The world's largest electric vehicle (EV) market is a gladiator battle. Close to 50 producers in China are offering about 90 EV brands and 430 models, and most are loss making. Incumbents are relentlessly upgrading and expanding their portfolios while new entrants strive to catch up. Within this arena, only some will survive and thrive.

S&P Global Ratings believes many Chinese EV startups will fail or be consolidated as they burn cash with sustained operating losses and high capital spending. Most of these entities are privately owned. They entered the field with great enthusiasm, induced by robust growth prospects and supportive government policies. But operational setbacks have mounted amid difficulties in developing technology, launching products, and obtaining funding. Even the best performers will be racing against the clock to improve volume, profit, and cash flow to stay viable.

The credit standing of large legacy car firms may also slip as they embark on the challenging shift to electrification. Traditional local auto makers that are advancing faster on electrification, including some that we rate, have seen pressure on margins and cash flows. They are striving to expand EV scale to bring down costs and restore profitability. Joint-venture companies are also accelerating their electrification strategies with their market positions at risk.

The pace of EV transition of these traditional auto makers, the competitiveness of their EV products, and the resilience of their gasoline vehicles will determine the progress of consolidation.

Startups Generally Have Weaker Credit Quality

EV startups in China generally have less than 10 years of operation. Despite their short history, many have a record of quickly ramping up production to meet increasing demand. Some have benefited from collaboration with international auto original equipment manufacturers (OEMs). This has provided them with technology licensing fees, lower material costs via joint procurement, and likely support in overseas expansion by leveraging international partners' local production facilities and distribution networks.

That said, several factors constrain the startups' credit profiles. Despite expanding swiftly in recent years, their scale remains considerably smaller than that of many domestic and overseas peers. This means limited market share and pricing power. Some have a narrow product focus, and expansion into different sub-segments (through pricing or technology) carries execution risk. In addition, the companies' footprints are mostly concentrated in China and their brands are little known in the U.S. and Europe. This leaves them dependent on sales into China, the world's most competitive EV market.

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Moreover, most start-ups are still running at a loss due to small production volumes and high production costs and operating expenses. This constrains investment in technology and will hurt competitiveness if it drags on. In an even-worse scenario, liquidity issues may arise as loss-making companies with narrow funding channels gradually run out of cash.

Potholes On The Path To Profit

To make a profit, automakers must hit production thresholds. Market participants generally view an annual sales volume of 300,000-500,000 units as a breakeven point (at the net profit level) for EV makers.

But scaling up is no easy task. Incumbent firms are churning out new models, offering upgraded or revamped versions of existing vehicles at very short intervals to build market share. This is possible thanks to the simpler structure of EVs, improving battery technology and software, and more flexible supply chain management. These factors have shortened the product development cycle of EVs to one to two years. This is a significant reduction from the three to five years needed to develop an internal combustion engine (ICE) model.

New entrants including Xiaomi and Huawei (through collaboration with OEMs) are making the market even more crowded, including the premium segment.

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Price competition has intensified as EV supply continues to rise and demand growth slows. This state of play will likely continue for the next one year or so, in our view, further squeezing margins.

Falling raw material prices offer relief. The price of lithium nickel cobalt manganese battery cells was about Chinese renminbi (RMB) 465 per kilowatt hour (kwh) in March 2024. That means the unit production cost of an EV with a 70kwh battery pack will be roughly RMB20,000 lower than a year ago.

Most EV startups that we monitor are profitable at the gross profit level because they have improved their volume and product mixes in recent years. Some are still struggling to break even due to low utilization rates, price competition, high promotion costs, and inventory impairment.

Operating expenses are a big drain on profitability. R&D spending is substantial, given the continuous investment in electric architecture, autonomous driving, and intelligent cockpits. Other operating costs per unit are also high due to a lack of scale and suboptimal operating efficiency. In terms of EBITDA, therefore, the majority of the EV producers are making losses.

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Li Auto is the only startup with a positive EBITDA margin. Focusing on extended-range electric vehicles (EREV) in the premium segment, the company managed to increase volume faster than peers in the mass-market segment or those purely focusing on battery electric vehicles (BEV). Li Auto's quarterly sales volume exceeded 45,000 units in the fourth quarter 2022 (an annualized volume of 180,000 units). EREVs also have higher margins than comparable BEVs because of their smaller battery capacity and lower production costs.

Having said that, the company's recent performance indicated the fragility of China's EV startups. By our estimate, Li Auto's EBITDA margin fell sharply to about 2% in the first quarter of 2024. This happened as the company incurred higher selling and research and development expenses amid the launch of new products. Its quarterly sales volume also tumbled quarter on quarter amid fierce competition.

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For early-stage companies, their operational and financial performances are inherently more volatile than those with longer track records. This stems from their small scale, continuous shifts in product strategy, time needed to accumulating production knowhow and supply chain management, and changes in industry conditions including technology development, among other factors.

When Will EV Makers Become Profitable?

Most EV producers will likely continue making a loss in the next two years, in our view, due to their small size, high operating costs, and price competition.

A company's capability to turn profitable will depend on product portfolios, R&D investment, and execution. Battery costs and promotion-related expenses also matter. For makers in the high-end EREV segment, the breakeven point for volume can be lower given the high selling price, less severe competition, and lower production costs (versus comparable BEVs).

