How Google Hopes to Disrupt the Auto Industry

Will is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A couple of months ago, Google (NASDAQ: GOOG) CEO Larry Page opined that driverless cars could “change our lives, give us more green space, mobility, fewer hours wasted. The average American spends 50 minutes commuting. Imagine if you got that back.”

Of course, it’s easy to be skeptical of Google’s high aspirations. However, Google is not alone in touting the future of driverless cars. A General Motors (NYSE: GM) spokesperson mentioned the company’s consistent investment in the technology. A chief researcher at Continental Corporation (NASDAQOTH: CTTAY), an auto parts manufacturer, mentioned his belief that automated driving will soon be as standard as anti-lock braking systems. That seems a bit strong, but the tremendous press regarding the technology’s potential at least warrants a more in-depth look.

What Does Automated Driving Look Like?

Most of the advantages of self-driving cars are well-documented: less driving time, safer roads, and more space in an increasingly dense nation. For instance, 2010 saw 32,788 deaths from vehicle incidents, and one study attributed roughly 93% to human error. What’s more, the technology has largely already arrived. Google employees have logged hundreds of miles in self-driving cars. Aspects of the technology, such as the car automatically parallel parking or lane centering, is already in existence, and a semi-automated experience will be set to launch in 2015 or 2016. Meanwhile, in the research stage, "highly automated" cars prepare to take the world by storm in 2020, with highly sophisticated sensors around the car controlling when to break, accelerate, and even turn. As of now, there are still kinks in the development. Analysts are still unsure that the cars won’t, say, swerve around a grocery cart and hit a baby. But the technology exists, and is poised to expand quickly.

What About Tomorrow?

What does the future hold? As Hamlet would say, “therein lies the rub.” Studies cite a number of factors, including legislation, consumer confidence, and technology development, that will not enable immediate adaption to self-driving cars. Case in point: the technology typically costs $10,000 or more to develop, while according to some studies consumers are not willing to pay more than $3,000 (researchers hope that they can eventually converge two existing methods and reduce the price to about $1,500).

One thing seems certain, however, and that is the fact that self-driving technology will play some larger role in the future. Continental Corp. seems to be leading the charge among suppliers, announcing an R&D expenditure of $100 million for 2013. They also signed a research partnership with elite manufacturer BMW (not traded on U.S. markets) through 2014. Other big names litter the conversation. In addition to Google, Microsoft and Apple help lead the charge for technology development, along with major universities such as MIT.

True, the governmental impact remains up in the air. As of now, the federal government only recently began its investigation, and the ultimate decisions often depend on the election cycle and wider market sentiment. However, state legislators have begun to get on board, including California's state government and the massive market it oversees.

Google is gambling that legislation will work out. If market demand doesn't top $3,000, perhaps Google could sell its technology to a top automaker for $2,250 a pop (based on $1,500 development costs). With international car sales totaling 64.94 billion in 2012, suppose Google sees 15% market penetration (Ford, by itself, boasts 16.2% market share).

The 9.741 million sales, each netting $750, would improve profit-- without accounting for fixed costs--by more than $7.3 billion. Revenues, a more easily predictable number, would jump $21.92 billion--nearly half of Google's current revenues. Although the revenue would carry significantly lower margin than Google currently boasts*, the scenario would still soothe concerns about Google's slightly growth-heavy valuation (its P/E is over 27, compared to the S&P 500 average of 17.2).

In fact, one of the biggest knocks on Google has been its inability to make decent returns on capital spending. Google already owns around 70% of the U.S. search market, and--although internet advertising will most likely improve profits--there's reason to question whether Google will ever truly add value beyond its already-impressive internet domination. As the company's growth stagnates, perhaps investors should begin to consider automated driving as a feasible way for Google shares to push upward.

What Does It All Mean?

