This article is a small part of a 11-part analysis of Tesla, Elon Musk, and the EV industry by value investor Vitaliy Katsenelson. You can see the complete analysis here or here
Let’s go back to June 2008, when Apple (NASDAQ:AAPL) introduced the iPhone 3G and Nokia (NYSE:NOK) was still the world’s largest phone maker. What we did not know at the time was that Nokia was actually the largest dumb phone maker and that Apple was about to become the largest smartphone maker — a crucially important nuance.
Technological Change vs Domain Shift
In 2004, Nokia missed the flip phone boom and lost market share to Motorola (NYSE:MSI), which came out with the slick Razr flip phone. Nokia had a few quarters of disappointing sales, the stock declined, and we bought it. But then Nokia came out with its own flip phone and the status quo was restored: the company was again the king of the dumb phone castle. The flip phone was a technological change, but it was still in Nokia’s domain of core competency. We sold the stock and made money.
The mistake many investors made, including yours truly, was missing the fact that the iPhone was not a technological change like the flip phone, but shift into a very different domain with a very different ecosystem. It was not a phone, but a portable computer that also made phone calls. Nokia should’ve thanked Apple for showing the future of the phone and developed its own smartphone, but it didn’t. So Apple did not dethrone Nokia; Nokia did it to itself.
Which brings us to Tesla (NASDAQ:TSLA) and traditional carmakers. In theory, nobody knows more about making cars than the traditional internal-combustion-engine (ICE) carmakers, and so EVs made by these companies should be the ones busying our streets a decade from now. But the transition from ICE cars to EVs is not just a technological shift within a domain, like the transition from two-wheel-drive sedans to four-wheel-drive SUVs. This is a radical shift into a new domain and the success of ICE car manufacturers in this new domain is anything but guaranteed.
ICE cars are dumb phones; Tesla’s Model 3 is an iPhone 3G. Cars last about 12 years and phones two to three, so this transition will happen slowly.
Why Domain Shifts Are Tricky Business
In domain shifts, assets turn into liabilities. Nokia in 2008 was a master of hardware, but not software or user interface. It tried to respond to the iPhone by remolding its dumb-phone Symbian OS into a smartphone OS. That attempt failed miserably.
That’s because when you are in the middle of a transition from one domain to another, your knowledge of the past domain may cloud your vision. You’ll be seeing through the lenses you’re used to wearing.
Established companies also need the capacity and ability to suffer (lose money) to survive a domain shift. In 1997, Barnes & Noble (NYSE:NE) sold more books in a day than Amazon (NASDAQ:AMZN) did in months. But to snuff out Amazon, B&N would’ve had to lower its prices and hurt its very profitable business. We all know how that story ended.
Another example: Walmart (NYSE:WMT). As it’s trying to catch up to Amazon in online sales, Walmart needs to invest—and invest a lot. To do just that, the company is currently losing $1 billion (a tiny fraction of its profits) on online sales, but the company’s board and CEO Greg Foran are not very happy about these losses. This is a company that never lost money before. Losses are not in its DNA, but they are Jeff Bezos’ middle name. To make things more complicated, Foran’s bonus is tied to profits of both online and offline stores.
You can see how difficult it is even for a company as dominant and successful as Walmart to adapt to a shift in domain.
Nokia or Samsung?
Nokia wasn’t the only dumb phone maker at the time of iPhone’s release. There was also Samsung (OTC:SSNLF). Unlike Nokia, it successfully transitioned into one of the biggest smartphone makers today. So, established companies can and do transition during a domain shift.
But what about ICE carmakers? Are they going to go the way of Nokia, or the way of Samsung?
Tesla created its cars by entirely breaking out of the domain of existing auto manufacturers (well, except for the original Roadster). Because it created the EV industry, Tesla had the advantage of acting from first principles. It could start with a blank piece of paper. As Musk once told an interviewer:
“I tend to approach things from a physics framework … physics teaches you to reason from first principles rather than by analogy.”
This first-principles approach allowed Tesla to build EVs that are free from the limitations of gasoline-car thinking. No gears, a skateboard chassis, two engines, a “frunk,” a credit-card key, a mobile app that works as a key and controls the car, and no start button, among others. Tesla applied first-principles thinking to how its cars would be sold and serviced.
