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Wednesday, April 26, 2017

Tesla: First the Cash, Then the Crash

Tesla recently (briefly) surpassed both Ford and General Motors in market capitalization. My own prognosis for Tesla's longer-run prospects aside, once the Model 3 launches cash flow will improve markedly. Financial markets may interpret that as validation of the high price they've put on Tesla shares. That however is a predictable result of the nature of cash for an automotive assembler, and will have nothing to do with Tesla itself. But it does mean that you shouldn't short Tesla yet.

...you shouldn't short Tesla yet...

Why do I believe this will happen? As our alumnus Bill Cosgrove emphasized in him many visits to Econ 244, in up cycles car companies spin off stupendous amounts of cash. In down cycles they're cash incinerators. Let's examine one source of that (there are others).

Historically dealerships financed the biggest asset in the auto industry, the inventory that sits on their lots. In particular, they pay for cars as they roll off the assembly line. (To be precise, dealerships' banks pay for them via the financing of "floor plan".) Suppliers contributed, too, because they are paid 90 days in arrears. In the early years of the industry they were the biggest cost of production. From the 1920s that role diminished, as Ford and General Motors integrated vertically into making their own engines and frames and bodies. But over the last 25 years car companies systematically spun off their internal parts into standalone operations, Delphi in the case of GM and Visteon in the case of Ford. So paying suppliers in arrears is again qualitatively important. Now when sales increase, for example up 2% in the month, car companies then take in 2% more cash, but pay out nothing more. It's only after 3 months do the payments to suppliers start to rise. That process continues as long as sales rise, irrespective of underlying profitability. A rising tide raises all ... wait, that's not the right image.

Or maybe it is. Because at some point the tide goes out, and with it goes the cash flow. The process reverses. Now car companies are taking in less money, but they're paying out the same amount or – if sales were rising and not just flat – amounts that will continue to increase for 3 months. Worse, it often takes a while to react, as a car company you don't want to slow production because of one odd month. And so the factory pushes metal onto dealership lots. As sales continue to fall, inventory piles up, and at some point the dealers push back, and stop ordering cars. In other words, inventory adjustment amplifies the pace of the downturn. Cars companies burn through cash. They turn from printing presses of profits into incinerators of money.

So when the Model 3 launches, Tesla will report a significant improvement in cash flow. Tesla investors will get good news for a few quarters, as the first 100,000 cars roll off the line and make their way into the garages of the more well-heeled of the enthusiasts who laid down their $1,000 advance deposit. This shift in finances will appear to validate the case for Tesla's high stock price.

But sales can't keep rising forever, particularly as Tesla will only have this one new model, and in a market where consumers are shunning sedans. At that point Tesla will begin hemorrhaging cash. They will have to pay suppliers more and more even as revenue stagnates and then falls. Worse, because they don't have independent dealerships, their debt will also explode as inventories build up. They won't be able to cut output fast enough, because they will have to keep paying suppliers for the higher level of orders prevalent 3 months earlier. They won't be able to cut sales staff, either, if they want to stay in business. Unlike traditional dealerships, their stores won't have service revenue, because most Tesla's will be new. That will be made worse by the nature of their product, as there won't be the oil changes that help service operations generate profits for dealerships even when car sales tank.

...don't short Tesla – yet...

So don't short Tesla – yet. But that time will come, because of the nature of the auto business.

Sunday, March 26, 2017

NPR Marketplace: When it comes to NAFTA and autos, the parts are well traveled

Mike Smitka
Washington and Lee University

On the Friday 24 March NPR Marketplace did an extensive story on automotive parts and NAFTA. For the show, go to When it comes to NAFTA and autos, the parts are well traveled on the Marketplace website.

Scott Tong put together the story, with travel to Ann Arbor. The story that aired featured extended pieces of interview with Dave Andrea of CAR (the Center for Automotive Research) and with Michael Smitka of Washington and Lee University. Scott did a very good job addressing a complex topic.

This is part of a longer Marketplace series NAFTA explained.

