Strategies for Spotify

March 30, 2015 by Larry Sukernik in Strategy

Just recently we’ve taken a look at some strategies Beats could take to steal the throne from Spotify, and to a lesser extent, the other music streaming services (Rdio, Deezer, Rhapsody, etc). Since we don’t discriminate on music services here, we will be doing the same strategy recommendation piece for Spotify. Spotify will not just sit idle when the Beats redesign goes live, and it will presumably retaliate through its own strategies. I don’t know, of course, but I would speculate that Beats is one of the major topics that gets discussed during management meetings at Spotify HQ. If it isn’t, Spotify is doing themselves a huge disservice, by shutting their eyes from impending competitive pressures.

Before we get into the strategies section, let’s take a brief glimpse at the data. Currently, Spotify is the largest on-demand streaming service, with 60M users, of which 15M are paying subscribers (20% pay-to-free ratio). By my calculations, Spotify has been growing users at a rate of 3.75% per month. This percentage was calculated by taking the user-growth numbers Spotify has provided every few months. It is impossible to say with certainty if this is a high or low rate of growth, since none of the competing music services provide enough data to compare them to each other. If you want to read the technical details of my calculations, this post from November is your destination. Otherwise, we can continue to the meat and potatoes of this analysis.

Strategies for Spotify

#1 Partnerships with music social networks

In my strategies for Beats piece, one of the strategies I recommended was exclusives. Beats could pay labels $X amount in royalties in exchange for being the exclusive streaming provider for an artists newest album (I advised the period to be a month to lock users into Beats). Spotify doesn’t have billions in cash like Apple does, which is why the exclusives strategy is not feasible. Instead, Spotify should partner with music social networks, specifically The Hype Machine and SoundCloud.

Spotify is great for major artists who are signed with music labels. In my experience, it’s very rare that I can’t find an artist I like on Spotify. Kendrick Lamar’s latest album, To Pimp A Butterfly, was ready to stream the day it was released. Barring few exceptions (I’m looking at you, Taylor Swift), popular artists always have their music available on Spotify. The same can’t be said about many indie artists and song remixes, which are often found on sites like Hypem and SoundCloud. Spotify should partner with these indie music social networks, and structure the deal in a mutually beneficial way. Spotify would gain many users who previously listened to indie music on Hypem/SoundCloud. In return, Spotify would pay Hypem/SoundCloud for the access to their data and music. To be fair, this deal would benefit Spotify much more than the indie social networks, but so goes the nature of business. Hypem is run lean, so it’s probably profitable. What it needs is more users, which Spotify can provide. SoundCloud, by all acounts, is losing money, despite have millions of registered users. Getting paid by Spotify could help them become profitable. Ideally, Spotify could purchase either Hypem or SoundCloud, but it is doubtful they have the cash for it.

These partnerships would also be a powerful competitive advantage to retaliate against the personalized playlists Beats offers. Unless Beats makes its own partnership with Hypem/SoundCloud (doubtful), Spotify would be the only streaming service to offer the type of indie music that’s only available on these music aggregators.

#2 Audiobooks

The music streaming business is a loss-leader. It is an offering that adds value to existing customers in order to keep them attached to your ecosystem. That’s what Google is doing with Google Music, Microsoft with Xbox Music, and now Apple with Beats. I can’t say with certainty since the data is unavailable, but I have strong suspicions that the above companies are actually losing money on operating their music streaming offerings. We know as a fact that Spotify is posting net losses, and will probably continue to do so in the foreseeable future. The tech giants can afford to lose money on streaming in order to strengthen their ecosystem, but Spotify and the other streaming services can’t. Even if Spotify does manage to operate at extreme efficiencies of scale and achieve profitability (big if), that income won’t be enough for a company of that size, especially if Spotify has plans to go public. What then, could Spotify do to become profitable?

Spotify has an incredible engineering culture, and the service experiences almost no downtime. Compared to competitors, Spotify streams songs the fastest: I’ve been using Spotify for the past two years and I have never experienced any stream-related problems. I can’t say the same for Beats/Rdio (I’ve not used the other streaming services). Spotify also has well designed apps, which are only getter better (early on, Spotify was not well designed, but lately I have been very impressed with the UX). These strengths can be used to enter a new market: audiobooks.

