October 2019

Who will fall victim to the unprecedented changes in the automotive and transportation industries? There are several disruptions coming to a head—seemingly at the same time— from the transition to electric vehicles, to shared mobility, to online vehicle purchasing.

Auto dealers, manufacturers, parts suppliers, and subprime lenders face a tough road ahead, in our view. Some may already be structurally obsolete and unable to pivot given the capital intensity of their businesses—which is why we’re taking strategic short positions.

One of the most impactful moments in The Big Short, the iconic film based on the true-life build-up to the 2008 financial crisis, is when investors travel down to Florida where they end up interviewing a woman about how she was able to afford her multiple homes.

Despite her poor credit and meager five percent down payment, she qualified for

“several” home loans using adjustable rate mortgages. Perplexed, one of the investors asks her to clarify what she means. “I have five houses,” she tells the dumbfounded investors. “And a condo.” At that point, the investors seemed to know the housing market was ready to pop at any moment. Thanks to predatory lenders, a lack of regulatory oversight, and the false belief that the underlying value of an asset could simply go up forever—well, it was a toxic mix that clearly did not end well for our global economy.

However, a few investors—like Mike Burry and John Paulson, to name a couple—saw it coming. And they were able to get into position and essentially short the housing market.

More than a decade later, we believe our firm is seeing a Big Short type of situation, except this time, it’s not the housing industry—it’s the auto industry. It’s also not just high prices and leveraged purchases that spell trouble.

In short, we think much of the auto market is a ticking time bomb with multiple headwinds – from leveraged and slowing sales, to shared mobility and decreasing car ownership, to autonomy and electrification – all seemingly moving to the forefront at once. Unfortunately, it seems our country may not have learned from its past mistakes with the housing crisis, and similar patterns of behavior are playing out across the auto industry. Fueled by easy access to loans, predatory lending practices and little oversight, U.S. consumers have seemingly loaded up on cars they almost certainly cannot afford. Meanwhile, short-sighted car makers who focus relentlessly on hitting quarterly earnings targets have spent profligately on buybacks and have not made necessary investments or pivots to prepare themselves for the future electrification of transportation. Some have even doubled down on the production of gas-guzzling trucks and SUVs that provide the most profit—but made few long-term investments in battery production or development. It is a dangerous cocktail—and we believe it will end poorly for consumers, employees, and unsuspecting long-term investors.

The set-up for this potential crash is alarming: Since 2009, American auto debt has increased by 75 percent. Serious auto loan delinquencies are now at post-2008 crisis levels. A record 7 million Americans are behind on car payments, according to data released by the New York Fed earlier this year. Perhaps even more telling: Some major auto dealerships are reporting that over 70% of their customers are coming in with negative equity on their vehicles—meaning that roughly three out of four of their customers owe more on their car than the car is worth. Instead of pumping the brakes, dealers and lenders are offering these same subprime customers 72 and 84-month loan terms and refinancing their next car with interest rates exceeding 25%—a rate that is illegal in several states. Meanwhile, car sales for original equipment manufacturers (OEMs) have declined in 2019—and the only source of growth at auto dealerships is through service and “F&I”—essentially expensive financial products that load up consumers with even more debt. As the Wall Street Journal reported in October 2019, Americans are taking on longer loan terms (the average term for both new and used vehicles is now at all-time highs) to keep payments manageable—even though these consumers simply cannot afford the cars they are purchasing.

Despite the red flags, the auto industry has coasted along in a relatively stable manner—so long as residual car values have stayed buoyant, consumers have been able to borrow, and the unemployment rate has remained low. In our view, it appears all the levers have been pulled to keep car prices high and traditional auto sales up, but we believe that’s about to change in the next 1-2 years. In our view, the biggest threat isn’t reduced credit availability or lower employment rates. We predict one of the major potential catalysts for auto industry upheaval has more to do with the underlying technology in the industry that will upend traditional business models: The introduction of electric vehicles (EVs) at scale will have far-reaching and disruptive effects deep throughout the automotive industry.

