TheChek News Flow

Detroit automakers entered labor talks at cost disadvantage to Tesla

More than a day into the United Auto Workers strike against the Detroit automakers and one thing is clear: Elon Musk has already won.

And the billionaire tycoon isn’t even involved.

Musk won before the strike began early Friday. He won before negotiations started two months ago. From the get-go, General Motors GM 0.86%increase; green up pointing triangle, Ford Motor F -0.08%decrease; red down pointing triangle and Chrysler parent Stellantis STLA 2.18%increase; green up pointing triangle were expected to spend more on wages because of the union’s pressure. The question is just how much of an increase, and so far their offers haven’t pleased the union, igniting this past week’s work stoppage.

Whatever happens, more money surely will be spent. Any wage increase further advances Tesla’s TSLA -0.60%decrease; red down pointing triangle already tremendous cost advantage in EVs over its older U.S. peers, which are contending with generations of legacy expenses while trying to steer a costly transition to electric from gas-powered vehicles.

In March, Musk revealed plans to build on his advantage by setting a goal of slashing manufacturing costs for the automaker’s next-generation vehicles by 50%, an ambitious agenda that will depend upon advanced automation, savvy engineering and other changes.

The Tesla chief executive’s actions this year have shown how Tesla can take advantage of a lower cost structure to engage in price wars with rivals around the world to juice sales.

In July, Tesla reported second-quarter profit that rose 20% even after reducing prices. Around the same time, in the midst of steep losses from its electric vehicles, Ford said it would slow its EV production growth.

All of this is playing out as the UAW seeks more than what the Detroit automakers say they can afford and remain competitive. The companies have offered wage increases of varying sizes reaching as high as 20% over four years, while UAW President Shawn Fain countered with a mid-30% increase, down from a previous ask of at least 40%.

The Detroit companies’ labor costs, including wages and benefits, are estimated at an average of $66 an hour, according to industry data. That compares with $45 at Tesla, which isn’t unionized and was founded 20 years ago. Meeting all of Fain’s initial demands would boost average hourly labor costs to $136 for the Detroit companies, Wells Fargo estimated.

A key difference between Tesla employees’ compensation and that of the UAW workers revolves around company upside. UAW workers have been getting profit-sharing bonuses while Tesla workers receive stock options, which don’t have a direct cash cost to the company. Over the years, Tesla shares have risen like a rocket, though there have been periods of turbulence. Shares this year have more than doubled.

Fain argues that past contracts haven’t kept up with inflation, hurting the union’s roughly 146,000 auto workers’ spending power, and that members’ sacrifices have helped make the companies profitable in recent years.

“This is our generation’s defining moment,” Fain said late Thursday before the walkout. “The money is there. The cause is righteous.”

Shortly afterward, Ford responded, saying the union’s demands would “more than double Ford’s current UAW-related labor costs, which are already significantly higher than the labor costs of Tesla, Toyota and other foreign-owned automakers in the United States that utilize non-union-represented labor.”

Many analysts, so far, are expecting that the Detroit companies will ultimately absorb the added costs. “The much larger issue is that it adds incremental pressure to their already challenged transition to an EV world,” Dan Levy, an analyst for Barclays, cautioned investors in a recent note

Fain this past week sounded annoyed when asked about Tesla’s cost advantage.

“Competition is code word for race to the bottom, and I’m not concerned about Elon Musk building more rocket ships so he can fly in outer space and stuff,” Fain told CNBC on-air Wednesday. “Our concern is working-class people need their share of economic justice in this world.”

Focus on the labor-cost gap is a classic part of Detroit negotiations—raised by executives, investors and analysts every cycle. Before Tesla, there was Toyota Motor and its nonunion pay rates.

U.S. automakers spent years arguing that Asian rivals, without UAW contracts, benefited from cheaper labor costs that allowed them to plow savings into cars that appealed to consumers.

Narrowing the labor-cost gap was a key part of the painful restructuring of the auto industry around 15 years ago, when union members made unprecedented concessions to help save their employers and their jobs.

Art Wheaton, a labor expert at Cornell University, suggests that the UAW’s ability to get higher wages could help put heat on Tesla during any renewed effort to organize there.

“I don’t think Elon Musk has all of that superwonderful, high-polished glow anymore,” he said, noting the controversies the billionaire has had regarding his recent ownership of Twitter-turned-X. “Some of that patina has been wiped clean.”

The UAW had its best shot in years to organize Tesla during labor strife in 2017 and 2018, when workers were feeling the burn of “production hell” at what was then the automaker’s lone assembly plant outside San Francisco as it struggled with the Model 3 sedan.

But the organizing effort failed.

The National Labor Relations Board has ruled that Tesla violated U.S. labor law in its handling of the matter, including statements by Musk that were considered threatening when he tweeted that hourly workers would lose stock options if they joined the UAW. An appeal by the company, which has denied wrongdoing, is pending.

Musk has suggested that employee stock options make his factory workers the highest compensated in the industry, saying “quite a few” line workers have become “millionaires over the years from company stock grants.” Options allow workers to buy stock at a certain price after working at the company for a set amount of time.

