Research in action: EVs drive into a new lane for investors

Carolyn Bigda:  From Janus Henderson Investors, this is Research in Action, a podcast series that gives investors a behind-the-scenes look at the research and analysis used to shape our understanding of markets and inform investment decisions.

On today’s episode, we’re talking about electric vehicles, or EVs, an industry reaching an inflection point. In December, for example, Europeans bought more electric cars than vehicles with diesel engines. And in May, Volkswagen announced it had sold out of its battery EVs in Europe and the U.S. for 2022. But not all companies are likely to succeed, and production constraints are helping to punish EV stocks. Chris Benway, a research analyst who covers the industry says investors need to keep these factors in mind when looking at EVs.

Chris Benway: We are not worried about demand, we are worried about supply. And, you know, I think the industry rightly is focusing on that.

Bigda: I’m Carolyn Bigda.

Matt Peron: And I’m Matt Peron, Director of Research.

 Bigda: That’s today on Research in Action.

Chris, welcome to the podcast.

Benway: Hi, thanks for having me.

Bigda: Maybe a good place to start the conversation is just with an update on how large the EV market has become. What percentage of global auto sales do EVs make up now, and how quickly are those sales growing?

Benway: Sure, maybe I’ll provide a little perspective. So, back in 2019, before COVID happened, total vehicle sales globally were around 90 million [vehicles]. Then, when COVID happened, demand waned and sales went down to around 77 million, and they’ve only recovered a little bit to around 81 [million] to 82 million in 2021.

Now, from an EV standpoint, back in 2019, EVs were only about 2 million, a little over 2 million, or 2% or 3% of the total sales. Fast forward to 2021, and those sales have nearly tripled. And as we look into 2022, EV penetration will be around 12% or 13%. So, we’ve really jumped from 2% in 2019, to nearly 12% to 13% in 2022, in the midst of supply chain challenges, COVID. And so, you’ve really seen the demand jump as you described earlier.

Bigda: Right, so there’s growing demand even with the supply chain challenges, like you said. And for a while, though, it was start-ups such as Tesla and China’s BYD that captured the bulk of these EV sales, while incumbent automakers really lagged behind. But now it seems Ford, GM, Volkswagen and other legacy players are making a big push into the market. What’s changed?

Benway: Sure, I would say, you know, Tesla is what has changed. Tesla has really pulled the legacy auto OEMs [original equipment manufacturers] into more the EV framework versus their legacy ICE [internal combustion engine] framework, and a couple of reasons for that. One, just the tremendous success Tesla has had in opening that market, showing the consumer demand as they become a little more environmentally focused and friendly and, you know, kind of pulling that EV demand. Also, a big portion is the cost structure. So, legacy OEMs like GM had the Chevy Bolt, which didn’t really get a lot of traction and the cost structure was much higher because the battery technology was much more expensive than a traditional ICE powertrain or ICE engine, or internal combustion engine vehicle.

So, you have, now, consumers kind of pulling demand, you have the cost structure much more attractive than it was historically. And as a result, all of the legacy OEMs – GM, Volkswagen, Ford – are committing billions. GM is committing $35 billion over the next five years, Ford is committing $30 billion to building out EV facilities, EV vehicles.

Bigda: And by OEM, Chris, you mean original equipment manufacturer, correct?

Benway: Right, yes.

Bigda: Maybe just quickly, before we talk more about the industry itself, is there any good explanation for why there’s been this pick-up in demand among consumers?

Benway: I think it’s that they’ve experienced the vehicle, and the experience of an electric vehicle is superior to an ICE vehicle. So, when you get in, there’s things such as regenerative braking, where it breaks on its own largely. The acceleration is much better than the ICE vehicle. It’s much quieter. When I first got into a Tesla and then got back into my traditional ICE vehicle, you just, you notice the difference. So, I think it’s a superior experience, which is helping drive that demand.

Bigda: So, it’s actually a better product.

Benway: Correct.

Bigda: And that’s driving the demand, okay. Does the fragmentation of the EV market, as it’s happening now, does that make it harder to forecast which of these companies will gain that competitive advantage and be able to deliver sustainable growth in the years to come?

