Unless you think that the world will escape a recession and car sales are going to go up 100% next year, I recommend taking a short position in Volkswagen.  I cannot find a more overvalued company in the world than this commodity car manufacturer at 21x 2009 earnings.  That is not a typo; VW has a higher valuation than MasterCard!

 

            Of note, before I go into the idea, is that the VW preference shares trade at 107, while the ordinary shares trade at 240 (the prefs have a higher dividend but no voting rights).  Additionally, nobody believes the VW stock price is real because if you marked to market Porsche’s ownership in VW, you could buy VW through Porsche and get Porsche for a value of negative 15 billion euros.  To put this another way, Porsche’s stock is at 80 euros, and the value of its ownership of VW is currently 175 euros per share.

 

I am not going to spend a great deal of time on VW fundamentals, as they do not drive the stock.  All that really matters in the short-term is the relationship between Porsche and VW.  The history of the relationship between Porsche and VW is that Porsche started buying VW shares a few years back in order to protect VW from a takeover by private equity.  Various firms were circling VW at 50 euros a share as it had more value in Audi ownership and cash on its balance sheet than its equity value.  Why did Porsche want to protect VW?  Porsche had struck some extremely favorable deals with VW and did not want a new owner to unwind them.  For example, VW manufactures the Porsche Cayenne and Audi Touareg in the same facility and the costs are shared based on vehicles produced as opposed to profitability.  People thought Porsche was crazy to buy in VW but in reality they made a brilliant purchase and have made a fortune.

 

            Porsche increased its stake to 31% last year and has acquired cash-settled options for an additional 20% of VW at between 60-80 euros.  They have not said what strike price they have secured but you can back out the billions of options gains from their financial statements and the timing of the gains vs. the VW share price and get a number around 70.  Interestingly, they have made more on buying VW shares and options than they have made in the history of selling Porsche cars. 

 

I started doing a lot of work on Porsche and VW and was shocked at how bad Porsche’s investor relations and accessibility was.  I flew to Germany just to meet with Porsche and try to get a sense for what was going on.  Although sell-side analysts and others would characterize Porsche as slick and operating a complicated hedge fund scheme, I found them to be very conservative actually and focused first and foremost on engineering.  The reason they claim they purchased the incremental VW ownership was to “secure their industrial survival.” 

 

Porsche realized the value of VW before investors did and also concluded they would not be able to survive selling 100k cars a year.  The capital requirements from emissions regulations, hybrid engines, electric cars, safety, etc. are substantial so Porsche needs a large base of cars over which to amortize the increased investment.  Porsche was confronted with the choice of buying VW or selling Porsche to another auto manufacturer. 

 

So, why did Porsche not just buy VW shares instead of the options?  Well, it is a very good question and the answer is that Germany is a nightmare to navigate.  VW is owned 20% by the German state of Lower Saxony (think the equivalent of Detroit), and there was a law in place that restricted voting rights to a maximum of 20%.  This same law gave Lower Saxony blocking rights with its 20% stake as opposed to the 25% an investor needs to block for every other company in Germany.  What is the name of this law you ask?  It is a federal law called-you guessed it-the Volkswagen Law. 

 

Porsche did not want to waste capital and go over 20% because the votes would have been worthless; hence, they decided to buy the options so they “could be assured to be able to afford to buy VW later in case the stock went up.”  Then, they took Germany to the EU Commission and got the EU to strike down the Volkswagen law.  The short of it is that Germany got rid of the voting rights restrictions and a couple of other things, but they kept in place the 20% blocking minority for Lower Saxony.  Porsche has since challenged this again, and the EU Commission has ruled against Germany again.  It is likely that the EU will start imposing fines if Germany doesn’t comply.  I think any rational person would agree that Porsche’s maneuvering here has been brilliant. 

 

 Once Porsche attained the right to vote its pro-rata ownership a few months ago, they announced plans to increase their stake to 51%, pending approvals from several countries.  They have recently received the approvals and have started the process.  Yesterday, they went from 31% to 35% and VW stock roared.  This has created the mother of all short squeezes sending VW stock straight north.  Porsche owns VW through cash-settled options so many people think Porsche will be buying VW in the open market.  This is highly unlikely.  The banks that are the counterparties have said they delta hedged so they own the underlying shares.  They have the right to deliver those shares when Porsche wants to convert the options.  They are going to deliver shares because if they gave Porsche cash, Porsche could walk away with the cash and then the banks would lose a ton of money as VW shares plummeted. 

 

However, this has likely caused some banks who have been loaning out shares to hedge funds to call in those shares to deliver them to Porsche.  Additionally, given that hedge funds are derisking, they are likely starting to short cover as they get freaked out by the uncertainty of Porsche’s intentions and the timing of everything. 

 

I think this is an instance where rationality will prevail, but the misinformation is causing a crazy situation.  The argument against this trade would be that Porsche wants to go to 75% of VW and will pay any price.  Anyone who has followed Porsche over the years would learn that Porsche is one of the best run companies in the world, the most profitable by a huge margin, and has never wasted a dollar of capital.  Moreover, they have said publicly they don’t want 75%.  Porsche wants 51% because they can control the company and increasingly outsource production and capital investment to VW.  There are also other reasons such as they will avoid high carbon taxes on the Porsche by consolidating VW, etc.  In summary, Porsche had a large number of reasons to buy 51% of VW to secure their survival and they bought the stake at an all in cost of somewhere in the 60’s. 

