In this week’s article, we will be discussing two things:
- Are EVs the new smartphones? The reshuffling of the EV supply chain.
- Coinbase’s upcoming IPO.
Are EVs the new smartphones?
The old way of making cars
Car making is very difficult business. Not only does it involve a long and complex supply chain, but making an internal combustion engine is really difficult. In this modern age, if you want to start your own car company, you must be able to master both.
It is no wonder that until Tesla went public in 2003, there hasn’t been a single car company that has successfully IPO’d since 1956.
To understand why this is the case, we must understand how internal combustion engines (ICE) work. These ICE engines are exceedingly complex and work by controlling explosion/combustion of fossil fuel and translating the energy output into mechanical motion (see Figure 1 for a Gif taken from the here):
- We inject a mixture of fuel and air into the combustion chamber.
- We then pressurize the chamber and add an electric spark, which ignites the mixture, creating a combustion.
- This creates pressure and heat, which turns the piston.
- The exhaust gases from the combustion then exit the chamber.
You repeat this process thousands of times a minute, faster at higher speed and load. You also have to create an engine that is reliable and stable to last more than a decade, and meet the ever increasing emission standards imposed by different governments around the world.
This is no easy task. It requires decades of research and development to master the making of ICE engines. Currently, the US, Japan and Germany are top three in terms of ICE engines for passenger vehicles. Even China, with its manufacturing prowess, cannot master engine production. Its domestic car market is dominated by foreign brands.
Because of the difficulty of making ICE engines, leading car companies always build their engines in-house. They integrate the design and engine production closely to the rest of the vehicle to improve performance and fuel efficiency, and outsource the rest of the car production to multiple vendors, commoditizing those aspects. And because they control the aspect of the car that is the hardest to make, they are associated with the brand that the consumer purchases from, and they capture most of the value.
The new way of making cars – no more ICE
All these are now changing. ICE is going on the wayside. As the world transitions to electric vehicles (EV), ICE engines are no longer critical in the production of a car.
The implications of this are massive:
- The electric motor is much simpler to build than the internal combustion engine. The traditional ICE has more than 2,000 moving parts, while the electric motor that propels an EV has about 20.
- All of a sudden, almost everyone can make an electric motor. The critical moat that the legacy auto manufacturers have is no longer important.
- Because there’s no longer ICE, the car design is simpler. The design can be modularized. You can build the skate (the chassis + battery) separately from the interior of the car. As a car brand, all you have to do is pick the motor size, battery size and wheelbase (Figure 2).
- As a result, contract manufacturers started cropping up to help you build EV cars. All the sudden, building a car at scale is no longer so difficult.
You are beginning to see this being played out in the space.
- Nio and Xpeng, both EV makers from China, do not build their own cars. They rely on contract manufacturers. This means that their businesses are more capital light, but they also have less control over the process (still not profitable though).
- Apple has been rumoured to be in negotiations with multiple contract manufacturers to build its EV cars.
- Fisker signed with Foxconn to build its EV cars.
- Foxconn is also providing EV manufacturing services to Byton (a Chinese car maker).
If manufacturing is outsourced to 3rd parties, then what will the defensible moat that these EV car brands will have?
Here’s the dynamic in the smartphone market (and computers more generally):
- The rise of contract manufacturers in the world of electronics, called EMS (Electronic Manufacturing Services, for example: Foxconn) led to the explosion of smartphone hardware.
- Google entered the space by providing free to use Android Operating System (OS).
- Everyone can launch their own smartphones.
- In the world of abundant smartphones, components become commoditized, and since all these handset makers do not make their own OS, the device experiences are also very similar.
- In contrast, Apple maintains tight control over (1) industrial design, (2) sales and distribution (Apple Store), and (3) Operating system (iOS), creating a unique user experience
- As a result, in 2019, Apple, although generating only one third of the global smartphone revenue, captures two third of the profit of the industry. No one else comes close. At the bottom of the industry, some handset makers, such as LG, make a paltry US 1.2 cents per smartphone sold in 2015, and have not turned a profit since then.