Benway: Yes, you know, I would say our Research Team, what we fall back on is, like you just said, this superior product and what makes a superior product. So, something that’s really unique that I think gets lost in the conversation is that the Teslas of the world, the Rivians, the upstart auto OEMs, have been able to develop a vehicle from a clean-sheet approach. And as a result of that, what they’ve been able to do is make the vehicle software enabled. So, historically, legacy auto OEs such as GM, they had to come out with model years each year, which had small incremental updates. Now, you know, the Teslas, the Rivians of the world, they have a unique electrical architecture which allows them to update the vehicle essentially overnight. And so now, they’re really becoming – we hear the term software-defined vehicles – but that’s very true in that they can improve that vehicle overnight. Whereas the legacy OEs are challenged in manufacturing a vehicle that allows them to have what they call over-the-air updates and to consistently improve that vehicle. So, I think that is a very unique aspect and something that, you know, will really drive that secular growth for the new companies that can cross the chasm and can make it, in that they do have a much superior, software-defined vehicle in addition, to you know, the electric vehicle’s superiority itself.

Peron: And I think, Carolyn, it’s important to note that in addition to the trends that Chris identified, which he was on early about the complete integration of the whole hardware and software stack across the EVs and these new OEMs, in terms of picking the winners and the losers, that’s a nice hypothesis. But Chris logged a lot of flight miles, as we do on our Research platform; in general, we want to go out and see the companies. So, Chris, you know, found himself in all kinds of different interesting places.

Benway: Yes.

Peron: Normal, Illinois was one of them, and obviously, Fremont and some other places, too. You know, to actually see, does this work in practice? This is a nice concept, let’s see how it plays out. And that really helps identify the winners and the losers when you see it really in action.

Bigda: Yes, I think it’s interesting when you were talking about the software aspect of it because one way I’ve heard it, just heard the auto industry now being described is that they’re now turning into software companies. They’re not just manufacturing anymore. It’s definitely also about the software, and that that’s very important to determining who will sort of take the lead in this transformation of the industry itself.

Benway: Yes, and to Matt’s point and to that point of hardware versus software, I think, again, the Teslas of the world, they are hiring advanced engineers, they’re going to the MITs and the Carnegie Mellons. It’s not so much, you know, hardware engineering, it’s now much more software engineering. And, you know, I think that will only accelerate going forward.

Bigda: And Matt, this is creating a fair amount of volatility, though, in this area of the industrials sector, correct? Because as these companies try to transform themselves, there’s no clear insight yet as to who’s sort of going to take the biggest market share at this point. And so, can you talk a little bit about that volatility now that we’re seeing in this area?

 Peron: Yes, sure, that volatility is really reflective of the modeling challenge for these companies, right? What type of share will overall EVs get, which Chris mentioned is, you know, the adoption rate has been inflecting. That’s a big driver of the modeling, as well as the share of the individual companies, their ability to source materials, to have the technology stack, etc. So, Chris has the challenge of putting that all together and modeling that. And that, you know, the financial performance is very sensitive to some of these variables. Hence, that’s driving the volatility. That’s what’s behind it. And we are mindful of that, so during our modeling – as we do, you know, we produce scenarios and ranges of outcomes – and that helps guide us. But first and foremost is the primary research that we mentioned earlier, and then from there, putting the modeling together and doing the legwork.

Benway: I would also make the point that it just, in the uncertainty, we place a lot of emphasis on either free-cash-flow generation sustainability or having enough capital and backing to make it, you know, over a multiple-year time period through the volatility. Do these companies have legitimate healthy backers? So, we put all those into the framework as well, and you’re starting to see a bifurcation now of the Faraday Futures and the Lordstowns and the Bollingers, you know, that were upstarts a few years ago, are now starting to fall to the wayside. And you know, some others are rising to the top.

Bigda: Maybe we just take a step back a little bit and talk about why did a company like a Lordstown fall to the wayside, like you said, whereas a Tesla has been able to continue to grow from here?

Benway: Sure, I would say, you know, an anecdote of RJ Scaringe, who is the CEO of Rivian, has talked about, he’s always wanted to build a car company. But as he got into it, you know, over the past few years, he really realized to build an auto company from scratch required billions of [dollars in] capital. You know, we’re not talking about $1 billion or $2 billion, we’re talking about $10, $20, $30 billion of capital. And so, I think that’s one differentiation, is that, you know, some of these smaller upstarts, they just did not have the capital infusion or the commitment from their investors that, you know, this was just the first round of multiple rounds as they get there.

