At the beginning of the month, the Environmental Protection Agency (EPA) and the Highway Traffic Safety Administration (HTSA) proposed rule changes to the Corporate Average Fuel Economy (CAFÉ) requirements and greenhouse emission standards for new passenger cars and light trucks sold in US markets through model years 2021-26. The rule change would freeze fuel efficiency levels at roughly 37-mpg after 2021, doing away with the laddered fuel efficiency requirements envisioned by the Obama administration in 2012 with fleet averages at 54.7 mpg by MY 2025.
The policy differences between the two administrations couldn’t be more pronounced. The Obama administration saw the construct of federally mandated fuel economy standards as vital for curbing gasoline use in the greater economy. Zero emission vehicles waivers were viewed as equally singular in meeting the standards across corporate fleets. At the same time, these waivers would bring about an EV naissance, lifting zero emission vehicles from niche to a broad market acceptance.
Governments at all levels were to have outsized, public stakes in the equation. That meant any sign of wavering at the federal level on its commitment to CAFÉ regulations and the zero-emission standard applied all the more pressure is placed on state and local governments to keep apace. Bigger states like California and New York could, and still do, afford to offer tax incentives for the purchase of electric vehicles. In the absence or the reduction of federal incentives for buying or leasing EVs, smaller states with smaller revenue streams would struggle. Automakers, for their part, would pull back from the currently low-margin EV market as demand without governmental incentives makes investment in the EV space all the more problematic. Of course, the price of gasoline was always critical to the plan: The lower the price at the pump the higher the demand for roomy, gas guzzling - but highly profitable vehicles. The higher the price at the pump - the higher the demand for fuel efficient vehicles.
Accordingly, the Obama administration included myriad financial incentives for electric vehicles, hybrid, plug-in hybrid and fuel cell powered vehicles. Unsurprisingly, the Trump administration did not. The $7,500 federal credit for buying/leasing an electric car was reinserted into the Tax Cut and Jobs Act (2017) at the last possible moment. The Trump administration’s proposed change to the CAFÉ and zero-emission law of 2012 gloats in the numerical reduction of hybrid vehicles needed to comply with the proposed CAFÉ rules by 2030. The percentage of alternative fueled vehicles needed under the rollback plans falls from 56% under the Obama proposal to just 3% under the Trump plan by 2025.
While the Obama administration projected cutting CO2 emissions by more than 6 billion metric tons through 2035, the Trump administration estimated an additional 321 million and 931 million metric tons of CO2 being released into the atmosphere over the period. Where Obama in 2012 would reduce oil consumption by 2 million barrels/day by 2025, the Trump administration projects a net increase of 0.5 million barrels/day over the same period.
As part of the rule change, the proposal would also strip California of its waiver under the Clean Air Act (1970) that allows the state to set its own emission standards that historically have been stricter than those at the federal level. Since the passage of the Clean Air Act, 18 states and the District of Columbia have followed California’s lead on emission standards and fuel economy. Together, the group is responsible for about 40% of total US light truck and passenger car sales annually. Already, 19 state attorneys general have announced plans to sue the Trump administration if the rollback rule is finalized. The Trump administration faces years of litigation - most likely including a Supreme Court decision - in its attempt at stripping California’s emissions exemption under the Clean Air Act.
Figure 1: GM, Ford, and Toyota Ratios against the S&P 500
Unsurprisingly, the auto industry faces Brexit-like levels of uncertainty while the legal proceedings crawl indolently through the courts, upending investment plans and new model development for much of the duration. While the rollback of the Obama administration’s CAFÉ and zero emission requirements might be expected to be welcomed with relief by US and US-based automakers, GM (GM) (green bars), Toyota (TM) (orange line) and Ford (F) (red line) have slid disproportionately as a ratio of the S&P 500 (green area) in the first weeks of June. That slide continued through Friday’s market close. The main impetus for the market slide comes from the Trump administration’s 25% tariff regime on imported steel and 10% tariff on imported aluminum that went online on the 1st of June as custom inspections offer up heightened bureaucracy and lengthy delays to just-in-time supply chain operations that crisscross international frontiers, slowing delivery schedules and sharply increasing raw materials and transportation costs to auto and myriad manufacturers that use steel and aluminum in production (see Figure 1, above).
