Automakers: Driving Over a Cliff?

In 1974, on what was likely a smoggy day in downtown Los Angeles, a young progressive named Jerry Brown won California’s Governorship, in part, on a mandate to fix the State’s deepening pollution crisis. Over the following years, California’s environmental regulator began introducing the world’s most draconian vehicle emission, mileage and fuel standards. As the world’s largest auto market, California’s legislation had a disproportionate impact on the research budgets of automakers, spawning major innovations like catalytic converters, ultra-efficient engines and lightweight materials.

The most consequential legislation, however, came in the 1990s, when California mandated that zero-emissions vehicles had to comprise a small portion of each automaker’s annual sales, or be forced to buy emissions credits. This was, in effect, one of the world’s first carbon taxes, and while it was met with open hostility from industry executives, it probably marked an imperceptible tipping point for electric vehicle (EV) development, now 25 years ago.

In the years that followed, research breakthroughs and smart engineering slowly made the huge costs and daunting physics required for electric driving slightly less overwhelming. New technologies trickled into vehicles, first in the form of ‘conventional’ hybrids (1998), then plug-in-hybrids and battery electric vehicles (BEVs) with acceptable driving range (2008). Despite this, EVs remained a footnote in the broader industry, with small research budgets implying inherent doubts around whether EVs would displace the tried-and-tested internal combustion engine.

This view, however, has changed dramatically over the last 24 months, fuelled by accelerating advancements in battery technology, rapidly falling costs, regulation, rising consumer interest and perhaps most importantly, the success of entrants like Tesla. BEVs have now firmed as the market’s chosen solution (for now) to lowering the auto sector’s carbon intensity. There is also rising confidence that EV ownership costs can fall below conventional powertrains in the coming years, making them a viable option for a broad swath of consumers. An added industry complication is the prospect of autonomous driving, which has been enabled by advances in computing power, reduced hardware costs and the advent of artificial intelligence.

The seemingly inevitable shift of a large part of the market towards EVs as well as the potential for autonomous driving, raises fundamental questions around the future structure of the industry. EVs require new supply chains, new expertise in battery chemistry, a mastery of software and new manufacturing techniques. This array of newly required technologies and skills does not play to the historic strengths of the existing automakers and their suppliers, whose internal innovation and pace of change is additionally hampered by the maintenance of their old, yet still highly profitable legacy businesses.

This has opened the door to a flood of new entrants, including entrepreneurs, governments, quasi state-backed companies, and large businesses currently serving different industries seeking to exploit gaps left by incumbents.

The prize for whoever can crack the EV market and its various sub-segments (manufacturing, components, infrastructure, software, batteries) is massive. The sheer scale of the industry, means even taking a small share of the pie could be incredibly profitable. The pie gets even bigger if we also try to estimate the potential value of the autonomous driving economy.

The market has to date, responded enthusiastically to new entrants, with their valuations implying that they not only will collectively take large market share, but will also become highly profitable. The new EV entrants that are publicly listed are cumulatively valued at close to US$800 billion and have raised close to US$50 billion in new capital, which is despite large losses, and in many cases, products are either still being proto-typed or not available in large volume.^[1] These figures do not include the long tail of large unlisted start-ups, meaning the cumulative valuation and capital raised is likely to be far higher again.

This is remarkable when considering the established auto industry (including brands and suppliers) has a cumulative market capitalisation of around US$2 trillion against a pre-pandemic profit pool of over US$180 billion.^[2] Put another way, the listed value of the auto industry has increased by half, despite the low penetration of EVs and no clear indication (yet) that the industry can become inherently more profitable, or that the industry has escaped its historically high competitiveness, capital intensity and cyclicality. Historically, the opposite is true. When industries attract capital and new entrants, they go through prolonged periods of lower profitability and higher competitiveness, particularly when disruptive technology is involved.

