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Wednesday, September 28, 2016

How TrueCar and other Third Party Auto Retail Vendors Work

by David Ruggles

How do the third party vendors like TrueCar, and the others, actually work? It’s really quite simple. The auto buying Consumer belongs to retail Auto Dealers. They have the money invested in inventory. They have substantial investment in facilities. The third party vendors spend large amounts of money to “hijack” those auto buying Consumers and take them “hostage.” They then “ransom” them back to the Dealers for a sizable chunk of change. In the case of TrueCar the “ransom” is about $400. on a new vehicle and $300. on pre-owned. That money is reinvested by the vendor and used to “hijack” and “ransom” even more car buying Consumers. They are able to “hijack” these Consumers by pretending to protect them from the Auto Dealers, as if the Consumers are helpless sheep. These vendors don’t lead their message to Consumers with the fact that they raise the cost of the Dealer’s sale, and the Consumer’s purchase price, by the “ransom” amount. How many consumers would knowingly pay an upfront fee to these vendors?

The ultimate customers of these third party vendors are the Dealers. That’s where their revenue is derived. Most Dealers understand what’s going on and aren’t happy about it. A large number of them, however, have capitulated. Others use the third party vendor strategy in their favor without paying for it. For example, a TrueCar customer can come to a Dealership that isn’t a TC Dealer. That Dealer can go to the TC site and use the information provided there as a closing tool to negotiate the deal with the Consumer. Because the non-TC Dealer’s cost doesn’t include the “ransom fee,” the Consumer potentially gets an even better price while the dealer makes additional profit if they split the unpaid “ransom fee.” The Consumer becomes a higher value owner to that Dealer.

All Dealers have advertising and marketing budgets. These third party vendors would like everyone to believe that their fee would be spent in other areas of advertising rather than adding to the cost of individual the vehicles sold to Consumers the vendor took “hostage.” The vendors insist that their services allow dealers to target their marketing efforts better, thereby providing savings. The fact of the matter is that Dealer advertising budgets have done nothing but rise since the proliferation of third party vendors came into being. The Internet has spawned so many “leads” that Dealers are now struggling to figure out how to “weight” them, to distinguish leads in terms of “likelihood to purchase.” Despite the fact that TrueCar has yet to make a profit, despite reaching a Dealer saturation point that they used to claim would make them money, many third party vendors DO make money. They make enough money that there is about to be a flood of new major players enter the field.

In particular, enter Amazon Vehicles, with pockets deeper than any of the existing players. They will potentially have the budget to do almost anything they want. Indeed, they can afford to fritter away a lot of money figuring things out. Relative to stand-alone players they can lose money for an extended period of time, in a market where profits are already diluted, all the while using their competitors as “pricing cover.” Dealers could call a halt to all of this by just saying no, but while a few may hold back, enough will participate because they just don't get it, and their rivals down the street will join to make sure they don't gain an advantage. So collectively they won’t say no. There will be further consolidation in this business as players with really deep pockets enter the fray. In the meantime, neither Consumers nor Dealers will be well served.

Tuesday, September 27, 2016

Do the "Jobs" Arithmetic: Trump Calls for 19 million Immigrants

mike smitka

In the first presidential candidate debate Donald Trump proposed creating 25 million jobs. Now currently 152 million people are employed in the US, out of a potential labor force of 156 million. Yes, we're short – by 4 million jobs. Now because of baby boomer retirements and lower birth rates over the past 20 years, the size of the potential labor force will rise to only 158 million by February 2021. So while he could oversee an economy that creates 6 million additional jobs, the only way to add 25 million new jobs would be to bring in 19 million working-age adults from outside the US. Yes, Trump must be pro-immigration.

...Trump can only add 25 mil jobs by bringing in 19 mil immigrants...

There are other, less palatable alternatives, such as instituting a draft of all 22 million youth of high-school age. Since relatively few of them work or have family responsibilities, that could get him to the 25 million level.

So let's assume instead that he's not engaged in sophistry but is instead being sophisticated. That is, he's arguing about GROSS job creation, not net new jobs. In 2016, on a monthly basis about 5 million people leave their jobs, voluntarily or otherwise, and 5.1-5.2 million people are hired, in what to those individuals are new jobs. Then all Mr. Trump proposes is 5 months hires at the normal rate. Using this metric, over 4 years he needs to create not 25 million but 250 million jobs.

Now does everything Secretary Clinton has said on the economy during her decades of public life make sense? Unlikely! We all spout nonsense on occasion. But she does have staff, listens to them, and mainly gets things right. Once Trump proposes actual policies, I'll look at her proposals. But so far all he has are sound bites that don't add up.

Thursday, September 15, 2016

4% Growth?! – Trump channels Bush's 2015 pipe dream

mike smitka

Just a quick cross-reference to a February 2015 post on this topic, "Promises versus Deliverables: Jeb Bush and 4% Growth". The argument that 4% growth is unrealistic is even stronger than it was 18 months ago, as labor market slack is less. We do not have 25 million Americans just waiting for a job to be created. Here is the latest update with data through the September 2016 employment data release of my periodic projection of actual vs "normal" employment levels, where the latter is adjusted to reflect the slowdown in population growth including the retirement of the "boomers."

Wednesday, September 14, 2016

A Puzzle: long-term interest rates

mike smitka

I'm hesitant to post this graph: rates are volatile and I know that looking for trends in financial markets is silly. OK, provisos out of the way. But I've faced a puzzle for the past several years in the flatness of the yield curve. Comparing the difference in rates at various maturities, say between 7 year bonds and 10 year bonds, allows us to calculate the implicit return investors expect to have on a 3-year bond in 2023, some 7 years hence. I normalize all those into equivalent one-year bond rates. Here, that means the rate that you need for back-to-back purchases of three 1-year bonds to make the total return of a 7-year bond and three 1-year bonds equal to that of a 10-year bond.

The puzzle is that such returns have been very low. In the example I just gave, the dark brown line in the graph on the right, that's been below 2%. Are investors really rational in a belief that nominal interest rates will still be below 2% in 2023, due to some combination of (very) low inflation and very low growth? And what of a risk premium? – investors also have to believe there is no downside, that the "tail" of the distribution doesn't include bad outcomes for bondholders!

Now there are surely institutional reasons why certain maturities are focal points, for example there may be classes of investors who want bonds maturing in 2023 to match a need for liquidity at that point, and others who want bonds maturing in 2026, arbitrage possibilities be damned. Markets for intermediate maturities may be thin, so that you pay a penalty for trading non-standard paper. Traders also have finite time, and cannot follow everything, even with computers as aids. Senior managers certainly aren't inclined to spend their time thinking through whether they should be "heavy" at a maturity 8.7 years, and then explaining that to the Board. In sum, focal maturities are convenient for many reasons. But to me it's still a puzzle.

Again, it's only been the past two weeks that things have changed, too little to be meaningful in either duration or magnitude – see the graph providing data for the past 2-odd years on the bottom left, which shows many such blips. But likewise note the graph on the bottom right, which tracks the implied 1-year rate 7 years out since 1990. What we are seeing has no precedent over the past quarter century. Why anyone would buy a 10-year bond that yields under 1.75%? Yes, the Fed can push short rates down. Yes, they hold a lot at longer maturities, the result of quantitative easing – in which they no longer engage. Yes, other central banks around the world have been or are engaged in QE while pushing short rates into negative territory. Perhaps with the rich world aging there really is a demand for the "safety" of bonds that is "outstripping" supply to generate low yields? I remain puzzled.

Why anyone would buy a 10-year bond that yields under 1.75%?

Friday, September 9, 2016

Evolution or Revolution? Yes, and Margin Squeeze

mike smitka

When it comes to claims of technology revolutions, I'm reminded of The Who's song:

Won't Get Fooled Again

I'm in the last stages of reworking a book manuscript co-authored with Peter Warrian on the auto industry viewed through the eyes of technology (we're currently rewriting each others chapters). The final chapter will examine autonomy, electric vehicles and new mobility services. I think the bottom line is encompassed by a simple question: will these raise total revenue? The answer to me is so obviously "no" that I won't spell it out, at least here. But the flip side is also clear: will it raise costs? It already has, and those costs are incurred up front: financial analysts, to your net present value calculations! But (almost?) all auto assemblers believe they must play this expensive game. We have a classic prisoners dilemma: if you don't spend money, you will lose out very big [and your board of directors will replace you]. If you spend money, your firm loses big [and you're around to receive another bonus].