Essentially, Spotify will be diversifying its income streams by entering into a new market for audiobooks. While we again encounter the problem of a lack of data, this time on audiobook profitability, the nature of the business implies positive profit margins (unlike music streaming, a book won’t be bought twice). Spotify won’t be starting from the ground-up here, as their infrastructure is already set up, so it is likely that they can enter the audiobook business at a lower cost than music streaming through economies of scale and leverage.

In fact, there are already some audiobooks available on Spotify, but from what I found they mostly include public domain books (Pride and Prejudice, The Art of War, Romeo and Juliet). The Spotify app, however, is currently optimized for music listening rather than audiobooks, so listening to multi-hour audio streams is an obstreperous affair. Similar to how Facebook broke its main app into a web of focused applications (Facebook classic, messenger, groups, etc), Spotify should make a separate app specifically designed for audiobook listening. If that is seen as a big risk, I would advise to start with an app that provides only free, public domain books, since they’re already hosted on Spotify servers. If there is indeed demand for audiobooks, slowly add books from other publishers to eventually compete with Audible and iTunes.

#3 Podcasts

Podcasts are another vertical Spotify could enter, especially if they partner with SoundCloud. SoundCloud, by the way, already hosts thousands of podcasts, and makes the process easy for both creators and listeners. Despite SoundCloud’s podcast features, there is still no comprehensive platform (monetization, hosting, dedicated apps, portal, listener data) for podcasts, despite many years of existence. What’s more in their favor is that podcast popularity is increasing, as internet connectivity and better apps make them simpler to find and consume. The good news for Spotify is that it doesn’t look like Apple has plans to host the podcasts - instead, iTunes is merely a portal to find them.

Even if the SoundCloud partnership is not possible, Spotify already has the expertise to host and make them available to listeners. Not a podcast per-say, but spoken-word comedy shows are already available on Spotify. All it needs to add now is a dedicated app, a better way to find podcasts, and most importantly, the ability to host them. Podcast creators (especially indie ones) would be willing to pay for the service, and it would serve as another outlet to help creators find new listeners.

Coda

Spotify should do its absolute best to become the go-to audio destination on desktop, mobile, and wearable devices. Competition in music streaming is already fierce and will only get more competitive when the rebranded Beats enters the market. Worse, the music streaming business is currently unprofitable. Huge companies can afford to subsidize their music offerings as an additional value-add for their ecosystem, but Spotify can’t. Spotify can try to turn the industry on its head and attempt to become profitable, but it will be swimming upstream against the Niagara Falls. That is why it should be leveraging its existing infrastructure and competitive strengths to enter the other audio markets, audiobooks and podcasts. The partnerships with SoundCloud and Hypem (especially SoundCloud) would not only boost the value of its music streaming service, but also help them enter the market for podcasts. Spotify already has data about its users. Now imagine if they could provide this data to podcast creators, which in turn can sell tailored ad spots to advertisers. Being a music streaming provider is not enough for Spotify to turn into a profitable business. Platforms make profitable businesses, and Spotify should try to become a comprehensive audio platform: music, audiobooks, and podcasts (The Spotify MAP).

If you have anything to add, or just want to share your meandering thoughts about what we covered, please comment below! I’m also active on Twitter, so don’t hesitate to reach me at @lsukernik.

Automotive Industry Exploration (Part III)

March 23, 2015 by Larry Sukernik in Strategy, Industry Analysis

In Parts I and II of our Automotive Industry Exploration, we took a look at the revenues and costs of some of the largest players in the automotive world. We found that industry profits are quite low compared to those Apple is used to, mainly due to the intense costs of manufacturing a vehicle (materials, labor, equipment, etc). We also noted that if Apple were to enter the business of manufacturing cars, they would need to introduce some new technology into the equation. That new technology could come in the form of production efficiencies, new use cases, or something we cannot currently surmise. If not for this missing piece, Apple would be just like every other car manufacturer - high revenues, high costs, and average margins. If that doesn’t sound enticing to you, you might be right. It probably isn’t (for you and Apple).