Fig 1: Market Capitalisation: Legacy Autos vs. New EVs (US$ millions)

Source: FactSet Research Systems

Much of the market’s enthusiasm has been focused on new brands themselves, which have proliferated over the last 10 years, as they exploited the apparent gaps in the market left by slow-moving legacy automakers. They have also taken advantage of innovative financing instruments like special purpose acquisition companies (SPACs), which offer private companies an alternate and simpler route to listing on a public market.^[3]

Tesla is the most prominent, owing to its crown as both the largest EV manufacturer (producing around 500,000 vehicles in 2020), as well as its US$614 billion valuation (reaching over US$1 trillion at its peak in February 2021),^[4] which is roughly the size of the entire Western legacy auto market combined. Tesla shot to fame due to its high-profile CEO, innovative use of battery technology and ‘software first’ approach to car design. The secret ingredient to Tesla’s success, however, is likely its high vertical integration, which is unique in the auto world. The company designs its own battery cells, computer chips and software. It also manufactures a high proportion of its value-added parts (including battery packs, motors), assembles its own vehicles, sells directly to consumers and runs its own charging network. This vertical integration was necessitated by holes in the nascent electric vehicle ecosystem at the time, and means the business is closer to its customers, can run on lower costs (by shaving supplier margins) and innovate quickly. However, the downside of this model is that it ties up significant capital and leaves the business chronically reliant on growth, which can be dangerous in a cyclical and competitive industry.

Tesla’s success has paved the way for other EV-focused competitors, particularly in China, where the opportunity is the largest and the Government’s will to dominate the EV market is the strongest. The three most prominent entrants are XPeng, Li Auto and NIO, which have each followed a relatively similar route to market as Tesla. All are founded by ambitious tech entrepreneurs, have high-profile backing companies (including Alibaba, Foxconn, Xiaomi, Tencent, Baidu) and have vehicles with similar software and battery specifications to Tesla. These companies are scaling up quickly and are collectively expected by analysts to produce over 200,000 units in 2021, which compares with Tesla’s China sales of close to 150,000 in 2020.^[5] Gross margins are now also positive and are increasing alongside volumes. Their collective valuation at US$90 billion (10-25x trailing twelve-month sales) suggests the market expects this growth to continue.^[6] Perhaps the highest expectations are around China Evergrande, which is valued at US$78 billion, despite the company having no prior auto manufacturing experience and largely remaining in pre-production phase for its EV ambitions.

In the US, new EV entrants have taken slightly different approaches, with most generally less ambitious than Tesla and their Chinese start-up peers. These companies (e.g. Rivian, Lordstown Motors, Bollinger Motors, Fisker) are still largely in pre-production phase and taking a lower-risk approach to expansion, including targeting small niches not currently served (e.g. pick-up trucks, larger SUVs, performance sedans). They are also using lower-cost approaches to vehicle development, including the use of existing off-the-shelf technology. Fisker is perhaps the most extreme example, which has outsourced nearly every single technological aspect of its business model, including the use of contract manufacturing, with the company in essence, a capital-light brand. The valuation of US EV entrants (excluding Tesla) is also remarkable, with these brands collectively valued at ~US$47 billion, which is more than Ford,^[7]despite none of them having delivered a single vehicle, questionable intellectual property, unproven brands and many being asset light.

Perhaps the biggest disruption to the entire industry, including new entrants, may come from the emergence of large-scale contract manufacturers like Hon Hai Precision (the parent company of Foxconn – the producer of Apple’s iPhone). Hon Hai is pursuing a radically new approach to car development, which is based upon developing an ‘open source’ EV platform (see Fig. 2), with the goal being to cut costs by fully modularising all aspects of design, including hardware, electrical architecture, software and other applications. This leaves auto brands to choose parts/powertrains off a ‘shopping list’ and then design the upper body exterior themselves. An EV start-up named Canoo offers an example of the possibility of a modular platform, with simplistic delivery vans, pick-up trucks, sedans and ride-sharing cars all possible with one modular design.

