The Volkwagen Scandal has walloped its share price. Is this an opportunity to buy?
NOTE: These are some hastily put together thoughts on the Volkswagen scandal (XTRA:VOW3), originally intended only for the Forager team but Steve thought we could share them via the blog. It’s necessarily very back-of-the-envelope. I won’t outline the fiasco, which is well documented in the FT and everywhere, other than to note the gravity of the situation. Many crises are overblown at the time and soon forgotten, but this one is potentially quite unique. Most crises are either deliberate and small/forgiveable, or are massive but are caused by accident or incompetence (BP/Macondo, Exxon Valdez, GM ignition switch flaws), and thus the company is allowed to pay penance, change its ways and move on. The population of crises that are large in scale and involve deliberate, deeply-entrenched lying (fraud) is small. This could hurt.
The focus of this review is 3-fold:
- To quickly outline what the company owns and how profitable it has been in the past;
- To take a stab at how large the fines + recalls + other costs might be; can the company be salvaged?
- And a quick exploration into the prevalence of defeat devices in the auto industry. Today’s investor will be hoping other companies are get caught up in this; if the whole industry is doing it it’s better than just VW doing it.
1. Company description
VW is a massive car and truck company that sold 10.2m vehicles in 201. According to the company, that makes it the biggest carmaker in Europe and one of the largest in the world, with an estimated 12.9% global market share. The group owns, either directly or through controlling listed investments, VW, Audi, Seat, Skoda, Bentley, Bugatti, Porsche, Ducati (via Audi), Lamborghini (via Audi) and, in trucks, VW Commercial Vehicles, Scania and Man (~75%) owned). To clear any confusion, the company VW is controlled by listed company Porsche Automobil Holding SE (31.5% economic interest, 50.73% voting interest), itself controlled by the Porsche/Piech families through private companies. But the actual car brand Porsche is owned within the VW structure itself and is undoubtedly a valuable asset.
Of the 10.2m vehicles sold in 2014, 4.6m were VW, 1.4m Audi, 0.8m Skoda, 0.5m SEAT and 0.2m Porsche. They also sold 440,000 VW trucks, 80,000 Scania’s and 120,000 Man. Trucks are sold predominately in Europe, and about 4m of the total passenger cars also go to Western Europe. VW China is reported separately, as it is a joint venture that is equity accounted. VW China sold 3.5m vehicles in total, but then there is an adjustment of -1.5m to the total, presumably reflecting the joint venture partner’s share. So about 2m (net) of the 10.2m vehicles were sold in China.
The group naturally has a finance division which as at 31 Dec 14 had €137bn in total assets (€94bn receiveables), equity of €15.2bn and generated operating profit of €1.7bn in 2014. The division provides dealer and customer financing, leasing and fleet management. As with BMW, a good chunk of the finance division liabilities (€23.8bn) are direct banking deposits. My guess (if similar to BMW) is that this is mostly retail deposits from German yield seekers. A bank run couldn’t be ruled out based on this scandal.
2. The opportunity and key value drivers
Given the rushed nature of this analysis, the best way to take a stab at valuing VW on a pre-crisis basis is to take consolidated earnings at face value.
The group reported roughly €12bn in operating profit in 2014, on €212bn of revenue. A little under €11bn of EBIT came from automotive (€9.8bn passenger cars, €945m commercial vehicles) and the remainder from the financing division. This excludes almost €4bn (pre-tax profit, I think) from the equity accounted Chinese JV.
If you back out the finance division, the company is in a net cash position (as with BMW). The group claims that the automotive division has net liquidity of €17.6bn. But the great bulk of this resides in Audi, which is separately listed, and there will likely be tax consequences of bring it back to the parent. For the purposes of this analysis, let’s assume that EV=market capitalisation and recognise that the assumption provides a significant layer of conservatism.
