Driving Our Investments into the Future

By Brian Bath, CFA
December 2017

It has been nearly 110 years since the first Model T was sold and in that time we have yet to achieve another revolutionary change in personal mobility. There have been many improvements to the quality, safety, and performance of cars but the core of the vehicle is still an internal combustion engine with a similar mechanical process to that established in 1908. Today we are on the cusp of that next step in mobility, not only with a change in propulsion from a gasoline engine to an electric motor, but also the adoption of autonomous driving and merging cars into the internet of things. You may not be able to order an all-electric autonomous pod from your phone to take you to work tomorrow morning, but that day is rapidly approaching. With changes like these on the horizon, we must be able to understand how companies are positioned to succeed in today’s environment as well as in the future. This is one of the advantages of Diamond Hill’s long-term approach – we have the opportunity to look past the short-term noise in the marketplace to find companies that are positioning themselves for continued success over the next decade, not the next quarter.

The Global Shift to Electric Vehicles

The shift to electric vehicles (EVs) is partially being driven by government regulations. Norway has already announced a plan to have all new vehicles sold in the country be pure electric by 2025, and France intends to have all vehicles be hybrid or electric by 2040. While the size of these countries will not move the needle much in terms of total sales, it does give an indication of how Europe is beginning to think about EVs and how quickly the region could begin adoption. China is also making a significant push for EVs to represent 20% of new vehicles sales by 2025 by offering purchase subsidies and production credits. Outside of reducing pollution, China is pursuing EVs because they believe it will help their original equipment manufacturers (OEMs) compete with non-Chinese producers. BYD Co. Ltd. is currently the largest EV producer in the world (including buses) and has battery production capacity similar to that of Tesla, Inc. With these developments in Europe and China – two of the largest automotive markets – all major OEMs must pursue EVs in order to compete.

EVs have benefits beyond lowering emissions and saving money on gasoline. There are significantly fewer parts in an EV compared to an internal combustion engine (ICE) which means there is a lower probability of needing significant repairs and the elimination of regular maintenance like an oil change. The reduction in parts also opens up new design options and clears space for increased technology related to safety, connectivity, and entertainment. If other OEMs follow Tesla’s lead, then we should expect cars with active safety features, maybe some self-driving capability, and high levels of connectivity to support over-the-air software updates. Wireless updates can help increase performance without having work done on the vehicle and can potentially identify and correct issues, which further reduces the need for physical maintenance. This wide range of possibilities has created a crowded market with many suppliers competing to introduce infotainment, software, power electronics, safety features, and other additions to EVs.

Electric Vehicle Market Growth

Even with these added benefits, the market is still expecting modest growth over the coming years due to high battery costs, with EVs expected to be roughly 4-5% of the market by 2023. I believe this estimate is conservative and that we should be thinking about 5% as a minimum share level for EVs in that time frame. By 2025 I believe we will see exponential year-over-year growth in EV sales and a rapid adoption of hybrid and electric vehicles. Looking further out, we could see 15% EV market share in 2030 with risk to the upside.

The key to reaching these volume levels will be how much the cost of the battery can decrease within the next few years. Currently Tesla is the cost leader at approximately $190 per kilowatt hour (kwh), with the rest of the industry in the $250/kwh range. Tesla believes it can drop the cost of its battery by 30% in the next one to two years through the production process and by localizing some of the materials used, but this will still make an EV more expensive than a traditional ICE. If the industry can get the cost of the battery down to approximately $100/kwh, EVs would be at a breakeven point with ICEs.

As we wait for the cost of the EV battery to come down and for performance (range) to increase, we can expect increased penetration of hybrid vehicles to bridge the gap for automakers. To meet future emissions regulations, OEMs will need to use hybrid vehicles during a transitional phase which I would expect to last two to three auto cycles. The average age of a trade-in is about five years, which implies that for the next 10-15 years we will see an increased share of both hybrids and electric vehicles.

