From the June 2014 issue of Research Magazine • Subscribe!

The Hot Gadget in Your Driveway

A tech revolution is remaking auto industry prospects

The past decade has been tough on investors in U.S. car companies. It brought huge stock price volatility, bankruptcies and bailouts by Uncle Sam. A foreign automaker had to be brought in to save one of the Detroit Big Three. Having suffered such damage, it's understandable that investors remain apprehensive. But the future for the auto industry suddenly looks much brighter, as the high-tech revolution starts to shape the automobile of the future. U.S. companies are likely to be among the greatest beneficiaries of this trend.

The famous quote of Charles Erwin Wilson, the head of GM in the mid-1950s, who reportedly said “What's good for General Motors is good for America, and vice versa,” encapsulates the problems of the U.S. auto industry over the past few decades. Detroit was simply too big and too full of itself to think anyone could dent its dominance in car-making.

The industry famously missed the challenge from Japanese carmakers in the 1970s, and it slept through various other trends in the U.S. and abroad, such as the decline of industrial unions, falling production costs, new corporate management techniques, globalization, the rise of high-income buyers and the technological revolution.

Failure to Capitalize

Other U.S. multinationals were able to benefit from the opening of Eastern Europe and the rise of emerging economies, expanding their global footprint and dominating international markets. U.S. automakers were a notable exception. Even though GM and Ford had a jump on their competitors in international presence—they owned numerous top flight brands in Asia and Europe; and GM, was an early, successful entrant in the Chinese market—they weren't able to parlay their advantages into global domination. While a majority of companies on the Forbes list of the world's hundred most valuable brands are U.S.-based, Ford holds only the 44th place, behind two Japanese and three German brands. No GM or Chrysler nameplates are included.

Detroit was also remarkably slow to embrace Silicon Valley. To be sure, computers have long been part of motor vehicles. Electronic control units (ECUs) monitor and control engine and transmission functions; the average car has some 100 ECUs under its hood. However, even though the U.S. leads the world in innovation, its automotive companies have not been leaders in automotive innovation. Instead, they have tended to follow in the footsteps of Japanese and German producers.

The net result has been low profitability, depressed stock prices and bankruptcy—not just for companies but for the city of Detroit. The highly profitable top tier of the automotive market has been virtually monopolized by the Germans, with a smattering of British and Japanese brands; the green segment has been left to the Japanese and French, and U.S. manufacturers compete mainly in the crowded and unprofitable middle-of-the-road and economy segments.

Yet all this appears to be changing. In 2009, near-death experiences in the global automotive industry pushed car companies to change their ways. While the crisis was wasted by governments, which continued to borrow and expand public debt, automakers used it as impetus for introducing greater managerial expertise and innovation.

Earlier this year, a Boston Consulting Group report on innovation in the auto industry found that patent applications by original equipment manufacturers and their suppliers rocketed over the previous four years, while spending R&D expanded by an average of 8% annually over the past four years. The group saw the pace of innovation quickening and predicted that the auto industry is at a threshold of a technological revolution.

Tech Show

This year's Consumer Electronics Show in Las Vegas featured something really new. Even as traditional auto shows in Detroit, Frankfurt and elsewhere lose their luster, the International CES effectively turned into an auto show of its own. Carmakers and their suppliers showcasing new automotive technologies outshone other innovative companies with their gadgets.

Google unveiled its Open Automotive Alliance to enhance connectivity between the car and mobile phones using its Android operating system. Car dashboards, which already look very different from a decade ago, are about to become unrecognizable. Google and other tech giants are also working on self-driving vehicles, another major step into the automotive future.

Also in Vegas, Toyota announced plans to launch a hydrogen-powered vehicle in 2015. That project builds on an Energy Department public-private partnership to speed up the spread of hydrogen cell vehicles in Georgia, Kansas, Pennsylvania and Tennessee, unveiled in 2013.

Cars are getting away from gasoline, and those that are still using gas and diesel have become far more economical and cleaner. Cheap U.S. gas has always been a disincentive for Detroit carmakers to invest in energy-saving technology, a factor that eventually put their engineering behind European and Japanese rivals.

Then came the Obama Administration's tightening of mileage standards in August 2012, which required all companies to achieve a 54.5 miles per gallon fuel efficiency average across their entire fleet. This is already accelerating the drive for innovation in petrol-electric hybrid and fully electric technology. In a similar way, the powertrain revolution was driven by tighter EU regulations of emissions.

All this is making driving more efficient, cleaner and safer, while also personalizing the car to a degree that has never before been possible. In fact, the car could become something of a private office, where there are no drivers and where passengers can access the Internet, work, watch movies or television, etc.

These trends carry two major positive implications for car companies. First, the pace of innovation will quicken to match that previously seen in personal computers and cell phones. New technological enhancements will be coming fast and thick, at least for a while. Since the car is a more complex machine than a PC or a smartphone, it will be some time before engineers run out of areas in which to innovate.

Second, automakers will solve the most important challenge looming over the medium term: how to appeal to millennials—those between the ages of 18 and 34—whose car ownership rates and professed desire to own a car are significantly lower than in previous generations of Americans. Since innovation has also made cars more durable—the average rate of cars on U.S. roads hit a record of 11.4 years in 2013—accelerated innovation in energy efficiency, safety and new gadgets is probably the only way to spur new sales.

Cheap Stocks

Shares of Ford and GM had a strong 2013, but have declined since the fourth quarter. Despite paying dividends in the 3% range, they are still quite cheap, trading at P/E ratios of around 10. Fiat, which is now a full owner of Chrysler and is shifting its primary listing from Milan to New York, has a similar P/E ratio—which is also in line with other automakers around the world, even highly profitable ones such as BMW.

However, some automotive companies have already started to reward their shareholders at a spectacular rate. And not just speculative plays such as Tesla, which more than doubled in the past year but has been highly volatile, with short sellers duking it out with true believers.

A more solid example is Magna International, a Canadian component manufacturer. Its shares nearly doubled over the past year and quadrupled since the start of 2012. The company is highly innovative, investing in electric and hybrid technology and becoming a leader in lightweight, durable carbon fiber composite interior and exterior components.

For most automotive companies, near-term sales figures and fluctuations in consumer sentiment still play a defining role in stock performance. But a technological revolution has begun, and investors attuned to it now will benefit greatly over the long run.

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