The auto industry is unloved. Investors worry that profits have peaked, given a sustained period of over-supply and as vehicle demand slows into weaker economic growth. Meanwhile, it’s becoming increasingly important for car makers to invest if they want to remain relevant in a world of electric vehicles and autonomous driving.
Few investors have considered how the transition might look in practice and if the industry may actually stand to benefit. As investors in disruption, this is a hugely interesting idea to us. Controversy always offers opportunity and this becomes even more valuable as bull markets1 grow long in the tooth.
In Europe - the vanguard of environmental action against internal combustion engine emissions - the market is struggling to see how auto manufacturers can find a profitable way forward. From 2020, the EU will impose a fine of €95 per gram, per vehicle of carbon dioxide (CO2) emissions over 95g/km, based on a fleet average.
This alone could wipe out the profits of most auto manufacturers if it were to be implemented without any response.
The extreme alternative is to move to fully electric powertrains. A powertrain in a car includes the engine, transmission, driveshaft and any of the internal workings of the engine. In this case, zero emissions would mean zero fines. But this would erase profits too, as fully electric vehicles are currently loss-making due to expensive battery packs and the lack of economies of scale.
However, there are short-term work-arounds and longer-term solutions. We believe investors may be severely underestimating the ability of auto manufacturers to survive, or even thrive, using short-term fixes and as gradual a transition as costs permit. Furthermore, government assistance is highly likely, as the importance of the sector from a revenue, employment, trade surplus and innovation perspective is underappreciated.
A short-term solution mooted by automaker BMW, is to introduce small batteries to create plug-in hybrid vehicles. Toyota also offers hybrid equivalents of many of its models. These engines would still primarily rely on an internal combustion engine, but could comfortably avoid fines due to lower emissions. Part of the saving made in avoiding the fine would of course be offset by the cost of the battery pack, electric motor and power convertors. According to our figures, this option would diminish profit margins, but the outcome is still better than the “do nothing, pay the fines” route, which sees profits entirely eradicated.
What’s more, car companies are not only offering equivalent plug-in hybrid vehicles, but in general they tend to increase their prices. The price hike for the equivalent vehicle, compared to its pure internal combustion engine version, is between 5% and 11% for BMW. For Toyota, the range is an uplift of between 3% and 18% for a car of the same specification. For companies with this pricing power, the prospects for profitability of hybrid cars can be transformed.
A significant concern for investors has been how the transition to fully electric vehicles will be profitable, given the significant current premium on electric–only cars. This is an issue at the moment due to the high price of batteries and the concerns overlook how rapidly battery costs are falling.
Battery pack costs have been falling at an average of 22% per annum this decade, according to Bloomberg New Energy Finance, reaching $176 per kwh in 2018. By 2024, the cost is forecast to have fallen to just $94 per kwh. Along with density improvement of 6% per year (a lighter battery producing more power), we believe a battery pack - capable of producing a 300 mile range for a car like a BMW 3-Series - is likely to cost around $5,640 by 2024. At that cost, and also removing the price of the internal combustion engine, we have found that fully electric drive trains can materially increase profitability per vehicle, in stark contrast to consensus expectations.
A lot of this “best case” scenario relies upon higher prices, but the car industry has historically found them difficult to deliver. So, will consumers pay 20% more for a car next decade?
The table below shows that while US disposable income and auto expenditure increased by 41-44% over the past decade, within autos it was very much a story of volume rather than price. North Americans chose to buy 5 million more cars in 2018 than 2008 (a rise of 30%) but their spend per vehicle grew by just $1,800 (+8%).
| North America | 2008 | 2018 | % change | Abs. change |
|---|---|---|---|---|
| Units (millions) | 15.8 | 20.6 | 30% | 4.8 |
| Spend per vehicle (USD) | $23,127 | $24,963 | 8% | $1,836 |
| Autos spend (USD, billions) | $365 | $514 | 41% | $149 |
| US disposable income (USD, billions) | $10,941 | $15,774 | 44% | $4,833 |
| Auto spend/disposable income | 3.3% | 3.3% |
Supply-side factors may have also influenced these numbers. In Europe in particular, the industry has suffered from over-capacity for decades as national governments are always reluctant to see plants closed.
Naturally, many question whether consumers will be willing to pay more for electric vehicles and if the industry will maintain sufficient pricing discipline. In attempting to answer both of these questions, it will be important to differentiate between the “mass” and “luxury” ends of the auto market.
The running costs of electric vehicles are estimated to be one third of vehicles with internal combustion engines. Proponents say this offsets the higher upfront pricing. While this is true, we are sceptical that this will convince most consumers.
Human beings are typically poor at weighing cost now versus savings later (this is known as the “present bias”). That said, higher levels of absolute wealth also enable greater flexibility in thinking long term, so the luxury end should prove more receptive.
Investors should not under-estimate the importance of the sector to governments when assessing why the public would bother to convert. According to the ACEA (the European automobile manufacturer’s association), the European auto industry employs 13 million people. This equates to 6% of the EU workforce. The industry generates an €85 billion trade surplus, yields €485 billion in tax revenue and spends €58 billion per annum on research & development (28% of total EU R&D spend).
In Germany - Europe’s economic powerhouse of the last decade - the importance is even more pronounced. The autos sector contributes over $500 billion of output per annum, 65% of which is exports. It generates 15% of German GDP and much more when one considers indirect effects such as housing, general consumption etc. As a proportion of its home economy, the German auto sector is bigger than US tech.
Governments are therefore likely to play a much bigger role in the transition to EVs than many believe. Subsidies for EV purchases already exist in several EU markets and could be expanded. Duties on petrol or diesel could be increased to incentivise people to switch, while financing schemes can bridge the present bias gap described above.
It is also conceivable that other sectors may be drawn in to help this effort. Why should auto manufacturers carry all of the burden? BP’s Annual Energy Review for 2018 notes that “electrification without decarbonisation” is meaningless i.e. if an EV’s source of electricity is actually a coal-fired power station anyway, the net benefit to society and our environment may be zero. This bodes well for the renewable sector in our opinion and we expect more positive steps to be taken, potentially lifting some of the burden from autos.
The moving parts are in place. The transition to plug-in hybrid vehicles and EVs looks set to positively surprise the market. If the industry can adjust their prices on top, the potential increase in profits could be enormous. In short, investors may be severely underestimating the ability of auto manufacturers to survive, or even thrive, using short-term fixes and as gradual a transition as costs permit. Furthermore, government assistance is highly likely, as the importance of the sector from a revenue, employment, trade surplus and innovation perspective is under appreciated.
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1. A bull market is broadly defined as one that rises over time without falling more than 20% from its peak during the period.↩
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