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Mental Model: Customer Loyalty & Market Share Implications
One of the less discussed mental models investors can apply to various businesses is the telecom carrier way of looking at the world: a) gross additions (which ties to consideration), b) customer churn and c) the effects that this two-lane highway have on the customer base. We used this model to consider the downside effects of Apple getting “iPhoned” when we purchased the stock a few years ago (we are no longer holders). When there are industries where you can find “customer loyalty” and “net promoter scores,” then you have the broad statistics to start your telecom model. The major reason the model is actually useful is to think about market share in the specific industry. Highly satisfied customers, as in the case of Amazon, will not only have a very low churn or discontinuation rate, but they’ll also tell friends about the service and become a “promoter.” High NPS figures or loyalty figures relative to peers mean the companies can typically easily take market share away from other competitors, and the speed at which this process happens depends on the gap between the competitors on these key measures.
In our short report we issued last weekend on Volkswagen, we discussed a mental model we’ve used to try and figure out how quickly Tesla and potentially Apple and Google will have an effect on the incumbent, particularly German premium automakers. Because the Silicon Valley companies have incredibly happy customers, and German premium auto buyers are even less loyal the Detroit’s mass-market customers, we believe the shift away from incumbent premium automakers will be quite swift indeed. We are not long Tesla, nor would we even consider being long the stock above $150 a share, but we believe it will be creating a massive headache for the industry. Here’s a snippet from our 38-page report on Volkswagen.
The Premium Auto Segment’s iPhone Moment
We admit, we were Tesla skeptics until a few months ago. Yes, the company was sporting insanely high levels of customer satisfaction and the reviews were hyperboles. Consumer Reports wrote, “The all-wheel drive Tesla Model S P85D sedan performed better in our tests than any other car ever has, breaking the Consumer Reports Ratings system.” It was the automotive equivalent of the Chris Matthews and the “Thrill up his leg,” but was actually unremarkable when compared to other automotive journalists and Tesla drivers. Still, we were skeptical. That is, until March 31, 2016.
Elon Musk introduced the Model 3 and shrewdly opened orders for the vehicle, even though deliveries were more than a year away. He must have done some market testing, because the initial demand via orders was simply staggering. 400k orders that required a refundable $1k deposit were accrued in less than a month. By way of comparison, most vehicles end up annually selling 3-5x the number of orders they receive initially. Even if we just use a 2x multiplier on the order volume, we see that the Model 3 will by far become the best selling premium sedan in the world.
Even without an order multiple relative to the underlying annualized demand, the Tesla Model 3 will likely be the #1 selling premium sedan in the world, if we were to exclude the hatchback and wagon versions of the BMW 3-Series and Mercedes C-Class. The brand is coming into a gigantic consumer segment with abysmally low satisfaction. Consumers hate the dealer experience, they hate the frequent repair and maintenance experience, they hate the task of looking for parking spaces, they hate the hassle and the over-engineering of key user functions, particularly infotainment. They hate filling up their car with premium gasoline, and they particularly hate the high costs of repair work.
Exhibit 1: High-Volume Premium Sedan Annual Sales
Just like T-Mobile has systematically solved many of the pain-points in the mobile telephony experience, and subsequently taken a very large portion of the industry’s gross additions, Tesla has systematically solved all of these pain points. It eliminated the dealer. It eliminated a significant amount of components by eliminating the internal combustion engine. Shop visits are a thing of the past, as the vehicle can receive a software upgrade overnight wirelessly. The user experience has been so transformative, Tesla’s loyalty rates is at 99%. Do you know what the customer loyalty to the next best brand is?
Exhibit 2: Loyalty Rates of Premium Automobile Customers
Even upon introduction, the iPhone’s loyalty wasn’t even that high, although it was above 90%. Now, after the multiple iterations Apple has made to the iPhone, its loyalty has approached 99% in some recent surveys. Guess what the Blackberry had after the introduction of the iPhone.
75%. That was the drop in loyalty among blackberry users as it became clearly obsolete by the new touchscreen and intuitive operating system. As exhibit 2 shows, even the best premium brands have loyalty at half the rates that Tesla is starting out with. Although the average consumer only makes a new car purchasing decision every five years, the average premium auto buyers shops more frequently and this gaping difference in loyalty and customer retention will have a transformational impact on the premium automotive segment, much in the same way the iPhone has take a significant share of the smartphone industry worldwide, and a commandingly large portion of the profitability generated by the entire segment.
The telecom way to model out gross additions and churn has proven a useful mental model to have in the investor’s toolkit, and when we purchased Apple in 2013, the telecom model proved very useful in getting comfortable with the downside scenario. We nearly bottom-ticked the stock price, and we were able to purchase the stock at a valuation which was pricing-in an imminent obsolescence even though there were no competitor products that we saw coming close to another transformational moment in the smartphone segment.We can apply this mental model to the premium automotive segment to understand how large of an impact Tesla will make. Because Tesla is still selling cars priced at the top-end of the segment, in fact substantially higher in average transaction price than even Porsche, we can easily conclude that the current level of customer purchasing intent and consideration is lower than it will be when it has a $35k car on sale in just under a year. Accordingly, we don’t believe the current level of measured purchasing intent accurately reflects the underlying demand for its future products. So we turned to Google Trends to analyze the level of interest out there for Tesla as it relates to other key premium automakers. What we found was interesting to say the least.
