plans the Chinese Powers That Be (or Chinese PTB, for short) are pursuing for worldwide manufacturing domination. We observed that Tesla’s activity in Brandenburg has suddenly slowed, and cast doubt on whether Tesla has the capital to proceed with the factory teased for the U.S. heartland.

We explained why the COVID-19 crisis has deepened the Chinese grip on Tesla and accelerated the shift of Tesla’s center of gravity to China.

And we concluded by explaining why it's imperative that Tesla furnish detailed segment reporting on China so its investors can adequately evaluate the welter of issues Tesla Shanghai presents.

In this article, we note the points on which it appears everyone agrees, and then turn to questions and objections raised in response to our analysis.

(Tesla CEO Elon Musk and Shanghai’s Mayor Ying Yong attend the Tesla Shanghai Gigafactory groundbreaking ceremony in Shanghai, China January 7, 2019. Aly Song, Reuters)

The Points on Which All Agree

MOM and I received hundreds of comments (1,000 and counting as I write this). Many expressed disagreement with some of our analysis. There was, however, no controversy regarding several points we made:

• No one took issue with our contention that starting with the Q1 10-Q, Tesla must begin furnishing detailed segment reporting on the Tesla Shanghai operations.

• No one took issue with our contentions that construction progress at the Brandenburg site has stalled or that German officials are waiting on Tesla to submit a detailed foundation plan.

• No one took issue with our interpretation of Clause 11 of the Factory Loan Agreement, which makes it impossible for the Rest of Tesla to access any Tesla Shanghai revenues until all debt owed by Tesla Shanghai to Chinese banks (including the Factory and Working Capital Loan Agreements) have been fully repaid.

Still, many readers resisted the idea that the structure of Tesla’s Chinese agreements creates a dynamic in which Tesla Shanghai will be competing with Fremont for the same sales, and will be starving Rest of Tesla in the process. In pushing back against this unpalatable conclusion, commenters made six different arguments:

• Tesla can simply raise capital to retire its debt to the Chinese banks, and thereby freely access revenues generated by Tesla Shanghai.

• Tesla’s Fremont plant is and will remain supply constrained, and therefore will not be competing with Tesla Shanghai.

• Alternately, Tesla Shanghai will not be competing with Fremont because domestic Chinese demand will be strong enough to soak up all Shanghai's production.

• Tesla can refuse to allow Tesla Shanghai to export vehicles.

• China lacks a deep enough talent pool to manufacture Tesla cars suitable for export.

• No matter what happens, Tesla always will retain the exclusive right to the Tesla logo and brand.

MOM and I have considered and discussed all these arguments. Here, we address each of them in turn.

Can Tesla Raise Capital to Retire its Debt to Chinese Banks?

Our article left open the possibility that Tesla could free up the Tesla Shanghai revenues by paying off the debt owed to the Chinese banks. Several commenters seized on this as the obvious solution.

This would not solve the problem of Tesla Shanghai competing with Tesla Fremont, but it could, at least in theory, free up Rest of Tesla’s ability to capture Tesla Shanghai revenues.

How much money would Tesla need to accomplish a full loan repayment? The maximum debt Tesla Shanghai can draw under the Factory and Working Capital Loans is (translated to dollars at today’s exchange rate) .575 billion. It's unclear how much Tesla has drawn to date, so the outstanding balance right now is surely lower. However, every dollar not drawn down is simply another dollar Tesla must pay out of pocket.

So, Tesla would need to be prepared to come up with .575 billion and, as well, come up with whatever part of its 0 million capital expenditure obligation it remains obligated to contribute to the Shanghai project. The total is likely to approach billion.

Can Tesla raise billion in a capital raise? It raised .3 billion earlier this year, before the effects of the pandemic were evident. A capital raise in the present environment might be more challenging, but given Tesla’s market cap, could almost surely be done.

However, there remain several problems with raising capital to repay the China banks, and in the final analysis, such a repayment would leave Tesla in the same position (subservient to the Chinese PTB), albeit with more freedom to shift revenues between the Chinese venture and the Rest of Tesla.