For the interview with me Scott was actually sitting in the back seat of the Honda CRV that he discussed with David. Scott skyped me on my computer, I recorded it on my iPhone and then sent the audio files to him. That process worked well, though I had on headphones to lessen feedback which in retrospect probably didn't improve the sound that much, but did make it harder for Scott to piece together the specific questions he was asking as there was no recording of that.

Saturday, March 18, 2017

Oil Prices and Trucks and ICEs: Implications for Tesla's Model 3

As emphasized in Chapter 11 of Smitka & Warrian (up on Amazon Jan 1st!), battery electric vehicles (BEVs) offer many efficiency benefits relative to vehicles powered by an ICE (internal combustion engine). However, this benefit comes with an up-front cost premium that means that, absent subsidies, they fail to provide a value proposition to purchasers. There is no evidence that will change by 2020.

One aspect is that ICEs continue to improve. A quick glance at the Automotive News PACE Awards finalists for 2016-17 shows that 11 of the 34 innovations up for this year's awards improve ICE efficiency. (Winners will be announced in a black-tie event at the Fisher Theater in Detroit on Monday, April 3rd, just before the start of the big annual Society of Automotive Engineers convention. Yours truly will be in attendance.) So while the cost of battery packs continues to fall, and density to increase, they face a moving target. Turbochargers are widespread, start-stop systems are more robust, parasitic losses are being cut as electric motors replace hydraulics, and variable compression systems are starting to launch.

...this is not the time to be launching a new sedan...

Furthermore, there's some indication that the current approaches to Li-ion chemistry are reaching their limits, though the best lab technologies are years from commercial production so incremental improvement will continue apace. Similarly, economies of scale in cell and battery pack are less than expected, evidenced by the construction of multiple small plants. My reading is that costs bottom out around 100,000 vehicles worth of battery packs a year. Now today no single model is at that point, but that day is not far off. Furthermore, battery margins aren't great, so it's not as though car companies pay exorbitant prices.

In other words, manufacturing isn't like internet businesses, where up-front development is a significant part of overall costs and hence every additional user improves profitability. Elon Musk is a victim of the old and mistaken Stalinist belief that bigger is always better. In contrast there are only a handful of "fine chemical" producers, which is where DOE analysis suggests the profits lie. But that's not the end of the business that Tesla is in, nor is it the focus of the battery joint ventures of Nissan and others.

That leaves two markets for electric vehicles: the luxury end, where price does not dominate the purchase decision, much less fuel efficiency. There other is as a "compliance car" made to satisfy one or another regulatory constraint.

Model SJune 2008June 2012
Model XFeb 2012Sept 2015
Model 3July 2014? late 2017 ?

Tesla did very well in the $100K end of the market. Rather than supporting the Model S with a full redesign, Musk is instead moving downmarket. Slowly. After all, the company has limited engineering resources, and so can only come out with a new car once in 3 years. (They are promising an earlier date for the Model 3.) Unlike Jaguar, which will use the experienced contract assembler Magna Steyr for the 2018 launch of its I-Pace electric SUV, Tesla insists on going it alone. That eats up capital it could better use to replace its high-end product, and results in slow and late launches, replete with quality glitches.

So what will the market for the Tesla Model 3 be like? The bottom line is, not very good. First, direct subsidies are under attack (though what if anything the current US administration will actually do defies prediction). That is critical for sales of the Model 3, because sales targets transcend the volume the luxury market can generate. Then there are ZEV emission credits and more generally a car's contribution to meeting CAFE restriction. Tesla can't itself use ZEV credits; they need to sell them. And because they sell no fuel-gulping pickup trucks, what happens to CAFE is not directly relevant. Indirectly, though, the launch of the GM Bolt cuts into the ZEV market, and Trump's promised relaxation of CAFE requirements will shift the overall market even further away from the sedan segment. (Using BEA data, in Feb 2017 trucks ran at 11.2 mil SAAR, cars at 6.3 million.) This is not the time to be launching a new sedan, and Trump is promising to make the market less favorable. California is important enough to GM that they need to sell Bolts there to let them sell more high-margin SUVs and pickups. The compliance car market is not relevant for Tesla.

