Invariably, when I am mingling at the cocktail hour of an investment conference, I am asked my background (11 years as a sell-side autos analyst, in NYC and London) and my current job (managing portfolios for individuals). The next question is always: "Do you own auto stocks?"
The answer is no.
The developments at Volkswagen (VLKAY) over the last week were are all the proof one would need that this sector is a very difficult one in which to be a "long-term long."
Automaking for the mass market is just a brutal business. It really is.
There is no other industry that combines heavy industry -- making a car is an incredibly complex process - -and consumer marketing. Action Alerts PLUS holding Apple (AAPL) can sell 65 million iPhones in a quarter and it doesn't manufacture a single one. Trifecta Stocks position Boeing (BA) can win a $38 billion order from China for 300 planes without having to win over a single consumer. VW has to balance both. Every day.
It was a separate, but increasingly important challenge that tripped up VW: regulation. Governments around the world have targeted carmakers and the emissions from the vehicles they produce. The reductions targeted are absolutely draconian.
The European Union's Euro 6 regulations, which took effect this month, call for diesel cars to emit no more than 0.08g/km of oxides of nitrogen (NOx). The Euro 5 regulations, which took effect in January 2011, allowed for NOx emissions of up to 0.18g/km.
That's a 56% decrease in NOx emissions limits in under five years! Has any another industry had to reduce emissions that much, that quickly? Of course not.
Worse, here in the U.S., the EPA has "outsourced" its emission control legislation-writing to California. California Air Resources Board standards do not (unlike the EU) discriminate between gas and diesel engines for targeted emissions levels. That is a huge issue.
Diesel engines -- due mainly to the higher carbon content of diesel vs. gas -- have the virtuous property of higher energy efficiency than comparable gas engines. So, any diesel engine will produce fewer carbon emissions per mile driven than a comparable gas engine. A green win, for sure. The drawback for diesel is that because of a naturally "leaner" mix (more air, less fuel) a diesel engine will produce particulates and NOx in quantities that a gas engine doesn't.
So, a diesel maker wins on carbon, but loses on NOx. European regulators recognize that difference; California's regulators, perhaps scared by that smog that enveloped cities like Los Angeles 30 years ago, do not.
California -- and by the extension the rest of the U.S. -- has much lower standards for fleet-average NOx emissions (about 0.031g/km) than Western Europe does for diesel-only fleets (0.08g/km.). So, to meet the fleet-average standards propagated by California (Tier 2 Bin 5, to be exact) an automaker that has diesel as a significant part of its product offerings is disadvantaged.
In the short-term, that company could either:
1) Take extraordinarily costly measures to reduce NOx emissions;
2) Fool emissions tests for long enough until cleaner replacement engines are available
VW was already in the process of replacing the offending 2009-vintage EA189 diesel platform with the lower-emission EA288 in 2015. Also, VW's higher-end diesels include the AdBlue system, a Rube Goldberg-esque contraption also used by Mercedes and BMW that shoots a mixture of urea and water (no jokes, please, I have heard them all already this week) into the fuel line to help catalyze the NOx molecules.
So, in the intermediate term, VW has a workable plan for reducing emissions. In the short term, however, VW management had the choice between meeting an overbearing technological standard and generating a long-term return for their shareholders.
It's obvious which method VW management chose and the consequences are massive.
CEO Martin Winterkorn is gone, reportedly to be replaced by Porsche chief Matthias Mueller, and Reuters has basically been publishing a running count of executives who will be fired during Friday's meeting of VW's Supervisory Board (Aufsichtsrat). It will be a bloodbath.
So, there will be massive changes in Wolfsburg. But the challenges to the rest of the industry will be just as pronounced. The incredibly negative PR from "Dieselgate" will force all the world's automakers to spend even more on regulatory compliance.
It will complicate the already difficult task of generating shareholder returns from making mass market cars, and I just don't have room in my clients' portfolios for an industry that is facing even more profit pressures.
Therefore, my standard response to the cocktail hour question of "Do you own auto stocks?" will remain "No. Let's grab a Heineken!"