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Emerging from the smog

The future of electric motoring now looks assured - the only question is how to profit from the transition under way
October 13, 2017

We’ve been waiting for an opportune moment to review prospects for the wider electric vehicle (EV) market, but it’s become a real moving target over the past few months. Even as we were putting this article together, James Dyson entered the fray. The industrial designer has announced plans to build an EV that will be “radically different” from current models and go on sale in 2020. It remains to be seen whether the concept will have a similar impact to some of Dyson’s other innovations, most notably in the market for Hoovers, or ‘Dysons’ as they’re commonly referred to nowadays.

Nevertheless, around 400 engineers have been working on the £2.5bn project since 2015 – so it appears he means business. And he’s not alone; the likes of General Motors (US:GM), Volvo (owned by China-based Geely), and German auto-giant Volkswagen (GER:VOW3) have made firm commitments to a hybrid/EV future in recent months, while Japan’s Honda announced factory overhauls in response to an industry entering “an unprecedented and significant turning point in its history”.

 

Individual outcomes amid a state of flux

For investors, it’s that “unprecedented” bit that presents a challenge. For if we accept the proposition that the automotive industry is genuinely gearing up for fundamental change, then individual outcomes – the fate of auto manufacturers and ancillary industries alike – suddenly become even more unpredictable.

If confirmation was needed on this score, it has just been revealed that despite a waiting list of more than 400,000 customers, Elon Musk’s Tesla Inc (US:TSLA)had only managed to build 260 examples of the mid-size entry level Tesla Model 3 in the third quarter of 2017. Tesla had been targeting total production of 20,000 units by Christmas, which now looks wildly optimistic. However, like Apple Inc, the company enjoys a peculiarly loyal – almost cultish – customer base. How else can one explain the $600m or so in Model 3 reservation deposits on its books, effectively a massive interest-free loan? Brand loyalty is one thing; this is quite another.

Tesla customers are signalling something about themselves in terms of ethical and environmental considerations when making a foray into the EV market. That’s probably laudable on some level, but investors obviously need to take a more dispassionate view of a company not set to make a profit until 2019 in an industry where incumbent rivals are starting to get their act together. Any business in flux is inherently risky. So, even if it’s possible to build a meaningful picture of the industry’s metamorphosis over time; it’s probably too early to determine, with any degree of certainty, which companies and individual technologies will deliver returns for investors. That said, later in this article we’ve highlighted a couple of UK equity plays we think are well placed to prosper as part of an expanding industry supply chain (Brexit uncertainties notwithstanding). 

 

The commercial lag – real innovation occurs during execution

You can get some idea of how profitable applications lag technological advances by the early progression of the industry that electric motoring is poised to replace. It’s said that ideas are easy; implementation is hard. From an investment perspective, it means that you should temper any initial exuberance for a commercial concept in expectation that the real innovation occurs during execution.

For instance, you could arguably trace the development of the internal combustion engine (ICE) back to the start of the 18th century when Thomas Newcomen, an ironmonger by trade, designed a steam engine in which the condenser was replaced by a cylinder containing a piston – a fundamental breakthrough. A century later, François Isaac de Rivaz designed the first car powered by an ICE (fuelled by hydrogen). Famously, Karl Benz was to develop the first petrol powered automobile in 1885, but it took another quarter of a century until the Ford Motor Company’s Model T became the first genuine mass-produced automobile. The company produced 1,700 cars during its first full year of business in 1903. By 1920, Ford had sold over a million cars – perhaps this rate of increase hasn’t been lost on investors in Tesla Inc.

False dawns and vested commercial interests

Obviously, the rate of incremental technological change has accelerated since the pioneering days of the automobile, but most motorists still rely on a combination of mechanical and thermodynamic processes (fuel-mix, compression and spark) that would have been familiar to Karl Benz and his predecessors. However, change is on the horizon; 2017 has been touted as the “breakout year” for electric motoring in Europe and beyond, although most readers of this magazine would eye any claim like this warily, and with good reason – there have been any number of false dawns.

