Columbia Threadneedle Investments

Research Spotlight Q1 2023 Virtual Event

Transcript 03.15.2023

Jake Sluis:

My name is Jake Sluis, and I'm a regional investment consultant at Columbia Threadneedle Investments, and a member of our private client advisory team. I want to thank you all for joining today and welcome to Columbia's quarterly Research Spotlight webinar. If we go to slide two, I want to intro Columbia Threadneedle to you all.

Columbia Threadneedle is a leading global asset manager with approximately $584 billion in assets under management, over 650 investment professionals, and 200 plus research analysts. At Columbia Threadneedle, we pride ourselves on our research intensity and differentiated solutions. The reason for this call is to share some of that research to help you make informed investment decisions for your clients. Today's call will focus on the Inflation Reduction Act, the potential implications of the bill, and the potential opportunities for investors.

And today I'm pleased to have two of Columbia Threadneedle's analysts on the call with me, Charles Mann and Hannah Cao. Charles is a senior analyst in fundamental research and is responsible for auto, aerospace and defense verticals. Hannah is an associate analyst in fundamental research who works primarily with the industrials and material analysts.

If you go to slide four, I want to take a look at this and just say if you have any questions at any time during the call, please either message a question through the WebEx chat box that you see there on your screen, or email that address that you see on this page right here. We're going to try to address as many questions as we can, as we go along and after our prepared comments. And with that I'd like to turn it over to Charles and Charles, please take it away.

Charles Mann:

Excellent. Thanks Jake. Can we do the next slide please? There's a lot of words on this slide and it's a sound out of this research intensity, but this highlights really the depth of what we excel at here with CTI, which is stated there, research intensity. In today's world, it takes breadth and depth to succeed in markets that seem to present new challenges and opportunities every day. From rising ESG mandates and considerations to continued interest cycle challenges like the Silicon Valley Bank that we're seeing now. Therefore, the toolbox, the research toolbox must include RI, responsible investing, quant, data science, broad collaboration on big topics and deep research that has leveraged across products and geographies. This IRA presentation we're doing today is a great example of this deep research toolbox. So this presentation is not just one point in time. It evidences what we're saying on this slide.

It's a culmination of several years of research meetings throughout the ecosystem of electric vehicles. So it's an opportunity to explain and evidence. So this presentation represents many meetings with private companies, ranging from battery startups to mining companies, to auto companies. We've had meetings with academia, professors at MIT and Carnegie Mellon. We've spoken with industry experts, insights from interesting areas like retired leaders from companies like LG Chem, and also insights from regulatory experts. We've spoken with public companies throughout the supply chain in the US, China, Canada, Europe and India. A great example of this first specific to us and our team here that we have on the call is Hannah is fluent in Mandarin. That's given us an outstanding opportunity to speak with private companies in China. We've had many plant tours and meetings with second level managers and leaders, and engineers in many different companies. Hundreds of executive meetings with CEOs and CFOs from the most influential leaders in this vertical. Again for miners, battery companies, auto companies, utility companies.

And finally, what is really another part of the research intensity is the collaboration that we have internally, with analysts and PMs from across the globe in different sectors. So this in-house expertise on the IRA bill that we're going to discuss today, evidence is exactly what we mean by research intensity. It's what's on that slide. But what you're seeing today is really what that slide is trying to tell you. And this is now work. This IRA bill is work that we now leverage across our platform.

So with that, I'd like to hand over to my colleague Hannah. She's going to walk through the how, the what, the implications from the IRA bill. The IRA bill specifically, in the transportation bill. And from there I will discuss risks and challenges, and then after that we'll take some questions. Thanks. I'll hand it off to Hannah.

Hannah Cao:

Thank you Charles and Jake. Can we move to the next slide please?

So the Inflation Reduction Act bill is the most transformative bill for the transportation industry, and here we listed a few unique features of the bill. So the bill will provide more than 800 billion credits into the auto vertical. It has very material impact on cost reduction, which includes 10 to 20% cost reduction on EV, 40% cost reduction on battery, 30% cost reduction on EV charging and 10% reduction on lithium processing. It also has a very long duration. The credits will last around 10 years. It also has very broad coverage, extending from EV battery charging stations to critical minerals and electrode active materials that are being used in EV.

