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The automotive industry is reaching an
inflection point that will reshape its near-term future,
precipitated by the connected car era – also known as software
defined vehicles or “SDVs.” This will affect every aspect of future
mobility, from Generative AI implications in Level 2+ autonomy to
the HMI of the cockpit domain software.
On the eve of CES, automakers and suppliers are
closely monitoring the evolution of connected cars – encapsulated
in the “CASE” acronym of Connected, Autonomous, Shared, and
Electric. This transition will be crucial to rebalancing the
automotive value chain and to how OEMs exert control over the
vehicle assembly process. But this involves more than just the
building of the software-defined vehicle. Automakers also will
attempt to extract more value from the service life of these
vehicles.
OEMs are looking to wrest back control from
tier 1 and system-on-chip (SoC) suppliers involving revenue that
can accrue over a vehicle’s lifetime, including in-vehicle
applications and digitized services that SDVs facilitate with
ease.
The side effect will be a period of upheaval
and rebalancing in the supplier value chain, thus making the
transition complex.
This change threatens to upend the industry’s
value chain, which has been taken for granted since Henry Ford’s
first moving production line in 1913 at Highland Park, and the
accepted orthodoxy of the Toyota Production System that’s shaped
the industry’s value chain through the 20th century and early part
of the 21st.
Of course, such a reshaping of the automotive
value chain will be strewn with obstacles and opposition –
geopolitical and practical – and OEMs will face opposition from
industry participants reluctant to cede their place at the
table.
Historically, the automotive industry has
focused on cost-optimizing hardware, such as with semiconductors.
Software was seen as necessary, but not as strategically important
as hardware. Tesla’s unleashing of the software-defined vehicle –
with its over-the-air updates – challenged the status quo. It’s not
that software wasn’t strategically important, just that the
industry simplified software to the cost of memory.
Development of electronic functions was rooted
in both expediency and cost. The symbiosis between hardware and
software was straightforward: More code simply translated to a more
expensive microcontroller unit (MCU). Minimized hardware costs
minimized software size. This justified the proliferation of MCU
derivatives based on different memory sizes so long as smaller
memory translated into lower hardware cost.
This approach has dominated automotive R&D
thinking for decades, with gentle evolution fitting comfortably
within the existing automotive value chain structures and
traditional platform redesign cadences. OEMs orchestrated material
flows and wielded cost-down power.
Electric
vehicles and the connected car opportunity
OEMs are emboldened by the new E/E
architectures and product development process shifts taking place.
These changes will be evidenced in 2024 and 2025, when Level 2+
automated vehicles, complete with the widespread adoption of
over-the-air (OTA) updates, will become more mainstream.
OTA brings multiple
revenue opportunities. OTA updates also allow the vehicle to be
maintained, updated, and have features added over its lifetime
without visiting a dealership. With OTA, the initial sale of the
vehicle becomes the start, rather than the end, of the
value-extraction process for the automaker.
Within the current industry structure, there is
little incentive in terms of return on investment for automakers to
keep the status quo. The current practice is for hardware suppliers
to embed their software in deliverables. A case in point is
Mobileye’s dominant position in the computer vision space, where
they can leverage both their hardware and software stack. Where the
software is embedded and there is a requirement for post-delivery
customization, there either is a cost implication for the OEM, or
the revenue generated from the innovation is shared with the
vendor.
With the Level 2+ rollout, OEMs are wary of
repeating that experience and being bypassed. With an increasing
set of services being offered over a vehicle’s usage life cycle –
all enabled by software – and knowing that service revenues come
with two- to four times the margins of hardware, OEMs see an
opportunity not to be missed.
Tesla as
harbinger of change
The early success that new-era OEMs like Tesla,
Xpeng, and Nio have had in internalizing software development —
and therefore revenues — has aroused envious glances from
legacy automakers. And they have a point – up to a point. Tesla’s
EBITDA margin continues to outpace its competitors. In 2022, Tesla
recorded a margin of 21.4%, while a selection of 11 of its
established competitors managed an average of 12.6%. Tesla’s margin
in 2022 was nearly 50% more than that of Honda, which was the
strongest-performing competitor, according to S&P Global Market
Intelligence.
Of course, Tesla’s margins are not solely
attributable to its software approach, although it undoubtedly
helps. It eschews advertising, and its platform range is narrow,
which slashes costs. Additionally, other strategies such as the
one-piece gigacasting will
contribute to its bottom line.
But Elon Musk sees the sale of a software
defined vehicle as just the starting point of the consumer
relationship. During Tesla’s Q4 2022 earning call, Musk stated,
“We’re the only ones making cars that, technically, we could sell
for zero profit now and then yield tremendous economies in the
future through autonomy. No one else can do that.”
Musk put that claim to work at the end of 2022,
when Tesla began deep price cuts to its models which lowered its
margins – but still provided a greater return than its peers,
causing jitters in competitors’ electrification strategies.