And so that’s one point. The other point is just the, again, product superiority, the engineering talent, the focus over the long term, which again, attracts capital to those businesses that, you know, does seem like they will be sustainable and improve over time and have that superior product.

Bigda: And does the current market environment set the bar even higher for these companies, when you think about the supply constraints with just, you know, sourcing semiconductors, for example, or getting enough labor into the factories to produce these cars. I mean, is that making it just even that much more challenging for the startups, as well as the sort of legacy players to move forward?

Benway: Yes, I mean it definitely has posed challenges for the entire industry: getting the batteries, getting the raw materials, the lithium, copper, and other raw materials. So, yes, it’s been a challenge across the board. Scale does help, but at the same time, I think the suppliers also have to weigh, what is the industry going to look like in five years, in 10 years? And will the dominant players and the high market-share players now be in that position in five years’ time or 10 years’ time? So, the semiconductor suppliers, the raw material suppliers kind of have to weigh that they just can’t support GM or Ford. You know, I think they have to take kind of a broader, longer-term perspective.

Peron: So, I think what you’re getting at, Carolyn, is we’ve shifted from will there be enough demand to now, is there enough supply both of semiconductors and – a topic we touched on in a previous podcast – the commodity supply chain and just sourcing all these raw materials. Those are now more what we’re worried about than we are, will the demand be there?

Benway: Yes, yes, exactly. We’ve seen, you know, pretty much CEOs from every large auto company and upstart auto company talking about this as their main focus over the long term is, do we have enough batteries? Will we have enough batteries? And we’ve seen the large battery manufacturers put capital in the ground nearly daily, or announcements nearly daily, with CATL [Contemporary Amerpex Technology Co.] and LG and Samsung SDI, you know, all having joint ventures or building their own facilities as they try to supply the industry with enough batteries. And we’ve also seen the CEOs talk about going all the way to the raw material suppliers and securing contracts. You know, Tesla’s secured contracts with Vale and many other raw material miners and suppliers. So, yes, we are not worried about demand, we are worried about supply. And you know, I think the industry rightly is focusing on that.

Bigda: Talk to me a little bit about the different automakers’ approach to actually producing these vehicles. Is it becoming clear yet if there’s one way that’s better than another? So, for example, a company that sources all of its own materials, the lithium and whatnot that it needs, then developing its own batteries and then manufacturing its own vehicles. Or is it better to outsource some of these operations?

Benway: Yes, you know, [there are] multiple parts of that question, I would say. One aspect of it is, again, the upstart auto manufacturers who focus on EVs have been able to build facilities from scratch because an EV is a little less complicated to build than a traditional ICE vehicle. You know, there’s fewer steps, and we’ve seen Tesla really take the lead on improving the manufacturing process. So, that’s one aspect, in that the legacy auto manufacturers are having to refurbish and, you know, having to kind of fit their previous manufacturing facilities to fit the new EV production style, which is a lot less complicated and takes, I think, 40% or 50% less space, less capacity. That’s one aspect of it.

The other key part is that we’ve seen, you know, kind of GM, we’ve seen Ford and we’ve seen, you know, Tesla and Rivian partner with the battery manufacturers to help secure supply in JV [joint venture] agreements or public partnerships. So, yes, everyone is taking a little bit of a different approach, but at the end of the day, they’re all trying to get to the same endpoint of security of supply across the supply chain.

Maybe one last aspect that we’ve seen is more vertical integration, especially of the Teslas and the Rivians of the world. And that’s crucial because as we talk about, you know, more of a software-defined vehicle, if you can also vertically integrate the hardware, you can marry the two and that enables you to do much more versus, you know, just having a solo hardware supplier and a software supplier. If you can bring the two together, you can make them work much better together, you can write software that, you know, increases the functionality. So, I think we’ll see more vertical integration going forward.

Bigda: And does the benefit of the vertical integration justify the capital cost that has to go into that?

