Friday, December 04, 2015

Tesla is copying Apple's business model

One of the interesting things about Tesla is that the company is trying to copy Apple's business model. As a Silicon Valley entrepreneur myself, and an owner of a Tesla car, I thought I'd write up what that means.

There are two basic business models in the world. The first is cheap, low-quality, high-volume products. You don't make much profit per unit, but you sell of a ton of them. The second is expensive, high-quality (luxury), low-volume products. You don't sell many units, but you make a lot of profit per unit.

It's really hard to split the difference, selling high-volume, high-quality products. If you spend 1% more on quality, your customers can't tell the difference (without more research on their part), so you'll lose 10% of your customers who won't accept the higher price. Or, you are selling to the luxury market, lowering price to sell more units means lowering quality standards, destroying your brand.

Rarely, though, companies can split the difference. A prime example is Costco. While the average person who shops at Walmart (low-quality, high-volume store) earns less than $20,000 per year, the average income of a Costco customer is over $90,000 per year. Costco sells high-quality products to these customers, but it does so at high-volume, keeping the prices low.

Apple is another company that succeeds at this, selling higher quality products at enormous volumes, at mainstream prices.

It's at this point that those who don't like Apple laugh at me for calling it "quality" products. They are wrong. While many aspects of quality are subjective, leading some to dislike Apple, other aspects are objective.

Most luxury products are really only subjectively quality products. Take Ferrari cars, for example. Sure, they go fast, but they also spend a lot of time in the shop. Likewise, a lot of high-fashion falls apart if you wash it. The biggest lie in luxury is Whole Foods, which often sells crap products like bottled tap water for high prices.

At the same time, some quality measurements are objective. That's how Costco works. For every product category, their buyers apply rigorous quality tests before selling something under their "Kirkland" brand, whether it's soap, cola, vodka, luggage, or shoes.

Likewise, Apple is objectively a quality product. Take an Apple power supply, remove any branding, and give it to an engineer to compare against other power supplies. The engineer will tell you that the Apple product is better designed and uses higher quality components.

But being higher quality doesn't work if customers don't know it. That's why every other company has crappy power supplies, because it's not a value that companies can communicate to their customers. The customers don't care.

That's where branding comes in. The business models of Costco and Apple are precarious. As soon as customers fail to recognize their better quality, they'll leave these companies for cheaper products. That makes these companies focus obsessively on maintaining both subjective and objective quality. This communicates the brand of quality even when customers can't judge for themselves.

Look at the Apple power supply, on the outside. It screams "APPPLE". It's not (just) the logo that does this. It's the fact that the power supply has the same white plastic, curved edged design of the first iPods and MacBooks. Subjectively, every bit of the power supply feels different than the standard industrial bricks sourced from random vendors. Even if it's not actual quality, subjectively it feels different, and hence (if you like Apple) better.

The problem with all this "quality" is that it gets expensive. It can easily double the price. Customers impressed with Apple's quality wouldn't be willing to pay for it. Sure, they'll pay 30% more, because it's a status symbol and "cool", but they won't pay double. Therefore, Apple has to tackle the cost issue.

They do this with "NRE" or "up-front" payments. The reason quality components are expensive is because they are produced in low volume, the same business model duality described above. Apple has to push its business model down through the supply chain. That means going to vendor, giving them a bunch of money (Non-Recurring Engineering) to design a higher quality part, then capital so they can build a factory to produce that part in volume. In exchange, Apple then gets to buy that part at a low price.

Apple is so good at this that they can produce a high-quality iPhone at the same cost as low-quality competitors. This produces huge profits per iPhone. Even though Apple sells less than 20% of all mobile phones, it earns most of the industry's profits. Nobody can compete with them. Another vendor wishing to enter the market doesn't have enough capital to create the same deals Apple gets, so can't produce a quality phone as cheaply, and thus must sell in lower volumes for lower profits. And even then, they still can't compete because such a low volume product can't generate enough profits for the engineering required. And, there is certainly no money left over to create the luxury branding needed to support the marketing.

Thus, not only is Apple's model unique, nobody else can replicate it. At least, not in any market where Apple competes.


Now let's talk about Tesla. Their endgame is to be like Apple, but for cars. That means selling a high-margin product, but at volume competing against other lower-priced competitors.

That car will probably be the Model 3, a $35k car that sells against a Chevy Volt, Nissan Leaf, and BMW i3.

To get there, Tesla needs to first create a brand, namely "it's what the cool people drive". Branding isn't your name, logo, motto, or anything conscious. Branding is about unconconscious emotions. People move from Android to iPhones (and rarely the other direction) simply because of the emotional feeling that it's why the cool kids own. It's like buying a kid an XBox for Christmas, which objectively meets the kid's needs better any other console, but having the kid cry because all the cool kids at school have PlayStations. Tesla is trying to create a brand that'll cause kids to cry if you don't buy them one when they turn 18.

Part of that is their rebranding of "internal combustion engines", or "ICE", as uncool. It's weird talking to Tesla owners and their disdain for ICE, as if they all went to the same cult. It's like some shameful cooties that other car makers have that they'll never be able to get rid of. Even though BMW produces an all-electric i3, they still can't shake their ICE heritage.

And indeed, it is a hard heritage to move beyond, as this story describes. Existing car companies sell through dealers, which make their profits by servicing cars, which electric cars need less of. Thus, the sales people steer customers toward gasoline cars, or try to trick them into paying for a "service" plan that includes free oil changes -- something electric cars don't need. It's like watching Microsoft flail around with its tragicly un-cool "Zune" against the iPod. Objectively, it was just as good or better. Subjectively, they failed in branding against Apple in every possible way marketing people can fail.