For Part III of our exploration, we will be delving into the unit sales of the car manufacturers we visited previously. If you are like me, your best educated guess about which car brand is the most popular came from what you saw on the streets of your city, which may not be the most accurate data. After comparing the unit sales of the car manufacturers, we will dive into the unit sales of only one company: BMW. This choice was made for a few academically valid reasons. First, BMW is my favorite car manufacturer. Second, they gave the clearest breakdown of unit sales by car model (1 Series, 2 Series…). Third (and perhaps most arguable), out of all the car companies, BMW is most like Apple. They value design, they make premium products that are still affordable by most of the middle-class, and finally, they sweat the details. Part III will be the final post in this three-part series on the automotive industry as a whole. In future posts, we may explore some car companies independently (Tesla, Daimler, Volkswagen) and in greater detail, as well as keep a tab on what is happening with the Apple Car.

Big Picture: Automotive Industry

The companies in this chart sell roughly 60% of all the cars sold in the world. Estimates of global car unit sales range from 72M - 84M in 2014, and this chart covers 48M of those sales, hence 60%. If we assume the world population is 7 billion, then we can say that around 1 out of every 100 people buy a new car every year. In reality, that statistic is lower, but the thought is nonetheless intriguing. Some other points:

Toyota simply dominates the other car manufacturers: it sold 1.2x the cars of Volkswagen, 1.4x Ford, 2.1x Honda, and 4.3x BMW.
The German luxury brands (BMW & Daimler) together sold 3.7M vehicles in 2014. In terms of unit sales, they are positively paltry compared to the Japanese (Toyota, Honda, Nissan) and American (Ford, GM, Chrysler) titans. If we add Audi unit sales to 3.7M (since Audi is also a German luxury brand part of the Volkswagen Group), that number will equal roughly 5M. German luxury cars thus account for approximately 6% of global car sales.
For such an old industry, there is surprisingly lots of competition in the manufacture of cars. Although it is true that many car companies have over time consolidated (i.e. GM produces Buick, Cadillac, Chevrolet, and GMC), no one brand controls over 20% of the global market share. For consumers, this is great news. But if you’re thinking of getting into the car business, you better step up your game, because there’s plenty of competition.

Small Picture: BMW

In total, BMW sold 1.8M cars in 2014. The above chart gives us a breakdown of those unit sales, model by model (BMW uses the word “Series” in substitute of model). A few things stand out in particular:

The 1, 3, and 5 Series alone account for 33% of BMW’s unit sales. They are by far the most popular cars BMW produces.
70% of BMW’s unit sales are from compact cars (Series 1 - 7). 29% of the unit sales are from SUV’s (X1 - X6, no X2 exists yet). 1% is from the BMW i, which is their electric model.
If you wanted to compete with BMW, you could strike from one of three places (or all three, if you’re feeling audacious). You could attempt to steal from their most lucrative business, luxury compact cars, since there’s a huge market for them. Alternatively, you could make luxury SUV’s. Finally, and probably the best choice, you could make electric cars. BMW only sold 18K i cars in 2014. Perhaps there is no demand for them, or, most likely, BMW is underserving the market for electric vehicles. If Apple were to enter the car business, I’d wager they would produce electric vehicles (you will recall I am not a betting man though, so rest assured that your money is safe).

This chart is the same as the last, but it adds one additional detail - the base MSRP of each BMW model.

With few exceptions, it would be fair to say that the cheapest models sell in the largest quantities. Meanwhile, the most expensive models sell in predictably lower quantities. If you asked me, I would venture to say that the supply for low-end luxury cars matches demand. The supply of high-end luxury cars also seems to match the demand for them.
BMW covers a wide area of the pricing spectrum: the lowest MSRP is $32,100, while the highest is $76,100 on the opposite side of the spectrum. Of course, these prices are not at all indicative of what you will actually pay for a souped-up BMW - that price will be much higher. Still, I find it interesting how diverse the pricing is for a luxury car. It is much less surprising now to see that Apple Watch pricing is similarly spread out over a large area ($350 - $17,000).