It can also be easily monetized through different forms. So for certain credits, you could even choose direct cash payments from the IRS, or sell the credits to a third party. The bill also has high durability because risks are manageable and Charles will just discuss risks later. And lastly, the goal of the IRA bill is to build a domestic EV supply chain in the US. So on the right-hand side of the slide, I give a few examples on the Inflation Reduction Act credits. Next slide please.

So in this chart, we created a waterfall chart that breaks down the tax credits flowing into the transportation industry. In total, the transportation industry will likely receive more than 800 billion credits between 2023 and 2032. Around 65% of the total IRA credits will go to EV buyers and benefit the EV OEMs, which are shown on the left side of the charts. And almost 30% of the credits will go to battery manufacturers and the lithium miners. And the rest, 5%, will be allocated to advanced energy and EV charging investments. The credits will boost CapX and accelerate EV adoption. Next slide please.

For each qualified EV, it will be eligible for around $10,000 credits. The credits can be shared among the three parties shown in this charts, which are battery manufacturers on the left side, EV OEMs in the middle, and consumers at the right side. It is still uncertain how the credits will be shared among the three parties, however, because EV OEMs, they have a higher bargaining power over the other two parties, so we assume they will earn a bigger share of credits. Next slide please.

A question we often get is whether each OEM is equally positioned for the IRA bill and the answer from us is no. Only very few OEMs are actually well positioned for the IRA. In the top right corner, Tesla, GM and Ford are better positioned because they have achieved the vertical integration and they have been planning for the IRA, way ahead of others. In the bottom left corner, you can see companies that haven't established a battery partnership in the US, that have a high income consumer base and high vehicle prices. They tend to lag behind, in terms of collecting RA bill credits. Next slide please.

Another way to view the 800 billion credits is to look at on a relative basis, the IRA subsidies are 10 to 20% of total EV revenue every year. In other words, for every EV, 10 to 20% of the EV price will be funded by the IRA bill, and the benefits of the funding will be shared across the whole EV vertical, such as EV OEMs and battery manufacturers. The key takeaway here is, the credits will likely pull forward EV demand and accelerate penetration, which is the underlying assumption that drives our penetration forecast above the industrial level. Next slide please.

So, another question we get often is whether IRA credits will lower the expensive battery costs, and the answer is yes. The credits will likely reduce battery costs by 40%, which is important because battery is currently the most expensive part of EV production. So in total, we expect around 200 billion of credits will be allocated to battery cell and module production between 2023 and 2032. This will likely benefit these Korean Japanese battery makers, such as LG Energy Solutions and SK Innovation, because they have been building battery plants in the US for years. This will also likely benefit OEMs that have a joint venture structure with these battery makers, and OEMs that are manufacturing batteries on their own, such as Tesla. So the key takeaway here is that battery cost reduction will accelerate the arrival of price parity between EV and ICE vehicles, and again accelerate EV adoption in the US. With that, I will hand it off to Charles for a risk discussion.

Charles Mann:

There we go. Not on mute. Next slide please.

So the bill's big, it's massive, it's huge, prevalent, or it's going to be distributed amongst different verticals. So internally we asked ourselves, well the first risk, "What are the risks really?" And the first risk, what makes us really, what makes us not happen was the political risk. Basically, tried to answer the question of, "Could this be overturned?" So we tried to answer this question by looking at an important driver of political support which is, where is the money flowing?

So we went deep into 10Ks across many companies, and leveraged all the company meetings we also had, that I noted before, to ferret out where all the CapX is being spent for the battery manufacturing, and where the manufacturing plants for the auto will reside in different supply companies, and where will the benefits flow from these subsidies. What's interesting is that Republican states significantly benefit on a dollar basis and it's as evidenced in the graph there. While on the other side, democratic constituencies benefit from meeting clean energy targets. Basically, we see this bill as really a win-win and it's also great from a domestic manufacturing standpoint. As such, we expect this bill to retain bipartisan support over the 10 years for which it's currently currently authorized. Next slide please.

A busy slide here, but what this is highlighting is the second risk that we considered, which is technology risk. The question here really is, does the bill face technology risk at the end of 10 years? Said another way, will EVs be lower cost than ICE, internal combustion engines, after 10 years? So that in the interim period, the 10 years for this bill, the investments will be all in by the manufacturers. Will EVs be a self-sustaining technology trend? This is where we leveraged years of work we've done with battery technology, some of the private company discussions we've had, and the great access that we have with corporates and private companies. Our work highlights that the cost of EVs will be cheaper on a self-sustaining basis than ICE vehicles by 2030 or sooner. This will provide cost and utility profile that should enable the technology transition to EVs to be sustainable, past the expiry of the IRA Bill. Next slide please.

