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Saturday, January 11, 2020

GERPISA 2020: annual conference June 8-11 in Detroit

I'm in Paris right now, a mini-conference Friday at CCFA, the French auto industry association, and a planning meeting for the June 8-11, 2020 conference advertised at right. This conference will be joint with the Wharton PVMI, the successor organization to the influential MIT IMVP (International Motor Vehicle Program).

The GERPISA web site will have a link to the registration page, and we'll list keynote speakers and other details as they get confirmed. The conference will take place Mon-Wed in Ann Arbor, and Thurs at the Detroit Branch of the Federal Reserve Bank of Chicago, with an evening reception at the Piquette Museum, which is where production of the Model T commenced in 1908, a wonderful venue. We are finalizing details of industry events on Monday 8 June and Thursday 11 June, and an add-on event for Friday 13 June, after the end of the conference.

Note that this week corresponds to the press and industry days of the "new" (June not January) Detroit Auto Show, more formally the North American Auto Industry Show. Obviously we expect to leverage that, with details still under negotiation. Your truly and the others on are small planning committee will be very busy the next several months! Watch here and the GERPISA web site for more details; I'll post a bit on the conference content once I'm back in the US.

Tuesday, December 10, 2019

Interest Rates and US Investors: Don't Be Greedy!!

Mike Smitka
Professor Emeritus, Economics, W&L
Judge, Automotive News PACE Awards

I've now begun posting the occasional article to the financial blog site SeekingAlpha. I'll cross-post portions here. SA gives greater visibility than Blogger, and I even get paid a token amount. I've a couple posts on Tesla, and now one on Interest Rates and US Investors.

The core point is that very low interest rates are here to stay, because not just US growth but global growth is at a very low level, and for all the talk of new technology, appears likely to stay here. The bullet points from the article:

  • The latest unemployment data show a continuation of the steady increase in employment since the bottom of the Great Recession in 2010.
  • Interest rates show different patterns, with long rates going from low to lower.
  • For "value" investors, this poses two dilemmas. One is that low interest rates undermine the utility of discounted cash flow models. Caveat emptor!
  • The second is that low long-term rates imply neither growth nor inflation for the foreseeable future. Surely, stock market returns will be similar! Any claim of double-digit returns is too good to be true. Don't be greedy!
  • None of this applies if you're a (short term) speculative trader. As an economist, the short-run is "noise" - I can offer no analytic tools to help you.

In the article I note that George Soros, now focused on philanthropy, has moved his fund from macro speculation (cf. his [in]famous bet against the British Pound in 1992. Now he's in it for the long haul, instilling Dawn Fitzgerald as CIO. With a focus now on steady returns for the long haul – a reasonable goal for most personal investors – they're looking at returns of 5% per annum, with years when they'll do worse.

What are current bond returns? One approach is to look at current bond prices, which provide a 6-month yield of 1.58%, a 10-year yield of 1.83% [below the current level of inflation] and a 30-year yield of 2.27%. But another way to look at rates is to look at different rates across time to figure out the implied 1-year yield at different maturities, something I've posted about several times. That gives qualitatively the same picture: a steady secular decline over the past three decades, and (to allow reading individual series) the past 2-odd years. Implied one-year bond rates two decades from now are 2.55% using the most recent data (Monday, 09 Dec 2019).

Now these are nominal rates, which (by definition) are: i = real rate + inflation + risk premium. Unlike equities, US government bonds carry no default risk. At today's very low rates, the risk premium is also small: there's not much chance of bond prices rising [interest rates falling further], plus low rates imply bond prices are already high and can't go much higher. Markets are betting that inflation will remain low as well, and so there won't be much downside. Stocks ought to show a bit better return, the well-known and poorly understood equity premium. But the bottom line remains: unless you engage in speculation, you won't have returns much above 5%. And remember, most people leave casinos poorer.

Monday, October 28, 2019

EVs and the assembler business model

Michael Smitka
Prof Emeritus, Washington and Lee Univ
Judge, Automotive News PACE supplier innovation awards

This is an edited version of a post to the NBR email discussion forum, NBR posts are archived here.

Mochizuki-san raises an interesting question.

I append the Mr. Mochizuki's original post in this thread at the end.

The modern auto industry in the US began as pure assembly, initially Ford made no parts itself (zero!), but as it increased standardization it pulled more parts making in-house ca. 1910-1912. GM was built through M&A but was initially just a holding company, the parts makers didn’t necessarily supply any of its car assemblers. That changed in the 1920s, but GM spun off its parts making in the late 1990s / early 2000s, as did Ford. European car companies were never as integrated, we even have Magna Steyr assembling vehicles under contract.

In Japan in the 1950s, car companies didn’t have the financial resources to vertically integrate, indeed Toyota spun off internal operations such as electrical components into what is now Denso, which then could raise funds on it own balance sheet. Toyota and Nissan also acquired some of the floundering independent car companies (there were 30 or so in the 1950s), turning them into branch assembly plants. But again, their focus was assembly, though they had shareholding interests in suppliers.

So the major car companies around the world have long been focused on assembling components purchased from the outside (or into the 1990s in the US, from highly autonomous internal divisions), with drivetrains a partial exception (motors were generally “made,” except for diesels, but transmissions were sometimes outsourced - patterns in Europe were a bit different, transmissions were primarily outsourced).

So what do car companies do? Final assembly, and design/development, and marketing and the coordinating of distribution. Since the 1990s they developed a “platform” (chassis plus suspension plus steering/braking), stuck different “top hats” on them, and filled them with purchased components. That was done in line with a product portfolio, to try to serve a broad array of the market (from the same platform) while providing protection against swings in taste. That vehicles today might be based on batteries and electric drive motors doesn’t challenge the industry's core business model.

...no disruption here: batteries and electric drive motors don’t challenge the industry's core business model...

