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VW Onslaught in America Moves Up A Gear

New U.S. Strategy Designed To Turn Losses Into Profits
Analysts Believe VW Is On The Right Track, At Last

Volkswagen, Europe’s biggest automobile manufacturer, has been punching below its weight in America for years but with the inauguration of a new plant in Tennessee and new cars designed specifically for the U.S., VW is renewing its onslaught on the U.S. market.

Investment bankers from Morgan Stanley and Deutsche Bank agree that VW’s new plan conquer to America is on the right track, but Bernstein Research auto analyst Max Warburton said VW faces an uphill struggle to make it work.

According to Bernstein’s Warburton, VW’s U.S market share is stuck in a rut around three per cent, far lower than the level it reached in the 1960s and 1970s. Despite the new Passat designed for Americans and now emerging from the Chattanooga factory, the company’s fortunes will take a long time to turn around.

“In fact, VW has lost money every year since 2003 to the present. VW is determined to do better in the U.S. and is about to roll out a new strategy to improve its position, including U.S. focussed product to build in the new U.S. plant in Chattanooga, Tennessee. What are its chances of success?” said Warburton.

That’s a question that remains to be answered.

“In fact with VW spending over one billion euros on its U.S. expansion, we question whether this incremental investment is guaranteed to generate incremental return,” Warburton said.

It will be a long, uphill struggle.

Success in the end
“We believe there’s a good chance it will prove a success in the end, but the cost of expansion and near-term losses mean incremental returns on the incremental capital may be limited in the next few years – and possibly beyond,” Warburton said.

Morgan Stanley auto analyst Stuart Pearson thinks the investment in America will pay off and raise profits there because of –

·      A raft of fresh, dedicated U.S. product (including the new Jetta which is becoming a sales hit).

·      New local capacity in Chattanooga.

·      Lower lead-in price strategy.

·      Re-vamped dealer network.

Pearson said VW in America has been chronically loss-making with red numbers of about €500 million a year, reaching close to €1 billion in EBIT in 2006 and 2007, equivalent to a loss of about $1,700 for every car sold.

“We think VW could turn this into a profit per vehicle north of $500 if its latest model and production plans get it right. VW itself is targeting break-even by 2013 at the latest and in the long-term wants to see a five per cent operating margin from its North America business,” said Pearson.

(In a statement in late September from Detroit, VW of America CEO Jonathan Browning said the VW brand expects to be profitable this year, but later made clear he was talking only about the VW sales operation and therefore not including U.S. manufacturing, financial services, or VW’s contribution to global fixed costs).

Pearson said in the past VW has tried to sell cars that were too sophisticated or too small for their segment at a price too high for their perceived brand equity in the U.S. Pearson reckoned though that VW still had a huge £10 billion exposure to the American market despite the Chattanooga addition, and believed Audi might be pushed into building a U.S. plant, perhaps alongside the new one, which would allow it to use the local supply network without comprising the Audi brand by producing in the VW factory.

VW had a plant in the U.S. in Pennsylvania but it was closed in the late 1980s because of the poor quality of the Rabbits produced there. Bernstein’s Warburton said the new plant in Chattanooga would find it hard to reach European standards for a while, if BMW and Mercedes U.S. experience in South Carolina and Alabama is typical.

New workforces struggle
“The omens are not good – new workforces, with no prior auto industry experience, often struggle to come up to speed – especially with German cars that can be more complex and have more product variety than Asian cars. Perhaps VW will navigate these problems but given its historic problems in the U.S. in this area, it needs to be careful. Quality problems mean not just warranty costs but can also result in brand, pricing and volume damage,” Warburton said.

Warburton said it was strange that VW, Europe’s market leader and a huge success in China, has had such limited success in America. Warburton blamed this on poor U.S. management and decision-making, local quality issues, poorly targeted product, bad dealers, and a volatile exchange rate.

VW has said it wants to sell one million cars in America by 2018, up from 360,000 in 2010. That included 257,000 VWs and 103,000 Audis. Aggressive U.S. fuel economy standards will help VW, which sells many small cars in Europe with high fuel economy.

Cheaper than European equivalent
The new Passat is designed for America. It is a bit bigger than its European namesake with less equipment. Prices start at $20,000, at least 10 per cent cheaper than its European equivalent.

Deutsche Bank auto analyst Jochen Gehrke said VW’s U.S. strategy was “compelling”, and noted the success already of the new Jetta, while the U.S. Passat had been well received by the motoring media.

“We believe that in potentially significantly more challenging industry times, the U.S. turnaround could potentially provide a good “self-help” angle to VW as we continue to see a €1.2 billion through the cycle profit swing opportunity from this market alone,” Gehrke said.

Morgan Stanley’s Pearson worried that VW’s global strategy could be undermined if it was tempted to use up its large cash position by what he called “value-destructive acquisitions”. A decline in E.U pricing might threaten profit margins. VW’s increasingly complex array of brands might be a problem if capital discipline was eroded.

But overall, Pearson believed VW had built itself into a leading position compared to its main competitors, auguring well for the future.

“By many of its own competition’s admission, VW enjoys a significant technology lead over its mass peers that will accelerate in 2012 with the launch of its modular platform. As rivals focus on cash flow preservation, R&D and capital spending may fall by the wayside. VW could thus enjoy an extended period of super-normal returns,” Pearson said.

Neil Winton – October 5, 2011

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