At Tesla, the average pay for a manufacturing technician can range from $23 to $32 an hour, according to estimates by Glassdoor. Tesla advertises factory jobs in California with expected pay ranging from $24 to $67 an hour plus cash and stock awards and other benefits.

On Thursday, Musk took another jab at the UAW, after essentially daring the union last year to try again to organize his workers, boasting that his factories “have a great vibe.”

“We encourage playing music and having some fun. Very important for people to look forward to coming to work!” he tweeted recently. “We pay more than the UAW btw, but performance expectations are also higher.”

Wrangles loom between fund managers and their clients over who pays for the costs

Decades ago when I was a sellside analyst in the City of London doing the rounds of my firm’s fund management clients, I would regularly ask them a simple question: what did they want in research?

The answer back then was: every conceivable option. The fund managers’ desks were often overflowing with mounting stacks of unread research and their phones besieged by brokers brimming with ideas. But the investors still wanted more. Why? Because there was little direct cost to them. It was all largely paid for with commissions on trades. In turn, these were paid out of the pockets of fund manager’s clients — pensions funds and the like.

Eventually, regulators thought this was not such a great idea and in came Europe’s much heralded Markets in Financial Instruments Directive II — or Mifid II — from 2018. This aimed to shine a light on research expenses, unbundling research fees from trading commissions and making the costs explicit.

Now, though, regulators are carrying out what is known in my current trade as a “reverse ferret”. Pushed by the UK Treasury that is seeking to take advantage of its post-Brexit freedom from EU rule-setting, regulators at the Financial Conduct Authority have begun to rethink this unbundling of research and trading expenses. The European Securities and Markets Authority is carrying out a similar exercise.

The main driver of this extraordinary turnaround is the realisation of the unintended consequences that Mifid II has wrought. The directive undoubtedly brought more transparency. But there also have been complaints that the changes have damaged the financial ecosystem and diminished the supply of equity research, particularly for smaller companies.

Initially, Mifid II unbundling promised a means of promoting higher quality analysis and reducing any redundant reports. But it also began a period of vicious price cutting on research by the largest brokerage firms. 

As small, independent research houses watched with horror, prices for their services plummeted. Asset managers, who found they had to pay more explicitly for research costs, happily grasped at any chance for discounts. Bulge-bracket brokers tackled any competition from independents head on with all-inclusive research packages at very low prices. 

And even for large investment banks, there were downsides to Mifid II. It added layers of administration to win the research battle. Regardless of any subsidies provided by other parts of investment banks, research became even larger cost centres than they had been previously. 

“I would think that quite a few research heads will be happy to see the previous system go,” says Steve Kelly, an adviser to the European Association of Independent Research Providers.

Research remains a big business. Last year, global cash equities research was estimated to cost around $11bn annually, according to Kelly’s analysis of Integrity Research data. About $6bn comes from the US, with Europe and the UK providing $3bn or so. But research clients have become more careful with their budgets, even in the US. “When you go from an all-you-can-eat model to à la carte, you think more carefully about what you consume,” says one senior executive at a large US fund manager.

In the US, the investment community has long bundled research costs with trading commissions. Under the US Investment Act of 1940, professional investors cannot pay for research directly. Local concerns that US brokerages would have to create special investment advisers to accept direct payments under Mifid II were put to rest recently. A workaround will leave any UK and European research money paid sequestered in that region.

In Europe, things will not return to pre-Mifid II days. Even in the UK, a government-commissioned review by financial services lawyer Rachel Kent did not recommend a mandatory return to the commission-sharing agreements (via trading) of the past. But Kent did suggest more payment flexibility is needed. And even independent research groups are not expecting business will suddenly improve radically. “I expect an uplift of perhaps 5 to 6 per cent in our global revenues,” says Iain Johnston, chair at New Street Research. 

Having seen the backtracking by the government on Mifid II for research, many investment managers will want to delay having any cost discussions until confirmation of changes. Those discussions will no doubt be tricky. If their clients expect their asset managers to do in-depth analysis, shouldn’t this cost be shared? 

When seen as part of trading expenses the cost may be only a few hundredths of a per cent. Not so fast, asset owners may say. Mike Carrodus at Substantive Research quips that pension fund bosses ask, “If it’s so little, why don’t you pay for it?” Who forks out for research, not just how much, is the real issue.

The founder of Officine Générale adores Italian food, his vintage Tank and the WeatherPro app

My personal style signifier is colour matching, in my work and personal life. If I’m wearing navy pants, I have to have a navy sweater that matches perfectly. I’ve been dressing like this forever; it’s a kind of freedom for me, because I don’t have to think about what to wear in the morning. And I always wear a vintage watch – a 1979 Cartier Tank Chinoise, which is a pretty rare model.

The last things I bought and loved were two artworks by Michael Schouflikir, compositions made of recycled pieces of wood and metal, built on vintage frames. They are from a gallery I love in Saint-Germain-des-Prés called Tourrette, run by Carole Korngold, that shows a new artist every month; they’ve had Laurent Jaffrennou’s work on paper, Thomas Junghans’s sculptures and Mirco Marchelli paintings.

