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Volkswagen Faces Complex Issues

Volkswagen: a snapshot going into this crisis

Before “diesel-gate”, VW was facing a slowdown in emerging market demand and a stale product line up. VW is the global no 1 automaker with 12 brands but its reach is uneven.

The USA is a small market for VW, only 600k of VW’s 10.2m annual car sales (5.9%). A major issue is VW’s weak SUV line up (sports utility vehicles) – four new VW SUVs are planned by 2018. But VW is relatively poorly received in the Americas, unit sales fell by 2.4% in North America (0.88m) and 19.6% in South America (0.8m vehicles) in 2014.

China/Asia Pacific is vital for VW (4.1m vehicles) as the principal source of growth – unit sales were up 13.3% in 2014. To meet growth forecasts, VW’s joint venture with First Automotive Works is investing €22bn in facilities between 2015 and 2019.

Europe is VW’s largest market (4.4m vehicles) with growth of 5.2% in 2014. The outlook for 2015 is mixed with some countries expected to see sales growth but other areas flat or lower. Total revenues from passenger cars sold at €99.8bn in 2014 was only up 0.4% on 2013 €99.4bn, whilst operating profit fell 14.4% to €2.47bn.

VW Passenger Cars Sales Operating profit Unit Sales Growth
€99.4bn €2.47bn  -2.6%

VW Commercial vehicles (Scania, MAN, and Caddy) saw unit sales decrease 5.4% (646k) in 2104 with sales of €9.6bn with MAN sales falling 14.4%. Sales were hit by the introduction of the new Euro 6 emission standard at the start of 2014.

VW Commercial/ Power Engineering Sales Operating profit Unit Sales Growth
€33.9bn €0.9bn -5.4%

The VW Leasing business generates €22.1bn revenues and €1.7bn operating profit – but it has only €15.1bn of invested equity supporting a loan book of €137bn.

VW Financial Services Sales Operating profit Contract Growth
€24.9bn €1.9bn 14.3%

Source: VW Annual Report 2014

Liability estimation is difficult, precedents provide guidance

The problem with liability comparisons is VW has admitted criminal intent/ fraud. This is rare for a multinational in similar circumstances. BP argued negligence not gross negligence for years. In VW’s case this admission means the regulatory agencies, government, and other plaintiffs do not need to prove liability – it has been admitted. Hence the highest level of criminal damages can be levied –the issue is damages.

US safety regulators recently took a tough stance with Fiat Chrysler; in July 2015 they insisted c. 0.5m Ram pickup trucks, with defective steering had to be repurchased by the manufacturer. This was a first for the industry, but sets a precedent for VW. It is possible that the US Dept of Justice will insist on monetary compensation for US consumers.

In February 2014 GM recalled 3.3m cars due to a faulty ignition switch that shut off the engine while driving. This resulted in GM compensating for 124 deaths (vs 18 the initial GM claim). In addition GM was fined $900m by the US government. GM was an example of the US liabilities that can be incurred for negligence ($1,125 per car). It is worth breaking down the 2014 GM recall liabilities:-

GM 2014 faulty ignition switch- cost to date c. $5bn

Cars & Trucks Cars Sold / Recalled Recall Cost Regulatory Fines Compensation Fund for Customer Redress Future expenses
USA 3.3m $2.8bn $900m $400m $874m
Expense Booked H1 2014 H1 2014 Q3 2015 H1 2014 H1 2014
Claim basis/ expense $850 per car/ truck 2 yrs non-disclosure $1m per death 200 lawsuits

Source; GM

GM is a good example as it has been expensed in 6-24 months from initial disclosure.

VW’s problem with loss estimation is the complexity/ timing of global liabilities. There are many possible claimants from government/ regulators/ consumers/ class actions. It is not possible to quantify potential liabilities as different countries treat fraud differently.

Implications of VW “defeat device” software

Millions of consumers with VW diesels need replacement car software via product recalls and compensation. The cost of new software requires labour and software licence.

