The Year That Was: Volkswagen

2014 in all probability will be a record-breaking year for Volkswagen AG (OTCMKTS:VLKAY), which is expected to cross the 10 million unit sales mark by year end, and possibly even overtake Toyota as the world’s largest automaker. The German auto giant has delivered 9.08 million vehicle units through November, up 4.6% year-over-year, excluding sales figures for the commercial vehicle units Scania and MAN. Although Volkswagen might overtake Toyota this year in terms of volumes, the company still trails the latter’s 10% or so operating margin figures. Volkswagen’s automotive margins stood at 6.37% through September, and although this is a 50 basis points improvement over 2013 levels, the automaker will look to further push-up profitability, in tandem with the push for higher volume-growth, in order to boost cash flow.

This year also saw a slight hiccup in cash flow for Volkswagen, with the company’s joint venture FAW-Volkswagen being fined 249 million RMB ($40.6 million) by China’s antitrust regulator, the National Development and Reform Commission (NDRC), for monopolistic practices pertaining to highly inflated vehicle and spare part prices for its luxury division Audi. But minus the antitrust probe, it has been a good year for Volkswagen and its premium vehicle divisions, which carry higher margins and could be instrumental in bolstering overall profitability, going forward.

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

Luxury Brands Hold The Fort

Volkswagen boasts a wide range of brands, including Skoda, SEAT, luxury divisions Audi, Porsche, Bentley, and Lamborghini, Scania and MAN, and its own branded passenger and commercial vehicles. Around 60% of the net operating profits for Volkswagen so far this year have come from the luxury vehicle divisions, 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.

On the other hand, operating margins through the first three quarters for Audi, Porsche, and Bentley stood at 9.7%, 15.7%, and 10% respectively. In fact, Porsche earns industry-leading profit per vehicle, almost equal to the revenue per unit for a non-luxury passenger car for Volkswagen. Led by strong double-digit volume growths in all the leading premium vehicle markets in the world, Porsche’s volume sales have grown 15% in the first eleven months of the year. High demand for high-end luxury vehicles, and more return on sales for the Porsche brand, could be important in Volkswagen’s quest for more cash.

While Porsche is the most profitable brand for Volkswagen, Audi is the highest-selling luxury brand for the automaker, and also the second largest premium vehicle brand in the world, behind BMW. Audi has narrowed its gap with BMW through November, growing volume sales by 10.1% and outpacing the latter’s volume growth of 9%. China continues to handsomely contribute to Audi’s top line, forming nearly one-third of the brand’s unit sales. While Audi will remain behind BMW in terms of volumes in 2014, competition between the two brands could get fiercer in the next couple of years. Audi plans to step-up investment by 2 billion euros ($2.44 billion) to a record 24 billion euros over the next five years on new models, new plants, and newer technology, in a bid to catch-up with BMW. ^[1] Approximately 70% of the planned investment will be in new cleaner technologies such as plug-in hybrid vehicles. As the world gears up for cleaner low-emission and more environmentally viable vehicles, Volkswagen and its Audi division will also look to capture some of this growth. The global light-duty plug-in electric vehicle (PEV) volumes are expected to grow at a CAGR of 24.6% through 2023, compared to only 2.6% growth in the overall light-duty vehicle market.

New Modular Architecture To Boost Profits

Apart from greater proportionate sales of luxury vehicles, Volkswagen will look to cut costs of manufacturing and operations to save more cash. One of the more bankable initiatives by Volkswagen to cut costs could be the Modular Transverse Toolkit (MQB) and Modular Production Toolkit (MPB), introduced in 2012 and implemented for a handful of models this year. The MQB and MPB 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.

Volkswagen 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, and hopes to boost overall operating margins to approximately 8% by 2018, a two percentage point improvement from 2013 levels. While much has been said about Volkswagen’s push to be the largest automaker in the world by surpassing 10 million unit sales this year, we will also keep a close eye on the automaker’s profitability, which could improve come 2015.

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1. Volkswagen’s Audi to step up investments in 2015-19 on models, plants, reuters.com [↩]
2. Volkswagen seeks savings of 10 billion euros [↩]