The place that means a lot to me is Ibiza, where I have a holiday home. When I first went there I didn’t connect with it, but I think it’s a place that you have to discover. Now my wife and I have a house in the centre of the island with a beautiful view of the countryside; it’s absolutely charming. The house is a mix of an old finca and Bauhaus style so it has very interesting shapes. I do the opposite of what most visitors do on the island: I wake up at 6.30am, get a coffee from the village, and later have dinner with some friends.

And the best souvenir I’ve brought home is a sculpture of a man’s head that I got at Noordermarkt flea market in Amsterdam. We were supposed to be buying it for one of our stores, which always have secondhand objects and furniture in them, but I felt a connection with it and wanted to keep it at home. 

Moshiri calls time on Everton

Plus, West Ham’s Daniel Křetínský discusses takeover chatter

In the old days, football fans wanted a sugar daddy owner who could fund extravagant spending sprees in the transfer market to power their club to trophies.

Farhad Moshiri appeared to fit the bill. The British-Iranian bought into Everton in 2016 and took majority control two years later. He invested at least £750mn into the club to start construction on a new stadium and snap up players.

Except his cash never paid off on the pitch. When business partner Alisher Usmanov was sanctioned in the wake of Russia’s invasion of Ukraine, it exposed how reliant Everton had become on external capital. The club had to cut commercial ties with Usmanov-backed USM, while Moshiri’s own shares in the Russian company were put out of reach.

Following months of talks, Moshiri has now agreed to sell his 94 per cent stake in Everton to Miami-based firm 777 Partners, a serial collector of football clubs. It will mark a stark change in approach. Josh Wander, 777 co-founder, told the FT just a couple of week ago that fans “want to be monetised”.

The deal shows that one rich man is no longer enough in football ownership, as the numbers get bigger, the stakes get higher. A different breed of benefactors (sovereign wealth funds and private equity firms) are getting in on club ownership, while scrutiny of who is in charge intensifies.

Even so, £750mn should have bought a competitive team, not one scraping to avoid relegation. Dud signings, payouts to former managers and a capital-intensive new stadium are a bad combination.

It all fed in to the renewed push for financial sustainability in football, the theory being that clubs shouldn’t rely on one man’s wealth, or run up big debts while losing money. Look out this Sunday for a deeper FT dive on how football’s governing bodies are adapting the sport’s financial regulations to make clubs more business minded.

In the meantime, we give you more on private equity’s latest sports investment, and dish up an exclusive interview with West Ham United shareholder Daniel Křetínský, one of Europe’s richest men.

SoftBank seeks OpenAI tie-up as Son plans deal spree after Arm IPO

Japanese conglomerate is looking to invest tens of billions of dollars in AI after Arm’s blockbuster listing

SoftBank is on the hunt for deals in artificial intelligence, including a potential investment in OpenAI, after the blockbuster listing of UK chip designer Arm bolstered Masayoshi Son’s multibillion-dollar war chest.

Two people familiar with Son’s thinking said that the Japanese conglomerate’s founder and chief executive is looking to invest tens of billions in AI after completing Arm’s initial public offering.

Microsoft-backed OpenAI is one of several options SoftBank is considering for a handful of such deals. SoftBank could also look to strike a broad strategic partnership with the ChatGPT maker, these people said.

SoftBank is also looking at a range of alternatives to OpenAI, including making substantial investments in direct rivals of the ChatGPT maker, they added. The company also made a preliminary approach to buy Graphcore, a UK-based AI chipmaker, they said.

SoftBank said: “We do not comment on rumours.” OpenAI declined to comment. Graphcore denied that it received an offer from SoftBank.

Analysts say Arm’s IPO on Thursday, which raised almost $5bn in proceeds, will expand SoftBank’s war chest to as much as $65bn, including its own cash as well as using its remaining 90 per cent holding in Arm as collateral for loans.

Son, who said in June he was a “heavy user” of ChatGPT, has developed a close relationship with OpenAI’s chief executive Sam Altman. Son has described Altman as “one of the key people on Earth” and said he speaks to him almost every day. 

SoftBank’s mobile unit already has a business partnership with OpenAI to serve companies in Japan that want to deploy generative AI technology, such as chatbots. The service is based on the Azure computing platform developed by Microsoft, which is OpenAI’s exclusive cloud provider. Earlier this year, Microsoft invested $10bn in OpenAI, in a multiyear deal, according to people familiar with the matter. 

The SoftBank mobile subsidiary has also said it wants to develop its own Japanese equivalent of ChatGPT.

Son’s enthusiasm for dealmaking, according to people close to his inner circle, has rebounded strongly in recent months and culminated in the prolific tech investor saying in June he was going back into “offence mode”.

During the pandemic and through the tech downturn in 2022, Son was in a self-declared “defensive mode”, during which new dealmaking was heavily curtailed and the company set about bolstering its cash position. After concentrating on Arm for several months in the run-up to its IPO, its successful listing has freed up Son to resume dealmaking with renewed vigour, according to people familiar with his thinking.

