Lower-Than-Expected Volume Sales To Weigh On Volkswagen’s Financials In Q1

The German automaker Volkswagen AG (OTCMKTS:VLKAY) is scheduled to report its Q1 results on April 29. While lower-than-expected volume sales through the first three months are expected to weigh on the top line, profitability could improve for the group. Volkswagen has been in the news in the last couple of weeks as things heated up at the top management level, which led to the chairman’s resignation. The automaker, which has for the last few years aggressively pushed for higher volumes, is now expected to focus more on profitability, especially at the ailing Volkswagen Passenger Vehicles division. Investors have responded positively to this new development, driving a 4% growth in the stock price on Monday.

We have a $44 price estimate for Volkswagen AG, which is below the current market price. However, we are currently in the process of revising our forecasts.

See Our Complete Analysis For Volkswagen AG

Volkswagen has struggled in the first quarter, due to lower sales in some of its key markets. The automaker is expected to take over the worldwide volume sales lead from Toyota this year, however, a slow start to the year has impeded the German automaker’s pursuit for the global sales crown. Despite a 2.5% year-over-year decline in sales to 2.52 million vehicles through March, due to more focus on profitability and the ban on building new factories since 2013, Toyota maintained its lead over Volkswagen, which sold 2.49 million vehicles, up 1.8%.

What has hurt Volkswagen is slowing sales in the U.S., and lower-than-expected sales in its single largest market–China. The group also trails Toyota’s 9-10% margins, with approximately 6% operating margins for the automotive division last year. We expect a slight improvement in profitability for Volkswagen this quarter, partly due to improved operational efficiency, but mostly due to higher proportionate sales for the more profitable luxury brands Audi, Porsche, and Bentley.

Volkswagen Let Down By Lower Sales In Key Markets

• U.S. Sales Continue To Decline-

Volkswagen failed to capture some of the growth in the U.S. automotive market in the first quarter. Continual slowdown in crude prices has bolstered customer purchasing power, particularly in low fuel-tax markets such as the U.S. This, in turn, has boosted vehicle sales in the country, which witnessed its largest automotive demand since 2006 last year. Auto sales in the U.S. continue to grow this year as well, rising by 5.6% in the first three months. However, Volkswagen’s poor form in the country continued, with sales falling 1.4% year-over-year through March, following a 2% decline in vehicle sales last year. The German automaker has lost out on the strong sales growth in the U.S., which has benefited the company’s chief competitors Toyota and GM this year.

Part of the problem for the Volkswagen-branded vehicles in the U.S. has been a weak SUV/crossover lineup, a segment which grew by 11.8% to 5.38 million units last year, forming approximately one-third of the net light-duty vehicle sales in the country. Volkswagen Passenger Vehicles presently sells only two SUVs in the U.S., the compact Tiguan and the upscale Touareg, and despite a 12.4% rise in overall SUV/crossover volume sales in the first quarter, the total light truck sales for the brand fell approximately 8.5% in the country. The company is now working on a lineup of five new SUVs, aimed directly at the U.S. market, in a bid to turn its fortunes around in the country. But as of now, low sales in the U.S. are expected to drag down the group’s top line.

• China Volume Growth Slows Down-

While Volkswagen has for a few years now depended on its strong brand recognition and growth in China, sales growth in the country has decelerated, by more than anticipated. Hurt by weaker economic activity and industry overcapacity, China’s economy has somewhat slowed down, as compared to previous years’ levels. In the first three months, although automobile sales in the country was up 3.9%, this growth rate was 5.3 percentage points lower than the previous year. ^[1] Volkswagen, which is the highest-selling automaker in the country, sold only 2% more vehicles in Q1 compared to the year ago period. The German automaker seems to have lost out on the surge in demand for budget SUVs in China recently.

Production of utility vehicles increased by an impressive 36.7% to 4.32 million units in China last year, and could top 7 million units by 2018, according to IHS Automotive. Net passenger vehicle sales rose 12% in China in March, fueled by a large 64% increase in SUV sales. ^[2] Volkswagen has lost sales due to a surge in demand for budget SUVs/crossovers and minivans in the Chinese auto market, which is why the company lost some of its market share in the country in the first quarter. China is key to Volkswagen’s growth, and the Volkswagen Group China and its two joint ventures, Shanghai Volkswagen and FAW-Volkswagen, are planning to increase production capacity in the country to over 5 million vehicles by 2019, up from 3.5 million vehicles in 2014. Expanded manufacturing capacity will remove supply constraints for the group, but in order to stimulate more demand for its vehicles in China going forward, Volkswagen will have to respond better to the shifting market trends in the country.

Push For More Profitability

Volkswagen’s aim of building more manufacturing facilities across the globe, especially near to the end customers and in low-cost countries, will require large investments that are expected to keep profitability in check in the near to mid term. High initial costs of localizing the Modular Transverse Toolkit (MQB) and Modular Production Toolkit (MPB), the company’s new and flexible vehicle assembly platforms, are also expected to dent margins in the near term. But the high costs of research and development and large start-up costs that Volkswagen is incurring at present could pave the way for a stronger operating performance in the future.

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 (volumes declined 1.3% year-over-year in Q1), 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. ^[3] In effect, the automaker aims to improve operational return on sales for its passenger cars to at least 6% by 2018, up from 2.5% last year. This division forms approximately 60% of Volkswagen’s vehicle deliveries, but contributes only 8% to the group’s valuation by our estimates, owing to the relatively lower price-points and narrow margins. Curbing extra manufacturing costs and improving efficiency could have an impact on Volkswagen’s overall profitability going forward.

Apart from Volkswagen’s aim of becoming the world’s largest automaker in terms of volumes by 2018, the German auto giant is also looking to improve its operating margins to 8% by that time, almost two percentage points above last year’s level. Spurring profitability for the namesake passenger car division, increasing implementation of MQB, which could reduce development costs, start-up costs, and assembly costs associated with setting-up production of a new model, and leveraging the continual strong demand for luxury vehicles, could help the group meet its operating targets in the mid-term.

The resignation of the Chairman and grandson of the inventor of the Volkswagen Beetle, Ferdinand Piech, has also given investors reasons to believe that the group will now focus more on improving its profitability, and ease-off on the aggressive push for more volume sales. The Porsche and Piech families that control Volkswagen, were battling over the future leadership of the company. Ferdinand Piech said that he had lost confidence in Chief Executive Martin Winterkorn. The CEO resisted the efforts to oust him, and was backed by the board, which told Mr. Piech they had lost confidence in him as Chairman. Soon after, Mr. Piech resigned from the position of Chairman and from all company functions.

Mr. Winterkorn might stay in place as chief executive for a few more years, and is expected to emphasize more on plugging the structural shortcomings that have prevented the group from achieving higher operating margins.

Some of the confusion over Volkswagen’s immediate future might be over with the exit of Mr. Piech, possibly giving direction to the company’s mid to long term operating margin targets. However, as of now, lower sales in the U.S. and China, and declining sales at the namesake passenger vehicle brand, are expected to weigh on Volkswagen’s Q1 results.

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