Most obviously, such a move would undo the splendid deal Tesla struck to have China pay more than two thirds of the factory construction costs at very favorable interest rates and repayment terms. At a minimum, Tesla would have to make an inconvenient explanation to its bankers and investors about why it was directing funds to China.

Second, Tesla would need to be prepared to step in and supply a substitute working capital line to Tesla Shanghai. The existing RMB 2.25 billion (5 million) facility expires in December and, moreover, appears too small to support the full scale of Shanghai production.

Third, Tesla, like all manufacturing firms around the globe, is simply trying to hang on for dear life. Tesla especially will experience high cash burn with its balance sheet unwind (as explained here).

Fourth, Tesla has committed to build a factory in Brandenburg, which is certain to be significantly more costly than the Shanghai factory. We happen to believe the Brandenburg factory is ill advised, and reported last week that forward progress appears to have stalled, with the ball in Tesla’s court. That said, failing to go forward with Brandenburg, and meet the promised production start in mid-2021, would be harmful to Tesla’s growth narrative, which is so crucial to its share price.

Assuming it does not need all of the next capital raise simply to hang on until the world economy recovers post pandemic, Tesla can use the new capital either for a new factory in Brandenburg or for debt repayment in Shanghai, but it seems improbable it can raise enough capital to do both. Given the importance of the growth narrative, Tesla may do what it can to stretch out the Brandenburg expenditures, but likely will choose Brandenburg over prepaying Chinese debt.

Finally, if the Tesla Shanghai operation is not immediately profitable, then any loan repayment gambit would have been for naught. Tesla in Fremont has never been profitable, and given the recession now rocking the globe, it would hardly be surprising if Tesla Shanghai were also unprofitable, especially in the early years.

Will Fremont Remain Supply Constrained Despite Tesla Shanghai?

Tesla came close to having adequate demand to run Fremont at close to full capacity pre-pandemic, but that's clearly not true now. Let’s do the numbers, using estimates that are intentionally shaded to the positive. The idea here is not to project what probably will happen. Rather, the exercise is to estimate a best case for the near-term to see the implications for the future of Tesla’s Chinese arrangements.

A. A Fremont Best-Case Scenario

We'll start from last year’s result, rounding up to 368,000 units.

This year Tesla will add the Model Y (which already has begun shipping in the U.S.). We don't know when the European version will ship, but given the collapse we already see in U.S. demand, it seems certain Tesla will try to ship some of those high-end orders later this year.

In the happy days before the world had to deal with a pandemic, Tesla told us it would ship “comfortably more” than 500,000 units this year. In other words, a 36% YoY delivery increase. That internal estimate probably was based on 100,000 extra units from Shanghai, leaving 400,000 for Fremont. Tesla surely figured its Y sales would cut into X sales, and that some of those Y sales would be transfers from customers who would otherwise have chosen a Model 3.

A 36% increase in deliveries in 2020 would not necessarily translate into greater revenues or better financial results. Recall that, despite an approximately 50% rise in unit sales, 2019 automotive revenue from deliveries (leasing and sales) increased much less – up only 12.5% from 2018. This was due to the general drop of S/X sales, the price cuts for all vehicles, and the lower revenue per car on the Model 3s as the SR+ was introduced.

And Tesla managed to lose only a bit less over 2019 than it had in 2018 – 2 million vs. 5 million. Automotive gross margin revenues (inflated in Tesla’s unique manner) dropped from 23% to 21%.

Factoring in price drops on all vehicles and the lower-level mix, this gives us a back-of-the-envelope 2019 ASP of about ,600. We’ve factored in that the exchange of Y vehicles for Model 3 vehicles should increase the ASP in comparison to 2019, thus helping mitigate the declining S/X sales. Ex-China, but pre-pandemic, 2020 overall sales likely would have increased by at least 10%, even though the major markets (Europe and the U.S.) have been tending toward flattening or decline. For instance:

U.S. 2018 total unit sales: 191,627

U.S. 2019 total unit sales: 192,250.