...only one question matters: will industry revenue rise?...

Is there a way out? Perhaps, if OEMs can turn to suppliers to fund most of the R&D. Some of these are new entrants who are convinced it's worth paying up front to gain a seat at the table, or are soft in developing the business case (only a billion? not enough money to worry about). Or both. This is the same prisoners dilemma story, but OEMs may not have to pay the cost. However, the supply chain is also quite concentrated for such technologies, with a (global) Big Three in many sectors (eg, power control modules for electric vehicles). In my observation (backed by sitting through a smattering of internal business case presentations) these firms are more hard-nosed about funding R&D projects, hoping to recoup those that pan out (and pay for those that don't) through the high prices of early systems (which in turn are on luxury vehicles). However, they may maintain the ability to pass costs on to their OEM customers, that is, keep margins from compressing quickly. My bottom line is thus that OEM margins will get squeezed. The disappearance of the Chinese sugar daddy will accentuate that.

...OEMs are trapped in a classic prisoners dilemma: doomed if they do, really doomed if they don't...

More in teasers as the book content gets nailed in place. If all goes well it will be out in November.

For those unfamiliar with the PD (Prisoner's Dilemma) game, here's the basic 2-player layout:

New Technology Rat Race
Profits Relative to Starting Point
 Don't JoinJoin
Don't Join0, 0-10*, -2
Join-2, -10*-7,-7
If no one plays the game – the upper left box – profits equal the currently prevailing norm. If one plays and the other doesn't, then the player incurs costs greater than net revenue gain, but the non-player loses revenue, which in the auto industry results in a more than proportional loss in profits. Those are the upper right and lower left boxes. If both play the game, neither party sees a net gain in revenue, because these technologies don't expand the size of the overall market. However both see costs rise and hence profits fall.
The longer the lead time before new technologies actually affect sales – under the assumption that not joining the race does eventually cost sales and hence profits – the smaller this asterisked "-10*" loss will be (in absolute value, that is). Similarly, the greater the R&D share born by suppliers, the easier it will be to join the game at a later stage, improving the net present value (or here, reducing the net present loss!). If it becomes a loss of (say) -5, then it would be rational to stay out of the new technology game. If both players are rational in this narrow net present value sense, then we end up with no one entering the technology race, and are in the uper left box. However, I am not aware of any major firm that believes that to be the case, though in reality what really matters is likely the perception of the board of directors, many of whom are industry outsiders whose beliefs are influenced by the media hype around Tesla and Uber and Google's autonomous vehicles. After all, these decisions aren't made by some abstract entity called "the firm" but by individuals affected by career and reputational considerations. For examine, a director will face queries by their golf partners, and can boast about their firm's efforts rather than hem and haw about why there are none.
One final consideration: the above analysis is for 2 players, but the auto industry has multiple players, with for example 6 firms surpassing global production of 6 million units in 2015. I don't know the theory of n-person games; my assumption is that you need stronger assumptions to find a clear solution, but the standard PD result dominates. I've not systematically studied game theory – it wasn't part of the standard curriculum when I was a grad student, though I audited a one-term course in 1985 or so. My sense, however, is that introducing noise makes dilemma outcome more likely: as the likelihood that one player breaks ranks increases, so do the incentives for others to follow suit. My bottom line:

...OEMs are on a slippery slope, and it's started raining...

Friday, August 19, 2016

Durable Goods and Used Car Prices


Elizabeth Platt, May 2016. Reposted from the Econ 244 site.

As discussed in class, an automobile value depreciates as soon as it’s driven off the lot. A recent study using iSeeCars.com puts a number to that depreciation. Analyzing 15.7 million cars over the course of the year, the study finds the average car value loss is 17% of its value in the first year. However, individual models differ in their value loss. At the top of the spectrum, the Hyundai Genesis loses 38.2% of its value in the first year.

The study cites demand as a function of reliability, popularity compared to competitors, dependability, repair costs, and redesigns. Thus, many of the factors the study believes determine demand cannot be estimated until at the time of the purchase, making resale value more difficult to gage. The drop in value after the first year corresponds to a potential savings of $16,000 if the consumer purchases a slightly used model. Consumers have the option of buying a new car with little knowledge of its reliability or waiting a year to purchase a slightly used car with more information in one hand and savings in the other. One significant part of demand, though, is aesthetics. By waiting for a slightly used car, the consumer runs the risk the manufacturer may introduce a newer model. In a society centered on “keeping up with the Jones,” newer models make the option of a slightly used model unappealing to some consumers. On the other hand, not all cars depreciate at this magnitude, making a slightly used model less of a deal. The study found some models lose less than 10%, such as the Subaru Impreza which lost just 3% of its value in the first year. In the end, knowledge concerning the difference in value of a new and a used car can be extremely beneficial for the consumer.

UsedCarsSource: https://www.washingtonpost.com/news/get-there/wp/2015/01/21/the-best-bargains-for-buyers-looking-for-lightly-owned-used-cars/

...there is no such thing as a new car...

Chart by the Prof using data from the auto auction firm Adesa. These data are raw averages of varying mixes of vehicles. Tom Kontos, their chief economist, analyzes this in much greater detail, by brand, like-vehicles, with seasonal corrections and on and on.

The Prof's comments: This is a neat topic, because the physical depreciation of a car is different from the economic depreciation. It is also at least in part a strategic variable that car companies can influence, through adjusting competition among vehicles in their model lineup and the timing of new model introductions and (as noted below by Michael Adams) fleet sale and leasing policies.
The overall declining trend is a reflection of the Great Recession: no leasing and few sales of new cars and lower incomes led to a dearth of used vehicles amidst greater demand for generally less-expensive used vehicles. That effect lingers but has largely worked its way through the system. You can though see changes by category, e.g. trucks vs smaller cars. I don't know the impact of interest rates on the "yield curve" of cars. Lower rates make both bought-new and bought-used cars less expensive, at least for purchasers who are thoughtful about their financing options. Companies such as ALG that are involved in leasing surely model that. My hunch is that the income effect – higher purchasing power – offsets the substitution effect so that there is no net impact.

Comment by Michael Adams: This article helps to explain why firms, notably General Motors, have begun to scale back on fleet vehicles. The slightly used fleet vehicles, depreciated during their time of service, are quickly resold as used cars and compete with brand new models. Consumers can reap the benefits of a purchasing a gently used car if they are willing to wait for even a few months.

Murray Manley commented: I think this article is particularly interesting because it highlights the difference in some examples of consumer and producer preferences. For example, producers are always working on producing the next model and aiming to engineer the best car that matches or exceeds the car of competitors. This “keeping up with the Jones’s” in the producer and manufacturing world leads to increased profits- whoever can produce the best vehicle the fastest will ideally sell the most cars. On the other hand, while some consumers prefer to always have a new and fashionable model of a car, others cannot afford, don’t care about, or are unaware of style changes from year to year. In that respect, the customers who care less about new models benefit because slightly used cars will always be significantly cheaper if producers continue to come out with new models quickly.

Tuesday, August 16, 2016

Visit to Fox Recycling

Prof Mike Smitka

composite of student blog posts

In May 2016 I led students to Detroit, where we visited a wide array of auto-related businesses, as well as seeing something of the city and talking to residents (Tyree Guyton of the Heidelberg Project) and Martin Lavelle of the Detroit Branch of the Federal Reserve Bank of Chicago. This is the first of several posts that will convey student observations made in their online journals and blog posts. All the underlying material can be found at the W&L WordPress site for Economics 244. I've cut-and-pasted pieces, with prose to smooth the flow, but tried to maintain the voices of my students so am deliberately leaving it a bit choppy.

This post combines material from Barrett Snyder, Michael Adams, Elizabeth Platt, David Hochstadt, plus snippets and photos from others. Due to cutting and pasting, I've not attributed everything. Particular thanks are due Barrett Snyder, who set up our visit.

Class began the morning of Thursday, May 12th by traveling from our base at the Best Western Greenfield to Belleville, Michigan, about halfway to Ann Arbor. There we visited Fox Auto Parts, which has been in business since 1973. Here we met with Bill Fox, one of two brothers, who own both an automotive recycling facility and a self service “pick and pull” style yard. Mr. Fox explained to us the process of purchasing totaled vehicles from two main auction companies, Insurance Auto Auctions and Copart, and how cars are dismantled and parts are sold to body and mechanics shops. Mr. Fox stressed the importance of purchasing the correct number of vehicles and of the correct type in order to turn a profit in a business model with such slim margins and high overhead. Auctioned vehicles run between $1,000 and $10,000, depending on the model and the condition; the average acquisition price is about $1,800. Each day Mr. Fox checks out insurance auctions online and bids on several different cars electronically. If a vehicle is not from the 40+ acre IAA facility that is located adjacent to their property, then then have to pay shipping costs as well. The focus is on relatively new vehicles; the average car is less than 10 years old. After that demand falls off, both because there are fewer vehicles left on the road, and because fewer people are willing to pay the cost of installing a "new" engine in a car that age.

