Why is the automotive sector at a crossroads?

This week’s blog comes from Jon Slatkin, an EY Partner specialising in Rapid Transformation and Peter Matthews,Head of Advanced Manufacturing and Mobility.

The automotive sector is in the crosshairs of four of the biggest challenges facing businesses today. With such a potent mix of environmental, economic, trade and disruptive forces, it’s hard to say what the UK automotive sector will look like in ten or even five years’ time.

In this blog, we’ll look at how the automotive sector got to this crossroads and where we might see the greatest stress – focusing on the UK market, but with implications beyond.

The ‘death’ of diesel…and car ownership?

After the global financial crisis, the automotive industry continued to restructure and adjust to new economic realities. But new challenges just keep coming over the horizon – and one of the biggest challenges (and opportunity) is increasingly environmental legislation.

The industry is currently contending with a sharp decline in diesel’s popularity as a result of more stringent emission targets, consumers’ increasing environmental concerns and negative publicity following ‘dieselgate’. In addition, the whole automotive supply chain has been affected in recent months by supply-side disruption caused by the introduction of the “Worldwide harmonised Light Vehicles Test Procedure” (WLTP), required for any new car to be sold after 1 September 2018. A shortage of testing facilities has created a significant supply bottleneck and triggered multiple sector profit warnings ranging from parts suppliers, through OEMs to dealerships.

Diesel remains the focus of most concern and attention, but for governments to meet their clean-air targets, cars cannot be manufactured in their current numbers or in their current form for much longer. The UK looks set to phase out internal combustion engines by 2040 – or perhaps sooner? We’ve seen elsewhere how quickly consumers can change their behaviour once technology and economics combine to create accessible and attractive options.

UK car

Which leads us onto the greater existential threat to existing sales, ownership and driving models. By 2040, how many people will actually buy and then drive their car off a dealership forecourt? Car-sharing and ride-hailing is still at low levels and self-driving is still in its problematic infancy. But, ownership models are already effectively being disrupted through the growth of Personal Contract Purchase and future generations seem to put less store by ownership.

Brexit breakdown…consumer slowdown?

Meanwhile, another immediate threat to the sector comes from higher global trade barriers. The automotive sector has been highly vocal in opposition to increased protectionism for good reason. Automotive supply chains are amongst the leanest and most finely tuned in the world, with components often crossing borders multiple times in the course of production and a high proportion of finished products destined for overseas markets. As Moody’s noted earlier in 2018 with regard to a potential US-China trade war:

“A 25% tariff on imported vehicles and parts would be negative for most every auto sector group — carmakers, parts suppliers, dealers, retailers, and transportation companies. Only Chinese automakers would be unaffected.”

We cannot yet say what impact Brexit will have on UK-EU trade. But, given the extent of cross-border activity, it’s clear that automotive supply chains and just-in-time manufacturing processes would be impaired by any additional border friction – and perhaps irreparably damaged if the UK reverts to a World Trade Organisation rules model.

UK car stats

  • UK car exports remain at a historically high level, with 8 out of 10 cars currently exported.

 

  • BMW’s outgoing head of purchasing recently stated that: “A number of components cross the English Channel as many as four times before a vehicle is fully built and reaches dealers.”

 

 

  • Around 10% of UK automotive sector workers come from EU member states

 

  • The Society of Motor Manufacturers and Traders calculated that £1,500 could be added to the price of the average EU-built car if ‘no deal’ results in the imposition of 10% WTO tariffs.

UK car parts

ITEM Consumer Autumn1A hard Brexit poses risks to demand, as well as supply. Car registrations have risen across Europe in the last year, aside from Italy (down 2.8%) and the UK (down 7.5%). UK consumers have more pounds in their pockets going into 2019, but they seem more reluctant to spend – especially on high-value discretionary items. This could be due to exceptionally low levels of savings, falling house prices and an increasing chance of a post-Brexit rainy day.

EY ITEM Club now expect UK consumer spending overall to increase by just 1.4% in 2019, from 1.5% growth in 2018 – a far cry from 3.6% growth in 2016.

Keeping the show on the road

We said at the start of this blog that the automotive sector faces a crossroads. In fact it’s many crossroads, most with uncertain destinations. We can’t say what the outcome of Brexit negotiations will be in just under five months’ time. Let alone in five years’ time, if diesel will be ‘dead’ or even if many people will be ‘driving’ at all.

What we can do is highlight where we think Brexit and the ‘death of diesel’ in particular will cause short-term stress in the next 12-18 months.

Car dealerships: Most of the commentary around diesel and Brexit has focused on OEMs; but dealerships also face immediate and fundamental challenges. August’s peak in new-car sales suggests that UK dealers cleared a significant amount of stock pre-WLTP – but through what channels and at what cost to margin? Looking ahead, dealerships will find themselves at the sharp-end of the decline in popularity, and residual values of diesel vehicles could prove especially problematic if prices drop below the “balloon” payment levels at end of PCP credit arrangements. In the event of a hard Brexit, a tighter squeeze on consumer spending could coincide with a 10% increase in the cost of importing EU-manufactured cars. This could create a possible boon for those who already pay this tariff for cars imported from say Japan or Korea, but all dealerships will face a hard fight for the consumer pound – not least if OEMs increasingly target consumers direct. Dealers will need to address their sales models, including the number, size and location of their sites to match changing consumer behaviour.

OEMs: Sales should catch-up to some extent following WLTP supply disruption; but diesel is in long-term decline and beyond ‘clean’ options the future is in electric or alternative-fuel vehicles. More immediately, Brexit could fundamentally reshape car manufacturing in the UK. A number of UK manufacturers have put plans in place for short-term and longer-term closures in response to slower diesel sales and the potential impact of a ‘hard’ Brexit. These stresses come in addition to any further tariffs or barriers introduced elsewhere. OEMs also need to keep a close eye on the health of their supply chain, given their exposure to similar issues.

Component suppliers: UK-based suppliers could benefit from greater near-sourcing by UK-based OEMs post-Brexit – but only if UK car manufacturing remains tenable. If OEMs begin to feel the pinch from rising costs, they’ll also expect suppliers to shoulder some of the burden – with much of the negotiating power on the OEM side. A falling pound could boost exports – depending on the shape of future trade deals. Although, component manufactures are also exposed to increases in import costs and increased waiting times at the border – which will put increased pressure on working capital. Component manufacturers also need to adapt to the changing nature of cars, from the ‘death of diesel’ to the increase in digital components and self-driving elements.

If you’d like to speak to us about any of the issues raised in this article, please contact us.