BorgWarner

One company that has faced some uncertainty with regard to EVs is BorgWarner, Inc., a global supplier of engine and drivetrain components primarily designed to improve fuel efficiency of an ICE. With the looming transition to hybrid and electric vehicles, BorgWarner has reshaped its product portfolio to increase its offerings in this space. Through internal investment and recent acquisitions, the company has expanded into power electronics, electric motors, and other pipelines that not only add content in today’s environment but set up the company to maintain their content per vehicle as we move from ICE to hybrid and finally to EV. For example, BorgWarner’s most important product has been the turbocharger. There have been some concerns about this business because it’s hard to see a need for something that improves fuel efficiency in an all-hybrid and EV world, but we should see the market penetration of turbos actually increase with the adoption of hybrid vehicles to keep performance comparable to ICEs. BorgWarner has also increased the capability of this product by combining it with electric motors from the company’s Remy acquisition, making it more attractive for future hybrids.

The Impact of Autonomous Vehicles

Over the next few years, we also expect an increased push for autonomous vehicles as more companies test out the technology. For the next three or four years, any autonomous driving features can just be considered additional active safety content, such as automated emergency braking, lane keep assist, and self-park. Soon we will see the rollout of autonomous taxis working to provide a new model for transportation as a service (TaaS). Several companies (OEMs, ride hailing, and others) have set 2021 as a target for launching autonomous taxi fleets, with the goal of making the service cheaper than owning a car and enticing people to give up personal ownership altogether.

Today there appears to be a few possible scenarios for how the autonomous world will evolve and what TaaS will look like when fully developed. On the most basic level, we could see autonomous vehicles just replace traditional taxis, ride-sharing with a driver, and traditional modes of public transportation. In this scenario, the cost of these vehicles does not come down enough to entice car buyers away from owning a vehicle, and we would see little change to global sales and fleet size. The next step from here would be a mixed-use environment where the cost of TaaS is competitive for part of the population (mainly in urban areas), which would lead to a drop in vehicle ownership in metro areas but not in suburban or rural populations. If this scenario were to play out, there would be a noticeable drop in fleet size but a more modest drop in annual sales due to a higher usage rate shortening the vehicle lifespan. In an extreme case, which is highly unlikely to occur over the next 10 years, we could see TaaS lower the per-mile cost of travel to roughly $0.25 compared to about $1.50 for personal vehicle ownership (which could drop to $1.00 with improvements in EVs). With this dramatic difference in cost, there would be a material shift in the industry and TaaS would take over as the dominant form of vehicle transportation. This would make it difficult for any car owner to justify traditional ownership; however, some families might decide to own one personal vehicle (versus the current average of two per household) in order to hold on to the flexibility personal ownership provides. In this extreme scenario, we would see a significant drop in fleet size – maybe as much as 50% – with annual sales likely dropping at a more modest rate since vehicles would need to be replaced much more frequently.

Delphi Automotive

There is clearly a great deal of uncertainty surrounding autonomous vehicles and how they will shape the automotive industry, but Delphi Automotive PLC is one company that recognized the importance of this trend early on. When Delphi exited bankruptcy in 2012, it had a clear focus on three megatrends in the industry which it labeled “Safe, Green, and Connected.” The company made several acquisitions to build out its capabilities in all things active safety and is now capable of providing an end-to-end solution for a fully autonomous vehicle. The company also invested in areas such as cyber security and vehicle communication which will be crucial for autonomous vehicles moving forward. Delphi also evolved its powertrain business over this time to prepare for the transition to EVs and now offers a product lineup that could grow content per vehicle in a hybrid/electric world. Earlier this month Delphi split into two companies, becoming Aptiv PLC (“Safe and Connected”) and Delphi Technologies PLC (“Green”). Due to management’s ability to identify the long-term opportunities in the industry, Aptiv and Delphi Technologies are both well-positioned for the evolving landscape, with the ability to grow shareholder value over time.

At Diamond Hill, we look for companies like BorgWarner and Delphi Automotive that recognize important trends such as electric and autonomous vehicles and take the appropriate steps to position themselves for success over the long term.

As of November 30, 2017, Diamond Hill owned shares of BorgWarner, Inc. and Delphi Automotive PLC.

Originally published on December 13, 2017.

The views expressed are those of the research analyst as of December 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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