Volkswagen’s Split Could Be Good News

Volkswagen AG (OTCMKTS:VLKAY) has been in the news a lot lately, as the German giant prepares to completely overhaul its internal structure. The group, which employs roughly 600,000 people and has 119 factories around the world, comprises 12 separate brands ranging from mass market cars to luxury vehicles to commercial vehicles. Volkswagen’s chief rival Toyota, on the other hand, employs only around 330,000 people, but delivered more vehicles than Volkswagen last year to keep the global lead. Large overhead expenses and operational inefficiencies resulting from looking after a highly diversified, yet centralized business is considered a reason why Volkswagen hasn’t been able to improve its profitability. The company’s 6% automotive operating margins last year lagged Toyota’s 9.4% margins, and improved to only 6.2% in Q1, mainly because of higher sales volumes for the premium luxury brands that are more profitable.

Citing the highly centralized management structure as one of the obstacles in the way of the Volkswagen group and its profitability targets, the company is now reportedly planning to split its twelve brands into four holding companies, based on their inter-sharing of platforms, parts, and engines, in a logical way to better align its brands and strategies.

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

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This process started in April, with 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.

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 was expected to emphasize more on plugging the structural shortcomings that prevented the group from achieving higher operating margins, and splitting the company might be a step in that direction.

According to the new structure, the volume brands Volkswagen, Skoda, and Seat will join forces under one umbrella led by Herbert Diess, a former BMW man. Audi, Lamborghini, and Ducati will be managed by the current Audi executive Rupert Stadler, and the super luxury brands Porsche, Bentley, and Bugatti together will be led by Matthias Mueller, the existing Porsche chief executive. And the last unit will comprise commercial vehicles from Scania, MAN, and Volkswagen, run by the former Daimler truck chief executive Andreas Menschler. Mr. Winterkorn wants to give more autonomy to Volkswagen, Audi, and Porsche, and also different regional units, giving more decision power to its people working in crucial markets such as the U.S. and China.

Here are a few areas where Volkswagen could improve following the split:

  • Margins For The Namesake Brand Could Improve:

The Volkswagen Passenger Vehicles division continues to struggle, due to lower volume sales (volumes declined 3% year-over-year through May), 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. [1] 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. Operating margins stood at below 2% at Volkswagen Passenger Vehicles in the last quarter. This division forms approximately 60% of Volkswagen’s vehicle deliveries, but contributes only 16% to the group’s valuation by our estimates, owing to the relatively lower price-points and narrow margins. Curbing extra overhead expenses and manufacturing costs, and improving efficiency following the split, resulting in the combination of Volkswagen, Skoda, and SEAT, could have an impact on Volkswagen’s overall profitability going forward.

  • More Independence For China And U.S. Business Units:

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. Sales of passenger vehicles in the country rose 6.4% year-over-year through May, but volume sales for the Volkswagen group fell 1.1%. [2] 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.

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–which could happen following the split, with more decision making power in the hands of the people working on the floor in China.

On the other hand, while Volkswagen has been somewhat struggling in China, its single largest market, it’s going through a tougher time in the U.S. Volkswagen Passenger Vehicles presently sells only two SUVs in the U.S., the compact Tiguan and the upscale Touareg, and despite a 12.6% rise in overall SUV/crossover volume sales through the first five months, the total light truck sales for the brand rose only 2.6% in the country. The problem for Volkswagen in the U.S. is that its largest selling model is the sedan Jetta, which is witnessing a large percentage decline in sales in the country, where the mid-size and large sedan categories are struggling in general. Following the split, the namesake brand might be able to concentrate more on its U.S. operations, and could come out with products more in tune with the current demand trends.

  • No More Expensive Purchases To Hurt Profits?

The exit of Mr. Piech and the internal structure overhaul 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 in numbers. According to Bernstein Research, the Phaeton lost $2.7 billion or $38,000 per car since it was launched in 2002. [3] With the exit of the Chairman, the Phaeton project, along with other expensive and unprofitable projects in the pipeline, might be shelved.

Volkswagen’s internal split could, in time, lead to a more compact, decentralized, and better managed business, which could help the group and its subsidiaries compete better with Toyota, not only in terms of volume sales, but also in terms of profitability.

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  1. Volkswagen seeks savings of 10 billion euros []
  2. China passenger vehicles sales []
  3. Piech Demise Boosts Volkswagen Stock Price, Promising Focus On Profits []