Then there are gas prices. Saudi Arabia would like OPEC to cut output, but is in no position to do so unilaterally. It provides subsidies to keep its population (and ever-larger royal family) happy, and is running a deficit. It desperately needs revenue, but with only a 10% share of the global market – and US tight shale output staying stubbornly high – a cut in output results in a less-than-proportional rise in price. Even with inelastic demand (say, -0.3), revenue falls. So it needs to keep pumping. Nor are US drivers helping, as Bloomberg points out. That makes it even harder to sell a BEV on the basis of their savings on gasoline purchases.

..Tesla investors are set to learn the hard way...

Now I've no doubt that the Model 3 will be a nice car, though even if it does carry a $35,000 list price, you won't be able to find one that isn't loaded. Since on the basis of history there's every reason to believe that initial production volumes will be quite low, we'll be regaled with stories of high demand, cars snapped up as fast as they can be produced. But can they sell 100,000 in 2018? I doubt it, and a mid-sized car in the volume segment won't deliver high margins in a market where everyone wants a truck. Meanwhile the Chevy Bolt will have been out for a full year, the Nissan Leaf updated and BEV subsidies in China pared. Tesla will have to be very generous on the trade-ins they accept to keep sales flowing. They can bury that in their financial statements for a while. Those in the auto industry know how that ends. Tesla investors are set to learn the hard way.

note that Tesla just raised an additional $1 billion in cash


Chung, D., Elgqvist, E., & Santhanagopalan, S. (2016). Automotive Lithium-ion Battery (LIB) Cell Manufacturing: Regional Cost Structures and Supply Chain Considerations (No. NREL/PR-6A50-63354 Prepared under Task No. VTP2.6B01). CEMAC (Clean Energy Manufacturing Analysis Center).

Martin, R. (2016). Why We Still Don’t Have Better Batteries. MIT Technology Review, 119(6), 22–22.

Thursday, March 16, 2017

Intel + Mobileye: Strategic Sense, Financial Nonsense

Mike Smitka
Prof of Economics, Washington and Lee University

Cars employ more and more processing power, from chips that handle keyless entry and kick-to-open functions to engine controls and now ADAS (Advanced Driver Assist Systems). Someday there may even be autonomous vehicles, requiring GPUs (graphics processing units) to interpret sensor data and powerful CPUs to run the algorithms. Intel has a very small automotive footprint, having been in and out of several segments over the past 3 decades, at one time making engine control modules for Ford, and buying Wind River, which had projects with BMW and Magnetti Marelli. As the computer and server markets mature needs to develop a wider footprint. At a broad level the Mobileye acquisition could serve as an entrée into the automotive sector, bringing systems capabilities for interpreting vision data that would bring instant access to most global automotive OEMs and major Tier I integrators such as Delphi.

...automakers would welcome a stronger Intel presence...

The automotive end would welcome a stronger Intel presence as well. Over the long haul, no car company wants to be tied to a single provider. Intel rivals are moving. In 2015 NXP acquired Freescale, now Qualcomm is acquiring NXP. That combination will have over $30 billion in revenue. Renasas and Infineon are out there, too, and in individual niches there are players such as NVDIA for GPUs – that ADAS thing – and infotainment systems. Major automotive players would love to have another strong player that they can pull into development projects.

One challenge is execution: Intel has $60 billion in revenue, Mobileye perhaps $300 million. By reputation Intel tends to swallow up small companies, but not digest them and spread their know-how into the larger organization. Selling into the automotive footprint is not easy, with long lead times, complicated and very idiosyncratic test requirements (your cell phone won't work if it's been out in the desert sun, or put through engine compartment vibrations for a month). Mobileye knows how to do that, and could ease Intel's reentry. They also understand the software and data flows in a vehicle system; selling a stand-alone chip is an uninteresting business. Intel needs to add value by bringing to the table a palette of software tools and interface capabilities that let it provide systems-level solutions. Thus it is important that Mobileye not be split up and spit out. The deal has it remaining a subsidiary based as now in Israel, rather than trying to move it (which means its key personnel) to the US. Instead Intel will move people there. Automotive customers will need convincing that this arrangement isn't temporary, and Intel will have to learn how to tap Mobileye's automotive knowledge. That won't be easy.