For one thing, the auto market would look very different. Instead of a premium on manufacturing, technology trends would start to play a key role in the auto industry. Plus, as Larry Burns said, “Incumbent players rarely do well when industries disrupt.” Even if automated driving remains a pipe dream, the technology itself does not. Google claims that it only wants to enhance the driving experience, and make it safer. Companies are already starting to jump on board, so increased automated driving technology will hit the market, even if only as an anti-crash safeguard.

When it does, look for Google, Continental, GM, and Volkswagen (NASDAQOTH: VLKAY) to lead the charge. Continental in particular is in good shape, having already established relationships with major automakers and invested heavily in expanding the driverless car market. In part because of its experience in automated systems (Continental helped develop some anti-lock braking technology, as well as adaptive cruise control), the company's partnership with BMW shows promise. The company even envisions automated relief signals in the event of a crash. And as with Google, potential revenue benefits are astronomical; its $32 billion revenue could easily expand 20% on account of new technologies. If it manages even greater penetration, that 20% could quickly balloon toward 100%.

All of this would simply add to a cheaply-valued company that has grown revenues every year since 2009. With the company's heavy investments in automated driving, an investment in Continental is a gamble on if the technology ever becomes mainstream. But, on the other hand, this is not a last-ditch effort by a struggling company, or even a start-up trying to make a name. This is an established auto supplier that consistently spends around 65% of its operating cash flow on capital expenditures--and is now devoting a significant portion of that cash flow toward automated driving. 

For Volkswagen and GM--the automotive industry leaders--the benefits are a bit more nuanced. If the two companies finish product development and put automation-equipped vehicles on the road, revenues will pop, but the two companies already feature significant high-volume, low-margin sales. That being said, developing their own product would give both companies a huge leg-up. In addition to cutting out supplier mark-ups, the two companies could set industry standards in the technology, leaving competitors scrambling for cheaper or more effective alternatives.That last benefit, coupled with the aforementioned revenue increases, would spring both companies to enormous profit increases and expanding profit margins. At GM's current market share, for instance, even an extra $500 per vehicle would mean almost $6 billion extra down the line. It's reasons like these that leave competitors, such as Toyota, already launching similar programs.

They also strengthen investments in both auto manufacturers. With lighter investments in the technology, both GM and VW will survive regardless of how profitable automated driving becomes. What's more, the companies already sport some pretty impressive fundamentals. It may be that automated driving simply adds an extra incentive to invest in the two automakers:

<table> <thead> <tr><th> </th><th> <p><strong>Volkswagen</strong></p> </th><th> <p><strong>General Motors</strong></p> </th><th> <p><strong>Industry Average</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p><strong>P/E Ratio</strong></p> </td> <td> <p>4.1</p> </td> <td> <p>10.2</p> </td> <td> <p>13.8</p> </td> </tr> <tr> <td> <p><strong>Debt/Equity Ratio</strong></p> </td> <td> <p>.41</p> </td> <td> <p>.78</p> </td> <td> <p>--</p> </td> </tr> <tr> <td> <p><strong>Gross Margins</strong></p> </td> <td> <p>18.25%</p> </td> <td> <p>7.1%</p> </td> <td> <p>--</p> </td> </tr> </tbody> </table>

GM still needs to improve its profit margin, but I have reason to expect that they will. Otherwise, the future looks rosy for both auto manufacturers.

More than anything else, investors simply need to keep a close eye on how these trends play out. Even if the associated companies never meet their most optimistic goals, the automated driving industry should add at least $15 billion overall, which is not exactly chump change. There's pretty good reason to expect, though, that the companies will come close to those aggressive goals, and that's good news for all the companies involved.

*Google's profit margins drastically exceed those of automakers, since it has lower commodity/material costs. Thus, the revenue increases look a bit misleading. That being said, even at 10% margins, $31 billion turns into a 10% increase in profit for Google.

A report by KPMG and the Center for Automotive Research was frequently referenced in this article.

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Will Chavey owns shares of Ford. The Motley Fool recommends General Motors and Google. The Motley Fool owns shares of Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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