Coda

Overall, the car market is a competitive and somewhat unfriendly place to do business. If you had billions of dollars lying around and were interested in starting a new business, it is doubtful the automotive industry would be it. The profits are decent, but the costs and barriers to entry are huge (but not insurmountable, as Tesla has proven). Moreover, not that many cars actually get sold every year (around 78M). If you want to compete in this business, you’re not going to make much money using economies of scale, since margins aren’t good. The best way to make money in this industry is to be extremely efficient (Toyota, Honda), or to charge premium prices (BMW, Daimler). Even the efficient brands manufacture premium versions of their vehicles: Toyota makes Lexus, and Honda makes Acura. What you don’t want to be is Ford, GM, or Chrysler, which are neither efficient nor have successful premium brands (Lincoln and Cadillac barely qualify as such). As our previous analysis has shown, the American car companies are some of the least profitable car companies around, so replicating them is a fool’s errand. You can, however, make a healthy profit selling premium cars, as BMW has shown us.

So let’s return to our original question: what would Apple gain from entering the car market? In short, not much. Our three part analysis has shown that the automotive industry isn’t nearly as profitable as consumer technology. Of course, profits aren’t everything, and Apple’s goal when entering into the automotive industry could be a nobler one. But you would be hesitant to spend dozens of billions of dollars on a business that won’t return them to you. For this reason, I have come to the conclusion that Apple will not enter the car business as it exists today. If they do enter, it will have to be with something totally different. We’ve touched on what that difference could be in Part II, so I won’t go into that here, but it cannot simply be a superior version of a gas-powered car. Success might come from a place Apple has been before: Think different.

For next week, we will explore some strategies Spotify can take to combat the impending Beats (by Apple) release.

If you have anything to add, or just want to share your meandering thoughts about what we covered, please comment below! I’m also very active on Twitter, so don’t hesitate to @lsukernik me!

Strategies for Beats

March 16, 2015 by Larry Sukernik in Technology, Strategy

It has been quite some time since I wrote about Spotify and Beats, so let’s briefly step aside from the automotive and tech posts and into music. Some fairly important news got lost in the Apple Watch shuffle last week — music labels aren’t willing to go below $9.99 per month for music streaming. The most interesting information is tucked away in the last paragraph of the Billboard article (emphasis mine):

There’s also an element of geopolitics at play. A weakened Spotify could help create a more powerful Apple subscription service. That would remove the comfortable, valuable counterweight to Apple that labels don’t have in the digital download space. There’s even some doubt that Apple is out to beat Spotify rather than grow the music subscription marketplace. “If they’re out to kill Spotify, it’s news to us,” says an industry source. "And it’s the last thing we want. We want Spotify to be a strong competitor.

Spotify is king when it comes to music streaming — it has around 15M paying subscribers, and 60M free users. Probably the most important variable to Spotify’s growth is that it allows you to use the desktop apps for free, which is always the preferred option. Spotify is available in most countries and practically on every platform. It was also one of the first entrants in the play-on-demand business (Pandora doesn’t allow for this), which undoubtedly gave it a first-mover advantage in terms of total users.

Unlike what smartphones have become today, music streaming is a luxury that not every person needs. Therefore, the total market size for paid-for music streaming is quite limited. Although Spotify + Rdio + Deezer + Rhapsody have much more room to grow their paying subscribers, that growth is slowing down. The best way for Beats to grow is either to convert existing iTunes users into paying subscribers (a challenge made even harder if that user is already paying for a competing service), or to steal market share away from Spotify/Rdio/Deezer/Rhapsody. The best way to steal market share would be to offer Beats at a lower monthly price ($7.99), which reports suggest Apple has tried to do and failed. The music industry doesn’t want to make the same mistake as it did with iTunes, which allowed Apple to become a monopoly on music sales. The more competition exists, the more bargaining power the music labels have over steaming services. Since it is unlikely Apple will convince the labels to a lower price tier, Apple must find a different way to grow the Beats brand into the next iTunes. Here are some strategies I would advise Apple to partake with Beats (preferably more than one):

#1 Take the hit

Just because the music labels won’t go lower than $9.99 doesn’t mean Apple can’t. There is always the option of taking the difference ($9.99 - $7.99 = $2) as an expense, thereby subsidizing users. It’s doubtful that existing users of Spotify/Rdio/etc will be enticed purely by the features of Beats, which might be less expansive (compared to the competition) when Apple’s redesign of Beats goes live. A user of Spotify myself, I’ve been extremely impressed with the latest updates to their apps (ample gesture support, song lyrics, and the overall design aesthetic), and I can’t imagine the first version of Beats to be as fully fleshed out. Although features themselves won’t entice users to switch to Beats, a slightly lower price of $7.99 surely will. Finally, it’s worth pointing out that most of the existing streaming services offer a 50% student discount, effectively making the monthly price $4.99. I use this discount, and I know many other friends who do the same. Beats doesn’t currently offer any student discount, but they will have to if they want to reach the price-conscious college age audience.

