Profit Forecasts Raised For VW After Impressive Quarter

Volkswagen’s stunning first quarter results had investors swooning and then scrambling to raise profit forecasts for this year and next, but as always there were some noises off pointing to approaching clouds on the horizon.

Volkswagen’s first quarter net income more than tripled to €1.71 billion from €473 million in the same period of 2010 as sales of premium Audis boomed in China, and even the VW brand managed to raise profits.

Max Warburton, senior analyst with Bernstein Research, was impressed.

“We’ve long argued that VW’s number one goal is not profit maximisation, but rather full employment in its home state of Lower Saxony, but it seems as if VW is not only able to fulfil its employment obligations to its controlling state shareholder, but also report near best-in-industry profitability. VW was the only German (auto) company not to cut headcount in the recession. VW has labour productivity in its German plants that is about half what its international volume brand peers achieve. VW continues to carry many vanity projects that divert resources and or lose money like Bugatti and Phaeton, but it doesn’t seem to matter,” Warburton said.

Warburton said VW’s success was down to three main points –

• Long-term plan to build up Audi.
• Long-term commitment to sales in BRIC nations (Brazil, Russia, India, China.
• Price cutting/volume chasing in Europe.

Commerzbank analyst Daniel Schwarz shared the euphoria, and he raised his profit estimate for 2011 EBIT (earnings before interest and tax) to €9.6 billion – equivalent to a profit margin of 6.8 per cent – from the previous forecast of €8.3 billion (6.3 per cent). EBIT last year advanced to €7.14 billion, up from €1.85 billion in 2009.

Deutsche Bank analyst Jochen Gehrke raised his EBIT estimate by 18 per cent for 2011 and 15 per cent for 2012, although he acknowledged some challenges along the way.

“While foreign exchange and rising commodity costs should increasingly weigh on the results coming up, we regard operating momentum at the group currently as strong enough to offset this,” Gehrke said.

Gehrke said the VW brand’s profitability of 4.6 per cent in the quarter was back to levels reached in 2002, and was a “very strong” achievement.

IHS Automotive analyst Tim Urquhart said VW’s plan to be number one in the world by 2018 looked strong.

“The only real cloud on the horizon for VW is the sheer complexity of managing its aggressive expansion plans. The company is addressing its few remaining structural weaknesses, including a relative weakness in the United States, while it is also devoting time and resources to turning around the underperforming SEAT brand as it looks to meet its ambitious Strategy 2018 goals,” Urquhart said.

Modular
SEAT cut its losses in the quarter to a negative margin of 0.9 per cent.

Commerzbank’s Schwarz reckoned VW’s modular strategy would make it even more profitable.

“The switch from its platform strategy to a modular strategy will provide further significant cost savings potential. The component toolbox allows producing all cars ranging from the Polo to the Passat with a high degree of common parts and modules. The modular strategy will replace the existing platforms for the B to D segment. The upcoming Audi A3 will be the first model based on modular and will be launched in 2012,” Schwarz said.

This will allow VW to save 20 per cent in unit costs, 20 per cent in one-off development costs and 30 per cent in engineered hours per vehicle, he said.

“This allows VW to develop vehicles with reduced fixed costs and break-even levels. The modular strategy also allows for a higher degree of production flexibility, with cars of different segments being produced on common production lines,” Schwarz said.

Citigroup Global Markets wasn’t exactly negative on VW – it rates the shares as Hold-High Risk – but it did have some cautionary thoughts.

“We continue to be more cautious on VW than the other two big German companies, believing that its stellar operating performance may still be overshadowed by corporate activity,” said Citi auto analyst John Lawson.

Lawson said this includes the completion of the Porsche takeover, and VW’s truck strategy.

“We think the less complex stories at Daimler and BMW (amongst the German auto manufacturers) may prove more attractive short-term,” Lawson said.

And despite his enthusiasm and his three plus factors for VW, Bernstein’s Warburton also listed four areas which make him nervous.

• Mainstream China market slowing – VW and Audi have earned huge profit margins in China, but Bernstein is concerned that the marked slowdown in mainstream Chinese sales growth in recent months creates big risks for VW’s pricing and profitability.
• Brazilian profitability. VW, Fiat and GM have held on to close to 25 per cent of market share in this booming market, which has been a great source of profit for VW. “These companies ship obsolete tooling to Brazil to produce simple, out of date cars, then sell them at a premium to what they can command for cutting edge cars in Europe. Margins have been running at around 15 per cent.” Recently, Renault, Hyundai, Toyota and Peugeot-Citroen have started to target Brazil, just as demand is flat-lining.
• U.S. launch costs and challenges. VW will eventually improve its position in the U.S., but in 2011, financials there will worsen. “In 2011 we expect the financial result to worsen as VW will launch a brand new product (Passat) built in the brand new Chattanooga plant. Almost every manufacturer that has launched a new product in a new plant in the U.S. has faced big quality issues. Will VW in Tennessee be any different?”
• Underinvestment in Europe. “Is VW damaging its brand in Europe with underinvestment in its product range and price cutting?” VW has funded price cutting by face-lifting products rather than investing in new ones, and “decontenting”. VW has raised its market share, “but has probably damaged VW pricing for decades to come and hurt total industry pricing. The decision to not renew product but instead facelift it is also a concern – the current Golf Mark VI is a face-lifted Mark V, the ‘new’ Passat is a face-lifted version of the old. We fear further progress in Europe may be tough to deliver and capex and product spending will need to rise quite soon.”

Neil Winton – May 1, 2011