Here it's worth quoting an excerpt from the perceptive comment of @xonkd on the previous article:

I think the real issue is that the market just isn’t that big. Consider Tesla had 450k original reservations for the Model 3, but after 2.5 years still haven’t sold that many. So, is the global pool of Tesla car buyers simply around 500-600k no matter what the car looks like? Production restrained is BS; if it were true they would have 100k+ backlog yet they don’t.

The gentleman has a point. In order to stay slightly ahead of the game in the U.S., Tesla had to drop ASPs massively last year. In both China and the U.S., there was no expansion of the plug-in market from 2018 to 2019. There has been some shift to BEVs from plug-in hybrids, but the data belied theories that the BEV market was set to grow massively. Any growth remains dependent on subsidies rather than consumer preference.

It has to be obvious that as the market share of BEVs grow, governments will not be able to subsidize those sales to the same extent. Instead the policy efforts to boost BEV sales have steadily shifted toward mandates and penalties, but these efforts don’t seem as successful as large purchase subsidies, and of course the mandate and penalty approach pressures manufacturer profits. Whether the steady shift toward the penalty approach will survive a global economic crisis is highly questionable.

Yes, China is extending its subsidies due to the shock and awe crash in demand that occurred after the 2019 subsidy cut. However, that’s a band-aid. If you want to postulate that BEV share in China will grow from Q1’s sad showing of 3.3%, you also have to factor in the idea that China will not be providing large subsidies if and when the BEV share approaches at 8%. It can’t afford it. And neither can we.

B. TrueCar/ALG Sees U.S. Car Sales Dropping Hard.

So, what’s going to happen for Fremont in 2020?

Well, TrueCar/ALG's estimates for U.S. car sales have been dropping hard. ALG is the outfit used by organizations such as Moody’s to figure residual resale values. It’s highly credible. ALG's current forecast is for April U.S. retail new car sales to drop 54% YoY, with retail sales dropping 49% and fleet sales dropping 77%.

ALG also forecasts a drop for Tesla of 64% YoY in April, very much in line with BMW (OTCPK:OTCPK:BMWYY) (-69%) and Daimler (OTCPK:OTCPK:DDAIF) (-66.2%). Who's going to do the best (or, rather, get hurt the least)? Hyundai (OTCPK:OTCPK:HYMLF). Kia (OTCPK:OTCPK:KIMTF). GM (GM). VW (OTCPK:VWAGY). The less exotic brands are supposed to turn in 40% to 50% declines.

This is how it works. People who have to buy cars are on the lower rungs of the economic ladders. Those are not really discretionary purchasers, and on average, they are not affected by declines in their stock portfolios.

Who's gaining market share? Not Tesla. Not BMW. Not this year. Almost certainly not most of next year. These companies are projected to lose market share in the overall mix.

Over the full year, ALG now provides three forecasts for U.S. sales. The optimistic forecast, given only a 10% probability, is for US sales in 2020 to drop from the 17 million level to 13.1 million.

The pessimistic forecast, given a 45% probability, is for sales to drop to 11.3 million. It hurt to write that, so we'll use the optimistic one, which implies a 23% drop and an expected Tesla total this year of about 147,000 US sales. What the heck, add back in a 10% gain for Model Ys, and we are at about 160,000 in the U.S.

C. Shanghai Is Hurting Fremont And Will Hurt Even More Over Time.

Assume world market share shifts negatively in the U.S. because of added sales in China. Let’s peg U.S. share at 42%, and (continuing with our use of remarkably optimistic assumptions) we get world demand of about 380,000 Tesla vehicles.

So, where's Fremont? Even if production is restrained in China, Shanghai will produce at least 80,000 cars. Fremont, with a clear capacity of 400,000 vehicles, will be producing only 300,000, which is 75% of capacity, and a huge decline from 2019.

Next year? Add in a 10% increase, all in the second half of 2021. 420,000 vehicles, but Shanghai needs to take at least 100,000 of that, so just 320,000 left for Fremont.