Much like Amazon disrupted traditional brick and mortar retailers, we expect a similar dynamic to unfold within the automotive landscape. Right now, overall EV penetration rates are low, but they are accelerating, and we believe we’re headed for a step-change of rapid growth. When that happens, the dominoes will begin to fall, and, in our view, the house of cards may begin to crumble. Already, several countries have announced plans to outright ban combustion engines. China, the world’s largest car market, announced in 2017 it plans to completely phase out production of fossil-fuel-powered vehicles. Governments, businesses, and ordinary citizens are uniting in the fight to combat the existential threat of our global climate crisis—and accelerating towards EVs will be a natural consequence of this movement. In a more prosaic sense, this shift will affect the residual values of current car prices, as well as any industry levered to the combustion engine industry—a risk we do not think is being accurately priced in today’s market.

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The impact on dealerships — who will survive?

First, consider the position of auto dealerships. Across the board, automotive retailers are facing increased competition from new business, declining margins, and shrinking new vehicle sales, threatening their core business—which is why they have become so focused on up-charging customers using F&I and service and parts in recent years. Essentially, F&I and service rates are becoming a bigger slice of the pie in dealership revenue—a trend that cannot increase forever. Since 2009, service and parts sales in the average dealership have increased by 5.5 percent per year on an average annualized basis, according to a recent report NADA. There is no question that service and F&I revenue has become absolutely critical to the profitability and survival of dealerships, and executives do not hide this reality. The problem, then, is that the shift to electric vehicles and technology, like over the air updates, could radically affect the dealership’s ability to maintain profitability over the long-term.

This could be a business-ending scenario for many dealerships (but one that is a positive benefit for consumers): Electric vehicles are simply less costly to maintain. Electric motors are composed of fewer moving parts than an internal combustion engine, and EVs require fewer service updates throughout the year. New technology embedded within EVs also enables repairs performed over the air—saving costly (and frustrating) trips to the mechanic. A recent AAA report concluded that electric vehicles had maintenance and repair costs of 6.6 cents per mile – compared to medium-sized SUVs, which cost 9.6 cents per mile. A separate study, published by the University of Michigan Transportation Research Institute, found that EVs actually cost less than half as much to maintain as combustion engine cars.

The dealership industry has reacted defensively and aggressively to this transition. One of their primary strategies has been to deploy lobbying dollars seeking to stop the direct-to-consumer business models (focusing on Tesla) which fundamentally threaten the dealership business model. In fact, auto dealers spend more money lobbying congress than domestic automakers. Right now, there are still roughly 20 states that do not permit Tesla to do business. Other states limit the number of Tesla stores. Earlier this year, Texas, for instance, introduced a bill that would effectively ban manufacturers from being allowed to service its own cars through its own centers—directly targeting Tesla.

(The bill did not pass.) “Existing franchise dealers have a fundamental conflict of interest between selling gasoline cars, which constitute the vast majority of their business, and selling the new technology of electric cars,” Tesla CEO Elon Musk has written. “It is impossible for them to explain the advantages of going electric without simultaneously undermining their traditional business.”

Compounding the problem for dealerships is that some of the management teams appear, to us at least, to be in denial about the stark reality that electric vehicles require less service, and thus will provide less service revenue for the dealerships. Asked on a July 2019 earnings call about the impact of service profitability when EVs are introduced, John Rickel, the chief financial officer of Group 1 Automotive (which owns 184 dealerships worldwide) responded:

• There is an assumption out there amongst certain investors that battery electrics… have lower service dollars associated. The data that we have and what we shared with you here doesn’t really support that hypothesis. What we see is the battery electrics basically have about the same dollars per unit is what a nice engine would have. You maybe have a little less repair, but you have better retention because there’s no other place to take those units. [Full disclosure: Nightview Capital has short positions in GPI]

Concurrent to the move to electric will very likely be the push to online auto sales through channels like Carvana and Shift.com, which will put the long-term viability of brick-and-mortar dealerships in peril. (Not that this is a bad thing—does any consumer actually enjoy haggling with car salesman?)

Despite the cheerleading of dealership management to Wall Street analysts, there are signs they privately acknowledge things are not going well. KPMG, the global audit firm, recently sent out an anonymous survey to auto executives. The results found that the “majority of executives believe almost 50 percent of brick-and-mortar retailers will close” by 2025. That fits within our own underlying assumptions: We believe as consumers increasingly purchase electric vehicles (and purchase vehicles online) dealerships will be forced to drastically alter their business models, consolidate—or collapse.