Benway: Sure. Yes, you know, I think it does because not only does it make the product better – so where they can price the product a little higher – but I think it also, there’s also cost savings because you’re taking out, you know, the second-, the third-tier suppliers and the cut that everyone’s taking in between. So, I think the benefits definitely outweigh maybe a little bit higher costs.

Peron: And you see that evidenced by the [gross] margins, the superior margins that these companies are gaining. It’s really proving out this approach and this business model.

Benway: Yes, it’s pretty incredible. No one thought that the auto industry could produce 30% gross margins, and that’s what Tesla has done compared to the legacy; you know, always the best ones have 20% gross margins. So, yes, to Matt’s point, the vertical integration, the superior manufacturing capabilities, we’re really seeing them play out in the results.

Bigda: I think another sticking point that I read about a lot is the challenge that the legacy players have with creating new models or retrofitting existing models. And is it clear yet if one solution or one option is better than the other?

Benway: Yes, I mean that’s a great question. What we’ve seen – and Ford is kind of taking the lead on this – is that they’ve separated their businesses, and so, you want to have kind of that clean-sheet approach. You don’t want to be influenced by legacy thought, the legacy engineering and, you know, legacy way of doing things. And so, yes, they have tried to separate their businesses out to where they solely focus on EVs and then solely focus on ICE vehicles to allow the EV innovation process to be, you know, much better than it would be historically.

There’s multiple challenges for the legacy OEs, you know, in addition to that, in that their supply chains are very focused on the ICE vehicle. And so, they’re having to build out new supply chains, like we talked about. Their manufacturing facilities, you know, are much more oriented to ICE vehicles. And then also, just their electrical architecture is much more legacy, and so they’re having to try to update quickly to match, you know, some of the startup EV players.

And then at the end of the day, with global auto sales that won’t grow that much, you know, maybe grow with GDP [gross domestic product], give or take. And so, for the legacy OEs, one EV sold is likely one ICE vehicle not sold. And so, it’s a zero-sum game for them. So, their EV business may be growing rapidly, but their larger business, the legacy internal combustion business, is shrinking. And so, you know, they don’t really get to benefit from that rapid growth because, you know, they kind of have their legacy business that is declining.

Bigda: Right, so in some ways they’re almost just trying to tread water.

Benway: Exactly.

Bigda: And then the other, I guess, sort of negative, if we want to call it that, is that a lot of them are starting from a later point, right? So, Tesla has been doing this now for years, whereas I think I read that Toyota won’t have a true EV vehicle out on the market until something like 2024?

Benway: Yes, they’ve been very behind the curve. They’ve also been focusing on other options, hydrogen and what have you. But yes, we’ve really seen that in the relationships that Tesla has struck with their supply chain, with the innovation that they’ve been able to come up with. So yes, there is considerable first-mover advantage, and it seems like that’s only going to accelerate going forward. So yes, the legacy OEs have a lot of obstacles ahead of them.

Bigda: But the legacy OEs also have a very strong brand. I mean, they’ve been around for decades, and there’s a lot of people still in the world that don’t have an electric vehicle. So, could that brand value that they have with their existing customers, could that help buoy them down the road?

Benway: Sure, definitely. We’ve seen that with Ford. You know, they have their F-150 Lightning electric vehicle, and they had to shut down orders I believe at 200,000 because they had too many. So… Or they couldn’t fulfill that for multiple years. So, yes, there is brand value, there is, you know, loyalty. So, I definitely think the legacy auto manufacturers will be around. They won’t go away. But from an investment standpoint, that doesn’t necessarily make that, you know, a great investment case.

Bigda: So, let’s talk about the investment standpoint a little bit because given what we’ve talked about, it sounds like EVs have sort of moved beyond the hype cycle of their evolution. But there’s still plenty of potential volatility for investors to contend with. So, is there a way to kind of dip your toe into this space but avoid getting caught up in a bad current and lose everything?

Benway: Sure, I would say yes, there is. And going back to maybe what we discussed a little bit earlier is, how we try to insulate ourselves from that is, you know, is the company generating free cash flow? Is that free cash flow growing, or is their capital structure in a position that will enable them to ride out kind of that volatility that is inevitable over the next few years. And again, do they have, you know, solid financial backers that will help them, as we talked about. You know, a lot of these companies are still going to require additional capital in the years ahead, and so, you know, can we get comfortable that the investment base will be there to help provide that capital to get them to a point where they are free-cash-flow positive.

