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German Carmakers Can Still Win The Electrification Race—At A Cost


German Carmakers Can Still Win The Electrification Race—At A Cost

The race to turn the world's car fleet climate friendly will continue to heat up over the next five years. European regulatory demands to cut CO2 emissions by another 15% by 2025 will require a big push by automakers for more electric cars and a significant mind-shift by customers. Electrified cars will be crucial in reducing CO2 emissions until fuel cell or other technologies might bring additional benefits.

German car manufacturers are preparing stealthily for this industry transformation. By the end of this year, the three big premium automakers Volkswagen, BMW, and Daimler will offer at least one fully battery electric vehicle (BEV) and at least one plug-in hybrid electric vehicle (PHEV) in nearly all their existing models--totaling 38 electrified models. But the R&D costs for developing these cars are large, and extra investment in supply chain and technology developments will weigh on profitability in the coming years.

On the path to electrification, we think Germany's premium car segments will be able to leverage their strengths of higher profitability than mass producers and somewhat lower sensitivity to demand shocks. These strengths have to date supported the current ratings in the 'A' category at Daimler and BMW and in the 'BBB' category for VW. However, disruptive industry trends and the deterioration of market conditions globally may strain their profitability over a prolonged period and trigger rating transition. While U.S. automaker Tesla is currently the bestseller in the premium electric vehicle (EV) market, we expect German carmakers will exert a strong challenge by building on their brand reputation, ability to produce high-quality cars at scale, and consumer loyalty. Signs are that high-performance "green" cars are an increasingly important element of brand reputation for German premium car customers.

German Manufacturers Ramp Up Electric Vehicle Production

The big three German carmakers still have some catching up to do in the electrification race, but are picking up pace. BMW, VW, and Daimler (maker of Mercedes-Benz) together had captured only a 12.5% market share of the 2.1 million fully battery electric cars (BEVs) sold globally last year--itself only a fraction of all car sales. BMW is leading the German players with 140,000 electric cars sold in 2018, making it the fifth-largest seller of BEVs (see chart 1). While this is behind market leader Tesla, BMW has a larger market share in electric cars compared to its overall market. VW Group, with 80,000 unit sales, was also among the top 10 sellers of BEVs in 2018, followed by Daimler with 45,000 EV unit sales. All three target meaningful increases in their BEV sales this year, particularly VW, which is aiming for a 37.5% rise to 110,000.

VW is opting for a dedicated electric vehicle platform (MEB), mainly for its SEAT, Skoda, and Volkswagen brands, and has won Ford as a partner to use this platform in Europe with the aim of increasing volumes and reducing unitary fixed costs. The other two German competitors will take a flexible approach to platforms. The heaviest competition in terms of sales will come from Tesla and Chinese producers BYD, BAIC, SAIC, and Geely, although they are limited to their home markets. Daimler and VW have established partnerships with Chinese automakers, and Geely is among Daimler's most important shareholders, supporting their competitive positions.

Chart 1

image

We expect the breakthrough for German carmakers in electrification this year to come not just from BEV but from plug-in electric hybrids--vehicles that allow drivers to switch from battery-driven short trips to traditional internal combustion engines (ICE) for longer journeys. This includes mild hybrids--cars with small batteries that optimize fuel consumption and could prevent potential ICE bans in city centers. German manufacturers already have 38 such models on the road or launching this year, and will add another 23 next year (see table 1). VW has the most ambitious plans of the three: it promises to launch 50 new BEVs and 30 PHEVs by 2025, which could make it the largest supplier of EVs by that time.

Table 1

German Manufacturers Offer Electric Alternatives In Nearly All Their Main Car Series
--BMW-- --Daimler-- --Volkswagen--
--2019-- --2020-- --2019-- --2020-- --2019-- --2020--
PHEV BEV PHEV BEV PHEV BEV PHEV BEV PHEV BEV PHEV BEV
2-Series i3 3-Series iX3 C-Class* EQC CLA coupe EQA Golf GTE e-up! Leon ID.3*
3-Series Mini Electric X1 E-Class* fortwo* CLA shooting brake EQV Passat GTE* e-Golf Tarraco ID.CROZZ
5-Series S-Class forfour* GLA A3 e-Tron* Cupra Q4
X3 GLC eVito GLE coupe A6 Taycan Bentyga e-Tron
X5 F-Cell eSprinter AMG GT 73e A7 e-Crafter SUPERB
i8* GLE A8 e-load up! Citigo
Mini SE All 4 A-Class sedan Q5 Vision IV
A-Class hatch Q7 Mii
Panamera* el-Born
Cayenne E
*Several editions on the market.

We expect plug-in hybrids and mild hybrids to play a key role in German carmakers' strategy to meet increasingly more stringent emissions regulations, especially in Europe, over the next decade. This is because PHEV versions of their upper-middle class models typically emit two-thirds less CO2 than the same models with traditional ICE (see chart 2). At just 5% to 15% more expensive than traditional versions, they are increasingly popular with customers. Nevertheless, in the first half of 2019, sales of PHEVs fell 7% in the EU while mild hybrids and BEVs grew 36.5% and 90%, respectively, according to the European automakers association ACEA.