Have electric vehicle startups managed to successfully enter? My judgement is “no.” There are a host of EV companies in China, but that’s a result of massive subsidies. Despite subsidies, all startups in the US and Europe have flopped other than Tesla, and Tesla has survived only due to the Silicon Valley stock market bubble, they’re a quintessential “story stock” as they’ve burned through roughly $23 billion in capital. While they declared a very small profit for 2019Q3, it appears to be a result of one-off changes, as total revenue declined. Tesla is no longer a growth company, yet needs to raise more capital to stay in business. I didn’t think it would last through CY2019, but investors keep showering the firm with cash, and who is Elon Musk to say “no” to that?

I think the evidence is pretty clear: car companies are indifferent to what’s under the hood, and the same is true of most consumers. If it’s cheaper to make battery electric vehicles, then that’s what they’ll do. If government fuel efficiency regulations force them to do so, as is happening in Europe, then that’s what they’ll do. [Until Dieselgate the EU had effectively mandated them for small cars – diesels were 70+% of the market in France – but they are intrinsically more expensive to make, and so you find few diesels in Japan, or in the US outside of work trucks.]

Unfortunately battery prices have not yet fallen, and while there are almost daily announcements of “breakthroughs” none have made it into volume production – any new battery technology will show up first in cell phones and the like, and only (years) later in electric cars. The lead time to drive down production costs and build capacity makes it very unlikely that we’ll see high volumes until 2025, and unless chemistry cooperates, not even then. (There’s also the challenge of cobalt and lithium supplies, lots of exploration, not much investment in mines, even less in refining brine and ores, but all have multiyear lead times.) So car companies are looking at financial disaster, particularly in Europe, as regulations are pushing them to make cars that are too expensive for all except well-heeled consumers to purchase, but failing to sell EVs will result in fines in the euro billions per company per year, enough to bankrupt them. I expect to see a walk-back of such regulation.

But to reiterate, Mochizuki-san’s question is interesting, and one that researchers focused on the industry (as well as consulting companies and car company executives) have debated and continue to debate.

To return more narrowly to his query, the major electrical/electronics component suppliers have developed their own electric motors and specialized tooling (eg, for winding flat wires). It’s not clear though that they will dominate motors. There remain fundamentally different architectures, such as inductance versus permanent magnet motors, no standardization yet at even the level of the core technology, while packaging differs enough from vehicle to vehicle that there’s no standardization there, either. Will the car companies continue to make their own motors, using of course many purchased components, or turn to outside suppliers? I don’t think that will be apparent until 2030, after all sourcing component systems for EVs that will launch in 2023 has already been completed. It will take a couple model cycles – 8 years – for the dust to settle.

In contrast, drive electronics are outsourced, and I don’t believe that will change. The original EV1 team at GM stayed together in what is now Delphi and Aptiv. The other big players are also in the game, Bosch and Denso and Continental and Valeo. A lot of the value added will be in the IGBTs and other specialized chips. Since the start of the 1980s the auto industry has been a huge consumer of semiconductors, at one time Delphi was the 4th largest chip company globally. But to my knowledge they and other suppliers (eg, Denso) no longer run fabs (or only do so as they’re fully amortized legacy plants).

Battery cells are outsourced, except by the Chinese firm BYD, which began as a battery company, not a car company. In contrast, battery pack assembly is done in-house, again the packaging varies from car to car, and car companies know how to do assembly. That might change a bit, with outside firms supplying modules of cells that can then be assembled into packs. My hunch though is that in 2030 car companies will be making their own electric drive motors and assembling their own battery packs.

So … we won’t see a repeat of the FANUC case, no "disruption" here. And if I’m wrong, it’s likely to be a Chinese firm that will be the global gorilla, given the sheer number of players there trying out different approaches. If success is 99% perspiration, well, they’re more likely than anyone else to come up with the bits and pieces that produce a winner.

Mochizuki-san might be able to speak to that, the case of Kuka in industrial robots, which from touring factories is the big rival of FANUC. Why did they do so well, and not just FANUC. [Aside: Kuka is now Chinese-owned.]

mike smitka
now prof emeritus of economics
judge, automotive news PACE supplier innovation award
(with visits to suppliers in Japan and Korea in Nov 2019)
organizing team, June GERPISA 2020 auto industry research conference in Detroit

On Oct 27, 2019, at 9:42 PM, Minoru Mochizuki wrote:

There was a major metamorphosis occurred starting in 1960s in the worldwide machine tool industry. Up until 1950s, the world leaders by countries were US and Germany, providing all kinds of metal-cutting machines, large ones weighing hundreds of tons in weights for machining large components for electric generators and steam turbines, steel mills, ships and aircrafts, to small ones weighing less than a ton for machining small components such as precision shafts and screws. Those machine tools were controlled by skills of human operators.

With the introduction of computers into the machine tool industry, those metal cutting machines (lathe, milling machine, drilling machine, etc., generally called “machine tools”) came to be controlled by computers. They were thus came to be called numerically controlled (“NC”) machines, and further renamed as computer-numerically controlled (“CNC”) machines.

In the early days, the US machine tool industry led the way by inventing NC and CNC machine tools of all kinds. The computerization of machine tools, i.e., driving various types of cutting tools and grinding stones on and off, guiding the tools along the calculated loci three-dimensionally to form three dimensional shapes of the workpieces, were helped by electronic and computer engineers from the electronic and computer industry easily, thanks to the fluid employment practice in the U.S. Example of those US suppliers of NC systems were Bendix, Bunker Ramo, GE, etc. In contrast, those engineers existed only in the telephone and general electrical companies, so the Japanese machine tool companies were generally unable to develop the machines with the new kind of controls in-house. The machine tool manufacturers could not find electronic and computer engineers because of the lifetime employment system prevailing in those days. Thus, except a few cases of machine tool manufacturers, such as Okuma, the majority of Japanese machine tool manufacturers relied on the package consisting of central computer, sensor, and servo drive units, which can be easily connected to the machine drive axes, supplied by Fanuc, an offshoot of Fujitsu, a major Japanese telephone/computer manufacturer. Fanuc quickly became a major supplier of the backbone system of NC/CNC machine tools in Japan, This was essentially a standardization of the machine tool industry from the control and computerization side, making the Japanese NC/CNC machine tools more competitive in cost and performance. The predictable result was the conquest of the U.S. machine tool industry by the Japanese companies. Even in Europe, the world-wide home of the machine tool industry, although there were a few tries to compete against Fanuc, the competition ended when Siemens decided to cooperate with Fanuc.