Elizabeth Platt added notes on the process. The first stop was where the cars are brought in and the major parts are removed to be sold. While software helps Mr. Fox estimate of what the car is worth, until they actually get the vehicle they cannot know exactly which parts are salvageable. We watched them go through some of that process, as they inventoried a newly arrived vehicle for what sections of it seemed to have no damage – which lights appeared good and so on. They we visited the area where a power train was being dissembled and checked for leaks and other signs that it might not be good. There was also a bay where everything had been stripped all the way down to the frame of a F-150. Anyway, each pulled part is categorized with a tag to be easily accessible to be sold in the future. But once they've assessed the extent of the damage to the car and categorize all the parts from the car which they can sell, they then leave most of them on and use a forklift to put it in their yard. Then if they get an inquiry, their computer will let them know if they have a car where that part is undamaged out in their yard. That's a lot easier than pulling, categorizing and storing parts that might never sell.

The software used to purchase vehicles is called “Bid Buddy” and helps to generate a maximum bid for a vehicle by using a formula that accounts for part sales, activity, and current inventory. We also discussed the cooperation between independently owned salvage facilities. The greatest example of this was the PRP trailer system that runs across a good portion of the nation, used to transport brokered parts between recycling facilities to fulfill each others needs and help say “yes” to the customer more and more often. The network is run jointly by 80-odd recyclers, ranging from the Snyder family business in Texas at the southern extreme, through the midwest and into the northeast. Depending on locus a recycler gets a truck twice a day that can transport a body panel from Texas (no salt on the roads so no rust!) to Fox to sell to one of their customers. Fox in turn has a copious supply of Fords, including F-150s, and they may be sending a transmission from Michigan to Texas.

Sam Wilson noted that this cooperation was not just at the institutional level but also at the individual level. Not only did the owner of this yard know the father of Barrett Snyder, a member of our class whose family has owned and operated its own Auto parts yard for a long time in Texas. Barrett’s father had actually helped this owner expand into a secondary line of revenue, a You-Pull-It yard. The YPI yard was set up with many rows of cars by the same manufacturer and individuals could pay two dollars to enter the lot, search the cars and pull off/out whatever pieces that they needed. They paid a discounted price at the end for whatever they wanted to take home. From what Barrett explained, this is really becoming the larger end of the market down in Texas. This market is mainly made up of individuals who have some auto background and either: 1) are rebuilding for fun and need specific pieces for as a weekend hobby, or 2) their car broke down and rather than spend lots of money to take it to a repair shop will come to the yard and get the piece they need to be able to get to work on Monday.

They also have to judge how long to keep a car in inventory, as it uses both working capital and physical space – they keep their lot, which holds a bit over 900 vehicles, relatively full. We were all impressed that despite the outward appearance of the business as dirty and labor-extensive, it relies on a lot of technology. In addition to using a packaged computer program to assess the value of a car before bidding, Fox uses algorithms to track how often customers request certain parts based on inquiries and customer feedback; their sales staff do a lot more than just answer the phone. This information allows Fox to be sure to have high demand parts in stock at all times. The owner stressed to us during our visit that Fox is not competing directly with other salvage yards but is instead competing against auto parts stores such as Advance and NAPA, and even the OEMs. (For example, OEConnection uses their database of repair parts as the foundation for software systems that they sell to OEMs such as Ford, to help their dealers sell parts to independent repair shops including the in-house ones run by cities and other "fleet" operators.) Anyway, these national chains of parts shops and new car dealerships are the big players, along with a few large, publicly traded companies like LKQ that Fox and Snyder fee offer you poor service and a poor product because they lack the family touch.

Henry Schwartz noted that the cars are placed outside for an average of six months during which time Fox sells every part off the car that they possibly can. They can pull wires (copper), catalytic converters and other items of value. The car will be crushed and sold for scrap steel. (The don't have a shredder – for that stage of the recycling process see this blog post on the Prof's visit to one in Japan.) After six months Fox will only scrap a car after they have broken even on it by selling parts to customers. As Mr. Fox pointed out, more that 80% of the overall vehicle that comes into a facility is recycled, making it the “greenest” portion of the auto industry. Many people don’t realize that the shops that do insurance repairs for the public often use recycled parts. After receiving their vehicle back, most would assume that the parts used were brand new. All the while, that fender or windshield wiper motor that was installed is now living its life again in a vehicle instead of residing in a land-fill.

Platt was fascinated by the YPI yard. That business model illustrates how a company can make profit on items that would otherwise be discarded. By cutting out the cost of labor, the part can be sold for less and also attracts consumers seem to truly enjoy the process of finding parts and fixing their own cars. What however are the legal liabilities of this process? The customer must sign a release form and pay an admission fee, and bring their own tools, but the potential for accidents is still there. The owner did not go into detail about this. Nate Frank, another student, wondered if the ROI wasn't a lot higher in the YPI yard, as the 900+ cars in their main yard (plus the warehouse and so on) represents $8-$10 million.

David Hochstadt noted that there has been a decline in mid-sized salvage companies, many of which have been bought by larger, publicly traded companies. The smaller, family operated firms are left to fend for themselves and face the dilemma of either expanding or risking going under. Fox currently purchases around 100 cars per month whereas a firm like Barrett’s family will buy closer to 200 per month. The business is very fixed cost driven, building structures around items and engaging in capex intensive purchases like construction equipment and warehouse space, in order to move things around and store parts. In order to continue operating an expand, Fox needs to make shrewd decisions in terms of the price they pay at auctions as this will increase their margins and allow them to hire more employees, purchase more vehicles and expand their operations. It was amazing to see how much of a car can be reused even after it has been in a wreck and deemed totaled by insurance companies: everything from transmissions and engines to things like wire harnesses (as they have the highest concentration of copper in a car) and steering columns. He asked about the future of the car industry and how it would affect salvage companies as the average model year has been getting younger. Will they be able to salvage things like rear-camera systems, safety-critical parts where they would find it hard to judge whether they are truly without damage? In the next couple decades, won't the biggest threat to salvage companies be the shift to autonomous cars, as this would lower the number of accidents, hurting both how they obtain cars – supply – and demand for parts?

Friday, August 5, 2016

Tesla Note: Dealerships and Inventories

Mike Smitka

One point in my critique of Tesla's flawed business strategy is that by engaging in direct sales it uses up precious cash. First, it does continue to burn through cash, though at a slower pace: cash from operations plus financing in 2016 Q2 came to -$160 million, up from -$480 million in Q1. However, this includes $150 million in deposits for Model 3, so on a recurring basis they went through -$310 million. This was offset by $2 billion in new money, but I would expect financial markets to prove reluctant to keep providing new money at this pace. So Tesla needs to conserve on cash. Yes, they receive cash from leasing, $143 million in the past quarter. This is normal for the industry, particularly for high-end vehicles. However they and not their banks likely bear the residual risk. So this could prove to be very expensive cash if lease-end resale prices are less than those built into the leases. Such unpleasant surprises are far from unknown in the industry. Oh, and Tesla has also run through their subsidies from the State of California, in the form of ZEV credits: last quarter they were $57 million, but this quarter they were negligible. They won't be able to count on this cash and the fat per-vehicle margin it has provided as they move towards the Model 3.

So how can they improve their cash position? In two words: franchised dealerships. Ford Motor Co. had Q1 revenue of $36.9 billion and inventories of $9.8 billion, or 27%. Averaged across a few quarters gives a level of 25%. How about Tesla, with their direct sales model? They have inventory of $1.6 billion on revenue of $1.3 billion, or 125% – 5x the level of Ford.

Can Tesla afford to expand their direct sales network? My answer remains no.

