Volkswagen Earnings Review: China Growth And Luxury Volumes Lift Overall Profitabilty

Volkswagen AG (OTCMKTS:VLKAY) reported strong operating results for Q3 on October 30, highlighting the company’s commitment to expanding profitability, in addition to boosting vehicle deliveries. Revenues from the automotive division, which constitutes around 88% of the net sales, rose 2.2% this quarter to 48.9 billion euros (around $61.4 billion), to consolidate a flat sales growth through the first three quarters for this division. ^[1] Despite a 5% increase in vehicle deliveries through September, sales were marred by unfavorable currency translations, particularly in South America and Eastern Europe. However, what bodes well for Volkswagen is that sales this year in Western Europe have remained strong, following economic instabilities in the prior years, and could continue to drive vehicle volumes in the coming quarters. Despite the sales downfall in Russia and Ukraine, rejuvenated vehicle volumes in Western Europe fueled growth in overall passenger vehicle deliveries to nearly 3 million through September, up 5.4% year-over-year.

Apart from strengthening sales in the domestic market, Volkswagen’s China business, which is accounted for in the financial result using the equity method, continues to bolster income growth for the German automaker. The company recently announced plans of further extending cooperation with its joint venture partners in China, in a bid to expand production capacity in the country and further gain from future growth in the country’s automotive industry. In addition to the business growth in China, what boosted Volkswagen’s cash flow this quarter was a rise in automotive profits by 20% over 2013 levels, pushing margins up by almost 100 basis points to 6.4%. In this article, we will focus on Volkswagen’s China plans and anticipated margin growth, as the German company gears up to overthrow Toyota Motor Corp (NYSE:TM) as the world’s highest-selling automaker this year itself.

We have a $48.14 price estimate for Volkswagen AG, which is roughly 15% above the current market price. Automotive stocks have in general remained weak in the last three months, and Volkswagen’s stock has fallen 10% during this period, amid the news of China fines, and slowing automotive activity in South America and Eastern Europe.

See Our Complete Analysis For Volkswagen AG

Volkswagen’s deliveries have risen 5% year-over-year in the first three quarters to 7.54 million units, and if this growth rate continues in Q4, overall deliveries for the company will rise to over 10.2 million units in 2014. ^[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 74,000 units. But apart from gaining volumes over its chief competitor, Volkswagen eyeing strong growth in margins going forward, to near the 10% figure reported by Toyota.

Margin Expansion To Be Fueled By Modular Toolkit

Although Volkswagen’s automotive margins expanded 100 basis points to 6.4% this quarter, higher research and development investments, particularly related to the company’s own brand of passenger cars, are weighing down profitability. Volkswagen’s own passenger car volumes fell 3.2% through September, not only dragging down top line growth, but also narrowing margins for the group. The division’s operating margins stood at 2.3% for the quarter, mainly as volumes remained low in South America and the company continued to invest higher on new models. The company has now launched an efficiency program for its passenger cars in order to improve operational return on sales to around 6% by 2018. As this division forms over 10% of the group’s valuation by our estimates, curbing extra manufacturing costs and improving efficiency could lift Volkswagen’s overall profitability.

One of the main reasons for cost reductions in production could be 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.

Volkswagen’s own passenger cars have pulled down the overall operational return on sales in the recent years, but with an expected increase in this division’s margins in the mid term, coupled with the high margins for Audi, Porsche and Bentley, Volkswagen could very well reach the 9-10% operating margins figure in five years time. Owing to the high demand for luxury vehicles and their relatively high product prices, Audi, Porsche and Bentley’s margins stood at 9.7%, 15.6% and 9.9% respectively in Q3. These luxury vehicle divisions continue to outpace the overall volume growth for Volkswagen, and are expected to fuel growth in net profitability in the coming years due to higher proportionate sales.

China To Boost Overall Volumes Going Forward

Buoyed by a 15% increase in vehicle deliveries in China, Volkswagen’s single largest market, the company’s share of operating profits attributable to the Chinese joint ventures grew 11.4% to 3.9 billion euros ($4.9 billion) through September. Volkswagen, together with its Chinese automotive partners FAW and SAIC, already operates around 17 production locations in China. The company recently announced plans to further expand its manufacturing base in the country, to increase the volume of locally produced vehicles. Volkswagen’s joint venture with SAIC, Shanghai Volkswagen, announced the construction of a new production factory in Changsha, while FAW-Volkswagen will build two new production facilities in Qingdao and Tianjin. ^[3] 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. Moreover, amid increased scrutiny of China’s policy regulators on import of luxury foreign-based vehicles, expanding the local manufacturing base might bode well for Volkswagen in the long term.

Although the China Association of Automobile Manufacturers forecasts China’s automotive market to grow by 8.3% this year, down from the 13.9% growth seen in 2013, the country is still the fastest growing vehicle market in the world. Volkswagen already leads China’s automotive industry with around 14% volume share, and with volumes rising over 15% so far this year, more than the growth in the country’s overall vehicle market, the company is further growing its market share. Continual strength in Volkswagen’s China volumes is one of the reasons why we expect the German car company to overtake Toyota as the world’s highest-selling automaker this year itself.

View Interactive Institutional Research (Powered by Trefis):
Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap
More Trefis Research

1. Volkswagen Q3 results [↩]
2. Volkswagen September sales [↩]
3. Volkswagen press release [↩]