As is the tradition of my public account, there should be an annual article for 2022. But the end of the year was too busy, and my thoughts were too scattered to begin until now, as the pandemic has affected both my physical energy and mental clarity.
Over the past two years, I have rarely written about other companies in the automotive industry, mainly because, on the one hand, I lack knowledge of other companies and therefore lack the right to speak without investigation, and on the other hand, I do not consider myself knowledgeable enough about the industry and fear making incomplete statements.
However, this year’s annual article will focus on discussing the “investment analysis framework” for the automotive industry, not because I have finally come to a clear understanding, but because I have come to realize that I will never have a complete understanding. Therefore, the purpose of this article is mainly to summarize my past thoughts and hopes to provide a reasonable reference frame for future observations.
Do not fear an infinite truth, and every inch forward brings its own joy. Perhaps that is the case.
The new electric car and alternative energy industries have frequently been compared to the smartphone industry over the past few years, as when a new product appears, the easiest way to explain it is to borrow a concept familiar to everyone. However, this does not mean that we do not need to carefully analyze the substance beneath the superficial “similarities.” In particular, for long-term investors, their returns depend on correctly judging future trends and buying and holding at the appropriate valuation.
While there are many similarities between the “new electric car and alternative energy industries” and the “smartphone industry,” there are many more important differences. Firstly, automobiles account for a large proportion of disposable income, are optional consumer goods, and are subject to significant macroeconomic influences. Smartphones make up a smaller proportion of overall spending and are almost a necessity, and are therefore less affected by macroeconomic trends. Secondly, the smartphone industry has a complete software ecosystem with user logic, applications, cloud data, and high user retention. In contrast, the automotive industry has no significant software ecosystem, and the threshold for changing cars is low. Thirdly, the “price-to-weight” ratio in the smartphone industry is 16,000 RMB/KG while in the automotive industry it is only 138 RMB/KG, meaning the profit margin in the smartphone industry is substantial, while the automotive industry is far behind. This basic idea also applies to companies in the industrial chain of smartphones and automobiles.
These factors dictate that although the automotive and smartphone industries may seem similar, the underlying profit levels, replacement cycles and future concentration of companies will differ significantly. However, on the other hand, the overall size of the smartphone industry is not as large as the automotive industry, and if we were to include transportation and logistics, the gap would be even wider.
Although the profit level, replacement cycle, and market concentration of the automotive industry are not as good as those of the smartphone industry, the automotive industry can try to emulate the smartphone industry as much as possible, depending on the competitive strategy and resource allocation chosen by companies.
The most mainstream business in the automotive industry is the sale of car hardware and after-sales service revenue, and both have always been the main indicators for measuring the performance of a car company. Pursuing “selling cars” as the core goal is correct, but if “selling cars” is understood only at the most basic level, new cars and new energy vehicles are not much different from traditional fuel vehicles.
From the perspective of hardware products, hardware innovation brought about by engineering and design can provide an early advantage in the short term but is easily homogenized in the long term. This is because once a good product is launched, it can be copied, and the upstream supply chain of mature industries is essentially shared. From the perspective of production and manufacturing, the threshold for manufacturing is also constantly decreasing over time, as everyone can purchase advanced production machinery, and good production methods can also be learned.
A typical example is Berkshire Hathaway, which was a textile company operated by Buffett a long time ago. Before Buffett’s acquisition, the company was on the verge of bankruptcy. After analyzing a lot of operating data, Buffett found that updating the production machinery could double the profit and resurrect the company. It felt like he had discovered a gold mine, so he immediately decided to buy it at a price close to bankruptcy. After updating the new equipment and operating it for a period of time, it did indeed make a lot of money. However, after a period of time, the losses were even more serious than before. The reason was that Buffett did not consider the problem with a dynamic perspective when calculating operating data. He only calculated that Berkshire Hathaway would update the machinery to improve production efficiency. Under these circumstances, if the fabric price did not change, the profit could indeed double. However, in reality, after other companies learned that there was new machinery on the market that can improve production efficiency, they all updated their machinery, causing an oversupply of fabrics in the market, resulting in a drop in price. In the end, only consumers benefited, and all companies (including those that did not update their machinery) did not gain any advantage.
Therefore, it is difficult to maintain long-term advantages by relying on production and manufacturing advantages to “sell cars.” If you only compete at this level, it is still a traditional approach, and the long-term growth potential is worrying, not to mention compared to the smartphone industry.
