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COLUMN-A self-driven road to capital destruction: James Saft
May 28, 2015 / 8:28 PM / 3 years ago

COLUMN-A self-driven road to capital destruction: James Saft

(The opinions expressed here are those of the author, a columnist for Reuters)

By James Saft

May 28 (Reuters) - What happens to an industry which develops a new offering so fantastic that ownership of its product is cut in half?

Investors in the carmakers may in coming decades find out, as the advent of driverless cars disrupts (there really is no better word) an industry already suffering from over-investment and poor long-term performance.

Cars that drive themselves will do just that, allowing owners to keep a given vehicle working more of the time. That will lead to a more than doubling in annual mileage per car over the next 25 years but bring vehicles per household down by nearly 50 percent, argues Barclays auto analyst Brian Johnson.

That will translate to an annual drop in U.S. auto sales of about 40 percent and a 60 percent cut in the national car fleet, according to Johnson. To ‘survive,’ General Motors would need to cut North American production by 68 percent and Ford by 58 percent.

“A historical precedent exists: horses once filled the many roles that cars fill today, but as the automobile came along, the population of horses dropped sharply,” Johnson wrote in a recent note to clients. The U.S. horse population dropped from a peak of more than 21 million in 1915 to six million in 1949.

It isn’t just that the family car will be able to handle more of our needs, allowing for lower vehicle ownership.

Shared self-driving vehicles and pooled self-driving vehicles (think a self-driving Uber) will further cut back on demand. Johnson estimates that whereas Uber can offer shared rides at $3 to $3.50 per mile today, ultimately that service might fall in price to as little as 8 cents a mile if the car is doing the driving.

For those of us stuck chauffeuring our offspring from school to activities to playdates this may all seem a dream, but for investors in the automotive business, not to mention the car companies and suppliers themselves, it could be a bit of a nightmare.

It isn’t that there aren’t strategies to manage and profit from transformation and decline, it is that these are difficult to pull off, and are a game not every player can win.

Fiat Chrysler chief executive Sergio Marchionne has been unusually frank, not just about the poor performance of the industry, but about the need for combinations to bring costs, notably of research and development, under control.

“I am absolutely certain that before 2018 there will be a merger,” Sergio Marchionne said on Thursday in the wake of reports he’d explored a deal with GM.

BAD BUSINESSES AND GOOD STRATEGIES

Marchionne titled a recent presentation "Confessions of a Capital Junkie," arguing that the industry won't be able to make acceptable returns on capital without mergers and joint ventures. Ironically much of the capital will feed the investment in demand-killing, self-driving cars. (here)

You don’t often see industry titans not only admitting that their sector hasn’t covered its cost of capital but more or less begging to be put in rehab.

Aswath Damodaran, a valuation expert at New York University, says the auto industry qualifies as a "bad business." (here)

Not only is the industry globally not generating a return on invested capital equal to its cost of capital, which Damodaran calculates at 7.53 percent in 2015, but has only done so once in the past 10 years.

There are, according to Damodaran, four main strategies for bad businesses: sell up; starve it and take cash out; close your eyes and hum; or, finally, restructure aggressively.

The last, which Marchionne is advocating, has the potential for high rewards but also carries high risks. It is very easy to get the execution wrong and to make your outcome even worse.

As an investor, of course, it isn’t so much about the business model as it is about price. Pay the right price and you will do handsomely out of even a quickly dwindling industry.

But many investors, not to mention executives, are slow to recognize that the business they steer or own is on the slide and mark it down accordingly.

“If we attach large values to the disruptors of existing businesses, consistency requires us to reassess the values of the disrupted companies,” Damodaran writes.

“Thus, if we are bidding up the values of Tesla, Uber and Google (driverless cars) because they might disrupt the automotive business, does it not stand to reason that we should be bidding down (at least collectively) the values of Volkswagen, Ford and Toyota?”

That itself may be the biggest impediment to Marchionne's vision coming good. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)

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