Today’s ICE auto manufacturers are basically wholesalers of their cars to auto dealers that are their franchisees. This business model is a Great Depression relic that went basically unchallenged until Tesla came along. Tesla decided that the traditional business model was not appropriate for the new EV domain. Instead, it borrowed from Apple, which controls the full customer experience, from buying a phone to servicing it to upgrading to a new one.
Consider: My purchase of a $51,000 Model 3 was as easy as my purchase of a $900 iPhone. I test drove the car. A few days later, I called the Tesla store and told the salesperson I wanted to buy it. My information was already in the system. A few days later, I got an email confirming the delivery date and asking me to schedule a pickup time. One morning this past June, I showed up for my car at 9:30 a.m. — 10 minutes later I was driving home. It was that simple.
Tesla changed how a car is serviced, too. A few weeks after I bought the Model 3, its speakerphone stopped working. I went into the Tesla iPhone app and requested service. I was given a choice between bringing my car to the Tesla service center or having a service technician come to me. I chose the latter. Two days later, the technician showed up at my office. I gave him my car key and went back to work. An hour later my car was fixed. Tesla’s technician had simply restarted my computer. In hindsight, I could have called Tesla and my speakerphone issue could have been fixed remotely.
Now compare this experience with buying and servicing an ICE car. It is difficult for traditional car companies to adapt first-principles thinking, as it requires them to unlearn what made them successful in the old domain. They are going to have to retool their factories and go through a significant and painful change of their workforce. Their current employees have a different skill set and look at the world through petrochemical lenses (one reason perhaps why General Motors's (NYSE:GM) initial foray into EVs was the Chevrolet Volt, an electric car with a gasoline engine).
Auto dealers, an asset to car companies today, are tomorrow’s liabilities, as Tesla’s direct distribution and service model should provide a cost advantage once it gets to scale. Tesla’s model is more customer-friendly and efficient, allowing the company to capture the profit that ICE carmakers share with their dealers. Because a good number of Tesla’s cars are built to order, the company doesn’t need massive inventory sitting on parking lots. Moreover, ICE manufacturers may not be able to replicate Tesla’s direct-sales business model because they are stuck with the franchise agreements they signed with their dealers.
But while it won’t be easy for ICE carmakers to adapt first-principles thinking to their EVs, they may not need to: they can just copy Tesla, as Nokia should have done with Apple. William Durant, who turned struggling Buick into General Motors, originally made his millions on horse-drawn carriages. Samsung did a great job of copying the iPhone with Google’s help; instead of developing its own operating system, Samsung used Google’s Android.
Given the enormity of the needed investment, carmakers are creating alliances. Ford (NYSE:F) and Volkswagen (OTC:VWAPY), for instance, are working together on artificial intelligence (AI) and skateboard chassis for EVs. Historically, such alliances in the auto industry have had mixed success.
Traditional car companies do have strengths in designing, assembling, and marketing cars. They use legions of suppliers to make the parts that go into their cars. They can do the same thing when it comes to EVs. They can outsource the battery to LG or Samsung. They can outsource software design to the likes of Cognizant (NASDAQ:CTSH) and DXC (NYSE:DXC) (we own both of these stocks in our portfolios). They can use Waymo (NASDAQ:GOOGL) self-driving software and NVIDIA's (NASDAQ:NVDA) self-driving hardware. Plus, traditional automakers are in their best financial shape in decades and have capital to finance the EV adventure. They can afford to make an enormous investment in EV and absorb the losses that come with them. But will they?
To some degree, their job is more difficult than Tesla’s. They have to keep innovating as they make ICE cars because ICE cars pay their bills. At the same time, they have to focus on the future and invest enormous amounts of time and capital into EVs.
For ICE automakers to succeed in electric vehicles, they should set up separate EV units with management reporting to the board of directors. The EV management team should be given a blank check, equity in the new company, and the ability to hire people from inside and, most important, outside of the company. The existing ICE business should be run with a focus not on growth but on maximizing cash flows.
It is easy for me to write this, but it will be very difficult to do, considering that these companies will need to introduce new, exciting cars every four years and entice consumers to buy them, just to keep financing their losses on EVs.
Disclosure: Vitaliy Katsenelson is CIO at Investment Management Associates; His investment strategy is spelled out here.