The explosive growth opportunity in electric vehicles, and how to harness it

19 November 2019

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We don’t expect the attractive growth and returns to come from the auto makers.

Zehrid Osmani, Head of Global Long-Term Unconstrained, explains why the advent of electric vehicles (EVs) is one of the most exciting growth opportunities in the industrial investment universe.

Key points

In the context of the global challenge of decarbonising the economy, and notably focusing on transport which accounts for around 15% of global greenhouse gas (GHG) emissions, we believe the advent of electric vehicles (EVs) is one of the most exciting growth opportunities in the industrial investment universe.

  • The EV investment opportunity is a very attractive one and represents one of the rare times in history where an established market is legislated to shift rapidly from one technology to another in a short time frame.
  • Our proprietary market estimates project EV volumes with annualised growth of +30% CAGR to 20301.
  • But we don’t expect the attractive growth and returns to come from the auto makers.
  • Auto makers (also referred to in this paper as original equipment manufacturers (OEMs)) will continue to face strong competitive pressures, with limited upside to their returns outlook in our view, given increased R&D and capex requirements to position themselves properly for the shifting technology they are facing.
  • The EV ecosystem has a lot of attractive niche players further up the value chain, enjoying high barriers to entry, strong pricing power, attractive return on invested capital (ROIC) and good upside potential.
  • Mission critical companies further up the EV value chain help investors harness the attractive EV market growth potential, without the consumer brand risk.
  • We find some interesting opportunities within the technology and connectivity part of the car offering in particular, which permits us to avoid exposure to the competitive intensity that exists at the forefront of the consumer offering.
  • Our work highlights the need for investors to look at opportunities across the whole ecosystem to pick the best opportunities.
  • Finally, while our market projections in the early stage are still dependent on the level of state subsidies, the long-term market growth potential and take-up should come through even without subsidies. Although economic dynamics for original equipment manufacturer (OEMs) will be impacted negatively as subsidies reduce or disappear. This in itself is a further negative for the auto makers and confirms the need to look further up the value chain.

A regional bottom-up framework

Our analysis starts with a bottom-up, regional model of automotive unit volume growth, separating out internal combustion engine (ICE) from EV. Given the differences in the size of EV subsidies in each country, a regional rather than global approach is warranted, which is what we have behind this aggregate market projection.

Global passenger vehicles by propulsion systems (per units of new cars in millions)

EVvsICEgraph

Source: Martin Currie proprietary growth model as at May 2019.

This approach allows us to observe extremes at the country level. Take Norway for instance. With its network of renewable hydroelectric power plants, high GDP per capita and generous government subsidies, already 49% of all new cars sold in Norway are EVs. Indeed, its modest population of just 5 million (0.07% of the world) is no barrier to Norway sustaining the third largest market for EV, trailing only China and the US.

By far the largest market, though, is China. A market of more than 2.2 million units in 2018 (12x Norway for a population 264x larger), China accounted for one in two of all EVs sold worldwide. In terms of penetration, though, there is still a long way to go. Only around 8% of all cars sold in China in 2018 were EVs. Looking forward, China is the main ‘needle-mover’ in the global EV industry. Partly in response to public concerns about air quality, but also in an attempt to reduce the cost of fossil-fuel subsidies (U$17 billion per annum), the Chinese government is fully behind the development of a best-in-class EV supply chain. Its larger OEMs, mostly state-owned enterprises, have extremely ambitious plans to convert from ICE to EV in an accelerated manner2.

Putting this together with local developments in the US (especially California) and the European Union, our proprietary market model leads us to project a +30% CAGR in global EV volumes through 2030. By 2030, we believe unit sales of EVs will outnumber those of ICE (we forecast around 66 million EV units, compared with 61 million for combustion)3. In some countries (for example, the UK and Spain), we estimate that all new cars will be effectively zero emission by 2040, in line with regulations.

Thinking Laterally

The monumental shift to EV naturally draws the casual observer’s attention to what the auto makers are doing.

