It seems traditional to write about companies one invests in but I thought it about time to write about one we decided to pass on.
The turmoil at Volkswagen and the consequential effect on the share prices of other car companies caused us to look briefly at a number of car manufacturers, and in some detail, at Hyundai Motor Company.
We were particularly attracted to the preferred shares which trade at a significant, albeit highly volatile, discount to the ordinary shares.
The tech challenge
We also had to consider the economics and prospects of the car industry as a whole. There are two technological developments that are leading to what Tim Cook of Apple recently said was an ‘inflection point for massive change, not just evolutionary change’ for the car industry, namely – electric cars and driverless technology.
Over time, the hardware will be simplified while the software will become increasingly complex. As the hardware simplifies, the car company of the future might outsource its manufacturing, with its competitive advantage arising from its design capability and brand.
Taking things further, car manufacturers currently risk losing market share to new entrants such as Apple which have business models that are better suited to producing, what will essentially be, ‘smartphones on wheels’.
They may also cede profits to companies such as Google which is building an operating system for driverless cars.
It seems quite likely that a number of the major car companies will be unable to transfer their skills at designing and manufacturing traditional internal combustion engine cars into a radically new world.
Having spoken with several experts including a world expert in the field, Professor Paul Newman who leads the Mobile Robotics Group at Oxford University, we concluded that while aspects of driverless technology such as autonomous emergency breaking, self-parking and collision avoidance were likely to keep developing and would be incorporated into more cars, the technology for a fully autonomous vehicle that worked on all roads and in all conditions remains a long way off.
So, as autonomous technologies are incorporated bit by bit, it seems likely that the traditional car companies will be able to keep up by either developing or licensing the particular technologies required.
Electric cars
In contrast, we believe that the development of electric cars is a more fundamental challenge to traditional car manufacturers.
Tesla has proven that electric cars (aside from the obvious pollution benefits) have running costs per mile that are significantly less than the cost of petrol or diesel cars, even in a world of low oil prices.
They also accelerate better, are quiet and can cover 300 miles on a single charge. So the consumer driving experience is already superior.
There are only two problems with electric cars. The first is the network of recharging stations. However, as the number of electric vehicles increases, a market solution will undoubtedly develop, much as the number of mobile cells has grown with the number of mobile users and the number of Wi-Fi hotspots has increased in line with smartphones.
The second is the cost of the batteries. Tesla’s are more expensive than a petrol/diesel equivalent because they have c.$20,000 worth of batteries in them. The cost of lithium-ion batteries, which were first developed in the 1990s, is falling in a range of 8-14% p.a.
Exactly what this rate of decline will be in the future is a very important question. If the decline is 8% p.a., the price of batteries will halve every decade, but if it is 14% p.a. it will quarter.
These price declines could speed up if there is a significant step-change in technology, such as the commercial development of Lithium-air batteries. In comparison, internal combustion engines are a very mature technology whose cost and efficiency cannot improve at anything like this rate.
As prices of batteries decline, could the makers of petrol/diesel cars find themselves in the same position that Kodak found itself in when digital cameras became more cost effective than film cameras?
Bill Gates famously said that we always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next 10 years.
Although the analysis above suggests that traditional car companies have about 10 years to get themselves ‘electric car ready#, the change as it occurs will begin to eat away at their traditional businesses during the intervening decade as electric cars increase market share at the top end and in those countries which particularly favour them.
Hyundai
The problem for us is making any forecast about how Hyundai will do during this transition from one kind of car to another.
They seem to be betting more heavily on an alternative green car technology, hydrogen fuel cells. It seems to us given the relative complexity, cost and safety issues associated with using hydrogen as a fuel, that fuel cells are unlikely to win the battle with electric cars to become a mass market solution.
There are also a couple of additional points for Hyundai which are a concern. The first is corporate governance.
The Chairman of Hyundai, Chung Mong Koo, was found guilty of embezzlement a few years ago. He was convicted of taking $100 million from Hyundai which was primarily used to bribe officials.
More recently Hyundai paid $10 billion, c.3x the market price, for a plot of land in Seoul’s Gangnam district in what was widely perceived to be an act of corporate vainglory (its market cap fell by $10bn after it made the announcement).
It is clear from these and other examples that the controlling family regard Hyundai as a personal fiefdom to which Western standards of corporate governance do not apply.
When we come across management like this we either do not invest or, if we see evidence that things are improving, we downgrade our quality score until we are sure that things have changed.
Finally, on valuation, Hyundai had a margin of safety on the ordinary shares that was not sufficient for our investment processes, given its quality score, but on the preferred shares it was considerable.
The problem is that while each of the three categories of Hyundai preferred shares trade at a discount to the ordinaries, the discount is highly variable over time – ranging from 20% to 80% in the last few years. There is no discernible logic to this discount.
Unlike Samsung, there was no sign that Hyundai wish to buy their preferred shares back. A recent large investment in Hyundai by the Chairman’s son was in the ordinaries not the preferred shares.
Ultimately our conclusion was that we would have to put Hyundai in the ‘too hard’ pile. We will keep our eye on it, and on a handful of other car companies, to see if we can put our uncertainties to rest, whether the margin of safety increases and how soon we’re likely to be driving the next ‘iCar’.
Jonathan Mills is one of the founders and co-managers of the Metropolis Global Equity Fund and the SF Metropolis Value fund.
In the three years to the end of November, the Value fund has returned 39.2%, beating the peer group average of 35.8%