Given Fremont’s capacity of at least 500,000 cars per year, and the inefficiencies and losses that attend underutilization, there’s simply no doubt about it: Shifting China production from Fremont to Shanghai already has hurt Rest of Tesla, and will continue to hurt even more.

Is Chinese Domestic Demand Sufficient To Soak Up Shanghai Production?

Construction is proceeding right now on Phase 2 of the Tesla Shanghai factory. Given the speed with which Phase 1 was completed, it's realistic to expect Phase 2 will be completed, and producing cars, before the end of 2020.

We know from Tesla’s latest 10-K that the completion of Phase 2 will raise Tesla Shanghai’s annual production capacity to about 300,000 vehicles.

At Gigafactory Shanghai, we have installed annual production capacity for 150,000 Model 3 vehicles that we believe we will eventually be able to push to actual rates of production in excess of such number, subject to local production of battery packs, which we began ramping there later than other processes. We have also commenced construction of the next phase of Gigafactory Shanghai to add Model Y manufacturing capacity at least equivalent to that for Model 3.

The assumption that Chinese domestic demand will be adequate to soak up that level of production is highly implausible. To understand why, we first examine the interplay of the two primary factors affecting the growth of China's domestic consumption: Demographics and debt. We then turn to an analysis of demand, pricing, and consumer behavior in the Chinese EV market.

A. Demographics and Debt

Demographics and debt are the two key factors driving the decline of the Chinese auto market in recent years. Chinese auto sales peaked in 2017, slowed slightly in 2018, and slowed further in 2019. This year auto sales will, of course, slow even more.

Consider demography. If the domestic population is sharply growing, consumer consumption will of course rise. This is not the case in China, however, and policy measures to reverse the demographic shift (first easing the one-child mandate, and then dropping it entirely) have been massive failures.

Why have the policy measures to reverse the population decline failed? That implicates the second factor, debt. Chinese consumers carry high debt levels.

For readers without any patience or interest in the nuts and bolts, the short summary is that consumer debt as reflected in household debt-to-income (or DTI) ratios has reached levels that imply a natural slowing of domestic consumption growth. Indeed, those DTI ratios reached levels last year that imply future consumption will decline absent strong and continued GDP growth.

An article from The South China Morning Post covers the highlights:

The country’s household debt-to-income ratio rose to 92 percent at the end of last year, a sharp increase from only 30 per cent in 2008, the Washington-based Institute of International Finance wrote in a research note.

The ratio is higher than the 86 per cent in Germany and close to the levels of 97 per cent in the United States and 100 per cent in Japan.

Those numbers are from 2018, and of course the trend continued in 2019. Statistics from the Bank for International Settlements showed Chinese DTI had risen to about 99% of household income by late in 2019.

As natural economic growth slows, Chinese consumers have become more and more focused on getting on the property ladder, with continuing rapid growth in mortgages:

At the end of June 2019, outstanding mortgage loans stood at 28 trillion yuan (USD 3.92 trillion) – 17.3% higher than a year earlier and equivalent to 54% of all outstanding household loans, according to figures from the China Banking and Insurance Regulatory Commission.

China’s regulators are aware of the problems of slowing growth and rising household debt. They hit the first stimulus button years ago by dropping interest rates. Needless to say, that has its own natural limits. The inescapable reality is that generating internal consumption growth through debt growth is a strategy that has been mostly exhausted.

B. The Downturn’s Effect on Consumer Behavior

The downturn in consumer demand, and particularly automobile demand, was evident even before the coronavirus hit. Painful under any circumstances, it's especially painful given China’s massive automobile production overcapacity.

We now enter the pandemic era, with its consequent shocks. Readers should understand that economic shocks reduce consumer incomes and thereby further worsen DTI ratios. This will magnify sharply the inevitable negative effects of high consumer debt.

The early consequences are seen here, with total Q1 retail sales of consumer goods down 19% YoY. The decline excluding automobiles was 17.7%, meaning the decline was even steeper for the automobile segment.