The success by Fanuc and the Japanese machine tool industries continued in Europe and in Asia. The farming out of manufacturing of US products in China, for example, iPhones or automobile components, all relied on Fanuc and Japanese NC/CNC machine tools unanimously using Fanuc controls and drives.

The automotive industry seems to me facing now the same kind of fundamental change as the machine tool industry experienced about a half a century ago, with the advent of electric drive system in various formats, electric motors replacing internal combustion engines, and maneuvering to be controlled by big-data-based road information, sensors and computers. Will the history repeat the same course, where automobile manufacturing companies reducing their development efforts to the packaging of the chassis, compartments, mechanisms of steering, wheels and brakes, adopting the control system to be supplied by the outside source? Who will succeed to be the major supplier of the control system?

Minoru Mochizuki

Monday, August 12, 2019

Ridehailing

I've phased into retirement this year, and over the past two months cleared out my office [with 3000+ books now occupying my parking place in our garage], gave 3 independent presentations/papers at 2 conferences during 3 weeks of travel in Europe, painted my unsold "bubble" house, and have put in many hours on deferred yardwork. I've another month of travel coming up, but will gradually return to blogging.

Mike Smitka
Professor Emeritus of Economics
Washington and Lee University

...taxis have never made much money, so interposing an app between rider and driver can never make much, either...

Ridehailing is a financial disaster for investors, and for incumbents. By subsidizing riders, they've been able to capture market share from cabs and limo services, whose businesses appear to be down by over 50%. Medallion prices in NYC have crashed, so investors in such businesses, almost exclusively local entrepreneurs, have taken a bath. But it looks to me like investors in Didi Chuxing, Uber, Lyft and their many, many rivals will do the same. Indeed, neither Uber nor Lyft provide a compelling story that they have a route to profitability. Here are a few numbers.

Uber and Lyft provide varying levels of detail in their quarterly financial reports and IPO filing. For Uber, revenue per gross booking, ridehailing adjusted net revenue (RANR) and RANR per trip are all down. They provide almost no details of their costs. Here are two key metrics I've culled for them:

2017Q1Q2Q3Q42018Q1Q2Q3Q42019Q1Q2
Adj Net Revenue$1,309 $1,630 $1,982 $2,282 $2,423 $2,574 $2,656 $2,644 $2,761 $2,873
Ridehailing ANR$1,184 $1,447 $1,752 $2,000 $2,119 $2,223 $2,286 $2,282 $2,331 $2,314
Rideshareing ANR per trip$1.53 $1.63 $1.78 $1.84 $1.87 $1.79 $1.70 $1.53 $1.50 $1.38

Lyft does better in providing information. They stopped reporting total rides with 2018Q4, and they have only reported rider and driver incentives for scattered time periods; they do provide the total number of active riders. Excluding 2019Q1 with its IPO expenses, the only cost number that's improved on a per-active-rider basis is sales & marketing. In contrast, insurance reserves, costs of revenue, operations & support, R&D (a large and to me mysterious item) and general & administrative, as well as total operating costs, are all up on a per-rider basis.

Lyft 2017Q1 Q2 Q3 Q4 2018Q1 Q2 Q3 Q4 2019Q1 Q2
Rides70.4 85.8 103.1 116.3 132.5 146.3 162.2 178.4 no datano data
Active riders8.19.411.412.614.0 15.5 17.4 18.6 20.5 21.8
Insurance reserves per rider$21.96 $24.79 $26.75 $29.88 $33.30 $37.09 $39.76 $43.56 $45.71 $53.45
Revenue per rider$21.42 $25.29 $26.59 $27.34 $28.27 $32.57 $33.65 $36.04 $37.86 $39.78
Cost of revenue per rider$14.64 $15.31 $16.58 $16.51 $18.61 $18.92 $18.54 $19.73 $22.58 $28.90
Operations and support per rider$4.47 $4.57 $4.24 $4.44 $4.28 $4.35 $5.32 $6.38 $9.13 $6.97
R&D per rider$2.90 $3.00 $3.26 $3.79 $4.51 $4.15 $4.44 $5.17 $30.78 $14.21
Sales & Marketing per rider$10.42 $11.43 $14.50 $16.66 $12.05 $11.30 $13.86 $11.77 $13.42 $8.30
G&A per rider$1.90 $1.86 $2.38 $2.57 $3.19 $3.02 $3.58 $3.86 $9.95 $6.72
Total operating costs per rider$37.47 $39.31 $44.13 $46.98 $45.90 $45.07 $49.06 $50.52 $94.29 $70.65
Net operating revenue (loss) per rider ($16.14) ($13.89) ($17.50) ($19.63) ($17.53) ($12.50) ($15.44) ($14.52) ($56.43) ($30.87)

The whole sector is a disaster. I've scanned news for Didi, Grab and various others on a periodic basis, in several languages. Nothing I've found indicates anyone makes (or has ever made) a profit. Taking Lyft's 2019Q2 operating loss per rider, with about 10 rides per active rider per quarter (last reported 2018Q4), they need to increase what they charge by $3 a ride to break even. To make a decent profit, they have to bump prices by $5. That is an underestimate, because it will surely lose them market share, and drivers. And with fewer drivers, response times fall, making getting a Lyft even less attractive. In econ jargon, demand is surely relatively price elastic, and that's under the assumption that Uber also raises prices. And that means that Lyft and the others in the segment need to shrink if they are to ever make money.