Fig. 2: ‘Open Source’ EV Platforms – A Radical Approach

Source: Morgan Stanley 

Modularity has the potential to considerably lower costs, given a single platform and powertrain can theoretically be scaled over an infinite number of vehicles, which compares with the largest platform programs at Toyota and Volkswagen today, which produce an average of two to three million vehicles each per year.^[8] This could also solve one of the largest historic problems in the automotive space – the billions of dollars of overlapping research and development (R&D) and capital expenditure, which go into technologies that are ‘under the hood’ and indiscernible to consumers that are duplicated at each automaker – this is up to 50% of the total development cost of a car. To date, Hon Hai has signed over 1,000 partners/developers and has also signed agreements with automakers like Fiat-Chrysler, Fisker and Byton (though the scope of these arrangements is unclear).

A modular hardware platform could also mean consumers place more value on software and ‘killer apps’ than on the cars themselves, opening the door to tech goliaths like Apple, Google, Baidu, Didi and Huawei to enter the auto space. These firms, if they enter, will likely be focused on developing a fully autonomous vehicle, which could displace vehicle ownership as we know it, and allow companies to offer transport as a service and monetise consumer time inside vehicles with high-margin services. This is a daunting prospect for both legacy manufacturers and recent entrants, though given the most sophisticated driverless technology still requires consistent human intervention, truly autonomous driving that can handle the multitude of ‘edge cases’ that humans expertly deal with could still be decades away. The delayed timelines for existing leaders like Cruise (General Motors) and Waymo (Google) point to the difficulty of safely replicating human driving.

Based on this evolving landscape, one may be led to believe that legacy manufacturers and brands could be ‘finished’, firstly by new EV entrants and then over the long term, by the tech entrants. Indeed, their ultra-low valuations imply the market thinks that the legacy manufacturing businesses are close to worthless, particularly when considering the equity in their profitable lending arms and cash on hand.

We’re less sure it is likely to be this universal, with a formidable and credible response seemingly underway by many of the largest players.

The legacy automakers and their base of suppliers have been pouring billions of dollars into the development of their own EVs for a number of years with now promising results. The latest generation of vehicles are competitive with leaders such as Tesla on factors like range, acceleration, efficiency, connectivity and price. Furthermore, it is likely that EV functionality will soon exceed the minimum use for a vast majority of drivers, making the tech advances from leaders less valuable, at least for a large portion of the market.

This is likely why Elon Musk has stated that manufacturing will form a key part of Tesla’s long-term competitive advantage, and is where the legacy manufacturers still have some form of edge. It is hugely challenging to produce a car every 45 seconds on an assembly line that can meet safety standards, is of sufficient quality to withstand a typical four-to-eight-year warranty, and importantly, is profitable. For this reason, making cars has been described as a game of ‘picking up pennies’. In addition, most automakers can handle multiple powertrain types, multiple vehicle types, and individual customer specifications, down a single line. This flexibility is a key point of differentiation against new entrants and contract manufacturers, which thrive on scale and modularity. The legacy manufacturers also have other defences against modular vehicle concepts. While modular vehicles will likely have lower costs, traditional automakers will still have full control over their R&D spend, are better able to differentiate their products, better serve market niches, and have better control around safety and quality – a survey of the current auto market and indeed, most consumer goods markets, suggests consumers highly value individuality, choice and safety, as well as many of the other features of legacy autos (e.g. financing, servicing, warranties).

Finally, while the final shape and timing of the autonomous driving market is still playing out, it is likely that the legacy automakers will be competitive, owing to their own increasingly sophisticated software stacks, as well as deep technology partnerships of their own (e.g. NVIDIA, Intel).

Taking these points together, we think it is premature for the market to collectively ‘write-off’ the legacy automakers and ascribe such large valuations to unproven brands, particularly in an industry that has demonstrated consistently poor economics for new entrants and sub-scale players. Some, though not all, legacy brands are still likely to thrive in the coming years, particularly those with innovative technology and very strong consumer brands. We think the ultra-low starting valuations, highly profitable legacy businesses and compelling new EVs make some of these legacy companies attractive investments.