On Friday May 11, President Trump is scheduled to host a White House roundtable with the heads of the major automakers: here. It's about the future of government regulation of your car.
One might say that this is the modern automotive version of that famous scene in The Godfather, in which The Don proposes a new compromise to settle their disagreements, and chart a new regulatory path going forward.
In this case just as in the movie, there are not only five big players, but also a few lesser ones. In this 2018 version, the five biggest players include General Motors (NYSE:GM), Ford (NYSE:F), Fiat Chrysler (NYSE:FCAU), Toyota (NYSE:TM) and Nissan (OTCPK:NSANY). Smaller participants include Volkswagen (VLKAY), Volvo Cars, Mitsubishi, Mercedes, Mazda (OTCPK:MZDAY), Jaguar Land Rover, Hyundai and Kia.
At issue is, just like in The Godfather movie, structuring the "new peace." It's about the new regulatory framework, after the wars with the previous administration, which had been on a mission to penalize the auto industry and force it to produce products that couldn't be sold at a profit.
These are critical issues when it comes to the profitability of the automakers. Just imagine yourself in their shoes: They operate in a capital-intensive, low-margin, business, that broadly speaking is not growing any faster than the GDP.
In this cut-throat business, automakers are fighting not just each other, but also their cost of capital. Only three years ago, FCA CEO Sergio Marchoinne made an epic presentation called "Confessions of a Capital Junkie" - here.
When you look on page 14, you see that the ROIC (return on invested capital) in the industry is sitting at 7.8%, which is the lowest of the industries compared. It's small wonder that almost all automakers are trading at single-digit P/E multiples. It reflects the risk that their thin margins make them vulnerable to changes in volume in cost, which could cause them to go bankrupt. One such extra cost is to be ordered by politicians to produce cars that can only be sold at a loss.
Indeed, automakers haven't been fighting its competitors on just the generally crowded market turf. It's also been a collective whipping boy for the politicians, who seek to milk, penalize and regulate them at every step of the way. The issue at hand for this May 11 White House meeting is "emissions regulations."
Except, very little about this meeting is "really" about emissions regulations. It's about fleet mix, and whether some states should be allowed to dictate their own fleet mixes.
What's this "fleet mix" about anyway? It's about a government policy that dictates the production of vehicles in one direction or the other.
Explaining what it is, may be the easiest by way of giving an example of what it is NOT: A gasoline tax. Let's say that a government raised the gasoline (and/or diesel) tax. If everything else in the equation was unregulated, that would mean that consumers and automakers would meet in the market to yield whatever they were willing to buy, and willing to produce.
In other words, a gasoline tax doesn't say that an automaker has to produce a certain number of so-and-so type of electric or hybrid car, and it doesn't tell the automaker that it needs to make a smaller car. The supply and demand change, but it leaves it up to the market to decide what consumers and producers want to do, precisely.
No, the kind of "fleet mix" regulations that are governing today's U.S. auto market come in different flavors. For the sake of simplicity and brevity, I will put them in two buckets:
First, Federal regulations.
Federal regulations deal with setting rules for minimum fuel economy (averaged over groups of vehicles) numbers. They are not about emissions of actual pollutants, as each car is required to meet the requisite pollution controls. Rather, they are about forcing suppliers to sell a mix of vehicles that the consumers don't want.
How do we know that? Because if consumers were buying what the politicians wanted them to buy, then there would be no "need" for such legislation, duh!
Second, California and the ZEV states.
California together with about ten other states, jointly constituting close to 40% of the U.S. population, have concocted a scheme in which automakers are forced to sell a minimum percentage of all-electric, plug-in hybrid and/or hydrogen cars: here. As you can see on page 32 in this presentation, the numbers for all-electric and/or hydrogen cars alone rise from 2% in 2018 to 16% in 2025. Basically, this is a USSR-style "planned economy" where the government decides what must be produced in a five-year plan (except in this case, eight years).
What's on the table in the May 11 White House meeting?
There are two things to discuss in the meeting between The Don and the automakers:
What to do about the Federal automotive fleet mix regulations?
What to do about California's ZEV requirement? (This includes the states that join it.)
Federal reform: Abolish the fleet mix rules
When it comes to the federal regulations, the automakers have a pretty simple story: Stop telling us what to produce. If each car meets the requisite pollutions controls, the government should not get involved in the fleet mix. All fleet mix regulations, such as the CAFE (corporate average fuel economy) laws must be abolished. CAFE is the equivalent of the government dictating that only so-and-so many XL-sized t-shirts must be allowed to be produced and sold, whereas so-and-so many S-sized ones must be produced. It doesn't fit the reality, and obviously leads to lower profitability (or outright losses).
