The PACE of Automotive Innovation

Suppliers are integral to new technology in the auto industry to an extent not true since the early years of the 20th century, when ventures such as Ford began as mere assemblers, not manufacturers. That will be highlighted on Monday, at the 21st PACE "academy awards" for supplier innovation. (For those not in the know, Monday's the opening night of the SAE [Society of Automotive Engineers] in Detroit.)

Caveat lector: your not-so-humble author has been a judge from the competition's beginning.

General Motors began as a conglomeration of existing firms, both suppliers and assemblers. As it grew – and as Ford stumbled – it added more suppliers while dropping brands. By the 1960s it was highly integrated, with suppliers relegated to trying to make parts to GM's blueprints. Now that strategy had unintended consequences, as the route to the top became finance, with other functions such as making and selling cars treated as an afterthought. Be that as it may, come the 1970s, first emissions controls, then fuel efficiency mandates, and finally safety regulations forced car firms to engage with non-traditional, outside suppliers. Meanwhile, new entry meant that the comfortable Big Three oligopoly could no longer ignore the challenge of actually making and selling cars. One response was to spin off internal parts operations, and with it the ability to do the relevant component-specific R&D. Finally, alongside this demand-side story were two technology revolutions, those of materials science and of electronics and sensors that enabled these suppliers to turn to innovation as a way to build their businesses and preserve margins. The bottom line was that suppliers became central to automotive innovation.

This supplier-centric industry has lots of implications. For one, it may facilitate new entry; Aptera, Fisker, BYD, Chery, Geely, Great Wall, Tesla, Bright Automotive, Edison2 and others could buy drivetrains, transmissions, sensors and controls from existing, auto-tech-savvy suppliers. Not all have survived, due to a combination of undercapitalization, poor product strategy and bad luck. However none could have started had suppliers not controlled – and built their businesses around selling – core technologies. Exploring such implications, including for investors, is however a topic for subsequent posts.

Here let me briefly note the role of suppliers, using engines are an example. (My apologies to Europeans for focusing on gasoline rather than diesel engines.) Drawing from among PACE award winners, we see the following areas dominated by suppliers: fuel tanks, fuel pumps, fuel vapor recovery, injectors, injector electronics, spark plugs, valves, camshafts, pistons, piston rings, bearings, seals, sensors of many types, turbochargers and turbocharger escape valve technologies. There are other areas (engine block castings, machining) where car companies continue to dominate, but even there suppliers provide the machine tools that are critical to these operations. In short, while car companies may work on the configuration of the engine and the integration of these various components, the advances come from supplier technology.

It's not just engines. A wide array of vehicle systems are dominated entirely by suppliers, such as clutch components, transmissions, differentials and driveshafts, HVAC systems, lighting, ESC systems, tires, tire sensors, suspensions, ECUs and most other sensors and vehicle electronics, airbags, seatbelts, hot stamping, hydroforming, paints, structural adhesives, sound-proofing materials, water pumps, radiators, headliners, instrument panel surfaces and underfoams, starter/alternator systems, belt and pulley systems, timing chains, windshields and glass, wiper motors, wiper blades, radar, lidar and ultrasound sensors, cameras and image recognition systems, infotainments systems, and on and on. More important for Monday, you can find examples among the two decades of PACE finalists and award winners.

I've been privileged to judge this competition since its inception, thanks to the entre provided by my own research (my PhD dissertation was on automotive suppliers in Japan). As a result I've been able to visit 2-4 suppliers a year for in-depth presentations on technologies and their business case, and to sit with the judging panel to hear their summaries of similar visits. Along the way I've earned my PE degree as well. [P.E = pretend engineer] Now the entire process is under NDLs (non-disclosure agreements) so I have to be careful, but I have tried my hand (with co-author Peter Warrian) at analyzing the finalists using publicly available information for lessons on technology. You can find our initial paper here and a more recent analysis (incorporating 2015 finalists) here. photo: Federal Mogul's IROX engine bearing

Anyway, watch Monday night for the stream of press releases from the winners, and the Automotive News coverage of the entire award ceremony. I'll be there, in my tuxedo, enjoying the food and drink, and the celebration of innovation. It's a fun and thought-provoking event!

China: all's well ... for now

Today VW claimed sales of 2.35 million units in Jan-Sep. Meanwhile GM's PR machine releases brand sales monthly. I track these, out of curiousity and because I teach a course on the Chinese economy (in which I use Michael Dunne's American Wheels as one of 4 books I ask students to read). GM's 9-month total is ... 2.35 million units.

