VW's Shakeup Just What the Doctor Ordered

While former CEO Matthias Mueller had been under fire for the pace of change, we were somewhat surprised by his ouster because he had been credited with bringing about cultural change across the group and praised for his successful handling of the diesel crisis. Even so, we think the dramatic changes by the supervisory board in the composition of the management board and the company’s organizational structure will hasten cost-saving measures and enable relatively more nimble execution at a time of industry disruption from mobility services, autonomous driving, and vehicle electrification--just what the doctor ordered.

Diess has a reputation for cutting costs while maintaining brand integrity. At BMW, he oversaw more than EUR 4.0 billion in cost savings that bolstered the automaker’s bottom line during the Great Recession in 2009. In 2014, BMW appointed Harald Krueger as CEO, passing over Diess for the top spot; this precipitated the latter’s move to Volkswagen just before the diesel scandal in 2015. As CEO of the Volkswagen brand, Diess has navigated it through the diesel crisis and negotiated a labor agreement that will result in a head count reduction of as much as 30,000 for cost savings of roughly EUR 3.7 billion.

We expect the new organizational structure to yield better economies of scale more quickly than the previous structure could. Diess’ new responsibilities include research and development as well as connectivity, or as Volkswagen calls it, "vehicle IT." The volume group will include Volkswagen, Volkswagen light commercial, Skoda, and Seat. The premium group will solely consist of the Audi brand, while superpremium brands include Bentley, Bugatti, Lamborghini, and Porsche. The volume brands have been a concern for us. In our opinion, a lack of differentiation among the passenger vehicle brands has led to some cannibalization of the Volkswagen brand. Consumers recognize the commonality of certain vehicles across brands and have migrated to the less expensive options.

In our view, Diess’ BMW experience engrained the importance of brand. Volkswagen’s MQB, MLB, and MEB modular tool kits for vehicle architectures were meant to create more economies of scale to improve profitability and return on invested capital. However, execution has reduced differentiation among the passenger vehicle brands in the volume group. Diess will retain his position as the Volkswagen brand CEO, and with his background at a company that highly stressed brand identity, we think there is potential for improved brand differentiation in the volume group. With the industry’s disruption, having the group CEO lead R&D as well as vehicle IT should enable better identification of optimal resource allocation and cost-saving opportunities during a period of higher investment for new technologies.

What's Driving Our Fair Value Estimate Increase We have raised our fair value estimate for Volkswagen to EUR 230/$57 from EUR 221/$49. Most of the increase was attributable to the time value of money since our last update. Some, however, was attributable to a 15.5% jump in the book value of the financial services business as well as an improved unfunded pension and other postemployment benefits status, partially offset by higher debt and lower cash balances. We view the stock as attractively valued.

Our fair value estimate also takes into consideration potential risk from diesel. We maintain a EUR 20 billion reduction to our enterprise value to reflect potential litigation in Europe, where criminal investigations of diesel cheating persist and diesel equipment antitrust investigations of all three German automakers continue. Removing this carveout would result in our fair value estimate increasing 18%.

EU consumer agencies are seeking relief similar to remuneration received by U.S. consumers, who had the option to have Volkswagen buy back their vehicles or receive $5,100 in cash plus free repairs. European consumers were only offered free repairs. With regards to the collusion allegations, at this point, with an official investigation just opened in the fourth quarter of 2017, confirmed by regulators’ onsite raids last year of BMW, Daimler, and Volkswagen, we have inadequate information to assess the probability of fines to change our fair value estimates.

However, for Volkswagen, a fine of EUR 1.075 billion would result in a 1% variance in our fair value estimate. We estimate that if Volkswagen were fined a worst-case EUR 23.0 billion (our estimate based on EU antitrust law), our fair value estimate would drop to EUR 183 from EUR 230. We note that the worst-case antitrust outcome scenario did not include any of the EU’s potential “mitigating, leniency, or settlement” factors in calculating the fine.

We model automakers with their captive finance operations on an equity basis. This highlights the economic impact from the changes in the automotive operations’ financial statements in our discounted cash flow model. We include the valuation of the captive finance company in the fair value adjustment section of our model at a price/book multiple of 1.0 times. Our valuation multiple is based on a sticky funding source that results from the ownership of Volkswagen Bank, which provides deposits that fund a relatively smaller portion of Volkswagen’s loan and lease portfolio at slightly less than 14% of total funding, as well as the financial services group’s historically stable capital structure.

Since 2007, the finance group’s book equity/total capital ratio has averaged 11.1%, with a high of 13.7% (2017) and a low of 10.1% (2011). At the end of 2017, the book value of Volkswagen’s financial services group had increased 15.5% to EUR 27.5 billion from EUR 23.8 billion the year before. The increase in equity value resulted from the group’s 2017 performance, in which financial services group revenue increased 15.5% to EUR 31.8 billion versus the prior year. At a price/book multiple of 1.0 times, the financial services valuation in our fair value estimate is EUR 27.5 billion, up nearly EUR 3.7 billion compared with EUR 23.8 billion in our previous model.

Over our five-year forecast period, we assume annualized growth in consolidated revenue of 1% as auto sales level off in Western Europe, bolstered by demand recovery from cycle trough levels in South America and Russia. We assume EU region revenue averages a 1% annual increase during our five-year forecast period, reflecting our belief that demand in Volkswagen’s largest market is at a cycle plateau. While we estimate an average annual decline of 1% for North America, we also forecast a 7% increase for South America and a 3% increase in Asia-Pacific regions in our Stage I forecast.

We assume adjusted EBITDA margins (including income from equity associates and excluding special items) expand into the midpoint of our five-year forecast. Thanks to a healthy European market and solid capacity utilization at plateau volume, Volkswagen’s EBITDA margin (including China joint venture equity income) hit a 10-year historical high of 16.4% in both 2016 and 2017. We assume EBITDA margin expansion to 16.6% in the midpoint in our five-year forecast, then contraction to a midcycle margin of 13.7% in year five, roughly 70 basis points lower than the company’s 10-year historical median. Our margin assumptions reflect a slight expansion for Volkswagen’s modular tool kit manufacturing, which after a four-year rollout is beginning to meaningfully affect operating leverage. The positive effect of modular tool kit manufacturing is almost fully offset by the highly competitive mass market and increased spending for mobility services, autonomous driving, and powertrain electrification.

We discount Volkswagen’s future cash flows using an 8.6% weighted average cost of capital. Despite the diesel scandal but reflecting the company’s sensitivity to the economic cycle, relatively lower financial leverage, high cash balance, and operating performance, we assign Volkswagen an average systematic risk rating, which carries an assumed cost of equity at 9%. This is in line with the 9% rate of return we expect investors will demand of a diversified equity portfolio. Our pretax cost of debt assumption is 6.5%, taking into account the spread creditors are likely to demand given the credit quality. We assume a long-run effective tax rate of 23.5% based on U.S. tax reform, the German statutory rate, and Volkswagen’s historical results. During the past 10 years, average total debt/total capital for the automotive operations, with financial services on an equity basis, has been 10%. Consequently, we calculated an 8.6% weighted average cost of capital.