Some forward-looking dealership owners and industry participants already see the writing on the wall, and they’re willing to admit it and exit the business. “We’re not particularly pleased that the world is changing the way it is,” Brodie Cobb, the founder of Presidio Group, a dealership buy-sell advisory firm told Automotive News last November. “We would rather have it stay the same, because owning dealerships is a very nice return and profitable business that we enjoy very much. So when we talk about this, it hurts us, too. We, too, need to understand the future, form a plan and not just put our head in the sand and hope it goes away.”

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Will carmakers survive—or is this their Kodak moment?

Our research also indicates that auto manufacturers will face a perilous road ahead. All of the major OEMs, from GM to Ford to VW, have announced plans to eventually pivot to electric vehicles. But the question investors and long-term shareholders need to ask right now is this: Are these companies reacting swiftly enough to meet the consumer demand of the next 1-2 years? Our analysis suggests that, despite much of the marketing bravado about the move to electrify their fleets, few automakers are investing in the necessary supply chain or infrastructure to prepare for the coming EV disruption.

For instance, General Motors’ CEO Mary Barra has talked broadly about the move to an all-electrified fleet for several years now. In a statement she gave last year, “Our Path to an All-Electric Future,” Barra told investors:

• “Today, I want to focus on zero emissions, and how our electric vehicle strategy will get us there.” However, there have been delays, missed deadlines, and underinvestment in this promise.

In reality, it appears to us that GM management is more fixated on goosing the company’s stock price to appease the short-term interests of Wall Street investors than making meaningful developments in battery supply or electric vehicle drivetrains. Since 2015, the company has bought back more than $10 billion of its own stock—which could have bought them at least two mass-EV producing Gigafactories. It is mind-blowing to us that this was able to occur, given the fact they were bailed out by the government in the wake of the financial crisis—and given advantageous terms by the auto unions. The results of this decision are playing out in the marketplace as consumers simply migrate to manufacturers with more compelling value propositions. In its most recent quarter, for instance, Tesla sold more Model 3s than GM has sold Chevy Bolts since the electric car’s inception in 2017.

More devastating for GM shareholders is that the company’s stock price has stayed relatively flat since 2015, meaning that the buybacks were essentially wasted capital—at a time when GM should have been using the cash to invest in the future.

In the broadest sense, however, the OEMs face a marketplace on the precipice of industrial upheaval and the potential for a massive disruption. Cars, buses, trucks—all will go fully electric in our view. Eventually, we believe the demand for internal combustion engines will evaporate—it’s just a matter of timing. But, to be clear: We believe this change is more revolution than evolution: We believe we are in the midst of a monumental shift to renewable energy, and the electric car boom is just the tip of the iceberg. It could result in a profound shake-up, not just in business, but in society as a whole. Multi-trillion dollar industries are up for grabs. There can be many winners—but perhaps even more losers.

Unlike many of the projections from other asset managers and Wall Street investors that view a slow or steady drip of encroachment in electric vehicle penetration, we believe we’re headed into a full step-change of EV growth: We anticipate an S-curve-like growth of EV sales over the next 2-3 years. McKinsey, for instance, has forecasted global production of 3.5 million battery electric vehicles in 2020 and 14.8 million by 2025. Our forecasts are substantially higher. We are, essentially, at the tipping point of a full transformation towards electric vehicles.

We also tend to view economic subsidies and tax incentives for electric vehicles as important—but perhaps less crucial than many other analysts may suggest. As battery prices for EVs decline and cost-parity is reached with ICE counterparts, we project subsidies will fade in importance as consumers recognize the long-term value of an electric vehicle relative to gas cars. We also believe there is a strong probability that ICE depreciation rates will increase sharply in the near future. Consumers will never pay equal price for technology that is being phased out, especially given the high cost of an automobile.

As students of disruption, we tend to take the view that incumbents are slow to react to new technologies, allowing innovative upstarts to capture market share and build a large competitive advantage. But over the last two years, our firm has been relatively astonished at how much the traditional auto industry has lagged, missed deadlines, spent wastefully on stock buybacks, and failed to invest in necessary infrastructure (like Gigafactories) to prepare for the future of electrification.