In simple terms, they are all doing a lot, at least in terms of capital deployment, but it is worth focusing on what this mean for returns on invested capital, given the magnitude of the capital expense needed to catch up with some early movers within the sector. Strategically, some may be ahead of the game (a select duo – Tesla and BYD Company – which we call the New Entrants, have no legacy exposure to combustion). Others are tapping stakeholders for immense amounts of capital in the hope of not losing touch (we label them the Incumbents – for example VW, BMW, Ford and Renault).

In the 1840s gold rush, it was the sellers of picks and shovels, not the miners that made the best returns. Similarly, for investors seeking the best returns from this monumental shift to EV, we think most OEMs could be no more than an unnecessary distraction, and at worst could be at risk of sucking in vast amounts of capital that will not generate the required returns to cover their cost of capital. The real value is more likely to be found further up the value chain, in niche sub-segments where competitive pressures are lesser, barriers to entry are higher, and therefore pricing power is stronger, leading to higher return profiles.

We illustrate the whole ecosystem of the EV opportunity in the diagram below, to highlight the need to look across the value chain:

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In the 1840s gold rush, it was the sellers of picks and shovels, not the miners that made the best returns.

Below, we look into the various components of this value chain in broad terms.

Take your pick (...or shovel)

Metals

(i) Lithium

Around 40% of the cost of an EV is in the battery4. Despite its imperfections, lithium-ion is the technology of choice for every single one of the OEMs. Even if a superior, commercially scalable, alternative battery technology were to be discovered in the short term, we believe the OEMs are all-in on lithium-ion, for the next decade at least, given their capital commitment to the technology. As the lightest of all metals, lithium provides the highest-possible energy density (energy per unit volume). The downside is that lithium is inherently unstable, so lithium-ion is combined with some combination of ‘safe’ metal cathodes (nickel, cobalt, manganese and aluminium).

Around 85% of the lithium market is controlled by six players – most notably the US miner Albemarle, the Chilean SQM and China’s Tianqi5. Albemarle is the global leader, lowest-cost producer and a consolidator. While this concentrated market could create synergies, we are doubtful of the ability to find value-creation on a long-term sustainable basis in this segment.

(ii) Other metals

The two main versions of lithium-ion battery materials – NCA (deployed by Tesla, in partnership with Panasonic) and NCM (by every other OEM and battery integrator) – both contain some combination of nickel (N), cobalt (C), aluminium (A) and manganese (M).

Leaders in nickel production are Vale (Brazil), Norilsk Nickel (Russia), Jinchuan (Hong Kong), and Glencore (UK)6. Although for each of these companies, nickel is only part of their overall business exposure, with ROIC profiles that make them unattractive for our investment approach.

LTIIEVText4LithiumIon

Most cobalt is mined as a by-product of copper or nickel, Cobalt production is concentrated in the Democratic Republic of Congo (DRC) where artisanal volumes dominate. Sourcing cobalt responsibly is one of the biggest problems facing a cobalt-hungry EV supply chain.

Manganese and aluminium are too widely used in other industries to be unduly influenced by the EV market. We therefore again don’t find any sustainable opportunities in this segment of the value chain.

Battery Integrators

Rechargeable lithium-ion batteries have been around for almost 40 years. One of the principal developers of the technology, John Goodenough, has just been awarded the Nobel Prize in chemistry for his contributions to the field of research.

Building on Professor Goodenough’s research and admirable focus, and from the perspective of today’s capital deployment driving the technologies of the next decade, lithium-ion battery technology looks here to stay. We see investment attractions in the battery integrators where an oligopolistic structure looks to be forming, comprising the Koreans LG Chem, and Samsung SDI, together with the Chinese national champion CATL and Tesla’s partner, Panasonic of Japan.

We also see bright prospects for the cathode manufacturers serving these battery integrators. Umicore of Belgium seems to be one such investment prospect. Not only does it responsibly source and assemble rechargeable battery materials, it is also taking a lead in ‘closing the loop’ on lithium-ion battery recycling which will begin to gain traction in the mid-tolate 2020s. This is one sub-segment to keep an eye on, and where we could potentially find some interesting opportunities when looking past the short-term challenges.

Charging Networks

With first-mover advantage and an appetite to go early to secure scale benefits, Tesla has already built out the largest EV supercharging network in the world. Others are moving in, notably the fossil fuel giants BP and Shell, presumably as a strategic hedge.

The Incumbents are clubbing together to build out a uniform network, but this looks a little too late. Furthermore, there are competing technologies, so interoperability is an issue that will have to be addressed if drivers are to relax, rather than suffer from the dreaded ‘car range anxiety’.

There are no pure-play listed-charging networks of any scale for now. Privately-owned networks are drawing some attention from long-term pension plans (for example CPPIB’s investment in the US network, ChargePoint). This sub-segment of the value chain is therefore for now lacking meaningful opportunities.

With first-mover advantage and an appetite to go early to secure scale benefits, Tesla has already built out the largest EV supercharging network in the world.

OEMs

Strategically, we dislike this part of the ecosystem, given that it is right at the forefront of the consumer, and therefore, being at the sharp edge, it faces the most intensive competitive dynamics, and exposes investors to consumer choice risk. The New Entrants such as Tesla may have enjoyed an early mover advantage, and therefore benefited from being the only credible choice for consumers until recently, but most OEMs are now launching or have already launched very competitive alternatives. They are catching up, leading to price pressure building, which might have been a reason for Tesla’s sizeable cut in prices across its ranges earlier this year. We therefore believe that Tesla is a risky way to gain exposure to EV, and we predict a much tougher operating environment in the future for that company.

BYD Company is a New Entrant, having been a pioneer of EVs in the Chinese market for many years. While profitable, returns remain meagre at best for this company, in the next two years we will discover whether BYD has any proprietary advantage over other OEMs, given its experience with in-house battery technology.

The other wildcard Chinese player is Geely Automobile. As one of the few entrepreneur-led automotive OEMs in China, Geely and its founder Li Shufu has amassed a stable of global brands and leveraged off a shared R&D base, drawing upon the established expertise of Volvo Cars. Already successful in the rollout of the electric taxis now commonplace in London traffic, the ‘Blue Geely’ initiative targets 90% of sales to consist of ‘new energy’ vehicles by 2020, of which 35% is EV.

Traditional OEMs have had to spend a lot on R&D and capex channelled towards their EV offerings, and are still doing so, which is likely to weigh down on their cash flow generation outlook and will depress returns. Unfortunately, there is no alternative for them – they have to invest to make the seismic shift in technology, and to keep their businesses viable. In fact, while we are in this period of transition from combustion to electric engines, the OEMs will have to invest in new production lines to service the EV demand, while keeping their existing production lines running. This is likely to depress returns, and will add some complexity to their manufacturing processes. We note that some car makers are aiming to keep their capex and R&D broadly flat through this transition period, which we believe could either be difficult to achieve, or could risk leaving them behind in the technological race for leadership.

We also note from a top-down perspective that the autos sector has struggled to cover its cost of capital, with the global auto makers ROIC estimated at around 6%7, with limited upside being projected by consensus estimates – we also don’t foresee this picture to improve in any way (and, in fact, we think it will deteriorate further) as the sector shifts to the EV offering, with the increased investment needs that we mention above.

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In-car technology and connectivity

This segment is where we see the most attractive opportunities in terms of players offering products in niche submarkets, enjoying high barriers to entry, strong pricing power, and therefore emanating attractive ROICs and growth profiles. A notable beneficiary of the transition towards EV/Hybrid and autonomous cars is Infineon, the German semiconductor company. Infineon has a wide range of products for the automotive industry that goes from power controllers to Advanced Driver Assistance Systems (ADAS), and has a leadership position in the autos segment, further cemented through its recently announced acquisition of Cypress. It is benefiting from the increased use of semiconductors in cars – in a high-end car today we estimate there are around US$350 worth of semiconductors (mainly for safety); this number goes up to US$950 for an EV/Hybrid8. The charts below from a study by McKinsey illustrates the growth and growing importance of semiconductors in cars historically.

Automotive-semiconductor sales
($ billion)

Automotive-semiconductor sales
(as % of total semiconductor sales)

Automotive semiconductors

Source: McKinsey&Company; HIS; McKinsey analysis, April 2017.