Mass-market producer Geely Auto's EV business is still making a loss at the EBITDA level, despite an annual sales volume of close to half a million units. The company's overall EBITDA margin dropped to 1.9% in 2023 from 8.3% in 2021, as the EV penetration rate rose to 29% from 6%. This is likely due to the low selling price in the volume segment, high selling expenses of introducing new brands, and persistently high battery cost.

Many Startups Can't Survive The Cash Burn

Despite operating losses, EV startups generally managed to generate positive operating cash flow in 2023, thanks to good working capital management. However, their free operating cash flows are usually negative because of high spending on (1) constructing and upgrading production facilities; (2) developing new models; (3) improving technology; and (4) establishing battery-swap stations.

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While the impact has so far been limited, negative free cash flows will take their toll on balance sheets if sustained. Listed start-ups including Nio Inc. and Xpeng Inc. have accumulated large amounts of cash through IPOs and share placements amid high equity market interest in the EV segment in recent years. This has provided a buffer against cash burn. Nonetheless, access to capital market funding could narrow if their financial performance deteriorates and equity investors' preferences change.

We assume many of the EV startups in this space have cash reserves to last about one to two years, without additional equity funding or debt financing, while sustaining such losses. Entities must be able to generate free cash flow at some point to stay viable.

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With weak products and narrow funding channels, several cash-burning EV startups in China have gone bankrupt or grappling with tight liquidity. With price competition only getting more intense, more producers will likely see their leverage escalate and liquidity shrink in the coming years. Some could be pushed out of the market if local governments do not intervene.

BYD's Drivers: Economies Of Scale, Vertical Integration, Product Mix

BYD Co. Ltd. will likely remain China's biggest EV maker by sales for at least the next two years. The firm has the advantages of large scale, diversified offerings, proprietary technologies, vertical integration, and low costs. These attributes are difficult to replicate quickly, given the technology and investment hurdles.

The company rolled out a wide range of affordable models across different price segments and increased sales volume by 152% year on year to 1.9 million units in 2022. This, together with adjusting its product mix (increasing exposure to plug-in hybrid electric vehicles), helped the company improve its gross margin and EBITDA margin by 2-3 percentage points in 2022. It achieved this despite an increase in lithium carbonate prices of over 240% year-on-year. The margins further expanded by 2-4 percentage points in 2023, thanks to falling raw material costs and 62% growth in sales volume.

Apart from scale, the company benefits from vertical integration with in-house developed components including batteries and chips. These factors underpin the company's cost leadership position and allow it to better mitigate margin pressure amid the ongoing price war.

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Industry Consolidation Will Take Time

With the market gradually shifting towards EVs and new players emerging, China's auto industry has become less concentrated since 2020.

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The exit of weaker EV producers will help industry consolidation. However, the impact will be marginal given their small size.

The key for industry consolidation lies in the competitiveness of traditional auto OEMs that retain large (albeit lower than previous) market shares and still focusing on ICE vehicles. Their ability to protect their market position will depend on the resilience of their ICE vehicles and their progress in electrification, either through strengthening in-house development of their own products, or through collaboration with the more tech-savvy EV players. The incumbents may also seek to acquire small, struggling EV players to jumpstart the process. With ample resources and brand goodwill, some of them could plausibly make breakthroughs in the EV segment. As a result, the direction of these EV laggards will complicate industry dynamics over the next two to three years.

Positive Margins And Free Cash Flow Are Crucial For Sustainable Operations

China's EV startups are still in the early stages of development. Evolving technology, fast-changing industry dynamics, and a lack of long and stable performance records bring difficulties in assessing the credit profiles of these companies.

The evolution of our ratings on Tesla Inc. (BBB/Stable/--) is a good example of how creditworthiness can change in line with operational and financial performance. Our rating on the company remained at 'B-' for several years due to uncertain market demand, high execution risk in increasing production, high leverage, and negative free operating cash flows. However, we have raised the rating a number of times since 2020, when we expected continuous sales volume growth, meaningful margin improvement, and positive free cash flow to sustain.

For EV startups in the first few years of operation, liquidity will be an important factor in our analysis. Firms will find funding challenging before they prove the effectiveness of their product strategy, technology capability, and overall competitiveness. As they strengthen by enhancing portfolios and operating efficiency, the ability to build a record of healthy margins and consistent positive free cash flow will be pivotal to credit quality.

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Survival Of The Fittest

China's EV buildup has slowed in recent years after the initial frenzy. There were close to 500 EV producers registered in China in 2019. But many never even began production for various reasons. Only 46 EV producers have recorded EV sales. While we cannot rule out the possibility of additional entrants, market participants are becoming more rational. This comes after the phase-out of central government subsidies and escalating competition. Over 10 startup companies have gone bankrupt or entered a liquidity crunch in the past two to three years. Many more will likely go bust, but a handful very plausibly could go on to be large, profitable, global entities.

Related Research

• Asian Auto: Resiliency Over Adversity, May 23, 2024
• China Auto: Margin Pressure Heightens, April 29, 2024
• Global Auto Sales Forecasts: Slower EV Growth Offers Temporary Relief To Legacy Automakers, April 26, 2024
• Credit FAQ: China’s Different Paths To Driving Consumption, Electric Vehicles, April 24, 2024

This report does not constitute a rating action.