Ultimately, what Tesla is trying to do with the current model (Model S) is to create a "cool" factor that it can later apply to the later mainstream model (Model 3). It'll take them time to ramp up production and support network, so the number of cars they can build is limited anyway. Therefore, they make the coolest car possible for under $100,000.

And they succeeded. The Model S is better than every other sedan on the market, and also better than most all sports cars. It's better in every single metric but one (long distance driving). The huge battery means it drives three times further than any other electric car. Because of the huge battery, it can generate faster acceleration than any car costing less than $1 million. Because of the huge battery sitting at the bottom of the car, lowering the center of gravity, it's handling is better than any other car not specifically tuned for the track. It's not just this, but a long list of other cool features, like the central control unit, the aluminum body, the self-driving features, and so on.

In short, the Model S is iconic, like Apple. It's the mostly highly rated car in car enthusiast magazines ever.

The mainstream Model 3 won't be as iconic, because it'll be cheaper. But yet, the brand will be established. For example, the high-end Model S is nearly all aluminum, but the cheaper Model 3 will be mostly steel. But yet, marketing will still focus on the few remaining light-weight parts, extolling their virtues, even though in practice they are little different than competitors. The competitors won't be able to get into a fight over whose car is lightest, because then Tesla will always fight back with the Model S. Apple has been doing this for years with things like processor speed -- objectively, it's no faster, but subjectively, they convince the faithful it's somehow better.

In much the same way that Apple became the biggest consumer of flash memory, and used it's capital to guarantee it paid the lowest price in the industry, Tesla is doing the same with batteries. The Model S has three times the battery per car as any other electric vehicle, and sells more electric cars than anyone else. Thus, it drives the battery market.

That's why they are spending so much capital on the "Gigafactory" to produce batteries, currently partnering with Panasonic. Just like Apple has to spend capital to get low-cost parts and flash memory, Tesla has to spend capital to guarantee cheap batteries. That means when the mainstream Model 3 starts competing against the Volt, Leaf, and i3, it'll have larger batteries for a cheaper cost than its competitors.

It's weird watching business models like this unfold. Existing car companies aren't willing to bet that much capital in an unproven market. Tesla's investors, on the other hand, are betting everything to create that market. Thus, Tesla can do things that entrenched companies cannot. Assuming Tesla continues to be competent, and that the electric car market grows, then they should command the lion's share of it -- just like Apple.

Recently, industry veteran Bob Lutz wrote an op-ed claiming Tesla was doomed because it didn't have a dealer network like at traditional car company. It's just like reading the op-eds from Nokia, Microsoft, and Blackberry when Apple released the iPhone. Lutz might be partly right that Tesla needs dealers to provide capital to for inventory management, but he's otherwise profoundly wrong. Tesla breaks dealership model even if it didn't want to, such as different way electrics need servicing. Dealerships are corrupt quasi-monopolies, and nobody likes dealing with them. Sure, Tesla may lose some sales because customers can't drive a car instantly off the lot, but they'll also gain customers fed up with corrupt businesses. Putting showrooms in shopping malls instead is just one more way that Tesla easily makes itself distinctly different from its internal combustion competitors.

With all the good ways Tesla is executing on Apple's business model, it's also making a lot of mistakes. There are lots of small design flaws in the Model S, and some clearly lacking areas. For example, the voice command system is decade old crap. Tesla desperately needs to license a better one from Apple (Siri), Microsoft (Cortana), or Google (Ok Google).

What these flaws show is that Tesla doesn't have Musk's full attention. He's off dreaming about hyperloops, solar panels, and SpaceX. Tesla doesn't have somebody like a Steve Jobs, or even a Jonathan Ive, who obsesses over every small detail to make everything perfect. This flaw can be fatal. The Tesla Model S driving experience is so awesome is makes us look past the small flaws, but there's no excuse for those flaws to exist. If they persist, they'll kill the Model 3. Imagine test driving a Nissan Leaf with Apple Siri embedded, where you can ask about last night's game scores, and then step into a Model 3 which can't even dial a phone properly. Car innovation is continuing beyond the electric model and self-driving features -- Tesla needs to be up near the front on all of them.


When Apple released the iPhone during the recession, I bought a bunch of Apple stock -- enough to buy my Tesla Model S from the gains. Just by looking at the product, business model, and the market, it should've been obvious to anybody that Apple had changed everything.

Electrics aren't quite the same game changer -- they are still cars. The challenges of charging them, and the inability of pure electrics to drive long distances, mean that they won't take over the market. In a decade, though, even without government subsidies, they'll command a good 30% of the market. Even if Tesla isn't one of the top car companies, there's a good chance it'll be one of the most profitable -- if it can continue to execute on this model. High margins means that even if it's not selling the most cars, it could be earning the most profits in the industry.

Their stock is already high, and Musk doesn't seem to be executing as well as Jobs, so I'm not interested in buying their stock. But really, the Model S is an awesome car to drive.


faryal naaz said...

i appreciate your work this is really incredible i have get a lot of information from here thanks for providing such kind of information.
tech trends UK

Daniel Serodio said...

I drove a Tesla for a couple of hours, and the only problem I could notice is the excessive reflection from the central LCD panel. Depending on the sun's position, it becomes unreadable or (if the sunroof is open) reflects sunlight directly into the driver's eyes.

Craig Albright said...
This comment has been removed by the author.
Unknown said...

"Tesla doesn't have somebody like a Steve Jobs, or even a John Ivy…"

Do you mean Jony Ive?

Nigel said...

Spot on analysis.
Tesla are getting it right. I hear an advert for the i3 and think "But it's not a Tesla"!