Taxi services – indeed transportation in general – are an intrinsically low margin. Trying to capture part of that margin by interposing an app between the person paying the fare and the person receiving the fare doesn't change that fundamental fact. Uber and Lyft can never capture more than a slice of that low margin.

Of course not all adjustment need be on the revenue side, but Lyft's data suggest they've had no success in trimming the cost side of their business.

Tuesday, February 12, 2019

A Disconnect: Electric Vehicles and Cobalt and Copper Prices

Mike Smitka, Economics
Washington and Lee University

Some 80 battery EVs will be on the market by 2021. IF they sell at any volume, THEN demand for the underlying metals used in EV batteries, particularly lithium and cobalt, should rise. But instead prices have been falling for the past 12 months. So either traders aren't looking very far into the future, or they don't believe the EV revolution will actually occur.

First, the price of cobalt has dropped to about 1/3 of its peak of a year ago. Yet this remains a crucial component of battery cathodes for the lithium chemistries in current use. While the lithium spot market is thin and not where most trading takes place, those prices have also fallen (listen to the Global Lithium Podcast for details).

Cobalt Price from tradingeconomics.com, US$/metric ton
Lithium Price from tradingeconomics.com

The disjuncture surely isn't because investors aren't sufficiently forward looking. After all, the prices of both hit record highs in March 2018, as the Tesla stock fever took hold. Since then, however, the market has cooled – if not crashed.

One possibility is that there's a lot of metals production coming on-stream. That is, those close to the ground don't see a scarcity, rather they anticipate an increasing supply. That however is not what those in the mining industry are saying. While there's a lot of interest in brine extraction, none of those projects have started up. The geography makes that a daunting task – evaporating brine in a 4000m high desert remote from anything is a process fraught with challenges. Then the output has to be moved for refining. That refining is intrinsically expensive (you've a brine with Li and Na and K, all neighbors in the periodic table). According to insiders, capacity is not being added – again, listen to the GLP podcast. The various national governments also want to see that they get a share of the revenue, and so licensing is a drawn out process. In short, none of these are going to be producing much metal in the next 5 years. The same thing is true for hard-rock lithium resources in places such as Australia. Assessing the ore bodies, getting the permits, building the mine infrastructure, and building the refining capacity are all multi-year projects.

Cobalt is even more of a barrier. With the exception of a small mine in Tunisia, cobalt is a by-product of copper (and to a lesser extent, nickel) mining. However, the price of both of these metals has fallen, and mines are being closed, not opened. The best deposits are in the Democratic Republic of the Congo, which accounts for about 60% of global production. Much of the output includes metal from small, illegal mines employing child labor. While that may not matter for the Chinese market, it cuts into the amount available in countries with policies mandating ethical sourcing. Cobalt supply isn't going to grow in the next 10 years, and may even decline.

Copper Price from FRED
Nickel Price from FRED

the fall in prices ... must be a story of demand...

Thus IF the fall in prices is not a supply story, THEN it must be one of demand. Yes, interest rates have risen, and that ought to push commodity prices down. But the change in present value from discounting sales in 2022 at 3% instead of 0.3% isn't much – 3% compounded over 3 years drops the value 8.5%. That's a far cry from the observed 65% decline.

That leaves a decline in expected demand from EVs, which constitute the bulk of battery demand, and the fastest growing component. The main issue is that we now have increasing evidence that EVs don't sell. The GM Bolt, the Nissan Leaf, and the Renault ZOE have not been hits – though Renault to its surprise sells a lot of ZOEs in rural France, where home charging is practical. Ditto China, where BEVs sell in cities with high subsidies (including being able to jump the queue for license plates), and sell not at all elsewhere.

Then there's Tesla. Only in 2018 did the company reach cumulative US sales of 200,000 units [and hence the halving of the $7500 Federal individual tax rebate]. The Model 3 continues to garner news, but by Tesla's own admission it has tapped out sales in the US, and is switching its emphasis to exports to Europe and China. After all, the market for an expensive sedan is fairly small, particularly in a world in which demand is shifting to mid-sized SUVs. But while the target segment represents a strategic error on Tesla's part, the expensive part is common to all EVs. They just don't offer a compelling value proposition to consumers who don't care about fast acceleration, or about which drivetrain lies under the hood.

...people don't care what's under the hood of their car...

Part of the challenge is that, even with EVs in the mix, the fuel efficiency of vehicles on the road continues to improve. It's now possible to power a full-sized pickup truck with a 4-cylinder engine, thanks to improved turbocharging, fuel injection and computerized combustion timing, and a host of ancillary improvements such as lighter pistons, better piston rings and better bearings. Add to that improved body-in-white engineering with the mixed use of aluminum, magnesium, and varieties of high-strength steel, and modern vehicles can pass today's more stringent crash tests while holding down vehicle weight. (BIW improvements are of course available for BEVs.) Then there are today's 10-speed automatic transmissions, that leave the engine operating at its sweet spot more of the time. Meanwhile "light" electrification – electric fan and water and oil pumps, electric steering, start/stop systems, alternator power-boost systems, and potentially electric valves – are eliminating the parasitic drag of hydraulics and belts. As 48V systems diffuse, efficiency will continue to increase. Car companies, though, don't advertise these as "hybrids." But more and more, that's what people are actually driving. Again, people don't care what's under the hood.

For consumers, as Ed Dolan points out in a recent blog, fuel is a historically low component of the cost of ownership of a vehicle. Absent a carbon tax (or Persian Gulf war) that drives up the price of gasoline, the cost of batteries needs to fall below that of an ICE-powered car, given the perceived challenge of recharging on the fly. At present no such battery technologies are entering production, which means that they won't be available on a volume car in the next 8 years. Another alternative would be a change in consumer behavior, where households become comfortable with owning a small EV commuter car, and using short-term rentals for longer trips. In fact, people are opting for SUVs that can cover all usage cases, while short-term rental businesses such as ZipCar lose money.