Tesla violates two prime rules of new ventures: preserve cash and preserve management time

To be fair, there is a devil's advocate position. The land and structures of a dealership hold value, where used by Tesla or someone else. In particular, Tesla could lease its stores from existing car dealerships, with the added benefit that they might be able to avoid creating stand-alone service bays. Banks could also provide floorplan, industry jargon for the financing of dealership inventory. These would lessen the drain on cash – but on net they would not generate cash. Back of the envelope calculations – very round numbers – suggest that the cost of a national dealer network would run $5 billion. (I've gone back and forth on this with co-blogger David Ruggles and one other invidiual.) Net of financing, this might require $1 billion in additional cash, spread out across multiple quarters. So it is not out of the question. To my knowledge, however, Tesla has not demonstrated any distinct advantages to its direct sales approach, other than PR, at the expense of significant management time and (I suspect) legal and lobbying costs. In fact, on the Pied Piper dealership satisfaction index, which uses mystery shoppers, Tesla ranks dead last.

On the dealership issue Tesla violates two prime rules of new ventures: preserve cash and preserve management time. So I remain a skeptic.

Footnote: Nikkei just reported that Nissan – joint with Renault a larger electric vehicle manufacturer than Tesla – is selling off its battery making operation. Why? Doing it in-house is more expensive and slower in keeping up with new developments. Why should Tesla be an exception? Source: 日産、車向け電池事業撤退 子会社売却へ 2016/8/5 17:34 日本経済新聞 電子版

Saturday, July 30, 2016

Predicting SAAR, Deconstructing SAAR

Mike Smitka

As an economist, I avoid the prediction game. I am also wary of reading much into a single month's data. What an economist can do is to provide reasoning why over time a particular average level of sales makes sense, and levels significantly above/below do not.

Let me start with the monthly time horizon. Next Tuesday we'll get the latest sales numbers this coming Tuesday (August 2, 2016). Those numbers will tell use sales down to the last vehicle, except for Tesla, which reported sales of 2,250 for the past 4 months. That's a false level of precision. First, there's human error, though that ought to average out. A sale won't get reported, or digits will get reversed, or ... The Law of Large Numbers though means that while there will be over- and under-reporting by individual dealerships (and DMVs), those will average out and not cause much error in the total for the whole market. But one thing we know is that claiming there were exactly 1,513,086 light vehicles sold in the US in June 2016 is not true. When I present data, I try to round things off to 3 significant digits, here to 1,510,000 units.

I dutifully look at the numbers, but for the next year or so I really don't expect to learn anything from them

Then's there's the conceptual issue, that what "sold" means is less than clear. Dealers face incentives to tweak the numbers to earn "stair-step" incentives where one more vehicle can add a lot to their bottom line. Better to get the bird that's almost in hand by reporting a sale, than to carry it over to the next month when they might fall well short of (or significantly exceed) the threshold with an uncertain payoff. In Europe, discounting takes an indirect form: rather than placing cash on the dash, as it were, a car will be sold and reappear on the dealer's lot as a used car with zero mileage. They're "sold" and they're not. The data again offer a false sense of precision. Again, my sense is that an error (accidental or deliberate) in one month gets averaged out in subsequent months. But it does mean reading too much into one month is inappropriate.

Then there are the random factors, snow storms and holidays that fall midweek and ... there are such every month. Whatever the "true" level of demand, the performance in any reference period will deviate from that. Yes, we can apply seasonal corrections, and try to remember that February sales in a leap year will of course be higher, and sales in a month with 5 Saturdays may also be quite different. Such corrections however are but fancy averages, and so will never get the adjustment quite right.

So what can an economist say? There are the house economists at Ford and the others, who in conjunction with others in management need to provide a number for each product for the coming month and quarter and year for scheduling overtime and shutdowns at the plant level, for issuing purchase orders to suppliers orders for the next 30 days, and for planning capacity. In this role a house economist is as much soothsayer as professional. Formal models get combined with experience to which hunches are added, because at the end of the day there has to be a number. What will the Fed do? Over the past year, much less than the Federal Open Market Committee members themselves had predicted. But even if they bump short-term interest rates by another 25 basis points, will that affect the rates on car loans at all, or otherwise change sales? There's no reason to think they'll get this right any better than the traders who are betting billions on bonds.

why no mention of GDP: some "advanced estimate" components are good, the headline number not

An economist can however put some limits on what is likely to happen, using theory and a reading of the available data (which only show what happened last month or last quarter, never what is happening today, and absent theory tell us nothing useful about what will happen tomorrow). Here I look at two factors that influence automotive sales, interest rates and employment.

Employment first. Over the long run light vehicle sales correlate very closely with total employment, with about 1 sale for every .12 sales for every million workers, With 145 million people employed, that gives a SAAR of 17.4 million. This is not a tight relationship in the short run, and over the full period of the graph shows a downtrend. Indeed, a simple linear regression would suggest that I use .10, though for technical reasons that surely exaggerates the trend. In any case, that hints that 17.4 million is somewhat generous.

Employment continues to increase. Part of that is because the overall population continues to rise. Using age-specific population projections and the relatively stable rates of labor force participation prior to the Great Recession lets me estimate a normal level of employment, the red curve in the graph below. That's rising at about 58,000 a month in mid-2016, falling to about 50,000 by mid-2017 and 26,000 in 2018. In short, fertility plus immigration is barely offsetting the retirement of the Baby Boomers. On that basis the labor force will increase by only 900,000 workers over the next 2 years. That means we won't see SAAR rise by more than 100,000 units, which is smaller than the month-to-month volatility in the sales data.

But as we know, the US economy has yet to fully recover from our Great Recession. Compared against the demographic-corrected trend level, employment remains about 4.3 million below the pre-recession levels. The US economy has shown steady employment growth for the past 5 years, since summer 2011. We've also seen participation rates increase for prime-age workers, though that too remains below pre-recession levels. Barring a distinct slowdown or a boom – nothing in the real estate and residential construction markets suggests either – then we will keep adding jobs for another 2 years. Using the 0.12 figure, that will push car sales up by 0.5 million units. So if I were an optimistic, I could point to a potential SAAR of 17.5 + 0.1 + 0.5 or 18.1 million units by end-2018. I think the likely sustainable sales rate relative to employment is likely closer to 0.11, while the economy faces more headwinds than tailwinds...

How about interest rates? Here the picture is quite clear: they will stay low. First, the Fed is unlikely to raise rates aggressively, given the lack of signs of either inflation or accelerating growth. Second, across the globe growth are down. The developed world, plus China, are aging. The population of Japan is falling in absolute terms, and the working age population is falling in Europe and in China. Then there's productivity: an economy grows even with a fixed number of workers as long as output per worker grows. While we have new gadgets galore, the increase in productivity from having a smart phone is less than that from having a phone. We in the developed world see some gains, but the realignment of work that access anywhen to the cloud enables is only affects a certain share of jobs, is happening only gradually, and is not leading to large gains in output. That example can be repeated for a variety of technologies; see Robert Gordon's The Rise and Fall of American Growth for a systematic analysis. [The work structure example is my own.]

All of this is reflected in interest rates: they have fallen across all maturities, as reflected in bond prices. Furthermore, the yield curve suggests no upturn in interest rates for the foreseeable future (which for US bonds is 30 years), either due to stronger growth or to inflation (or, more accurately, the sum of the two). That strikes me as an odd bet to make at 20 year time horizon, and historically long-term bonds haven't been good indicators of what will happen. In the 3-5 year time horizon, however, the story told by bonds is more credible: we won't see a boom. I have both a basic interest rate graph, and one that looks at the implied yield on 1-year bonds, calculated for example from the difference in 2- and 3-year bond yields.

The final element is energy prices. My track record is abysmal, but so to my knowledge is that of everyone else. (For my posts on energy, See "Another Fracking Saudi Conspiracy Story" and here for "Peak Oil Revisited: Did I Get Anything Right?") From the perspective of extraction costs, the era of really cheap oil is over. For now, however, fracking offers a lot of potential at intermediate prices, while demand growth has slowed and the cost of alternative energy sources has fallen, including both solar and wind. The world has more natural gas than it can consume, and while over time the ability to transport it from where it is produced to where it might be consumed via pipeline and LNG ships will affect that, it's hard to see what might affect prices of gasoline in the US through 2018.

In conclusion, next week we'll see many column inches and blog posts dissecting the latest sales report. At the firm and maybe even segment level, it could contain information, though at the monthly level I'm still reluctant to play that interpretation game. More generally, we'll have more of the same. I dutifully look at the numbers, but for the next year or so I really don't expect to learn anything from them.

