As car manufacturers, retailers and suppliers, along with insurers and finance providers, grapple with a revolution in the sector, investors may struggle to call the winners. Alex Janiaud reports.

The first stationary gasoline engine roared into life on New Year's Eve in 1879. But the one­ cylinder two-stroke unit, developed by Karl Benz, did not make it into the first motor car.

Completed in 1885, the three-wheeled Benz Patent Motor Car, model number one, ran with a single­ cylinder four-stroke engine, installed horizontally at the rear with an output of 0.75 horsepower.

Today, you can buy pool pumps and sink waste disposal units with a greater driving force. But these early engines propelled humankind into a new era. Petrol and diesel engines in motor cars have shaped cities and economies, and changed human behaviour. Motion, since the late 19th century, has been slowly rolled out in increasingly safe and affordable pack­ ages, to humans otherwise used to the limitations of walking and horseback. Motion has liberated us. We learned to drive the car, and we gained autonomy.

And now we're trying to hand autonomy back. Autonomous cars may make automotive travel safer, easier and more environmentally-friendly. They threaten social upheaval, too, as part of a grander rowback from asset ownership.

Futurists lust for driverless electric vehicles, ferrying commuters, travellers and inebriated revel­ lers. From 2022, new cars in 40 countries, including the UK, will have to have autonomous components. Suppliers are responding accordingly, and are engi­ neering specific technologies for self-driving cars. There are also questions surrounding the ethics that govern autonomous vehicles. These will affect areas more familiar to drivers, such as insurance. But pro­ ponents of self-driving cars urge patience. We may be decades away.

Electricity, the other prime mover, has fuelled cars for years now. Toyota's (Ja:7203) Prius, the ubiquitous hybrid electric vehicle (HEV), was launched in 1997, and more than 10m have been sold. It is arguably the most important car of the past 20 years. It, too, will soon be obsolete, as fully electric vehicles (EVs) gain a foothold in the market. From 2040, new petrol and diesel cars will be banned in the UK. This has hastened innovation, not just within car companies, but down the supply chain. The government is being urged by some of its advisers to bring its target forward, to 2035, or even 2030. Again, some caution that this may be premature.

And as the car changed consumer habits beyond the automotive sector, consumers too have changed the way they consume their cars. The internet has disrupted car retail; car finance has evolved from cash, into a litany of arrangements between retailer and consumer.

The car, that great disruptor since the 19th century, is being disrupted at a greater pace than ever before. But for investors, positioning is less straightforward. Do gilded opportunities await? Would the smart money adopt Warren Buffett's "short horses" idea for a new century? Or is it simply too early to call the likely winners or losers?

An anaemic car market The UK car market is weak. UK car production has fallen for 10 consecutive months, accord­ ing to data from the Society of Motoring Manufacturers and Traders (SMMT).

Anaemic demand in key Asian and European markets continues to be a significant drag. But Brexit poses a poten­tially existential threat for the UK car industry. The SMMT fore­ casts a dire impact on production should the UK leave the European Union without a withdrawal agreement and fall back onto World Trade Organisation (WTO) rules. Under this scenario, output is predicted to fall around 30 per cent on recent levels to just 1.07m units by 2021, a level consistent with the mid-1980s.

"Just a few years ago, industry was on track to produce 2m cars by 2020 - a target now impossible with the UK's reputation as [a] stable and attractive business environment undermined," said SMMT chief executive Mike Hawes, in his commentary of the fore­ casts. At least one car manufacturer is already working in a self-imposed Brexit world. Owing to the 12-week lead time required to manufacture its cars, Aston Martin (AML), the sole UK-listed car manufacturer, began operating under WTO conditions in the lead-up to Britain's intended Brexit date, 29 March 2019.

Some suppliers, too, are feeling this heat. In its latest annual report, automotive engineer Ricardo (RCDO) recognises that Brexit disruption could lead to "delays in the placement of new orders or insourcing of activity, the redirection, deferral or curtailment of existing contracts, slippage in payments or variations in demand for resources, and availability of research and development funding". Others are less worried. Engineering group Senior (SNR), which makes vehi- cle components in its 'Flexonics' division, thinks that the impact will be "limited and not significant given the group's global positioning". It observes, however, that stringent global carbon emis­sions targets will influence demand for land vehicles, which represent 16 per cent of the division's market.

Searching for clean air

But Brexit is not to blame for the weak­ ness we have already seen in the car market. Much of the disruption in the car market has taken place in response to pressures over the car's impact on the environment. The scrutiny on emissions has ampli­ fied following theVolkswagen (Ger:VOW3) emis­ sions scandal four years ago, when it was discovered that the German automotive giant had sold um cars equipped with software to obfuscate pollution levels. In 2017, VW pleaded guilty in the US to programming diesel cars to activate emission controls only during testing, which meant the vehicles met US standards

during testing, but actually produced up to 40 times the allowed level of nitrogen oxide in the real world. The crisis has cost VW more than €3obn (£26.28bn).