While the US and China trade tariff regimes grow on ever-increasing dollar values of goods, the first seven months of 2018 saw Chinese vehicle sales increase 4.3% YOY. The seasonally adjusted annualized rate of car sales here in the US for the period comes to -0.06% YOY. China’s EV sales for the month of June reached 86,000 units, up almost 43% YOY with strong government financial incentives driving sales. Plug-in hybrid sales increased 102% YOY. Here in the US, EV sales totaled just over 25,000 units for the month.
Figure 2: Nucor, US Steel and Alcoa Ratios against the S&P 500
Steel prices in the US are up by a third and are expected to peak in the 3rd quarter before falling off in the 4th quarter and into 2019. For smaller companies without the wherewithal to stockpile steel and aluminum, raw material costs are even higher with spot prices rising as market availability tightens. Adding further impetus to the upward flight of steel and aluminum prices, on Friday, the Trump administration doubled the import duties on Turkish steel and aluminum products to 50% and 20%, respectively. Turkey is the sixth largest foreign steel supplier to the US market. Most of the increase in steel prices is due to cross-border supply chain disruption resulting from customs inspection. Trade friction at the border and increased transportation costs are expected to continue so long as the tariff regimes are in place. While demand in the greater economy remains strong, supply chain disruptions are on the rise. In its latest survey of US manufacturers, the Institute for Supply Management found that more than a quarter of respondents indicated that raw materials took longer to arrive in July than in June. Years of work and billions of dollars have been spent on making supply chains uber-efficient with just-in-time delivery schedules upon which many a manufacturer has become umbilically dependent. The Trump administration’s sanction-based trade policy does little more than throw sand in the gears of these hard-fought efficiencies - harassing production schedules, threatening jobs, and compromising bottom line calculations. All told, it’s a curious application of national security.
Though down almost 5% on the year, Nucor (NUE) (green bars) put up strong 2nd quarter numbers. Earnings per share rose 113% through the end of June YOY. The company’s steel products segment was up 27% at $1.74 billion YOY. Since the end of July, however, the company’s stock price has lost just under 7%. US Steel (X) (red line) experienced similar increases in product sales, up just short of 15% through the end of the 2nd quarter. Realized debt during the quarter, however, shaved net earnings to $214 million, a drop of just over 18% YOY. US Steel is down 34% through Friday’s close from its peak in the second week in March. On the aluminum side of the equation, Alcoa (AA) (black dotted line), simply found itself on the wrong side of the border in the US-Canadian aluminum dispute. The realization forced the company to request an exemption on tariffs from its three smelting facilities in Quebec. Alcoa incurred $15 million of costs through the end of June and expects to pay between $12 million to $14 million a month on imports from Canada that now are subject to Section 232 tariffs. Alcoa’s stock has fallen over 25% since its YTD peak of $60.23 on the 19th of April, a stock peak ironically achieved as a result of the administration’s sanctions against Russian oligarch Oleg Deripaska that were put into place against Rusal in the first week of April (see Figure 2, above).
An interesting side note: Of the more than 20,000 requests for steel tariff exemption received by the Department of Commerce through the end of July, about 639 requests have been denied. Half of those denials were a result of US Steel, Nucor or AK Steel Holding (AKS) filing objections. The rest of the denials came from submission errors of one sort or another. Commerce granted no exemption requests over an objection. Such industrial participation in formatting national trade policy lacks historical precedence. Complicating the mix is the present Turkish crisis where investor confidence and the country’s currency have simultaneously hit historic lows. US trade sanctions are now being applied to market-driven forex changes - under the Section 232 guise of national security. A template for manipulating world currencies appears to be in place - as witnessed by the wide depreciation of currencies in the EM space over the past month - with Turkey, Brazil, South Africa, Russia, Mexico, and China being the most noteworthy to date.