Thanks to Dr. Paul Traub of the Federal Reserve Bank of Chicago, Detroit Branch and former head economist of Chrysler for pointing out the strong correlation between employment and sales. This idea can be tweaked in various ways, setting up a multiple regression framework that would incorporate changing vehicle longevity, putting in a separate variable for those employed but over age 65 and for under 25, putting in a variable for changes in gasoline prices, and for the interest rate (or perhaps, using a combination of loan rates and loan maturities and vehicle prices, monthly payments). Obviously I've not done that.

Tuesday, July 26, 2016

Book Review: Nick Kachman's Paint it red

Mike Smitka

Nicholas Kachman, GM: Paint it Red. Paperback. Buena Vista, VA: Mariner Publishing, 2015.

Businesses fail all the time, indeed a new business is lucky to last 5 years. Few notice such passings. It's more puzzling why big corporations on occasion self-destruct. They command substantial resources and have professional staff to follow market developments, and to handle operational aspects of the business with a level of sophistication and specialization that the handful of individuals in a small firm cannot hope to match. In the case at hand, General Motors helped define not just the auto industry, from market segmentation and the annual model change to consumer finance and the management of styling. They also helped develop modern management, as the exemplar of the multidivisional company with the separation of staff and line and the use of return-on-investment accounting to allocate capital. It's appropriate that the business school at MIT bears the name of Alfred Sloan, the single most important individual in the transformation of the company from a flailing conglomerate to displace Ford after 1921 as the dominant force in transforming the industry. Market research, corporate-wide applied engineering that helped lower costs year after year, a strong dealer system – the company seemed to be all strengths. During the 1960s it was not only the largest manufacturing enterprise in the world, but it systematically earned a double-digit return on sales, returns on investment of over 20% and returns on equity of 40%.

Yet fail GM did, maintaining high levels of investment and an overall lack of panic as they lost 2/3rds of their 1960s market share. Unlike with smaller firms, that's horribly costly not just to investors: many retirees and pension funds were GM-heavy. It was also costly to hundreds of suppliers and customers (for a car company, that means dealerships), to a quarter million or more individuals with family members who worked there, which combined to traumatize whole communities. Unlike a small business, where the owner as manager bears both responsibility and loss, most of those hurt in GM's failure were innocent participants who had no input into the decisions that led to failure, and often little ability to insure themselves against the consequences.

So why did GM decline, year after year, with little apparent concern in the C-suite? Unions weren't responsible for cars not selling and plants sitting idle. Nor were they behind poor financial decisions, from the depletion of cash reserves (the proximate cause of any bankruptcy) to investment projects that failed.

Nick Kachman's book, ably edited by family friend Ethel Burwell Dowling, provides insights into this on two levels. First, it portrays the power plays within the company at the senior management level where accumulating personal power while undermining rivals became central to the fight for promotion. While he is not particularly analytic on this, the essence seems to be that those good at this sort of infighting were highly sensitive to anything that might leave them open to attack. In particular, several key individuals took reasoned criticism of proposals via memos and discussions at committee meetings as personal attacks and not normal professionalism.

The second, and more carefully argued part of the book looks at specific strategic decisions and how (and by whom) they were made. That GM was dysfunctional is not in itself a novel insight. Covering some of the same time period there is for instance Maryann Keller's 1989 book, Rude Awakening: The Rise Fall and Struggle for Recovery of General Motors. This however is a top-down analysis, highlighting costly strategic mistakes but not providing much insight into why and how they were made. Others, such as Steve Rattner in Overhaul: An Insider's Account of the Obama Administration's Emergency Rescue of the Auto Industry or Bill Vlasic's Once Upon a Car: The Fall and Resurrection of America's Big Three Automakers--GM, Ford, and Chrysler, provide insightful accounts of top executives and decisions more proximate to the Detroit Three's 2008-2009 crisis. Both – particularly Vlasic – point to toxic corporate cultures. They do not however provide insight into how those developed and how they molded decision making. By focusing on detailed examples Kachman makes a major contribution. At the same time that focus on detail makes it a challenging read.

Paint matters, and that is his story. As it happens I've been in paint shops at Toyota, Ford, GM and BMW. Paint was the big barrier to mass production in the 1920s; Henry Ford could assemble vehicles with great efficiency, but he was unable to shorten the weeks it took to get the paint on car bodies to dry. The development of the all-steel body by Budd and Chrysler in the 1920s changed that, as the entire body could be put in an oven to dry in hours. DuPont's new paints helped.[note] Almost a century later paint shops remain the most expensive single section of an assembly plant, are the most energy-intensive section of a plant, are toxic, are the bottleneck in the flow of production, and are critical to visible quality. Kachman does a good job explaining that context.

So ... paint remained a headache, and it was also a target of environmental regulations, a mindset reflected in Richard Nixon's creation of the Environmental Protection Agency, which began operating in 1970. Paint goes on best when it is in a solvent, and at GM those solvents were volatile organic compounds (VOCs). They could be mitigated through better paint formulations, paint processes that got more paint onto vehicles and less on the floor, through sealing paint shops to keep fumes contained (which of course in a dust-filled factory is a good idea anyway), and through burning off the VOCs in a smokestack (and collecting waste paint and neutralizing it). But that was not the route GM took. Instead they wanted to move to water-borne paints that would eliminate the VOCs entirely.

The senior executives in charge fixated on using such paints. Those technologies now exist, but they did not in Kachman's day. With EPA deadlines looming, executives pushed ahead, without waiting for the development work that would "prove out" the processes. They weren't chemical engineers, and brushed off the concerns of Kachman, who by that point had almost 2 decades of experience and was justifiably worried that the commitments GM made would be impossible to keep. They were in addition expensive commitments, because shifting to water-based paints would entail closing assembly plants while paint shops were rebuilt. But by this time two key senior managers had bought in, one little-known outside narrow industry circles, and one of whom was the future CEO, Roger Smith. To cancel the project would jeopardize their careers. Neither chemistry nor expense mattered. Soon GM was committed to spend roughly $45 billion on new and renovated factories, with scant attention to the details of which plant would be built when and how that would affect the production of key products. Again, Maryann Keller and others had pointed out the huge investments made under Roger Smith in plants that never operated to potential. But her focus was on untried automation and failed product plans, and not on paint. As Kachman details, the addition of robots was an afterthought, something that could be done at the same time as the new paint shops to give GM a second "leapfrog" technology, while the product plans went awry in part because of the lack of planning on which plant would be redone when, leading to premature product terminations, premature introductions, or models kept in production too long. Keller and other contemporary critics focused on the robots and the cars that sold poorly, and thereby vastly underestimated the magnitude of paint decision that had more wide-ranging ramifications. They thereby also underestimated the poisoned nature of politics at the top of GM.

I won't provide more detail; I want you to read Kachman, not me. So far I have passed the book on to retired executives from a major global automotive paint firm and to a very senior person from one of GM's rivals, who worked directly with 4 CEOs. I'm a paint dilettante, and while to me Kachman comes across as someone who knows his stuff, my chemical engineering friend could attest that Kachman really does get the technical story straight. Then there's the more general management story. As my auto exec friend put it, someone who preferred overseas assignments to the politics at corporate headquarters (to which he was repeatedly promoted), "and I thought we were f...d up".

I may not use Kachman's book in my teaching, because my class is only 4 weeks long and I need to prep students in the first week for a series of visiting speakers and visits to auto companies, ranging up and down the value chain from suppliers to salvage yards. But I'm glad I stumbled across his book, thanks to meeting his editor/co-author Ethel Burwell Dowling, who ended up in the same rural Virginia community as myself. I will re-read it at some point, and keep recommending it to others in the industry. I hope to meet Kachman, too, and will ask Ethel for an introduction prior to my next trip to Michigan.

Monday, July 25, 2016

Clearing the Smoke on Tesla Deux

Mike Smitka

While Tesla the car company continues to burn through cash, Elon Musk is touting a capital-hungry vision of integration of his multiple ventures. As emphasized on Slate (The Folly of Elon Musk's New Master Plan), his core vehicle operations are crying out for operational attention. But without the battery plant, his future products won't exist, and without both the cars and the solar panels, his battery plant can't keep busy enough to make ends meet. Any one of the pieces alone is a daunting business challenge. Peer through the PR smoke-screen, and what he's saying is that none of the pieces stand alone. It's triple or nothing. That should give investors nightmares.

...[his strategy] is triple or nothing ... that should give investors nightmares...