Another critical risk is raw material supply. For this question, we reached up into the mining channel and did differentiated work to model out lithium supply and demand by region. We specifically focused on North America and the resources that are available to the US, and there is plenty of lithium to support the IRA bill, well into a global oversupply situation out into the 2030s. Meetings we have had with company executives also evidence the strong efforts be NA being made now to lock up lithium supply well past 2020. 2025, excuse me. What this translates to, what this really means, lithium may be in global tight supply right now, but not for the US. Tesla, Ford, General Motors, among others are making sure of this now to ensure that lithium will not be a gating factor for the IRA bill. Next slide please.

One of the last major top risks that we dove into was the question, is there enough electricity? Based on modeling we have done with our utilities team and doing scenario analysis for different charging periods, we expect there is enough grid capacity to support the IRA bill, well into the mid-decade period. Home charging and current auto manufacturing charging investment trends are the main driver of this conclusion near term. While longer term, we expect rising state level investments to build over time, with grid storage subsidies from the IRA bill likely to play a very big role. This will not be linear and there will be challenges along the way, but the IRA bill is a significant catalyst which is already focusing investment plans on the long-term solutions. With that, I will close. Go to the next slide please. And hand off to Jake for any conclusions and Q&A.

Jake Sluis:

Thanks, Charles and thanks, Hannah. Really appreciate your commentary on this important bill, and the potential implications for investors out there. We've gotten a few questions from the audience, that I'd just like to take this time to remind how you can ask a question. You see there on your screen, you can email that address that you see there, and also ask your question within the chat box on the WebEx application itself. So we got this one question, "Does this bill enable new technology development, any long-term technology implications?" Charles or Hannah, I'm not sure which one of you wants to address both of those questions.

Charles Mann:

I'll start. I've been looking at it for a little while. I mean this is a very important question. So Tesla really started the trend of EV, many years ago. So this is a path that's been taken for the last 12 years, is the technology development. The current technology development pattern, let's say 12 months ago, 18 months ago, was a strong trajectory towards cost parity by the mid-decades. Inflation's impacted that by a year or two and pushing that out.

What difference the IRA bill has is that it is accelerating that investment pattern. An example at a very top level is the IRA bill has a $45 subsidy for the manufacturing of battery cells. Battery cells need to be around a hundred dollars to be cost competitive with ICE vehicles. They're around 150. So the IRA bill alone almost creates that cost parity. So the amount of investment now is looking not at this, "Wow, it's going to be really hard to get there." It is actually cost competitive now. So it is accelerating investment to ensure that you can do this over the next 10 years.

And what I'm seeing, and Hannah and I've had some calls with the private companies, they're getting significant funding and pulling forward some technologies, I thought maybe we would be here in a year or two, but well to say three to five, but are one to two years away, and specifically with nanotechnology. So we're highly encouraged by what we're seeing right now, and it's quite bullish for the technology path.

Hannah, do you have any thoughts that you'd like to add?

Hannah Cao:

So in terms of technology, I'm seeing some, so for this bill, the bill provides 10% cost reimbursement for lithium mining. So lithium mining has always been a concern. Lithium mining, doing lithium mining in North America has always been a concern for a lot of companies and investors, because labor shortage, very expensive equipment and also permitting issues. So, the 10% lithium mining cost reimbursement enables company to develop lithium technology, lithium extraction technologies in the US, and apply that in the US without too much concern on the cost and other factory issues.

Jake Sluis:

Excellent, thank you. And looks like we got another question from the audience. "Your chart mentioned an oversupplied environment for US supply of lithium, yet the price for lithium has been volatile and up dramatically. How many vehicles could this oversupply in the US support?" Not sure, Charles or Hannah, if either of you want to take that.

Charles Mann:

I'll start with the very top level. Hannah's the expert here and she's done some incredible work here. What I'll highlight here is, first the chart was a representation of what the global demand and supply looks like. I think that was a light blue bar and there's an under-supply. The supply available to the US is a different definition. The supply that's available to the US is that which is domestic with, excuse me, that which is North America, and that which is also available in free trade agreements, FTA countries. That's what the bill stipulates. So when we look at it by region, where the supply resides regionally. Regionally, there's a lot of opportunity for the North America supply chain to source. So the question is, are they sourcing it, are they able to source it and at what price?