...metals markets implicitly believe EVs are not the wave of the future...

To return to the main theme, I conclude that recent price movements in metals markets reflect a growing realization that battery electric vehicles are not the wave of the future. That will change if new battery chemistries prove out. But those chemistries won't use cobalt and may not use lithium. Hence sales of those metals into the EV market will remain small, and eventually disappear.

1. In some parts of the world, such as Brazil, this is complemented by the availability of biofuels and CNG competitive with petroleum-derived gasoline and diesel. Even with a carbon tax, there is no business case for a BEVs. Likewise work continues of fuel cells, which may prove a good match in countries that turn to storing intermittent "green" energy output as hydrogen. Particularly for readers in the US, it's easy to overlook the country- and region-specific variety in markets for motor vehicles.

2. Lithium-ion batteries are a poor match for utility-level energy storage, where on the battery side vanadium-flow technologies are already superior.

3. Having just visited suppliers and looked at their order books, MY2022 is basically a done deal. The validation - pilot production - volume production cycle for a new battery will take at least 5 years before it can be incorporated into a high-volume passenger vehicle. So as of early 2019 we're looking at MY2027 as the earliest date for the rapid expansion of BEVs.

Thursday, February 7, 2019

Tesla and Elasticities: An Economics 101 Lesson

Mike Smitka
Prof of Economics, W&L

An elasticity is a qualitative and quantitive tool to put bounds on real-world behavior. If a change in one variable leads to a more than proportional change in another, then the relationship is "elastic." Numerically, it's the ratio of percentage changes. Here I apply it to a simple but interesting case, Tesla's $1,100 price cut.

The demand for cars is not very elastic in price. There are lots of 300+ models to choose from in the US, from a variety of manufacturers and in types ranging from compact cars such as the Fiat 500 and the Smart to full-sized pickup trucks replete with towing packages and other options. Then there are performance cars, and most popular of all, small SUVs and crossovers, such as the Toyota RAV4 and the Honda CR-V. There's very little substitutability across vehicle classes; someone looking for a pickup truck does not cross-shop the Fiat 500. The price isn't terribly important. And so demand for any single model is inelastic – it can help sway the choice against a similar vehicle.

(Mea culpa: my wife drives that latter. I prefer a smaller sedan with a stick shift, in my case a Chevy Cruze. My son drives a Subaru Forester, bought used, and we have a F-250 pickup to handle the tasks of living in the woods.)

...a 2% drop in price leads to an 8% drop in gross revenue and a 60% drop in net profit...

For the Tesla Model 3, there are (at least according to afficionados) no similar vehicles. Someone either wants one (and has the money to make that happen), or they don't. A $1,100 difference in price, or a decrease of about 2% with average sales prices (ASP) of $50,000, won't lead to many more sales – if you can't afford a $50,000 vehicle then you probably can't afford one at $49,000. It might make a big of difference if you're comparison-shopping against a similar-sized BMW or Audi. Let me ere on the high side, and assume a 1.0 elasticity. That is, the 2% drop in price will push up the quantity demanded by 2%. As a result, total revenue for Tesla will be unchanged: the drop in price will be just offset by the increase in sales.

I ignore the impact of the phasing out of Federal tax credits. As of January 1st, those drop from $7500 to $3750 so net of the just-announced price cut by Tesla, the bottom line cost to US consumers has in fact risen by $2650.

But for a company with a parlous balance sheet, what matters isn't total revenue but profits and cashflow. Now Tesla claims a gross profit margin of 24%. They don't calculate that in the same way as other car companies – despite self-proclaimed industry-best margins Tesla has never earned a full-year profit. But for the sake of argument, and to keep numbers round, let's us 25%. Given an ASP of $50,000, they then have a gross profit of $12,500 per vehicle. And they've just cut that by 8%.

The bottom line is clear: if Tesla is extraordinarily lucky, they'll maintain total revenue. But they'll earn 10% less gross profit on that revenue. With automotive revenue of $6.3 billion, and a gross margin of 25%, they've gross income of $1.6 billion. Lop off 8%, and this falls by $126 million. So assuming nothing else goes wrong relative to 2018Q4, net income falls from $210 million to $80 million, or a 60% drop in net profit. While timing may affect that – lower sales in Q1 as Model 3s sit on ships en route to Europe, and then higher revenues in Q2 as they make their way to customers – the impact is permanent.

Note that at each step along the way I have rounded numbers in favor of a better profit number for Tesla. Tesla has also cut prices for Model S and Model X over the past 6 months, without any increase in sales. I don't try to factor that in, again to provide a more optimistic case for Tesla.

Saturday, November 24, 2018

Chinese Industrial Policy: an automotive example

In Japan, motor vehicles were few and far between in the 1950s, and in 1956 half of all vehicles produced were still 3-wheelers. Car production surpassed that of trucks only in 1969, and it was only from the mid-1970s that there were more cars than trucks on the road. Even in 1985 there were only 711,000 full-sized cars on the road. It was not a big market for higher-end vehicles.

But a November 22nd Bloomberg story on the (to date) counterproductive outcomes of the "China 2025" industrial policy leads me to address a different set up issues, whether automotive industrial policy makes sense. To do I switch back and forth from automotive historian mode to economic analysis.

In Japan, promoting the auto industry via import substitution industrialization was costly. That's one reason that there were so few vehicles on the road. Industrial policy imposed a cost not just on vehicle users, but on everyone who relied on logistics – which was, of course, everyone. And because there were so few vehicles, the postwar plans for highways and local roads got moved to the back burner. The Yokohama ring road was laid out in 1950, but completed only in 2005. The outer Tokyo ring was planned back in 1927, but not completed until 1985, and at only 4 lanes. The last segment of the inner portion wasn't completed until 2015. Some of the connecting roads and junctions are still under construction. (In Chinese, ring road is huánlù 环路; in Japanese, 環状線 kanjousen.)