But the cost of what the group did has rippled across car manufacturers, down their supply chains, and into the dealerships. Partly as a result of the scandal, the European Union introduced the more stringent Worldwide Harmonised Light Vehicle Test Procedure (WLTP) in September 2017, to better assess pollutants, emissions and fuel economy across differ­ ent drive speeds. The test caused delays in produc­ tion for the VW group, according to its 2018 annual report, with Volkswagen's passenger cars and Audi particularly negatively affected. "By increasing test capacities and reducing the range of variants, we intend to pass through the next level of the WLTP more smoothly," the report was forced to promise. Daimler, meanwhile, cited the certification process associated with WLTP as a reason for decreased unit sales, which in turn had a negative effect on its share price, it claims.

Car retailers Lookers (LOOK), Marshall Motor

Holdings (MMH) and Vertu Motors (VTU) have all pointed to WLTP as a drag on sales. In its 2018 results, Lookers said that the new car market "was affected by a continuation of the anti-diesel theme and a shortage of supply of new vehicles" in the final quarter, as the cars had to be tested against WLTP. "We had antici­ pated that these supply issues would have cleared during the last three months of the year, but unfortu­ nately they remained an issue for the rest of the year," the retailer told the market in March.

Andy Goss, a non-executive director at Vertu, told us that heightened regulatory pressure has pushed car manu facturers on to electric vehicles. Every car manufacturer has a glide-path towards its own emis­ sions targets, he observes, which were put in place before the world started to shift from diesel vehicles towards petrol cars.

"We know that the CO2 on petrol cars is higher than diesel vehicles," says Mr Goss, "and that has brought with it an incremental challenge to achieve a higher percentage of sales of battery electric vehicles and plug-in hybrids" - all in order to achieve compli­ ance. "WLTP has created a degree of transparency on the real CO2 figures, so that has added further flavour to the task," he adds.

Hybrid vs electric

The electrification of the car is therefore key to its future. It has been under way for some time in the modern conscience, most publicly through the afore­ mentioned proliferation of the Toyota Prius. A 2009 Boston Consulting Group study predicted that in the year 2020 we'd see 11m hybrid vehicles sold, compared with 7.8m diesel cars and 1.5m electric vehicles (there were, in fact, 2.1m fully-electric cars sold in 2018).

It seems as though every car manufacturer is embracing electrification. From 2019, every new car made by Volvo (Swe:VOLV-B) will come fitted with an electric motor and by 2025 the company aims for half of all its new cars sold globally to be fully electric. The Swedish group appears comfortable with electrifica­ tion as a major disruptive trend within the industry.

This trend offers ample opportunity down the supply chain. A spokesperson for TI Fluid Systems (TIFS) - a manufacturer of automotive fluid storage, carrying and delivery systems - says that the shift towards hybrid­ electric (HEV) and fully electric vehicles (EVs) "provides significant content expansion opportunities". Many of Tl's fluid carrying systems division's thermal manage­ ment products are used in HEVs and EVs, including battery cell thermal lines, vehicle chassis thermal lines and power electronics thermal lines.

The rise of restrictions within cities on combustion engines is also pushing car manufacturers towards an electrified future, according to Dave Shemmans, chief executive officer at Ricardo. Transport for London operates an ultra-low emissions zone in the centre of the city, for example. But he spots a circular problem in the transition towards EVs.

"You've got this dynamic going on whereby the cash generation for the car indus­ try is very much combustion engines today, and that is most of the market," he says. "But they need to be making profits on those to be able to fund the development on hybrids and electrics, to be able to move to an electrified future."

With the car market as stagnant as it currently is, the requisite level of investment may not be forthcoming. "If the volumes are down on their traditional [vehicles], they're not making the money, and therefore it's difficult to invest in the future," Mr Shemmans observes. Electrification nevertheless is offering Ricardo the opportunity to pioneer a pres­ ence in EV powertrains and battery systems. Last October, the company announced it had entered into a partnership with Volvo to assess the performance of battery cells.

Others recognise the limitations of EVs. The infrastructure network required to support a com­ prehensive adoption of the vehicles in the UK is so far lacking, while the technology itself is in need of further development. In November, Johnson Matthey (JMAT) chief executive Anna Manz told Investors Chronicle that "if you look at what a con­ sumer wants and needs... battery electric doesn't yet provide all of that".