And that's the work I've done within the auto vertical is talking to executives. It was a couple weeks ago, talking to the CFO of General Motors. Speaking specifically about this because they've made, actually they're making some capital investment allocations, hundreds of millions of dollars into the supply chain to do this and lock this up. So the North American OEMs, the auto manufacturers are contracting and are actually, General Motors and Tesla already have done this now, well through 2025. To look what that blue bar, it's a lot that's out there, that's available. They're locking that up now.

So globally, when we look at the price of the commodity, it represents the global supply demand metric, which is the light blue bar. But what's available for North America is significantly different. So the OEMs have the opportunity to get that and to lock it up with longer term contracts that have more favorable pricing than what we're seeing in the spot market. We're seeing it from an inflated market. So the supply that's available to fill what we think is what the OEMs will build to and what their supply demand for, there's ample supply. So Hannah, I'll hand that off to you. You've got further color.

Hannah Cao:

Thank you. Thank you for the question. It's hard to calculate here in my brain, but I can give you a very, very vague number. I think the lithium supply will enable US to produce millions of vehicles every year. Because like Charles said, a lot of the North American volume, lithium volume, actually not only comes from North America, but also come from the free trade agreement countries, which include Australia, which is currently the number one lithium producing country, and, not Argentina, but Chile and some other free trade agreement countries. So all of these, if US OEMs can opt in contracts, have agreement with these free trade agreements country lithium suppliers, then US will have way over supply of lithium in the next 10 years.

Jake Sluis:

Excellent, thank you both. Appreciate the commentary on that question. We also have a few more questions here. Hopefully we can get to them all. Are there any industrial implications for the Inflation Reduction Act bill?

Charles Mann:

I'll start again. Just from my experience in working in the industrial vertical across different sectors, yeah, this is a big vertical. This is a really big vertical. When we think about what is this going to mean, there are new plants being made now. There's new battery plants, there's new manufacturing plants, there's going to be mining investments. When we think about the implications there, that's a lot of money that's spent in the United States. Broadly speaking, think about everything that goes into an EV, and goes into the building of those plants. So things like just pumps. I follow on the industrial side, I follow a company that specializes, its the number one manufacturer of pumps in the United States specifically of fluids. Caustic fluids. And they're seeing a significant order flow right now. We're seeing some domestic supply chains being built around semiconductors, which actually from a power supply standpoint and power content is pretty high in EVs.

That's also, those are being built for maybe other reasons as well, but it's helping support this as well. The mining companies are going to need equipment. From a railroad perspective, there's a lot of big things that are going to be moving around. Some of the railroads, North, Norfolk Southern or CSX carry a good portion of auto in those zones, in the geographies where there's investment being made. There's connectors. A lot of connectors are going to be made, and there's some companies which are connector companies which are going to benefit. So when we look across the industrial complex, there's a lot of CapX and that's going to flow through. It's going to basically have what's called a ratio. A ratio of amount of money spent, and then the amount of money that's filtered out through the economy. That's going to be helpful.

Hannah Cao:

Thank you, Charles. I also have some other implications. So with the increasing, with pull forward demand on EV, and as EV penetration rate goes up, we are seeing increasing demand for EV charging stations. And this is a huge benefit for the utilities companies, because a lot of EV charging stations, they're actually educating their EV customers to charge their vehicles overnights, which will dramatically reduce the charging cost. And that is part of what utilities companies have always wanted to do, which is smart grade investment, smart grade development. This is a huge CapX for utilities companies in their business. So that's for utilities companies.

In other parts, I am also seeing investment implications for cathode and anode producers. Currently, a lot of cathode and anode producers, they are located in South Korea and in China. With the IRA bill, they actually provide a certain credits for cathode processing, cathode production and anode production. So that's why we are seeing a lot of Korean producers and the US producers, they're building factories, cathode, anode factories in North America. So for example, POSCO, they just launched their cathode factory in Quebec, Canada, and we see LG Chemistry, LG Chem, they're manufacturing, they're constructing building constructions for their NCMA cathodes factories in Tennessee, US. So that's also, cathode and anode, that's also where I see investment implications.

Charles Mann:

And, Jake, if I may, one other on the other side of this. There are other things, the way that we look at this, when I mentioned collaboration. We ask the question, aside from what we just noted in regards to going vertical on an investment side, all the different implications is, what else must be true? The other implications, what does this mean for a dealer network? Is the selling channel exactly the same? Because what we're looking at is a large industrial vertical that's a huge installed base. So what are the implications as that installed base changes over time? What are the implications for the fuel side? We're talking about charging stations. You could talk about the other side, what it might be replacing. So we do discuss that.

