Volkswagen Looks To Boost Profits For Its Own-Branded Passenger Cars


Volkswagen AG (OTCMKTS:VLKAY) is on its way to overthrow Toyota Motor Corp (NYSE:TM) as the world’s largest automaker in terms of volume sales this year, while simultaneously crossing the record 10 million annual unit sales mark. Volkswagen’s deliveries rose 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. [1] Toyota, on the other hand, witnessed only a 2.8% rise in volumes through September, allowing Volkswagen to narrow the sales gap to roughly 74,000 units. Volkswagen might win the battle of volumes with Toyota, but the German manufacturer still trails the latter’s operating performance. While operating margins at Toyota range between 9.5-10.5%, Volkswagen’s margins remain below 7%.

We have a $44 price estimate for Volkswagen AG, which is roughly in line with the current market price.

See Our Complete Analysis For Volkswagen AG

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Let’s deconstruct Volkswagen’s profit problem. Around 60% of the net operating profits for the company last year came from the luxury vehicle divisions Audi, Porsche, and Bentley, which together formed only 16% of the vehicle deliveries, mainly due to the comparatively higher product prices. The let down for Volkswagen has been its own namesake passenger vehicles division, which is dragging down the company’s overall operating performance as margins remain below 3% for this division.

The main reasons for lower profits at Volkswagen Passenger Cars is lower volume sales, and high research and development costs incurred by the group to push for innovation at the ailing vehicle division. The company is now aiming to save around 10 billion euros ($12.4 billion) through efficiency initiatives, with the target of 5 billion euros worth of cost-savings at its own-branded passenger vehicle division by 2017. [2] In effect, the automaker aims to improve operational return on sales for its passenger cars to at least 6% by 2018, up from 2.9% last year. 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.

Large Cost-Savings Expected From Implementing The Modular Toolkit

Volkswagen boasts a diverse brand portfolio, including its own branded passenger cars, Skoda, luxury vehicle divisions Audi, Bentley and Porsche, and commercial vehicles Scania and MAN. In 2012, Volkswagen introduced its Modular Transverse Toolkit (MQB) and Modular Production Toolkit (MPB), to help the automaker create a single, more flexible platform to produce vehicles for all the brands across its portfolio, limiting extra assembly costs. The start-up costs for MQB run high, but in the long run, this extremely flexible vehicle architecture is capable of bringing down manufacturing costs significantly. Going forward, increasing implementation of MQB will also allow Volkswagen to reduce development costs, start-up costs, and assembly costs associated with setting-up production of a new model. For example, Volkswagen is currently planning on building a compact SUV in India, and could build this model using the MQB platform. Although localizing MQB would be more expensive at first, other Volkswagen brands in the country such as Audi and Skoda could leverage the very same platform in the future to build their own compact or subcompact SUV in India.

The MQB 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.

The company is looking to boost overall operating margins to approximately 8% by 2018, a two percentage point improvement from 2013 levels. We currently estimate adjusted EBITDA margins for the Volkswagen Passenger Vehicles division to rise only to 4.7% by 2018, up from an estimated 4% this year. However, if Volkswagen manages to extract higher profits through the ongoing efficiency program, and adjusted EBITDA margins rise to 7% by 2018 for this division, there could be a sizable 20% upside to our current price estimate for Volkswagen.

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Notes:
  1. Volkswagen September sales []
  2. Volkswagen seeks savings of 10 billion euros []