How Screwed Is The European Car Industry?

This morning’s volume of The Morning Dump will be a little different. Rather than break down the day’s news into a bunch of smaller, partially interwoven stories, I’m just going to tell one big story in an effort to answer the question: How screwed is Europe’s car industry?

There’s a lot of chatter and teeth-gnashing about the death of Europe’s car industry, which feels a little premature given that most European carmakers are still making money and still selling a lot of cars. Is the future of Europe’s car industry one of immediate collapse, eventual decline, or merely cyclical disruption?

Buckle up folks, we’re in for a long ride.

Europe, And Especially Germany, Are Freaking Out A Bit

Your perspective on what is happening in Europe will be colored by your pre-existing notions of the world and, perhaps, by how many people (or bots) you follow on Twitter who have blue checkmarks next to their names.

The extreme bear case for Europe is that the continent (particularly economic powerhouses like Germany and France) is simply not built for the new world. They are old-fashioned carmakers making old-fashioned cars, and they’re not able to adjust to the new EV-centric building environment because of large structural issues.

If you want to fully understand this view, there’s a long thread from investor David Galbraith on Twitter in which he lays out the case, but the key bit is below (quoted, because embedding all these Tweets now is annoying):

Industrial production is obviously about making things. But it is no longer about making industrial era things. Cars are a great example here. as although EVs look the same as the type of cars that Germany produces, the way they are produced and their business model and margins are totally different.

The economic model of these large industrials is based on the, ‘them and us’’, industrial era social pact between workers and owners and mimics the state itself. Industrial workers are unionised and get defined benefit pensions but there is no shared ownership or options pools and all profits go to the top, often family dynasties.

Over time, these companies become more like a family owned pension funds rather than a manufacturer. They are highly resistant to change, structurally, so they can only innovate within the existing paradigm, not for expertise reasons (BMW management went all in on electric a decade ago, but the unions pushed back) but structural ones.

[…]

EVs, on the other hand, are digital era products. Their margins come from batteries and software. Asia has control of the entire battery supply chain and Asia and the US have control of the software one. Europe is nowhere. The German, French and Italian car manufacturers are like Nokia, post smartphone.

If you accept this scenario, it’s difficult to see a future for European carmakers who lack both the software expertise and the battery expertise to be successful. Certainly, the Volkswagen investment in Rivian is more proof that big automakers struggle with software. After spending billions on its own software unit, Volkswagen has partially given up and will instead install Rivian-based software in some of its future vehicles (and Apple software in other ones)

Facing a lot of pressure and crashing operation margins, VW just demoted its CFO Patrick Andreas Mayer and promoted Seat CFO David Powels in his place. From Manager Magazine:

[T]he numbers for the VW brand had gotten out of hand. When the operating return on sales in the first half of 2023 landed at an unsatisfactory 3.8 percent and the forecasts continued to point downward, brand boss Thomas Schäfer (54) and finance manager Mayer had set up a profit program: an additional 10 billion euros were to be needed to secure a return of 6.5 percent in 2026. Schäfer and Mayer also found what they were looking for. But it took them a good six months to get started; there were fierce negotiations with the employees and, not a good signal in the Volkswagen empire, the search for the billions was critically monitored by the major shareholders and supervisory boards of the Porsche and Piëch families.

Indeed, the old families play a big role in European automakers. For VW it’s Porsche and Piëch, and for BMW it’s the Quandts. For Fiat and Stellantis it’s the Agnellis. Daimler (Mercedes) and Renault are the outliers, here, though Renault has a considerable state investment so that might not be any better.

The unions in Germany are not pleased with Volkswagen’s threat to start closing plants to try to fix their problems. Here’s a fun anecdote from an opinion piece in The Guardian this weekend titled: “An ‘earthquake’ at Volkswagen – and a crisis for Germany?” that summarizes the mood at a meeting between workers and leadership:

Workers unleashed their collective anger, unfurling banners and chanting protest slogans, among them: “We’re Volkswagen, you are not.” For about 20 minutes, according to eyewitnesses (media were excluded from the hall), the din from the chants and whistles prevented the bosses from speaking. Instead, they stayed behind a long table, stony-faced, looking a little embarrassed. Dressed in open-necked white shirts and dark jackets, their summer tans appeared to have faded in the bright lights and the frosty atmosphere.

“We are short of around 500,000 car sales a year,” VW’s financial chief, Arno Antlitz, reportedly told the hall. That, he said, was the equivalent of production from two factories. “It’s not to do with our product or poor performance. The market is simply not there any more.” He gave the company “one or two years” to turn the situation around. Experts estimate that VW has about 20,000 employees too many.

Oliver Blume, chief executive of Volkswagen Group, might have been a father addressing his family at the dinner table as he told the employees in no uncertain terms that the company had been living beyond its means – drawing an estimated annual €1.5bn from its cashflow for around 15 years – and that things would have to change. He compared the situation to a “family kitty” which “by month’s end is empty”.

I love that little bit about “summer tans” fading under the bright lights. If you’ve never worked with Europeans you might not know that, somehow, it feels like the entire leadership of every company goes to Ibiza or Mykonos or wherever for all of August.

