Getting Fired Up on Cleaner Internal Combustion Technologies

Although the writing has been on the wall for some time now regarding Obama's willingness to move aggressively on the environment file, few expected his first substantive move to have to do with vehicle fuel economy. On Monday, the President requested that the EPA reassess its earlier decision (taken when the Bush administration was still in power) to deny California the right to set and enforce its own fuel economy and car emissions standards above and beyond those set at the federal level.

Not only are California's standards much tougher than the current federal ones (the state is seeking 42.5 miles per gallon by 2020 vs. 35 at the Federal level, a nearly 22% difference), but 16 other states plan on eventually following suit, together accounting for at least 50% of all cars sold in the U.S. Unsurprisingly, the auto industry, which is currently contending with a complete collapse in demand, isn't impressed.

While this move might seem counterproductive at a time when the government is expending vast sums of money trying to salvage domestic car companies, it is actually very much in line with two of Obama's defining features - namely that (1) he is concerned with weaning the U.S. off foreign oil and tackling climate change and (2) he believes that regulation can be a force for good. How does the latter point work? Let's go through the main arguments.

First, take the dramatic increase in gasoline prices that occurred over the past few years. There is no doubt that the scale and rate of the rise in energy costs, which far outpaced workers' ability to obtain matching wage increases, left many households feeling significantly poorer, potentially having acted as one of the triggers to this recession. Petroleum accounted for about 39% of primary energy consumption in the U.S. in 2007, the single largest category. A serious push toward raising fuel efficiency can thus be seen as a means of lessening the blow from a sudden and sustained rise in petroleum costs, something that will almost certainly happen again.

A related argument in favor of fuel economy regulation looks not so much at the negative wealth effect of expensive oil, but rather at the massive transfer of wealth from North American households to potentially-hostile countries that occurs under such a scenario (the U.S. imports about $5.7 billion worth of oil each week).

Sure, imposing standards that are ahead of what industry can meet given its current technological capabilities and operational configuration (a claim that is questionable if not spurious, at least on the technological capabilities front) creates a transfer of wealth, except this time the money flows to companies that are overwhelmingly not based in hostile nations and that often pay taxes here. In an environment where expensive oil is likely to become the norm, the wealth transfer will occur one way or another - it's about deciding where the money flows to.

Lastly, there is the view that regulation can have positive economic impacts by encouraging innovation and spurring job creation. The German Renewable Energy Law is an example. By mandating outcomes rather than means, government lets the market choose the most efficient path to get there. Under a best-case scenario, the innovations made along the way become commercial and export success stories. After all, the global trend toward greater fuel efficiency will intensify in the years ahead, and a continuation of the U.S. government's complete aversion toward raising fuel economy standards (helped of course by a healthy dose of whining from Detroit every time the topic comes up for debate) would play right in the hands of the Big Three's competitors.

While the arguments presented above will sound preposterous to many individuals, investors with an interest in alternative energy need to understand that this is in fact the stance that will prevail in Washington for at least the next four years. It will feel a little strange at first given how out-of-favor this worldview has been over the past eight years, but soon people will realize that this is the norm rather than the exception, and that interesting opportunities are emerging as a result.

It is therefore important to start looking beyond the current bailout package toward where the Obama administration will go on the regulatory front when the storm has passed. In my view, Monday's announcement provides a good prelude, and tougher fuel economy targets could be on their way at the federal level before too long.

Fuel Efficiency & Emissions Control

There are two main ways to control car emissions and increase fuel economy: (1) make incremental improvements to existing technologies (e.g. more efficient internal combustion engines, catalytic converters, use of lighter alloys and composites in car bodies, etc.) and (2) boost the deployment of disruptive technologies such as natural gas powered cars, hybrids, plug-in hybrids and electric vehicles. While #2 will offer the most significant growth opportunities in the mid and long terms, #1 will play a key 'bridge' role and will continue to receive much focus. What's more, established companies, which tend to dominate #1, provide in theory safer investments in the current environment where investor appetite for risk has all but disappeared.

