Automotive industry: the calm before the storm
The automotive industry in Europe seems to have stabilised as supply chain problems and cost inflation due to the Covid-19 pandemic have eased. However, the shift towards electric vehicles is profoundly affecting the sector and presents challenges for traditional manufacturers. The shift is squeezing car companies' margins through a decline in profitable combustion engine cars and low utilisation of electric vehicles. The semiconductor shortage, which affected the industry in 2020 and 2021 has shown that automakers prioritise prices over volumes. This has translated into high margins despite record lows in the number of cars sold. Competition in the sector has also increased with the rise of a well-known American electric car maker and its disruptive autonomous driving technology. Disruption stemming from AI-based technology is set to not only affect the automotive market but also the mobility sector as a whole.
By Philipp Stumpfegger, Portfolio Manager & Sector Analyst Automotive and Industrials at DJE Kapital AG
Growing pains for the electric vehicle sector
At first glance, the European automotive industry seems to have calmed down after disruption from the Covid-19 pandemic and the semiconductor shortage. The post-Covid-19 supply chain issues for semiconductors have been largely resolved, cost inflation has now returned to normal, sales figures are exceeding pre-Covid-19 levels and most automotive companies are achieving margins close to record levels. However, the electric vehicle transformation is fundamentally changing the automotive market - not only from a technological perspective, but also in structural and financial aspects.
We note that the global automotive market usually only grows at GDP rates over the cycle even if electric vehicle production and demand is rising fast. Therefore, the sector as a whole is not growing at the rates some OEMs (large carmakers) or suppliers’ numbers would suggest. According to IHS Markit forecasts, global car sales are expected to reach 87 million vehicles in 2023, which would be above average in the context of the last decade.
However, the supply of electric vehicles has strongly increased and at the same time the electric vehicle market has seen high rates of consolidation since its inception. In China, for example, the number of electric car companies has fallen from around 500 to almost 100 since 2019 - some high performing companies with enormous growth plans have emerged in the region.
Changing strategies in the automotive industry
In the global electric vehicle industry, there is also considerable competition from the US, primarily from a well-known American electric car manufacturer. We are not going to make a statement here about whether the listed company is an AI technology company on the verge of a revolutionary breakthrough in autonomous driving, or a completely overvalued conventional car manufacturer.
However, what is clear is that Elon Musk’s company is pursuing a business strategy with far reaching consequences for the industry as whole. The company currently manufactures almost 500,000 cars per quarter, or about 2.3% of the world market, with an upwards trend. From 2030 onwards, the company plans to sell 20 million vehicles per year, which is more than the two largest manufacturers Toyota and VW combined. Even with moderate market growth rates (2% CAGR), this would mean a market share of about 20%. While this ambitious target is anything but certain, it’s an indication where things are potentially headed. The electric vehicle pioneer proved in the past that it can deliver on its targets.
In 2015, for example, many market observes had doubts whether it could achieve the announced sales target of 500,000 cars for 2020. In the end, the company came very close to this target – falling short by just 450 cars.
At this point, the management of the electric vehicle company is not prioritising maximising profits and focusing on further developing its autonomous driving system. Unlike many other manufacturers, the technology is based on camera-supported artificial intelligence (AI) learning, so increasing the number of kilometres driven with its FSD (Fully Self Driving) solution is the key to success from the company's perspective. In other words, the goal is to push as many cars as possible into the market in the short term, even if the margins suffer.
With its proprietary self driving solution, the company would once again have an extremely disruptive technology at its fingertips. Robotaxis, one area the company is working on could potentially become the cheapest means of transport in terms of cost per kilometre- even more cost-effective than taking the train. For the taxi industry, business models such as Uber or even traditional rental car companies, a breakthrough in this area could lead to considerable upheavals – and would have far reaching consequences for the transport sector as a whole.
The effects of the American pioneer’s strategy are already evident in the market. Management has cut prices for the seventh time in a row this year - most recently in China last month. What is concerning for the competition is that the car and battery manufacturer has comfortable headroom for further price cuts due to its efficient production and high margins. The management probably takes a pragmatic view- if demand falls significantly below the planned volume, the customers must be stimulated with more attractive prices.
The electric carmaker is not the only company in the automotive sector with strong growth and ambitious plans. Another example is a leading Chinese manufacturer, which is currently the largest electric car producer in the world (as of 2022, including hybrids). The highly integrated group entered the European market this year and plans to enter the top 5 in Europe in the mid-term. A rumoured acquisition of the mothballed Ford plants in the German town Saarlouis could further accelerate the company's European expansion and shield it from protectionism. Chinese passenger cars have been gaining ground in Europe in recent years – and this trend is likely to continue.
German carmakers' exports shift into reverse gear
A similar trend is also emerging looking at exports. Since 2019, Chinese carmakers exports have risen while German and Japanese companies have tended to lose ground. This trend is likely to continue, even if the threat to European manufcaturers tends to be downplayed within the industry. The manufacturing capacity of electric vehicles is expanding but demand will most likely not be able to keep up. In terms of car volumes, the industry is almost a zero-sum game - what one gains in market share, another must lose.
Electric car margins likely to depress market share gains
There are two problems with electric car margins.The battery is the most expensive part of the car, which is clearly not a relevant cost item for combustion engine cars. This is why the electric version of the same model is generally more expensive than the “traditional” version. In Germany, for example, the basic price of an electric Mini is about 20% more expensive than the combustion engine version.
This means for large models, which require large batteries, the cost is proportionally very high. The American electric car manufacturer mentioned above assumes, for example, that the Cybertruck, for which deliveries are expected to ramp up this year, will generate negative margins to begin with. Even in the longer term, the model will probably have lower margins than comparable models because of the battery size required. From the customer's point of view, price is a major factor when deciding between a combustion engine and an electric version. This could stall the share of electric cars, especially without government subsidies. In China, electric cars (taking into account government subsidies) are occasionally offered at lower prices than their combustion engine counterparts.
The second problem, which mainly affects conventional OEMs is capacity utilisation. The majority of western car companies have ambitious growth targets for electric cars. However, the ramp up phase puts pressure on margins in two ways: the currently highly profitable internal combustion engine cars lose market share, pressuring capacity utilisation in factories while electric car manufacturing capacity is relatively low at the same time.
More resilience in the luxury car market
However, there are also big differences between market segments in the automotive industry. Mass-market focused manufacturers without strong brands and unique features are highly vulnerable in the years ahead. Luxury brands and - to a lesser extent - premium brands, should be more resilient.
Prices take priority over volume
The semiconductor crisis has shown that prices are more important than volume for the sector. Global sales figures fell to 10-year lows in 2020 and 2021. But most Western car companies were able to achieve strong margins and delivered impressive profits by reducing discounts, raising prices and by benefitting from positive changes in the mix (semiconductors allocation was shifted towards models with higher profitability).
Historically, due to the prevalent overcapacity in the automotive market, there has unfortunately been little price discipline, which, along with the cyclical nature of the sector, was reflected in low share valuations in the sector.
Regarding the outlook for the second half of the year, the availability of cars is already improving considerably and consequently price discounts have started to increase again. The consultancy firm PwC Strategy& recently reported that discounts in July for premium electric cars averaged 14% - about a quarter higher than in the previous month.
When looking at various listed companies in the sector, we are considering what incremental improvements are possible. For traditional manufacturers focusing on the mass market production there are few positives factors and significant risks from our perspective.
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