...the acquisition makes strategic sense...

So the acquisition makes strategic sense, even if there are non-trivial barriers to successful execution.

It does not make financial sense. Rounding so as to make the arithmetic easy, Intel has a P/E of 15. To pay back the $15 billion up-front price, they thus need to generate $1 billion in profits. That won't happen immediately, so we're implicitly doing a net present value calculation. Thus we should ask whether in 2025 the acquisition will be generating $2 billion in profits. (I used a 15% discount rate; assuming Mobileye is making $100 million, this requires that profits increase at an 80% annual rate.) Now maybe that can happen. Both Intel and Mobileye have fat profit margins, so in principle the combination will need to add incremental revenue of $8-$10 billion. But reaching that level will require continuing high levels of up-front investment, call it research. Unlike with making a chip, it will also require continuing R&D, here with an emphasis on the development side of the equation. This isn't like developing a chip, where all the costs lie up front, and the profits flood in once sales commence.

...yet Intel investors should be hearing a warning BZZZ...

Furthermore, the automotive development cycle is long. For all the hoopla about autonomous vehicles, we're looking at a few hundred experimental cars on the road globally in 2020. If that goes well, work will begin on real cars that will launch in the 2025 timeframe. But they will still be high in cost, and the market uncertain. (At the rate Uber and its ilk are losing money, they won't be customers.) Volume, if any, won't come until 2030 and beyond. The holy grail that will make cars a shell for expensive software systems run on expensive hardware will remain out of reach in a timeframe relevant even for patient investors.

In contrast, ADAS is already here. What isn't known is how well received it will be as it moves downmarket. There also remain major problems with the human interface. Drivers can't zone out on the interstate while lane-keeping and adaptive cruise control are engaged, and then just pop back in when there's a warning signal. The systems have to be fail-safe, or more accurately lawyer-proof. Yes, car manufacturers can try to force a driver to keep their hands on the steering wheel. The immediate market is commercial trucking, and in that footprint Intel has already purchased Peloton Technologies (not Peloton, the exercise equipment company!). However, that segment won't generate sufficient revenue to justify the price being paid for Mobileye. In the passenger setment, the rollout of ADAS technologies has been most aggressive in Europe, which is a more technology-friendly in its regulatory and legal system. Vehicle margins in the EU are thin. The big and profitable vehicle markets are NAFTA and China. In Asia, urban congestion and aggressive (random!) driving habits make the ADAS consumer value proposition challenging: when cars move, the warning systems would be producing a constant BZZZ.

Intel investors should be hearing a warning BZZZ, too.

Tuesday, March 14, 2017

Musk’s Facts Are Wrong (Maryann Keller guest post)

Maryann Keller
Principal at Maryann Keller & Associates LLC

Musk’s Facts Are Wrong Regarding the Termination of NUMMI Joint Venture

Published on February 11, 2017 on LinkedIn
cross-posted with permission

In response to Tesla workers at its Fremont, California assembly plant contacting the UAW to possibly seek out representation, Elon Musk responded that the former GM-Toyota NUMMI joint venture, at the same facility Tesla occupies today, was closed because it was a UAW plant and therefore not competitive. In fact, there is nothing further from the truth and his claim is likely due to the oft-prevailing view of the UAW’s role leading to General Motors’ bankruptcy. 

