Market comment: European car manufacturers: undervalued or under threat?

^{[1] As measured by the STOXX Europe 600 Automobiles & Parts EUR index.}

On Monday, French car manufacturer Stellantis and British car maker Aston Martin issued profit warnings for fiscal 2024. These announcements were the latest in recent guidance cuts from European automobile producers. The profit warnings were, to a certain extent, driven by company-specific factors, such as an aggressive reduction of high inventory levels by Stellantis, supply chain issues at Aston Martin and an expensive recall due to brake failures at BMW. But two pronounced and overriding factors affecting the entire sector can also not be ignored, namely an increasingly competitive global auto market and weakening consumer demand for electric vehicles.

Volkswagen (VW), BMW and Mercedes (Benz), previously classified as the German Big Three, once dominated the car industry. VW was one of the largest in terms of volume, and BMW and Benz benefitted from high brand desirability in the premium car segment.

In the late 1990s, the German Big Three successfully managed the increasing competitiveness of Japanese and Korean auto manufacturers, driven by higher manufacturing efficiency, quality and reliability. The market standard at that time, however, was still combustion-engine cars. This time is different. The move toward electric vehicles (EVs) has changed the game. With EVs, competition is no longer about car specifications such as engine horsepower. Instead, competition is based on software engineering skills, charging infrastructures, access to battery components and the consumer’s driving experience.

Companies such as Tesla (US) and BYD (China) now have the upper hand, especially in terms of mass market sales. Chinese companies account for approximately 20% of the global car manufacturing market, and this is expected to rise to more than 30% in 2030.²

In China, the competition among car manufacturers is intense. China was once a significant market for the German Big Three, but the appeal of these premium brands is deteriorating. In particular, Volkswagen has failed to keep pace with the rapid shift to EVs in China  -- the biggest auto market. And, in Europe, EV sales have slowed due to weakening consumer confidence and reduced or removed EV-related incentives in countries such as Sweden and Germany.

European auto manufacturers are increasingly confronted with low-cost cars exported from China. In July, the European commission concluded that the batteries of electric vehicles produced in China benefitted from unfair Chinese subsidies, which is viewed as a threat of economic injury to the EU's own EV makers. In response, the commission imposed provisional duties of 17 to 38% on major Chinese manufacturers.

The CEOs of VW and BMW have already openly criticized increasing China export duties. This is largely out of fear, as China is a crucial supplier within the EV car manufacturing industry, given that a large portion of components needed to make cars and batteries are controlled by China. A tariff battle could be bad news for all concerned. Export duties would, generally speaking, be also only a temporary solution for the German Big Three’s problems, as Chinese manufacturers will likely begin to produce more and more cars in Europe. And outside Europe, in South American and Asian growth markets, for example, the Big Three is already facing Chinese competition. The only real answer is for the Big Three to become more competitive.

Fixed costs account for a high percentage of the total cost base of European original equipment manufacturers (OEMs). This can lead to operational leverage and attractive returns when car deliveries are increasing. Unfortunately, high fixed costs become a negative factor when volumes are declining due to weaker demand and loss in market share. In order to cope with this situation, manufacturers need to trim costs through job cuts and, potentially, factory closures. At VW, closing factories is unprecedented but clearly needed, according to CEO Oliver Blume. VW is now on course for a protracted conflict with powerful labour groups over this issue.

Mass market EV adoption remains the long-term ambition for both the global auto industry and domestic policymakers. It will likely require more collaborations (strategic partnerships, joint ventures) between European OEMs and Asian EV players in order to increase competitiveness and to comply with the relevant 2025 CO2 targets. The strengths that European car manufacturers bring to a partnership are extensive distribution networks, strong brands and engineering know-how.

Investing in the auto industry is not without risks, and the stakes are high. The European car industry is at a critical juncture, grappling with a confluence of challenges that have weighed heavily on stock prices and profitability expectations. Current price/earnings ratios and share prices are below their long-term averages, and dividend yields are higher than usual, but these metrics alone do not provide a complete picture.

It's crucial to recognize that European auto manufacturer stocks are cheap for valid reasons. Investors must weigh the high risks against the potential long-term rewards. The current low valuations reflect the market's pessimism about the industry's immediate prospects. But the market might also be ignoring the potential for increased competitiveness in the longer term with or without political support and strategic adaptations.

In the face of formidable challenges, European car manufacturers are navigating a complex landscape in order to emerge stronger and more resilient. For investors with a high-risk tolerance and a long-term horizon, the current undervaluation could represent a compelling entry point. We prefer, however, to hold off at this stage and to wait for more clarity in terms of competitive intensity and political support.