The first lead-managed equity deal I ever worked on was saving Chrysler from bankruptcy in 1991. Investment banks led by the old Salomon Brothers and First Boston (where I worked) raised $140 million for the near-dead automaker in November 1991. Money was so tight at Chrysler that our capital markets desk had to wire proceeds directly from the settlement account to some of the company’s parts suppliers, who themselves were days from insolvency.
The biggest reason investors bought into the deal: Chrysler was about to launch the Grand Cherokee, a direct competitor to Ford’s successful and highly profitable Explorer. Four door SUVs were rare back then, and consumers loved them. So much so, in fact, that the average gross margin/unit was +$15,000 versus a corporate average of $3,000.
That experience, and many more equity deals in the years after, taught me 3 things about the auto industry:
- Cyclicality is brutal on profits, but at least that cuts both ways. The Chrysler deal went off at $5/share because the company was losing $1/share in earnings. Five years later (in a better economy and with a raft of new products) the company was earning close to $5 in EPS.
- That volatility in earnings can play havoc with product development. Research & development/tooling costs for a new vehicle start at $1 billion. In 1991 Chrysler was still selling “K cars”, a platform developed in the 1970s, because it had delayed new car development during the 1988 – 1991 downturn.
- The auto global auto industry is deeply dysfunctional. Chrysler was a simple story: one region (US) and one product segment (trucks like SUVs and minivans). The worldwide auto industry is far more complex. Product preferences vary depending on everything from government regulation to fuel taxes. And, worst of all, there are far too many automakers and overcapacity leaves industry returns well below the cost of capital.
How all this relates to tech-based innovative disruption: autonomous vehicle (AV) development, design and production sits squarely atop the global auto industry’s cyclical (and fundamentally shaky) foundations. Three thoughts here:
#1: We don’t seem to be at “peak AV development spending” just yet, with several key players either raising outside capital or planning to increase their spending dramatically in 2019. Consider just a few examples:
- There was news out just today that Uber is seeking $1 billion of outside capital to fund AV development. Recent reports say that the company is spending $20 million/month on these efforts. Rather than have that cash drain be an issue in its upcoming IPO, Uber is ready to sell a piece of this business.
- While GM “only” spent $728 million on its Cruise AV division last year, the company’s CFO recently told analysts it is still budgeting $1 billion in 2019.
- Google’s Waymo AV division, which by most accounts is far ahead of its rivals in autonomous miles driven, is reportedly considering taking outside capital.
#2: Global economies are set to slow in 2019, touching every major car-producing region of the world. The best-case scenario is for flat sales in the US and modest declines in China and Europe. That is why earnings estimates for US automakers are either even to last year (GM) or down (Ford).
#3: Pull the two concepts together and add the lessons from Chrysler, and I conclude that a US/global recession will slow the development of AVs. “But what about all the Big Tech companies investing in the space?” you might say. “Certainly they will fund development through a downturn…” Perhaps, but….
- The regulatory side of things is moving slowly, and development has remained quite regional. For example, GM has still not received US Federal government approval to test vehicles without driver controls, a year-plus after filing the paperwork. And while it is fine to test Waymo vehicles in the American southwest, we have yet to hear of many AVs daring to compete on NYC streets…
- That even Google is looking to raise outside capital shows its board/management is concerned with how much money it will take to complete development and commercialize an AV solution. Yes, perhaps they are just looking for a strategic partner to accelerate the Waymo program. But if you were really close to a commercial concept, would you sell equity now? No, you would not.
- Uber’s similar move ahead of its IPO shows that it is concerned public market investors understand the gist of this note: AVs are a promising technology, but the timing and magnitude of any payoff is both uncertain and subject to cyclical factors.
The upshot to all this: I suspect most of you think there will be at least a US recession if not a global one in the next 2-3 years. If and when this happens, it will disproportionately affect the auto industry but also impact technology companies as well. This will slow AV development and commercialization because that’s simply what happens in cyclical industries during downturns.
So yes, self-driving cars will one day be commonplace but this sort of technological disruption is so capital intensive that we cannot ignore prosaic factors like economic cycles. In that respect, AVs are different from smartphones and software-based disruptive technologies like social media or fintech. Any company involved in this space knows they are billions of dollars away from the finish line.
Or we should say: billions of dollars, and at least one recession.