The company is covering its bases. Johnson Matthey's Clean Air division, one of the world's three leading suppliers of catalytic converters used in HEVs, continues to perform well. Until the world does make a successful jump into EVs, improving engine manage­ ment systems that alternate hybrid cars between pure electric and more traditional fuel usage will offer the group two significant opportunities. It can continue to sell its catalytic converters, but Johnson Matthey also expects to start producing its eLNO battery material in 2021-22, which it can also sell into the hybrid market.

How the automotive retailers are faring

The whole of the UK retail skewed slightly, as demand There are also question- sector has been struggling bounced in April 2018 follow- marks hanging over car

lately, but the automotive re- ing snow in March. finance. The Financial Conduct tailers have had a particularly Mr Forrester added that Authority recently concluded unenviable time. Alongside market disruption could end its review of the motor finance the Brexit uncertainty one up being beneficial for the mar- sector, finding the commis• might expect, a plethora of ket's larger players, creating sion models used, which challenges threaten the sector. opportunities for consolidation. allowed brokers to set cus- However, executives insist that What's more, as registra- tomer interest rates to earn opportunities remain. tions have declined, take-up a higher commission, were

The numbers are not of alternative fuel vehicles not "controlled adequately encouraging. The latest data such as electric cars has been by lenders", leading to

from the SMMT showed new rising. More equipment - and customers being overcharged. car registrations were down therefore capital expenditure It is currently assessing its

4.1 per cent in April, and 2.7 - is required to sell and service options for intervening in the per cent in the year to date. more technologically advanced market to address the harm, However, Vertu Motors' chief vehicles, further compounding and the ultimate impact on executive, Robert Forrester, the advantage of better funded, companies in the sector is not said these numbers were bigger companies. yet known.

Enjoy the ride

Electric vehicles are already with us, and it is almost certain that they will eventually eradicate petrol and diesel cars. Much less certain, and arguably more revolutionary, is the prospect of driverless cars.

Again, regulation is pushing car companies and their suppliers towards the disruptor. Draft regulation laid by the United Nations Economic Commission for Europe (UNECE) and signed by 40 countries, led by Japan and the EU, mandates for the installation of assisted emergency braking and other advanced driver assistance systems (ADAS) in all new cars from 2022 onwards.

Car manufacturers aren't the only ones pioneer­ ing the technologies. The likes of Tesla (US:TSLA), Alphabet (US:GOOGL) and Uber are also racing to produce autonomous vehicle technology.

This inevitably creates opportunity in the supply chain. AB Dynamics (ABD), which supplies testing systems to the automotive world, has pioneered a sim­ ulator for driverless vehicles, and recently delivered its second order to Kempten University in Germany, following a first delivery to a customer in China.

This technology may prove vital in ensuring that a concept designed to make roads safer doesn't make our streets more dangerous in the process. In 2018, a self-driving Uber killed a pedestrian in Arizona in what was the first fatality associated with autono­ mous vehicles. The chief executive of Volvo Cars, itself a pioneer, Hakan Samuelsson, has warned against an "irresponsible" premature roll-out of self-driving cars. And, owing to the complexity of driverless tech­ nologies, their ascent into public life may not be as close as some excited journalists might say. Dr James Routh, AB Dynamics chief executive officer, envisages that their introduction is "probably 15-20 years away", owing to the complexities of the technologies.

Autonomous cars and consumers

The impact of these cars upon daily life, particu­ larly in cities, has the potential to increase mobility. They could also slow us down. Speaking at a recent Association of British Insurers (AB!) event on autono­ mous vehicles, Michael Hurwitz, director of transport innovation at Transport for London, hopes that self-driving cars can help solve the city's objectives over mobility and the operation of its transport net­ work, and cautioned against the technologies acting against these goals.

"We would love autonomous solutions if [they] can allow people who are less able, to remain active," he said. "We like it if it can allow a more efficient running of the network... we like it less if autonomous vehi­ cles, for example, take 60 people out of a well-stacked double-decker bus and spread them into sixty pods, all across the network," he added.

Then there are second-order issues surrounding consumer behaviour and ethics. A utilitarian thought experiment, known as "the trolley problem", asks whether an autonomous vehicle should voluntarily veer away from three bystanders and into one pedes­ trian, given the choice, in order to minimise loss of life. Although perhaps the obvious solution would be for the car to stop altogether.

More serious, and applicable, is the question of car insurance, a surprisingly tricky area for regulation. This is partly because the UK asks drivers to be insured, while in other countries vehicles are insured instead. The Automated and Electric Vehicles Act, passed through UK Parliament in July 2018, was intended to bring automated vehicle insurance in line with historic motor insurance practice, and ensure that motorists are covered both when in control of a car themselves, and when they have handed control to the vehicle. When the legislation passed, Jesse Norman, roads minister, said that "this act will ensure that the UK's infrastructure and insurance system is ready for the biggest transport revolution in a century".