Peron: I think to sum up what Chris is saying is that they have to have the technology, they have to have the capital to ride through what will be a long development cycle, and they have to have the supply chain. And so those, in general, help us sort out what might be a good investment. But I would caution this is not for the uninformed. This is a complex space, and it requires a lot of research.

Bigda: What about potentially more tangential ways of getting exposure to EVs? Can you do it through semiconductors or other suppliers?

Peron: Well, you know, we touched on this in the last podcast around the supply chain, is a way to play the electrification theme in general, which includes EVs, as well as new transmission lines, wind and solar development – renewable fuels, I should say. So yes, this is a narrow space of a broader theme, for sure, that we’ve been talking about for some time, which presents multiple opportunities. But in terms of EVs in particular, it’s a very nuanced and complex space.

Bigda: Does the market sell-off of recent months make the industry or the stocks, I guess, more appealing, or just lower the temperature in terms of the risk with these stocks?

Benway: Yes, I would definitely agree with that. I mean cost of capital has gone up because interest rates have gone up. Access to funding, you know, might be a little more limited, so, you know, I think what’s occurred is rational. But yes, we see some of these stocks as very attractively valued.

Peron: The market has treated them all as one bucket and has not differentiated as much between the winners and losers. And I think you’ll be able to look back in five years, so the ones that have survived, and say, ‘Wow, you were able to buy it in 2022 at that price.’

Bigda: So even with the market sell-off and valuations looking more attractive at this point, what are the biggest risks, in your mind, for EV growth at this point?

Benway: Sure, yes, so taking demand off the table because we’re confident that demand will be there over a multiyear time period, I think the issue is supply and specifically, the supply chains and can they be built out quick enough to match the demand. And can they be built out in a cost-effective manner to where that demand sustains over long periods of time? So yes, we’re focusing on the battery manufacturing: Is battery capacity ramping quickly to meet the demand? Are the raw materials suppliers ramping their mining and their production fast enough to meet the demand? So, yes, it’s, you know, very tight now, but we’re seeing huge incremental capacity adds, and we think that will continue going forward. And we think the auto OEMs will demand that as they look to fulfill the demand. So, the supply chain is going to be a little bit of a challenge and volatile year to year, but we think ultimately it will be addressed.

Peron: And one thing Chris mentioned there is batteries. That’s a really important part of the EV story here. And while I don’t think it’s necessarily a risk to EV adoption, we do need battery technology to get better. It’s slowly getting there, we’re doing a lot of work on that on our Team in terms of looking at the pace of battery improvements, but that’s a key gating factor to the growth rate in this space. And I think if we could have a step-up in battery capacity, we’d see demand really take off.

Benway: Yes, that’s true. It would be a multiple benefit that we would see. Obviously, the availability of the product would be there if we had more battery capacity, but also you would get the benefits of economies of scale, you know, as we really leverage the fixed costs and the capital investments, which would help drive the battery price down. Interestingly, over the past 10 years, the cost of a battery cell has declined by 90%. So, we’ve made tremendous leaps and bounds in advancement, but we’ve started to plateau a little bit, and so, a lot of the battery manufacturers are now and even the OEMs – so, Tesla being, you know, kind of a main one – are now starting to innovate and trying to move that curve down, you know, even more to where we are able to lower that cost to make the overall vehicle price much more attractive to a wider range of consumers.

Bigda: Is there a risk that a new technology could come along that would supplant the batteries that are being used today to drive electric vehicles? Because hydrogen fuel cells seem to be standing in the wings as a potential other option for replacing the internal combustion engine.

Benway: Yes, there’s a lot in the works. Maybe just sticking on the battery side, currently, they use lithium batteries, but potentially, there’s use of manganese and other chemicals within the battery that could make it cheaper. And then kind of longer term, there’s a lot of companies focusing on what they call solid-state batteries, which store much more energy. That technology is still very nascent, and, you know, still the range of outcomes is very wide on when we’ll be able to crack the code there. But there are a lot of companies trying to figure this out and trying to innovate. And you know, I would say in five [years’] or 10 years’ time, there probably will be some technology – be it hydrogen, be it battery – that does lower the cost and make it much more economical. So, you know, this is something that we’re spending a lot of time on. There’s still, you know, a lot of uncertainty in this space, but we’ll continue to focus on it.

