Is the automotive sector prepared for a UK demand shock?

The scale and importance of the UK Automotive market both at home and on the continent has become a staple topic in the Brexit debate. However, is this a distraction from the very real fragility of the UK market – independent of Brexit?

As recently highlighted by the EY ITEM Club, the UK economic outlook arguably creates the perfect storm for a UK automotive demand shock, impacting an industry already finding itself in the middle of unprecedented transformation.

The UK automotive market is indeed a major consideration for the UK and our European trading partners. UK production was 1.7 million vehicles in 2016, with the vast majority (78%) going to export [1]. This production and the broader value chain currently supports 814,000 UK jobs [2]. 

The UK is also the second largest car market in Europe after Germany, hitting a 17 year high last year with 2.7 million new car registrations, generating £71.6 Bn in revenue, with around 2.3 million of those cars being imported [3].

However, the critical discussion which should be exercising the minds of automotive leaders and politicians is the health of this market, and the resilience of the players, independent of Brexit.

The automotive sector is a cyclical, thin margin, volume-driven business. Annual R&D and product investment is measured in billions, and has historically been fuelled by free-cash-flow generated across three main income streams - vehicle sales, captive vehicle financing and parts sales.

In recent years the world has been changing and the industry faces an unprecedented tidal wave of investment requirements. A proliferation of infotainment and safety technology requirements have significantly driven up both unit cost and investment. 

Connectivity and the associated consumer services have become a battleground requiring investment in both technology and new capabilities. 

Sector boundaries have been blurring. Technology giants (including Google, Apple & Baidu), disruptors (such as Uber, Lyft & Didi) and a myriad of start-ups are all encroaching. New mobility business models are undermining traditional vehicle ownership, and Connected & Autonomous Vehicles (CAV) will enable a new transport paradigm. As a result, there is increasingly heavy investment in technology and talent through M&A and partnerships in order to compete with firms who move at a different pace.

The diesel emissions scandal has also uprooted European compliance plans across the industry, potentially with the exception of Toyota and Tesla. The political and social agenda has moved sharply away from CO2 performance towards local air quality, which has finally created vote winning environmental policy options. The 95 g/km fleet CO2 performance target still looms large in 2021 [4], but for many delivery was reliant on a heavy diesel mix. Electrification investment needs to be both scaled and pulled ahead right across the supply chain.

In short, determining where and how to strategically invest across this broadening set of requirements to both protect near term cash flow and future positioning, has never been so complex.

Given ability to invest is based on the health of the market today, it is worth considering how the UK market has reached this 17 year high, what has driven demand and what are the risks associated with the broader UK economic outlook?

In 2016, over 80% [5] of new retail car purchases were financed, with a significant portion being via Personal Contract Plan (PCP), which enables consumers to only finance the depreciation of their car. The mainstream emergence of PCP since the financial crash has gathered momentum with a fivefold increase in the last five years [6]. This coupled with historically low interest rates, has made new car ownership more widely affordable in spite of stagnant UK household incomes [7].

Increasing finance penetration has allowed automakers to get closer to their customers, and PCPs have enabled them to shorten replacement cycles and pull ahead demand. Strong residual values have enabled customers to hold equity in their vehicles over the outstanding balloon payment due, and automakers are often able to offer customers key-for-key upgrades into new vehicles with minimal or no deposit before the end of the original term.

Current market demand is therefore arguably built on a foundation of a new automotive finance paradigm which the Bank of England has raised concerns over, but which may be more fragile than many realise. This PCP virtuous demand cycle can only be sustained if the residual values do not fall.

Residual values meantime are also under pressure. The shortening of first owner replacement cycles, and an increase in PCP handbacks (customers can exit their contract without penalty and hand the car back after 50% of payments have been made), means the supply of younger, high quality used cars entering the market is rising. Diesel residual values have already been falling since 2013 [8]; given many brands are at around 60% mix this has the potential to drive a broader residual value correction which could both unwind the virtuous cycle, and create significant write downs for car makers' captive finance arms which are so critical to their free cash flow generation.

We are already starting to see early signs of a slowing demand, with the overall market falling for the first time in 6 years in 2017. Sales have fallen by 9.3%, with diesel cars being hit the hardest seeing a reduction of 21.7% year on year [9]. 

Couple this picture of softening residual values and market oversupply with an economic outlook of continued wage stagnation, shaky consumer confidence, significant household debt exposure (mortgages and credit cards as well as automotive) and increasingly likely interest rate rises, there is a real risk of a significant UK automotive demand shock and market correction lasting several years with significant cash flow implications for the industry.

Which in turn raises the question: How do automotive players with heavy UK exposure ensure they have the resilience to withstand a UK demand shock and continue to fund unprecedented investment level in the future of their business?

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@jnicholson_ey   

*[data source reference]