At the current market capitalisation of €57bn, the stock is trading at an EV/EBIT ratio of 4.7, completely ignoring the net cash pile and the contribution of the China JV. It is well under 4 times if you add in the Chinese JV and perhaps under 3 if fully adjusted for the cash pile. But I’m not sure that the net cash is really available.
Various other metrics to note: the PER, which better encapsulates China and any interest on the automotive cash pile, is 5.0x (2014 EPS=€21.90) and 5.5x (2015e Cap IQ); and the stock trades at a discount to book value (about 0.6x BV), despite typically generating low teens returns on equity over the past few years.
We can also look to the listed markets to get a sanity check. The two chief listed investments are Audi and Man SE. Free float sizes are negligible and both trade with a VW-control discount, but might offer some hint to value. Note, Audi has been walloped too as some of their vehicles are involved in the fiasco, these are post-crisis values:
Company VW’s % stake Value of VW’s share
Audi 99.55% €29.3bn (includes substantially all of VW’s net cash)
Man (incl RENK AG) 72.18% €9.6bn
Total equity stakes €38.9bn
So the company owns listed stakes worth €39bn. It has a financing division that I’d argue is worth at least 1.0x book value (€15bn). That brings us to €54bn. Given today’s closing market cap of €57bn, you’re effectively paying zero for the remaining assets. You get the brands VW, Porsche, Skoda, SEAT, VW-branded trucks, Scania trucks, VW’s share of the China JV and more for nothing. VW, VW China and Porsche are compelling assets, as are the truck businesses.
That’s not quite the right way to think about it, of course, because it doesn’t take into account the defeat device scandal, which is going to present real costs. So let’s try and factor that in.
Again, I’m not going to cover the basics here but focus on the potential magnitude and rebuild. The potential hard dollar costs include fines, recall costs, lawsuits, new tests and altering models so they actually comply with standards.
The figure being discussed in the media is that the EPA can charge a maximum fine of $37,500 for each diesel vehicle sold in the US post 2008 (almost 500,000 cars). So the maximum fine imposed in the US is supposedly US$18bn. It seems highly unlikely the company will need to pay that amount in full. GM recently settled for US$900m for a faulty ignition switch linked to at least 124 crash deaths. Incompetence is less severe than deliberately lying, but the real-world consequence of the VW scandal is arguably much lower. It’s a rough guess and in no way a ‘worst case’, but I would find US$5bn present value a disappointing outcome.
Of course, the US sales accounted for only 0.5m of the total number of cars affected, which VW admitted is roughly 11m. The rest of the world is hopefully less fine-driven, although I’m sure the EU will have a go. France has already committed to it (unless/until it finds that Renault is doing the same?). €10bn for whole world fines is my guess of a reasonably bad outcome (number plucked from thin air). I doubt the regulators want to destroy the company, but probably will want to hurt it severely and make an example of it.
I have no idea how any recall plays out. A recall hasn’t been called but is likely in the US, at least. I suspect they’ll need to remove the defeat devices, and then shift the software to lower emissions (no doubt resulting in worse power and performance for the car). I have no idea whether software changes alone will bring it within emission targets or whether mechanical changes are also required or even possible. This is a longer term issue, perhaps taking up to a year before any recalls start.
Again, it’s plucking a number out of thin air, but I’d hope €2.5bn is more than adequate (€5,000*0.5m). It’s unlikely they’ll need to do recalls everywhere, but they might need to do some in Europe and elsewhere. Maybe another €5bn for whole world recalls/adjustments. It’s an unknown I find it hard to quantify without knowing how much it might cost to fix each vehicle.
Lawsuits are another unknown. The potential is large. Imagine the EPA-enforced changes means your VW Golf now has far less power than before, and less power than when you did a test drive. It has ‘class action’ written all over it. There’ll be a costly but hopefully affordable settlement. I’ve read that dozens of actions have already been filed.
