Fuel for Thought: As the industry goes electric, expect a shakeout among internal-combustion suppliers

Fuel for Thought: As the industry goes electric, expect a shakeout among internal-combustion suppliers

Time Stamp: May 1, 2023 1:49 AM
Source Node: 2623231

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The time for denial is over. There are still
suppliers of parts related to internal-combustion engines that are
steadfast in their belief that the looming (and eventual) shift
away from ICE toward any number of battery-electric propulsion
formats is just a passing fad.

In their view, scores of OEMs, suppliers, dealers, and
infrastructure partners have it completely wrong. That the billions
in investment earmarked in virtually every major global market to
build a new ecosystem is capital that is misallocated. That years
of industry strategic moves and government regulations to position
both nations and organizations for success in a battery-electric
vehicle future are in haste.

Or, conversely, these legacy players may recognize that change
is coming, but their corporate strategy is paralyzed by the surge
of electric vehicle introductions.

They will be the losers when the next history of the auto
industry is written.

While the pace and timing of this transition will be variable
(read: lumpy), working under the premise of, “When, not if,” should
be the rally cry among the supplier base. This existential threat
is already separating winners from losers – whether they know it or
not.

That’s not to say the shift will be immediate, or that there
won’t be strong revenue streams to be had during this
transformation. It will be protracted, and there are still
tremendous profits to be made in the internal combustion space over
the next couple of decades – especially in the aftermarket.

After all, there are 1.3 billion internal combustion cars on the
world’s roads today, according to S&P Global Mobility
estimates, and they aren’t going to just vanish. Nor will BEVs take
dominant share of the vehicles in operation for many years to come.
But the shift is happening.

There are thousands of moving parts in the internal-combustion
powertrain; battery electric vehicles have only a couple dozen. As
a result, there will be a brutal shakeout and consolidation among
engine, transmission, and driveline suppliers in addition to those
in the fuel and exhaust systems sectors. The victims will be those
who failed to plan ahead and listen to their customers.

As S&P Global Mobility sees it, those suppliers have four
strategic choices:

  • Divest from ICE, and shift to BEV components

  • Milk the cash cow dry, while shrinking to an eventual
    shutdown

  • Double down to become the dominant part supplier

  • Position to be acquired

We will delve into the strategic ramifications of those choices,
but first, a bit of history to set the gameboard to enable the
decision-making process to begin.

The ICE-to-BEV transition is but one recent
concern

The last handful of years have been unkind to light-vehicle
component suppliers. Impacted by numerous disruptions and resultant
erratic production volumes, the recent past has been more of a
daily dumpster fire for supplier executives.

These mounting issues date back to early 2019 when once surging
production volumes in China started to take a breather. According
to S&P Global Mobility’s light vehicle production research,
Mainland China’s annual volumes more than doubled to 26.6 million
units between 2009 and 2018. But in 2019, volume slipped greater
than 8% in one year and started an endless cascade of industry
hurdles. Meanwhile, in North America, a late-2019 labor spat
between General Motors and the UAW impacted scores of
suppliers.

Then COVID hit, shuttering output for almost two months and
crippling output for months to come. North American production
slipped more than 20% in 2020. In many respects, the light vehicle
production ecosystem has been reeling ever since, with few
opportunities to come up for air.

Macroeconomic impacts started with ongoing semiconductor
shortages for automotive-grade chips, followed by growing
geopolitical trade tensions spiked by Russia’s invasion of Ukraine,
and capped by mounting labor availability issues. Though abating in
amplitude of late, the industry will still feel these extraneous
pressures through the end of 2023.

But there were industry-specific issues as well. Suppliers were
sandwiched between OEMs and their capability to lever vehicle
prices/content upwards with end customers. Meanwhile, upstream
material suppliers gained new pricing leverage due to the strength
of demand as COVID abated. As an example, hot rolled steel is
expected to rise 14% from last fall to the end of next year. As a
result, tier 1 and 2 suppliers are caught in the middle.

Add to this other external cost pressures such as wages,
logistics, and energy prices – suppliers are longing for the days
of predictable output and cost stability. Adding to the equation
are rising interest rates, which increases the cost of debt service
among lending institutions with a renewed focus on debt
quality.

The supplier cost squeeze has limited strategic
options

Why the history lesson, the circumstances of which would hurt
the industry even if there weren’t a fundamental shift in its
propulsion method? Because it magnifies the situation.

Even if it were the best of the times, an industry experiencing
this sort of transformation from ICE to BEV propulsion would have
its fair share of participants throwing in the towel. Add the
aforementioned financial pressures and risk dynamics impacting the
industry since 2019, and you have a recipe for significant industry
turnover.

This frantic pace of change and its inherent risks for capital
in a rising interest rate environment, the skills/process
transition required, and the advantages gained by innovators and
first movers in this new environment is head spinning. Emerging
from this unfortunate timing combination of significant competitive
challenges will be an ecosystem which will not resemble the one in
which we entered this century. Despite the challenges, nimble
industry participants – be they OEMs, suppliers or dealers – will
leverage this tumult to their advantage.

