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The road to telematics

Analysts are bullish about the market for cars boasting high-tech communications systems. But McKinsey is flashing a cautionary yellow light. Its advice: Choose investments carefully.

Backseat video, gadgets that automatically notify the authorities of a crash or help drivers navigate, sophisticated diagnostics, and their kin--in the mid-1990s all this was expected to bolster the stagnant car industry by offering a flood of new revenue.

But telematics, technologies centered on communications systems within cars, now seems less likely to alter the economics of the automotive industry so radically.

Telematics technologies might deliver an enticing variety of in-car services, which may still revolutionize the experience of driving. But carmakers aren't likely to capture a huge windfall from them. First, the total market won't be as big as predicted in some of the more optimistic forecasts. Second, the vehicle itself won't be critical to every application. Automakers should therefore shift their strategies and focus on dominating a few core telematics applications--not all of them. In the long run, investing primarily in the development of great cars while selectively pursuing telematics will have a much better payoff than pouring funds and management effort into a full offering.

Some analysts and executives, eyeing the fees and valuations cable television operators netted by offering information and entertainment services to a ready-made audience, have predicted that by 2010, total annual U.S telematics revenue could reach $40 billion. For carmakers, the lure has been the promise of a steady revenue stream from the subscription fees that their own captive audience--drivers--would provide.

As players in an industry whose growth is estimated to be 2 percent to 2.5 percent a year, it is hardly surprising that many carmakers want to grab a piece of the telematics pie. General Motors leads the pack. Its OnStar system, first installed in Cadillacs in 1996, is now available in 36 of GM's 54 models as well as in some cars from Honda (Acura) and Toyota (Lexus). OnStar's features include voice-activated telephoning, navigation, roadside assistance and remote diagnostics.

Another competitor is Wingcast, a joint venture created in 2000 between Ford Motor and the U.S. wireless provider Qualcomm. DaimlerChrysler and BMW, working with Texas-based ATX Technologies, are in the race as well. But the attractive revenue payoff these companies seek seems increasingly out of reach now.

To find the explanation, we considered four growth paths that telematics might follow over the next few years, looking particularly at potential differences in demand and in the availability of products. Although the most optimistic projections still have supporters, we believe that annual revenue will likely come to $15 billion to $20 billion.

Automakers should shift their strategies and focus on dominating a few core telematics applications--not all of them.
What will keep the market from reaching $40 billion quickly? Available technology and current demand simply don't support such rapid development. For the revenue of the U.S. telematics industry to approach $40 billion a year, every car off the assembly line would have to be fitted with a telematics system, and average monthly revenue would have to be at least $50 per car owner.

Comparisons with similar industries are enlightening. U.S. cable television subscribers, for instance, pay an average fee of about $35 a month, while the typical U.S. mobile-phone bill is about $50 a month. OnStar throws in a year's free subscription and thereafter offers three packages ranging in price from about $17 to $70 a month. If other offerings followed a similar price structure, at least 40 percent of telematics subscribers would have to enroll in top-tier plans. That seems unlikely.

Moreover, penetration probably won't reach 100 percent. McKinsey research shows that for a new automotive technology to achieve blanket penetration, a regulatory push (as in the case of air bags and fuel injection systems) is generally needed. For telematics, regulation may instead inhibit development as the authorities limit some applications that might distract drivers. Without a government mandate, the penetration of features rarely tops 80 percent and typically takes 12 years to reach even 50 percent. Niche products, such as power seats and car-based computers, spread out even more slowly.

Furthermore, strategies to increase the penetration of telematics come at a price. Most estimates suggest that it costs about $200 a car to install the hardware. Assuming a monthly subscription of $30 and a monthly profit to carmakers of $10 a subscriber, it would take 20 months to recover the cost of the hardware alone. Add a year's free subscription, and a car has to be off the showroom floor for almost three years before telematics begins to pay off.

Of course, some car buyers won't subscribe, and others won't renew after signing initially. If the hardware's cost isn't added to the sticker price--and so far it doesn't seem to have been--the paying customers will have to subsidize the hardware installed in all of the cars. For carmakers to recover their costs, about two-thirds of all owners of each model would have to subscribe. To be sure, equipment costs could fall over time, but competitive pressure on subscription fees could also erode whatever profit margin there might be.

We feel that in a more realistic short-term picture, telematics would be installed in half to three-quarters of all new cars, with average monthly fees of about $30. Foreseeable technology and a moderate increase in demand would bring the market to about $15 billion to $20 billion in all.

The limits for carmakers
How much of the potential revenue will actually reach the carmakers? When the buzz around telematics began, automobiles seemed the best candidate to be a star in a mobile world where everyone was connected anywhere, anytime. In those days, mobile phones were expensive, analog-based power guzzlers. PDAs were weak and rare; cars and trucks, by contrast, had enough electrical output to handle more powerful phones and other devices. Since then, mobile phones and PDAs have pushed cars from the limelight, and their diminishing role in consumer electronics works against automakers trying to capture the value from telematics applications.