Finally, they will presumably have to alter models to comply with standards. This is could be huge or minor; it’s another variable I can’t get my head around but I think is perhaps smaller than it might seem. The ‘major’ argument revolves around complete redesign of car models – that ain’t cheap. Here’s the ‘minor’ argument: if you make the assumption that VW has genuinely come clean here and that ‘only’ 11m vehicles sold since 2009 are affected, the company has sold more than 40m compliant vehicles over the same period (non-diesel). If they can’t find easy/cheap workarounds, they could stop selling those non-compliant models and still have a viable offering. Bear in mind this affects only diesel vehicles and there’s (almost) always a gasoline equivalent for each model affected, ready to go, so there could be some substitution effect. So there might not be even a 20% fall in volume, even if they simply stop selling all these non-compliant models. And that’s the logical action to take if the redesign costs are too prohibitive, at least for the current generation of vehicles.
The stock has fallen €24bn in market capitalisation over the past few days (down approximately 1/3rd), and €70bn (55%+) since the peak in April. I can certainly imagine the recent €24bn reaction being fair, even an underreaction, to the eventual costs involved.
More important than the outright cost of the issue is whether VW’s licence to operate has been irrevocably damaged. If not, the company will be allowed to work through this, and the cost will soak up a few years’ worth of EBIT and equityholders will have something viable and valuable on the other side. I have no final answer to this, but here are some important variables to consider:
a) How high up did the fraud go?
It’s certain that a very large number of engineers knew about the defeat devices, and I would be astounded if the knowledge didn’t reach up at least towards the top of the company.
CEO Martin Winterkorn claims he had no knowledge of the devices, and in his resignation announcement Wednesday, the board effectively agreed with that version of events. It seems likely that any knowledge he has of the devices doesn’t go back years, but might go back months (see my speculation below). 2nd and 3rd level employees are almost guaranteed to get caught up in this, though.
b) When did senior management know?
Here’s where it gets more speculative. But it’s my punt that, while very senior management weren’t involved in the development of the device, they have known about it for some months, and may have been involved in trying to cover it up. I think this is important. If it turns out they’ve been doing a cover up the past few months, it’s harder to emerge the other side of this.
Back in April 2015, the company tried to recall all affected cars in California. This smells. It is possible the company noted the difference between spec and real-world performance by happenstance while being oblivious to the defeat devices, but it also could be that they recognised the issue by April, recognised the EPA threat and attempted a cover up (remove the defeat devices quietly) of the software. I’m sure this will be part of the investigation:
Note at the same time – also April 2015 – VW chairman and one of the Porsche family members, Ferdinand Piech, publically expressed dissatisfaction with VW CEO Winterkorn in Der Spiegel. This is despite Piech being media-shy and despite the two having been close for decades. It looked like the beginning of a coup until other members of the Porsche family backed Winterkorn, and Piech stepped down as chairman. Nobody has suggested this is related to defeat devices, but I find the timing suspicious and wonder if both Piech and Winterkorn, and perhaps the rest of the board, knew by this stage:
To add to the conspiracy theories, the stock peaked in April and had already fallen 35% before the announcement last week. But this isn’t much different to BMW or Daimler, and so I’m not sure the market’s opinion is highlighting anything there.
c) Are other auto companies playing similar games?
This matters. If it turns out that several companies are engaging in similar practices, it makes the VW incident less important and also means the future playing field is more level. BMW, Honda, Renault and Toyota all came out promptly and said they don’t use defeat devices or game emissions tests any other way. But BMW fell 10% intraday today (Thurs 24/9) on a report in Auto Bild claiming the BMW X3 SUV was found in road tests by the International Council on Clean Transportation to generate up to 11x EU norms (I think of nitrogen oxide).
It was apparently ICCT tests that put the EPA into action checking VW, and it’s telling what ICCT’s Peter Mock had to say in that German language article:
All measured data suggest that this is not a VW-specific issue,
BMW have again denied use of defeat devices today. But I wouldn’t be surprised if other companies get caught here, and I think that would be good for VW.
