Volkswagen Earnings Preview: Luxury Divisions To Drive Margin Expansion In Q3

Volkswagen AG (OTCMKTS:VLKAY) is on its way to cross record volume sales of 10 million this year, and possibly even overthrow Toyota Motor Corp (NYSE:TM) as the world’s largest automaker this year itself. The numbers so far this year support this estimate. Volkswagen’s deliveries have risen 5.3% year-over-year in the first three quarters, and if this growth rate continues in Q4, overall deliveries for the company will rise to over 10.2 million units in 2014. ^[1] This figure still excludes volumes for the commercial vehicle brands, MAN and Scania, which could then increase net volumes by around 2%. Toyota, on the other hand, has witnessed only a 2.8% rise in volumes through September, allowing Volkswagen to narrow the sales gap to roughly 215,000 units.

Toyota has stressed on its focus on building better cars and improving profits, rather than selling more volumes. While the company’s operating margins for the automotive division stood at 10% last quarter, Volkswagen’s automotive margins were only 6.3%, on the back of poor volumes and operating margins of only 2% for its own branded passenger vehicles. Volkswagen might not have let up on investing aggressively in its own passenger vehicle division this quarter again, and coupled with the fact that deliveries for this division remained flat in Q3, segment margins could remain low and drag down the automaker’s overall profitability. Volkswagen expects margins to range between 5.5-6.5% this year, and with low profitability for its namesake passenger vehicle division, which constitutes just over 10% of the company’s valuation according to us, much of the margin expansion in Q3 will be expected to come from luxury vehicle brands Audi, Porsche and Bentley.

In view of the scheduled announcement of Volkswagen’s Q3 results on October 30, we focus on what could drive the company’s margin expansion, if at all, this quarter, apart from a rise in volumes. We have a $48.14 price estimate for Volkswagen AG, which is roughly 16% above the current market price. Automotive stocks have in general remained weak in the last three months, and Volkswagen’s stock has fallen 12% during this period, amid the news of China fines, and slowing automotive activity in South America and Eastern Europe.

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Expect Audi, Porsche And Bentley To Drive Profitability In Q3

Audi, Porsche and Bentley together formed 16% of the vehicle deliveries for Volkswagen last year, but these divisions contributed over 60% to the net operating profits for the automobile division, mainly due to the comparatively higher product prices. Our estimated EBITDA margins for Audi, and Porsche and Bentley in 2013 were 22% and 40% respectively, while the overall margins for the company stood at only 13%. The automaker’s profit growth this quarter again will depend on its premium car segments, amid flat volumes for its own passenger vehicles and anticipated lower volumes for commercial vehicles. Volkswagen’s own commercial vehicles delivered 4% fewer vehicles in the third quarter, and together with MAN and Scania, could lower the top line and reduce profits for the company this quarter. This is mainly as volumes remained low in Europe in Q3 due to the large-scale pre-buys of the Euro 5 trucks at the tail-end of last year, and slowdown in the commercial vehicle industries in South America amid tough economic conditions, especially in Brazil.

Audi grew vehicle deliveries by 8% in the third quarter, mainly on the back of higher sales in China and the U.S., the world’s two largest premium automotive markets. Audi enjoys the lead in China’s automotive market over its compatriots BMW and Mercedes-Benz, with over 30% volume share, according to our estimates. In fact, Audi has sold more than double the vehicles sold by Mercedes-Benz in China so far this year. According to China Association of Automobile Manufacturers, the country’s automotive market will grow by 8.3% this year, down from the 13.9% growth seen in 2013. But luxury demand in the country still remains strong and this segment is expected to grow by 13.5% or so in 2014, fueled by increasing disposable incomes and high popularity of entry-level luxury sedans. On the back of its stronghold in the Asian country, Audi is expected to sell higher volumes this year. The luxury brand is already the market leader and has further expanded its share in China, by improving volume sales by 16% through September in the country, outpacing the estimated growth in the overall premium vehicle segment in the country so far this year.

On the other hand, Porsche, which sells mostly in North America, witnessed an impressive 25% growth in vehicle deliveries in Q3, buoyed by rebounding Western European markets and high growth in the Asia-Pacific region. Porsche volumes also grew 12% in the U.S., its single largest market, while the country’s overall premium vehicle market grew 4% through September. ^[2] Although Porsche constituted only around 2% of the net volumes for Volkswagen this quarter, we expect the brand to significantly boost the company’s operating profits. In fact, Porsche earns industry-leading profit per vehicle, almost equal to the revenue per unit for a non-luxury passenger car. Last year as well, while Porsche and Bentley together formed only 2% of the overall unit sales, the two high-end luxury vehicle brands formed 22% of the net operating profits for the automobile divisions, owing to the relatively higher price points.

Volkswagen Looks To Expand Margins Through Lower Costs Of Production

Audi sells around one-third its volumes in China and Porsche sells around 26% of its volumes in the U.S., and with premium vehicle demand in both these countries remaining high this year, contribution of the luxury vehicle divisions to overall Volkswagen deliveries has increased. This favorable product mix should be one of the main reasons if the automaker manages to expand its profitability this quarter, despite the slowdown in sales for the Volkswagen branded passenger and commercial vehicles, Scania and MAN.

Going forward, another reason why Volkswagen’s margins could expand is 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. This platform allows the German car maker to standardize its production process for small, medium and long cars. So far the system has been used to manufacture the Volkswagen Golf, Audi A3, Seat Leon and Skoda Octavia, and the company plans to use this system for most cars in the Volkswagen, Audi, Seat and Skoda portfolios in the coming years. The platform enables the company to make enormous cost savings by reducing weight and enabling easy installation of luxury technologies in high volume models, which then allows the automaker to lower the average price of its vehicles. As a result, Volkswagen could not only compete better on a pricing front and further improve volume sales, but the large cost reductions could help boost profits and subsequently cash flow for the automaker in the coming years.

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1. Volkswagen September sales [↩]
2. Auto sales in the U.S, wsj.com [↩]