Given the discussion above, I thought I would revisit four auto parts stocks we have discussed in the past and that are direct plays on fuel economy and reduced car emissions (they all belong to #1 rather than #2). The auto parts sector has been experiencing significant difficulties of late.

Company	Ticker	12-Month Return (%)	Debt-to-Capital	Current Ratio	Cash Ratio
Magna International	MGA	-4.9	0.07	1.56	0.43
BorgWarner	BWA	-16.4	0.26	1.19	0.10
Valeo	VLEEY.PK	-67.6	0.45	1.06	0.24
Linamar	LIMAF.PK	-49.4	0.35	1.62	0.12
All figures for Q3 2008 except for Valeo which is Q2 2008

I decided to look specifically at three balance sheet items that are good indicators of a company's ability to weather a period that could be marked by significant reductions in sales, margin squeezes as utilization rates fall, and an overall reduction in operating cash. What I found was broadly in line with my expectations: Magna (MGA) has the cleanest-looking balance sheet and is thus in a strong position to deal with a cyclical decline in sales.

Not only is the firm virtually debt-less, but it's got sufficient short-term assets to comfortably meet its short term liabilities (although the cushion isn't huge). What's more, Magna has a comparatively good cash position. Compare it to Linamar (LIMAF.PK), for instance, that has a higher current ratio but the second worst cash ratio. That's because much of its working capital is tied up in inventories and receivables. In the current environment, inventories will be challenging to liquidate and receivables may be difficult to collect as suppliers go under.

Of course, none of this has been lost on the market, and that's why Magna is trading at a healthy 13.4x TTM EPS, versus 4.13x for Valeo (VLEEY.PK) and 3.02x for Linamar. However, it remains cheaper than BorgWarner (BWA) at 18.77x. Both Magna and BorgWarner are in a strong position to benefit from the new regulation, but I can't help feeling a tad uncomfortable with the latter's PE in an environment fraught with so much uncertainty and where economic forecasters have been missing the mark so frequently.

Lastly, Magna and Ford's (F) commitment to bringing a fully electric, battery-powered car to market within about two years is pretty exciting. If the firms can execute on this plan, it would mean that Magna would be a dominant force in #1 (evolution) and #2 (revolution), something that companies in any industry typically struggle to achieve.

Conclusion

The swiftness with which Obama moved on the fuel economy file is, in my view, the clearest indication yet that we have entered a new regulatory era, especially where the environment is concerned. This era will be defined by a belief that regulation can be a force for good, and regulation will thus be designed in a way to encourage innovation. This, in turn, will create plenty of investment opportunities in the alternative energy and cleantech spaces.

While there's ample focus on the stimulus package and what green industries will benefit as a result, investors should keep a close eye on the auto sector when we emerge from this recession as that is likely to be a prime target of this administration.

DISCLOSURE: Charles Morand does not have a position in any of the securities discussed above.

Comments

[SPEEDOMOTIVE:]

From one who works in this industry, complying with Gov't regulations is hampering alternative fuel technology implementation not causing it. As an investor FSYS is a much "cleaner" trade than the parts suppliers listed. I guess I'm supposed to disclose I'm not long any shares now but will be when the chart technicals improve. If anyone is interested, I will publish the chart on the site.

Jan 30 07:33 AM

[ROLEX18K:]

Every investor believes his stocks are the best, ask any investor from any country what he thinks about his stock or even if he holds 1000 stocks, he will say you endless stories why his stocks are better than the rest.
I hate stocks as I don't trust people who run and milk them, I can only buy stock if it is well hedged with 2X3X short index ETF.
Also many investors wonder and follow hedge funds holdings, without understanding that successful funds don't make money in stocks, they only made money is selling against it SP 500 index futures.

Jan 30 08:26 AM

[john s. gordon:]

precedent exists for encouraging a state or states to exceed the federal standard.

