Automakers weigh EV spinoffs to protect their future

Automakers have spent more than a century refining gasoline and diesel engines -- and creating a network of factories and research centers to develop and build them. Now they face a worrisome prospect: The quickening transition to electric cars is sharply devaluing those assets, threatening not only short-term profits but also their long-term survival.

It's a question that is weighing on every automaker, analysts said. In recent months, some have taken action by creating separate business units for EVs and combustion cars, shifting internal combustion engine activities to separate companies, and even separately listing electric car brands.

In doing so, they are hoping to ensure their futures and unlock some of the capital -- and attention -- that has flooded in to Tesla and other EV startups, as their own share prices have stagnated.

"From an operational point of view the most immediate aspect that currently preoccupies many OEMs concerns ICE product retirement planning," Tom De Vleesschauwer of IHS Markit wrote in a report last year. "In other words, how do they gracefully, or at least orderly, exit the ICE market without too many self-inflected wounds such as declining profit margins, layoffs, drastically changed product plans, and ultimately stranded manufacturing assets?" 

Among the moves already announced:

• Polestar, the electric car venture spun off from Volvo Cars under Geely, is planning to go public this quarter through a special-purpose acquisition company, or SPAC;
• Renault is studying plans to create a separate division for its EV assets, which could lead to a separate listing, CEO Luca de Meo has said;
• Ford Motor has announced a new corporate structure, with separate Model e (EV) and Blue (internal combustion) divisions;
• Mercedes and its minority shareholder, Geely, have repositioned city-car maker Smart as a 50-50 JV that will build European-designed electric cars in China, starting with the #1 ("hashtag one"). 

Some automakers are pushing internal-combustion activities off to the side. Geely and Volvo have created Aurobay as a separate company to develop and sell internal-combustion powertrains, including to outside customers, while Mercedes and Geely have already announced they will develop small hybrid engines together that will be used by Volvo.

BMW is shifting production of internal combustion engines to Austria and the UK, as it retools its German factories to build electric cars and components.

And while not directly related to EVs, Volkswagen Group and Daimler both spun off their trucks divisions in the past two years, VW with Traton and Daimler recasting itself as Mercedes-Benz Group for passenger cars and separately listing Daimler Trucks. This has allowed each to focus on building electric passenger cars, VW's ID lineup and Mercedes' EQ branding.

Even so, VW Group is not considering splitting its combustion engine and battery-electric car businesses. "We think making the best use of ICE assets to be fast and competitive in the electric world is the best way forward for us," CEO Herbert Diess said during the automaker's first-quarter results call on May 4.

Andreas Tschiesner, who heads McKinsey's automotive practice in Europe, said: "We do see different business models at this point in time, and I think the majority is at the moment in the middle where you are doing the in-house separation, and trying to bundle competencies into EVs or combustion."

"Running a successful ICE business and a successful BEV [battery-electric vehicle] business are not the same," Ford CEO Jim Farley told investors in January as he explained the reasoning behind the "Ford +" plan to create Ford Blue and Ford Model e. "The customers are different. We think the go-to-market is going to be different. The kinds of products we develop are different."

Not only that, Farley continued: "The procurement, the supply chain are all different. The talent is different. The level of in-sourcing is different. And actually the rhythm of the business is different -- fundamentally different."

It will be important to manage the two sides of the business differently, Tschiesner said. "On the one side, you will have the leadership team focused on the phase-out of that technology and operational excellence," he said. "You can free up engineers who are focused on things such as solid-state batteries or the software stack."

Tier 1 suppliers -- facing the shift to electrification and costly new technologies such as software expertise, connectivity and autonomous vehicles -- made similarly hard decisions several years ago, with mixed results.

Some spinoff or "root" companies were acquired by other suppliers, including Delphi Technologies by BorgWarner and Veoneer by Qualcomm; while Vitesco (ex-Continental) had a rocky market debut but has recently landed some big wins for its electric-powertrain components.

"In an ideal world, you could transform the production of ICE components to EV components, but that will not be the case 100 percent," said Harald Proff, global automotive sector lead at Deloitte. "One is electrochemical based; the other uses traditional machinery and equipment."

Investors are treating combustion-engine "legacy technology" as a dead weight on the balance sheet, analysts say -- but at the same time, nearly all automakers earn the vast majority of their profits from internal-combustion-based vehicles. That is likely to continue for years to come.

