Volkswagen AG (OTCMKTS:VLKAY) announced its Q2 and half-yearly results on July 31. The German automaker delivered 5.067 million vehicles in the first six months of the year, only 30,000 units shy of the vehicle deliveries reported by the global leader Toyota.  Growth for Volkswagen came on the back of strong volume rises in China, and year-over-year unit sales improvement in Europe, as some of the key markets returned to positive growth. Vehicle sales were up 6.8% from 2013 levels to 5.207 million units. However, the company witnessed a 2.2% contraction in revenues in Q2, hurt by unfavorable currency translation, mainly in Russia, Brazil and Turkey. Owing to the weak economic conditions in South America, and due to the large-scale pre-buys of Euro 5 trucks in Europe in 2013, Volkswagen’s commercial vehicle deliveries, representing just over 6% of the overall deliveries, declined 4.8% through June. The company expects around 3% top-line growth in 2014, after revenues remained flat in the first half. Revenue growth might slowdown given the tough conditions in South America and slower sales in North America.
Margins expanded 12.5% in the second quarter on the back of higher profits for the luxury brands Audi, Porsche and Bentley, despite a 32.5% fall in operating profits for the namesake passenger cars lineup. Going forward, Volkswagen’s profitability could rise with the increasing implementation of the Modular Transverse Toolkit (MQB) and Modular Production Toolkit (MPB), creating an extremely flexible vehicle architecture capable of bringing down manufacturing costs.
We have a $51.34 price estimate for Volkswagen AG, which is roughly 10% above the current market price. However, we are currently in the process of incorporating the latest quarterly results into our forecasts.
China Fuels Growth In Operating Profits For Volkswagen
Volkswagen China & Affiliates are accounted using the equity method and witnessed 10.6% growth in operating profits to around $3.5 million through June. Volkswagen’s passenger vehicle sales in China rose by an impressive 17.5% to over 1.8 million units, owing to the high vehicle demand coupled with the group’s strong brand recognition in the country. In fact, Volkswagen, which leads China’s automotive industry with around 14% volume share, outpaced the overall 8.4% passenger-vehicle-volume-growth in the country through June. This means that the group grabbed further market share, and could continue to leverage its strong positioning in the country to drive growth in the coming future. China leads the global passenger car market, accounting for 28.6% of all passenger car registrations or sales last year, and is expected to form 30% of all global volumes by 2020. ((“New PC registrations or sales“)) Although China’s economic growth is expected to slowdown in comparison to the double-digit growth rates seen in 2010-2011, it is still the world’s fastest growing major economy and continues to attract large-scale investments in the automotive sector. The country’s auto market is projected to grow by around 8.3%, down from last year’s 13.9% volume rise. 
Going forward, Volkswagen, in partnership with the SAIC Motor Corporation and the First Automotive Works (FAW) Group, will invest a whopping 18.2 billion euros (nearly $25 billion) in China between 2014-2018, for the purpose of development of green technologies and resource-efficient facilities. Local production helps Volkswagen evade China’s 25% import tariffs, in addition to the value-added and consumption taxes, allowing the company to compete on a pricing front. As part of this expansion, FAW Volkswagen is investing around $2.7 billion to build new manufacturing plants in Qingdao and Tianjin.  Vehicle demand in China might be slightly affected by the strict emission standards put in place to control pollution. However, in addition to augmenting production capacity to feed the rising vehicle demand in China, Volkswagen is also on a green-drive in the country, in line with the rise in demand for energy-efficient vehicles. The company will launch ten green vehicles in the country by 2018, including launches of the e-Up! and e-Golf this year. This means that Volkswagen is also well poised to make inroads in the electric vehicle market, which presently represents a negligible proportion of the overall market but is anticipated to rapidly rise.
South America Slowdown Impacts Commercial Vehicles
Amid weak economic conditions and weak currencies in South America, Volkswagen’s passenger and commercial vehicle volumes declined 20.2% and 32.6% respectively in the region in the first six months. In particular, the economic slowdown in Brazil and Argentina dragged down volumes, owing to the high vehicle prices and an unfavorable financing environment. Scania and MAN contributed roughly 5% and 8% respectively to net revenues for Volkswagen last year. MAN deliveries fell 11% over prior-year levels to nearly 58,000 units. Going forward, poor conditions in South America could continue to hinder growth in Volkswagen’s commercial vehicle volumes.
Audi Volumes Boost Overall Growth For Volkswagen
Volkswagen’s premium vehicle division Audi, which constitutes about 21% of the company’s valuation by our estimates, posted a strong 11.4% growth in worldwide volumes through June. The German brand is the second largest luxury automaker in the world behind compatriot BMW, and ahead of Mercedes. Audi not only bolstered growth in overall volumes for Volkswagen, but also improved profitability, owing to higher vehicle prices and greater profits on incremental sales. While operating margins for Audi stood at 40% in 2013, the figure for Volkswagen’s own line of passenger cars was 25.5%. With relatively higher growth in Audi volumes, as compared to the namesake passenger cars division, profitability for Volkswagen could further rise this year. The company expects margins to range between 5.5-6.5% in 2014.
In addition, Audi is also expanding its production capacity in North America, in a bid to close-in on BMW and Mercedes in the region. U.S. volumes constituted nearly 10% of Audi’s net unit sales in the first six months of the year. Audi volumes rose by 13.6%, less than Lexus’ 17% growth, but more than the volume rises seen by both BMW and Mercedes. Audi plans to ramp-up production in North America by building its first manufacturing facility in the region in Mexico. The new plant at Puebla will open in mid-2016, and will be the exclusive producer of the next-generation Q5 SUV. For this purpose, Audi is investing around $1.3 billion in Mexico for constructing the facility and developing the new model. Year-to-date sales for the mid-size SUV Q5 rose 8.8% in the U.S. and could continue to rise owing to the high demand for luxury crossovers/SUVs in the country. Luxury SUV volumes rose 10.3% in the U.S. through June, constituting 13.3% of the country’s premium vehicle market. Audi will utilize the Mexico plant, which will have an initial production capacity of 170,000 units, to feed the luxury demand in North America, particularly in the U.S. In addition, local production will help evade the high import tariffs and transportation costs, and along with the cost benefits associated with manufacturing in a low-cost country, Audi could further expand its margins in the coming years.Notes: