Thanks in large part to the outstanding success of Tesla’s electric vehicles and ongoing innovations in terms of driverless cars, media interest in the so-called ‘car of the future’ continues to grow.
While there are a number of potentially disruptive innovation themes related to automobiles, this Perspective takes a closer look at the battery technology angle in particular, with Fidelity’s current thoughts on investment prospects in this area.
Successive advances in automobile technology, particularly the ‘powertrain’ – the engine and transmission elements – have already significantly boosted automobile fuel efficiency over several years. As Chart 1 below shows, in the US, following almost 30 years of relative stagnation, fuel efficiency has increased by over 20% in just the last five years. The key driver of this has been government efforts to reduce fuel emissions in order to combat global warming. As Chart 2 below shows, despite significant reductions, many governments have aggressive targets in place to reduce fuel emissions by a further 20-40% by 2025.
The important question for both the industry and investors to consider then is: how can tough future emissions reductions targets be achieved? The two principal routes to meeting this goal are: a reduction in the emissions of the entire fleet by 20-30% over the next decade, or an increase in the mix of zero-emission electric vehicles into the fleet.
The successful emergence of Tesla’s electric vehicles, mainly in the US market, has raised the possibility that electric vehicles (EVs) could be something of a panacea for meeting emissions reduction targets. Tesla has made some impressive technical advances, with more than double the mileage range of EV models from established car manufacturers. Moreover, it is clear that Tesla is achieving significant media traction which is helping to transform public perceptions of what EVs can achieve.
While there is no doubting Tesla’s emergence as a positive and potentially disruptive new force in the global automobile industry, much of this potential has already been priced in. As the Chart 3 below shows, Tesla’s share price has risen by over 1000% since its launch in June 2010 and the company currently trades on a remarkable price-earnings ratio above 200. As a result of its stratospheric rise, Tesla now has a market cap exceeding US$30bn, almost half that of an established player such as Germany’s BMW, a company with a 23% market share of the US premium market compared to Tesla’s less than 1% share. Of course, lofty market valuations need not be a concern if a company can consistently meet very high growth expectations, but at the current price, even the smallest disappointment could be punishing for Tesla investors.
Another area of concern for Tesla is the possible emergence of new competitors – although the EV industry cannot be considered as having low barriers to entry, it is nonetheless conceivable that the remarkable success of the Tesla brand in just five years since launch, could encourage new entrants seeking to emulate its success.
A key constraint for the EV industry is the lack of infrastructure that is needed to support the uptake of EVs. Electric vehicles need a network of charging stations to enable more mainstream take-up, but this will take time and investment to achieve with incumbent players having a vested interest in not participating. So, while demand is growing, so far, adoption of EVs has been consistently and significantly slower than anticipated. As Chart 4 above shows, EV and hybrid sales are still barely 1% of the most important auto markets.
Given concerns about Tesla’s valuation and the risk of new entrants joining the market, perhaps a more promising way to play the electric vehicle theme could be to focus on the broader EV supply chain, in particular, the power providing component – the batteries.
Rechargeable lithium batteries that have higher power and higher ‘energy density’ (enabling increased acceleration and range with fewer batteries cells) have existed since the early 1990s. Moreover, battery costs have generally trended downwards and are expected to come down by a further 30% over the next three-four years. Since the battery cells themselves make up over 60% of the total EV powertrain cost, the impact of this should be beneficial for the EV industry, enabling lower-cost production and prices. As a result, this should create a positive demand feedback loop due to increased economies of scale.
While continued technological progress that exerts downward pressure on battery costs seems like a good bet, the other key variable for the EV industry is the price of fuel. Indeed Chart 5 above shows that the economic logic of EVs in general is predicated in large part on the assumption of high fuel prices, which of course requires high oil prices. Given this, the recent 30% decline in the oil price since mid-June 2014 and the associated lower fuel cost is a major negative factor for the EV industry in general because it clearly boosts the relative attractiveness of traditional internal combustion engine (ICE) vehicles.
In any case when it comes to investing in battery producers, it is difficult to see viable investment opportunities that give good exposure to the EV theme. A major challenge is finding suppliers with sufficient exposure to this area instead of consumer-focused batteries. Although some pure-play EV battery producers have emerged as start-ups, their track record is not very auspicious, with a number of producers including A123 Systems and Valence Tech all going bust in the past few years.
Given the evident high risk of pure-play EV battery producers, an alternative may be to invest in the components and materials of EV batteries. It is the cathode component that arguably holds most promise with considerable embedded intellectual property being showcased by different suppliers.
However, as Chart 7 illustrates, there is a lot competition between cathode material producers. This is problematic in itself for investors but a bigger concern is uncertainty about which particular technology will eventually win out. Since different producers are championing materials with limited cross-over potential, picking the wrong technology means picking the wrong supplier. By way of some specific examples, Belgium’s Umicore is the dominant cathode supplier in Nickel Manganese Cobalt but non-existent in the Lithium Manganese Oxide space which is dominated by Japan’s JGC.
As mentioned earlier, increasing the mix of EVs is by no means the only possible way to achieve fuel emissions reductions targets. Indeed, as the chart below shows there are numerous incremental steps that that can be taken within traditional (non-EV) powertrains. More importantly, from the consumers’ perspective, many of these methods are substantially cheaper in terms of the unit cost per gram of CO2 reduction. From the incumbent car companies’ perspective too, the major advantage of these types of incremental solutions is that they can be pursued within existing frameworks.
As Chart 8 above shows, 48 volt (’micro-hybrid’) batteries would very much fit into the category of low cost-to-emission technologies. The way these batteries work is by delivering a mild degree of electrification to existing ICE powertrains. This ‘low voltage hybridisation’, is essentially like a highly simplified version of existing hybrid technology (as seen in models like Toyota’s Prius) that enables engines to be downsized and fuel efficiency to be increased by 15-20%.
Most importantly, this can easily be achieved as an add-on to new vehicles at a cost of less than $1000 per vehicle using existing production lines, suppliers and infrastructure. At a small fraction of the cost of hybrid or full electric vehicles, and with the potential to allow car companies to meet their environmental requirements over the next vfive-10 years, 48 volt technology is the emissions-driven innovation angle that appears most exciting to us at present.
From a wider perspective, among the likely beneficiaries of the broader drive to focus on non-EV powertrain technologies such as 48 volt technology will be those incumbent car companies with the greatest capacity to invest in new developments. The two companies that have comparatively very large R&D budgets are Toyota and Volkswagen. Notably, as Chart 9 on the next page shows, this is the case even while the R&D expenditure per unit is comparable or lower than most other car producers. The continuous push for powertrain enhancement should also favour auto suppliers like Delphi Automotive and Continental, which have strong intellectual property and R&D track records in powertrain efficiency technologies such as hybrid systems, direct fuel injection and turbos.
While Tesla’s EVs are rightly seen as a positive disruptive force in the global automobile industry, as a cheaper and easier-to-implement alternative, we think 48 volt battery technology, could itself prove highly disruptive to Tesla’s own plans. The existence of a viable alternative technology would make it more likely that the burden of rolling out a nationwide network of electric charging stations would still disproportionately fall on Tesla. More importantly, even if we assume that Tesla does eventually achieve an EV revolution and meets its long-run production targets, what if it takes longer than expected due to competing technologies such as 48 volt batteries? By slowing the rate of EV take-up, 48 volt technology, particularly when combined with lower oil prices, could drastically alter the net present value assumptions embedded in Tesla’s current lofty share price.
In terms of individual stocks that might benefit from the increasing adoption of 48 volt technology, a stand-out candidate is Johnson Controls in the US. With a reputation as a traditional lead car battery manufacturer, the company does not command any kind of premium, but it is the only company in the global market that is developing new 48 volt batteries that combine cost-effective lead materials in combination with relatively small amounts of more expensive lithium. Moreover, there is optionality embedded in the stock – large-scale adoption of 48 volt technology could see its batteries division, currently the smallest and most profitable area of the business, double or triple in size to become the dominant driver of the company’s earnings.
Increasing fuel efficiency is being driven by tough global emissions reductions targets. In order to achieve further mandated target reductions, one avenue is to increase the mix of zero-emissions electric vehicles. Tesla is the global leader in this field and has made remarkable headway since its launch in 2010. Falling electric battery prices should support the EV industry but falling oil prices are a negative factor for the EV industry because associated lower fuel prices boost the relative attractiveness of traditional internal combustion engine vehicles. In any case, the current very high valuation makes Tesla a very high risk investment proposition.
The other more traditional alternative for achieving emissions reductions targets is via ongoing incremental fuel-efficiency enhancements. This has the big advantage for incumbent automakers of being possible within the existing production and research infrastructure – however progress on this front requires significant investments in technology, thereby favouring those global auto companies with the most research resources at their disposal.
One of the most exciting prospects and cost-effective ways to reduce emissions is via the use of 48 volt (‘micro-hybrid’) batteries. Widespread adoption of this new battery technology could be highly disruptive for Tesla and the wider EV industry but could be a positive game-changer for leading manufacturers such as Johnson Controls.
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