@holdandforget “Vertical integration failed in the automotive industry because automakers discovered that steelmakers are the best at making steel, pump makers are best at making pumps, etc.”
Adam Smith knew it almost 250 years ago. He used pin makers to illustrate the point in his opus ‘The Wealth of Nations.’ Division of labor is the small scale version of free trade while horizontal value (supply) chains are a macro version.
That does not mean there is no room for vertical integration. Since EVs are a re-nascent industry, the complete horizontal supply chains do not yet exist. Tesla has a lot of suppliers, specially battery cell makers but there is much that can be done more efficiently in-house. Currently, partly on account of Covid, the global supply chin has been disrupted, another reason for vertical integration.
Years ago I listened to Jeff Bezos talk about the founding of Amazon. He confided that Amazon could only exist because all the infrastructure was in place, but Bezos was just selling books, not reinventing surface transportation.
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We are witnessing this struggle between integration and modularity play out in the auto industry. Like IBM in the early 80s, traditional OEMs such as Volkswagen, GM, and Ford are good at “designing, assembling, and marketing” and perform very few functions in-house.
The shift to electrification and autonomy, however, shifts the basis of competition. Many suppliers and components simply do not exist. In its Q3 2020 earnings call, Elon Musk called the modular approach of incumbents “catalog engineering.” The industry evolved towards catalog engineering over one hundred years of innovation and consolidation. But in the new basis of competition, there is no catalog
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WOW!!! Great article, a bird eye’s view of the state of the art but the bird is not flying high enough! This issue could well fill a book which, of course, I’m not going to write.
I’m going to write a fuller reply later on today or tomorrow. For now just some background.
Consider, for example, IBM’s decision to outsource the microprocessor for its PC business to Intel, and its operating system to Microsoft. IBM made these decisions in the early 1980s in order to focus on what it did best—designing, assembling, and marketing computer systems.
I started my professional career as a programmer at an IBM Service Bureau in 1960. I loved the company and admired the founder’s philosophy, Thomas Watson Sr. He learned or practiced his trade (sales) at The National Cash Register Company (NCR). After IBM I worked for one year at NCR as a programmer and later as a sales rep. NCR’s founder, J. H. Patterson was possibly the first to systematize the art of selling. These two jobs gave me a lot of insights into both companies.
Fast forward some 15 years, after ten years as a management consultant and five selling insurance I became an Apple reseller, selling Apple ][ and Apple /// mostly to business customers and in competition with the IBM PC.
Fast forward another 15 years or so and I took up investing, learning a lot at several TMF boards and reading many books on both management and investing. It was during this period that I read Adam Smith’s The Wealth of Nations which should be required reading for investors and business leaders. This is my background for discussing these issues.
But just now I have to take advantage of a break in the weather to go walking.
The secret sauce hidden in plain sight is volume. You need volume to afford a seat factory of your own. Low volume luxury brands don’t have it, popular brands that make 30 models don’t have have it. But there is more to it, to have agile manufacturing the whole line has to be agile. What this means in practice is that you only want to buy from outside suppliers stuff so standard that it is highly unlikely to change.
Thinking along these lines, this is what makes it difficult to catch up with Tesla at least in the cost of product sold and gross margins.
The Captain
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BTW, will Optimist be able to replace those factory hands putting the leather on the seats? Why not???
There is so much that Optimist can learn working for Tesla!
I took six quotes from the article to comment on. The biggest flaw I see in all of them is that they ignore the fact that businesses are “complex systems,” a comment that might be right at some point can be wrong at another stage of the business or better said, the technology.
I would set the stage by starting with Adam Smith and his belief in the benefits of the division of labor. He uses the making of pins as his example but that is at the lowest level of division. So called value chains are a higher level of division of labor. The highest level we have is globalization where anything can come from anywhere on Earth. At higher levels we call it free trade. What’s missing in Adam Smith’s division of labor is the concept of ‘complexity’ which was discovered some two centuries after he died.
One wonderful description of globalization is the essay I Pencil which I urge you to read before continuing reading this essay.
I Pencil - My Family Tree as told to Leonard E. Read
I am a lead pencil—the ordinary wooden pencil familiar to all boys and girls and adults who can read and write.
Writing is both my vocation and my avocation; that’s all I do.
Covid 19 showed us what happens when some part of the global system fails. At a more fundamental level, division of labor cannot happen unless all the bases are covered. Until they are, vertical integration is required. Once they are covered, division of labor is more productive at the price of being fragile. Since we are dealing with complex systems all manner of mix and match are possible.
