In our opinion, Volkswagen is the premier auto company in the world, yet it is undervalued by the market trading at a discount to most global peers.

VW probably does not require much of a background, but it is important to highlight its diversification across brands and geographies.  It reports along several brands: VW (which includes Golf, Passat, and Jetta), Audi (includes Lamborghini and Ducati), SEAT (originally from Spain), Skoda (originally from the Czech Republic, expanding into Eastern Europe; today its top market is China), Bentley, Porsche, Commercial Vehicles, Scania, and MAN.

Geographically, of the 9M+ vehicles delivered in 2012, 34% were in Western Europe, 35% in Asia-Pacific (China accounting for 31%), South America 11%, North America 9%, Central/Eastern Europe 7%, and ROW 4%, with increasing and many times dominant market shares across all regions :

We should point out that they are gaining share in a market that should grow over time – IHS was forecasting the world car market to grow 29% in units between 2012 and 2018, with North America increasing 14%, South America 33%, Western Europe 17%, Eastern Europe (including Russia) 36%, and China (including HK) 55% - despite an expected decline of 14% in Japan.

The attractiveness of VW hinges on three key drivers:

1)      Premium segment – VW is more of a luxury automaker today (which has been a faster growing segment, more profitable and which has proven more resilient as well).  The luxury market has been evolving as a de facto oligopoly among the German automakers BMW, Mercedes, and Audi/Porsche.  They represent 80% of the luxury market in China, which has been the fastest luxury market in the world (already ranked 2^nd in terms of luxury car sales, versus 14^th in 2002; and expected to surpass the US by 2020 - McKinsey estimates the Chinese luxury market to grow at 12% per year until 2020 versus 8% for the overall market).  In addition, the momentum behind the Audi brand, which is the single largest contributor to profits for VW, should allow VW to gain market share in the US, the notable weakness in VW’s dominance. 

2)      China – already the key geography for VW, representing over 25% of profits, and where it enjoys a dominant market share; and perhaps most importantly,

3)      MQB  - VW is a play on the rollout of the most comprehensive modular component system that arguably an OEM has ever seen.  We list some industry comments that illustrate its importance and magnitude:

[The MQB platform] “could be the single most important automotive initiative of the past 25 years. It really changes the game.” -- IHS Consulting

"It could also make VW one of the most profitable carmakers in the world“ -- Automotive News Europe

 “There’s no doubt we’ve fallen behind. We have not even begun to make the fundamental structural changes that VW has” -- attributed to Toyota executive

 “Both analysts and the auto industry believe that the MQB could prove to be as revolutionary as Henry Ford’s production line or  Toyota’s ’just-in-time’ system.”-- Car Scoops

Once fully deployed, annual savings, even assuming half of the benefit is reinvested or passed along to consumers, could reach €3.5B, or 30% of 2012 EBIT.

The current numbers don’t reflect significant drivers of earnings growth for Volkswagen, which is why we believe we should look at least a year or two out.  These include synergies and full consolidation from Porsche, and especially a more considerable impact from the MQB program.  It has just rolled out in 2012, with only 100K vehicles being impacted.  This year, it could reach 1M and double that rate the next year.  The goal is to have 4M vehicles impacted by 2016.  We have decided to look at 2015, when the savings from MQB start becoming extremely relevant and visible as the associated front-end loaded expenditures are diminished. 

So this is the analysis for the 2015 results.  We start by providing a bridge from 2012 reported EBIT to what we expect to be the pro-forma 2015 numbers:

(1)    The Company has guided for full annualized synergies of €700M, and having realized about half that on an annualized basis.  Given Porsche has been consolidated since August 2012, it implies about €145M is already reflected in the EBIT, with the balance of €554M to flow through.  While this is what we are assuming in the numbers, we believe this is likely low.  In multiple conversations with Volkswagen, they have openly been saying that is the minimum level they now expect and that it could trend to close to €1B over time.

(2)    Given that going forward, Porsche will be fully reflected above the line, and the 2012 EBIT only includes 5 months worth of Porsche, we are adding to the 2012 what would have been the full year impact (and assuming zero contribution on equity income going forward).

(3)    As per our conversations with the Company, they expect €200M in synergies, with about €100M having been realized thus far. We also believe this should also prove to be conservative given indications by Scania and MAN in the past.

(4)    This will be a key driver of value.  Based on their projections of 4M vehicles under the platform in 2016 and 2M in 2014, we interpolate and assume 3M by then.  Based on company’s guidance, the MQB program is expected to save 20% of the material costs involved in the program, which are expected to represent 50% of overall material costs (which in turn, represent about 60% of sales).  We further assume that half of the gains are realized with the rest being reinvested and adjust the numbers to account for the MQB-related production that comes out of China, where we must deduct the benefit that goes to the JV partner.  Next year, about 300K out of the 2M MQB vehicles are expected to come out of China (or 15%), however that percentage should increase over time. 

(5)    Assumes that global demand growth ex China is around 3.2% based on Volkswagen’s recent presentation.  Further assuming no further market share gains (which has not been the case recently), nor a change in mix towards the luxury segment, which would imply higher margins.  The increase in car sales will also result in a greater number of financings, benefitting Financial Services.