The Chinese consumer is still in shock mode, as detailed in the release from the National Bureau of Statistics in China. Specifically, spending in Q1 on food increased 12.6% YoY, whereas highly discretionary spending on items like gold, silver, jewelry, cars, appliances, etc., all had double-digit drops. In March the same pattern held.

C. The Chinese Auto Data

Can the Chinese domestic market absorb 250,000 to 300,000 Tesla vehicles per year? The Chinese automobile sales data, considered against the backdrop of the debt and demography considerations, and even without regard to the advent of the pandemic, strongly suggest the answer is no.

In both 2018 and 2019, total annual sales in China of EVs (most of them far less expensive than the base level Model 3) were only some 1.2 million. Let’s focus on the 2019 data. The NEV (new energy vehicle) market did not grow overall, but there was a shift from plug-in hybrids to BEVs sparked by subsidy changes. The extent of the subsidy-influenced changes in purchase patterns show that this is a very price-sensitive market.

China’s top-selling BEV in 2019 was the BAIC EU-series, which racked up 111,047 unit sales for a 9% market share. This vehicle is priced at about 230,000 to 240,000 yuan. In comparison, the much more expensive Tesla Model 3 closed out 2019 with total sales of 29,389 units for a total of 2% of market share.

It seems obvious that MIC (made-in-China) Model 3s and Model Ys will gain significant market share because of lower pricing and better specs. However, VW is making its own strong bid for this market, so Tesla is not going to have an easy go of it.

In the second half of 2019, subsidy changes sharply reversed what had been very strong growth in NEVs. BEV share increased vs. plug-in hybrids as subsidies shifted to favor longer-range BEVs, but BEV December sales overall, although a vast improvement from earlier months, were down 17% on a YoY basis.

Fast forwarding to Q1 of 2020, Tesla Model 3 achieved a total of 16,747 first quarter sales and a total of 13% of market share.

This was a very good result, but the pre-existing backorders probably pushed Tesla's market share higher than would have otherwise been the case. And the NEV share of the overall automobile market fell from 2019's 5.5% to 4.2%. Tesla was a much bigger fish in a significantly smaller pond, with Q1 BEV sales dropping 49% YoY.

Overall, we have a picture of an exceptionally price-sensitive market which is heavily influenced by subsidies. There's no reason to expect that dynamic to change, and Tesla will be disfavored later this year by the just-announced subsidy changes which favor vehicles priced just below Tesla's price point.

The Model Y is priced above the Model 3, and we expect Model Y sales to be relatively constrained by this price sensitivity. Similarly, the planned introduction of the long-range Model 3 will be affected negatively by the coming subsidy shift.

In big picture terms, if Tesla were to gain 10% of the total NEV market of 1.2 million units (an optimistic projection), it could expect about 120,000 units sales domestically. The market is not growing overall, and debt ratios imply that it will not grow that much over the next few years.

There simply is not market room for Tesla to sell 300,000 BEVs within China. Or even 200,000 BEVs in China. There wasn’t room before the pandemic shock, and even assuming a relatively full recovery by 2022, the internal market at these price points does not exist. And it really cannot exist. If China wishes to force ever-larger shares of the internal market to be BEVs, it will have to cut the overall vehicle market, and that it cannot afford to do.

Can Tesla Prohibit Tesla Shanghai From Exporting Vehicles?

In our article last Friday, we argued that, producing many more cars than it can sell domestically, Tesla Shanghai will turn to exporting cars, and suggested the target markets would be Australia, Japan, South Korea, and eventually Europe.

Some commenters said that a simple way to assure Tesla Shanghai would not compete with Rest of Tesla is simply to have the parent company decline to agree to those exports. Then, the thinking goes, Tesla Shanghai would simply scale back its production to conform to Chinese demand.

A. China Ultimately Calls the Shots in Shanghai.

This argument is fatally flawed for two reasons. First, under the Grant Contract, the Chinese PTB are always free to determine Tesla Shanghai has failed to live up to the “public interest” (Article 22) or is not conforming to “relevant standards” (Article 48), and revoke the land grant. Whatever the Chinese PTB want, the Chinese PTB will get, and if they want exports, they will get exports.