"The profitability of ICE is very important because it gives us optionality, not only of scaling BEV, but also vertically integrating BEV, which is increasingly becoming important for a profit lever," Farley said.

So, a spinoff poses certain risks: Will an EV-only company be able to attract enough investment to fund its operations? At the same time, can the wind-down of internal combustion businesses be managed in a way to avoid mass layoffs or restructurings? Ford in late April announced it would cut 580 positions from its U.S. engineering teams as part of the move to the Ford + plan.

Moves such as a separate listing or internal reorganization may be painful for current employees and fraught with risk for stakeholders -- but they are going to be increasingly necessary, analysts say.

The conventional wisdom is that a gradual transition to electrification was needed to protect jobs. But that thinking may be outmoded, analysts say, as EV market share grows quickly, calls to decarbonize the environment become more urgent and new entrants without legacy costs threaten established automakers.

"From 2021 on, the pace at which OEMs withdraw capital from ICE and shrink legacy may matter more to valuation multiples than investing in EVs, which is now a cost of doing business," Philippe Houchois of Jefferies said in a recent report.

Houchois says automakers are now in "Phase 2" of the transition to EVs. In the first phase, automakers increased capital spending to start the transition; now, they "are starting to pull capital from ICE and older technologies" to compensate for higher spending on EVs and autonomous vehicles.

Both Houchois and Proff speak of avoiding the "zero-sum" trap, in which margins on internal combustion cars fall faster than EV margins improve.

"Equity markets are more likely to reward legacy OEMs that proactively shrink stranded legacy assets," Houchois said.

Houchois says "Phase 3" will involve shrinking or spinning off existing assets, for example, exiting segments or brands or combining internal-combustion assets off the main balance sheet, such as the Mercedes-Geely engine agreement.  

It's too early to say how recent moves will play out. While Polestar's reverse-merger SPAC offering has not yet been finalized, there are encouraging signs.

Hertz last month signed an agreement with the brand to buy 65,000 electric cars over the next five years, and Polestar CEO Thomas Ingenlath has said he expects the company's valuation to be well above $20 billion -- a figure that would put it on par with Volvo Cars itself, despite selling only 29,000 vehicles in 2021 compared with Volvo's 700,000.

Renault has not yet said in which direction it will go, but investors are already cheering its intention to undergo a radical makeover.

"Splitting ICE and BEV could be the long-overdue strategic reset that puts Renault back on investors' maps," Houchois wrote this month. 

Automakers are looking enviously at the market capitalization of Tesla and newcomers such as Rivian, Nio and Xpeng as they weigh their futures.

"The market cap of the pure-play EV players is creating a lot of pressure on the legacy automakers to show the capital markets that they are sustainable players," McKinsey's Tschiesner said. 

As Deloitte's Proff put it: "They want to be valued as tech companies not as a production unit that is using assets that people no longer want." Compared with EV pioneers such as Tesla, "they are not in such a comfortable position. They have to earn the money for the transformation."

But automakers that might want to split off EV operations in hopes of attracting capital cannot simply do so without rethinking other parts of their business, Proff said. 

"You can't preserve your valuation by simply splitting and saying, 'OK, we have two companies, now we will keep everything the way it is'," he said. "You will attract all of the value to the new company." 

To avoid having to shut down money-losing assets or selling to a third party -- what he calls a binary choice -- Proff said automakers should work on building "flexible" value chains rather than a traditional supplier-automaker relationship. He envisions a "constantly changeable production footprint" in which companies connect with others in an "asset light" arrangement to manage future internal-combustion engine production.

Other scenarios could include contract manufacturing of internal-combustion powertrains, perhaps as Geely's Aurobay envisions, or the entry of private equity money to manage the wind-down. 

"This is going to be a cost game," Tschiesner said. "It's all about operational excellence, taking complexity out, having plants running at the best possible operating points. You will need management teams that are fully focused, as little overhead as possible, and as little investment as possible."

Although the notion of private equity companies swooping in to squeeze value out of a declining industry through layoffs could stir fears, Tschiesner said the industry may have enough of a lead time to make the transition to EVs less painful.

"Combustion engines still produce very nice industrial cash flows, and they will for the next 10 to 15 years," he said. "If the private equity players invest, they are looking at the relatively stable cash flows for the years to come. Through achieving a leading cost position and adjusting the plant network you can generate healthy returns."