EPA has done this for many yrs in regard to power-plant emissions - you are allowed to pollute less than the feds allow on a national basis. as a result of this, new mexico has the cleanest air in the country, they have an important tourist industry & visibility impairment is a no-no.

encouraging cleaner-than- (federally) required technology allows new cleaner technologies to compete against same-old-we've always done it that way technologies.
> jack

Jan 30 08:43 AM

[BlueOkie:]

California is surely the leader. The already have a different fuel mixture and the highest gas prices in the country. Maybe they should work on paying their bills. Oh they are - with IOU's.

Jan 30 08:56 AM

[fg144331:]

Sounds good, B U T until we get the jobs situation under control, no one is going to have the money to buy a new car, especially when the mfgs are talking about increasing prices because more efficiency is needed. I think this Country
is between a rock and a hard place..........very sad indeed. I really blame WalMart for starting the outsourcing to China, by making their (want to be) suppliers leave the USA and move to China for cheaper prices and I blame the bush admin for not reacting (at all or much sooner) to our downward spiral of our economy.

Jan 30 09:01 AM

[fg144331:]

Yep, what I DO and what might make a change is continue to vote incumbents out of office! Our Leg does nothing but fight and get nothing done as you can see with the MESS we are in now! Politics is being carried a bit to far.


On Jan 30 08:56 AM BlueOkie wrote:

> California is surely the leader. The already have a different fuel
> mixture and the highest gas prices in the country. Maybe they should
> work on paying their bills. Oh they are - with IOU's.

Jan 30 09:05 AM

[finmah@yaho...:]

Regarding the fuel economy part of regulations -

if people drive x amount of miles per day - does increasing fuel economy reduce driving? Obviously it would be cheaper to drive so now people will be encouraged to drive the same or more even with an offsetting increase in gas. There will be an inverse effect on emissions - cheaper mileage expense more DRIVING - greater emissions.

If the gas price does rise - hostile nations gain revenue people can now offset the price increase with better fuel mileage.

Ca -clearly the most important issue is air pollution around the city -

The higher economy cars cost more to the consumer and impact car co and their research budgets for alt energies.

The fuel economy sometimes goes by category - now people will upgrade to bigger categories to gain interior space while gaining greater fuel economy.

The argument is increasing fuel economy will reduce overall consumption of gas - but this is not No 2heating oil for the home where demand is constant - it has behavioral demand characterstics such as cruising - home buying, second homes, vacation travel, no of household vehicles etc.

Overall as a policy for tens of millions car drivers - regulations such as these need more transparency.

Jan 30 09:08 AM

[Steve in TN:]

Why don't our elected representatives have the courage to raise the gasoline tax? This is a much more efficient way to decrease petroleum consumption in the U.S. than CAFE regulations. This area is where the Europeans have a big advantage over the U.S. If we raise gas taxes, those extra funds will stay in the U.S. rather than flow directly to OPEC. If gas prices remain low, auto mfgs. will produce cars no one wants to buy. We then want bigger cars. It's pushing on a string.
If gas prices were higher with additional taxes, consumers will want to buy more efficient autos. Let's face it, the Europeans have a much better system than we do.

Jan 30 09:19 AM

[auto44:]

The auto companies a while back were charge by the congress to reach a mpg figure for the total fleet they sold. I don't know by what miracle congress produced this good law. They must have made a mistake! Anyway electronic fuel injection and electronic ignition timing and a system of variable valve timing which sprang out of the necessity created by that that law reduce very substantially air pollution and incresed in a major way Miles per gallon. How ever and with laws there is always a how ever, trucks were exempt from mpg cap and with a small dose of lobbying pickups and suv's were included as trucks and there wild popularity sent our dependance on fossil fuels rocketing instead of reducing it.

Jan 30 10:07 AM

[X Oil Man:]

This is a financial web site, BUT the issue of fuel consumption and emissions is far bigger and far more important than how to make a fast buck on trading auto parts suppliers.
Morand's article is on target. Clean air is good, but the bigger benefit will be decreasing oil consumption. We can legislate any mpg standard we like; however, the science of Thermodynamics regulates the mpg results. We must set the bar high, but attainable.
More important, we must omit loopholes like exempting pick up trucks and SUV's. Obama is on the right track for lasting improvements in America and repairing the Bush damage.