Like the Soviet Union before it, China prepares Five-Year Plans. The latest such plan includes ten key “Made in China 2025” targets. No. 1 is NEVs.

B. The Shanghai Export Boat Has Long Since Sailed.

A second flaw in the argument is its assumption that Tesla would veto export activity by Tesla Shanghai. In fact, Tesla already has agreed to Chinese exports. When Tesla signed the Grant Contract, it implicitly agreed that Tesla Shanghai would become a major exporter. The evidence is apparent in the Grant Contract’s Article 20:

The Grantee agrees that within 5 years after the land delivery (i.e. before December 12th 2023, the incomes of the construction project on the Granted Land for sales reaching target production will be no less than RMB SEVENTY-FIVE BILLION (RMB 75,000 million) per year and the total taxes for reaching target production will be no less than RMB TWO BILLION AND TWO HUNDRED AND THIRD MILLION (RMB 2230 million) per year…

(emphasis added, failure to close parenthesis in published translation)

How many cars per year does the emphasized language work out to? With the annual sales requirement of no less than RMB 75 billion by 2023, and Tesla vehicles at an ASP (average sales price) of, say, RMB 250,000 (,000), Tesla Shanghai will need to be selling 300,000 vehicles per year to meet the requirement. If we use the current lowest price of approximately RMB 300,000 for an MIC Model 3, the requirement dips to 250,000.

How many of those 250,000 to 300,000 vehicles did Tesla commit to sell to Chinese purchasers, thereby generating VAT revenue for the local government? The answer also appears in Article 20, in the portion not emphasized above, but emphasized here:

The Grantee agrees that within 5 years after the land delivery (i.e. before December 12th 2023, the incomes of the construction project on the Granted Land for sales reaching target production will be no less than RMB SEVENTY-FIVE BILLION (RMB 75,000 million) per year and the total taxes for reaching target production will be no less than RMB TWO BILLION AND TWO HUNDRED AND THIRD MILLION (RMB 2230 million) per year…

Again, let’s translate this to a vehicle number. Assuming a VAT of 10% and ASP of RMB 250,000, Tesla can meet the VAT threshold by selling only 90,000 vehicles per year.

In other words, Tesla signed on to produce 250,000 to 300,000 vehicles a year by 2023, but with only 90,000 or so of them to be sold in China. What will happen to those excess vehicles? Some, perhaps, also will be sold in China, but certainly not all of them. It's clear from the structure of the Grant Contract itself that Tesla Shanghai knew it was signing on to become an exporter of high-tech, high-quality vehicles when it entered into the initial agreements with China in October of 2018.

C. Shanghai Mission Creep Has Already Begun.

The shift of the center of gravity to Shanghai, and the consequent financial damage to Fremont, already is evident. The original theory was that Shanghai would make the SR version of the Model 3, which Fremont could not make profitably, but would leave the higher-margin profitable models (LR, AWD, Performance) to Fremont. Further, adding the Model Y to Fremont production would compensate for the Model 3 SR production ceded to Shanghai.

That has now changed, though, with Shanghai manufacturing LR Model 3s, and now erecting Phase 2 of the factory for Model Y production. These changes happened pre pandemic. Post pandemic, the lower revenue and under-utilization at Fremont will be even more dire.

Does Tesla Shanghai Lack the Manufacturing and Engineering Expertise Needed for the Export Market?

One commenter urged that China’s talent pool in manufacturing and engineering was too shallow, thanks to competition from many foreign enterprises doing business there, to produce cars of high enough quality for the export market.

We lack the knowledge to address this question, and invite comment from those with relevant experience, training, or expertise. But, does it matter to our central thesis?

In setting forth its strategic goals and its Five-Year Plan, China made clear it intends to become an automobile exporting powerhouse. In executing the Grant Contract, Tesla committed itself to the Shanghai factory’s mission of developing the expertise required to successfully export a large number of quality vehicles over a five-year period. Tesla management believed it could do this, and we are not prepared to claim it cannot.