#2 Exclusives

There is a new Kanye West album coming out later this year. What if Beats were able to snag it as an exclusive for the first month, thus having it before all of the other streaming services get it. That would be a very powerful value proposition, and one only Apple can negotiate. Of course Kanye wouldn’t be the only artist Beats would have exclusive rights to — they should negotiate similar exclusivity rights for as many artists as possible. If you knew that your favorite artists new album will only be available on Beats for the first month, you sure as hell would consider switching to Beats. It should be noted that these type of deals are expensive and difficult to negotiate, but Apple has money, and money talks.

#3 Preinstalled with hardware

Apple has complete control over the hardware and software of its products. Just as the the music app is bundled with all devices, so should Beats. The Beats app should come preinstalled on the iPhone, iPad, Mac, and the Apple Watch. This will serve two main purposes. First, it will cement the brand name. Most people aren’t as familiar with Beats music streaming as the Beats headphones, mostly because the service has done very little promoting of itself. Coming preinstalled with Apple hardware would certainly fix that.

Deriving from this first benefit of being preinstalled on hardware is the second benefit — increased usage of Beats. If more people are aware of the Beats music service, it is logical to assume more people will use it. Where these users come from doesn’t matter; it may be those uninitiated to any music streaming service, or those switching from Spotify/Rdio/etc.

#4 First-party advantages

As the software chieftain of its products, Apple can use API’s not available to 3rd party streaming services. You don’t need to search too hard to find miffed developers complaining online about their apps not being able to using the same API’s Apple uses in its apps. These API’s are locked from 3rd parties for safety and privacy reasons, but they allow for many functions regular apps simply cannot do. It’s still not clear how Spotify will work with the Apple Watch, but I imagine the limitations will be plentiful. For one, the Apple Watch comes with 8GB of storage, but only 2GB are available for storing photo’s and music, with the remaining 6GB used to store the OS. Perhaps the Spotify app will be limited to offline storing of only 2GB of music on the Watch. Meanwhile, the Beats app will allow for more, since it will be graced with Apple’s first-party stamp of approval. This is all conjecture, of couse, but you can bet that Apple will use 1st-party API’s to allow for more features that 3rd party apps can only dream of.

Précis

I have many more ideas for what Apple should do with Beats to make it overtake the other streaming services, but we can leave that novella for a later time. The four strategies I have listed above are the most vital to the success of Beats. So vital, in fact, that I don’t think Beats will succeed unless at least two of the four options will be chosen. Realistically, options 3 and 4 will be implemented by Apple, mostly because they come with no additional costs. I do not think, however, they will be enough to convince people to switch to Beats. To steal market share from the other music streaming services, options 1 and/or 2 should be chosen. They will likely cost an additional few hundred million per year, but I think those costs will be indemnified by the goodwill they generate, and the influx of new, paying users.

For next week, we will continue our automotive industry discussion by comparing the unit sales of the major automotive manufactures.

If you have anything to add, or just want to share your meandering thoughts about what we covered, please comment below! I’m also very active on Twitter, so don’t hesitate to @lsukernik me!

Automotive Industry Exploration (Part II)

March 09, 2015 by Larry Sukernik in Technology, Industry Analysis

The automotive industry is a huge place, so it is best we tackle it one step at a time. For our first stride, we took a look at the revenues, expenses, and incomes of only a few car manufacturers: GM, Ford, BMW, and Volkswagen. For this next step forward, I have added Daimler, Honda, Toyota, and Nissan to our repertoire of car companies. Let’s take another look at the cost structures of these companies (as compared to each other and Apple), this time with additional companies and a better understanding of the automotive industry. Again, please excuse the slight variations in years, which are due to the different fiscal year end each company uses, and the delay in reporting annual figures.

