About The Authors

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:

There's nothing in the streets / Looks any different to me ...
Don't get fooled again!
Meet the new boss / Same as the old boss ...

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...