Three Scenarios That Could Impact Volkswagen’s Valuation

Volkswagen AG (OTCMKTS:VLKAY) is a juggernaut in the automotive space, selling more than 10 million vehicles last year, second only to Toyota. It has been a rather rough start to the year for the company, which has underperformed in North America, and has sold fewer than expected vehicles in China — its single largest market. The strengthening dollar has been a boon for Volkswagen, which reports its earnings in euros, and its luxury brands Audi and Porsche are seeing continual strength in sales. However, with the namesake passenger vehicles struggling, lower demand for commercial vehicles, and narrower operating margins, Volkswagen still has a lot of gaps to plug. The uncertainty at the helm of the management has also stirred up a lot of investor interest in the last few weeks. There are a number of factors that could have a major bearing on Volkswagen’s future, and here are three scenarios which could disrupt the group’s valuation at present.

We have a $52 price estimate for Volkswagen AG, which is above the current market price.

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• More Focus On Cost Cutting Than Scale- (15% Upside)

Volkswagen has been in the news in recent times due to the exit of the Chairman and grandson of the inventor of the Volkswagen Beetle, Ferdinand Piech. 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. Piech’s resignation has 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.

Under Mr. Piech’s reign, Volkswagen acquired Scania, MAN, as well as Lamborghini sports cars, and Bentley luxury cars. This aggressive expansion in capacity left many holes in operational efficiency at Volkswagen. 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. This might be the end of an era, and prompt a shift from more acquisitions to more profitability. Volkswagen’s own luxury saloon Phaeton, which was conceived by Mr. Piech, cost fortunes to build and sold only a few numbers. According to Bernstein Research, the Phaeton lost $2.7 billion or $38,000 per car since it was launched in 2002. ^[1] With the exit of the Chairman, the Phaeton project, along with other expensive and unprofitable projects in the pipeline, might be shelved.

The turmoil at the helm of Volkswagen might in time pave the way for higher margins, in particular at the namesake passenger vehicle brand, which has operating margins of less than 2% at present. The Volkswagen group’s automotive margins are just above 6%, thanks to the more profitable Audi and Porsche luxury brands. The strategy now for the company could be getting the profitability at par with the likes of Toyota, which reports around 9-10% margins. Our estimates for this scenario include an increase in operating margins at Volkswagen’s passenger cars division, and a slight cutback on volume sales. This scenario can be viewed on the Trefis website, and further tampered with. In this scenario, Volkswagen’s valuation rises 15% over our base estimate.

• If Volkswagen Loses Out On U.S. Growth- (10% Downside)

The U.S. automotive market has returned to solid growth in the last few years, but Volkswagen seems to have lost out on the surge in sales in the world’s second largest automotive market. Vehicle sales in the country crossed 16.5 million units last year, up 6% from 2013 levels, but, Volkswagen’s volume sales fell 2% year-over-year, and that of its own-branded passenger vehicle brand declined 10% in 2014, despite the strongest vehicle demand in the country since 2006. Volumes continue to drop in the U.S. for the group in 2015. Seeing how Volkswagen Passenger Cars alone forms more than 55% of the net deliveries for the group, a continual fall in sales has kept the group from reaching its target of selling at least one million annual units in the U.S. by 2018. U.S. deliveries dropped 2% to less than 600,000 units last year, and have remained flat in the first four months of this year.

Part of the problem for the Volkswagen-branded vehicles in the U.S. has been a weak SUV/crossover lineup. Volkswagen Passenger Vehicles presently sells only two SUVs in the U.S., the compact Tiguan and the upscale Touareg, and despite a 13.3% rise in overall SUV/crossover volume sales through the first four months, the total light truck sales for the brand fell 2.2% in the country. On the other hand, both GM and Toyota (the closest competitors for Volkswagen) have fared well, with their light-truck sales (which mainly comprise SUVs and Crossovers) up 20% and 14.4% year-over-year, respectively, through April.

Conducive market conditions in the U.S., and a strong SUV/Crossover lineup has allowed GM and Toyota to get an edge over Volkswagen in recent times. Considering that automotive demand is expected to remain strong in the U.S. for some years, Volkswagen might continue to lose out on this growth to its competitors. If Americans continue to opt for vehicles made by automakers other than Volkswagen, there could be a considerable downside for the German company. Our estimates for this scenario can be viewed on the Trefis website, and further modified. Global market share for Volkswagen’s passenger cars will fall further in this case, and the group’s valuation could fall by more than 10% over our current base estimate.

• If China Demand Slows Down By More Than Expected- (10% Downside)

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 four months, automobile (passenger plus commercial vehicles) sales in the country were up only 2.8%, 6.3 percentage points lower than the previous year. ^[2] Volkswagen, which is the highest-selling automaker in the country, sold only 0.2% more vehicles through April 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. For the first fourth months, sales of SUVs were up 48.7% year-over-year, while passenger car sales declined 2.7% in the country. ^[3] 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, and could continue to do so. 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.

Considering that most of the growth in automotive sales in China in the next few years could come from SUVs, and also that Volkswagen already is the largest selling automaker in the country and could lose sales due to stiffer competition in the country, market share for the group could fall in the country. Volume share is expected to fall due to lower sales of the own-branded passenger cars, which form a massive ~55% of the net volumes for the group. Approximately half the net volume sales for the namesake brand are from China. If Volkswagen and its affiliates’ market share falls to just under 10.5% in China by the end of our forecast period, from 13% currently, and down from our present estimate of the market share rising to 13.4% by 2021, the group’s valuation could fall by 10% over our current base estimate.

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More Trefis Research

1. Piech Demise Boosts Volkswagen Stock Price, Promising Focus On Profits [↩]
2. China vehicle sales and production through April [↩]
3. China passenger vehicle sales data [↩]