Tesla’s SDVs also challenge vehicle development
orthodoxy. Rather than a vehicle undergoing costly minor physical
engineering changes every three years, then major architectural and
platform redesigns every six years, the SDV allows for a different
approach via OTA updates. Legacy OEMs will dissent, however,
stating that adopting Tesla’s practices will result in volume decay
for vehicles that suffer long cycles between design changes.
The chart below indexes sales of E-segment
vehicles that compete with the Tesla Model S globally over a period
– beginning with the Model S’s launch year of 2012 through 2022.
Over the 10 years, competing models all underwent significant sheet
metal changes, while the Model S’s 2021 ‘Palladium’ update was far
less involved on a material basis. Whether legacy OEMs will stomach
the prospect of such pronounced sales decay is a moot point.
Middleware and Connected Car development
The battleground for the SDV value chain is
already developing – and the main clash involves middleware.
Foundational components like operating systems
are not an area that OEMs will strategically invest in, but instead
treat like a commodity by signing long-term contracts. The
development of a virtual software layer between hardware and
software by automakers is another area of intense research. This
layer would enable the translation of complex hardware and software
resources into a more straightforward format in the upper layer
software stack.
Achieving this objective allows the separation
of the hardware lifecycle from the software function development.
Each can then function independently, providing more options for
future collaboration with the new software supply chain.
The commodity middleware link will have a
degree of customization and there will be some collaborative
investment, but it will be with one eye on future infrastructure
requirements for SDVs. Currently, this is where companies such as
Mobileye and Nvidia exist.
But automakers want to develop and own the
strategic middleware space. Vendors would have to keep the vendor’s
code or its interfaces, leading to a cost for every customization
and, sometimes, a license fee payable on a per-vehicle basis.
Suppliers rebut this position, insisting that software is not a
core OEM competency – pointing to VW’s notoriously troubled CARIAD
software development. Furthermore, vendors such as Mobileye have
built a formidable power base that will prove challenging for OEMs
to separate responsibilities for software from hardware.
Not all OEMs will have the wherewithal or
desire to own this area of the value chain. Some automakers
actually see a turnkey middleware solution as attractive. This
could be due to the OEMs lacking in-house software capability, not
actively developing SDVs or Level 3 vehicles, or a preference to be
a fast follower rather than a first mover and take advantage of
lower development costs.
The human-machine interface (HMI) and user
experience (UX) is a key part of any OEM’s core competency – and a
brand differentiator in a world of increasingly homogenous vehicle
design. If control of the API and middleware is secured, this will
be an area of 100% OEM participation.
There also is the SDV’s backend to consider.
SDVs need an instantaneous uplink and downlink cloud connection. As
latency is essential in supporting the new business model, it is
likely that OEMs will also seek to own the connection between cloud
platform services and the middleware. This is a path that BMW, VW,
and Tesla have already embarked upon, and others are sure to
follow.
SDVs and
parallel value chains
The decoupling of the vehicle development
process from a vehicle’s hardware and software integration under
the SDV megatrend will see two value chains develop in tandem.
While the traditional view of the value chain will last, its focus
will shift to what makes the vehicle move, change direction, and
start and stop.
Electrification will diminish the value that
traditional mechanical components contribute to a bill of materials
(BOM), due to the battery and electric motors becoming bigger
constituent components compared to internal combustion. Because of
the E/E and software revolution, traditional mechanical components
will become increasingly commoditized, placing pressure on the
supply base.
Tier 1 suppliers hoping to use their automotive
software expertise to cash in on SDVs and migrate from their role
as system integrators to software integrators face a battle. In an
idealized scenario, OEMs are reluctant to cede ground to either the
SoC vendors or the tier 1s. However, given the choice of who is
more central to future business, they are likely to choose the SoC
vendors.
OEMs will lead the
decision
Automakers are essential in determining how the
SDV value chain develops. The extent of their involvement will boil
down to the level of in-house software capability. This can be
shaped from a philosophical or strategic viewpoint, or it can be
due to the availability of financial and human resources.
Those without the financial capability to go it
alone will opt for development partnerships in commodity middleware
and foundational parts of the strategic middleware. Here, an OEM
can then use the platform a partner supplies to develop their API.
This allows an OEM to at least have some skin in the game.
For the supplier of the middleware platform
such a partnership also offers a way forward — but relies upon
the supplier having developed a solution set in-house (e.g., Bosch
and ETAS, ZF and Mediator) or acquiring the capability. Such an
arrangement was formed in April 2023 by JLR with Elektrobit, which
is owned by Continental. From 2024, JLR’s EVA Continuum platform
will use Elektrobit’s software platform and operating system.
These new partnerships could portend the end of
eras defined by often confrontational and adversarial supplier
relations. The advent of the SDV could usher in a more
collaborative era, allowing more industry participants to share in
the spoils on offer from the SDV revolution.
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Dive deeper into these mobility insights:
MORE ON THE FUTURE OF MOBILITY AND
CONNECTED CARS
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ELECTRIFICATION
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TECHNOLOGY VEHICLES IN
OPERATION
This article was published by S&P Global Mobility and not by S&P Global Ratings, which is a separately managed division of S&P Global.
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