Of course there's the contribution to the domestic economy. If it's being subsidized, through policies that allowed firms to charge prices far above international levels, then the contribution of that industry is smaller than that of non-subsidized sectors of the economy. That's made worse in this case by the negative externalities of costly logistics. The Japanese domestic auto industry likely wasn't competitive in the subcompact segment until the mid-1970s, and from then on could survive without subsidies. But competitive full-sized cars came even later. BMW made a fortune in the 1980s and 1990s in Japan because they could charge higher prices than in other global markets, suggesting that the Japanese producers weren't competitive in that segment until the 1990s, and (given branding) perhaps not even until 2006, when Toyota at last launched their "German-killer" Lexus marque inside Japan. While Japan removed formal trade barriers by 1971, Japan's domestic market was small. The preferred route for the Detroit Three was via acquisitions, not de novo "greenfield" plants or exports (which would have been compact cars from Europe, not large cars from the US).

Trade models don't show that subsidizing industries saves on foreign exchange, because (cf. expensive domestic transport above) it raises costs for exporters and for firms that face import competition. Japan's surge in exports to the US following the 2nd oil crisis was brief, as the market for subcompacts collapsed by the mid-1980s. But in the meantime the US formally subsidized direct foreign investment (via the VER, voluntary export restraint, imposed by the Reagan Administration in May 1981) and encouraged imports (a side effect of the strong dollar policy of the early 1980s, one of the channels through which high interest rates helped quell inflation).

So I don't think that "It would have been self-defeating not to support MITI's policy to nurture - and protect - Japan's infant auto industry." (citing Roger Schreffler, of Wards Automotive, arguing on the NBR Japan Forum about US policy towards Japan in the Cold War.) It would have made more sense in the 1950s to welcome imports, and particularly to welcome direct foreign investment. The industry would have been more efficient early on, to the benefit of the growth of the economy as a whole. Through 1967 Japan faced periodic balance-of-payments crises, including a trip to the IMF in 1961, but by 1969 foreign exchange reserves were robust for the first time in the post-WWII era, while 15 years of rapid growth had raised incomes and automotive sales – it was only in 1967 that passenger cars first outsold commercial vehicles. Policy was to open the industry up to trade – while a grad student some decades back I read through many contemporary Japanese sources, where the need increase competitiveness was touted year in and year out, even while agriculture was fenced off from such pressures. It didn't hurt that there were several large car producers, and several that failed – when everyone was lowering costs, it was improve or die. Toyota did the former better than anyone else, for regular cars, while Suzuki was the undisputed champ for minicars (in Japanese, "kei" cars or 軽自動車 / 轻汽车).

China's industry provides a case in point. The early industry began with a turnkey car factory built by Soviet engineers; it focused on trucks, but from 1955 made small numbers of cars so that the senior leadership could appear at public functions in a Chinese vehicle. A few joint ventures were allowed in the 1980s; that of VW in Shanghai did well, at one point accounting for 80% of all passenger cars made in China. The was also an Audi plant in Manchuria, which used an assembly line exported from a plant VW was closing in South Africa; that helped lay the groundwork for a black Audi becoming the vehicle of choice for Party officials. (There was also an engine JV of Mitsubishi Motors, which supplied truck plants throughout China.) Meanwhile protectionism allowed lots of inefficient assemblers to exist, at peak around 200 – in the 1950s Japan had 30 or so manufacturers, which wasn't all that different given the 12-fold disparity in population.

In Japan those small, inefficient producers were whittled down in numbers, some through M&A (Toyota of the firms that became Kanto Jidosha and Toyota Auto Body, Nissan of Prince, 3 different Mitsubishi companies into Mitsubishi Motors), some via exit. But it took a long while for others to attain scale, and in 1980 there were still 8 passenger car makers (Toyota, Nissan, Honda, Subaru, Mitsubishi, Isuzu, Mazda, Daihatsu – did I forget one?).

China took a different route, touched off by the entry of GM in 2001, and a wave of subsequent ventures by the top global motor vehicle manufacturers (ditto agricultural and construction equipment firms). Motor vehicle prices fell rapidly, and continue to fall 17 years later. Exports? – not so much, because the economy grew so fast that the leading firms (the various joint ventures GM and VW) had no excess capacity, and as long as that was true, margins on sales within China remained more attractive than those on exports, which have to cover the costs of shipping and tariffs (2.5% for the US, now 10%). And they've worked on their road network, at the regional and the national level – unlike Japan, congestion isn't for a lack of planning and effort.

So the bottom line is that import substitution industrialization was an utter and complete failure before 2001. Allowing global companies to dominate the industry has been a boon: high quality, lower cost "global" vehicles made with Chinese labor, and Chinese-made parts (every global supplier for which I've tracked down information, an ongoing research project, has a substantial presence in China). All of this now comes with increasing levels of local engineering, as local staff gain experience. So it's a tale of two China's, the worst of times under Japanese-style industrial policy, and the best of times when the market was opened.

There's a bit of irony: China's domestic market is slowing, so in an early 2017 book (Smitka and Warrian, $9.99 on Kindle) and in a January 2016 blog post, China's Auto Industry Meltdown, I predicted excess capacity and exports within a couple years. Indeed, GM and Honda make niche products in China that are too low in likely sales to justify production in NAFTA, and had begun exports. Those have ended, at least to the US. A few "local" firms that aren't doing well inside China do have excess capacity and exports – I rode in one such in Lima, Peru, but definitely a step up from a used car but a step down from the entry-level global products of Toyota (the Yaris) and Kia (the Rio). There's no sign that China will manage to build significant levels of exports (through 2017 they've run a trade deficit on automotive products), because the most competitive firms – Toyota, Nissan, VW, GM, Hyundai-Kia – have local production bases around the world. But China remains a labor-abundant, capital-scarce economy for which the auto industry is still a weak fit. I've heard though that China does OK on the international trade front without the auto industry.

