Thoughts on Auto Industry

The automobile industry is facing potentially massive disruption with the advent of new technologies. Electric vehicles, autonomous driving and ride sharing have the potential to alter industry value chains that have been in place over the last several decades. Thus, many established automobile companies could see their profitability erode as new competitors capture more of the value created.

There are no moats in the auto industry as it currently exists. Thus technological changes are inherently bad to the industry, because companies have to spend money to keep up with the changes and any benefits get passed on to the consumers. Any advantage gained from being a first mover are easily copied over.

1.      Electric Vehicles

The key technology to develop is to be able to produce batteries both in capacity and at low cost. Only Tesla is investing in battery production at this time but it should be possible for other companies to catch up as it might only take 2-3 years to bring a new factory online. There does not seem to be much of a barrier that would give one company a lasting competitive advantage over others in this area.

A charging network is another area that needs to be built up to sell electric vehicles to the general public. Here again there does not seem to be much of a barrier as current incumbents can subsidize existing gas stations to provide such facilities. A payment of $250K per gas station seems to be a reasonable price to pay which means that a network of 20,000 stations can be built at about $5 billion.

One potential risk is if Tesla cars turn out be like the iPhone and comes to dominate the auto industry, capturing the vast majority of the profits. There are a few factors that would mitigate this risk:

  • It is likely that Tesla would not be able to meet the entire demand all by itself – in fact the company acknowledged this when it released its patents. It is more likely to take up a share of the more profitable premium/luxury segment. Thus there would be a place for other auto companies.
  • The majority of the profits of the three Detroit auto companies is from pickup trucks. The owners of pickup trucks seem to have a high level of brand loyalty. These owners are mainly in the sparsely populated interior of U.S. rather than on the densely populated coasts where Tesla has built up a brand following. Still even if Tesla does not capture a vast majority of the market, it can kill industry profitability in this segment if its product gains significant acceptance.
  • Looking at the history of the automobile industry, there had been several improvements in the vehicles themselves but it has never made a meaningful difference in terms of changes to market shares of the companies involved. These improvements have always been copied by the other companies and the company that introduced the innovation did not enjoy any sustained increase in profits or market share.

Assuming a very rapid adoption of electric vehicles, in the scenario where people en masse decide they want to drive only EV’s say by beginning of 2018. Then many companies would rush to build out Gigafactories and this likely would grow exponentially. Starting with say 4 factories in 2018, then 8 in 2019, 16 in 2020 and peaking at 32 in 2021. It is likely that there would be many constraints even to reach a capacity of 32 factories in an year. Assuming very aggressively that companies can build a factory within one year, there would be 60 factories in operation at the beginning of 2022 meeting the needs of about 30 million cars or about 30% of the worldwide production during that year. This is very unlikely, but that is the maximum possible adoption rate for EV’s.

It would also be wrong to assume iPhone like adoption rate in the automobile market. iPhone reached a market share of about 35% of unit sales in 2016 since its introduction in 2007. Tesla and the whole BEV had reached a market share of about 0.4% in 2016 after it was introduced in 2008. Electric vehicles need a whole new infrastructure to be built up to support them whereas iPhone is leveraging existing infrastructure. Thus EV’s adoption is more likely a gradual process rather than a sudden spike.

The threat of electric vehicles is likely to show up 5 to 10 years from now when the technology would have established itself with electric vehicles making up 2-5% of the total automobile fleet in United States. It is less of a threat in the next 5 years as there is no existing or planned production capacity for electric vehicles to be a significant portion of the annual sales until then.

The real risk with electric vehicles to the existing automobile companies lies in improvements to the production processes. Companies that have sustained competitive advantages in this industry have relied on improvements to production processes like Ford’s assembly line and Toyota’s Toyota Production System. Incumbents have vast experience with internal combustion engines (ICE) but electric vehicles are much simpler and there might be better ways to assemble them. Tesla might gain such advantage if it is able to come up with such improvements based on it being the first mover.