 

The underlying question that needs to be answered is even if Porsche were lying publicly (which could put them in a bad situation with the German government given how sensitive this situation is) and wanted 75% ownership, what would it be worth to them.  The price that would need to be paid would be extremely high because Lower Saxony owns 20% and they have said they will never sell.  Also, another 4% of shares voted against Porsche in VW’s Annual General meeting so Porsche would have to acquire perhaps 25% out of 26% of the outstanding shares.  This is not a very good supply and demand situation.  The other wrinkle is that there is not much to be gained by going to 75%.  The only real advantage of going to 75% would be that they would get to control the VW cash flows and the cash on its balance sheet.  Thus, they could use some of that cash to finance the purchase theoretically.  The flip side to this is that Porsche could not stop at say 65% ownership because the huge amount of debt they would need to take on would not be serviceable through Porsche’s cash flows.  Finally, Porsche cannot go to 75% until the VW law situation is clarified.  Right now Lower Saxony has the 20% blocking minority still in place so additional ownership would not get Porsche anywhere.   Indeed, they would go bankrupt with additional debt without the control of VW cash flows.

 

Porsche does believe they can make VW more profitable and get margins that will someday approach Toyota’s.  They plan to cut wasteful projects like the Phaeton and anything else that is not profitable.  Porsche’s CEO is an incredible capitalist, but there are limits given VW is heavily unionized and is not a low-cost manufacturer.  That said, you can already see Porsche’s influence in the VW margin enhancement over the past few years.  VW has a good market position in Europe, great one in China, and pretty good one in other emerging markets.  They have no share in the U.S., so that is a real opportunity.  All this and more, however, is baked into the current stock price.

 

            The only way to justify VW at 21x earnings vs. other car manufacturers at sub-8x is to argue Porsche will buy 75% of the company at a price higher than today’s.  For the reasons above, this is incredibly unlikely.  Additionally, Lower Saxony threatened to buy another 5% of the company last week if the VW law is overturned, which would bring their ownership to 25% and permanently block Porsche.  Why would they do this?  Well, as Lower Saxony is controlled by the car manufacturing unions, they don’t want Porsche to come in and cut costs and jobs.  All they care about is securing VW jobs.  If Lower Saxony is not bluffing, Porsche has no chance at ever dominating VW.  It is possible Lower Saxony is buying right now or has secured options itself, but there is no way of knowing. 

 

If Lower Saxony is bluffing and you believe Germany will eventually roll over to the EU, the relevant question is what Porsche really gains by buying the other 25% to get domination.  At some price it makes sense as they can attain control of the VW cash but they can control what they need to strategically through their 51% stake.  In other words, going from 51% to 75% is not a strategic investment, it is a financial investment.  At some price it makes sense and at another it doesn’t.  Given that Porsche has never made a bad investment in its history and everyone in the world thinks VW is overvalued, it seems extraordinarily remote they would pay a high price for VW.  Perhaps there could be a conspiracy theory that Porsche already has 75% of VW secured through options.  Well, if they had bought the options, the gains would have gone through the income statement.  The only remaining possibility is that Porsche bought options at 150-180 since their last reporting period (which is still 17x earnings), but given the high price of VW stock the banks would already have delta hedged and there would be no float left to trade.  The volume on VW is millions of shares daily so this does not seem possible. 

 

Given that Porsche secured the 51% at an all in price of well under 70, it seems a stretch to think that they would pay these prices for another 25% ownership when that remaining piece would not give them any of the strategic benefits they secured with the first 51% ownership.  Additionally, Porsche has historically been cash rich and would have to go into debt at perhaps the worst time in Porsche’s history to acquire the shares.

 

What does seem likely is that banks are calling in shares, hedge funds are unwinding, and nobody can get in touch with Porsche so people are freaked out.  What is a fair price for VW?  The preference shares are at 107, but I believe these are overvalued because people are long the prefs short the ords.  If this trade were unwound, VW would trade at under 90 a share or at 8x earnings at a maximum.  If Lower Saxony does go to 25% or the blocking law is maintained at 20%, the voting rights of the rest of the ords would be worthless.  An interesting thought is that at some point the prefs could become more liquid and put in the indexes at the expense of the ords, leaving the prefs at a higher price than the ords due to the higher dividend and liquidity.    

 

The interesting thing about this crazy situation is that it could all come to a head very quickly.  Lower Saxony said for the first time last week they would go to 25%; they could be buying right now and be the ones driving the price up.  The politicians could easily justify this in saying they think it is a good investment and it will save hundreds of thousands of jobs.  If this were the case, the stock should/would plummet. Porsche would unwind all its options and VW would start trading on fundamentals.  Also, once Porsche converts to 51%, all the speculation that they will go into the open market will be gone.  Finally, once hedge funds stop short-covering, there should be no remaining buyers of VW shares.  I haven’t done the analysis yet, but I would bet VW is one of the best performing stocks in the world this year which is shocking.  Their business has held up well, but they will get hammered next year along with everyone else.  Given their already low margins and European exposure, they face the very real risk of a slowing economy and financing problems. 

 

Other trade possibilities are long Porsche, short VW.  This is a valid idea and makes a lot of sense.  Porsche is undervalued on a sum of the parts basis and look-through earnings basis.  Additionally, they hide a great deal of their earnings to lower their cash taxes.  For instance, they have expensed the entire R&D from the new Panamera coming out next year.  This four-door sports car could increase their earnings by 25%.  The other trade is long VW prefs and short the ords-this also makes sense.  I think these are all ways to play it, but the best idea is just to short VW.    

 

The risk is really the continued craziness of the market, which is utterly shocking considering VW’s market cap is 81 billion euros.  The sheer size of the moves with respect to euros is astounding.  I do not know anyone who is buying VW on a fundamental basis right now, so it seems that these other factors are driving things right now (no pun intended).  The catalyst is that once Porsche goes to 51%, I think a lot of the speculation over Porsche going into the open market and crazy options activity will abate.  This could happen tomorrow or at the latest November.  It will all be over sooner if Lower Saxony decides to go to 25%.