Son holds wider ambitions to establish his Japanese technology conglomerate as a credible competitor in the field of AI, including in the chips that power the technology.

At the moment, the big winner from AI has been Nvidia. The Silicon Valley-based company’s dominance in the market for AI chips has propelled its market value to more than $1tn this year. SoftBank took a stake in the chipmaker in 2017 but sold it in 2019.

Arm made AI a key part of its growth story to investors during this month’s IPO roadshow, as it looks to diversify from its core smartphone market and expand its reach in cloud computing.

However, analysts said Arm plays a much smaller role in the creation of large language models — the technology that powers ChatGPT — than Nvidia.

Czech billionaire has been on a buying spree but says he will not pay outsized prices for ‘trophy’ assets

Czech billionaire Daniel Křetínský has entered the auction to acquire the UK’s Telegraph Media Group, joining bidders including Daily Mail and General Trust, people close to the process said. 

Křetínský, a lawyer-turned-energy tycoon who has been on a dealmaking spree across Europe, signed a non-disclosure agreement in recent days to join the auction process for the parent company of The Daily Telegraph, Sunday Telegraph and The Spectator magazine.

However, in a wide-ranging interview last month with the Financial Times, Křetínský said that he would not pay outsized prices for “trophy” media assets.

While declining to comment specifically on Telegraph Media Group, the 48-year-old said: “We normally invest in media that is in need of some sort of support . . . It is not in our DNA to fight for trophies.”

The FT previously revealed that Křetínský wrote to the then owners of Telegraph Media Group in late 2020, expressing interest in making an offer for the UK publisher. He later abandoned the idea.

In June, Lloyds Banking Group seized control of the group from Britain’s Barclay family, which bought the company for £665mn in 2004, in an attempt to recover some of the more than £1bn in debt the bank is owed. 

An auction led by Goldman Sachs, which could fetch more than £500mn, is set to begin in the coming weeks. While Křetínský is unlikely to seek control of the group, he may support other offers and end up with a minority stake, the people with knowledge of the process said.

Other bidders include Lord Rothermere’s DMGT, publisher of the conservative tabloid the Daily Mail, and NationalWorld, a local newspaper publisher founded by media executive David Montgomery. 

Křetínský’s holding company, EP Group, has emerged as one of Europe’s most active dealmakers in recent years using record profits from its coal, power and gas businesses to build stakes in well-known but unloved media, retail and infrastructure in the UK, France and Germany. 

The most significant transactions, which include a recent agreement to bail out heavily indebted French food retailer Casino and plans to purchase Atos’s loss-making IT services unit, will diversify his business significantly.

Křetínský told the FT that the common thread behind these deals was that they are all investments in businesses that provide services that are essential to modern life and often have a large asset base.

“Our role is to deliver . . . in an efficient way by properly managing the cost, being disciplined, being obsessed with the numbers, being obsessed with understanding where value is created and avoid situations where it is lost.”

He added: “When we talk about our investing philosophy, it is also probably fair to mention that we effectively like to invest in companies that are not indebted.”

In media, Křetínský has used a series of deals in France to burnish his credentials and break into the establishment outside central and eastern Europe. His media transactions are typically executed via Czech Media Invest, which is part-owned by his longtime partner and collaborator Patrik Tkáč, a Slovak businessman. 

CMI’s portfolio includes a roughly 17 per cent stake in France’s Le Monde, according to Křetínský.

This year, CMI agreed to carve out Editis, which is behind a group of magazines including the French edition of women’s magazine Elle, from Vivendi’s purchase of Lagardère. Křetínský’s investments also include a 5 per cent stake in French commercial television group TF1.

“I have to say that commercially what we have in the press is not too relevant to the overall group, but we are very proud . . . the social responsibility is very important and I’m very satisfied with the investment,” he said.

In the UK, Křetínský has bought 25 per cent of Royal Mail, 10 per cent of supermarket chain J Sainsbury and 27 per cent of football club West Ham United. 

While he has ruled out a full bid for the club, Křetínský told the FT he may increase his stake in West Ham. “In some situations, for instance in media or sport, you don’t necessarily need to always go for a majority position.”

He added: “If you talk about assets with a very strong emotional connotation, you really need to think twice or three or four times whether the overall equation gives you the right to nominate yourself into the position of the majority owner just by money.”

Křetínský explained that, despite the batch of recent transactions, his team continued to hunt for assets. “We still have some capacity to do some more, but it’s not unlimited. For instance, our retail team has the capability to probably do one more [deal].”

The labor action highlights the biggest issue: Can the auto makers afford to spend what it takes to thrive in the new world of EVs?

A strike is only the most immediate issue facing the two biggest U.S. auto makers. The existential threat posed by electric vehicles is the bigger problem.

EVs are finally taking off in the U.S., but EV-related losses are growing for Ford Motor and General Motors

GM. Now, the companies have some hard decisions to make about how they will spend billions of dollars, decisions sure to have serious consequences for their stocks.

