Frustrated carmakers upend industry after chip shortage shatters their faith in suppliers

Frustrated by how his suppliers have bungled the procurement of critical semiconductors, the head of operations for Mercedes-Benz is taking matters into his own hands.

“The chip (crisis) is not giving me any rest,” admitted Markus Schäfer during a press briefing earlier this month.

In order to prevent another shortfall from crippling production in the future, Mercedes is dispensing with the usual industry etiquette and talking directly with semiconductor manufacturers. The aim is to contractually ensure the carmaker’s array of suppliers won’t continue to be always fed by the same gigantic foundries—usually a limited few found in Taiwan. Going forward, he said, his European car plants will ideally source their processors locally rather than importing from Asia.

“In a more volatile world, whether it be the climate crisis or a pandemic, we want to be more resilient when it comes to chips,” he said.

Sidelining his traditional Tier 1 suppliers, which deliver the parts straight to Mercedes assembly lines, is a drastic step by industry standards. Yet Mercedes is not the only one to enter talks directly with chipmakers, and given the extent of the crisis, it’s not hard to see why. On Thursday, consultancy AlixPartners said it expected roughly $210 billion worth of revenue to be lost as automotive production is halted over a lack of semiconductors, nearly doubling its estimate from May.

One of these elite suppliers, Robert Bosch GmbH, did not dispute the direction its customers are moving. But it did take issue with the portrayal that automakers were caught entirely off guard when the necessary parts could not be delivered to the assembly line.

Not only did some brands have the foresight to stockpile a greater number of chips, according to a senior Bosch executive, but proposals made prior to the crisis to approve the design of alternative chips for a rainy day were ignored.

“Did this always meet with a lot of enthusiasm? The answer was no, since that would have met much higher development costs,” Bosch’s Markus Heyn told Fortune. “Now I think the benefit of having a back-up solution when there’s a crisis is well understood.”

Heyn’s company knows what it’s talking about as it has decades of experience in this field: Bosch happens to be a rare exception among its peers in that it manufactures its own semiconductors in-house and recently celebrated the opening of a €1 billion ($1.2 billion) chip fab, its largest individual investment ever. As fate would have it, though, the shortfall is predominantly in older microcontrollers rather than the latest specialized ASIC circuits that emerge from Bosch’s brand new clean room in Dresden.

Fewer cars built equals more profit made

Fortunately for carmakers, investors have been relatively complacent about the chip scarcity, even celebrating the shortage after it became clear that it was forcing carmakers, often called “OEMs”, to finally de-escalate the ruinous price war that has been a hallmark of the industry for so long.

Arndt Ellinghorst of Bernstein Research highlighted the peculiar phenomenon last week in a report, citing as proof the highest collective first-half earnings, margins and cash flows carmakers had ever recorded in their history.

“Isn’t autos a funny industry—the fewer cars OEMs sell, the more money they make. The current pandemic and semi shortage have forced OEMs to produce fewer cars, which has lifted pricing, mix and residual values,“ summed up the veteran autos analyst.

Creating artificial scarcity has long been the strategy of luxury brands like Porsche. It turns out that if every automaker followed the approach of always delivering one car less than their customers demand, returns would suddenly soar.

This isn’t to say that the industry takes the crisis as lightly as investors just because they’re enjoying fat profits. First off, carmakers need a supply chain healthy enough to continue providing all the content found in a car. With fewer vehicles manufactured, every company that makes parts that are built into a car ends up paying the price for the chip crunch. The last thing automakers need now is for key companies lower down in the chain to go bankrupt as a result.

“While OEMs can compensate with higher vehicle prices, suppliers are struggling and are much more affected by the shortage in semiconductors,” said Marcus Kleinfeld, managing director at AlixPartners in Germany, in a statement.

Secondly, profits don’t pay bills—cash does—and automakers need a steady stream of revenue to meet the interest payments for their captive financial services subsidiaries. Much like commercial lenders, their business model is predicated on taking on debt in order to provide attractive conditions for loans and leases that can move metal off dealer lots.

Finally, car buyers tend to be more often than not loyal repeat customers. Premium brands have had so much success in recent years at the expense of their volume counterparts in part because they moved downmarket.

By attracting demand from young buyers, they gain access to a greater pool of clients who often remain with the brand as their income and wealth grows over time. The business is typically zero-sum, in other words: if you don’t make the sale, chances are your competitor will and you end up losing a customer, potentially for life.

Consequently, carmakers like Mercedes are fundamentally reevaluating their relationship with the semiconductor industry—previously, a link so far down the chain that even those managers with responsibility for ensuring a smooth flow of production knew little about the inner-workings of the sector.

‘Ain’t seen nuthin yet”

The head of procurement for Volkswagen Group, the world’s second largest carmaker, wants to circumvent his Tier 1 suppliers by building up his own independent ties to companies like Taiwan Semiconductor Manufacturing Company. And that could just be the start.

“We’re also considering whether we should begin designing our own chips,” VW Group’s Murat Aksel told German business daily Handelsblatt in June.

The reason brands are taking matters into their own hands is the growing importance of software. Tesla has proven that expertise in this field will be the key competitive differentiator in the future. The processors on which their firmware will run will become so critical to the equation that traditional carmakers can no longer afford to leave their choice in the hands of their Tier 1 suppliers.

Forecasts suggest the conclusions of Aksel, Schäfer and of course Tesla, are accurate. Intel estimates that the share of semiconductors in a premium brand car’s total bill of materials will jump from just 4% today to 12% in 2025 and eventually reach a full fifth by the end of the decade. By that point the automotive chip market will be worth $115 billion versus $80 billion in 2025 and only $50 billion this year.

“Semis become central to every aspect of innovation and the supply chain for cars. As important as it is today, you ain’t seen nuthin yet,” Intel CEO Pat Gelsinger said during a keynote address in Munich.

This summer, [hotline]Volvo[/hotlink] inked a deal with graphics chip specialist Nvidia to access their latest technology for highly automated driving. Mercedes went a step farther last year and outright cancelled their self-driving cooperation with Stuttgart neighbor Bosch in order to pair up directly with Nvidia instead.

For Mercedes-Benz’s Schäfer, the next step is to radically slash the sheer variety of semiconductors found in cars, for example through standardization: the Nvidia Orin processor will be rolled out across all Mercedes models from the humble A-Class compact hatchback to the luxury Mercedes-Maybach S-Class. Tier 1 suppliers will effectively have to buy the semiconductors the brand tells them to.

“We want to be in control in the future, determining which chips are built into each individual control unit,” Schäfer said.

This suits chipmakers like Qualcomm perfectly. The fabless semiconductor provider hopes to extend its dominance in smartphones to passenger cars in the future, and sees this playing straight into their hands.

“Although they are not our customers, it’s critical for us to talk directly to the automakers so we can design our roadmaps according to their requirements. Mediation by Tier 1 and Tier 2 suppliers is not really needed,” Qualcomm Europe president Enrico Salvatori told Fortune. “We’re quite used to this model, because it’s analogous to smartphones, where we work a lot with operators like Deutsche Telekom and Vodafone, even though do not buy chipsets from us.”