To us it seems clear that much of the rhetoric is lip service, and in reality, they are fundamentally resisting change. This is understandable given the billions of dollars of assets and technology OEMs have tied up in ICE manufacturing. Ford, for instance, claimed back in 2017 to be working on “all-new fully electric small SUV, coming by 2020, engineered to deliver an estimated range of at least 300 miles.” No such vehicle has materialized. “Instead, more delays, and job cuts,” one perceptive journalist has noted at Jalopnik.

Meanwhile, BMW executives have recently been caught in some bizarre claims about their perceived lack of demand for EVs. As The Verge reported over this past summer:

• BMW executive and board member Klaus Fröhlich told reporters this week that the shift to cars powered by electricity is “overhyped,” and said that there is “no” consumer demand for them. Curiously, Fröhlich made these comments at an event where BMW proudly announced it will accelerate plans to release 25 cars that are partially or fully electric, moving the timeline up two years from 2025 to 2023.

Despite many of the recent claims and speculation about Tesla, the company has seen unprecedented growth, suggesting that the shift electric vehicles is anything but overhyped—and that there is immense consumer demand. In the last five years, we calculate CAGR unit sales at Tesla to be roughly 50%, at a time when other automakers are struggling to post positive comps. (Tesla, by our calculations, is the fastest-growing American manufacturing company—perhaps in history). Growth does not appear to be slowing. This fall, Tesla will open its third Gigafactory in Shanghai, where the local Chinese market will easily outnumber the entire American market for electric vehicles.

The question for any investor interested in the future of transportation should be this: Can any of the automakers catch up to Tesla’s lead? Competitors are openly acknowledging Tesla’s lead in software and efficiency. (One Volvo executive recently proclaimed: “Tesla is far ahead of everyone else on energy efficiency.”

Can they pivot entire supply chains and manufacturing processes from ICE to EVs? In our view, without radical changes and massive capital investment, incumbents are increasingly at risk of obsolescence and may ultimately be left with stranded assets.

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The future for the auto industry

In our view, once EVs enter the mainstream (which we believe will happen sooner than most other market participants), the disruption of the internal combustion engine industry will bring about a cataclysmic effect down the automotive value chain, affecting the OEM to dealers to lenders to rental car firms. The chain of events will get very ugly for companies (and their employees) that move too slowly.

Above all, we do not believe this risk is currently priced into current quotes, which makes it an attractive long-term short opportunity, especially at some of the more highly leveraged businesses in this category. Once it becomes apparent that the residual value of internal combustion cars may in fact be in steep and accelerating decline, fissures will turn to cracks. Depreciation rates can skyrocket, slamming fleet owners like Avis (CAR) and Hertz (HTZ), turning their cars into stranded assets. Subprime lenders like Santander USA (who verify income on just 3% of borrowers) will likely face an influx of delinquencies and repossessions.

Unfortunately, we are predicting large losses for many long-term investors, including pension funds and institutional investors, who have investments tied to the internal combustion engine industry. Sadly, it is a bubble we think will burst, leaving many victims in its path.

The good news is that the future, ultimately, is bright for this industry: Electric cars are cleaner, safer, and ultimately a better experience for us as consumers. It will simply be a painful ride for those who are too slow or reluctant to react—and they may get caught up in the eventual crash.

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The opinions expressed herein are those of Nightview Capital and are subject to change without notice. This is not an offer to sell, or a solicitation of an offer to purchase any fund managed by Nightview Capital. Such an offer will be made only by an Offering Memorandum, a copy of which is available to qualifying potential investors upon request. This material is not financial advice or an offer to sell any product. Nightview Capital reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Nightview Capital and clients are currently long Tesla (TSLA), and stand to benefit if the trading price of Tesla increases. Nightview Capital and clients are also currently short Group 1 Automotive (GPI), Lithia Motors (LAD), Avis (CAR), General Motors (GM), Ford (F) and stand to benefit if their trading prices decreases.

Nightview Capital Management, LLC (Nightview Capital) is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Nightview Capital including our investment strategies and objectives can be found in our ADV Part 2, which is available upon request. WRC-19-08