The numbers are huge. Ford is planning to spend roughly $7 billion over the next few years to build brand-new battery plants and EV manufacturing facilities in Kentucky and Tennessee, while GM has committed to spend $35 billion from 2020 to 2025. All told, EV development will probably eat up roughly half of the companies’ spending on new models, plants, and equipment over the next three to four years.

It’s an enormous bet on the growth of electric vehicles—one that should be paying off. Sales of U.S.-made battery-powered EVs rose 47% in the first half of 2023, compared with the same period of 2022, while first- and second-quarter sales for EVs were both record highs. EVs now account for about 7% of new-vehicle sales in the U.S. and 22% in California, showing what’s possible for the rest of the nation.

The problem is, most of the rewards are flowing to just one company, Tesla

TSLA

-0.60%

(TSLA). Despite big pushes by a raft of rivals, Elon Musk’s pioneering company still accounts for nearly 60% of all EV sales in the U.S., down only slightly from two years ago. GM has managed to take just 6% of the market, while Ford has 5%. If the two Detroit icons hope to be long-term players in EVs, which look to be the future of cars, they have little choice but to keep spending huge sums of money.

That goes a long way to explaining the intense contract negotiations with the United Auto Workers, whose members launched strikes after the 11:59 p.m. Thursday deadline expired. Union leadership initially asked for 40% wage increases over the four-year life of the new contract, to compensate for high inflation and past concessions that helped the companies through dark times. The companies, however, say they need the money to fund their huge transition from gasoline to electricity.

The standoff probably means that GM and Ford will have to pay employees even more than what they do now in relation to nonunionized companies like Tesla and Rivian Automotive . “Accepting anything north of 20% pay increases [over the life of the contract] would be a tough pill to swallow for the business model of GM,” says Wedbush analyst Dan Ives. “The winner here is Tesla and Rivian in their nonunion stance.” In other words, Tesla could wind up with still-greater dominance of the industry.

Already, Ford and GM are absorbing big losses from their pushes into electric vehicles. In July, Ford increased its EV division’s full-year projected loss to $4.5 billion from $3 billion, while pushing back a goal of producing roughly 50,000 EVs a month from the end of 2023 to some point in 2024. In the U.S., Ford sold 32,000 EVs in the first seven months of the year, up 3.5% compared with 2022.

GM had a better start to 2023, selling about 36,000 EVs, up from fewer than 8,000 in the first half of 2022, though the 2022 figures were affected by battery problems experienced with the Chevy Bolt. First-half sales increased about 15% from the second half of 2022, putting GM back in position as the second-best seller of EVs in the U.S. GM says it doesn’t expect EVs to be profitable until 2025, but it doesn’t break out figures for the division.

Tesla is the one U.S. EV maker that can accurately be called a success. The company sells more than 58,000 cars a month in the U.S. and produces 150,000 EVs a month around the globe, dwarfing the totals that GM, Ford, and other traditional auto makers sell in a year. Tesla is firmly profitable, with Wall Street projecting a 2023 operating profit margin of about 11%.

From inauspicious beginnings in 2003, Elon Musk launched expensive vehicles like its Roadster, Model S, and Model X before releasing the mass-market Model 3 in 2017. The crossover Model Y followed in 2020. The Model 3 became the first battery-powered vehicle to top one million in total sales.

Tesla’s success seemed to create a blueprint for other auto makers to follow: launch high-price vehicles as a proof of concept, and follow that up with a crossover SUV to tap into America’s love of souped-up station wagons. But the blueprint proved difficult to follow. Everyone from start-ups to legacy auto makers assumed that producing EVs would be relatively easy. There are fewer moving parts, simpler motors instead of internal combustion engines, and even more commonality among vehicle platforms. The same batteries go into a Ford F-150 Lightning as a Ford Mustang Mach-E. But production has been far more difficult than many expected. Ford ran into some battery problems with the Lightning, which halted production for weeks early in 2023 just as sales were picking up steam. GM ran into its own battery issues with the Chevy Bolt. EV start-ups have been hampered by production problems, as well.

“Everyone has struggled to manufacture EVs,” says Benchmark analyst Michael Ward. “Everyone. They’re not easy.”

EV players also thought they could follow Tesla’s strategy of launching expensive vehicles, often north of $100,000, a niche that counts for roughly 2% of the overall auto market, according to data provider Cox Automotive. The Tesla Model S and Model X, GMC Hummer, BMW i7, Lucid Air, Porsche Taycan, Mercedes EQS, and the slightly less expensive Audi e-tron Q8 and Mercedes EQE sold a combined 24,328 units in the U.S. in the second quarter. Tesla’s X and S models captured roughly one-half of that total. There’s just not enough of a market for nine models that are out of reach for most car buyers.

