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Imagine for a moment that you are a CEO of a major auto maker and you have a serious problem. You produce these internal combustion engine (ICE) cars and they net you a good 20% profit but the market is starting to demand long range EVs. The problem is those gosh darn battery packs are so expensive. How can you start selling long range EVs but maintain your margins?

While there is some opposition against EVs, the supporters of EV are almost religious in their belief that EVs are the future. In anthropology it was discovered that when 10% of a population holds an unshakable belief, the idea will spread. I personally believe that at least 1 in 10 people, if not more, now hold the belief that EV powered by renewable energy sources is the future. This renders all the nay-sayers somewhat irrelevant.

This article is going to focus on what the large automakers are inevitably going to do to bank on the "EV revolution".

Current EV Costs
With the exception of Tesla, all the other pure EVs are short range. One of the major reasons for this is that batteries are expensive and in order for an automaker to maintain their profit margins they need to increase the price over cost to build. With short range EVs the profit margins are maintained but, unfortunately, consumers are largely not interested.

CEOs have even pointed out that the cost of EVs are inhibiting adoption rates. Is it even possible for an automaker to build EVs and maintain their profit margins? I believe the answer is yes and, probably sooner then later, the automakers are going to figure it out.

The Light Bulb
Somewhere in an office someone is going to have a light bulb go off in their head and the idea will be a very simple one, "we can make more money off of batteries than car sales."

Who is going to be the first to realize this? Tesla Motors (NASDAQ:TSLA), General Motors (NYSE:GM), or my personal favorite Toyota (NYSE:TM)? While I can't be 100% sure, I am sure one of them is going to do it.

You will know it when you see it because the first EV to utilize this new business model is going to be ridiculously cheap or, at the very least, at parity with other vehicles.

Printers & Ink
The printer companies realized that while you might only buy a printer once every several years, you need to replace the ink more often. The companies realized that if they sold the printers near whole sale and double and tripled the cost of the ink that your commitment to the printer in the form of familiarity and setup will force you to buy their ink cartridges at obscene prices.

I am forecasting that within the next 5-10 years we are going to see a fundamental paradigm shift in the auto industry as a whole. They will shift from making money off cars to being battery resellers with some cars attached.

What about spare parts?
The primary argument may be that selling batteries may not be as lucrative as selling all the different parts of an ICE vehicle; this, in my opinion, would be an incorrect assumption.

While GM made about 150B TTM, Delphi (NYSE:DLPH), which is their automotive part manufacturer subsidiary, only made 15.52B TTM.

But an EV can do X amount of miles?
When it comes to batteries in EVs, it is not about total mile capacity, it is how often you need to charge. For instance after 5 years if you lose 25% capacity, you would need to charge 25% more to fill your battery. Anyone who has had a laptop can easily relate to this.

Even if an EV is capable of doing a million miles before the batteries are completely dead, people will get them replaced before that because they will not want to charge their EV more often. The smaller the battery pack, the more often you will need to get them replaced.

How much money are we talking about?
Conservatively, an automaker can at the very least maintain its current profit margins even at present day battery costs. Optimistically they could potentially increase their net income substantially.

GM sells around 200,000 cars a month. So for the sake of forecasting, I am going to assume that all of these cars in their life time will go through at least one full battery pack change and this will net the automaker $2500 over a 10 year time frame. I am going to be very optimistic for the consumer and say that $7500 will cover 10 years. An example might be a full battery pack replacement costs $7500 (750/year) and 25% of that cost is profit.

Theoretically if GM sold 2.5 million EV cars this year, and replaced the batteries on them every 10 years, in 10 years they would make roughly around 6.25B or half that every 5 years if you are talking about partial replacements in net income from that batch of EVs.

(click to enlarge)

In terms of business, this is magical. Unlike ICE vehicles, EVs have massive battery packs that need to replaced by the OEM. Tesla for instance is offering to replace the 85-kWh pack for $12,000 with their warranty any time after eight years.

The reason it is magical is because the OEMs can lock in this price even if battery prices continue to drop and the consumer won't really have a choice of getting the battery replaced by a third party. Their only option may be to buy a completely new car similar to how a person might just buy a new printer instead of buying the replacement ink.

However, if battery costs do come down the automakers can still make the same net and charge the consumer less for the batteries.

Retention
The above chart assumes that the consumer will buy a car, replace the battery after 5-10 years, and then in 10-20 years buy a new car. EVs have less moving parts which means there is the potential that an EV can have a longer life span. Depending on brand loyalty, this could be very good for the automakers.

So let's assume that an automaker sells 2 million cars in a year, and 5% of those consumers keep the car for life and continue to pay about $1250 in net income (out to the automaker) every 5 years. What would that look like?

(click to enlarge)

To get the above chart I assumed an automaker could net approximately $1250 every 5 years in battery replacement/labor. I then assumed new car sales of 2 million per year with a 5% life time retention rate.

Auto Sales
Selling cars with large battery packs is expensive and this is unavoidable. However, because of the revenue they would be making off battery sales, even if an automaker took a hit to their profit margins on the physical car sale they would actually end up coming out on top.

Even if they had to cut their profit margins in half, they would still make more producing EVs then traditional ICE cars. So for the sake of argument, regardless of the cost of the vehicle, let's say an automaker can only make $1500 on any EV. If we assume 2 million car sales a year and add that to the above chart, let's see what we get.

(click to enlarge)

These very rough numbers would put an automaker selling 2 millions units per year at just under 6 billion by 2018. To put this into some context, GM made about 5.756B TTM.

This is a worst case scenario because it doesn't include the dropping cost of batteries, the fact that they would need to maintain much smaller inventories of spare parts, or that a particular brand might have a much higher rate of life time retention then 5%.

Outlook
If the demand continues to grow for long range EVs, I am fairly certain that automakers will shift their business model in order to make money off of battery pack replacements.

While this might be completely contrary to what almost everyone thinks, I believe the large automakers could be looking at a more profitable future by creating EVs...they just haven't realized it yet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: A New EV Business Model