Equities 2021-11-29 13:00 10 minutes to read

Summary:  In today's equity research note we take a look at the global car industry. Since late 2005 it has been a low growth industry also reflected in the low total return of the industry prior to the pandemic. But during the pandemic and with the high revenue growth rates of pure electric vehicles makers the industry's combined market value across traditional carmakers and pure EV-makers has gone to unprecedented levels reflecting excessive expectations that we do not think can hold. The reason behind this is the acceleration in EV adoption and we provide concrete alternatives to bet on this transition without getting exposure to pure EV-makers with elevated equity valuations.

Market value does not add up with structural growth profile

This year should have been the year when the global car industry came back from the dismal 2020 impacted by the global pandemic and a 6% rise in global new passenger car registrations could be interpreted as the industry coming back. However, as the chart on car registrations in the US, Europe, and China shows, the global car market has been weakening the past couple of months and most notably in Europe. In fact, the combined new car registrations across the three largest car markets in the world are down 19% from the peak in August 2018. Since December 2015, global new car registrations have only grown by 1.8% annualized with a clear saturation starting in early 2017 and then turning into a longer term decline by late 2018.

It seems that the global car market has become saturated and the pandemic exacerbated an already weak industry on the demand side. As demand came back, the car industry faced new issues on supplies of semiconductors. In the early days of the pandemic, car manufacturers cancelled orders on semiconductors as they believed demand to be weak for a long time, but as governments unleashed unprecedented stimulus economies weather the pandemic and with the vaccines approved in late 2020, the economy came roaring into 2021. But car manufacturers buy lower margin semiconductors and as they were late to come back ordering semiconductors, the semiconductor industry had already found willing buyers due to high demand on graphics cars for gaming and crypto, and semiconductors used in datacenters and computers. Car manufacturers were put back in line and have ever since scrambled to get priority causing production to be reduced on lack of semiconductors.

The pandemic and climate change awareness also happened to ignite demand for electric vehicles (EVs) and the EV transition may have reached an inflection point where it is beginning to drive postponement of buying a gasoline car. Why buy a technology that is being phased out and why not buy an EV when governments are providing incentives to do so?

Despite these structural challenges and low growth profile the MSCI World Automobile Index has exploded in value over the past 18 months driven by a bonanza in EV-makers and excessive expectations best exemplified around the Rivian IPO. From December 2005 to the peak in new car registrations in August 2018, the index gained 5.2% annualized compared to 3.9% annualized gains over the period in new car registrations. This highlights that market value more or less follows volume plus/minus changes in price mix and operating margins.

With the recent gain in the global index on car manufacturer the industry’s market value has become completely unanchored to the underlying structural growth rate. The only explanation that can justify this is new car registrations quickly closes the drawdown from August 2018 and that EVs can be manufactured at higher operating margins, but this requires that competitive forces do not force retail prices on new cars down to the old profitability level on gasoline cars.

Source: Bloomberg

EV bonanza will end in a graveyard

The key change in the car industry is the production ramp-up of EVs as consumers are increasingly demanding these new cars. Public markets have been flooded with new car companies producing only EVs and the market is currently putting a higher market value on the 11 largest EV-makers compared to the 11 largest traditional carmakers. As we have written in previous research notes this reflects excessive expectations on EVs that we find difficult to justify given the structural growth profile of the overall car industry.

Having said that the outlook for cars over the coming three decades is clearly in our view. ICEs will experience a negative growth profile while EVs will have a steep growth curve over the next 10 years before gradually slowing down. But are pure EV-makers the best play? At current market values, we believe expectations are set above what these companies can deliver and we encourage investors to find other ways to bet on the high growth rates in EVs. One way is to find exposure among semiconductor companies with exposure to cars, lithium miners or battery makers for the batteries to EVs. The list below highlights a few names across this supply chain for EVs.

• Infineon Technologies (semiconductors)
• NXP (semiconductors)
• Renesas (semiconductors)
• Texas Instruments (semiconductors)
• STMicroelectronics (semiconductors)
• Jiangxi Ganfeng Lithium (lithium miner)
• Albemarle (lithium miner)
• SQM (lithium miner)
• Livent (lithium miner)
• Orocobre (lithium miner)
• Panasonic (battery)
• QuantumScape (battery)
• TDK (battery)
• Gotion High-tech (battery)
• Varta (battery)

Should carmakers spin off their EV units?

Given the market value on pure EV-makers the traditional carmakers should in our view consider spinning out their EV units into separate businesses with their own public listing, but maintaining majority shareholder control. The higher market value for a pure EV-business could be used to raise significant amount of capital to accelerate growth in production, but a separate business unit could reduce friction from internal culture and political fights. The recent problems internally at VW show that labour unions and workers in the traditional internal combustion engine divisions will make the transition difficult. Porsche is a good bet on a specific EV spinoff from a traditional carmaker and something that could yield a significant valuation improvement. Porsche is aiming to get 40% of revenue from EVs in 2025. If traditional carmakers are not spinning off their EV units, we believe they will have difficulties keeping up with pure EV-makers.