Figure 3: Albemarle, Sociedad Quimica y Minera and Wealth Minerals Ratios against the S&P 500
Albemarle (ALB) (green bars), Sociedad Quimica y Minera (SQM) (red line) and Wealth Minerals (OTCQB:WMLLF) (orange line) are companies in the lithium space, each holding expansive leases on land tracks in the Atacama region of Chile, arguably the richest source of brine lithium currently in production. The Atacama is currently responsible for about a third of total world production. The Shenzhen listed Tianqi Lithium recently paid $4.1 billion for a 24% stake in SQM, stemming from last year’s Nutrien (NTR) merger between Potash Saskatchewan and Agrium. The stake now makes Tianqi one of the biggest players in the global lithium space. The company already owns a 51% stake in the hard-rock lithium Greenbushes mine in Australia, a joint venture with Albemarle. Combined with the Fujian-based Contemporary Amperex Technology (CATL), the world’s largest producer of lithium-ion batteries, China now dominates the production and refining of battery materials and its raw material inputs. Last year, Chinese consumers bought 770,000 EV cars out of a total global market of 1.23 million, just under 64%. The US total numbered 199,000 or about 16%. In 2015, the US total came to 21% while the Chinese total came to 61%.
A strong dollar, growing trade war intensity, and the lack of strong federal government leadership have left investors wary of investment opportunities in the emerging market space - particularly in the EV space. Net income for US-based ALB was up 173% through the end of the 2nd quarter with EPS up 196% for the same period. The stock is down 28% at Friday’s market close from its YTD peak in the first week of January. Chilean-based SQM’s profit margins were more modest, up just over 10% through the end of March with EPS increasing by the same 10% in US dollars. The stock is down almost 27% from its YTD high posted in early January. Wealth Minerals is a small mining company based in British Columbia that has assembled one of the most impressive portfolios of brine lithium assets in the world. The company’s prime assets combine for a total of over 100,000 hectares, much of which is located in the Atacama just north of those held by SQM. WMLLF has just concluded an agreement with its Chilean state partner, Empresa Nacional de Minería de Chile (National Mining Company of Chile) (“ENAMI”), which gives the company export authority of brine lithium produced on its leased holdings in the country. WMLLF is currently starting the production phase of its program. The stock is down 57% from its March high of $1.50/share (see Figure 3, above).
Figure 4: Tesla against the S&P 500
As we have seen, China is by far the largest EV market in the world, and that dominance is clearly on the uptick. China has worked hard at cornering international EV supply chains to which the production, the raw materials, and manufacturing of critical battery packs readily attest. The Chinese market accounts for just over 17% of Tesla's (TSLA) (green bars) total revenue through the first three months of June 2017. That total fell to 13% through the end of June 2018, despite YOY growth of just under 14%. That revenue stream is likely to fall sharply by year’s end. Now facing a 40% tariff at the border on its vehicles imported from its lone manufacturing facility in Fremont, California, Tesla faces the prospect of either diverting its production away from the Chinese market or making good on its long promise to establish a manufacturing facility in Shanghai. Either option is wrought with difficulties. Successfully dispersing such a large percentage of its historical earnings about its North American or European markets is easier said than put into practice - particularly using a model of exporting finished product from Fremont. Facilities in China and in Europe would likely be necessary to circumvent current trading restrictions whose duration remains unknown. New facilities cost money, and Tesla is already a highly leveraged company. The Shanghai facility alone would require local funding in the neighborhood of $2 billion, according to news reports - just about doubling the company’s current $2.6 billion debt pile through the end of June.