The automotive industry certainly talked up prospects for electric motoring in the wake of the 1973 oil crisis, complete with predictions that EV technology would be widespread by 1980. As we know, that didn’t quite pan out. In the early 1990s, GM tried to launch an electric car in California – the benighted EV-1 – which foundered in the face of industry collusion (bizarrely involving GM itself), an influential oil lobby, apathy on the part of consumers, and spineless state legislators. The demise of the EV-1 was the subject of a 2006 documentary Who Killed the Electric Car? by film-maker Chris Paine, which outlined the level of resistance to the technology from entrenched commercial interests. Even relatively recently, Barack Obama predicted that 1m electric cars would be on US roads by 2015; in January of that year the total stood at 280,000.

Presumably those commercial interests are still firmly entrenched, although the political argument (backed by greater environmental awareness) does seem to have moved on since the Reagan era – the then president famously had the solar panels, installed by his predecessor Jimmy Carter, removed from the White House. The proliferation of motor vehicles – at least those powered by conventional means – and their effects on built-up areas is riding up the political agenda.

 

The UK and France pledge – the tail wagging the dog?

Both the UK and France have committed to a green motoring future, although you suspect that both pledges might have been designed to play to specific political constituencies (President Trump’s decision to withdraw from the Paris climate change agreement was explicitly cited as a factor in France’s new vehicle plan). And we all know that big government policy announcements, especially those featuring distant targets, are readily forgotten once the initial hoopla subsides. However, some commentators believe that the pronouncements represent a case of the tail wagging the dog: consumer and automotive trends are already well entrenched.

Whatever the reality, the French will need to get cracking: hybrid cars make up about 3.3 per cent of the French market, with pure EVs accounting for just 1.2 per cent – and most of that within public sector fleets. France’s ecology minister, Nicolas Hulot, said that poorer households would receive financial subsidies to replace polluting vehicles with new technologies, but there has been rather less detail on how Peugeot, Citroen and Renault would be expected to meet the capital demands brought about by the proposed transition. As they’re effectively state-controlled, would this amount to another public levy at a time when the republic’s new president, Emmanuel Macron, is attempting to reduce the role of the state?

 

A fiscal shortfall at the forecourt

Even though UK sales of plug-in hybrids (PHEVs) and petrol electric hybrids grew significantly in 2016, with demand up 41.9 and 25.1 per cent, respectively, our recent pledge isn’t quite as expansive as that of our Gallic brethren. However, it probably takes fuller account of the potential disruption to the economy – and the danger to public finances for that matter.

UK policymakers have decided to mandate in favour of hybrid, as opposed to pure EV motoring – and it’s not difficult to fathom why. When you fill up a conventional petrol and diesel vehicle at your local station forecourt, around 65p of every £1 spent is destined for government coffers through a combination of fuel duties and VAT. That equates to nearly £30bn a year through to the exchequer (equivalent to roughly two-thirds of the MoD budget). An electric car charged from the grid will currently generate just 5p in VAT for every pound spent. But if, say, the car is charged directly from solar panels or some other source of home-generation, the treasury is likely to miss out altogether.

 

Other potential knock-on effects

The UK switched from being a net exporter to a net importer of energy in 2006, as production from our North Sea assets began to dwindle. By 2016, we were importing 52 per cent of our primary energy consumption, much of which fuelled private motoring. Few countries have so rapidly transitioned from being largely self-sufficient to such a large and growing dependency on imported energy.

The negative effect on our balance of trade, particularly following sterling’s depreciation against the dollar, has been pronounced. Last year, imports of mineral fuels, oils and distillation products accounted for 6.2 per cent of imports, or $39.6bn in monetary terms. Put another way: in 1999, the UK exported 54.7m tonnes of petroleum products (net); through 2016 the UK imported 24.4m tonnes (net). It’s perhaps fanciful to suggest, but a substantive shift towards EV/PHEV motoring could dramatically narrow – or perhaps even eliminate – the UK’s trade deficit (assuming there is a corresponding increase in the UK’s renewable generating capacity).