Apropos to this blog, let me focus on the vehicle end of his house of cards. All would-be electric vehicle manufacturers continue to face the challenge that customers are uninterested in paying for being "green", outside of Musk's status symbol segment. Subsidies can kick-start the segment, but the budgets involved explode if sales prove robust, and become unsustainable politically. Even China set up its subsidies to phase out over time, or as sales (and costs to the government) rise.

His plan dismisses the competition. Musk isn't the only one aiming to reduce battery costs, but the gigafactory is a gigabet on one product. Others are ramping up in increments, as they add customers, with an "s". Now scuttlebutt from my co-blogger who lives in the vicinity is that battery plant is way behind schedule. Meanwhile if you add sales of the product pair of the Leaf and the Clio, you'll find that Nissan-Renault outsells Tesla. Their products are assembled on the same lines as standard "sister" cars. So they don't have to keep a billion-dollar factory busy with just one product. Plus when GM or R-N announce a new product to launch in 3 years, they hit that launch date, give or take a couple weeks. Not plus a handful of quarters.

One additional piece: inventory. To survive Musk will need dealerships that can provide service. Currently he has to haul cars that need repairs to and from one of his handful of shops, and provide "loaners" in the interim. As he moves downmarket, people won't have multiple "drives" in their car warehouse, and that will be both unacceptable to customers and too expensive relative to the cost of the product. Tesla dealers will also need 30-60 days of cars, and an ability to take trade-ins and provide finance. All these functions require real estate, too.

Carmakers have tried direct sales on and off for the past 100 years, including Henry Ford himself, and at Ford in 2000 (under Jacques Nasser). Now the success of dealership groups shows that it is possible to manage dozens of stores; dealerships don't have to be family businesses dominated by locally-based entrepreneurs. But Tesla ranks at the bottom in surveys of the quality of dealerships. If he is to move towards the mass market in the next 5 years, he really should be rolling out sales points, building service bays, hiring better managers, and spending hard cash on training now. After all, by the time he gets to market there will be multiple electric vehicles available. Customers may come to him, but as it stands his distribution system will drive them away.

...Musk is set to run out of cash and credibility, much the same thing...

The capital requirements for distribution are daunting. In the aggregate in the US there is $230+ billion in inventory for new cars. Real estate adds tens of billions more. Thanks to just-in-time production, inventories in manufacturing are but $30 billion, and that includes parts suppliers and not just vehicle manufacturers. If Tesla wants 2% of the market – 320,000 cars – then Musk will need to raise a lot more cash than he has to date, perhaps $5-6 billion just for distribution. Or he has to admit that his vision was illusory, and change his business model. He's running out of time – unless his next model really won't be ready until 2020. In that case, he'll have run out of cash and credibility, much the same thing.

To his credit, Musk has shown that thanks to the capabilities of supply chain and independent engineering houses, the entry barriers into manufacturing motor vehicles are lower than they have been in a century. The Chinese firms Chery, Geely, BYD and Great Wall, among others, provide additional testimony. Manufacturing however isn't enough; 30% of the industry's costs lie downstream, while keeping factories busy requires a careful product strategy that can roll out new vehicles on time and on budget. For new firms, those vehicles also have to be consistent good sellers. Musk has shown little or no recognition of those barriers, which have been the death of the visions of 4,000-odd ventures since the start of the industry. Tesla will make 4,001.

Friday, July 1, 2016

BEVs, AVs, Mobility 2.0: Disrupters?

Michael Smitka, Professor of Economics, Washington and Lee University
Judge, Automotive News supplier PACE Awards

The media are enamored of electric cars, autonomous vehicles, and "new mobility" as disrupters. "Just look at Tesla" is the logic and evidence: they have it all! Well, look quick, because Tesla continues to burn through cash at a prodigious pace. But the lack of a compelling path towards commercialization is only half the story. Alongside diminishing returns for additional features, the supply side also presents the challenge of increasing costs. For better and for worse, that pairing means that in 2030 self-driven internal combustion engine vehicles will still be how people commute to work, get their kids to soccer and do their shopping.

...the business case for new technologies is problematic...

From an analytic perspective, both the supply side and the demand side are a function of multiple, deeply embedded social structures, from where we live versus work and shop, to how roads and fueling and legal liability are organized. Changing one piece of the puzzle is very hard, a reality urban planners have longed faced: improving urban transportation incrementally by widening roads in bottlenecks does not solve problems. Here I'm thinking of the I-66 corridor west from Washington, DC, where I've seen 30 years of steady improvement. To the road, that is. The bottom line is that more people find living west of Dulles airport an option, so that not only does congestion continue, it continues for many more miles than in the past. Now I can provide a counterargument for this specific case. My point is that there are no simple fixes to complex systems.

look quick ... Tesla continues to burn through cash at a prodigious pace

So...we already have had autonomous vehicles on the road and in the air. Let me start with the latter: planes can and do fly themselves, and yet we have both a pilot and a co-pilot. Flying remains safer than driving, but we can point to clear instances of pilot error (including fly-into-a-mountain suicide) among the very small set of commercial air crashes. These sorts of systems are very, very hard to change.

What of passenger vehicles? Many of the requisite technologies were on vehicles by 2000, such as adaptive cruise control. These include electronic steering, brake-by-wire and radar to "assist" drivers. Self-parking was on the road in 2008. Yet uptake of the latter has been limited. Yes, early systems had challenges. But equally important was how much vehicle purchasers would be willing to pay for a car that would handle the challenge of parallel parking. Adding features adds costs. Cars will now keep you in your lane and brake automatically if the car you're trailing stops – in fair weather. How much are they willing to pay to have the capability in a greater range of road conditions? Clearly less, while such systems will cost considerably more. Yes, that equation will improve over time, but the challenge of finding a successful business case for additional capabilities remains. I won't go through the technical issues, or the legal.

Mobility 2.0 points to a different set of issues and a seemingly compelling business case. We have perhaps $3 trillion in assets in the NAFTA vehicle "park," registered if not regularly driven. Indeed, few are regularly driven. Let's say that vehicles are used an average of 1 hour per day (my family pickup truck seldom leaves our driveway, even when used). That's 4% of the time, so you've a lot of assets sitting idle. If you can monetize 1% of those assets, then potentially $30 billion are in play. Entrepreneurial mouths water. But that calculation is of the stock of vehicles, not the flow. The impact on new car markets will be small and spread over years. With NAFTA new car sales of 20 million units, new mobility models may generate a few billionaires but won't measurably shift the car market. (Now I started from a different point: if 5% of the vehicle fleet can be used 10% of the day, that's .1% of $3 trillion or $3 billion. But if the return on comparable investments is 20% (not what my retirement investments get!) then the amount of money at play drops to $600 million a year. Of course, shared mobility has been a option for a century. What is different today that will lead to widespread ride-sharing? Still, Autolib' in Paris deserves watching.

Then there are electric vehicles. They were the largest segment in many markets until a bit over a century ago. For example, internal combustion engines began pulling ahead of steam and electric in the US by 1904, but electric taxis remained on the road in New York City for another decade. Despite an intervening century of R&D, the low energy density of batteries compared to gasoline remains a barrier. Now a quiet revolution means that near-electric capabilities are more widespread, with start-stop systems far more widespread than more capable hybrid systems. There is steady progress in batteries. However, and contrary to expectations of 2 decades ago, there has likewise been steady progress in downsizing and improving the efficiency of standard internal combustion engines and particularly diesel engines. With the current level of gasoline prices, there is no good value proposition for the ordinary driver. Will that set of factors change?

...the benefits of adding incremental improvements falls, while the cost rises...

I believe that in the long-run we will be in a world of all-electric vehicles, but that will not happen quickly. Government policy can accelerate that transition, through the provision of better charging infrastructure. The various current policies of subsidization however are not sustainable. Rebates of 50,000 vehicles a year are one thing, those on 5 million are another. Similarly, rolling out showcase charging projects can fit inside government budgets, but building out a nationwide system quickly runs into budget constraints.

