The auto business has been a notoriously poor industry for long-term investors. Look back over a century, and automakers have gone boom and bust, with very few companies spared from the industry's volatility. Over time, there aren't many durable competitive advantages in mass-market vehicles, whether you're looking at styling, brands, or operational excellence, and margins are thin as a result.
Add in volatility in auto volumes and you have a recipe for disaster for investors, which is why legacy automakers like General Motors, Ford, and Toyota all trade for price-to-sales ratios under one and often have P/E ratios in the single digits or teens.
Investors haven't given electric vehicle (EV) stocks the same low valuations. And in some cases, they haven't even waited for the companies to generate revenue before giving them multibillion-dollar valuations, betting their business model will be better and more profitable long term.
Tesla (NASDAQ:TSLA) and automotive upstarts like Rivian, NIO (NYSE:NIO), Nikola (NASDAQ:NKLA), and Lucid Motors have innovations like new business models, over-the-air software updates, and autonomous driving that could make the auto industry more profitable this time around. In some ways they're right. But long term, even that thesis may fall apart, and the latest round of automakers may run into similar problems that legacy automakers have seen.
This time really is different
There are some fundamental innovations that newer EV manufacturers have brought to the market that are improvements and disruptions to traditional automakers.
The most important is their lack of third-party dealers, which are a legacy business model that traditional automakers may never get away from. Dealers take some of the profit margin out of the sales process and create inconsistent customer experiences -- from prices to services.
And dealers can have different incentives from the larger manufacturer. We see this today because at many dealers where trucks and SUVs are their most important models, EVs are rarely front and center in dealer showrooms, despite being crucial to automakers.
As manufacturers think about how to service vehicles, we're seeing new business models there as well. Tesla does a lot of service at customers' homes, and Rivian says it will follow that model as it launches sales next year. It's not yet clear whether an at-home service model is better, but it's definitely more convenient for customers and is more scalable than building service centers across the country. If this model is better, it's hard to see existing dealers make the transition en mass, so this could be a differentiator.
Chargers have also proved to be a way to add value and take some of the revenue away from other parts of the traditional value chain. In the gasoline vehicle market, automakers aren't involved in selling fuel after a vehicle is purchased, but Tesla has proved it can build a large business charging vehicles. It's not clear if that will be a profitable segment for Tesla long term, but it's added value for customers who buy vehicles today.
Where the growth story may fall apart
As much as I think the factors I outlined above create the possibility for real disruption of the auto industry, there are some areas where I think EV manufacturers and investors may be seeing more financial opportunities than actually exist.
1. Software may not be a high-margin differentiator
Tesla has started testing the waters of selling software as a service for its vehicles. Its available self-driving features are now a $10,000 add-on for customers, and Elon Musk has indicated that the price will continue to rise. There could also be features that turn off if a subscription isn't renewed.
There's reason to be excited about software improving vehicles on an ongoing basis, but the idea that people will pay tens of thousands of dollars for a vehicle and then more year after year for software updates seems questionable to me. A vehicle is already a big expense for consumers, and adding potentially thousands of dollars in costs that have never been a part of the user experience may be too much to ask.
And then we should consider where software is going to be truly disruptive to the auto industry: in autonomous driving.
2. Autonomous driving is coming, and that's not good
Most automakers are developing autonomous features in some form, but the model in which they bring them to market will vary. Tesla has been talking about autonomous driving for years, but it's using autonomy as a feature to sell vehicles and software, rather than as a disruptor to being a manufacturer long term.
Companies like Cruise, Waymo (owned by Alphabet), and Nuro are designing the technology behind entirely driverless autonomous vehicles that will transport people and goods around cities. Why isn't this the future of transportation rather than owning an autonomous vehicle and keeping it in the garage?
I think the transportation-as-a-service model in autonomous driving is what's going to be truly disruptive over the next decade -- even more disruptive than the transition from internal combustion engines to EVs.
I don't think a transition to fully autonomous driving is good for companies like Tesla, Rivian, Lucid, and many others that are building manufacturing plants and a model built on selling vehicles to consumers.
3. Competition is coming
EV manufacturers are being treated a lot like tech stocks today, which are highly valued based on price-to-sales and price-to-earnings ratios. But the tech industry typically has better margins than manufacturing (even Tesla's margins of around 20% don't come close to tech margins that can exceed 70%) and is full of companies that have some kind of network effect or winner-take-all market in their business.More customers fund more features, which brings in new business partners, which makes the software more attractive to customers. It's a virtuous loop that's common in technology stocks.
Network effects aren't really a feature in the auto industry. There's nothing that one company does that another can't copy, and there's nothing keeping customers from switching brands. I don't see that changing with EVs.
Tesla's customers are extremely brand loyal, but as new EVs hit the road, there's no reason to think a current owner will have a big incentive to stay with Tesla or that a new customer won't consider a different brand. The stickiness may be with the brand itself, but that's not the same as a network effect in technology.
As competition improves and dozens of new EV models hit the market in the next few years, I think it's possible we'll see the same weak margins we're used to in auto manufacturing. And even Tesla hasn't proved it can be profitable long term without subsidies or regulatory credits.
Lofty valuations may come back to bite investors
We're used to tech companies earning lofty valuations, whether you're looking at P/S or P/E ratios. And today we see EV companies trade at similar multiples.
But are those multiples deserved if EV makers don't have software-style margins, and if they have little stickiness with customers, competitors breathing down their necks, and the possibility of complete disruption by fully autonomous ridesharing fleets?
And aren't companies like Tesla, Nikola, Rivian, Lucid, and others fighting for the same pie already owned by traditional automakers? They aren't making the pie bigger or expanding into other services, they're just taking market share. So do they deserve to be worth more than all legacy automakers put together?
Long term, there's a lot of competition and disruption coming to the EV industry and companies like Tesla, Rivian, Nio, Nikola, and others may just be fighting to be the next generation of relatively low margin auto manufacturers, not the disruptive, high margin tech companies in a winner take all market they're being priced as. This time may be different and auto manufacturing may be a better business for EV manufacturers than it was for mass market auto manufacturers, but as investors we should be cautious about pricing these companies too highly before they prove they can make money consistently making cars. Because that's been easier said than done historically in the auto industry.