Governments in the UK and elsewhere will need to plot a careful course as the transition to ‘green’ fuel sources takes shape. They’ll be under pressure to provide incentives to the automotive industry and motorists, yet they’ll also be expected to manage public finances even as previously predictable sources of duty revenue dry up. However, we needn’t fret too much about the public purse. As mentioned, the UK policy seems designed to ensure a relatively gradual take-up of the new technologies. Chances are, once the dust settles, the early incentives handed out to EV/PHEV motorists will have gone the way of the diesel industry. And there will be innovative new measures in place to keep tax revenues from motorists rolling in.

 

Oil majors evolve to match demand trends

Investors are also presented with a dilemma if demand for petroleum products falls significantly over the next few decades. The governor of the Bank of England, Mark Carney, has consistently warned that fossil fuel companies cannot burn all their reserves if western governments decide to double-down on climate change legislation. Now the most acute danger here is probably presented to the coal industry, but oil & gas companies are already diversifying and/or altering their revenue streams to meet anticipated demand trends.

The decision by Royal Dutch Shell (RDSB) to outlay $50bn for BG Group at a time when energy markets were in the doldrums now looks inspired. We thought the move made strategic sense at the time given the projected roll-out of gas-driven electric turbines and the target company’s vast offshore gas deposits. But it would be interesting to know if the strategists at Shell factored in the likelihood of electric motoring becoming part of the mainstream when they were weighing up the prospective BG offer.

Industry peers have stepped up investments in alternative energy suppliers. Last month, France’s Total SA paid €238m for a stake in EREN Renewable Energy SA – that’s a serious commitment – but it is still far from certain how power grids in Europe and elsewhere will be able to meet the increased demands placed on them by EVs (let alone whether there will be enough charging points available).

Meanwhile, National Grid (NG.) recently posited that if, say, the UK found itself with 9m plug-in cars on its roads by 2030, peak electricity demand could jump by more than the capacity of the Hinkley Point C nuclear power station. If EVs were not charged efficiently to avoid peaks and troughs in power demand, such as when people return home between rush-hour at 5pm and 6pm, peak demand could be as much as 8GW higher. To put that into perspective, the UK’s peak electrical demand stood at 52.7GW in 2015, and the extra capacity required for EVs does not yet exist in the UK’s generating mix.

 

Deteriorating air quality the real driver

There’s another point to consider: since Henry Ford started rolling out the Model T in 1908, the US (a country with a large land mass and a relatively low-density population) has largely determined which technologies gained primacy in the private transportation market – ergo the ICE. With consumers in a densely populated China now driving global demand for autos – and with city populations now outstripping those of rural areas globally – the technologies of the past may not be appropriate for today’s circumstances. Closer to home, even prior to ‘dieselgate’, public opinion across Europe had turned decisively against diesel. Concerns over urban air quality – in particular, street-level nitrogen oxide concentrations – has fanned pressure-group action. Governments have simply bowed to the inevitable.

According to the US Federal Highway Administration, the total number of vehicles on America’s roads has increased by an average of 3.69m vehicles a year since 1960. Even given advances in emissions technology, this represents a major issue for town planners. Closer to home, recent government research revealed that 7.9m Londoners, about 95 per cent of the population, live in areas that experience pollution levels that exceed the World Health Organization’s limits on dangerous airborne particulates by at least 50 per cent. We’ve previously argued that even though Donald Trump has pulled the US out of the Paris Climate Agreement, the transition away from conventional motoring isn’t being driven so much by the desire to limit greenhouse gases as it is by the pressing need to improve air quality in urban areas.