Tesla’s free cash and restricted cash on hand improved somewhat in the 2nd quarter to about $717 million, an improvement over the $671 million on the books through the end of 2017. Yet current accounts payable for the quarter topped $3 billion, up from $2.34 billion through the end of 2017. Total revenues topped $4 billion for the period, an increase of 43% YOY. The company’s net loss of $7.43 million is a full 85% higher than the net loss of $401.4 million posted in June 2017, reflective of its Herculean effort at increasing production of its Model 3. Earnings per share dropped to -4.22/share from -$2.04/share for the same reporting period.
Even with Tesla’s market following that is more than willing to march to its fife and drum corps, the company largely followed the greater market’s slide starting in July. By the end of July, short interest came to almost 34 million shares, just over 27% of the company’s outstanding shares, earning the dubious distinction of being the most shorted stock of the past decade in dollar terms. (Alibaba (BABA) likely owns the laurel on the global stage.) Tesla was in bear territory from its YTD June peak as the books closed on July. And then the bombshell: A cryptic Tweet of a plan to go private at $420/share, valuing the company at just short of $80 billion including debt - with funding already secured. Share soared 11% by Tuesday’s market close (red circle), on top of a $2 billion capital infusion from the Saudi Investment Fund that scrupulously fell just shy of the required disclosure threshold of 5%, as short sellers lost billions on the two announcements. Curiously, no 8K announcement was filed with the SEC, the usual way of disseminating material news to shareholders. Even more curiosity stems from the duration of time it took the NASDAQ exchange to halt trading in the stock. With so much money exchanging hands on either side of the trade, lawsuits appear more than likely. Meanwhile, the announcement places all the more pressure on Tesla’s board. Historically, company boards wield enormous responsibility to shareholders in takeover and buyout bids. It appears more than incumbent given recent events for the Tesla board to actually demonstrate their independence. The stock retreated by Friday’s close, erasing just over 6% of Tuesday’s gain (see Figure 4, above).
Whatever the reasoning behind the announcement, Tesla’s financial position reflects poorly on its ability to garner sufficient funding for new manufacturing facilities in either China or the EU. Taking the company private requiring tens of billions of dollars amounts to a giant media distraction in comparison - one that could have legal implications if stock manipulation charges are filed as a result. Tesla’s well-honed profile of burning through cash is hardly one close to the hearts and minds of most buyout companies. Further, the company’s current liability picture is not one that could likely absorb much in the way of additional debt. The $80 billion deal would be twice the current record holder, TXU Corporation, a Texas utility which was taken private in 2007 for about $32 billion. Reincarnated as Energy Future Holding Corporation, the company went bankrupt in 2014.
Tesla is more than likely to fall victim to similar market forces that continue to deflate the US EV market, burdened as they currently are in a sea of tariffs and countervailing tariffs with no proverbial light at the end of the long, dark tunnel. Financing issues could easily preclude Tesla’s build-out of Chinese and European manufacturing facilities for the foreseeable future. Other hurdles include countervailing sanctions on exports to the EU market if upcoming trade talks with the Trump administration fail. Meanwhile, China’s July reduction of duties on imported foreign cars to 15% saw record shipments of vehicles to the country from European and Japanese automakers, with high-end brands like Japan’s Lexus, the UK's Land Rover, and Germany’s Porsche, Daimler (DDAIF) and BMW (OTCPK:BMWYY) leading the charge. Unsurprisingly, up-market US brands - particularly those from Tesla - were conspicuous for their absence from the mix. US and foreign-based automakers exporting from US soil face an additional 25%, pushing total duties to 40% duty at the port of entry. For BMW and Daimler, the Chinese duty reduction had mixed results on the company’s respective sales numbers. Both German companies manufacture and export heavily from US soil.
Here in the US, the Trump EPA is bent on reducing the role of government in determining air quality and emission controls which will require a host of legal opinions at literally every level of the justice system - including Supreme Court - to rectify the situation. A final decision will be years in the making. In the interim, China, the largest car market in the world, will continue to own the global EV space.
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Disclosure: I am/we are long WMLLF, SQM. 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.