There is one other problem common to all three: that 300 million "park" [note: all round figures here]. Modern passenger vehicles last a long time, now an average of 12 years (my pickup truck is 28 years old). Somewhere on the order of 12 million vehicles are scrapped a year; 16-17 million are added. Put that into a spreadsheet, and even if in 2020 a full 100% of new vehicles are (say) autonomous, it takes another 10 years before half the vehicle would be. But new technologies don't roll out that quickly. First, they have to be designed into vehicles, and the drivetrains for model year 2020 are already pretty much locked into place, even if there's still room to play around with styles. So adding these will take place in stages, model by model. The core portion of Ford's F-150 probably won't be changed for another 6 years, maybe longer, and adding electric steering on large vehicles is more challenging than on small. But that's the biggest selling vehicle on the market. So even with a highly optimistic scenario we're looking at 2035 and more likely 2040. Interim technologies will be pervasive – lots of electric motors will be necessary to hit new fuel economy and emissions standards. But change will be evolutionary, not revolutionary. Put another way, piston makers continue to work on technologies that they don't expect to launch until the mid-2020s. Given that they sell into a growing global market, Mahle and Federal-Mogul expect to be making more pistons in 2030, not fewer.

So in the short run these technologies present long-run challenges to vehicle assemblers. They are not short-run threats. Sensibly or not, incumbents are also investing lots of funds in all three areas. Now there can and likely will be new entrants, but the Tesla's of this pending new world will account for only a trivial share of global production. In contrast, incumbents – here I'm thinking Nissan-Renault – already sell more electric vehicles.

This may be an opportunity for suppliers with big footprints in vehicle electrification, sensors and the like. Some new players will turn these into the core of their business, though the hurdles are great. The chip sets that go into a vehicle have to operate from -40ºC of northern climates to the 60ºC [140ºF] inside temperature of a car sitting in the sun in a desert. They have to withstand vibrations that on a cumulate basis resemble dropping a cell phone on the floor continuously for a month. And they have to keep working for 15 years. Furthermore, initial quality has to be extremely high, with defects of single-digit parts per million. Going from lab to vehicle is done all the time, but new entry is harder than at first glance. Meanwhile for the incumbents of the world, the Delphi's and Denso's and Bosch's, these are extensions of existing product lines. For companies that earn profits of $1 billion or more a year, new technologies won't have a (positive) impact on their bottom lines anytime soon.

...new technologies won't have a (positive) impact on bottom lines anytime soon...

What of Auto Alley in the US and the Auto Corridor in Europe, in which production is currently concentrated (see the work of Thomas Klier and Jim Rubenstein for data and analysis)? Yes, car companies are setting up R&D facilities in Silicon Valley, alongside in-house venture capital funds. But actually incorporating new systems into vehicles requires working closely with supplier and OEM engineers. That means locating somewhere near the Detroit-Ann Arbor Michigan nexus, that includes substantial facilities for the Detroit 3, Honda, Toyota and Hyundai, as well as virtually every global supplier. The reality is that Silicon Valley is setting up engineering operations in Ontario, Michigan, Ohio and Illinois. [Nissan, too – they employ about 1,200 in Farmington Hills, north of Detroit.] Apple and others are establishing their own partnerships, in Detroit. I don't have data, but my suspicion is that there's a net flow of jobs into the core US region, not out of it.

My thanks to the members of the "ToTo" Toronto-Torino conference for the opportunity to develop these ideas earlier this week at the University of Toronto. And happy Canada Day to one and all!
Bruce Belzowski of UMTRI is my source for the implications of vehicle park and the gradual roll-out of new vehicle models for the length of time it takes for new innovations to become dominant on US roads. For more on Mobility 2.0 from an investment perspective see Morgan Stanley's Bluepaper on Autos & Shared Mobility [the fully study is available only to clients], and also Arthur D Little The Future of Urban Mobility 2.0. Sources on electric vehicles and autonomous vehicles are too numerous to need links, but see a July 1, 2016 Bloomberg post "Fatal Tesla Crash Spurs Criticism of On-The-Road Beta Testing" that includes links and analysis of social and legal issues in which autonomous vehicles are embedded.

Wednesday, May 4, 2016

When Detroit looked like Silicon Valley

Mike Smitka

Autos are today a hi-tech industry; more on that in subsequent posts. The same was true circa 1900.

A quick window on the contemporary mindset lies in the pages of Scientific American. The late 19th century was the world of Thomas Edison (incandescent lighting was first used in the 1880s), of Dunlop and rubber (1889) and bicycles (1885 for the first chain), of more powerful (steam) locomotives, of battleships and bridges. Searching the titles shows only scattered mentions of automobiles. During the first half of the 1890s, the hot topics were developments railroads, followed closely by marine transport, and then steel and electricity. By the end of the decade, topics electrical dominated, with railroads close behind, followed by bicycles and then ships. Electricity remained the hot topic at the start of the 1900s, but now automobiles came in second, followed closely by ships. Railroads were fading as an area of interest for technologists of the era; bicycles were a mature technology. The last four years of the decade saw electrical developments as the most common, followed by railroads, automobiles and ships. Throughout the period 1890-1908 advances in transportation were presumed a major interest of readers.

Detroit was the Silicon Valley of the 1905 era

So did the venture capitalists of the day. Ford's first commercial attempt at making automobiles (1899) failed within 2 years, and he soon left a second venture in the hands of unhappy investors to found today's Ford Motor Company in 1903. That startup began with $28,000 in seed money. That was a tidy sum – a $2.50 workday and a six-day workweek meant a decent job paid $750 a year – but not out of reach for wealthy investors.

Ford was not alone in this. While the modern automobile originated in Germany, and many of the key technical advances were then made (and first commercialized) in France. Europe though was fragmented, and remained so through 2003, when the end of the Block Exemption finally allowed a fully integrated market across the continent. The U.S. was a bigger market, unimpeded by tariffs and in sheer numbers a larger middle class, the China of its day. Entrepreneurship was everywhere – new towns needed their retailers, farmers needed to sell their produce to people who could store and ship it, and provide financing; reapers and other new-fangled agricultural implements needed sales, financing, repairs. Dynamism is both provides the opportunities and is an outcome. Cars were just one avenue.

As with Silicon Valley, the industry was populated by serial entrepreneurs and networked individuals. For the US, Thomas Klepper [2002] analyzed data on 725 ventures for which sufficient records survived to confirm that they sold at least one vehicle. (Others have subsequently expanded that list.) About 120 were manufacturers of other products that tried their hand at cars; another 145 were spinoffs from existing car companies. Finally 108 were headed by entrepreneurs with prior industry experience. In total, just over half of all ventures were part of this broad start-up community.

Early entrepreneurs had to battle with the physical layout of cars, which gradually evolved away from being mere horseless carriages, and with what would provide the motive force – steam, electricity, or internal combustion engines. It took until 1903 for the industry to focus on the latter. Who would buy cars? The early market was partly for well-heeled enthusiasts, spurred on by racing. It took a while for them to become practical, but by 1905 there was a reasonable chance that someone would be able to both get where they wanted to go, and return. Dreamers could easily point out the limitations of horses: costly to keep up, a public nuisance because they were inefficient in eating [almost a pound out for a pound in], limited in distance, and needing a wagon to convey more than a single rider. Automobiles were touted as the way of the future.

Initially these ventures were scattered around the US, with only 1 of the first 69 firms during 1895-1900 located in Detroit. But by 1913 there were 41. In a later study, Klepper [2007] traced the process of spin-offs and the movement of experienced managers from existing firms to new firms. Detroit however had a diverse and large manufacturing base, including rolling stock for railroads, cast iron products such as stoves, shipbuilding for the Great Lakes, and other diverse industries. It was centrally located, and large enough to provide sufficient labor. Other industries, such as the (horsed) carriage makers of Flint (home to Billy Durant), were nearby, and there was a bounteous supply of wood for making car bodies. With the success of Packard and Olds, this base proved larger than in New York City, St. Louis, Chicago, Rochester (NY) or Indianapolis, which were the other five early centers. (This is from Cabral et al. [2013] who revisited the issue to focus on determinants of firm survival.) These all had a broad base, but through chance a couple Detroit-based firms did better, and spin-offs (such as Chrysler) were more numerous and more likely to survive the initial start-up period. The semiconductor industry saw entrants such as Texas Instruments outside of the Bay area, but that developed into Silicon Valley. The same thing happened with autos and Detroit.

Nor is venture capital new. The public, or at least the stock market, believed that cars would be the wave of the future before the rise of the "killer app" of Ford's Model. Entrepreneurs could aim for an IPO at an early stage; Billy Durant was able to scrape together a bunch of such ventures in 1908 to create General Motors, which effectively failed in 1910 and again in 1920 only to rescued by creditors. Investors wanted into the new hot thing – which included the formation of other "general" "American" and "trust" agglomerations such as General Electric (1896), American Sugar (1891) and American Tobacco (1890). Durant and his General Motors were part of a boom of such firms in the years leading up to WWI that found a ready market for their shares, even if there was not much of a market for their products.