But how about electric vehicles, one focus of the Bloomberg article. They estimate that between them the national and provincial / local governments have spent $59 billion between 2009 and 2017. If you pay consumers enough they will buy them – Tomasso Pardi of ENS-Paris Saclav and Director of the GERPISA auto industry research association, together with Deng Xiaoxiang, analyzed insurance data on EVs in China. (Why insurance data? – you can't use sales data due to the fraudulent registration of EVs by unscrupulous "manufacturers" to pocket subsidies.) They found that despite the equivalent of US $8,000 in direct subsidies from Beijing, in many provinces there were effectively zero sales. EVs sold only in cities that added their own cash subsidies – in Beijing, up to US$15,000 – and indirect subsidies (such as getting license plates immediately, while waiving the US$2500 license plate fee and the 10% sales tax). In Beijing, with a quota of 50,000 licenses, total sales of EVs were 58,000.

...from a selfish perspective, we should cheer China 2025 on...

Beijing's China 2025 policy may sound great, but it can't overcome the limitations of lithium electrochemistry that keep battery cell prices high. China does lead the global electric vehicle industry, not because they're better, but because they have spent more. I'm guardedly optimistic that it is possible to develop better batteries. However, until scientists find ways are found to get around the current limitations, mass-market BEVs remain years down the road. Even if it's Chinese labs that develop the core technologies, that won't give the Chinese industry an advantage – second movers in the rest of the world will be able to improve on their chemical engineering. (No, that would not be stealing – you can't patent basic science.)

So from a selfish perspective, we should cheer China on – let them be the ones to invest in creating global public goods. The more China 2025 money spent on battery R&D, the more likely improvements will come our way!

Monday, August 6, 2018

Quick thoughts on the stock market impact of the trade war

Mike Smitka, Economics, W&L

What are the market implications? Below are quick thoughts. I will refine this initial and very tentative analysis over the next month. Above all, I need to add detail on the investment implications.

There can be little doubt that we are moving to higher and higher tariffs against China; the must-be top-of-the-news mindset of President Trump makes it very hard for those on the other side to defuse things, much less back down. Trump may be riveted on the stock market, and think that swings in Chinese equity prices drive politicians there. He apparently has never heard that all politics are local, and that the Chinese leadership can scarce be seen to "cave in" to a foreign power. Will the war spread? That depends on whether the Administration lashes out in the face of a global trade deficit that is more likely to grow that to shrink. That's thanks to their own actions, the fiscal stimulus packaged passed by Congress earlier this year with Presidential support. Demand will increase, even if not by much, and that will require more (net) imports. After all, few Americans remain unemployed, so factories can't expand and we won't see much uptick in domestic output. Goods (and services) will have to come from somewhere, which means reduced exports and increased imports.

Complementing that demand-and-supply story are higher domestic interest rates. Thanks in part to a growing Federal deficit amidst a strong economy, Treasuries are more attractive to global investors, and to get those they have to buy dollars. The White House will talk of a Chinese currency war, but the dollar is stronger across the board – Canada, Europe and Japan, along with most of our other trading partners. This will offset some of the pocketbook impact of trade, keeping imports high, while the strong dollar and the higher cost of intermediate goods such as steel will hurt exporters. Again, this complements the above analysis of supply and demand. [Wonks will recognize that a net increase in Treasury purchases by non-residents must necessarily be matched by a net increase in the trade deficit.]

Myths abound. One is that tariffs will cut our deficit. A quick glance at the data should inject a dose of realism, but twitter and TV "sound bites" aren't a good way to highlight basic arithmetic. Numbers aren't the story-monger's strength. So ... to data: in the year through Q2 we collected under $45 billion in customs duties, and that's already up sharply this last quarter. With higher tax rates, the total might go to $100 billion, paid of course by US consumers. Why not more? – we import $3 trillion a year, so shouldn't revenue approach 25% of that, or $750 billion? No, because all sorts of things will continue to face no tariffs. Examples include most of the goods shipped to us from Canada and Mexico ($300+ billion each) and the $250+ billion we import in energy products. That drops the amount subject to taxes by almost $1 trillion. Of course higher taxes also induce shifting to avoid them. Trade is no exception. Again, we might, possibly, collect $50 billion in additional revenue. That offsets little of the $1 trillion-a-ear increase in the budget deficit from early 2018 tax cuts passed by Congress. [Wonks should look at the history of the US prior to 1914 and the imposition of a national income tax.]

Now the Administration is encouraging the belief that the Chinese will back down, and we can return to the good old days of a strong US. Unfortunately — unless Trump caves very soon — there will be a permanent impact, as the rest of the world evolves to take advantage of the absence of the US. A lesson in point is that several of our "temporary" retaliatory tariffs to the 1963 "[frozen] Chicken War" with Europe are still in place over 50 years later. In addition, China's biggest trading partner isn't the US, it's Europe. The world will evolve without us, to our detriment, and to China's advantage in its quest for global power.

Part of the reason the impact won't soon be reversed is that no one will want to waste time negotiating with the US. After all, a 3am tweet storm can undo everything. The President has been less than consistent, and doesn't engage in the sort of careful, briefing- and reading-intensive memo and staff work to see that he understands what negotiators can achieve, and they understand his priorities as they consider many hundreds of policy options. Plus we lack negotiators: the Administration has lots of unfilled positions at USTR, among other places. But above all the other side understands that the people across the table have no idea whether Trump will back them, and has little incentive to make a counter-offer that might be on the news an hour later and claimed as a "victory", as the new starting position.

Investors:
    several takeaways

For investors, what matters are identifying stocks and bonds that will be differentially affected.

