Global Autos: The Bumpy Road Ahead - Part 2

Automaker profitability to remain under pressure from strict regulatory requirements and the need to adapt to rapid technological changes.

Eric Espeseth, Senior Credit Analyst

In "Global Autos: The Bumpy Road Ahead - Part 1", we addressed how slowing consumer demand and uncertainty from trade tariffs are negatively impacting the profitability of the global automotive manufacturers. But increasingly stringent regulatory requirements and monumental technological advances pose an even greater challenge over the long-term.

As climate considerations become more pronounced, vehicle emissions are squarely in the crosshairs of regulators which are requiring better emissions testing and improvements in emissions quality and fleet mileage. European manufacturers - already facing strict CO2 emissions requirements - are now subject to new emissions testing procedures designed to better measure on-road fuel consumption and CO2 emissions. These procedures have added significant costs and delayed release times for new models.

Within the U.S., the State of California recently agreed to a framework with four major automotive manufacturers - Ford, Honda, Volkswagen and BMW - to reduce emissions, increase fleet mileage and encourage the transition to electric vehicles. The agreement calls for annual greenhouse gas emission reductions of 3.7% through 2026 and improved fuel economy requirements leading to a 20% increase in fleetwide miles-per-gallon by 2026.

While the new framework will likely require considerable resource allocations from these companies, we expect other automotive manufacturers to come onboard as regulatory pressure grows and the long-term trend points to ever more stringent requirements across various jurisdictions.

In addition to growing regulatory challenges, the automotive industry is entering a once-in-a-lifetime transformational period driven by rapid technological innovations and social changes. This period is highlighted by four major themes: connectivity, automation, sharing and electrification. These themes are having a profound effect on auto manufacturer's capital spending and R&D budgets and will shape the global automotive industry going forward.

The themes are largely interconnected but the predominate investment focus has been on the near-term growth in electric vehicles and long-term development of fully autonomous vehicles. Electric vehicles accounted for around 3% of new vehicle sales globally in 2018, but growth is projected to increase sharply with BloombergNEF forecasting electric vehicles will make up nearly 60% of global passenger vehicle sales by 2040.

Growth expectations - along with increasing regulatory pressures - are driving all major automotive manufacturers to focus on developing and producing expanded line-ups of electric vehicles despite a current lack of profitability - Tesla, Inc. consistently produces negative quarterly operating profit losses. Development and testing of autonomous vehicle technology also remains a strong focus of the automotive industry despite regulatory approval likely being more than a decade away.

The focus on electric and autonomous vehicles has forced auto manufacturers to invest billions into their research and development and capital infrastructure. While the push for new innovative products and technologies may provide growth opportunities, we expect the increased investment to weigh heavily on operating profit margins over the near-term. A heightened focus on cost-cutting programs and production efficiencies will be key to maintaining adequate levels of profitability. Corporate alliances are also being formed to create additional efficiencies and share costs and knowledge involved with developing advanced technologies.

Throughout this period of heavy capital investments and changing societal trends, we believe credit quality will remain strongest with those companies that are best able to balance current customer preferences and demand with the need to allocate significant resources toward evolving regulatory and technological requirements.

 

Sources:

BloombergNEF, Electric Vehicle Outlook 2019, May 15, 2019

California Air Resources Board, Press Release 19-33, July 25, 2019

European Automobile Manufacturers Association, What is WLTP and How Does it Work?, WLTPFacts.eu

PBS News Hour, California Signs Deal with Automakers to Raise Gas Mileage Standards, Ellen Knickmeyer and Tom Krishner, July 25, 2019

Tesla company fillings