Shifting gears

By Gary A. Silberg, KPMG

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Published May 12, 2009 at 4:15 PM

EXECUTIVE SUMMARY

The auto industry is experiencing unprecedented turmoil.
KPMG offers a market outlook for technologies, segments that may be the most active in the coming decade.
Among them, biofeuls, cleaner diesel and electric power.

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The global automotive industry is experiencing unprecedented turmoil.

Oil prices peaked in 2008 at $145 per barrel and then hit a three-year low. The credit crunch challenged consumers and vehicle manufacturers, pushing North American vehicle sales down by one-third or more in the fourth quarter of 2008 with a similar decline in the first quarter of 2009. Meanwhile, Congress and the European Union continue to urge building more fuel-efficient and environmentally friendly "green" vehicles. The cumulative effect is an industry undergoing major restructuring in the short term amid a mounting liquidity crisis, while winners quickly adapt and balance economic issues with cutting-edge technologies in the long term.

Vehicle manufacturers have invested in alternative fuel technology for more than a decade, while automotive suppliers have made tremendous strides in parts that improve fuel efficiency. Fuel-efficiency regulations and shifts in consumer demand appear to be leading larger and better-financed suppliers to seek further opportunities as well as paving the way for new entrants. Both financial firms and strategic investors are becoming active as they seek new technologies to meet consumer and regulatory demand.

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KPMG LLP analyzed several alternative fuels to provide an assessment of which technologies and segments could become the most active in the coming decade.

While gasoline will most likely continue to be the fuel of choice in the foreseeable future, three alternatives for powering automobiles -- electric, diesel, and biofuels -- appear to be viable near-term options. Their appeal comes from their potential ability to lessen U.S. dependence on foreign oil and reduce harmful effects on the environment. Kevin Cramton, managing director of the investment firm RHJ International SA and former director of corporate business development at Ford Motor Co., said consistent, long-term energy policies supporting alternative vehicle powertrains and fuels will be necessary to attract private equity firms and companies interested in investing in these technologies and could create opportunities throughout the value chain.

Here is the market outlook for the alternative fuels analyzed in the study:

Electric power. Consumer concern for the environment, increased fuel economy standards and oil price volatility have led car manufacturers to consider HEV (hybrid electric vehicle), PHEV (plug-in hybrid electric vehicle) or full EV (electric vehicle) models. According to J.D. Power and Associates, the market for HEVs in the U.S. is forecast to grow from 2% to 8% in 2011, with 47 hybrid models available in the North American market in the next three years. PHEVs and EVs are the next step in this evolution. Both financial and strategic firms have closed deals or made venture capital investments in the batteries that power electric cars. Venture investment in car batteries rose to $434 million in 2007 from about $100 million in 2006. Sovereign wealth funds and other financial investors have taken positions in startup electric car companies in the U.S., including new Silicon Valley startups, such as Tesla Motors Inc. and Fisker Automotive, with more to come. Although significant challenges remain, consolidation in this segment is likely, as the auto industry moves to a select number of standardized battery solutions. Interest in an Internet-based smart energy grid that assists in monitoring the power charge of an EV could also provide attractive investment opportunities as the administration's economic stimulus package provides additional financial capital for deployment of a smart grid. Consolidation of smart grid companies appears to be under way as some of the larger, well-funded companies buy technologies of smaller players.

Cleaner diesel. Diesel engines have become both more efficient and less damaging to the environment in the past two decades. Although only 3% of light-duty vehicles in the U.S. run on diesel, some momentum appears to be building for the fuel, with U.S. market penetration expected to increase to 14% by 2017, according to J.D. Power. Several European manufacturers plan to introduce diesel-powered luxury sedans, heavy-duty pick-ups and SUVs to the U.S. consumer in the next five years.

To date, most of the investment in diesel technology has come from strategic buyers trying to consolidate market positions or increase capacity ahead of expected demand. As emerging diesel technologies require changes in engines and their electronic components, new entrants with experience in sensors and controls are likely. Suppliers providing engine seals, thermal and acoustic shielding, turbochargers and engine castings could see increases in demand from a shift to diesel vehicles as well.

Biofuels. Biofuels like ethanol are produced from renewable resources such as corn or sugar cane, are used as supplements in conventional fuels and amount to 3% of current gasoline supply. Early investment in this technology was spurred by government policies, including a tariff on imported ethanol, tax credits for ethanol producers, and a federal mandate that transportation fuels contain a minimum amount of renewable fuel. While ethanol production has steadily increased and the value of ethanol deals peaked in 2007 at more than $2.4 billion in North America, several producers filed for bankruptcy last year, a result of volatile commodity prices and tight financing.

As a result, the biofuel sector is going through vertical and horizontal integration. Companies with strong intellectual property, as well as better plant design and fermentation processes, should receive attention from investors. Other biofuel investment opportunities include companies that target bottlenecks in the supply chain, such as those that provide distribution, storage and the next-generation feedstock capabilities.

Other alternate fuel technologies -- natural gas and solar power -- have received some attention, but their commercial viability is currently limited to niche applications. One of the most exciting and promising technologies for future generations of automobiles is fuel cells; however, the plans for mass adoption of this technology are unclear and may require additional government support. A breakthrough in technology, fuel delivery and cost structure of fuel cells could be game-changing and dramatically alter the industry landscape.

Of course, with progress comes new opportunities. The transformation of the auto industry is expected to attract financial and strategic investment in technology and spark a new race for the next generation of personal transportation. Given the plethora of new technologies and research, it is unclear which fuel should prevail. Moreover, given government intervention and influence, pure economics alone may not determine the ultimate winner. It is certain though that the powertrain of the future would look dramatically different from today, and the impact of this transition on the industry will be significant.

Gary A. Silberg is a Chicago-based partner with KPMG LLP's transaction services practice, and is the firm's national advisory auto industry leader.

— Analysis —

Shifting gears

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