Diesel cars Cars Sold Recall Cost Regulatory/ State Fines Customer Redress Legal/Class Action
USA 0.48m $408m ($850 GM) EPA ($37.4k)

  1. $18bn
$1bn $6bn
EU 5m $3bn c $5bn $2bn $2bn
RoW 5.5m $3bn c $5bn $2bn $2bn
Total 11m $6.4- $8bn c $28bn $5bn $10bn

Source: CSS Investments Ltd

It is very early into “diesel-gate” to give anything other than rough estimates of possible liabilities. These may be way off. The total arrived at above is c $50.2bn or €44.6bn (€/ $1.125). This would be a pre-tax expense hence it would need to be adjusted for tax to get to the net income impact. Using the 2014 tax rate as representative (25.18%) it is possible to derive a very rough estimate of €33.4bn as the after tax cost to VW shareholders. The above is conservative, it assumes fines levied by the US Department of Justice, and US government are lumped together under the US Environmental Protection Agency (EPA levy).

The capital structure of VW is complex with 295.09m ordinary shares (with voting rights) and 180.64m preferred shares (no voting rights but with an enhanced dividend entitlement). The movement in both share classes has been substantial.

VW Capital 17 September 7 October No of shares Valuation Loss
VW ord shares €167.60 €116 295.09m €15.22bn
VW prefs €168 €105 180.64m €11.38bn
Total €26.6bn

Investors have priced in a loss of €26.6bn into VW equity c.€6.8bn under our estimate.

Reputational loss and other factors

Reputational loss is hard to quantify numerically but the scandal is likely to mean:-

  1. Decline in demand for diesel cars (whose performance has been over stated) partly due to concerns over resale value / environmental damage
  2. Loss of trust in the brand / possible need to apply sales discounts not just for diesel cars (VW has limited room to discount 6.27% operating margins).
  3. Concerns over leasing rates/ financing rates becoming less competitive due to the pressure on VW from higher internal financial costs
  4. Negative brand perception due to shelving / reduction in new product (SUV) launches.
  5. Lower growth due to less investment in capacity ie. the €22bn Chinese joint venture commitment and all discretionary expenditure is at risk

Quantifying the reputational “repair” issues is difficult due to the lack of precise strategic plan – VW will need to incentivise purchasers. It is too soon to quantify how much it will cost for reputational loss remedies. It is worth noting that BP did not lower petrol prices post 2010.

How can VW fund these requirements?

In 2010 the BP crisis team determined that funding the liabilities from BP’s Gulf spill was possible via a) internal cash/ short term cashflow b) dividend savings, and c) asset sales in that order. Other measures, high yield bonds and emergency/ rescue rights issue were considered, but moved down the priority chain, because the US liabilities were payable over a number of years. BP went into the crisis with low gearing and did well to avoid a heavily diluting rights issue (unlike the UK banks in 2008).

VW will tap a) internal cash, it can draw down loan facilities and can shelve the dividend. What internal cash is available? There is a short term loan facility of €5bn repayable in April 2019 alongside cash balances of €18.6bn hence c. €23.6bn. VW will need to make some allowance for the likely increased working capital requirements of VW’s dealer network. It is safe to assume c. €10bn-€15bn is theoretically available (this assumes VW does not tap the €5bn facility). In our view VW is unlikely to draw the facility soon as it would cause VW bond yields/ borrowing costs to increase.

Can VW extract b) dividend savings?

The capital structure has two share classes. The preference shares do not carry voting rights but must pay a €0.06 premium to the ordinary share dividend. The preference shareholder is entitled to a vote if unpaid for two years. The Porsche family (50.76% of VW ords) and VW’s controlling shareholder are unlikely to enfranchise the preference holders hence the ordinary holders are likely to get a nominal payment (1 cent) in 2016 in order to pay a preference dividend (7 cents).

Capital 2014 Payout No of shares Saving 2015 Saving 2016
VW ord shares €4.80 295.09m €1.41bn €1.41bn
VW prefs €4.86 180.64m €0.88bn €0.867bn
Total €2.29bn €2.27bn

Source: VW Annual Report 2014

Dividend cancellation over the next two years is likely under the VW CEO’s plan to axe “non-essential spending”. Savings of c. €4.5bn are helpful but not the major lifting required.