Now that we’ve introduced additional companies to the mix, we can see that Apple’s impressive annual revenues of $182B in 2014 are actually dwarfed by the revenues of Toyota ($249B in 2014) and Volkswagen ($241B in 2013). The higher revenues of auto manufacturers have very a simple explanation: a car costs a lot more than a consumer technology device. Therefore, I wouldn’t place too much importance on the revenue figures - they are best suited for comparing the car manufactures to each other, rather than to compare them to the revenues of Apple.

I should also point out that the revenues used for our purposes are consolidated revenues. They include revenues from all of the segments each car manufacturer operates in (cars, trucks, motorcycles, financial services, etc). The revenues we used for our selected car manufacturers also include the income from companies they hold an equity interest in (which is usually other car companies). Unlike the relatively simple financials of Apple, the auto companies are full of incestuous relationships that heavily cloud their financial metrics.

Though we now know that revenues are not the end-all-be-all, the same cannot be said about gross profit (which is calculated as revenues - cost of sales). Software companies, for example, tend to command the highest gross profit because the cost of producing an intangible good is tiny compared to what you can charge to sell it (think Windows, or Mac OS X before it went free). On the other hand, a car is as tangible as a good can be, and requires copious amounts of materials and labor to manufacture. As a result, the cost of sales for car companies is proportionately higher to that of software, which results in a lower gross profit. Apple is somewhere in the middle of software and cars. Most of Apple’s revenue and cost of sales comes from the hardware products it sells (iPhone’s, iPad’s, Macs) but Apple also makes some money from intangible services like iCloud and iTunes. That is all to say that if Apple entered the car business, its gross profit would look more like what it is for car manufacturers than what it is for Apple now.

It comes as now surprise then that Apple has the highest gross profit out of all the companies we profiled for this analysis. It costs less to make an iPhone/iPad/Mac than it is to manufacture a car.

Restating gross profit as a percentage gives us even more valuable insights into the manufacturing intensity of Apple vs. the auto companies. To calculate how much each company keeps for every $100 of revenues, just multiply $100 by the percentage in the above chart. For Apple, that would be $100 x 39% = $39. For Honda it would be $100 x 26% = $26. -

You can see that the luxury auto brands have higher gross profit percentages, while the American car companies have the lowest (no wonder many went into bankruptcy!). Tesla has a gross profit percentage of 28%, Daimler (Mercedes) of 22%, BMW of 20%, and Honda of 26% (Honda does have a luxury brand (Acura), but the disproportionally higher gross profit is probably attributable its to operational efficiency).

Apple is well known for its operational efficiency (it has the highest gross profit percentage out of all smartphone manufacturers). But how well would this efficiency transfer to the manufacture of cars? I would venture to say that if Apple made a car, the margins would be slightly higher than those of Tesla, or around 30 - 35%. This would translate to much higher margins than what traditional car manufacturers are used to, but lower than what Apple is used to.

Non-finance people usually despise discussing margins since they have nothing to do with the product itself. Despite my rather traditional accounting background, I also tend to favor looking at the product instead of its profitability. But margins are helpful to understand because no reasonable company would enter an unprofitable business. If Apple’s research labs find that their is little money to be made in cars, it is doubtful we would see any Apple Car released at all. Before billions of dollars are spent on R&D, someone at Apple Finance needs to give the go ahead, which will only happen if there are profit margins to be made. Of course it is possible that Apple will develop a car with shockingly high margins (>40%), but I think it would have to be assembled from thinly cut paper for that to be true.

The mother of all financial metrics is net income, which lets us know how much a company has left over after all expenses, interest charges, taxes, and “extraordinary” items. Net income is the holy grail of business; it is why investors invest, and what a company wants to attain in order to be successful. It can be used to pay dividends to investors, it can be reinvested into the company, or it can simply be stashed into retained earnings. As you can see from the chart above, Apple made around $39B of clean, unadulterated income.

Just to put things in perspective for you, here’s something to ponder about: Apple had a higher net income in 2014 than the combined net income of GM, Ford, BMW, Volkswagen, Daimler, and Honda (I would include Tesla too, but it posted a net loss of -$294M in 2014).