There are some pretty explosive allegations of widespread involvement (at least VW, Chrysler, Ford and GM) from a former EPA staffer in How Common Are EPA “Defeat Devices” In The Auto Industry? Note the EPA tend to consider Japanese cars clean:
When I worked at the EPA, finding these defeat devices was “part of the job.” We never had any trouble with the Japanese, but all the other manufacturers were doing highly suspect things. With microprocessor engine controls in every car, it is very hard to find what is going on.
Once, a VW was in the middle of failing a 100,000-mile driving test (pollution devices had to work for 100,000 miles) and suddenly caught fire, so the test had to be restarted. EPA engineers joked they were sure they saw a broken “Molotov cocktail” on the road next to the car. There were some other VW shenanigans, but they were too complicated to explain. I owned a VW at the time, but it was falling apart constantly so I had no sympathy whatever for VW.
Chrysler got caught doing something like VW, but was caught in testing, so it paid a smaller fine.
Ford lied like crazy and the EPA director had a big photo over his desk of the million $ check for a fine they had to pay. They were also ordered to “behave cooperatively” as opposed to the snarling obnoxious behavior they had formerly exhibited.
I also caught Ford in a defeat device and had to write a memo to them asking for written info instead of the lying (but sooo friendly) PR guys they sent out. They never answered, so my letter was used in court as proof that we had tried but they hadn’t cooperated.
GM was no better, but they were cleverer so we couldn’t catch them in testing. Enforcement division out in the field got them.
Honestly, it was just an “EPA doesn’t tell US what to do” attitude — it would have been cheaper for them if they had followed the Japanese example and just made clean cars to begin with.
Fiat Chrysler’s US unit has in recent days claimed it doesn’t use defeat devices but I haven’t seen any emphatic denials from the head of FCA, and note its stock is down 10% the past few days
d) How can they rebuild
This is a mammoth breach of trust, but they’re taking the right steps. They’ve apologised, they’re cooperating with authorities, they’ve come clean about the 11m vehicles rather than just the US vehicles and they seem determined to ferret out everyone involved and fire them and perhaps initiate criminal proceedings. Next step will be for someone to come down from Porsche and take the reins, or the appointment of a high profile ‘independent’ of unimpeachable pedigree. I think the latter would be ideal if they can find the right person. These steps can all go a long way to rebuilding trust and brand. Forgiveness/absolution is the key here, I think, and more important than the euro cost of the scandal.
A summary of risks
- All the usual you would expect from a car company – cyclicality, capital intensive etc
- Specifics of this fiasco have mostly been covered already, but are largely unquantifiable. You could imagine it destroying the company but I don’t think that’s the most likely outcome. I think it will destroy a few years’ of profit (in present value terms, with the actual costs spread over numerous years), and perhaps impinge margin going forward from there. The margin issue will mostly depend on whether this is a VW-only issue or something much of the car industry worldwide has been involved in. We’ll know soon enough.
- There is going to be massive scrutiny on other issues – fuel efficiency is the most important one that comes to mind, I don’t know whether safety is another. There have been tamperings going on in fuel efficiency too, with German automakers the chief suspects:
Any hope they had for this issue to stay in the shadows is now gone; if they’ve been fiddling it will come to the surface. From a customer forgiveness point of view, this could be a more important issue than the emissions one.
- A bank run on the deposits arm of the finance division
- I haven’t talked much about this, but longer term damage to the brand. According to one poll I read today, this makes 72% of poll respondents ‘less likely to buy a VW’. But I’m pretty sure that changes in a month, and such polls are always ridiculously biased, not-the-least because anyone who never had any intention of buying a VW gets a feel good rush from saying Yes to such a poll.
A correct response to the crisis can rebuild this trust. A fuel efficiency crisis stacked on top would be a major negative though, and I can’t rule that out.
- The autocratic nature of past, and possible future, management. Minority shareholders have never been their chief concern.
That’s a long ramble and, as you can probably tell, we’re still sitting on the fence. If you have any insights into the potential fallout here we would love to hear them.
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