Emerging market equities: China’s “smart” opportunity
Emerging market equities: China’s “smart” opportunity
Emerging markets Portfolio Manager Daniel Graña and Assistant Portfolio Manager Matt Culley explain why China is well positioned to lead in electric vehicle manufacturing.
Key Takeaways
- Software and data will be at the center of the next generation of vehicles.
- With propulsion commoditized by electric engines, China’s low-cost manufacturing base will make the country competitive in the global marketplace.
- China’s government would champion the domestic EV industry as it furthers the goals of value-added technologies and decarbonization.
When the winds of change blow, some people build walls and others build windmills ~ Chinese Proverb
Most prior seismic shifts in technology over the past 50 years have been precipitated by the commoditization of what were uniquely hardware-oriented products toward software-oriented solutions. The pace of change during these shifts feels glacial, then sudden. Their potential feats trivial, then limitless. Incumbents fight the imminent change until that tipping point where it becomes apparent, then rush to catch up. The future is always obvious in hindsight.
Electric vehicles (EV) are the future. “Electric,” however, is just an enabling technology and can be seen as commoditizing the hardware cost of transport. We believe the winners in the EV revolution will be “smart” and defined by software in much the same way we have seen in prior historical analogues. China has the opportunity to be a leader in not only the design and production of the next generation of vehicles, but also to leverage the power of software and big data to reimagine the entire automobile industry.
Total estimate EV fleet size
Source: CAAM, CEIC, Morgan Stanley Research. e = Morgan Stanley Research estimates.
Hardware was king because it was expensive, software was a necessary accessory
To better understand this perspective, we just need to look at two of the prior seismic shifts in technology – the invention of the personal computer and the smartphone. The incumbents in the 1970s during the rise of the PC were premier electronics engineering companies such as Digital and Hewlett Packard. Similarly, telecommunications equipment vendors including Motorola and Nokia dominated the handset industry in the early 2000s. Today the automotive original equipment manufacturers (OEM) are the premier mechanical engineering companies. What made these companies special was their relentless innovation to solve distinctly physical problems. The winners in the race to reduce hardware costs historically won the marginal profit pool. Years ago, and similarly, the Digital Equipment PDP-11/70 minicomputer could be configured with up to a “full meg” of RAM. The cost of that memory board was about a million dollars, so memory-intensive software was simply not an option. The value they brought was in the hardware.
During these shifts, however, we see software completely redefine what the hardware can do. When the cost-per-bit of compute power fell far enough, it gave way to the rise of Microsoft’s Windows. When the same happened with bandwidth, we saw the rise of Apple’s iPhone. In much the same vein, we believe EVs are not special because they are electric, but because of what electric can enable.
Mentality of incrementality vs. exponentiality
It was the culture of incrementality that made these companies great. Automotive engineering focuses on a traditional hardware-centric approach. The OEMs take their starting point, “A,” as a given, and work forward to “B.” There are physical limitations on the power that can be extracted from combusting gasoline inside a cylinder and small changes to the engineering of these components could yield improvements in fuel efficiency over competitors. Their cultures have been built on constant innovation at the edge of these physical limitations. As recently as five years ago almost every automotive company in the world was dismissive of electric as too costly versus the present internal combustion engines. They poured billions of dollars into diesel, turbochargers and hybrid solutions to meet increasingly stringent fuel-efficiency requirements.
Technology, however, deals in exponents. Software companies architect their cultures from a solutions-oriented mindset. They begin with the vision of the end goal, “Z,” work backward to the present, “A,” and assume the hardware cost convergence as a given. With the exponential improvement in battery costs, these two do not meet in the middle. When it becomes apparent that the hardware has been sufficiently commoditized, the incumbents find themselves caught out along that continuum, say at “D” or “E” where the software companies find themselves somewhere closer to the end goal, say “S” or “T.”
China wins in manufacturing
One of the most important results from an emerging markets perspective stemming from these seismic shifts was the geographic move in manufacturing from West to East. As software began to define the value add of the personal computer, both assembly and component manufacturing shifted to Asia, primarily China. Automotive production has historically come from developed markets given the national importance of industry employment, union presence and intellectual property in manufacturing. However, the number of moving parts within the engine in an EV shrinks by orders of magnitude, from 2,000 to just 20. What was once a marvel of engineering is quickly becoming obsolete. Put simply, it is much easier to build an electric car than an internal combustion one. It is perhaps for this reason that we see so many EV start-ups coming out of China. China has the unique capability of being able to leverage their low-cost manufacturing base and support innovative start-ups to focus on a software architecture from the outset.
A software defined experience
Perhaps the most important aspects of EVs are that they offer a better value proposition to the end user. The Chinese start-ups like Nio, Xpeng, and Lixiang have designed their vehicles with a unified software architecture that is capable of being dynamically updated over-the-air down to the firmware and component level. As noted by a predominant executive of a major legacy automotive manufacturer, “mechanical engineering has a cycle time of two to five years. Now when it comes to software, we are talking two years to two weeks.” Incumbents’ products are built upon hundreds of outsourced vendors using broadly incompatible software code. By developing a unified software stack these innovators can continually improve the vehicle after the initial sale. This fundamental shift has the potential to turn industry economics upside down and slow the natural depreciation of their vehicles. Consumers now have access to the most modern technology for longer and are embracing “smart” electric vehicles much faster than expected.
Expected revenue contribution from software services
Source: CAAM, CEIC, Morgan Stanley Research. e = Morgan Stanley Research estimates.
Diminishing returns vs. accelerating returns to scale
Perhaps one of the most important changes is the fundamental shift in the driver of long-term returns. Traditional OEM business models are predicated on selling volumes of cars through their dealer network. Given differentiation has fundamentally been hardware oriented, as manufacturers exhaust the limits of any one model, they have expanded their vehicle lineup. This has led to the development of lower margin products in order to maintain manufacturing efficiency, economies of scale and to hit regulatory requirements. Bypassing the legacy dealerships, Chinese manufacturers have adopted a similar strategy to Tesla of selling direct to consumer. With software at the center of the consumer experience, data emerges as the key. Start-ups in China are collecting more data every day and improving their products at an accelerating rate, requiring fewer models and less hardware investment. They have built their business from the standpoint of engagement to build the flywheel around data. It is no surprise that the three current listed manufacturers are all backed by the Chinese Internet giants. Nio is backed by Tencent, Xpeng is backed by Alibaba, and Lixiang is backed by Bytedance, owner of TikTok and its Chinese counterpart Douyin. As they shifted their mindset from units and price to minutes of time spent and miles driven, it fundamentally opens different avenues for monetizing the vehicle-based on software, which is their core competency. What differentiates this from traditional industry is that businesses built upon data see their competitive advantage grow exponentially, rather than decay. Outside of Tesla, no other major automaker has architected their business models this way.
China leapfrogs to prosperity
This would not be the first time that China has capitalized on innovation to bypass iterations of a particular trend. China has been a first-mover in 5G and wireless technology instead of deploying a broader wireline network. They were an early adopter of digital payments, skipping the credit and debit card trends that thrived in the West. E-commerce proliferated to globally leading penetration ahead of a more formalized offline retail trade. Importantly, the central government appears to back rapid advancement of the industry as it aligns with its goals of dominating select advanced technologies and – with the accompanying transition to electric propulsion – achieving carbon neutrality by 2060. By providing an accommodative home market, Chinese manufacturers will be able compound these natural data scale advantages and export globally. China has the unique opportunity to win on both the manufacturing and technology fronts and surpass the Western incumbents who have dominated the industry for the last century.
Auto market cap by country - USD billions
Source: Refinitiv, Morgan Stanley Research.