If Tesla management is wrong, then it will lose the factory. Which brings us to our next section.

Will Tesla Retain Rights to its Brand Regardless of What Happens?

Some commenters suggested that because the Tesla Shanghai obligations are non-recourse to the Rest of Tesla, Tesla could simply walk away from the Shanghai project. That, they believe, would disable China from manufacturing vehicles with the Tesla name.

First, to be clear, because Tesla has mortgaged the Shanghai factory to secure repayment of the Factory Loan (Item 12 of Clause 11), abandoning the project would leave the factory, the equipment, and whatever funds remain in the Tesla Control Accounts in the hands of the Chinese banks, with the land reverting to the People’s Republic of China. (The same result, of course, would obtain if Tesla Shanghai were to default on its loan obligations at any time before repayment in full.)

But, what about the Tesla brand and all the intellectual property involved in building MIC vehicles? We believe it's possible if not likely that in the event of a Tesla Shanghai default (whether by abandonment, non-payment, or otherwise) the Chinese banks (and, hence, the Chinese PTB) would end up with the right to use the Tesla name and all the IP embodied in the factory’s processes.

The applicable Factory Loan Agreement provisions are:

• Clause 1’s definition of “Security Interests” to include (among other things) any “pledge, lien, deposit or any agreement or arrangement having the effect or for the purpose of a collateral security”;
• Clause 1’s definition of “Finance Documents” to include “this (Factory Loan) Agreement, the Mortgage Agreement over the Land, the Account Control Agreement, and any agreement that is designated as a Finance Document by the parties”;
• Clause 1.2’s “Principle of Interpretation” spelling out that the term “assets” is to be “construed to include all present and future, tangible or intangible asset, property, income, revenue, account receivable or each right and benefit in any asset”; and
• Clause 4.2, which requires Tesla to have executed “Finance Documents” before making its first draw on the loan line.

Putting it all together, it seems quite possible that Tesla executed (in addition to the Mortgage and Account Control Agreements) other Finance Documents in which it pledged “assets” related to the Shanghai factory. And, if that happened, the Tesla name and logo would fall under the broad definition of “asset” or “benefit in any asset.” One may argue Tesla Shanghai owns no brand name or insignia, but it clearly has the right to use the brand name and insignia.

If Tesla disagrees, it could resort to the dispute resolution procedure (Clause 21.2), which calls for binding arbitration before the Shanghai Sub-Commission of the China International Economic and Trade Arbitration Commission. Such a proceeding, of course, would be time consuming and uncertain, to say the least.

To escape this issue, Tesla could of course pay off the banking consortium. But the diversion of badly needed cash would be a bad outcome, and even worse if Tesla could not meet the annual sales threshold in the Grant Contract.

Tesla would wind up having paid billions to walk away and return to the position it had in 2018 in the Chinese auto market. The reputational harm would be immense.

Conclusion

For all these reasons, it seems Tesla has no real choice but to try to make the Shanghai factory work as originally envisioned and specified. It calls to mind the distinction drawn by the great English Prime Minister, Benjamin Disraeli, when asked the difference between a disaster and a catastrophe.

A disaster, he said, would be if my esteemed friend and colleague, Mr. Gladstone (a lifelong Disraeli antagonist), were to fall into the Thames. And a catastrophe would be if someone were then to pull him out.

The pandemic frustrates Tesla’s expectations and will require a disastrous shift of resources and market share away from Rest of Tesla. But the disaster is obligatory simply to forestall the catastrophe of forfeiting China altogether.

Final Note - Trading Tesla

Does it even need to be said again? Tesla’s share price remains altogether innocent of its business realities and financial fundamentals.

Options market action? Maybe. Chinese retail? Maybe. Forces larger than us? Definitely.

Just stay away.

Disclosure: I am/we are short TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short TSLA via long-dated calls. I view the share price as completely detached from fundamentals, and discourage selling the stock short unless any position is carefully hedged, long-dated, and a tiny part of one's portfolio.