  1. With taxes on intermediate products (steel), avoid final goods producers (autos). However, that advice has to be muted because many such firms are global businesses that earn only a minority of their profits in the US. Be wary of "US" brands, as those may be hit by future anti-American campaigns in China, and not just what happens to their sales in the US. General Motors sells more vehicles in China than in the US, and is highly exposed to such risk. Anyway, if you can quickly spot individual intermediate goods producers (that is, still overlooked by the market), their profits may rise. And I suspect that in a market dominated by trends, many hard-goods firms are already underpriced.
  2. Amazon and Walmart may be hurt, as their sales depend on final goods—their customers aren't buying rolls of steel. The lower half of the income scale in the US are the ones who have benefitted the most from trade. Here's an example—I ask my students how big their closets are, and then point out that older houses (pre-WWII) in rural Virginia often have NO closets. Why? – clothing was too expensive for all but the wealthy to have more than a couple changes of clothing. With various trade deals, even the poor in the US can have 5 pairs of trousers and 20 shirts and lots of shoes, socks and underwear. Then there is consumer electronics, including cell phones. China runs labor-intensive "screwdriver" plants that import components from the US [and elsewhere] and export complete units back to the US. So the Chinese economy obtains relatively little of the value added. Unfortunately, tariffs are blind to such details, taxing the gross and not the net amount. Again, Walmart and Amazon sell a lot of those, and will be hurt. Can Apple lobby for an exemption? If I were China, I'd try to turn on the PR machine to make it hard for Trump to carve out highly visible exceptions...
  3. Extrapolate: I expect the pain will show up in places we don't initially expect.

Details on the trade front are still few: most tariff hikes are still at the "promised" stage and are not yet effective. Second, much trade is under long contracts, so historically it takes 18 months for measures to work there way across the Atlantic and Pacific. Yes, tariffs can (and will) affect goods while they're in transit, so the price impact will be felt more quickly than changes in quantity. But the impact will consist on small increases in the prices of a large number of goods. Consumers may not connect the dots between trade policy and why they're having such a hard time making ends meet. But that won't be hidden to mass-market retailers, whose sales will inevitably be hit.

Thursday, July 19, 2018

Tesla Bond, again

Mike Smitka

I posted an article on Seeking Alpha on Tesla's junk bond. It may be behind a fire wall. In any case, here's the key chart, updated subsequent to the SA post to include data back to November 1, 2017 (previously I'd only taken things back to December 1st, 2017).

There's only a very weak correlation between the stock price and difference in the bond yield (relative to a "B" bond index) prior to the March 27th downgrade of Tesla's straight bond (5.3% yield, 8/15/2025 maturity, semiannual coupon). There's a strong correlation after the downgrade, usefully exactly 1:1, that is Stock $1 ↑ <==> Yield differential 1 bp ↓.

=========
Regression results:
Stock price ==> bond price relative to "B" bonds

March 28 - Jul 18: 1.01 (±0.01) t=10.77 observations=77
Nov 1 - March 26: 0.38 (±.11) t=3.43 observations=100

Friday, May 11, 2018

Tesla Bond Yield

Mike Smitka
Economics, W&L

Tesla has one straight bond, an 8-year bond at 5.3% with a semiannual coupon payment, maturing Aug 15, 2025. I have been putting trade data into a spreadsheet for several months, with the underlying goal of comparing that bond with "B" rated bonds. Does the Tesla bond track other low-rated bonds? The quick answer is "yes." That has two caveats: first, the bond is thinly traded, and I benchmark against one bond fund that provides only a daily closing price. Second, the differential moves around, with one obvious discontinuity: yields jumped when Moody's downgraded Tesla.

...bond traders trade the rating, not the company...

First, the graph below provides trade-by-trade yields and a trade-volume-weighted moving average (a lot of 1,000,000 counts more than one of 5,000). These data are only for sell-side prices, and don't differentiate between various markup strategies. There are days with a dozen or fewer trades, and only the occasional day with 30 or more. Crude, but I chose not to throw out observations or try to adjust for markups (I could see no pattern). I did look at buy-side data, but there are very few trades reported, so I kept them out of the mix.

What do we see? Back in early April the yield jumped to 8.5%, and over the past month has gradually rise back to 8.4%. However, that's in the context of rising interest rates. So comes the second chart, to which I added additional days on a sampled basis (every 25th screen of prices...). When Tesla first issued their bond, it traded at a 40bp premium to the ICE BofAML US High Yield B Effective Yield. That disappeared within a month, and thereafter (with noise) the Tesla bond traded at a 25bp premium to B-bonds. Then came the Moody's downgrade, and yields instantly jumped by 150bp relative to B-bonds. Yields then fell back for most of April, but are now back to the immediate post-downgrade level.

...I see noise, not trend...

My hunch is they'll stay at about where they unless (or if you're a bear, until) there's another downgrade. That's based on the assumption that those buying such bonds assemble a broad portfolio, particularly for ones with a low rating. In other words, bond traders trade the rating, not the company. Nothing in bond prices suggests that they read Tesla's financials closely. Yes, yields climbed almost 40bp after the earnings call – but in a noisy manner. Indeed, the most recent date (Thur 10 May 2018) shows yields dropping a bit. I will revisit in a month or so, but for now what I see over the last month is noise, not trend.

.

Notes:

  1. I could not get excel to label the axis sensibly for trade data, which provide the hour and minute and not just the day. So the axis is trade by trade, rather than by date.
  2. Trades are detailed by the Financial Industry Regulatory Agency at Tesla bond yield.
  3. On some days there are as few as 3 recorded buy-side transactions. I don't report those data, but the yield differential tracks that of the sell side. While logically buyers pay more than sellers, fees get buried in prices and I cannot in general match a "buy" with a "sell." When I can, the price is typically identical, that is, fees aren't built into the reported price.
  4. I had been intending to track data longer, but post now in response to Bill Maurer on Seeking Alpha.