The success of Tesla’s crossover Model Y, the best-selling car in the world during the first half of 2023, spurred other auto makers to launch their own small electric SUVs. That includes the Hyundai Ioniq 5, Kia EV6, Volkswagen ID.4, and Ford Mach-E, among others. The proliferation makes sense: Small and midsize SUVs are among the most popular vehicles in the U.S., accounting for about 33% of all cars sold. But something isn’t translating: The Tesla competitors sold fewer than 80,000 small EV SUVs in the U.S. over the first half of 2023, or about 1,000 per model a month on average, not nearly enough to make the economics work.

Part of the problem is that the average range of a standard and long-range Model Y is about 300 miles per charge, while the average range of the competitors’ EVs is about 240.

“At the end of the day, what consumers care about is the cost of the EV and the range,” says Eli Horton, ETF portfolio manager at activist investor Engine No. 1.

Batteries need to improve, but so does the messaging. Ford and GM can’t use the same marketing strategies that they have used for generations to sell their traditional vehicles—and they can’t rely on the fact that the cars are better for the environment than their gas-guzzling cousins. The Pew Research Center found that about 43% of Americans looking for a car are willing to shop for an EV. Of those, about three-quarters lean Democrat.

“I think there is a political conversation here,” says Global X ETF research director Pedro Palandrani, though he is optimistic that EVs will knock down political walls when they finally become cheaper overall than traditional cars.

The buyers for EVs and combustion-engine cars at the same company even appear to be different: Ford says more than 60% of its EV buyers are new to the Ford brand. That’s good for bringing in new customers, but it also means that existing Ford drivers prefer gasoline. It means that ads have to focus on safety, cost, power, or any other selling feature. But mostly, it comes back to making cars that people love, says Ted Cannis, CEO of Ford Pro, the company’s commercial business. “Businesses are pretty rational [buyers]…they run Excel spreadsheets, ROI models, total cost of ownership,” he says. “People fall in love with cars or a feature in the car…it’s emotional.”

Both companies tell Barron’s they are confident that their strategies will work. That doesn’t mean things can’t be improved.

So, what are Ford and GM to do? Morgan Stanley analyst Adam Jonas expects Ford to lean harder into hybrids, which Ford continues to make and which account for roughly 7% of its U.S. sales and 10% of all F-150 sales. “We’re looking to go to at least 20% next year,” says Andrew Frick, Vice President of sales, distribution, and trucks in Ford’s traditional car business.

But Ford also makes cars that people love—the Ford F-150 and the Ford Mustang come to mind—and it’s betting they will become EVs people love. The market for trucks outside of the U.S. favors smaller vehicles, the size of a Ford Ranger or Toyota Tacoma. A hybrid and all-electric version of the Ranger should be a priority for the company. It’s a market occupied only by Rivian right now with its R1T pickup.

Ford is also the largest seller of commercial vehicles in the U.S. and Europe, with roughly 265,000 fleet customers and 40% of the U.S. market, and that might give it a leg up in the race to sell EVs. “You can see a third of that market easily being electric,” says Benchmark’s Ward.

GM, for its part, needs to target more segments of the EV market. Its recent launches, including the GMC Hummer and Cadillac Lyriq, are priced at the higher end, and the coming Cadillac Celestiq starts north of $300,000. GM is betting big on its EV technology investments, which will lower costs while providing longer range and more features than the competition, and it plans electric versions of the Chevy Blazer and Chevy Silverado, which are due before the end of the year. An electric version of the lower-priced Chevy Equinox is scheduled to be released in 2024.

“I think [GM] is making great strategic decisions with vertically integrating their battery platform,” says Engine No. 1’s Horton, who once owned GM stock in the Engine No. 1 Transform Climate exchange-traded fund (NETZ), but doesn’t right now.

The challenge is to make sure those vehicles don’t go only to early EV adopters but to GM drivers who are trading in gasoline-powered cars at the end of leases or loans. Whether that means offering free charging, free lease payments, or other radical incentives, it doesn’t matter. “A couple of lease payments isn’t a costly incentive,” says Benchmark’s Ward.

Both companies could also take a more holistic approach to targeting EV sales. “The industry thinks of every purchase as an independent purchase,” says Stephen Beck, managing partner at consultancy CG42. “Auto makers need to target households.” There is a compelling case for a least one EV per home.

Yet there is no easy solution for shares of GM or Ford, which have fallen about 21% and 20%, respectively, over the past 12 months. Demonstrating momentum in EV sales—which would bode well for margins—would help shift investor sentiment. With EV profitability not due until 2025 for GM and 2026 for Ford, however, the stocks will still be dominated by interest rates and overall auto sales—assuming the strike is settled—for the next 12 to 24 months.

There is some good news on that front. Car sales are improving, with about 15.3 million new cars sold in the U.S. over the past 12 months, up about 11% compared with the year-ago period. If interest rates and car prices have peaked, that number should move to 16 million or 17 million units. More volume for GM and Ford should be enough to keep profits and cash flow strong while investors wait for EV profits.

The potential rewards could be substantial if the auto makers can deliver. Their stocks are priced, to some extent, for a disaster scenario—an EV market that never develops. GM trades for less than five times 2024 earnings estimates, while Ford trades for less than seven times, both well below the S&P 500 index

SPX

-1.22%

‘s multiple of 18. Those multiples imply there is essentially no growth in profits in either business and that the EV transition will, at best, be neutral to both companies and, at worst, a total loss.

