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September 5, 2012 8:11 pm
Grösser ist besser – bigger is better. Or so believes Volkswagen. In 2007, under formidable septuagenarian chairman Ferdinand Piëch, the German group set out to become the world’s biggest and most profitable carmaker. Tuesday night’s launch of the new Golf Mk7, VW’s bestselling car, is the latest step towards this goal. The challenge was to outsell two rivals, Detroit-based General Motors and Japan’s Toyota. If affiliates are included, VW was still short by about half a million vehicles in the first six months of 2012. But after a one-third increase in deliveries in just five years, the goal is in sight.
The paradox is that this drive for global supremacy is not exciting investors. True, recent share price performance has been creditable: VW’s more widely traded, non-voting preferred shares have produced a total return of 85 per cent in the past three years, against 33 per cent for world markets generally and 20 per cent for Germany’s DAX.
But the stock’s valuation is fender-deep in the mud. At €135, the shares trade at only 5 times estimates for 2012 earnings, against 7-8 times for much of the sector. The enterprise value of the industrial business – that is, VW’s market value after stripping out its finance operations and including net debt – is just two times earnings before interest, tax, depreciation and amortisation. Some analysts think the group’s constituent parts are worth more than €200 per share in aggregate.
Wow, that car is cheap
So why is a company that is widely admired for its industrial performance and well on its way to meeting lofty growth targets viewed with such scepticism?
Perhaps investors remember the bad times. Formed in the 1930s in the Lower Saxon new town of KdF-Stadt (now Wolfsburg) after Adolf Hitler called in designer Ferdinand Porsche to help produce a “people’s car”, VW was listed in 1961. But by the early 1990s it was weighed down by rigid management structures and a flabby workforce, and was facing a global recession. Rivals, notably in France, were improving efficiency more quickly. Just as Mr Piëch, a grandson of Ferdinand Porsche who had headed VW’s upmarket Audi division, prepared in 1992 to take over as chief executive, the group crashed into heavy losses.
The subsequent overhaul was long, sometimes brutal, and driven by a focus on product and costs. But VW now aims for sales of more than 10m vehicles a year by 2018, a 60 per cent increase in less than a decade. More than 1m sales are targeted in the US alone, triple the 2009 figure. And over the same period the group plans to lift its profit margin to 8 per cent.
Given that there are few signs this vision will turn out to be unrealistic (last year VW delivered 8.3m vehicles with underlying profit margin of 8 per cent), something else must be bothering investors.
The bigger they are . . .
Perhaps they look at the bumpy records of GM and Toyota, and wonder whether scale is all it is cracked up to be. In spite of growing demand from emerging economies, the global industry suffers from chronic oversupply. Consultants at LMC Automotive estimate that only two-thirds of Europe’s capacity is being used, for example.
Sure, economies of scale matter. These come in the form of both manufacturing and marketing cost savings – in particular, so-called platform-sharing among models – and the potential for squeezing component suppliers. With a product range from Skoda to Lamborghini and an unparalleled geographical spread, VW has taken this to heart more than most. And Mr Piëch’s vision is not confined to cars: in the past 12 years VW has built up majority stakes in two big truckmakers – Sweden’s Scania and Germany’s MAN.
On the sales front, this diversification is widely seen as a strength, providing stability but also meaning about half of last year’s light-vehicle deliveries were drawn from emerging economies. The trouble with being big and global, however, is that there is nowhere to hide. VW’s biggest market in terms of sales volumes is China, which now accounts for a quarter of units sold in 2011. Many worry about the economic slowdown there.
Investors might also be nervous about the almost 40 per cent of sales that come from western Europe. Here, though, the signs are that the company is lapping up market share, helped by a strong balance sheet (net cash of €11bn at the end of 2011) and a large finance arm. Some estimates suggest VW enjoys a funding advantage of at least 400 basis points over its main European rivals. The strong residual value of its cars also provides a big competitive edge. Indeed, VW’s European market share, which hovered around 21 per cent in early 2010, is 24 per cent two years later.
The new VW potential
By contrast, the only way seems to be up in the US. Thanks to industry-wide restructuring, this is now one of the world’s most profitable markets. VW had only a 4 per cent share of light-vehicle deliveries last year and has struggled to find a satisfactory production strategy. This might now be resolved thanks to a new plant in Chattanooga, Tennessee, augmenting a Mexican facility. But the group still does not sell many trucks, spurring occasional speculation that it could be a suitor for Chicago-based Navistar.