2.      Autonomous Driving

Many companies are investing in autonomous driving including Google. It is likely that all the companies would have the technology that is on par with each other as they cannot be deployed until it works nearly flawlessly. Alternately, optimal solution in this case would be for the best autonomous software to be widely adopted by all the market participants. It would be in the best interests of the industry that all vehicles have the best possible software. In any given road, an autonomous vehicle would be just as safe as the least safe vehicle in that particular area. Thus, even if one company had a superior autonomous driving technology, it would not be a big competitive advantage by itself if it is the only one using it. There are further advantages to using autonomous driving software from a single provider as it would be simpler and probably more safer to coordinate and manage interactions between vehicles.  The company whose technology was adopted would end up with a royalty stream that all companies would have to pay for using that software.

So most likely scenario is that one or two companies would have a dominant share of on autonomous driving software but that company would not be able to monopolize the profits as much as the market share would indicate. All the automobile companies would have to cooperate and this would be more akin to Visa/MasterCard when they are owned by the banks.

An annual subscription to a mapping and navigation system that is accurate and up to date would also be required. Here again pooling of resources makes sense as having as much data as possible would make the system more accurate. This situation again points to a solution similar to autonomous driving software with Visa/MasterCard type provider owned by the automobile companies.

It would take another 5 to 10 years for the technology to mature itself to a stage where level 4 automation gains market acceptance as the technology needs to be validated in actual usage and regulations adopted for them. Since any failure can be fatal to both occupants and others on the road, the key system components would need to meet high manufacturing, testing and maintenance standards that are closer to the aviation industry.

This technology might have significant impact on the relative position of the various companies. For example, the enthusiasm for fast acceleration is absent for anyone other than the driver – passengers tend to be more sensitive to acceleration than drivers. When there is no driver, there is little advantage to buying a sports car or any premium features related performance. Factors such as interior design might take on more importance but where there is little chance of any sort of competitive advantage.

The advantage then would reside with the low cost mass producer based on scale. Autonomous driving would commoditize automobiles even more than it is now and industry is likely to consolidate into a few global companies.

An additional risk to this technology is if a technology company that relies on other sources of revenue (search or advertising) and which can derive additional revenue from data generated from autonomous software, subsidizes its vehicles, it could destroy industry profitability for the legacy automobile companies.

Even Tesla would lose some of its allure to customers when level 4 autonomous driving becomes fully operational, assuming autonomous driving software itself would either get monopolized by another company or commoditized without much differentiation. People would care less what car they are riding when they are just a passenger and are engaged in some activity and not focused on driving. A few of the advantages of the electric vehicle are partially mitigated as well – vehicle maintenance or refueling is less of a concern if you can ask the car to go to a dealer or an gas station by itself.

3.      Ride Sharing

This is likely to have only a marginal impact as many people would still prefer to own a vehicle – because they keep their tools handy in their pickup trucks, or drive a lot for those who are using pickup trucks as their work vehicles, families with young children who have a lot of things to carry and prefer to leave them in their vehicle, etc. This is more likely to reduce buyers only in dense urban areas but some of that compensated by higher usage from people who now take public transportation.

The risk is more when autonomous driving and ride sharing both take off. Then utilization per vehicle can be increased very significantly on the order of 10x from 15,000 miles per year to 150,000 – 200,000 miles per year. Even if this doubles the number of passenger miles used, this has the potential to dramatically cut down on the number of automobiles needed each year perhaps to half the current levels.

Since this would require level 4 autonomous driving to be operational, it would take another 5-10 years before it starts impacting the auto companies.

Summary

A risk with all these new technologies is that it would raise consumer expectations of what is needed in an automobile. If Tesla comes up with new features, the other automobile manufacturers need to match them and this could consume most of the free cash flow currently generated by these companies. Or it could reduce the prices the companies charge on their products. Thus overall profitability of the industry would decrease. Similar to Amazon’s impact on retailers. This is all the more likely because the companies that are driving these technologies have different motivations – Tesla seem to be driven more by environmental concerns and less profit minded; Google probably plans to use the data generated in self driving vehicles to improve its search/advertising business;

These risks are however at least 5 years away and more likely closer to 10 years. The risks are far away enough that one need not be completely scared away from currently investing in automobile companies, but they are not that far off that the risks could be ignored. Thus position size in this industry should be limited to a small percentage of the portfolio.

| May 19th, 2017 | Posted in Uncategorized |

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