That scenario is not out of the question. John Murphy, an analyst at BofA Securities, sees the whole industry falling behind. He had been expecting EV sales to amount to 11% of new U.S. vehicle sales for 2023, not the 7% registered in the first half of the year. If the demand just isn’t there, a “significant amount of capital has been wasted,” he says. “Yes, it could end up looking like a disaster.”

But Murphy and others tend to think that EVs will prevail. In fact, some analysts project EVs could make up half of global car demand by 2030.

“One thing we remain highly [convinced of] is that the transition to an electrified economy [will] happen,” says Engine No. 1’s Horton. “We’re hitting speed bumps and hurdles all over the place.…There will be more.”

It will be up to Ford and GM to navigate them.

Everyone goes through growing pains, and defense contractor Mercury Systems MRCY –0.16% is suffering from them in a big way. Now a new CEO has the chance to help the struggling company mature into what management—and investors—always envisioned.

Based in Andover, Mass., Mercury (ticker: MRCY) specializes in electronics and chips for the aerospace and defense industries of the U.S. and its allies. Mercury says it has more than 300 programs with some 25 defense contractors, and its products are found in F-16, F-18, and F-35 fighter jets; Predator and Reaper unmanned aerial vehicles; and RTX RTX +0.40% ’s (RTX) Patriot surface-to-air missiles, to name just a few.

Where it once specialized in simpler circuits, switches, and sensors, Mercury Systems has been moving up the value chain from components to entire subsystems—a transition that requires spending billions on mergers and acquisitions and research and development. The company has made 14 acquisitions since 2016, including firms that make aircraft display systems, radio-frequency components, ruggedized computers and servers, and flight control units.

Mercury’s plan on paper has been to combine disparate components into larger subsystems to sell to its defense-contractor clients—boosting sales and profit margins.

“It’s a good strategy because when you’re a subsystem provider, it’s a stickier business than just selling individual components,” says Randy Gwirtzman, co-manager of the $1.4 billion Baron DiscoveryBDFFX –1.18% fund (BDFFX), which owns Mercury shares. “So it was a smart play—it just hasn’t been executed as well as we hoped.”

Mercury may have bitten off more than it could chew, while Covid-19 supply-chain disruptions made the situation worse. Earnings in its latest fiscal year dropped 54%, to an adjusted $1 per share, while revenue was close to flat, at $974 million.

Mercury’s stock, meanwhile, has tumbled from a closing high of $92.80 in April 2020 to $44.74 at the end of 2022, before slumping to $31.50 in June after the company announced that an attempt to sell itself, begun at the behest of activist investors Starboard Value and Jana Partners, would end without a deal.

That’s where the new management comes in. Jana pushed to add Bill Ballhaus—a trained aerospace engineer with a career at a number of major defense contractors—to Mercury’s board last year. He took over the CEO and president roles on an interim basis in June, positions the company made permanent last month.

Mercury also has a new chief financial officer—David Farnsworth, formerly of Raytheon—and several new board members. It will be their job to turn around stalled programs under development that have been tying up resources and weighing on overall profits.

“[Ballhaus] has an outstanding track record executing turnarounds and driving shareholder value, comes in with a head start having been on the board for a year, and he is highly aligned with shareholders with his compensation plan,” says Scott Ostfeld, managing partner and portfolio manager at Jana and a Mercury board member since July.

Ballhaus calls fiscal 2024 a “transition year,” with revenue about flat but profits and cash flow steadily improving through the period. “In my experience, this is not uncommon in businesses that grow rapidly via acquisitions,” he said on the company’s fiscal fourth-quarter earnings call in August. “At Mercury, the immaturity and lack of full integration of key functional areas have led to the serious challenges the company experienced forecasting business performance over the past several quarters. That said, maturing in these areas is doable, within our control, and under way.”

Those operational improvements should start showing up in the numbers in coming quarters. Sales won’t grow much in the new fiscal year—management guidance calls for $950 million to $1 billion in revenue in fiscal 2024, and Wall Street analyst consensus splits the difference—but profits are forecast to rebound 33%, to $1.33 per share. That’s due to tighter integration and oversight of Mercury’s acquired operations and other cost-cutting measures, which will help lower expenses by some $21 million this fiscal year and improve profit margins, the company says.

The key to the turnaround, though, will be getting troubled programs back on track. Just 20 programs subtracted some $56 million from Mercury’s fiscal 2023 adjusted earnings before interest, taxes, depreciation, and amortization, or Ebitda, which would have been $188 million without them.

Those programs have also been a drain on cash flow due to a buildup in inventory, with the company’s working capital totaling 65% of revenue last fiscal year, up from 35% in fiscal 2020. Once those programs—and the R&D dollars spent on them—begin to generate sales, Mercury can release that working capital into free cash flow. Margins should expand as well, and management is targeting a return to low-to-mid-20% adjusted Ebitda margins “over time”—their words—after a dip to 14% in fiscal 2023.