And just as the US is cause for some optimism, so is the potential for manufacturing cost savings. VW has tended towards over-engineered products. It is trying to reduce complexity through what it calls a modular toolkit programme – or Modularer Querbaukasten (MQB) – used in the new Audi A3 and now the VW Golf model launched this week. The aim is to cut unit manufacturing costs by 20 per cent. This involves hefty upfront costs – one reason investment in the automotive division is projected to be €60bn between 2012 and 2016. But with a material costs bill last year of three-quarters of sales – the potential for savings to flow to the bottom line is large. Morgan Stanley estimates that MQB will bring gross annual savings of €14bn by 2019, of which two-thirds might be reinvested.
So being big and global does not seem too bad. Thus the answer to the valuation conundrum must lie elsewhere. And so it probably does: in the company’s tangled ownership structures and disregard for corporate governance norms.
The reality is that family ownership by the sometimes fractious Porsche and Piëch clans is embedded at VW. With this year’s accession of Mr Piëch’s wife to the company’s supervisory board, they also hold five of the 20 seats there. In fact, once employee representatives and appointees of two other big stakeholders are excluded, there is just one independent supervisory board member to challenge group strategy. Outside investors tend not to like such arrangements much.
A VW and a Porsche collide
And that is only part of the story. There has also been a longstanding quest to unite the separate Porsche and VW groups, although family members differ on how to achieve this. Four years ago, for example, it emerged that the much smaller Porsche company, using a contentious options strategy, had secured control of more than 50 per cent of its sister organisation. As VW’s share price jumped, it briefly became the world’s most valuable company.
But the situation, which pitted Mr Piëch against his cousin, Wolfgang Porsche, soon led to severe financial problems at Porsche, and litigation from aggrieved hedge funds. After months of negotiation and fevered speculation, a partial solution emerged in August 2009: the Qatar Investment Authority took over most of Porsche’s options in VW, giving it a significant minority stake (now 17 per cent) in the bigger group; and VW acquired a large interest in Porsche’s main car subsidiary.
Recently, the relationship was untangled further – much to VW’s advantage. The larger group bought out the rest of Porsche’s carmaking operations for €4.5bn. That meant it had acquired one of the world’s best premium car businesses for just four times earnings before interest and tax. Meanwhile, the parent Porsche company, where 90 per cent of the voting rights are controlled by the Piëch-Porsche families, was left with a 50.7 per cent stake in VW’s voting shares; a net cash balance; as well as most of the litigation liabilities stemming from its 2008 stakebuilding.
VW’s governance complications do not end there. For years, EU officials have taken issue with legal provisions put in place when the company was listed in the 1960s, which shield the carmaker from takeover. These, they say, breach EU rules on the free movement of capital. Germany reworked this “VW law” in 2008, and changes were made to the group’s articles of association. Nevertheless, Lower Saxony still retains a blocking 20 per cent stake and EU officials are not satisfied. A fresh legal challenge looms.
Finally, not all the empire-building has gone smoothly: arbitration is scheduled next year with Suzuki over a 20 per cent stake in the Japanese company that VW acquired for €1.7bn in 2007. Hopes of technical co-operation and a leg-up in India, in particular, have floundered.
If all that is not enough to put off investors, succession questions hang over the group. Mr Piëch is 75; Martin Winterkorn, VW chief executive, 65. It is not clear who will pick up the reins when either steps down or when this will happen – but one possibility is that Mr Winterkorn takes the chairman’s seat.
No change, it’s an automatic
So, does VW recognise these investment obstacles and want to address them? Only to a very limited extent. Some analysts think financial disclosure and engagement with the investment community has improved. But control issues remain opaque. Mr Piëch’s holdings, thought to be among the largest in the parent Porsche group, have reportedly been shifted into two Austrian foundations, making it harder for his children to sell shares in the event of his death, but information is scant. As one pundit puts it: “Outsiders are always going to be in the passenger seat.”
No wonder then, that investors, with access to just 10 per cent of VW’s voting rights, demand a discount. Daimler and BMW (where there are also some family problems) trade on 7.5 times forward earnings; GM, 7 times.
So is VW’s 5 times rating mean, generous or about right when weighing up the strengths (and some weaknesses) of the businesses against the governance issues?
VW is cheap – but for a reason. What can be said with certainty is that Mr Piëch, an engineer at heart, is its biggest asset and will rightly claim a place in the pantheon of car industry greats. Sadly for investors, he and his relatives are also the company’s biggest liability.
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