Chart 2

image

However, to meet the much more stringent EU targets to cut CO2 emissions by 37.5% by 2030 from the 2021 baseline, we expect carmakers will have to increase BEVs significantly, which could be difficult. One obstacle is the high cost of batteries. EVs could become more attractive to customers if battery prices come down in the next few years, as many industry experts predict (see chart 3). In addition, possible regulatory penalties on ICE cars could make BEV cars more attractive. Among the biggest uncertainties for carmakers is the current misalignment between stakeholders involved in shaping the future of mobility--including infrastructure, commercial real estate developers, and urban planning agencies. This ends up pushing a large part of the burden of this transition onto the auto industry, which is already experiencing various issues related to funding technology developments, setting up a sustainable supply chain in every key market, and determining production strategies that enable minimal unitary fixed costs.

Chart 3

image

Luxury Electric Cars Are Becoming Hot Property

While manufacturers are rapidly expanding their model mix of PHEV and BEV, the question is whether electric car brands can win customers' motoring hearts as well as their eco minds. The proportion of electrified cars on the road is likely to remain small over the next five years (see chart 4). We expect that the percentage of electric cars sold by the three German manufacturers will vary between 25% and 40% by 2025.

Chart 4

image

The heavy price premium for an electric car still deters most customers. This is especially the case in the mass market--defined as cars priced below €30,000--where electric versions can be doubly as expensive as conventional engines, and are therefore not an affordable option for most buyers (see chart 5). But the price premium for luxury electric cars is less stark and therefore less of a hurdle. A Mercedes E-Class or BMW 5-Series plug-in hybrid is priced only about 10%-15% above the comparable ICE version. However, fully electric cars, such as the Mercedes EQC, Audi E-tron, or VW ID.3, do not have directly comparable ICE models.

Chart 5

image

Yet, there are signs that car buyers are starting to warm up to electric cars, especially in Germany. In the first seven months of 2019, EV sales in Germany grew by 87%, and about 7% of all newly registered cars in Germany were electrified.

A big impetus of this change is growing customer demand in the premium segment. Porsche recently said it already has more than 30,000 pre-orders for its new electric car Taycan, which will launch in 2020--more than it expects to sell of its iconic 911. The Mercedes EQC is also receiving positive market buzz. One attraction for luxury sports car buyers is the performance advantage: electric cars often provide faster acceleration than comparable ICE cars. High performance alongside "green" credentials are helping premium carmakers build on brand promise.

High R&D Costs Will Hit Profitability And May Harm Ratings

Electrification is costing the auto industry dearly in R&D investment and capital investments for new or upgraded production lines, and this will likely continue to depress profits over the next three to five years. VW was the world's third-largest spender on R&D in 2018, behind Amazon and Alphabet, while Toyota, Ford, GM, Daimler, Honda, and BMW were also among the top 25, according to a PWC Global Innovation 1000 study. The auto sector is the largest contributor to R&D in the EU (28%), with average spending exceeding €50 billion per year (source: ACEA). We believe that manufacturers' intention to reduce R&D spending over time is one of the main factors behind industry consolidation. We also expect that manufacturers will reduce capex spending on ICE developments and increase the spending for electrified and other alternative drives in the coming years.

The higher cost of batteries is the main reason why electric cars are currently also meaningfully more expensive to produce. Although the price per kilowatt-hour (KWh) has been declining rapidly--from about $1,000 in 2010 to about $190 in 2018--it will likely only reach breakeven with the combustion engine car at about $100/KWh, which we expect will be achieved only through further optimization and production scale in 2022-2024. For larger cars, in particular, the crossover point will likely come in 2022, according to Bloomberg NEF.

Chart 6

image

One competitive advantage the German car manufacturers have over competitors such as Tesla, however, is their relatively high production volumes in the premium segment (see chart 7). Tesla, nevertheless, has the advantage of insourcing battery production.

Chart 7

image

Premium carmakers' use of PHEVs to ease the transition to electrification should also protect profitability margins because batteries are relatively small and less expensive than BEVs, and the cost can largely be passed through to customers.

Over the past seven years, the profitability of premium carmakers was higher and less volatile than mass manufacturers (see chart 8). We expect this trend to continue over the coming years. Still, their profitability will likely stay lower than in the past because they will need to invest in other new technologies, such as self-driving and battery cells. Longer-term lower profitability levels would drag on ratings over time.

Chart 8

image

Financial Services Units Will Help Develop The EV Market

As the electric car market develops, German premium manufacturers' strength in leasing and financial services through their captive finance entities will also make them particularly well placed to benefit. We believe customers will be increasingly attracted to car leasing to alleviate risks surrounding higher entry prices (especially at mass-market brands), performance, and resale risks of electric models (see chart 9). German car manufacturers' financial services arms will likely base their marketing and commercial strategies on the full ownership costs for electric cars for customers. As a result, we expect that they will gain greater exposure to residual value risk, which could weigh on their ratings.

Chart 9

image

(Research contributor: Patrick Wolf)

Related Research

  • European Corporate Credit Outlook Mid-Year 2019 A Switch In Time?, July 25, 2019
  • In Europe's Auto Market It’s All About Curbing CO2 Emissions, June 17, 2019
  • Credit FAQ: Questions Over Electric Vehicle Residual Values In European Auto ABS, May 31, 2019

This report does not constitute a rating action.

Primary Credit Analyst:Tobias Mock, CFA, Frankfurt (49) 69-33-999-126;
tobias.mock@spglobal.com
Secondary Contacts:Vittoria Ferraris, Milan (39) 02-72111-207;
vittoria.ferraris@spglobal.com
Eve Seiltgens, Frankfurt (49) 69-33-999-124;
eve.seiltgens@spglobal.com
Anna Stegert, Frankfurt (49) 69-33-999-128;
anna.stegert@spglobal.com
Matthias J Raab, CFA, Frankfurt (49) 69-33-999-122;
matthias.raab@spglobal.com

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