Product life cycles represent another barrier for carmakers. Consumer-electronics companies often release several versions of a product a year, each version embodying changes in technology or consumer tastes. Carmakers, however, release new products every several years, with yearly iterations. Lead times required for car iterations can stretch out to months or years, putting automakers at a disadvantage.

It is unlikely that an automaker forced to develop a telematics offering several years before a car is launched will be able to make that offering attractive throughout the car's eight- to 10-year life span. When proprietary hardware is bolted onto a car with such a long lifetime, the problem is exacerbated. Standard interfaces might address it by allowing hardware to be installed late in the design cycle or even after the car was sold, but they would also allow third-party developers to bypass carmakers and market their own applications.

Even if consumers don't balk at feeding their carmakers information about their driving habits, those carmakers already have trouble sorting through the volumes of data available today, and telematics would add to the deluge.
Besides generating increased revenue, it was thought that telematics would help carmakers improve their relations with customers and differentiate their products more extensively. Customer relationship management (CRM) was expected to improve in several ways: through the entrenchment of relationships with consumers who subscribed to services, the provision of data on driving behavior (how much, when, and where cars were used, for example), and the ability to alert manufacturers when their customers' cars broke down and had to be rescued.

But even if consumers don't balk at feeding their carmakers information about their driving habits, those carmakers already have trouble sorting through the volumes of data available today, and telematics would add to the deluge. More contact with customers could certainly improve a carmaker's image, but the effects on business are hard to quantify, and companies have traditionally struggled when basing big strategic moves on such intangibles.

As for differentiating products, telematics might at first help distinguish the vehicles of a company from those of its competitors and thereby raise its market share. But this effect is likely to wane as more cars offer similar services. If a gadget proved tremendously popular with customers, rivals of the company that introduced it would probably follow with their own versions, quickly eroding its distinctiveness. In fact, as telematics becomes more commonplace, customers will likely demand standardization for ease of servicing and greater flexibility in applications.

A change in strategy
Carmakers have already sunk billions into telematics. We think the risks of investing heavily in this area are high for these companies, while the revenues remain uncertain. Moreover, telematics must compete directly for capital with the core business of vehicle design, which is what the market expects carmakers to do best. Vehicle design should be the priority, since its return on investment will be higher and more secure than the potential return from providing a full collection of telematics services. Telematics embodies higher risks for carmakers because they have little experience in the field, and the consumer market remains untested. Therefore, carmakers should pursue telematics selectively, choosing the most promising areas for investment and keeping options open in others.

Look at the numbers. Designing a new vehicle based on a common platform or chassis costs $300 million to $500 million. A popular design, such as Chrysler's PT Cruiser or Ford's Expedition, can add more than $500 million to the maker's operating profit annually during the model's four-year life span. Although the carmakers have a century of experience, successful car designs remain elusive, and less than 10 percent of all designs are hits. Of the remainder, about 70 percent are modest successes, generating $100 million to $500 million in annual operating profit, and about 20 percent fall below this level, often making no operating profit at all or losing money. On average, $500 million invested in a new automobile design might return $600 million--a 20 percent return on incremental investment. Some years are good and some bad; the overall return is unexceptional. But the mix of hits, modest successes, and misses moderates the risk carmakers face.

Compare these returns with the likely risks and returns of telematics. The carmakers' current business models provide for a full suite of telematics services and the supporting infrastructure, demanding hundreds of millions of dollars a year in up-front investment. Optimistically, the payoff could reach $750 million a year, but profits would take several years to reach this level. Our research suggests that investing several billion dollars in a full-scale telematics package could bring carmakers returns of 15 percent to 20 percent under the best-case scenario and much less under the pessimistic ones. But even in the most optimistic conditions, the returns would roughly equal those of a good car design, while the risks would be much greater.

Given the unattractive risk-reward profile, selective investments in telematics make more sense. The selective approach raises two questions. First, is an application's value proposition credible? Right now, all telematics players--carmakers and others--are struggling to understand what features customers are willing to pay for and how much they are willing to spend. Given the uncertainty around demand, a probe-and-learn strategy, in which companies make many small bets on a number of applications and gauge the response, might be most appropriate.

The second question is whether carmakers are the natural owners of the businesses surrounding a given application. Carmakers know about air-bag sensors, for example, and are thus in a good position to develop applications such as crash notification systems that rely on data from them. Carmakers would also be well positioned to take ownership of applications (for instance, diagnostics equipment) that require integration with vehicles.

