Car of the Future Doesn't Come Cheap

Conti's R&D budget is a warning.

As driving becomes automated, electric motors displace combustion engines and cars are crammed full of gizmos, the companies supplying all that new technology are in the ascendancy, right?

Multiple Choice

Investors value car suppliers' earnings more highly than their customers'

Source: Bloomberg

Maybe not. A profit warning from Continental serves as a reminder that the "triumph of the automotive suppliers" -- a popular idea among investors -- isn't certain.

Of course, most of the approximately 480 million euros ($530 million) hit that the German manufacturer anticipates to this year's operating profit -- about 10 percent of the Bloomberg consensus -- comes from one-offs such as antitrust cases and earthquake-related production problems.

Yet Conti said R&D spending on infotainment and eco-friendly drive systems will also be about 60 million euros higher than anticipated. Not huge, but potentially significant.

Conti says the revolution in carmaking calls for a "strategic adjustment" of its own. This includes trying to better target R&D spending, which last year totaled almost 9 percent of its automotive division sales.

Future Costs

Conti's R&D spending has increased as cars become more automated and electrified

Source: Continental annual reports

And change is needed. While carmakers have been talking about electric vehicles for years, the recent acceleration of their plans has been dramatic. Diesel car sales look to be in structural decline in Europe. Along with falling battery costs and Tesla's sales, that's forced carmakers to move much more quickly.

Even long-time electric skeptic Volkswagen, chastened by dieselgate, predicts that sales of these cars will account for one quarter of its total by 2025.

And while there's an expectation that more of the value from making tech-heavy cars will shift to component makers, there will be a cost. First, the electric shift means there's little chance suppliers can reduce already high R&D spending any time soon.

Second, to offset their own bigger investments, carmakers will have to drive an even harder bargain with suppliers. Volkswagen, for one, is slashing costs. 

And third, if battery vehicles win market share more quickly than expected, suppliers might not make as much money from the hybrid technologies they've developed for more environmentally friendly combustion engines. Kristina Church, a Barclays analyst, fears Conti "may have over-invested in technologies that may prove to be fleeting."

Still, Conti's better placed than some, despite the 25 percent drop in its share price since last year's high. Only about 3 per cent of its business is diesel-related, while the tyre business -- contributing more than half of operating profit -- is a counterweight to slowing sales of new cars in the U.S.

Tune-Up Needed

Continental's shares have rocketed since 2009 but investors have grown more cautious lately

Source: Bloomberg

Thanks in part to cheaper raw materials, tyres generated a 23 percent operating margin in the first six months of this year, double the group average. These cash flows let Conti spend more on R&D than smaller rivals.

It's still fair to assume large suppliers will probably profit more than most from all the electronics, software and sensors in tomorrow's vehicles. But costs and returns could suffer at the start, as carmakers chop and change their technical requirements at short notice. Continental won't be the last supplier needing a tune-up.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Chris Bryant in Frankfurt at

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    James Boxell at

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