If we fast forward 3-5 years, will the same evolution occur in the EV space? Tesla, as the first mover in this space, has tight control of its R&D and Design, vertically integrates and controls its own manufacturing, has tight control over its own distribution, and writes its own software. Does this make Tesla the Apple of EV?
What about everyone else? WIll they be overly reliant on 3rd party contract manufacturers and build EV cars from the same part bins, creating non-differentiated solutions?
If so, who will be the Android for the EV? Who will create an operating system to run the car?
To prevent reaching the same fate as Android device makers, the non-Tesla EV brands need to not only have their own unique design, but also create their own EV software. But can they do this?
In many ways, the operating system for the EV is much more complex than the smartphone. Nevertheless, the reason it has been difficult to displace iOS and Android as the dominant smartphone operating system is because of the network effect of the app store. Many have tried to introduce their own and have failed.
It’s unclear if there will be a network effect in the EV operating system (App store for the car?). What is clear is that it will be harder to make the operating system for cars. The software platform will have to control the car’s battery, electric motor, cooling, infotainment and possibly autonomous driving.
The entity that might be best positioned to develop this software platform might be the contract manufacturer themselves. In the reshuffling of this automotive value chain, Foxconn is trying to move vertically into the software platform as well. As part of its manufacturing as a service platform for EV, it has announced that it will also deploy the open source operating system layer to control the car (MIH EV Open Platform). Its goal is to become the Android of EV.
If Foxconn becomes the Android of EVs, what will make Fisker (or the plethora of EV brands for that matter)? How will these EV brands avoid the fate of the many android smartphone makers?
The Chinese government perspective
The Chinese government sees this as a massive opportunity; They were not able to become the world’s supplier of internal combustion engines.
But currently, the country is spending the most compared to others in creating the largest domestic market for EVs. With this investment, the Chinese government also demands that all cars sold in China are made with Chinese components. This incentivizes the growth of the domestic Chinese supply chain ecosystem. Moving forward, as with the smartphone supply chain, they want to become the global supply chain center for electric cars, providing components for the rest of the world.
Last week, Coinbase, the premier crypto trading app in the US, dropped its S-1 prospectus ahead of its upcoming direct listing (which still might be some weeks away).
What is Coinbase?
In the early days, Coinbase was more focused on enabling Bitcoin as digital money (medium of exchange) and gained early traction when it was able to acquire large businesses to accept the then nascent crypto currency through its Bitcoin wallet.
But as we discussed two weeks ago, adoption of Bitcoin as a replacement of money has not taken off. As a medium of exchange, Bitcoin is too volatile and too slow (Bitcoin’s throughput is 7 transactions per second, while Visa’s network can handle up to 24,000 transactions per second).
Instead, Bitcoin has emerged as an alternative store of value, a vehicle for speculative investment. And Coinbase was there to take advantage of the trend.
How does it make money?
It is often said, it is best to sell pickaxes during a gold rush. In a way, that has become the primary way Coinbase makes money.
When a user transacts, Coinbase primarily generates revenue from two sources:
- Margin fee: Coinbase makes money by adding margin, or spread, to the market exchange rate.
- Commission fee: a variable percentage fee it charges on the value of the transaction.
As a result, the company makes about 0.59% total cryptocurrency transacted on its platforms (See Figure 4).
The only certainty is uncertainty
Because of the nature of Coinbase’s revenue is highly tied to the value of Bitcoin and the amount of trading occurring (which itself is tied to the value of Bitcoin), the company’s earnings will be highly volatile.
Here’s a snapshot of its multi year estimated revenue from here (Figure 5). Revenue spikes when the price of crypto runs up and declines sharply when trading activity falters.
With about US $1.3 billion in revenue (2020), the company was recently valued at US $100 billion in private share transactions, giving the company a revenue multiple of 77x! (even Tesla only has about 20x revenue multiple)
In addition to the revenue volatility risk, Coinbase also has significant regulatory risk from CTFC (the Commodities Future Trading Commission, which regulates cryptocurrencies, as they are considered digital commodities; CTFC is mentioned 31 times in the S-1).