Multiple technologies are converging on the auto sector. What does it mean for investors?

The news media, Wall Street, government and business leaders have been busy exploring the future of transportation lately. Concerns over the climate impacts of fossil fuels and challenges of congestion in urban areas, combined with optimism on technology, have created an anticipation of fundamental change on a global basis. This is more than ‘50s style futurism, however, and the advances “in the lab” are coming at breathtaking speed, with major implications for manufacturers and suppliers—and potential opportunities for investors.

New Tech Is Coming Quickly

Historical Penetration Rates of New Auto Technologies

Source: WardsAuto, BofA Merrill Lynch.

Move to Automation

Whether in video or live, most everyone has seen the sensor-laden test vehicles that are being employed to make autonomous driving a reality. Every major car company has been at this work, along with tech companies such as Google, Apple and Intel, and ride-hailing companies like Uber and Lyft. It is a race long in the making. The growing ubiquity of sensors and cameras, the ability to map all our roadways, advances in robotics, the spread of personal technology—all have contributed to the re-creation of the skills and knowledge needed for the task of driving.

No one is traveling in fully self-driving cars just yet. There are about 90 million cars manufactured each year globally and none have fully autonomous capabilities. However, what they do have are the building blocks: autonomous emergency braking, radar for adaptive cruise control, traffic jam assist for driving in congestion, blind spot monitoring and “lane keep” assist, to name some examples. But the technology is developing faster than most people think, likely putting commercially deployed autonomous vehicles on the road by the early 2020s.

There are some hurdles to overcome. First, the public is currently wary about handing over the wheel to a machine. For example, 55% of U.S. and German respondents in a recent Gartner survey said they would not ride in a fully autonomous vehicle due to concerns about the ability to handle unexpected situations and other issues. However, 71% might consider riding in a semi-autonomous vehicle, and we believe that with real-life experience, people will gradually become more comfortable with autonomous technology, particularly as 94% of accidents are caused by human error.

Second is the matter of cost. Initially, even basic autonomous vehicles are going to be very expensive. That’s an issue similar to televisions and computers back in the day, and it will take time to move down the cost curve in this case as well. Assuming the initial sticker shock is too great for most individuals, where will the initial demand emerge for self-driving cars? We think a key factor will be ride sharing.

Despite their innovative approach to the taxi/livery business, companies like Uber and Lyft still have a significant, potentially non-negotiable cost: the driver. The ability to remove humans from the equation would be a boon for profits, which is why ride-sharing companies are spending so much time on autonomous driving. Other commercial uses could support near-term demand. For example, Ford recently entered into an agreement with Domino’s to deliver pizza, and we see other opportunities within the truck and rail, and mining industries. Greater use of autonomous vehicles in public transportation could also be a viable middle step. And exposure to autonomous car services, food delivery and other services could help with acceptance of the technology.

Longer term, the appeal of self-driving cars may in part lie in their potential impact on personal finance. People typically use their vehicles only 3% – 5% of the time. Currently, sharing services like Zipcar essentially operate as very short-term rental agencies, good for those who live where car ownership may be impractical or who need rentals on an ad hoc basis. Then there’s Turo, which allows car owners to rent out their vehicles to others. These companies have operated with mixed success due to issues like competition, insurance coverage and vandalism, but the addition of automated cars would likely make their offering more flexible and appealing. Ultimately, talk is of a full ecosystem in which people are able to use cars only when they need them, and to rent them out when they do not, as a potential revenue generator.

Is an Automation Wave in Store?

Advanced Driver Assistance/Automated Vehicles

Development Speed

Source: CLSA and Neuberger Berman. At levels 1 and 2, a human monitors the driving environment, with the car’s systems providing (1) assistance or (2) partial automation. At levels 3 and 4, the car provides primary monitoring of its environment, with increasing degrees of automation. Level 5 represents fully automated driving.

Estimated Unit Growth

Source: Intel.

Building a Better Battery

These two elements—automation and ride sharing—are symbiotic, but another trend is related closely to both, and that’s electrification. Much of the world is convinced of the relationship between man-made carbon and climate change. They see cleaner automobiles as a key element in the fight to reduce global warming—in the short term by vastly reducing tolerated emission levels from traditional cars and, in the intermediate to long term, mandating a complete shift to electrified cars.

