How It Might Be A Lose-Lose Situation For Volkswagen In China

When the tide is high, it takes out everything in sight, even the entities that once seemed formidable. Volkswagen AG (OTCMKTS:VLKAY) has for a few years now depended on its sales in China to fuel overall growth. The group is the highest-selling automaker in the country, where the motorization rate is approximately 100 vehicles per 1000 individuals, compared to nearly 800 vehicles per 1000 individuals in the U.S.– so there is still room for growth in China. However, in China, the slowing economic conditions, precipitous fall in the stock market, slowdown of infrastructure and real estate sectors, has hurt customer sentiment, and the spillover of this can also be seen in the country’s automotive market.

We have a $46 price estimate for Volkswagen AG, which is above the current market price. The stock has declined a considerable 26% in the last three months alone.

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Sales of passenger vehicles in China are up 3.4% year-over-year through July, but sales have fallen in each of the last two months, including a 6.6% decline in July. The volatility in the Chinese auto market could continue through the rest of the year, and the market could possibly even see a decline in the number of vehicles sold for the full year (over 2014 levels), as per the low end projections by Ford, for the first time since at least 1998, before which only production numbers are available for China.

Earlier in the month, China devalued the renminbi against the U.S. dollar, the biggest one-day currency move in over two decades, in a bid to spark an increase in exports and boost economic growth. And now the country has cut interest rates, flooding its banking system with liquidity. A devalued renminbi might be helpful for domestic manufacturers who export, although some still argue how the one-off devaluation might not be enough, but where does it leave the foreign automakers?

The Chinese customers, who typically chose the globally recognized and popular foreign brands are now reverting to the domestic manufacturers. Why? Because the price sensitivity of consumers has increased amid the slowdown and crashing of the stock markets, and the domestic makers have considerably lower price-points when compared with the foreign automakers who import their vehicles. A tough pricing environment in China, and slight reduction in disposable incomes, have impacted the financials of key foreign automakers, which have lost approximately 3.7 percentage points of market share to domestic manufacturers so far this year in the country. Volkswagen has also surrendered share in China this year, with its vehicle deliveries declining by 5.3% year-over-year through July, compared to the 0.4% rise in all automobile sales in the country.

Devaluation of the renminbi will further hurt Volkswagen. Although the Volkswagen Group China and its two joint ventures — Shanghai Volkswagen and FAW-Volkswagen —  locally produce almost 95% of the vehicles, the sales of the rest of the volumes, which are imported, could take a hit due to the lesser valued local currency. In an already tough pricing environment, Volkswagen might look to protect its profitability by scaling up prices of the already premium-priced imported units such as the Audi Q3 and Q5, which presently hold leading positions in the imported SUV market.

And speaking of SUVs– that’s where Volkswagen has struggled too. There has been a shift in customer preferences from sedans to SUVs/Crossovers, and this has caught Volkswagen somewhat off-guard. Sales of SUVs are up approximately 45% in China through July, even when the rest of the market crumbles around it. Budget SUVs are the biggest success, and are the primary reason why the domestic manufacturers have seen strong growth in a slow market this year. Other foreign automakers have also had to adjust their strategy in China according to the shifting demand trends. GM’s volume sales in China declined 4% in July, but year-to-date, the sales are up 3.4% over 2014 levels. Around 83% of GM’s China volumes constituted sedans last year, but the company has emphasized  sales of its SUVs, such as the Baojun 560, to gain from the large demand for these larger vehicles.

So Volkswagen is not only losing volumes in China due to a slower market, but is also losing share to its competition– both domestic and foreign automakers. And now the currency devaluation means that the imports could suffer. Volkswagen reports the earnings from China as per the equity method, and the weaker renminbi will mean lower revenues for the group when converted to euros.

It’s really a trade-off between lowering production levels in China due to the slowing demand, or losing profits due to the unfavorable currency translations. Either way, it isn’t a rosy picture for Volkswagen in China. And given that the country forms over one-third the net vehicle deliveries for the entire group, a group that delivers over 10 million vehicles annually across the globe, the downturn in China and Volkswagen’s weak performance in the country are expected to continue to drag-down the automaker’s financials.

See the links below for more information and analysis:

• Volkswagen’s troubles run deep
• How premium automakers are faring in a slower Chinese market
• Volkswagen’s split could be good news
• Volkswagen: turnaround in the U.S. fortunes?
• Mercedes-Benz is catching up with competition in China
• Who will gain most from the large SUV/Crossover demand in the U.S.?
• Trefis analysis: Volkswagen China and Affiliates Vehicles Sold
• Trefis analysis: Volkswagen Passenger Cars, SEAT, LCVs Revenues
• Trefis analysis: Volkswagen Audi Revenues

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