Now, you might ask - why would Apple get into the car industry if there is little profit (by Apple’s standards) to be made? After all, it’s doubtful that Apple would be able to sell as many cars as all of those automakers combined, and even if it could, Apple’s net income from car sales would be lower than its income from technology products. To play devils advocate, you can argue that if Apple were to assemble cars, its operational efficiency would keep margins high and thus allow for a higher net income. This is certainly a plausible scenario, but how many cars would Apple have to sell to reach even $1B in net income? The answer to that question remains a mystery, but hopefully for not much longer, as we will dive into automotive unit sales soon.

Takeaways

Just as with the first automotive industry exploration, we are left with more questions than answers. That doesn’t mean this post wasn’t worth writing, however. We learned that car makers have ballooned income statements; exceptionally high revenues, and exceptionally high costs. We also learned that automotive margins are fairly low, especially for U.S. carmakers. As a result of their cost structures and the nature of the industry, the net income’s of car companies are paltry compared to that of Apple. In order to make money in this industry, you have to be extremely efficient, which, fortunately for Apple, it is known to do.

Undoubtedly, there is a sizable team of finance/accounting/operations employees at Apple that are doing the very same market research as we are here. Their data is likely to be much more comprehensive and detailed, but I can’t imagine the results to be far different from ours. As we continue our exploration, we will learn more about the business of making cars, but for now, it doesn’t look like a great business for Apple to be in. Revenues are high, but profits are low (we should note again, low by Apple’s standards). It is still way to early to have any conclusive thoughts, but who says we can’t have opinions!

What If

You can probably tell from all of the data we have analyzed thus far that the traditional car market isn’t the most appealing business to be in. But what if Apple totally changed the game? The current production system for cars is arduous and expensive - but does it have to be that way forever? What if the margins on cars were dramatically higher? Or what if the use-case for cars were expanded or altered? At the moment, the driving age in most jurisdictions in the United States is 18. But cars are expensive, and most teenagers are forced to use their parents’ car rather than to purchase their own. Suppose, however, that Apple is able to cheaply manufacture tiny cars (work with me here) that cost under $5,000 and take no gas. All you need is a battery charger. How many parents would buy their teens a car now?

To stretch things even further, let’s make these cheap Apple cars self-driving. Instead of having to drop your kids off at school or have them take the bus every morning, you could just pack your child into these small autonomous self-driving vehicles. And if you’re thinking this sounds very sci-fi, you’re on the right track. If we are to believe Apple is making a car, and that automotive profitability is quite low, something else should be going on, and spreadsheets alone won’t help us find it.

In future posts, we will be taking a look at automotive unit sales, break-downs of revenues by brand (Volkswagen vs. Audi, Toyota vs. Lexus), and a much deeper look into the electrically charged darling, Tesla.

If you have anything to add about the automotive industry, or just want to share your meandering thoughts about what we covered, please comment below! I’m also very active on Twitter, so don’t hesitate to @lsukernik me!

Slide Gallery

Automotive Industry Exploration (Part I)

March 02, 2015 by Larry Sukernik in Technology, Industry Analysis

It is no secret that I am fascinated by Apple and the technology industry as a whole. I have written amply about Apple and the neighboring technology industry for the past few years (and have read about them for almost nine years now). When news broke that Apple was working on a car, my Twitter timeline was evidence of my not knowing of what to think. Although I don’t follow the automotive industry as closely as tech, I am a fan of cars and car design. I know when the new car models are released, what they look like, and what features have improved over the previous models. What I don’t know, however, is how the automotive industry operates (who are the suppliers, what materials are used, and so on), who the key players are, what the market share of each key player is, competition in the industry, and how profitable the automotive industry is in general. When I began following the technology industry, I didn’t know any of the above questions either, but through time I developed a thorough understanding. It is now time for me to develop an understanding of the automotive industry, which seems ripe for disruption.

If you’re reading this, I imagine you are in a similar boat to mine; you follow the tech industry closely, and have a newfound interest in cars after the recent Apple Car rumors. In the next few months, I will starting delving into the auto industry (in addition to the usual tech posts I publish) to gain a better understanding of it. Some questions I want to answer early-on are: what would Apple gain from entering the car market, how much profit is in selling cars, and what are the unexpected consequences of entering a wholly new market (in addition to many other questions). So sit down, buckle up, and enjoy the ride.