On to the quotes
Consider, for example, IBM’s decision to outsource the microprocessor for its PC business to Intel, and its operating system to Microsoft. IBM made these decisions in the early 1980s in order to focus on what it did best—designing, assembling, and marketing computer systems.
IBM did indeed outsource to Intel and Microsoft but not necessarily for the reason given, “in order to focus on what it did best—designing, assembling, and marketing computer systems.” This is hindsight to make the decision fit the conventional wisdom narrative.
Since I was in the business at the time I believe I’m more aware of the reasoning. IBM’s business was Big Iron, mainframes and later minicomputers. For them the microcomputer was just a toy, what possible use could it have in business? They even called one of their microcomputers “The IBM Peanut” the year was 1983.
PERSONAL COMPUTERS
PERSONAL COMPUTERS; IS THE I.B.M. PEANUT REALLY IN THE WINGS?
If I’m right, IBM was suffering from the Innovator’s Dilemma, they gave away the business to Intel and Microsoft just like GM gave away the EV business to Tesla instead of pursuing the EV1 initiative.
General Motors EV1
But there is another aspect. During the past century there were three companies that were highly vertically integrated, Ford Motor Company, AT&T better known as Ma Bell:
For decades, AT&T (known as “Ma Bell”) provided “end-to-end” telephone service: It owned the phone inside the home; the wiring inside the home; and the nationwide complex of wires, cables, and switches that made up the phone network.
but Ma Bell also owned Bell Labs one of the century’s greatest research labs
The third was IBM which made everything from the components to the equipment and even the punched cards. They too had great research labs headquartered in Yorktown Heights, NY
The Thomas J. Watson Research Center includes facilities in Yorktown Heights and Albany, New York as well as Cambridge, Massachusetts. It serves as the headquarters of IBM Research – one of the largest industrial research organizations in the world – with 12 labs on six continents.
By 1971 the old guard retired and Thomas Watson Jr., the creator of the IBM S/360 died in 1981. Management was taken over by professional managers, I suppose today called MBAs, and the company started it’s long downhill path. As far as I know, outsourcing the micro processor and the operating system of the IBM PC was the first time IBM broke the time honored vertical integration policy. being a toy, why waste resources on it. Sounds like MBA thinking! Lack of vision.
And yet in the process of outsourcing what it did not perceive to be core to the new business, IBM put into business the two companies that subsequently captured most of the profit in the industry. How could IBM have known in advance that such a sensible decision would prove so costly?
That is the incumbents dilemma. What is not mentioned the article is one of Steve Jobs’ biggest mistakes which he eventually corrected. Anyone remember Apple’s 1984 Super bowl ad?
That was not the mistake. The mistake was going head to head with IBM for the business market. Back the the mantra was “You can’t lose you job picking IBM.” It worked in my favor while I was an IBM sales rep. It worked against me while I was an NCR sales rep.
The Mac was perfectly positioned for the creative market, leave the IBM PC to the boring accountants! Steve Jobs learned his lesson while exiled to NeXT. On his return Jobs made Apple one of the world’s largest enterprises
Christensen and Raynor, however, explained that modularity eventually wins
“Modularity” means horizontal value chain as covered in the intro.
Ben Thompson, however, has shown that this model is incorrect. The reason is that Christensen and Raynor rely on businesses making purchasing decisions, not customers. When it comes to customers, “good enough” doesn’t exist; they are, in the words of Jeff Bezos, “divinely discontent.” The dashed line can therefore never be crossed, and the orange line—the integrated player—will remain perpetually ahead of the modular player.
Again the comment lacks context. It would be true when there is abundant supply but not when there are shortages, in that case customers cannot be “divinely discontent,” it’s take it or leave it.
Incumbent automakers are not standing still. They are now attempting the quantum leap from blue to orange line by increasingly vertically integrating their operations. So far, it is not working out.
The solution is to separate the new from the old like Lockheed did with the Skunk Works
Missions Impossible: The Skunk Works® Story
Ford is doing it,
Ford Splits In Two: Model E Division For EVs, Blue For Gas
I believe the above explains why there are so many Tesla bears, for one they don’t know complex systems and for another they are using valuation tools adequate for valuing bonds (DCF) but not fast growing technology. There is nothing wrong with DCF in theory, the problem is that the required input data is not available for growth stocks. By relying on conservative guesstimates they undervalue the growth stocks.