Laurenz Gerger, a policy adviser at the ABI, says that while it is difficult to make predictions, existing insur­ ance cover is likely to be sufficient for now, but it will have to evolve. "If you were to own a vehicle that drives itself autonomously with goods or passengers in it you would have to cover those losses as well," he says.

Under the new legisla­ tion, should an accident occur involving an automated vehicle, the insurer will have primary liability and pay that claim. The insurer then has the right to make the recovery against the vehicle manufacturer.

"However to do that, you need to establish as the insurer whether the car was in self­ driving mode, or whether it was driven by the human driver," Mr Gerger says. "And to do that, there will need to be a set of data points that has to be shared by the vehicle manufacturers with third parties, including insurers, so we can adequately investigate those claims and defend ultimately our policyholders' interests," he adds. David Stevens, chief executive officer at Admiral (ADM), recognises that "insurance needs are moving more towards cyber risk, product liability and liability analysis". Admiral is supporting tests on autonomous vehicles, insuring vehicles that are being tested for self-driving by Cambridge-based Wayve Technologies, and is also supporting a project conducted by Parkopedia, which is pioneering autonomous parking. While convinced that self-driving cars will even­ tually arrive, Mr Stevens believes that there are "still many barriers to widespread adoption", and that some early predictions on the speed of adoption of autonomous cars "have already proved wide of the mark". "Autonomous cars will only happen if they crash very rarely, if at all," he adds.

Axa (Fra:AXA), meanwhile, has assisted the UK government in drawing up legislation for autonomous vehicles. Daniel O'Byrne, head of external communi­ cations for the insurer, says that the laws have been designed to preserve the status quo for consumers, in a bid to retain consumer trust. "I think there was this sense that automated vehicles could fundamentally dis­ rupt motor insurance in the UK and change the market in a way that perhaps we hadn't imagined. And the truth is, that's a really good thing," he says.

"We are looking at the potential of saving thou­ sands of lives with the increased use of this technol­ ogy," he adds. "And that's just got to be a good thing."

Disruption from purchasing choices too

In the world of car finance, personal contract plans (PCP) have surged in popularity. The attraction of PCP for drivers is that it allows them to afford a more expensive model, with lower monthly payments than using traditional hire purchase or unsecured personal loans.

That is because motorists only fund a deposit and the difference between the cur­ rent value of the car and the expected value of the end of the contract. If the trade-in value of the car is above the minimum guaranteed by the dealer, the buyer can use that capital to reduce their next deposit or trade in for a more expensive model.

In turn, that has boosted the churn rate of sales for manufacturers, although the continuation of that circle depends on used car prices continuing to rise. However, there are signs of a slowdown - used car values declined by 2.3 per cent in April, according to Cap HPI, the largest drop in valuations since December 2015. Meanwhile, used car transaction volumes fell 0.6 per cent during the first quar­ter, according to the Society of Motor Manufacturers.

Rising competition for volume growth and "the ongoing blurring of a retail or business car" has started to spur growing popularity of personal contract hire, accord­ ing to Steve Oliver, director at Oliver & Twist Consultancy. Under personal contract hire agreements, manufacturers provide volume discounts to leasing companies to enable competitive monthly rates. "Manufacturers want to cover all aspects of the market," he says. "Despite focuses on production levels and efficiencies, they are also very competitive with each other." What's more, company car tax as a benefit-in-kind continues to rise and for many employ­ ees a cash alternative may be better, he says. Opting out of the company car scheme may also provide greater choice to employees, as the car scheme might only be offering up to three brands.

Aston Martin: iconic but not immune

Despite its relatively unique position­ ing in motoring, Aston Martin isn't im­ mune to the change sweeping through the car indus try. Indeed, the iconic luxury car manufacturer is undergoing its own revolution. It recently unveiled the Aston Martin Rapide E, its first

all-electric model, which "has been designed to enhance and build on the feel, character and delivery of the V12-engine Rapide AMR" model, the company says. It aims to sell 14,000 cars in the medium term, once it has refreshed its range and its battery­ powered Lagonda cars are on sale. Its shares have halved in value since list­ ing in October 2018 at £17 a pop. Its targets look ambitious, and we have questions over its transparency on key metrics, such as the way it capitalises almost all of its research and develop­ ment spend. Aston may be the only listed car manufacturer in the UK, but we think Ferrari (US:RACE) is a better bet for investors seeking exposure to luxury cars. Sell.