On c) asset sales, history is littered with failed auto sector deals. These are worth reviewing:-

  1. Daimler/ Chrysler 1998-2007; Daimler paid $38bn for Chrysler in 1998 only to sell to Cerberus in 2007 for $7.4bn. There was a cultural clash between a conservative, hierarchical Daimler and an adventurous, team orientated Chrysler.
  2. Ford/ Volvo 1999-2009; Ford paid $6.45bn for Volvo in 1999, it sold to Geely for $2bn in 2009. A major reason for failure was Volvo’s lack of sales traction in the USA (similar to VW’s experience).
  3. BMW/ Rover 1994-2000; BMW thought Rover was cheap at £800m it had numerous brands, and low manufacturing costs relative to Germany. That advantage was lost by sterling appreciation and Honda’s exit from its JV. Rover was running up £400m-£500m of annual losses by the late 1990s.

Merging product lines requires closing plants, with unions and EU governments focused on keeping plants open. It would run counter to VW’s acquisitive culture to dispose of brands. We conclude that it would be difficult for VW to sell brands. More likely are sales of the football club investments such as Wolfsburg/ other football club assets possibly worth about €1bn.

This leaves VW dependent on internal cash balances (€10-15bn), facilities (€5bn), 2 years of dividend savings (€4.5bn), other assets (c.€1bn) and possible rights issues/ bond issues. There is also annual cash generation assuming 2014 levels of c. €6bn. This totals around €32.5bn of financial firepower to handle this crisis over the next two years. This is quite a lot.

Conclusion

VW’s current provision of €6.5bn ($7.3m) is a good first step. But the total potential “Dieselgate” cost is difficult to estimate as these are global liabilities. A key issue is the timing of liabilities, whether or not these can be stretched out and for how long.

Car recalls, customer redress/ compensation are the most immediate task and the cost will likely be mostly a 2016 expense. In our view the €6.5bn VW provision comes within our recall cost estimate and is realistic. However customer redress is harder to figure in terms of what precisely VW will have to offer to obtain regulatory sign off.

Regulatory/ state/ governmental fines might be determined quickly given VW early liability admission. It is possible that the US and EU will determine fines over the course of the next 12-18 months. Settlement speed may be a factor in VW’s favour as it can argue it has “come clean” by admitting fault early on and getting a discounted “early bird” settlement. However the quantum of damages remains highly uncertain.

Legal claims and class action lawsuits is a concern. This area has the most potential to drag on and the most cost variability. This cost centre is the most unquantifiable in the United States.

VW ended 2014 with €90.2bn of balance sheet equity and €261bn of liabilities hence has gone into “dieselgate” with relatively high 74% gearing (unlike BP whose gearing was c.20%). This crisis will be more of a test for VW in terms of avoiding a rights issue than it was for BP. The positive from our review is the finding that the VW’s short-term expenses can be met from internal sources without the need for shareholder dilution. There are many financial levers VW can pull in the next 12 months. Whether VW can avoid tapping shareholders entirely is a moot point that will depend on claims/ other legal entanglements.

Assuming VW did organise a rights issue, it is possible its dual share class structure might not survive as new investors are likely to want voting stock hence diluting the controlling shareholder. It is possible a rights issue of around €10bn-€15bn to replenish cash balances/ meet liabilities will be required over the next 12-24 months. This is possible for VW, given market capitalisation of c€53.4bn. It is also possible that VW goes the bond route or some combination of the two.

It took around 4 years for BP to get to a totally reliable cost estimate for Macondo, we mention this as a possible reference point for VW. This is an unquantifiable liability hence the precise impact on profits and dividends are so uncertain as to make the valuation purely speculative at this stage.

VW is likely to survive “dieselgate” albeit in a weakened state, with liabilities crystallising over the next 2-24 months. The Board approach has been measured so far. We would stress this is a fast moving situation in which liability evolution will be closely watched. Due to these material uncertainties we feel it inappropriate to comment on the valuation.

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