Early evidence of a looming propulsion transition emerged even
before 2019. Both China and the European Union understood (albeit
for differing reasons) that legislating vehicle emission reductions
through the coming decade was going to upend the competitive
dynamics of their home market vehicle manufacturers and the
suppliers which served them.

As a result, OEMs will be required to devote a substantial share
of capital expenditures to battery-electric propulsion systems and
platform structures. They are understandably reducing their focus
and resources on traditional ICE systems due to limited payback and
slowly abating volumes/utilization.

Back in 2015, the number of new engine combinations
(family/program) launched for production in North America reached
13; in 2025, this will plummet to two, according to S&P Global
Mobility forecasting data. The result of this transformation is
predictable. Impacted suppliers in these ICE-focused systems are
being asked to extend programs past their expected life cycles,
slow efforts to integrate innovation, and search for efficiencies
to lower/control costs.

Some ICE powertrain suppliers may discover they are unable to
pivot to a BEV world. One option for entrapped medium-sized
suppliers may be to ride an ever-decreasing ICE revenue stream
until the business is unsustainable; Wall Street tends to look
unkindly on that business model. Another path is to become the
dominant supplier in a niche segment – be it for throttle bodies,
ignition coils, exhaust manifolds, or some such – and hope that the
aftermarket business is sufficient to keep the business afloat.

While traditional propulsion systems suppliers face these
challenges, an opportunity is emerging for others to build new
value chains and differentiate innovations and competitive
advantages as first movers.

The new world: Think global, source local, build
local

Though the number of new BEV platforms (all-new structures and
processes) has primarily been initiated in China and the European
Union through this decade so far, North America is catching up
quickly. Installation of new, highly flexible BEV platforms is
already underway in North America. According to S&P Global
Mobility, 84 BEV nameplates, built at 47 vehicle production lines,
are forecast by 2025 – and North American numbers may surge due to
benefits incurred under the Inflation Reduction Act (IRA). For many
of these offerings, development and component sourcing occurred
years ago.

The emerging BEV production ecosystem has few similarities to
that of today’s ICE-focused version. For decades the advantages of
a globally-rationalized industry were touted as optimal – the tide
is now turning.

For instance, the days of efficiently sourcing engines and
transmission from over an ocean has given way to propulsion systems
(battery cells and enclosures) produced regionally. We are entering
a BEV chain based on localism – usually within a couple hundred
miles of the final-assembly plant. While this new supply chain was
forming well ahead of the recently enacted IRA, financial
incentives will drive even greater value-add through the upstream
battery inputs (anode & cathode material) within North
America.

What’s more, geopolitical risks, potential trade frictions (such
as between the United States and China), sustainability and ESG
concerns, and growing logistics issues will drive tomorrow’s supply
chain even closer to home factories. Suppliers will need to adapt
to nearer supply networks, an even-greater concentration on
efficiency, and labor stability to build robust upstream
chains.

Irrational exuberance and overcompensation

There also is a danger in changing course too quickly. What
happens to suppliers that go all-in on an electrification push that
does not meet expectations?

After all, it’s an industry truism that, if you added up each
automaker’s calendar year sales projections, the US market would be
22 million vehicles. Of course, it has never come close to
that.

Mike Wall, executive director of automotive analysis, warns that
sort of overexuberance in sales projections seen with
internal-combustion vehicles could happen just as easily with
electric vehicles. And suppliers could end up holding the bag.

“Automakers are making some big production projections. One will
say, ‘We’re going to sell 1 million EVs.’ Then the next one says, ‘We’re going to sell 2 million.’ And suppliers are being told to
plan for this much capacity,” Wall said.

“If you are a supplier told to plan for a vehicle with
150,000-unit volume, what if it happens to come in at 50,000?
Besides altering the basic profit potential for the part, if you
amortize tooling and development costs into your piece costs, it
will take much longer to recover those costs, if it ever happens.
If you are a supplier, you won’t be selling at 100% capacity at job
one,” Wall added.

These are important considerations as suppliers venture into the
quoting process for any new business, particularly electrified
vehicles.

Additionally, going it alone may not be the optimal path.
Reacting to new opportunities through alliances and partnerships
will be key as the speed of vehicle development rises. A new
competitive dynamic will emerge as reliance on past advantages
gives way to a new definition of success or failure.

Those suppliers slow to transition to BEV technologies have
missed the initial surge. Remember that there are three timelines
in the industry:

  • Development (which occurs up to five years before start of
    production)

  • Tooling for production (two to three years before start of
    production); and

  • Service/aftermarket requirements once in service.

It’s a harsh assessment, but given the time-factors involved, a
supplier’s strategic perspective needed to be in play years ago. In
an industry built on relationships, the need to break into the BEV
supplier base will be frenetic. But BEV propulsion uses a fraction
of the parts required for internal combustion, and as a result,
more than a few suppliers will be left standing without a chair
when the music stops. The level of displacement and disruption will
be significant. Planning ahead is critical to survival.

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This article was published by S&P Global Mobility and not by S&P Global Ratings, which is a separately managed division of S&P Global.

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