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Most Investors Agree VW Set Fair For The Future

That Doesn’t Mean They’re Right
Bernstein Research Says VW Profitability Overrated

Will Take Huge Hits In Germany, Britain; Modular No Panacea 

Everybody seems to think Volkswagen is a model company which has a rosy future, including a relentless increase in sales and fatter profits. Most everybody; but not Max Warburton, analyst with Bernstein Research.

Last year VW reported an operating profit of almost €1.9 billion, more than 70 per cent lower than the previous year, but when most European car companies were drowning in red ink, it was an impressive performance.

Bank of America Merrill Lynch had a typical investor reaction to VW’s 2009 performance, saying thanks to its exposure to merging markets, strong profitable sales growth will continue.

“With a strong balance sheet, strong brands and a superior business model, we believe VW is ideally positioned in tough markets,” Merrill Lynch said in a report.

Merrill Lynch wondered why stock markets valued VW at significantly less than Ford and Toyota.

“VW is more profitable than both. VW has a far greater structural growth opportunity in emerging markets. Why is VW at such a discount? VW’s sustainable EBIT (earnings before interest and taxes) margin is over five per cent, in our view, versus 10 year average margins of 0.1 per cent at Ford and 6.2 per cent at Toyota,” asked Merrill Lynch.

Over-rated
Bernstein Research’s Max Warburton begs to differ, reckoning that VW will make at best three to four per cent margins, long term, with current 5.6 per cent long term profits an aberration.

According to Bernstein, VW faces two big and imminent challenges; drastically weakening German sales which will cost it €1 billion in lost profits this year, and a huge foreign currency hit of €1.4 billion next year because of the weakness in Britain’s currency.

Warburton expects Toyota to again outstrip VW profitability when it recovers from its current ailments in the U.S., VW productivity issues remain unsolved, while the much trumpeted modular strategy won’t have much impact on the company’s competitive position.

Weakest recover potential
“We believe VW has the weakest cyclical recovery potential and the weakest earnings momentum of any company within our coverage over the next two years with 2010 EBIT impacted by circa €1 billion due to German sales decline and 2011 EBIT impacted by about €1.4 billion due to U.K. sterling hedges expiring,” Warburton said.

Warburton said most estimates of VW’s long-run earnings power look too positive.

“VW bulls appear convinced that VW is a five to six per cent margin (company) over the business cycle, using the margins achieved in 2007/2008 as a guide (5.6 per cent). We believe this to be a fundamental error. 2007/2008 represented a brief period of temporary profit maximisation delivered by a now departed temporary management team who made temporary, emergency cost cuts and who drove market share gains in Europe with unsustainable price cuts,” he said.

“We believe VW is at best a three to four per cent margin company over the cycle,” Warburton said.

Warburton said it was preposterous to compare VW’s earning power with Toyota, saying VW had the poorest labour productivity of any volume mass car maker, and suffered from high rates of uneconomic vertical integration.

Poor productivity
“Compare poor productivity with VW’s heavy exposure to the small car focussed, low margin European market, and it is clear to us that VW cannot and will not make Toyota level margins,” said Warburton, adding that the much revered modular strategy won’t pay off big for VW, because everybody else is doing it. As for emerging markets, margins may have peaked in Brazil and China.

Just because Warburton seems to be in a minority of one on VW’s future, doesn’t mean to say he’s wrong. But the Financial Times Lex column is certainly on the other side of the argument.

“VW enjoys leading positions in key emerging markets, a well constructed brand portfolio, and cost savings from its “modular” strategy of standardising engines and components across models, increasing sales from 6.3 million last year to a planned 10 million by 2018 – in a global market forecast to grow 40 per cent – looks feasible,” Lex said.


Neil Winton – March 30, 2010

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