The value of semiconductor content is structurally growing at around 8% pa9. When compared with the cost of a car, the benefit of increasing technological content in a car (safety and environment) comes at a really small additional cost, making this stock an attractive way to play the strong growth potential we foresee in EV, but also benefiting from adjacent trends related to autonomous driving that is coming at the same time.

There are other ways to play this specific area, for example through chipmakers, given the increased need for more chips in cars to power the whole technology and connectivity. As a result, Dutch firm ASML has an enviable position as the key supplier to the major semiconductor-chip suppliers for these growing markets. ASML makes precision lithography systems that pattern transistors and other components onto chips. With a strong market position (around 85% total market share, and 100% share in leading-edge technology) and close relationships with customers, the company is critical in enabling innovation and development in the semiconductor industry. Its pricing power is therefore very strong, and its returns and growth outlook very attractive.

The electric vehicle enhanced value-chain analysis

What our extensive work on the electric vehicles investment opportunities highlights is that it pays to look across the ecosystem and explore the whole value chain of any subindustry in order to harness the best opportunities to benefit from the explosive growth that we foresee – as illustrated in the previous supply chain diagram (shown on page 4).

As we mentioned earlier, being at the forefront of the consumer would expose our clients’ assets to the unnecessary risk of consumer choice of car brands. We believe this isn’t a risk that we need to take – in particular, given that there are attractive opportunities further up the value chain which operate in segments where there is less competition and therefore more pricing power.

We believe companies in sub-segments such as in-car technology and connectivity have the potential to grow their returns the most – from already higher ROIC levels than other sub-segments of the value chain. It is also worth highlighting that these attractive opportunities further up the value chain sell to all car manufacturers, no matter what car brand the consumer chooses, therefore effectively eliminating the risk of brand fashion.

Subsidies - helpful but not critical

We cannot discuss the EV market opportunity without touching on the subsidies that are offered to consumers to entice them to purchase an EV. Looking at the US market alone, subsidies have been in the region of a high-single-digit percentage of the retail price tag of a car but have recently come down to the mid-single digits.

In China, a similar trend to reduce subsidies has been taking place, with a halving of subsidies this summer. Norway has by far the most generous subsidies policy (which explains why it is the third market by size behind China and the US) and highlights the stimulative effect of subsidies on consumer demand.

Clearly, consumers will be sensitive to the level of subsidies when making their purchasing decisions, and there is therefore a risk of slower take-up as subsidies reduce and/ or get eliminated. However, we think the risk to our market growth projections from subsidies being reduced is only related to early years in terms of speed of take up. We believe the long-term growth potential remains intact and will benefit from price reductions as the industry builds scale in the production process. Where there is a risk is, once again, it is with the OEMs, as reduced subsidies will potentially force manufacturers to pick up some of the price incentives offered to consumers. This will negatively impact their returns profiles, leading to reduced attraction of the economics for them.

We believe companies in sub-segments such as in-car technology and connectivity have the potential to grow their returns the most – from already higher ROIC levels than other sub-segments of the value chain.

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The benefits of taking a long-term approach and of looking at opportunities more widely

The EV industry is a perfect example of the way we approach investing in companies. Fundamental data analytics and a clear understanding of industry structures and dynamics are important aspects to help us generate attractive returns for our clients.

By taking a broad and deep approach to analysing segments of the market across the entire value chain, we are able to deploy our clients’ capital on the very best ideas. Specifically, gaining exposure to attractive long-term growth opportunities by focusing on sub-segments of the value chain that offer the best source of returns. It is a good time to be a long-term unconstrained investor.

The EV industry is a perfect example of the way we approach investing in companies.


1Source: Martin Currie proprietary growth model as at May 2019.
2Source: Martin Currie and the European Automobile Manufacturers Association, as at November 2019.
3Source: Martin Currie proprietary growth model as at May 2019.
4Source: Statista and Bloomberg New Energy Finance 2018.
5Source: Statista; Mining.com; Sociedad Química y Minera; Investi News Network 2019.
6Source: Statista; various sources (company data); The Balance.
7Source: Martin Currie and FactSet 2019.
8Source: Martin Currie as at November 2019.
9Source: Martin Currie, McKinsey & Company and Infineon as at November 2019.


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