The federal government should say what's the maximum that a car can pollute, and leave it at that. Let the automakers decide on how to meet that simple standard, and let consumers buy whatever they want from that menu of choices.
If an allegedly free-market Federal government can't make that simple deregulatory reform happen, they might as well go home. And if the automakers can't ask for that basic regulatory reform, they should stop saying that they are working in the interest of their shareholders.
California reform: Price according to cost
Most of the debate you have heard, with respect to a Federal-California automotive regulatory conflict, is completely missing the point. As a states-rights matter, California can - or should - set whatever rules it wants. However, if California (and the other states which joins it) sets rules that impose costs on the companies doing business in those states, such cost should not borne by people in the other states.
The way it works today is that if an automaker is forced to sell more electric vehicles (EVs) in California - and in states that follow it, such as New York and Massachusetts - than the market equilibrium, then the automaker loses money on those cars. If the automaker must sell an additional 10,000 or whatever EVs at a loss of $10,000 or $30,000 each, then such losses must be added to the price of the non-EV cars that subsidize such losses.
It's obviously absurd and unjust that someone living in Oklahoma or Wyoming should have to pay extra for his regular car, just so that someone in California or Maryland gets to buy an electric vehicle at a subsidized price. That's the effect of today's ZEV requirement.
Rather than telling California to get rid of its ZEV requirement, the federal government should allow - and indeed encourage - the automakers to simply add a "California ZEV emissions surcharge" to all of its (non-EV) cars sold in the ZEV states. There's no telling exactly how much such a surcharge would have to be in order to truly account for all of the automakers to comply with ZEV, but let's say it's $2,000 per car, just as an example. It would of course be up to each automaker to set this number to the best of its ability to account for its extra cost.
If ZEV state consumers - such as those in California and New Jersey - saw a $2,000 bump in prices of every Chevrolet Cruze, Toyota Corolla, Jeep Cherokee, etc., they might finally become aware about what's going on and start to question whether this ZEV "fleet mix" regulation makes any sense. Is there any doubt that as of today, almost zero consumers have the faintest idea what ZEV is, and where those costs show up? If it's even as much as 0.0001%, I'd be shocked. I doubt it's 100 people in the whole country. 99% of the people inside the automotive industry with whom I talk don't even know much about it.
Impact to Ford, GM, FCA and the other automotive families
If the automaker meeting with the Trump administration on May 11 yields an end to the Federal government telling automakers what kind of fleet mix to produce, and if it means that the automakers will respond to California's ZEV rules by raising prices in those states (while lowering them elsewhere), then it ought to be clear that automotive industry profitability will be going up. It's difficult to say how much, but we can use Mazda as an example of how to perhaps back into a financial number, which in turn governs the stock price.
We can start by reading the March 2018 financial report from Mazda (OTCPK:MZDAY), which was published on April 27: here. Look at page 17. It shows that 34.3 billion Yen is expected to be spent for the current fiscal year on "investment for US sales network reforms and increased costs for compliance with environmental regulations."
The document doesn't explicitly say that it's about the ZEV legislation, but I believe that's effectively the legislation that costs a company such as Mazda - which doesn't sell the largest SUVs, with V8 engines, or any pickup trucks at all - much of this money. As a result of this impact - which I'm suggesting is at least in part a result of the ZEV legislation - Mazda is estimating (on page 15) that its operating income return on sales will fall this year from 4.2% last year to 3.0% this year. Going from 4.2% to 3.0% is a 29% reduction in profitability.
Most other automakers have not spelled out the numbers this way, at least as far a I have seen. However, that doesn't mean that they too aren't impacted. If Mazda, which has the industry's lowest fuel consumption on a fleet-wide basis in the U.S. market (here), is seeing a 29% reduction in profitability at least in part from this ZEV regime, imagine how much it is hurting companies such as FCA, Ford and Daimler, just to mention a few?
The inverse of a 29% reduction is a potential 40% increase in profitability. While that certainly would be a giant number, it just goes to show what is potentially at stake in this May 11 meeting. I can't think of a single other issue that could impact automaker profitability more than the outcome of this negotiation. We who are investors will be watching this most carefully.
Disclosure: I am/we are long GM. 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.
Additional disclosure: At the time of submitting this article for publication, the author was short TSLA and long GM and GOOGL. However, positions can change at any time. The author regularly attends press conferences, new vehicle launches and equivalent, hosted by most major automakers.
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