Jan 30 11:09 AM

[anarchist:]

Another point that seems to missed by post above is that Morland is also talking about "where the money goes". We may or may not save money using clean and green transportation but for sure we will start putting more money back into our pocket instead of the Middle East.

Jan 30 12:35 PM

[Urbane Gori...:]

We just have the yearly legislative log-jam. This year it seems that the reduced GOP presence in our State and in DC has caused some polarizing, which is exacerbating the problem. My take is that the GOP is drawing a line in the sand and the economy, and State be damned in the process. For example, I hear complaints about the 'pork' in the new stimulus bill. Politics as usual, but remember what happened when the GOP blew off the first TARP? The market dropped like a rock and lost some horrendous amount that day. It was only when 'pig-fat' was added that the GOP got on board and it passed. The same issues are being played out here in Kah-li-foor-ni-ah!

Disclosure. Lifelong GOP... Became a Libertarian in Bush's first term, Dem in his second. Until the GOP becomes Republican again, I will remain Dem.

jegan ;-)

On Jan 30 09:05 AM fg144331 wrote:

> Yep, what I DO and what might make a change is continue to vote
> incumbents out of office! Our Leg does nothing but fight and get
> nothing done as you can see with the MESS we are in now! Politics
> is being carried a bit to far.

Jan 30 02:02 PM

[john s. gordon:]

auto44 - daimler-benz was using fuel injection (mechanical pump, not electronic) in 1954 - big deal. performance advantage. general motors used it later.

i was using capacitive-discharge (electronic) ignition in 1962 - big deal. performance advantage.
> jack

Jan 30 02:12 PM

[Alex Filonov:]

I remember California law requiring 10% of cars to be electric. Where is it now? You can create any stupid law, it doesn't mean companies can comply. The simplest way to boost fuel economy is a move to diesel, but diesel is outright banned in California for cars. Fuel economy can't go against Second Law of Thermodynamics, and gas engines are not far away from the limits. If you want a big boost, it's either hybrids or diesel, or even diesel hybrids. Every approach has it's own trade-offs, and each is very expensive.

Jan 30 03:21 PM

[isaac the t...:]

How about plug-in hybrid NG vehicles?

Jan 30 04:30 PM

[a. palmer jr.:]

I think higher mpg would be fairly easy to attain...it's just getting the people to buy and drive them. All they have to do is make cars lighter and gear them up a little, put smaller engines in them. We've already done this, but the first opportunity Americans get, such as this temp. drop in gas prices and they get out the suvs again. I think possibly in the future, if we're really serious about this, those overweight personal vehicles(over 4000 lbs.) are going to have to be banned.

Jan 31 01:03 AM

[WayneS:]

On Jan 31 01:03 AM a. palmer jr. wrote:

> I think higher mpg would be fairly easy to attain...it's just getting
> the people to buy and drive them.

You are right on. Chevy had a car in the 80's that got 40-60 mpg.
There were numerous cars in the 60's that got over 30 mpg.
There were propane, butane and methane-fueled vehicles in the 60-70's.

If the car makers are forced to quickly make higher mpg vehicles, people would spend whatever it takes to rebuilt "old classics" and not buy new.

As stated, higher gasoline taxes would work. $4 gasoline saved 1700 lives last year. We could outlaw racing and tractor pulls. We have the technology to enforce zero-tolerance speed limits, atleast on freeways and many highways. The average driver wastes 25-40% of the fuel they purchase.

Jan 31 06:38 PM

[Stockguy456:]

internal combustion engines are inherently inefficient.

Insanity: doing the same thing over and over again and expecting different results. Albert Einstein

Do you really think we will be using gas 50 or 100 years from now?

Feb 02 04:47 PM