Diesel-Gate Dings VW

Until last week, the only formal statements on criminality in

Even after assuming harsher fines and penalties, as well as our assumptions for degradation of the brands, Volkswagen shares appear to us to be oversold, trading at a wide discount to our fair value estimate. Even so, under the current circumstances, Volkswagen stock is not for the faint of heart. Caution is warranted as the shares are likely to be volatile from heavy news flow hitting the markets on the likely myriad company announcements about management changes and the criminal investigation.

Our EUR 190 fair value estimate includes punitive fines and assumes consumer rebellion against the tainted brands, with the consequences potentially coming from all global markets where Volkswagen sells the illegally polluting diesels. We have more than doubled our original enterprise value carve-out to EUR 20 billion from EUR 9 billion. Our fair value estimate also assumes a negative impact on demand and pricing to account for brand degradation in what is sure to be a marketing nightmare for Volkswagen. We estimate year-over-year declines in 2015 and 2016 revenue (excluding financial services) of 2% and 15%, respectively. Through the first half of 2015, revenue was up 8%.

Our original EUR 9 billion carve-out had been our best guess on the potential impact from a deferred prosecution settlement in the United States, plus penalties and fines, class-action litigation from car owners, and shareholder class-action settlement. That was until recent press releases undeniably confirmed for us that there was indeed criminal intent.

Prior statements that in our view indicated that the company was not admitting criminality include: "Volkswagen is working at full speed to clarify irregularities concerning particular software used in diesel engines....Further internal investigations conducted to date have established that the relevant engine management software is also installed in other Volkswagen Group vehicles with diesel engines....The U.S. Environmental Protection Agency and the California Air Resources Board revealed their findings that while testing diesel cars of the Volkswagen Group they have detected manipulations that violate American environmental standards....The board of management at Volkswagen AG takes these findings very seriously....We will cooperate fully with the responsible agencies, with transparency and urgency, to clearly, openly, and completely establish all of the facts of this case....Volkswagen has ordered an external investigation of this matter....We do not and will not tolerate violations of any kind of our internal rules or of the law." While the statements reflect accountability for excessive diesel emissions, we found no implication that the company was admitting to criminality.

However, Winterkorn's resignation statement appears to be an admission of intentional wrongdoing by the organization, which had not been the case in prior press releases. He said, "I am shocked by the events of the past few days. Above all, I am stunned that misconduct on such a scale was possible in the Volkswagen Group." Contrast this with his statement from earlier in the week in which he said, "I personally am deeply sorry that we have broken the trust of our customers and the public....Volkswagen has ordered an external investigation of this matter....We do not and will not tolerate violations of any kind of our internal rules or of the law."

The executive committee of the supervisory board unmistakably admitted that it believes there was criminal intent within the ranks of Volkswagen, with its press release saying, "The executive committee has decided that the company will voluntarily submit a complaint to the state prosecutor's office in Brunswick. In the view of the executive committee, criminal proceedings may be relevant due to the irregularities."

Comparing With Others' Recent Penalties So, how does our EUR 20 billion enterprise carve-out stack-up against other recent automaker and EPA penalties? And what about our assumptions for volume and revenue declines as a result of tarnished brand images? Hyundai/Kia reached a settlement in 2014 to pay $100 million in civil penalties, pay $50 million to establish an independent fuel economy certification group, and forfeit $200 million worth of carbon emission credits for violating the Clean Air Act by overstating vehicle fuel economy on roughly 1.2 million vehicles in the U.S. From 2013 to 2014, Hyundai U.S. sales increased 1%, and while Kia's sales rose 8%, the group's total revenue increased 2% during the same period. We see very little or even no damage to the Hyundai or the Kia brand demonstrated in this information.

In a deferred prosecution settlement of criminal charges reached in spring 2014 with the U.S. Department of Justice, Toyota paid $1.2 billion as a result of its unintended acceleration scandal. The company actually made several recalls in 2010 and 2011 involving approximately 8 million vehicles for accelerator pedals sticking under floor mats and for antilock brake software. Toyota U.S. sales volume in those years declined 6% and increased 2%, respectively. For 2012, the company's U.S. sales volume jumped 26%. For 2010, 2011, and 2012, total Toyota revenue declined 8%, increased 1%, and declined 2%, respectively. While the results appear mixed, in March 2011, Japan was struck by a devastating natural disaster that sidelined significant portions of Toyota's capacity and severely reduced the car company's domestic demand. Very little damage to the Toyota brand is apparent.

In September 2015, General Motors reached a $900 million (excluding potential litigation) settlement with the Justice Department to defer criminal prosecution and has paid the victims' fund roughly $600 million for a total of roughly $1.5 billion plus a $35 million maximum allowable U.S. fine for delaying a recall. General Motors' ignition switch scandal broke in early 2014 and eventually included about 29 million vehicles in North America, but 30 million vehicles globally were recalled for various reasons. Despite the debacle, General Motors' U.S. sales volume rose 5% in 2014 while North American revenue increased 6%. We see no detectable brand damage in the sales and revenue numbers of General Motors.

The BP Deepwater Horizon oil spill in the Gulf of Mexico had a potential EPA fine of $13.7 billion, but BP struck a deferred litigation settlement for $5.5 billion. Of course, the company has spent tens of billions on remediation plus the economic loss to fishing and tourist businesses. While this is not the same type of environmental debacle, we have contemplated in our EUR 20 billion carve-out that Volkswagen will incur class-action lawsuits for the economic loss to vehicle owners who thought they were buying environmentally friendly transportation and "clean diesel" technology.

Our EUR 190 fair value estimate includes an assumption for a full-year 2015 Volkswagen brand global sales volume decline of 12% (up nearly 9% year to date in August), followed by a 20% decline in the brand's volume for 2016. While less than the Volkswagen brand, we have also assumed declines in Audi, Skoda, and SEAT volume for the second half of 2015 and for 2016. As a result of assuming lower overall group volume and our assumption that average revenue per unit also declines on price discounts to move the tarnished brands' vehicles, we model total Volkswagen Group automotive revenue declines of 2% in 2015 and another 15% in 2016.

Even though there has not been a recent auto industry scandal that seems to have had a permanent substantial impact on brand image, sales demand, or revenue, we have assumed a substantial impact to Volkswagen on its potentially tarnished brands. With the exception of incomparable BP remediation and economic loss litigation settlement costs, there has not been a recent automotive industry scandal resulting in a settlement the size that we have carved out of our enterprise value for Volkswagen. To incorporate more unfavorable operating leverage on less volume, plus the possibility that costs may be higher than expected to affect recall repairs on 11 million vehicles and to compensate dealers for idle inventory, we have also substantially lowered Volkswagen's profitability for the next three years. Our forecast includes 2015, 2016, and 2017 EBITDA margin assumptions of 10.0%, 8.3%, and 9.3% versus our prescandal model of 12.6%, 13.1%, and 13.4%, respectively.