(6)    Below the line, we assume that Chinese deliveries will total 3.5M, based on stated capacity growth (expecting to have 3M capacity by 2013), which might prove conservative as it is a 2% discount to VW’s growth assumption for the Chinese market (of 9.7% CAGR between 2012 and 2015).  In addition, not assuming any margin improvement (aside from the benefits from the MQB program). 

(7)    I assume a tax rate of 28%, as per my discussions with the Company, which is not applied to the Chinese results, as that number is already a net contribution number to VW

(8)    For minorities, we deduct the after tax impact of Scania and MAN, which are fully consolidated (as VW owns respectively 62% and 73.72%), and add the estimated, based on 2015 consensus, after tax contribution from VW’s non-controlling stakes in Suzuki (owns 19.9%) and SGL Carbon (7.9%)

Comment on numbers:

We believe these numbers are not aggressive as not assuming market share gains (nor losses for that matter), no benefit from a mix shift towards the premium segment (which has been growing faster and carries higher margins), no benefit from improvements/growth in the truck division, no upside on the Porsche synergies, arguably conservative growth rates from the overall Chinese market, and potential increase in EBIT from a lower depreciation due to lower required investments in the future around the MQB program as well as lower PPA charges.

Valuing Volkswagen:

A word of caution – one must make sure to be consistent if using an EV to EBITDA or EBIT, as might not get an apples-to-apples comparison with other automakers. The first issue is due to the EV: Volkswagen’s balance sheet should not be taken at face value, as it has a substantial financing division, including a bank, as close to a third of its vehicles are financed. In fact, stripping the financial division would leave the Company with a net cash position.  The denominator is also not accurate as excludes the very profitable China JV, which contributes to over 25% of profits.  While it is true that other automakers have similar JVs set up in China, we would venture to say that the magnitude is relatively greater for Volkswagen.  The P/E will capture both aspects (value of bank/financing reflected in earnings and equity income also fully incorporated) – therefore we have chosen to value VW on a P/E basis. 

At €155 per share, the stock trades at a 5x P/E.  The average peer group P/E today based on 2014 earnings is over 8x.  We believe VW should deserve a higher multiple given its higher than average growth, both from market share gains and savings from synergies and the sourcing program. Historically, its two year forward multiples, over a seven year period, normalizing for the anomalies in ‘08/’09 (due to the Porsche related short squeeze), gives us  a multiple of closer to 9.5x, although the multiple has tended to come down post 2009 (the multiple compression has not been unique to VW, but to other auto makers as well).  Assuming an 8x forward multiple implies VW should be worth closer to €250 a year from now, or over €220 today (as a comparison, note VW’s after tax cost of capital is 7.8%), or a 40%+ upside.

A question to be asked at this point is why is VW cheap today? Part of it is related to recent guidance for flat earnings in 2013 versus 2012.  This was somewhat surprising given the tailwinds from the Porsche synergies and the initial wave of benefits to be accrued from the MQB.  The Company blamed FX (which has been performing better than feared thus far), continued investments in MQB offsetting the early benefits, and especially expectations that Western European markets will decline this year (which could also cause customers to trade down, hurting the mix).  We believe VW is being conservative – last year, it grew deliveries 11% worldwide even with the overall car market declining over 8% in Western Europe, helped by a 25% growth in deliveries in China, where VW outperformed the market.  Despite concerns that China will slow down this year, car sales have accelerated in the first quarter (+21.6%, also outperforming the overall economy). Meanwhile, competitors such as Peugeot, the #2 European automaker, have been hurting, experiencing negative free cash flows, in the face of deteriorating volumes, prices and higher costs, which have allowed VW to gain share and continue to outpace peers in terms of R&D (many of which cannot keep pace).  VW is definitely not immune to a slowdown in Europe, but will be in a much better shape when the market bottoms – note this would be the 6^th year in a row if the European market were to shrink (as of March, auto sales in Europe had slumped 18 consecutive months).  Aside from exposure to China and the luxury segment (which tends to hold up better), VW will benefit from the Porsche consolidation and synergies, lower PPA charges and the continued rollout of the MQB, which will be less of a headwind (although likely more visible in the back-half of the year).

Risks: 

• Slowdown in end markets – monitor further deterioration in Europe and any potential slowdown in China (as well as government interference and rhetoric)
• FX risk of strong Euro hurting competitiveness; also potential competitive threat from Japanese automakers given the weaker Yen
• Execution risk, primarily around MQB – cost overruns, timing and recall risk
• Poor return on their significant level of investments (€50B earmarked for the next 3 years, aside from close to €10B to be self-funded from the Chinese JV)
• Governance issues (VOW3 are the preferred shares, with no voting rights – although interesting to note that it trades at a premium to the ordinary shares given the higher liquidity, perhaps indicating the Market is not as concerned with the governance and would rather place a premium on liquidity).

Bonus idea: If one is comfortable getting exposed to legal risk, Porsche is a cheap way to play Volkswagen, as trading at a significant discount to its NAV (VW shares and cash). Overhang is mainly due to ongoing litigation against Porsche. I will not go into the legal discussion here – there was a very nice post in VIC on Porsche analyzing the situation. 

Catalysts:

Earnings, further evidence of synergies from Porsche and Scania/MAN, increased rollout of MQB, recovery in European auto/truck markets