Tuesday, March 7, 2017

Ride Sharing (Maryann Keller guest post)

Guest Post, Maryann Keller, Principal at Maryann Keller & Associates LLC and Ken Elias

David Ruggles speaks regularly with Maryann Keller; we cross-post from LinkedIn with her permission. She is the single most highly regarded auto industry analyst, and has sat on the boards of rental car companies (and was president of priceline.com) so has a good understanding of the economics of ride sharing in one of its "traditional" segments. David took her on her first UBER ride in Washington DC in February 2016. She's since done research on this new "disruptor." They do huge business but lose money doing it. What can be their end game?

Ride-sharing Apps: Low Fares Can’t Last
Published on March 6, 2017

It’s no secret that Uber, Lyft and other ride-sharing apps offer fares less than taxis; exactly how much less depends on metro area, time of day, and ride length. Lower fares, the ease of using the app to summon a car, and cashless payments have built a large user base for the dominant players, Uber and Lyft. But with both companies losing hundreds of millions of dollars a quarter, how soon will investors demand a path to profitability? (TechCrunch.com reports that sources suggest Uber lost three billion dollars last year!)

Saturday, February 25, 2017

Peak Auto (III): Global Margin Compression

A teaser, not yet written, but do see parts I and II below!

Peak Auto (II): Tesla Valuations

Mike Smitka

My previous post looked at frivolous investments by assemblers as evidence that's we're at the peak of the automotive cycle. Of course that doesn't mean that we're heading into a trough, just that there's not much upside. Investors in Tesla ought to take that to heart. The company sold about 80,000 vehicles last year in a 90 million unit global market (order of magnitude) that's growing by over 3% (again, a round number). That translations into 2.7 million incremental units a year, the equivalent of 11 new standard 240,000 unit annual capacity assembly plants. From a global perspective, Tesla isn't even a rounding error. In the $100,000+ performance car market they're more of a player, but Tesla's rivals are all launching their own battery-beefed-up or full-battery performance vehicles. Those rivals have global distribution and service networks in place, too. So if Tesla is to expand it must be in the volume segment end of the business.

Tuesday, February 21, 2017

Peak Auto (I): Frivolous Investments Rise

Mike Smitka, Prof of Economics
Washington and Lee University
Co-author The Global Auto Industry: Innovation and Dynamics, 2017.

The auto industry is at peak. The best indicator lies not in the sales numbers, but in the behavior of the OEMs. Flush with cash, they are again buying businesses peripheral to their core operations, such as ride sharing services.

...car companies frittering away cash is the best indication of peak auto...

Saturday, February 4, 2017

Review: The Bug Movie

Mike Smitka

The Bug Movie: Life and Times of the People's Car Produced and Directed by Damon Ristau, Co-Produced by Jason Willenbrock and Tory Alonzo. Chassy Media, November 2016. $14.99 Downloand/DVD, $17.99 BluRay. Available at https://www.chassymedia.com/product/the-bug/.

Publisher's Description: The Bug Movie is a feature length documentary film about the most recognizable and beloved vehicle on the planet: The Volkswagen Beetle. From its dark past in pre WWII Germany, to the Summer of Love, this car captured the hearts of millions of people worldwide. This film explores not only the history of this automotive icon, but also the intense emotional connection it has with its owners past and present… Including Ewan McGregor and his experience with his first VW Bug as a sixteen year old.

I am not a "car guy." My drives have never had a nickname, and seldom get cleaned. The rusted through body panels on my 1988 pickup truck are going to get more rusted. My son can point out cars of note on the opposite side of the freeway. I'm not sure what a Tesla looks like. I live close enough to Hershey, PA that I could visit the classic car fest come October. Indeed, as a member of the Society of Automotive Historians I receive an invitation to their dinner there. I've yet to make it. For me this documentary was thus an introduction to the culture of car buffs, in this case those in love with the classic VW Beetle. Three sorts are depicted in vignettes that develop over the course of this video. Some grew up with memories of it as the family vehicle; for others their strongest memories came through The Love Bug and the other five Disney Herbie films in which a 1963 Beetle was the star. Some just like fixing up old things. Restoring a Beetle to working order is feasible: so many were made that parts remain readily available.