Global Car Sales

Scotiabank published a great report on global auto sales, and it is as good of a place to start as any. In 2014, a total of 71M cars (includes light trucks) were estimated to be sold around the world. For comparisons sake, Apple sold 74M iPhone’s during the last quarter. Obviously a car is a much more expensive and thoughtful purchase, but hopefully you notice the great disparity in scale between the tech and the automotive industry on a unit basis.
Most car sales occurred in Asia (32M), North America (19M), and Western Europe (12M), followed distantly by South America (4M) and Eastern Europe (3.8M).
2015 forecasts have global car sales increasing by 3M to 74M, which implies a 4% growth rate. It appears the automotive industry is not a growth market by any means (feel free to prove me wrong).

Automotive Industry Profitability

I chose some of the better known car manufacturers for this next chart, just to compare them to Apple. Academically, it is wrong to compare a company in one industry (tech) to another (auto), since two the industries are different in almost every regard. That said, doing so establishes a nice sense of scale which can help us understand the relative sizes of the companies. It may also help to answer why Apple may be interested in making cars in the first place.

In terms of yearly revenues, Apple is second only to the Volkswagen Group, which is a holding company that owns brands such as Volkswagen, Audi, Bentley, Bugatti, Lamborghini, and Porsche. It is also worth mentioning that the revenues included in the above chart are comprehensive, meaning that they include the revenues not only from vehicle sales but also from the financial arms of the automotive companies. I did this deliberately because if Apple got into the car business, they would presumably get into the leasing business as well. Also note that I used the 2014 figures for Apple, GM, and Ford, and 2013 figures for BMW and Volkswagen. This is because the annual reports for the German car companies weren’t released yet. I doubt the 2013 figures would differ materially from the 2014 ones, though.

Apple had by far the highest gross profit out of the companies in this comparison. You would assume that automakers make boatloads of profit on each car they sell, but the data says otherwise. The costs in selling a car are not much higher than the costs involved in making one.

In terms of a gross profit percentage, Apple is the victor once again. For every $100 in revenues, Apple keeps $39. For every $100 the car companies make, GM keeps $11, Ford $14, BMW $20, and Volkswagen $17 (this is before any operating expenses, taxes, and interest charges). Although I did not include Tesla in this analysis (it deserves its own analysis, which will come later), you might wonder what its gross profit percentage is. By my calculations, it’s 28%, meaning that Tesla gets to keep $28 per $100 of revenues, which is the highest gross profit percentage out of all the other car companies compared in this analysis.
It doesn’t take a genius to see that manufacturing cars is an expensive business. If Apple entered the auto industry, they would either have to get used to lower margins, charge higher prices to offset the cost of sales, or lower manufacturing costs. That is a difficult problem to solve - no wonder Apple is on an automotive hiring spree.

The culmination of all the above information leaves us with the net income of each company. As you would expect based on what we learned previously, Apple had the highest net income out of all of the car companies. Not only is it higher, but Apple’s net income in 2014 is 1.5x higher than the net incomes of GM, Ford, BMW, and Volkswagen combined. Apple’s calendar year ends in September, mind you, and the data from BMW and Volkswagen is for 2013, but the size of Apple’s profits is still mind-boggling.

Early Thoughts

While the above analysis was rudimentary and not enough to paint an accurate picture of the automotive industry, it is a good start at understanding the size and profits of the automotive industry. In a nutshell, here’s what we can takeaway:

Even if Apple made a successful vehicle, it is highly unlikely the car business would be as large as the iPhone business. Apple sells more iPhone’s in one quarter than all car companies combined sell cars in a year.
Making cars is extremely expensive. The price you pay for a car isn’t far from what it costs a car manufacturer to make one. We will delve into the profit margins of luxury vs. base cars in a later analysis, but as a whole, cars don’t have the best gross margins. They definitely don’t come near the gross margin percentages Apple is used to.
The key element in the manufacture of cars is suppliers. Essentially all car manufacturers purchase parts from hundreds of different suppliers. Apple would presumably have to do the same (they so for their current products).

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