To increase hardware profit margins, the automotive industry can be divided into short-term and long-term directions. In the short term, enterprises should cut into the industry chain and lay out vertically and horizontally, with direct sales, transportation, production, components, and even upstream raw materials. They should be compared with the efficiency of direct procurement at different stages, where the advantages of vertical layout should be greater if the company’s scale is large enough. However, these advantages are always part of the production and manufacturing advantages, which will lead to homogenization and cause the profit margin to be unable to maintain if competitors catch up.So what about the long-term direction? Let’s take a look at the smartphone industry. The reason why the industry can maintain high hardware profit margins and company concentration in the long term is due to the “high replacement threshold” brought by the software ecosystem behind it. The higher the replacement threshold, the easier it is for users to indulge in one company’s products, which makes it easier for the company to have pricing power when selling new hardware.
The secret to maintaining long-term advantages in the automotive industry is similar to that of the smartphone industry: it lies in software.
Autonomous (assisted) driving is the main direction for long-term advancement. I believe this technology will be linked with car insurance to realize its actual value. About 50-60% of insurance premiums each year go to accident compensation, while the remaining 35%-45% is comprehensive operating costs (most of which are channel expenses). Insurance companies have a profit margin of less than 5% each year, and even lose money in some years. Autonomous (assisted) driving claims to greatly reduce accident rates. If the technology can achieve this and reduce the accident rate to 1/10 or even lower than that of human driving, it means that the accident compensation rate of insurance can be greatly reduced, and the saved costs can be returned to users. Implementing a “low-price strategy” will automatically attract users to purchase their own insurance, while reducing the channel expense rate of insurance, which can lower the cost paid by users and increase profit margins. This creates a product flywheel: choose or subscribe to autonomous driving software to get low-price insurance. Only autonomous (assisted) driving technology can achieve this flywheel.
In addition to reducing accident rates, autonomous (assisted) driving can also transfer rigid payments from insurance premiums. At the same time, it can also reduce driver fatigue and bring users additional value in terms of experience. Mainstream users are also likely to be willing to pay for this.
The threshold for this technology lies in the maturity of software. To achieve a certain level of maturity, a company needs to have strong capabilities in software development and hardware design integration at the same time. In terms of strength, it should be no less than Apple’s ability to combine iPhone+iOS. Therefore, in-house development of both software and hardware should be at least a standard configuration to have the qualification to enter the market. An automotive company that has mature autonomous driving software can sustain high profit margins in the long term by continuously turning this flywheel until the second company catches up.
However, just talking generally like this seems to have no specific meaning for investment analysis in the industry. Therefore, it is still necessary to talk specifically about the framework for investing in the automotive industry now. Combining the cycle of capital shortage and consumption decline, the companies in the industry can be divided into two categories: companies that may go bankrupt and companies with declining profits. Most of the companies that have not realized positive cash flow belong to the former. The automotive industry has a long product cycle, and the cash on hand is especially insufficient to support 36 months. The companies that have realized positive cash flow belong to the latter.Companies without positive cash flow need to focus on their basic competence in selling hardware and ensure that their vehicle models can maintain a certain growth rate of sales. Companies that have achieved positive cash flow need to observe their market share at the same price point, which should reach at least 20% to prove the competitiveness of their products. Additionally, it’s necessary to examine the management’s understanding of competition and whether the core resources are invested in building long-term advantages.
For companies without positive cash flow, there is no discussion on the issue of long-term advantage building, as they must prioritize obtaining positive cash flow by any means necessary. Especially in the short-term, all resources should be focused on achieving positive cash flow.
The beginning sentence highlights that the returns of long-term investors are built upon roughly accurate trend predictions, in combination with buying at appropriate valuations and holding. The discussion below aims to explore what constitutes an appropriate valuation, but avoids specific valuation analysis to prevent errors in precision, instead looking for general correctness. We will discuss the logic hierarchy of valuations for different companies.
The valuation hierarchy of companies can be simply divided into seven levels:
- Traditional automobile companies/new energy companies that may go bankrupt (staying afloat is the most important thing, the odds of valuation should reflect this)
- Traditional/new energy companies with positive cash flow + no long-term investment (in the context of the automobile industry, it’s difficult to maintain profit margins in hardware manufacturing)
- Traditional/new energy companies with positive cash flow + same price point market share over 20% + no long-term investment (according to industry valuations)
- Traditional/new energy companies with positive cash flow + long-term investment (slightly above industry valuations)
- Traditional/new energy companies with positive cash flow + same price point market share over 20% + long-term investment (slightly above industry valuations)
- Traditional/new energy companies with positive cash flow + same price point market share over 20% + long-term investment + revenue transformation has begun (higher than automobile industry, lower than technology industry valuations)
- Autonomous driving companies unrestricted by conditions (higher than technology industry valuations, using technological advantages to expand revenue ceiling in transportation and logistics industry)
This article is a translation by ChatGPT of a Chinese report from 42HOW. If you have any questions about it, please email email@example.com.