The market doesn’t appear to give Mercury much credit for its ability to figure out its engineering roadblocks and grow up. Shares, at $37.93, currently trade for about 28 times 12-month forward earnings, a discount to the 30-plus times that they received in 2019 and 2020, despite what should be trough profits. It wasn’t that long ago that Mercury was compounding earnings at a double-digit rate and trouncing the market and its peers’ stock performance.

It’s not hard to imagine a world where Mercury matures—and if it does, shares could double in the next three years, especially if they follow earnings growth higher and regain their premium valuation multiple.

Growing up may be painful, but for Mercury Systems stock, it should be worthwhile.

It turns out that the tech IPO market isn’t dead.

In an event that could mark a turning point for both Silicon Valley start-ups and Wall Street investment banks, Arm Holdings ARM –4.47% (ticker: ARM) this past week completed a highly anticipated initial public offering. The deal was a smash hit.

It’s the first tech IPO of any consequence since Intel (INTC) spun off Mobileye Global MBLY +4.00% (MBLY) 11 months ago—and it went as well as could be hoped. At $51, Arm shares priced at the high end of the expected range and opened 10% higher. The stock closed the week up 19% from the offering price, at $60.75. The public market is valuing Arm at $65 billion, about $10 billion below memory chip leader Micron Technology (MU), which generates 10 times as much revenue as Arm .

Arm is now trading for about 25 times its most recent full year of revenue—and at more than 100 times profit. And that could be where things get tricky for the new stock. Needham analyst Charles Shi picked up coverage after the first day of trading with a Hold rating, writing that “valuation looks full.”

The list of medium- and large-size tech companies trading at more than 25 times sales is short: It includes Nvidia NVDA –3.69% (NVDA). And no one else.

Heading into the IPO, some investors expressed concern about Arm ’s soft recent financial performance. The company had revenue in the March 2023 fiscal year of $2.68 billion, down a hair from $2.70 billion the previous year. Net income was $524 million, down from $549 million.

In an interview on listing day, Arm Chief Financial Officer Jason Child said that the year of flat revenue followed a year of outsize growth, when some customers accelerated licensing activity in advance of Nvidia’s then-pending acquisition of the company. Child said investors should look at Arm ’s three-year average revenue growth—around 15%—as a proxy for potential growth.

This was a stock market homecoming for Arm , which first came public in 1998, before being taken private by Japanese holding company SoftBank Group 9984 +2.08% (9984.Japan) in 2016 for $32 billion. In early 2022, SoftBank’s deal to sell Arm to Nvidia fell through in the face of sharp regulatory objections.

Arm has an unusual business model, with no true peers. Founded in 1990 as Advanced RISC Machines, Arm focuses on semiconductor designs. Chip makers license Arm’s work and then pay a small royalty for every Arm-designed chip they sell.

The company generates about 45% of its revenue from the mobile phone market—99% of the world’s mobile phones include Arm-based processors. Arm’s second-largest end market is the Internet of Things, the buzzy name for network-connected gadgets. That business is about to be eclipsed in size by chip designs for cloud computing. The automotive sector is another fast-growing area for Arm.

This is a volume business, and investors will want to see Arm grow its royalties per unit, particularly in mobile phones. In its March 2023 fiscal year, more than 30 billion Arm-based chips were sold, up 70% since 2016.

Arm generates just six cents in revenue per device shipped, according to Child, but he notes that the figure should increase over time as more customers shift to products that use Arm’s more-advanced platforms.

Much of Arm’s pricey valuation is tied to its potential attachment to artificial-intelligence trends. Child calls AI a “huge opportunity” for the company. The market has focused on training large language models, which require the kind of computing power provided by Nvidia’s graphics processors. Over time, though, Child says that more of the opportunity will be in “inference,” software that leverages those models.

Child thinks a lot of that inference work will take place on the devices themselves, where Arm designs are prevalent. HP HPQ –1.73% Inc. (HPQ) and Dell Technologies (DELL) have told Barron’s in recent months that they expect to launch AI-capable laptops in the months ahead.

“The killer app of AI will be that you’ll love your PC again,” Dell Chief Operating Officer Jeff Clarke said in a recent interview.

Child says that most laptop and phone AI workloads will be based on CPUs—central processing units—rather than Nvidia’s pricey graphical processing units. He says that Arm has been in talks with PC makers—including Dell and HP—about designing models with Arm-based processors to supplant the traditional x86-based chips from Intel and Advanced Micro Devices (AMD).

But for all the AI talk, Arm’s near-term revenue is still closely tied to the smartphone market, where growth is slow. Given its rich valuation, Arm will have to quickly prove its AI chops. If it sputters, the stock could as well.

Arm’s strong debut will raise hopes for two venture-backed tech IPOs due in the next few days: Maplebear, parent of the grocery delivery company Instacart, and Klaviyo, the e-commerce marketing automation software company. If those also go well, a flood of additional offerings could follow.