Either way, things are not good. This is a lot of text, so here’s a graph from the ACEA, which is the trade group for the European car industry:

Those are EU car sales for the overall car industry, and you can see that sales have risen a bit since the pandemic, but it’s not the kind of huge growth that carmakers might want. If we’re looking just at Volkswagen, the company was quite profitable last year, with $24.5 billion brought home, albeit on revenue of around $350 billion. This year, profits have dropped, but costs have remained stubbornly high.

A lot of these companies have made a lot of money selling cars in China, so a downturn in European car sales isn’t that bad, right? Right? Well… European (particularly German) automakers have been struggling in China, where car sales have dropped for five straight months. The companies that are succeeding in China are either Tesla or homegrown electric carmakers like BYD.

It gets worse.

European automakers are racing to make more efficient cars because, in the grand scheme of things, if you believe that a slight increase in global temperatures is a risk to life as we know it on this planet, then who really gives two sausage-y craps about the operating margin of any company? I can’t prove that anyone in the leadership of any of these companies actually believes in the existential threat, but it doesn’t matter because European lawmakers do and are going to charge automakers for exceeding C02 limits, and the results could be million or billions of dollars in fines.

The theory that the government (and automakers, and the media) had, was that EV adoption would accelerate and that all the EVs would offset all the gas-powered cars. That didn’t happen. So either automakers can lose more money paying fines on cars or, simply, just make fewer gas-powered cars, thus losing more money…

That’s basically what Renault CEO Luca de Meo said this weekend in a radio interview:

“If electric vehicles remain at today’s level, the European industry may have to pay 15 billion euros in fines or give up the production of more than 2.5 million vehicles,” de Meo told France Inter radio.

“The speed of the electric ramp-up is half of what we would need to achieve the objectives that would allow us not to pay fines,” de Meo, who is also president of the European Automobile Manufacturers Association (ACEA), said of the sector.

In theory, European carmakers could import cheaper EVs from their Chinese partners but, again, the European Union has put large tariffs on Chinese imports, making that harder (and potentially making Britain a prime spot for Chinese cars).

Looking at all this information it’s hard not to draw the conclusion that European carmakers are uniquely screwed.

I don’t entirely agree. First of all, there was plenty of hand-wringing about Toyota and its future, and Toyota just had its most profitable year ever. That’s not to say that Toyota is a perfect company — it isn’t — but its exposure to the United States has been a huge benefit, and its forward-looking view of hybrids has helped it survive a downturn in China and questions about domestic demand in Japan.

Second, this idea that electric cars are “digital” products and so simple that they don’t need a ton of suppliers or traditional dealers has been disproven many times. All electric cars rely on numerous Tier 1, Tier 2, and Tier 3 suppliers. Even Tesla, as we discussed last week, relies on suppliers or partnerships with other companies for batteries for its most popular vehicles. BYD is probably the most integrated company as it builds its own batteries, but BYD also uses dealerships. Few new automakers have been able to be truly successful without some sort of dealership, making Tesla more the exception than the rule. Also, Fisker was premised on the idea of cars being “digital” products and, yeah, it didn’t work out so well.

The world of carmaking is way more complicated than can be summed up in a thread and, while things look bad now, European automakers have a lot of safety valves.

Third, as Tesla disrupted the world so, too can Tesla and Chinese automakers be disrupted. European and Japanese automakers are investing heavily in solid-state batteries which, if they actually work, could help reduce the stranglehold that China has on EV production and fundamentally alter the value structure of new cars. The same can be said for hydrogen, e-fuels, or even just a smart model for making a very affordable and nice EV.

And, finally, all of this hand-wringing isn’t a bad sign. Many of Europe’s carmakers, high off of pandemic-era profits, are facing a grim few quarters. Their approach to EVs has been mixed, their ownership/production model is challenged, and traditional money-printers like China (and even the United States) are under attack.

They should be freaking out! Then they should do something about it. Carmakers, unions, and leaders will need to decide exactly what the future looks like and will have to make some hard choices. They’ll also have to attract more Chinese auto production (as they’ve done with Leapmotor in Poland and BYD in Hungary).

Where should Europe look? America! For all of our problems, of which I’d rank Justin Verlander’s pitch location near the top, we’re not doing so poorly. Early on, the government, under the Trump Administration, decided to keep Chinese-built EVs out of the country. This helped relieve pressure on domestic automakers to adapt.

While the Inflation Reduction Act isn’t perfect, it’s helping get more people into electric cars by continuing to make them more affordable and, even better, is encouraging a lot more domestic battery production. We’re still far behind in charging infrastructure and cost, but companies like Ford and GM have a lot more breathing room to get to a sustainable future. We, too, have increasingly tough C02 requirements, but we also make huge allowances for hybrids and PHEVs.

The EU is going to have to decide what it wants: More domestic production? Cheaper electric vehicles? Higher C02 allowances? More hybrids? They’re tough choices, but it’s not like Europe has no choices.

What I’m Listening To While Writing TMD

I miss Whitney Houston. What a galactic talent. Also “Didn’t we almost have it all?” just felt appropriate this morning.

The Big Question

How screwed is Europe, on a scale from the Chicago White Sox to the New York Yankees?