Peron: And Carolyn, we see that more as opportunity. You framed it as a risk. A breakthrough would be terrific for the EV OEMs, in general. So, I think that’s more opportunity than risk.

Bigda: Because that breakthrough means that they wouldn’t have to reinvent themselves again, right? It would just be putting in a better technology into these existing cars that they’re creating?

Benway: Correct, yes. I think the main thing would be it would lower the cost. It would lower the cost of the vehicle; it would make it even more attractive than a traditional ICE vehicle. And then when you layer on top of the technology advantage that we talked about in the software-defined vehicle, it would just be a much better product at a cheaper price.

Peron: And it would lower the infrastructure lift, wouldn’t it? Right, one of the issues around consumer adoption has been range anxiety, right, the recharging. So, lowering the time it takes to recharge or raising the capacity of the battery in terms of its energy density, would really make it even more appealing to consumers.

Bigda: And you actually bring up an excellent point, which is the charging stations and just the infrastructure that’s in place – or the lack of infrastructure – for electric vehicles. Is that another risk that we are keeping an eye on? Or do we see that changing over the next couple of years?

Peron: Well, certainly, I think it’s back to the earlier point: It limits the growth rate, wouldn’t you say, Chris?

Benway: Yes, because we’re still so nascent, you know, it does seem like multiple companies are building out the charging infrastructure. And, you know, while we can charge in our garages, we’re still, you know, at kind of low teens adoption. And so, charging at home should enable continued rapid adoption, and then it’s kind of a self-fulfilling prophecy. The more EVs are out there, the more it makes sense to build out the charging infrastructure. And so, I think, you know, it will be addressed and resolved to where it’s not a massive gating factor.

Bigda: And maybe just to round out the discussion, what is happening that is most exciting to you right now in the industry that perhaps maybe doesn’t get a lot of attention but could be important for EVs in the months or years to come?

Benway: Sure, I would go back to, you know, the fact that these vehicles are becoming software-defined or becoming software-enabled. And, ultimately, the holy grail of that is if the vehicle is software-enabled, it could potentially have autonomous software and it could potentially drive itself. And there’s been a lot of claims and a lot of back and forth, and I think we’re still early stages of that. But, you know, I think the fact is that the structure of the vehicle is being built to where it could have the autonomous capability over time.

Peron: That’s a really important point, if I can. The change from a traditional vehicle to a software-defined vehicle that, you know, Chris has highlighted throughout his work on this sector, is really important and game-changing. And you see it – as a former technology analyst myself – you’re starting to see these look like technology companies. You have a platform, you can download software, it actually can control the car in a much better way. EVs are just an enabler of that because it simplifies the actual hardware required. But that’s a really big change, and you see it as a true innovation that will drive better consumer experience, like a smartphone would. You see it come through in the margins to business models. These margins are starting to look more and more like a technology – we’re not all the way there – but like a technology company. That’s really exciting.

The other thing that’s exciting, from my standpoint looking across sectors, is the more adoption of EV vehicles by the consumer will just drive so much more investment in batteries, like we’ve seen. And batteries really are a game changer – or could be, have the potential to be – for broader societal goals, such as the transition to alternative energy. So, seeing the EVs drive and be at the front of the spear for battery technology is really exciting, and I think it’s going to pave the way for some significant step-function gains in the future for consumers.

Bigda: So, even though EVs seem like a big transformation right now, they’re really just a launching point at this point, it sounds like.

Peron: Yes.

Bigda: Well, Chris, thanks so much for joining us today. We’ve really appreciated having you on.

Next month, we will get an update on the latest developments in biotechnology, which, despite a brutal sell-off in the sector’s small and mid-cap stocks, continues to churn out life-changing medical breakthroughs. We hope you’ll join us.

Until then I’m Carolyn Bigda.

Peron: I’m Matt Peron.

Bigda: You’ve been listening to Research in Action.