In sum, from the perspective of technological innovation, venture capital finance and a geography-based entrepreneurial start-ups culture, Detroit was the Silicon Valley of its era.

Table details. The categories represent counts based on the following search terms in the ProQuest database of back issues of Scientific American, which ends in 1908. There is likely some double counting, if for example the title included "horseless steam carriage." Search terms were: electrical = elect*; rail = rail*;ships = ship* OR boat* OR vessel* OR sail* OR steamer*; automotive = automo* or horseless; steel = steel* OR iron* OR metal*; engine = engine or engines; bicycles = bicycle*; wood = wood*; chemistry = chemi*. I did not try counting articles on geology and paleontology (lots of dinosaur finds!) or biology, medicine, agriculture, or astronomy.

Cabral, Luis M.B. M., Zhu Wang, and Daniel Yi Xu. “Competitors, Complementors, Parents and Places: Explaining Regional Agglomeration In The U.S. Auto Industry.” National Bureau of Economic Research, 2013. 6114.

Klepper, Steven. “Disagreements, Spinoffs, and the Evolution of Detroit as the Capital of the U.S. Automobile Industry.” Management Science 53, no. 4 (April 2007): 616–31.

–––––. “The Capabilities of New Firms and the Evolution of the US Automobile Industry.” Industrial and Corporate Change 11, no. 4 (2002): 645–66.

Tuesday, April 26, 2016

Another fracking Saudi conspiracy story, or Chapter 11 is a marvelous invention

Mike Smitka

Let me revisit a topic that matters a lot to the auto industry, what's happening in the energy sector. Frank Gaffney, of the Center for Security Policy, is pushing a case against Saudi Arabia. While this may be a good thing for him to do to drum up business in the national security arena, the claim that "Saudis Waging ‘Economic Warfare’ Against U.S." (this is as reported on the web site of something called the Open Fuel Standard). This is laughably wrong, except for it involving a set of serious policy issues.

low prices can’t destroy the fracking industry, they can only change who owns the debt

To quote:

“You know, they said explicitly when they were driving down the price of oil ... that they were doing it to destroy our fracking industry. That is a hostile action. They’re now talking about dumping Treasury bills ... That’s an act of economic warfare as well."

First, the Saudis are desperate for cash flow, but the only thing they can do is to produce more. They’re simply not big enough. If they cut output 10% global output drops by under 2% and prices only go up by less. Let's be wildly optimistic and assume prices rise 2%, more than any demand elasticity estimate I've seen. That means their total revenue drops 8%. [The arithmetic is P(1+2%)Q(1-10%) which is original revenue PQ(1-8%).] So if they cut output they cut their own throats (or more accurately, invite a palace coup or worse that will cut their throats for them). Next, the secondary recovery they’re using also makes cutting output hard, they lose output permanently. [Once they stop forcing high-pressure water around the perimeter of fields and the compensating withdrawal of oil from the center, oil will flow back towards the edges and they'll be unable to get it out.] Third, OPEC is not a functioning cartel where the Saudis can get others to coordinate to cut output. It’s too big a group and there’s no enforcement mechanism, everyone cheats to the point that agreements are meaningless. That's been true in the past – empirical work by both economists and political scientists – and nothing has happened to change the incentives of Saudi Arabia's erstwhile co-conspirators. [The theoretical case requires that members can monitor output, and that they have some option to punish cheaters. For OPEC neither holds.] It’s a convenient boogeyman so the myth doesn’t go away.

The Saudis make a good foil for energy debates; it helps that no one feels much sympathy for them. But oil is a global market, and while it's not perfectly competitive, as economists define the term, changes in supply or demand in one part of the globe (the US and China) affect prices throughout the world. Furthermore, the market for petroleum interacts with developments in supply and demand for other sources of energy. In that context, the Saudis have stood out in periods when short-run increases in demand were large relative to the ability of energy suppliers to respond. But that’s not because they held back output, or otherwise did much beyond pump what they could.

Today they are desperate for revenue. What they do is thus dominated by the short run. They have not always been so thirsty, and so short-term in focus. In the past those in the government and Aramco could think about the long run, whether they should pump less when prices were low to have more oil to sell when prices were high. However, even in the past they reacted to the market, they didn't set the market. Their strategic space has shrunk, and they no longer have the option to hold oil production back. Yes, people watch Saudi Arabia. Perhaps their strategic concerns are sufficiently representative of the Middle East that this disproportionate focus isn't entirely silly. But it doesn't mean that their pronouncements will have more than a fleeting impact.

Finally, there's the US end. How long does it take to restart production? Fracking wells see output decline about 60% in the first year, it’s not like wells in Texas that have been producing for decades. [There's one under the state capital building.] If you have cash, you can kit yourself out for the next bump in oil prices at pennies on the dollar, and there are businesses that are doing exactly that. Plenty of pipes in inventory, too, not just rigs. Chapter 11 is a marvelous thing: low prices can’t destroy the fracking industry, they can only change who owns the companies and their debt.

Oh, and dumping treasuries is an old canard that is constantly touted by fearmongers but never observed in practice. If you have a lot of Treasuries and you try to dump them, prices fall and you lose a lot of money. And if you're Saudi Arabia, what will you buy with your dollars, Euros? Those will become more expensive, a double whammy. Now the reality is that the Saudis are issuing debt, not buying debt. So are they selling some Treasuries? Maybe. Have they stopped buying? Already. Have US interest rates spiked? Not at all. OK, I can't resist: what we have is one short, albeit oft-repeated paragraph, Ney-deep in Gaffs, replete with claims that are not fracked up to what they ought to be.

I've updated the content a couple times based on email interactions with others.

Friday, April 8, 2016

Thank you Baby Boomers: The new norm is 60,000 jobs

Mike Smitka, Economics, Washington and Lee University

A simple projection from pre-Great-Recession levels suggests we need 150,000 new jobs each month to keep up with population growth. (See this WSJ blog post.) This is wrong. Lower fertility 20 years ago means that we are not seeing a steady climb in the number of young people are entering the labor market, while we are seeing the baby boomers gradually exit the labor force. My bottom line: 58,390 jobs a month. Now such precision is illusory, labor market data aren't that precise, and these are projections. So let's use 60,000 as a rough guide.

The implications are significant. If we use the sort of simple projection that lies behind the WSJ projection, then (using 2007 as a base), then in a normal economy we would today have a labor force of 160 million million. With an actual labor force in the latest survey of 151 million, this would indicate that we are 9 million jobs short of where we should be, and thus still deep in recession. That's clearly not the case. Across a variety of metrics we're approaching "full employment" (which ought not be pinned to a specific number as measured using one particular data set). Jobs are easier to find, even if wages are not yet rising. To give one qualitative indicator, during the depths of the recession in 2009-2010 "quits" in the JOLTS survey (Job Openings and Labor Turnover Survey) were at 1.3%, the lowest in the history of the data. The level is now 2.0%, near the pre-recession average of 2.2%.

Why 60,000? Prior to 2007, the labor force participation rate of prime-aged workers was nearly constant. So the core of my projection was to use the Census Bureau population projections by age, and multiply by this "normal" level of participation to get the number of jobs. I did the same for younger ages (16-24, where in the Great Recession participation fell by far more than other groups), and older ages (where participation actually rose – the "Boomers" have been slower to retire than their elders). I've not redone this estimate to use the most recent population projection, but today's the last day of the W&L Winter Term, so I won't do that now. When I do, I'll provide an upper and lower bound, but I don't anticipate much change.

So how do things stack up? I provide below my own projections of "normal" employment versus where's we're at in the March 2016 data. To that I add a graph of age-specific participation levels. (Data are available to do that by gender; I don't report that here.) The bottom line is that at the current rate of job creation, we'll be back to normal in about 2 years.

One apology: at the bottom of the WSJ post they do quote FRB Chair Janet Yellen that the number is now under 100,000 jobs a month. You have to read to the bottom, however, to see that. For regular commentary on labor force development, see the Atlanta Fed's blog.

Indeed, the Atlanta Fed's latest post notes these various factors, including the one I've not built into my formal projections: the increased participation of older, post-normal-retirement, Americans. Their estimate is that over 2007-2011 increased participation fully offset the onset of "boomer" retirement. (Click HERE to see their graph.) Now that's not the case the past 5 years, but I still ought to revisit my baseline and put in adjustments for this, which shows up so vividly in the age-specific participation rate graphs I generate.