Electric Vehicles – The Opportunity of Which Decade?
Hardly a day passes without some talking head breathlessly describing electric vehicles as the opportunity of the decade. The fine point most investors miss, however, is that the decade they're describing won't begin until 2020 and for the next seven to ten years electric vehicle manufacturers like Tesla Motors (TSLA) and lithium-ion battery manufacturers like Ener1 (HEV) and A123 Systems (AONE) will hemorrhage cash as they try to traverse the trough of disillusionment that runs through the cruel black heart of the valley of death.
The following graph is a stylized view of the valley of death from Osawa and Miyazaki with a red overlay that highlights the trough of disillusionment. This is the most difficult period in the life of a product when its manufacturer must identify and eliminate any defects, optimize manufacturing processes, minimize production costs, establish a market presence and earn market share. For big-ticket items like cars, the failures and mediocre performers outnumber successes by a wide margin.
Today we're witnessing the first product launches for the Tesla Roadster, the GM Volt and the Nissan Leaf. Despite their gee-whiz glamor and sex appeal, the crushing economic reality is that it takes $46 of incremental capital investment to save a gallon of gasoline per year with a plug-in while it only takes $24 of incremental capital investment to save the same gallon of gasoline per year with an HEV. Under those circumstances, the tyrannical laws of economic gravity dictate that the time between the "Product launch" and "Success as a new product" will be five to seven years under optimal conditions and a decade or longer under likely conditions. Let's be honest, an 8-year payback on an HEV premium is nothing to write home about but a 15-year payback on a plug-in vehicle premium is absolutely atrocious.
My optimistic self wants to believe that plug-in vehicles will eventually offer a sensible value proposition for the average consumer, but my rational self knows that it won't happen quickly because paradigm shifts never do.
In 2000 Toyota introduced a new fuel efficiency technology to the US market called a hybrid electric vehicle, or HEV. The idea was to improve fuel economy by capturing braking energy and immediately reusing it for electric launch and acceleration boost. While HEVs didn't require drivers to change their driving habits or their behavior, they were met with polite skepticism until they proved their value and performance over a period of several years in the hands of consumers. The following graph summarizes annual HEV sales by manufacturer from 2000 through 2010.
In 2010, HEVs accounted for a miniscule 2.4% of light-duty vehicle sales in the US. It took eight years to sell the first million units because an eight-year payback was hard for consumers swallow and manufacturers were fighting a constant uphill battle with the laws of economic gravity. It took Toyota six years to top the 100,000 vehicle a year mark. Last year Toyota booked 69% of domestic HEV sales, Ford and Honda each booked 12%, GM and Nissan each booked 2.5% and the rest were insignificant. The only HEV model that can fairly be classified as a commercial success is the Toyota Prius.
President Obama may dream of a million plug-ins on the road by 2015, but a 15-year payback will be a non-starter for most buyers. Unless and until the technology premium falls to a point where the incremental capital investment per gallon of annual gasoline savings is competitive with an HEV, plug-ins will only appeal to a niche market of philosophically committed and mathematically challenged buyers.
The crucial fact that talking heads fail to grasp is that plug-in vehicles are not an incremental advance in automotive technology. They're a paradigm shift that will force consumers to change their driving habits and their behavior. Those realities bring human inertia into play along side the laws of economic gravity. It's not an easy market dynamic.
Since paradigm shifts are very rare, it's hard to find a current and directly comparable example. Instead we need to study historical paradigm shifts to see how they unfolded and how long the process took. One of the best examples I could find was the paradigm shift from draft animals to tractors on US farms. In that paradigm shift, the new technology was clearly superior to the legacy technology. The only real drawbacks were higher capital costs and less flexibility. Even so, this graph from Wessels Living History Farm shows that the paradigm shift occurred very slowly and it took 35 years for the new technology to earn a dominant market position.
The decade from 2020-30 may prove to be a golden age for plug-in electric drive if reliability, performance, consumer behavior and cost issues can be overcome during the next 10 years. Until then, the knock down drag out marketing battles will focus on direct competition between HEVs and plug-ins because it's extremely unlikely that electric drive will be cheap enough to compete head-to-head with internal combustion engines before 2020.
Under all reasonably foreseeable scenarios, the major business opportunity for the next decade will be improving efficiency for the 90% to 95% of new vehicles that won't have electric drive. In Europe, existing regulations require automakers to achieve an average fuel economy of 42 mpg for gasoline engines and 48 mpg for diesel engines by 2015. In the US, existing regulations require automakers to achieve an average fuel economy of 37.8 mpg for passenger cars and 28.8 mpg for light trucks in the same time frame. Stricter rules are already being discussed for 2020 and beyond. The specific fuel saving technologies automakers choose to meet these new fuel economy standards will not be offered to consumers as options. Instead they'll be standard equipment. Given a choice between relying on marketing and relying on government regulation, I'll bet on government regulation every time.
While emerging mechanical efficiency systems are a bit out of my depth, the leading electrical efficiency system for the next decade will be stop-start idle elimination. If you think about it for a second, it's the most sensible idea around - turn the engine off while your car's stopped in traffic. For simple systems that improve fuel efficiency by 5% the cost is only a couple hundred bucks. For more complex systems that improve fuel efficiency by 10%, the cost is still under $1,000. The one thing that both types of stop-start systems need is better starter batteries, which sets up a wonderful business dynamic for old line lead-acid battery manufacturers like Johnson Controls (JCI) and Exide Technologies (XIDE) and emerging lead-acid technology developers like Axion Power International (AXPW.OB). They may not sell any more batteries, but they'll sell better batteries that have higher prices and higher profit margins. Once you understand that an estimated 34 million new cars a year will need better batteries by 2015, the top line revenue impact and the bottom line profit impact will be stunning. It's a bird in the hand and nobody's paying attention because the application isn't sexy.
I've spent the last 30 years working as securities counsel for companies that were trying to traverse the valley of death. While it's always a miserable time for management teams, it's a disastrous time for investors and it's not unusual to see equities lose 90% of their value before the price begins to recover. Despite the media hype, investors in electric drive are in for a decade of unrelenting pain as plug-in vehicles experience slow uptake rates and have to compete with simpler and cheaper HEVs for market share. With slow plug-in vehicle uptake rates, it will be at least seven to ten years before widely heralded but vaguely defined economies of scale kick in.
If we learned anything from Microsoft and Apple, it's that the objectively cheap technology is the place to be for the first ten to fifteen years of a technological revolution and the objectively cool technology is only a reasonable investment when they figure out how to make cool cheap.
Disclosure: Author is a former director of Axion Power International (AXPW.OB) and hold a substantial long position in its common stock.