At one level it seems rather silly for a manufacturer to seek to be the market leader – after all, you can typically boost sales through aggressive discounting, and while a price war is great for consumers and car dealers, it's really, really bad for manufacturers. However, journalists find "who's first" makes good copy, and from a corporate perspective that's free PR. Does it solidify brand image and encourage people to shop your vehicles? Maybe. But whether being first is a good image to create among potential consumers is at base an empirical question, about which I've not the foggiest idea.

it seems rather silly ... to seek to be the market leader

Let's think about this from another perspective. [I round everything – these are back-of-the-envelope calculations.] Given market growth, another 3 months ought to add another 35% and 40% to their annual total – let's call it 6.5 million units between the two. With a total market of perhaps a bit under 20 million this year, and somewhat less if we focus on passenger-oriented vehicles, that comes to a 35% market share.

Now in the hypercompetitive US market Ford and GM, the top two firms, have a combined market share of 34% over the past 12 months. If we expand to the Big Three – GM, Ford and Toyota – their joint share is 48%, down over the past several years. I don't track the Chinese market closely enough to have put together a spreadsheet; my sense is that Ford (story here) is growing its share, while Hyundai and Nissan are strong (and Toyota weak). The purely domestics are much, much smaller though Great Wall with its Haval (web site here, Bloomberg story here) has what is by far the best-selling SUV.

In a market expanding as fast as China's it's possible to preserve margins despite this level of rivalry. First-movers can push down costs and try to build share, thinking of the long run. But in that long run the market will likely have more brands and certainly more manufacturers than either NAFTA or the EU. Once sales slow, profits will plummet towards the global normal, which is such as to make being an assembler barely sustainable.^{Note 1} [The parts sector is different in that regard, with far few players for many of the major vehicle systems.]

That will be worse news for some, because virtually all production in China is through joint ventures.^{Note 2} As long as the market is expanding, well, that can be made to work. However, joint ventures are inherently unstable, and when – not if – profits disappear, China will prove no exception. (Indeed, while I know of no breakdown the past few years, in an earlier era Beijing Jeep imploded, and a Peugeot venture stalled. Indeed, an October 14th Bloomberg story notes they may sell a portion of their stake in 3 factories jointly owned with Dongfeng, among other measures designed to raise cash amidst the 6th year of declining sales in the EU.)

It's common to find policymakers thinking of technology as a set of blueprints. In that case, transferring technology is a function of bargaining power. In the real world, however, it's the ability to engineer a car. That is "embodied technology" in the literal sense: it requires building a large team backed by sophisticated management and computer tools for purchasing and other functions. Some firms, notably GM, have chosen to build such capabilities in their ventures, while stressing that the ventures remain independent from either partner. For now GM can use a variety of strategies to increase its own returns – China is part of its global operations, and the vehicles sold in China rely on engineering done elsewhere covered by licensing fees. The longer run though is that it will become more and more a stand-alone operation, paying less in fees to outsiders and even generating some revenue from its own engineering efforts. GM (and SAIC and other partners) will become shareholders, and finesse the underlying tensions of the joint venture structure.

GM [may] finesse the ...tensions of ... joint venture[s]

However, my educated guess^{Note 3} is that GM has been far more proactive than other ventures. So along with falling profits I predict rising feuds. Chinese government policy in principle promotes fewer players and the pursuit of economies of scale (while in practice proving unable to prevent new entry, most recently through formal permission to allow the domestic assembly of Volvos). There used to be 120 or so domestic makers, but now there are only a few dozen, and some of those exist mainly on paper, selling trivial numbers. Given the instability of joint ventures, though, for some ventures the road ahead will be bumpy and may in fact lead to a dead end. In the coverage I read of the Chinese market, I see an almost single-minded focus on sales and rates of expansion. I read almost no analysis of whether that expansion is taking the right path.

Note 1: for economists, think "monopolistic competition".

Note 2: For general background see China Auto Web. Then there's Automotive News China. Others obviously cover this, such as a nice IBT article. After all, how can you not write about the world's largest car market?

Note 3: I use the phrase "educated guess" very deliberately. I read a lot and strive to integrate that using the analytic skills for which a PhD represents but one step. However, while my Chinese is sufficient for navigating web sites and is improving, my reading speed is still too slow to be a practical research tool – unlike my Japanese and German.

mike smitka