 

China is driving the narrative

Nowhere is this better illustrated than in China’s big cities, particularly those located in the heavily industrialised north of the country. Air pollution is thought to cause around 1.3m premature deaths a year in the country, in addition to high rates of respiratory disease. This represents a structural drag on the economy, in addition to the misery it inflicts on individuals, so Beijing has been actively implementing emission controls in the wake of the Action Plan on Prevention & Control on Air Pollution (2013). These measures obviously extend to China’s automotive policies. For example, China has set a 2019 deadline for global carmakers to meet new quotas for so-called new energy vehicles (NEVs), meaning their annual sales in China must hit a specific threshold of electric cars or plug-in hybrids. 

China’s determination to rapidly increase the proportion of NEVs on its roads is driving the narrative for western automakers. China became the biggest passenger car market in the world in 2009, and has remained the largest ever since. Last year, automotive companies sold more than 28m vehicles in China (95m units sold globally), representing an increase of 13.7 per cent on the previous year. Of those, 375,000 were EVs produced by Chinese manufacturers, representing 43 per cent of EV production worldwide. Add in PHEVs and total units sold expands to 507,000 – a 53 per cent increase from 2015.

Here’s the growth dynamic: combine China’s massive population with fast-rising median incomes, and the number of vehicles produced is expected to hit 40m by 2025. In China, there is just one private vehicle for every six individuals; the ratio in the UK is around 1:2 but it’s approaching parity in the US. Even if China was to approach the rate of penetration in the UK, it couldn’t hope to achieve it using traditional technologies without choking up its cities even further. The health costs of the growth would almost certainly outweigh the economic benefits. From a utilitarian perspective, China effectively has no choice other than to go electric – or, at least, non-ICE. And the rest of the world will follow.

 

A quarter century of change beckons

In 2015, the number of EVs in Europe finally moved past the symbolic 1 per cent barrier in terms of new cars sold across the continent. That’s often been touted as the point at which governments and local authorities would swing behind efforts to provide the necessary infrastructure to perpetuate the roll-out. The last point is obviously critical; a slow build-out of charging infrastructure could seriously constrict EV adoption rates.

Recent analysis from Bloomberg New Energy Finance suggests that EVs could account for as many as half of all new cars sold globally by 2040. Meanwhile, the Organization of the Petroleum Exporting Countries (Opec) has revised its worldwide forecast to 266m electric cars by 2040, against the previous estimate of 46m. Matters are being helped along within the corporate sphere. An alliance of big-name businesses (Baidu, Deutsche Post DHL Group, Heathrow Airport, HP, Ikea, LeasePlan, Metro AG, Pacific Gas and Electric Company (PG&E), Unilever, and Vattenfall) recently launched EV100, the first initiative of its kind to accelerate the uptake of EVs and accompanying infrastructure. If, as seems likely, this forms part of a wider commitment on the part of business, it is highly significant. Just consider: of the 2.7m vehicles registered in the UK last year, 1.48m were attributable to fleet and business sales.

 

Battery innovation will determine the speed of the roll-out

An intensifying focus on improving battery technology is driving down prices and improving the affordability of EVs; the second-generation Nissan Leaf electric car has just gone on sale in the UK, priced at £26,490 (including a government grant). That’s hardly ‘bargain basement’ territory, but when you factor in other incentives linked to fuel duty, vehicle excise duty, congestion charges and company car tax, then it begins to look a much more viable option. 

The cost of batteries is central to the commerciality of EVs, and recent analysis from McKinsey & Co demonstrates this is moving in the right direction; increased economies of scale and technological advances have resulted in the price of the average battery pack reducing from about $1,000/kWh to $227/kWh since 2010. In separate analysis, Bloomberg forecasts that EVs will become price competitive on an unsubsidised basis from 2025.