This past summer was a particularly active news period for this trend, with France and the U.K. announcing the potential elimination of gas and diesel cars by 2040. China, the world’s largest emitter of greenhouse gases, said it would eventually impose a ban on traditionally powered cars, although it has yet to set a timetable. In the U.S., some states have reaffirmed their dedication to curbing carbon emissions and supporting alternative fuels and electric cars. California, as the most influential state on safety and environmental regulation, is being particularly vocal on this front.

Of course, cars with an electric power component have been around for a long time. It’s been 20 years since Toyota first released the hybrid Prius, and despite often frothy predictions about the potential growth of electric cars, their development has been sluggish at best. The reason? Batteries.

The technology revolution we are currently experiencing is in large part due to advances in digital processing, allowing greater amounts of data to be transmitted at ever-increasing speeds. However, progress in battery effectiveness has been far more incremental. It took 150 years from the creation of lead-acid battery cells to the introduction of better performing nickel-metal-hydride batteries in 1989, and 10 years for now-commonplace rechargeable lithium-ion batteries to move from the lab to video cameras in 1990.

For cars, a key issue is that liquid batteries cannot be closely packed together without creating a fire hazard. Hence, the battery life and thus the range of electric cars has been limited—to some 75 – 150 miles per charge in most cars. Charging speed is typically quite slow, sometimes requiring several hours to completely power up, particularly if the battery has little charge remaining. That’s less of an issue if you plug the car in at night, but a practical impediment on longer trips. The longer the battery life and faster the charger, the more expensive the car—a key issue in the overall affordability of electric cars.

Infrastructure to support electric cars is crucial. This is less of an issue in Europe (particularly Scandinavia) and California, which have been supportive of alternative fuel vehicles. However, the U.S. generally has very few charging stations, and is providing little reassurance to offset general driver anxiety about getting stranded. Moreover, the question of whether electric cars would actually be “cleaner” is an issue in the U.S., as much of the electrical grid is still dominated by coal—something that is changing only gradually.

Progress is being made, both on battery effectiveness and cost. For example, Toyota has announced development of a solid-state car battery that could potentially double the range of its cars. Nissan recently reintroduced its affordable Leaf electric car with vastly improved range. Companies like Samsung and Panasonic are investing billions of dollars in battery technology, and China—which has dived wholeheartedly into new generation autos along with other tech sectors—has invested $10 billion in the area.

As charging times move down, battery capacity increases and the number of charging stations goes up, we believe that current consumer ambivalence will gradually dissipate. And as costs decline for electric cars, the cost/benefit analysis that has thus far benefited traditional cars is likely to shift. In the meantime, hybrid cars are the most likely solution.

Addressing the Transition in Portfolios

What we find interesting about the current trends in the auto sector is not just the end integration of automated cars, electrification and ride sharing, but how things could evolve along the way. Cars are getting smarter, and that means more sensors, processing power and software. For investors, we believe that this creates opportunity in companies that are well-positioned to supply these elements to the car makers, as well as aggregators who can package multiple products for them.

In contrast, things could get harder for pure “metal benders” that provide parts to the auto companies. With limited after-market business or value-add technology or service, they will likely have to rely on cost cutting to transition to an era with lower car volumes.

For the large original equipment manufacturers (OEMs), the picture is mixed. How companies do over time probably depends on how they handle the technological evolution and its ramifications. For example, if you assume that autonomous-capable cars take off, and there are more on the road, then it’s also likely that ride sharing will expand as well. If so, car companies will probably produce fewer cars. However, this could be partially offset by higher usage, which could drive greater aftermarket work.

Despite the looming changes, however, we believe auto OEM earnings and thus share price behavior are unlikely to change much in the near term. Their fortunes should continue to be driven by the economic climate and their ability to weight their sales mix toward larger, more profitable SUVs and trucks. Even firms that are doing things right on the technological front appear unlikely to see a significant bounce from those efforts given their relatively limited impact on the current bottom line.

A more transparent, and direct, way to access the transformation in autos is in companies that are supplying the new technology. If a given company is able to put a camera in a car, that could constitute a real win that would potentially be reflected in the stock price. Indeed, much of the tech world is salivating over gaining share in the auto market, where the fleet is currently very old and so much change is happening. Separating the winners from losers in this area may be much more akin to traditional tech investing—with its corresponding volatility—than it is to blue chip auto investing. So, in our view, the need for careful analysis and diversification is essential.

Ubiquitous Change: Automated Driving Technologies

Source: SAE International.