What are the implications for the residual value of financial companies? So you have an auto book and as the fleet changes, the residual value profile of certain products may change. So there's a lot. And we'll learn more. Maintenance is another one. Actually, on the maintenance network, because the maintenance profile is a lot different between the two vehicles. So there's a lot of different channel implications and those are the things that we discuss internally.

Jake Sluis:

Excellent. Thanks, Charles. And thanks, Hannah. We've got another question here. Speak about all the implications of the bill. "How do investors position portfolios to take advantage of what's going on in this environment right now?" Anything, any advice or any pointers that you give to the audience on positioning portfolios around that?

Charles Mann:

There are, as we noted, the industrial implications. Thinking through, are there? I would say that number one, start with follow the money. Where's money being spent? What are the investment? What are the industrial verticals that may benefit? How are they positioned? How are they competitively positioned? Consider that. And you know what? Maybe it's another area that may benefit. Earnings and free cash flow growth over a decade. That's an important thing.

The other side, I would make sure I'm not making an unintended bet. What's an unintended bet? As the fleet changes, the installed base of the vehicles change. I mentioned several things to think about. You definitely want to say, "If this happens, what else must be true?" And don't make unintended bets against it, if you believe it's going to happen. So tack to it, and there are many different creative ways. And if you believe it and say there's a lot of money that's here, I want to follow the money, don't bet against it unintentionally.

Jake Sluis:

Excellent. Looks like we've got time for one more question here. Implications for Europe. "What does Europe do in response to this bill that we've passed here?"

Charles Mann:

I think it's interesting. Pardon me, Hannah, I've started. Keep going with this.

Hannah Cao:

Oh, oh, go ahead Charles.

Charles Mann:

No, no. I'll tell you.

Hannah Cao:

Okay. So in terms of Europe, so there's another bill, there's a very special credits in this bill, which is the Commercial EV bill. It enables ... It does not have any strict made in US or critical mineral battery component requirements, as well as the vehicle is running in the land of US. The company or the taxpayer can claim $7,500 credits on the EV. This largely enable a lot of European OEM, like for example, Porsche and BMW, they sell expensive cars.

They produce their cars in Germany and they don't have many battery partnership in the US. This enable them to lease or rent their vehicle to consumers, to enable consumer, enable whoever the taxpayer is to claim that $7,500 credits. And that's the same $7,500 credits, the same amount as the other very strict EV credits, only apply to made in US vehicles. So this kind of give a lot of relief for people who are concerned about the increasing tension between US and Europe. So that's a very positive signal. And last week, I actually went to Porsche's website and I saw they are offering $7,500 credits for people who lease their new Taycan. So a lot of the credits are already being applied by these OEMs these days.

Charles Mann:

The leasing mechanism is one that is kind of a relief valve for any pressure, that BMW or Mercedes may feel. We shall see the duration of that. On a longer term perspective, Hannah, you were discussing this with me, is maybe some of the FTA agreements may change.

Hannah Cao:

Yes.

Charles Mann:

Open up more opportunities for European countries, but also on a longer term basis, what we're seeing is, an example is Volkswagen. Volkswagen has announced a plant to build the Scout. If anyone is a old, looks at heritage vehicles, to build the Scout in the United States. So the Europeans are also pivoting to develop their own vertical channel in the United States. So it feels like there's a path forward for it to not be acutely painful for the Europeans. But then, we're also seeing long-term investments being planned right now.

Hannah Cao, CFA, Associate Analyst, Equity Research

Hannah Cao:

Yes. And also, yeah, and then I don't know if we have more time, but recently the US and the Europe, they just had agreements that critical mineral source from Europe can also qualify for the very strict, clean vehicle credit in the US. So that kind of, that's also a positive signal for the IRA bill and for Europe.

Jake Sluis:

Okay. Excellent. Thanks, Charles, and thanks, Hannah, it was a great commentary. Appreciate you both joining us today on this Research Spotlight call. And want to thank everyone also for joining us today as well. As this call ends, you're going to see a survey that's going to appear on your screen. Your feedback is incredibly important to us. It helps us inform future calls. If you could, please fill out that if you have some time. Also hope that you can join us for the next Research Spotlight call, June 14th. Thank you all again. Have a great rest of the week. Take care. Bye-bye.