• The transition to electric motoring does appear to have passed a tipping point. China is effectively driving the industry forward as the health costs of industrialisation start to outweigh their benefits, though the rate of change will be determined by technological innovation in the battery industry. Of course, there will be winners and losers as the automotive industry evolves, but we believe that companies within the supply chain (or ancillary service providers) present a more likely source of returns for investors, rather than the actual manufacturers of plug-in or hybrid vehicles. Obviously, this will be a theme will revisit frequently over the coming months and years as it will undoubtedly throw up major growth opportunities for your portfolio.

 

The UK supply chain is already gearing up for change

There are numerous potential overseas plays in this space; the likes of EV battery producers LG Chemicals (KS:051910) and Umicore (BE:UMI) readily spring to mind, but UK companies are gearing up as important links in the supply chain, too. Companies such as TT Electronics (TTG) have already started moving specialist parts and devices into the Chinese market, while specialist automotive testing outfit AB Dynamics (ABDF) will continue to profit from tightening performance and safety standards within the automotive industry, regardless of the underlying power source. The UK supply chain is already gearing up for change.

Johnson Matthey (JMAT) has significant exposure to the automotive sector as one of the world’s leading suppliers of catalytic converters – a potential casualty of a rapid transition to electric motoring given three-fifths of its revenue is derived from emission control technologies. We believe that demand for this technology will hold up longer than expected due to the probable primacy of hybrid vehicles, though time will tell. However, the speciality chemicals group, already a major supplier of lithium iron phosphate cathode materials for light and heavy-duty vehicles, is investing heavily in a bid to tap into the evolution of the automotive industry. Its battery materials business hit break-even for the first time in 2015-16, and the group invested over £440m in capital expenditure and R&D combined in the year to March 2017. Johnson Matthey has been around for over 200 years and has every intention of exploiting the industrial requirements of the next couple of centuries.

We’ve had GKN (GKN) on a buy call since April 2016. And while the call hasn’t been a runaway success (+26.7 per cent); at least the rating now seems slightly less out of kilter with the organic growth rates on offer. The anomaly with GKN is that even though the engineer rarely disappoints from an operational perspective, its valuation has been held in check by supposed poor cash flow and a weighty pension deficit. The result is that the shares trade at a much wider discount to industry peers than the average enterprise/cash profit (EV/Ebitda) multiple over the past five years.

The Driveline business continues to be a growth machine, easily outperforming global auto production. So, the group’s adaptation of electric/hybrid motoring technologies is keenly anticipated. GKN unveiled its advanced eTwinsterX electric axle concept for cars at the Frankfurt Motor Show. Admittedly, continued investment in eDrive trimmed the division’s full-year margin by 10 basis points to 7.8 per cent, but it’s worth remembering that the group was one of the first movers in this space, with more than 400,000 of its eDrive systems delivered thus far. The good news is that cash flows are improving and it has closed its defined-benefit pension scheme, which should help bring the valuation into line with the underlying asset base.

Ricardo (RCDO) is another diversified engineer we think is ideally suited to benefit from the roll-out of EV/PHEV motoring in the UK and beyond. The group’s automotive business had to contend with order deferrals through to the June year-end, due in part to the ripple effects of ‘dieselgate’ and anxieties over how the Brexit negotiations might impact the UK auto supply chain. However, the group finished the year with a record £248m order book, buoyed by strengthening demand in the hybrid and EV sector (17 per cent of order intake and rising). Management noted “a return to more normal order intake patterns” in the fourth quarter, while it has delivered its 10,000th engine to McLaren, and was also selected to design and produce an advanced ‘hypercar’ transmission for Aston Martin.

It’s this high-end automotive expertise that places Ricardo in an ideal position to capitalise on the gathering momentum in unconventional motoring. It has gained exposure to many of the new entrants in the EV market, in addition to well-established relationships with key existing original equipment manufacturers (OEMs). The group’s increased diversification into rail and energy & environment (where growth rates are generally better), will support the group’s activities in EV/PHEV motoring, as they will invariably draw in capital.