Choosing your application
Three applications satisfy the criteria for ownership by carmakers: reselling mobile-phone time, safety and security, and telediagnostics. The former makes sense because the carmakers can deliver millions of customers and thereby eliminate the big acquisition costs facing wireless providers. By purchasing wireless time at bulk discounts, carmakers should be able to resell it at a profit to their telematics customers and remain competitive with companies offering standard wireless rates. A significant portion of the carmakers' profits from telematics will probably come from this source.

Automakers can also claim ownership of the telematics markets for safety and security and for telediagnostics. These services--such as systems that use wheel-based sensors to warn drivers when their tire pressure is low and systems that alert call centers when air bags inflate--must be tightly integrated with vehicle systems. Safety-and-security hardware must be able to call for help after surviving crashes that destroy vehicles. Designing such gear requires the automakers' expertise.

Vehicle design should be the priority, since its return on investment will be higher and more secure than the potential return from providing a full collection of telematics services.
Telediagnostics devices must also operate in the harsh environment under the hood, where temperatures range from below freezing to beyond boiling, and components are exposed to rain and road debris--clearly not the normal environment for consumer electronics. Here, too, carmakers have accumulated expertise that strengthens their right to ownership.

In these cases, carmakers should seize control of the applications and invest to become leaders in them. But instead of putting telematics hardware in all cars, these companies should offer it as an option and target customers who are relatively likely to subscribe to the services. This approach not only lets the carmakers concentrate on customer demand but also eliminates the hidden subsidy of giving away hardware to customers who end up not subscribing.

Carmakers should also crank up their marketing machines to create demand for these features and ensure that their customers benefit from the ability to get discounts on mobile-phone time. By offering below-off-the-shelf wireless fees, carmakers can migrate their customers from mobile telephones to telematics systems.

Playing a supporting role
If the value proposition of an application is clear but carmakers are not its natural owner, they should avoid large investments and instead attempt to capture part of the value, typically by using their vehicles to enhance the application. Into this category fall two applications--driving services (navigation, traffic reports) and in-car commerce--that can be provided or installed relatively easily after cars are purchased but work better if integrated into them. If automakers aren't the natural owners, which companies are?

Content and hardware providers will likely be the key players in applications such as navigation and traffic reports, which require a reliable voice-activated interface plus sophisticated software that can solve real-time problems. In-car commerce would call for products that people want so urgently as to purchase them from behind the wheel. No such products have yet emerged, but one offshoot of the application is worth noting: transactions closely linked to the telematics equipment already installed in cars. An auto insurer, for example, could gather location and usage data from vehicles equipped with OnStar and use this information each month to adjust premiums to actual risk.

Automakers also seem better-positioned to support rather than own the operations of a solutions provider: a company that offers a range of services centered on gathering information and delivering it to vehicles. Companies that have experience integrating information from disparate sources and the ability to keep down labor and other costs will have an advantage in providing solutions using telematics. These companies could range from established portals such as Yahoo to experienced call-center operators such as AT&T. Carmakers, which typically pay union wages and have little experience specific to these applications, do not appear well-positioned to enter this charmed circle.

To play a supporting role in these applications and claim some of the revenue from them, carmakers must form alliances with key players to ensure that the applications are enhanced by a car's design. Consumer-electronics companies might, for example, offer both systems that integrated telematics content (traffic reports, navigation directions) into the stereo systems of cars and built-in microphones tuned to the cars' acoustics. While the potential revenue for solutions providers is large, the investment carmakers would have to make to develop the necessary infrastructure and expertise in operations such as call centers makes this a difficult road.

Waiting in the wings
Finally we come to applications whose value remains murky. Although these applications--including high-bandwidth information and entertainment as well as bureaucratic applications such as the automatic registration of vehicles and certification of up-to-date insurance coverage--may hold dizzying potential, they are too uncertain and too recent to justify huge investment by carmakers now.

In general, such applications require a car's telematics system to accommodate many of the customer's portable devices, such as a PDA or mobile phone, in addition to content ranging from games to movies for backseat passengers. To stay involved in these areas without investing massive amounts of money, carmakers should consider options that allow them to add and subtract applications quickly rather than develop a multi-featured product that would be expensive though likely to fall short of what customers need.

Carmakers could, for example, install sockets allowing several hardware configurations to be plugged into the telematics hardware. Then they could license access to these sockets to applications developers. The danger for carmakers from this strategy is that by providing a standard interface, they would help outside developers create compatible applications.

Times have changed since telematics arrived as a white knight and carmakers seemed destined to lead the mobile world. Today, those betting on a full suite of telematics services face strong competition from entrenched devices such as mobile telephones and PDAs. To win by providing a full suite, the automakers would have to force their customers to pay for overlapping services and somehow make those customers at least partly satisfied with last year's technology--a difficult proposition. When carmakers update their telematics strategies, they must abandon the hype that surrounded the field, focus on building great cars, and carefully choose where to invest.

For more insight, go to the McKinsey Quarterly Web site.

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