Exhibit 3: Google Search Trends on Key Premium Auto Brands
Google Trends highlight some interesting aspects of consumer’s interest in premium autos. First observation is that since 2011, the entire segment has risen in level of interest and search. The two exceptions are actually Volkswagen’s money-makers: Audi has remained flat over the last five years and Porsche interest has declined. Tesla has now overtaken Porsche in customer interest, and when Musk unveiled the Model 3, again priced at $35k in the heart of the bread & butter midsize sedan price points, consumer interest reached levels in line with both Audi and Mercedes. This is unsurprising to us, in that one month’s worth of orders eclipsed the total annual midsize sedan sales of both Audi and Mercedes.
The Google Trends also highlight the significant threat Tesla is currently posing to Porsche. After it launched the Model S, sales of the comparable Porsche Panamera declined over 30%. This year, Tesla has launched the Model X crossover, and it has partially also effected sales of Porsche’s Cayenne, even though the starting price of the Cayenne is 20% cheaper than the Model X. To be fair, Porsche’s Cayenne sales have recently been also negatively affected by its own introduction of the cheaper and smaller Macan crossover (also 20% cheaper than the Cayenne). We’re talking about purchase intent and consideration because these statistics will lead to each brand’s “gross additions,” going back to the telecom analogy. The inverse of the loyalty / retention figures are the churn rate. With these two metrics, we can roughly calibrate how quickly Tesla will destroy the other brands.
What’s also important to note is that Tesla will only have one moderately-priced vehicle next year, and it will no doubt be launching many subsequent products after its executes upon the the Model 3 opportunity. In exhibit 4 we estimate that Tesla’s purchase consideration will approximate Audi’s and Mercedes (roughly equal to each other, and in line with the Google Trends results) by 2020 and hold steady thereafter. Because the customer defection from other brands is so much higher, and therefore the theoretical customer churn is so much higher, the rate at which Tesla will conquest the industry’s sales figures is truly staggering- something the automotive market has never seen. It’s also never seen brand loyalty of 99%. Only more modern forms of technology have seen the kind of market share grabs that we would expect for Tesla in the future. Online commerce and online activity (think AOL vs. Facebook) as well as the mobile phone market, television manufacturing, music distribution and other similar industries have seen the type of seismic shifts that can happen when customer loyalty is even just 95% vs. 75%. When one pits a 99% loyalty rate against 30-50% rates, the shifts can look fairly dramatic.
Exhibit 4: Market Share of Premium Automobiles by Brand
Before we go on, let’s pause here and talk about alternate versions of the future. The best-performing (fact, not opinion) and smartest CEO in the industry (opinion), Sergio Marchionne, doesn’t believe Tesla will be profitable selling the Model 3 for $35k. Should the company need to lift its price in order to earn a return on capital, it won’t be covering the same segment territory that its competitors do, and thus will have a reduced effect on the demand shift portrayed in exhibit 15. While we agree that robust profits are unlikely for the Model 3, we are skeptical that Tesla actually needs to earn a return on capital for its Model 3. Because the company’s market capitalization is three times that of Fiat-Chrysler’s, despite the company selling 1/25 of the volume of cars, Tesla’s stockholders are holding onto dreams rather than valuing the company based on anything remotely fundamental. Other companies that get this benefit from the capital markets typically can earn little to no profits, all in the name of conquering market share. We think, like Amazon, Tesla will likely maintain its lucky market position and even if the Model 3 doesn’t generate any profits for the company, stockholders will continue to give Musk the benefit of the doubt. The other major problem looming for electric cars is a shortage of raw material. Ignoring demand for lithium ion batteries coming from consumer devices, the cobalt reserves on the planet will be entirely used up after demand for 176 million vehicles has been satisfied. That’s only two years of current global auto sales, which means that the prices for lithium ion feedstock could be rising to levels which can no longer compete against a $35k BMW 3-Series.
Yet if the telecom model on customer loyalty and satisfaction is remotely close to being applicable to the premium auto industry, capacity utilization for all premium automakers will drop below 80%, or the rough level of being breakeven, within the next few years.
It seems pretty hard to believe, and we’re quite sure there are thousands of skeptics on this point, but we’ve successfully applied the telecom mental model to other industries, and the results have predictably come to fruition. Anyone long premium automakers should hope we’re wrong. But at minimum, investors should keep this tool in their toolkit as a useful way to model out market share in specific industries. We believe it’s the only way to quantify what previously unquantifiable financial implications to happy or sad customers.
This article has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to invest in any investment product or strategy related to such securities or assets. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this article. Persons reading this article should seek professional financial advice regarding the appropriateness of investing in any securities or assets discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities or assets discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC.
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