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Will VW’s Aggressive Sales Push Damage Profits?


Some Say Aggressive Unions Mean Costs Will Remain Crippling
Others Point To High Efficiency Of Automation

“preposterous to compare VW’s earning power with Toyota”

The tsunami of red ink which drowned General Motors and Chrysler and left most of the rest of the global automotive industry gasping for breath, seems to have barely touched German giant Volkswagen.

And yet investors seem unconvinced. Stock markets value VW shares much less than Toyota or even Ford.

VW is Europe’s biggest auto company and market leader. It is ranked 3rd in the world in terms of sales behind Toyota and GM. VW has big plans to leapfrog over Toyota and GM and sell VW has earmarked vehicle sales of 8 million in the medium term, rising to above the 10 million mark by 2018. It sold 6.3 million vehicles last year, up 1.1%, to grab 11.4% of the global vehicle market. VW has earmarked vehicle sales of 8 million in the medium term, rising to above the 10 million mark by 2018. It sold 6.3 million vehicles last year, up 1.1%, to grab 11.4% of the global vehicle market.

VW has earmarked vehicle sales of 8 million in the medium term, rising to above the 10 million mark by 2018. It sold 6.3 million vehicles last year, up 1.1%, to grab 11.4% of the global vehicle market. VW has earmarked vehicle sales of 8 million in the medium term, rising to above the 10 million mark by 2018. It sold 6.3 million vehicles last year, up 1.1%, to grab 11.4% of the global vehicle market.more than 10 million cars by 2018. Last year it sold 6.3 million automobiles. At the same time VW wants to finally make the breakthrough in America. Next year its Chattanooga, Tenn., plant will start producing sedans specially designed for the U.S. market, spearheading its plan to boost U.S. sales to 800,000 a year by 2018, up from just over 200,000 in 2009, and its target of 450,000 by 2012.

Last year VW operating profits dived about 70 per cent to $2.6 billion, but when most European car companies were making huge losses, it was a relatively impressive performance.

Bank of America Merrill Lynch said thanks to VW’s exposure to healthy global markets, it should now experience strong, profitable growth.

Aggressive unions
Stock markets remain to be convinced that VW is the real deal. Many potential investors shy away from investing in VW because of the huge costs associated with producing in Europe, which include high wages, expensive benefit packages, and aggressive unions. VW also has a reputation for keeping shareholders in the dark. But Merrill Lynch still wondered why stock markets valued VW at significantly less than Ford and Toyota.

“VW is more profitable than both (Ford and Toyota). 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,” said Merrill Lynch analyst Harald Hendrikse in a report.

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

VW not only sells its own branded cars, including the little Polo which has just won an award for global car of 2010, but also premium Audis, and working class names like Skoda, and SEAT. The stable also includes exotica like The Porsche mark will be the 10th brand in VW’s stable that already includes Audi, Bugatti, Bentley, Lamborghini, Skoda, Seat and Scania. Bentley, Lamborghini, Porsche, Bugatti, and Scania trucks.

Some analysts believe VW is more a rheumatic, over-weight and over ambitious giant, which will be crippled by its high home market costs, and held back by a European market where sales are about to fall off a cliff. Home market sales are expected to dive by about one million or close to 30 per cent in 2010.

Bernstein Research’s Max Warburton reckons 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 $1.4 billion in lost profits this year, and a huge foreign currency hit of $1.9 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.

“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 ($1.4 billion) due to German sales decline and 2011 EBIT impacted by about ($1.9 billion) due to U.K. sterling hedges expiring,” Warburton said.

The British market is one of VW’s most important, but profits have been hit by the falling value of the pound against the euro. This forces VW to either raise prices, or take less of a profit. VW has sought to mitigate the problem by using foreign currency hedges as an insurance policy against this.

Too positive
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 maximization 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 labor productivity of any volume mass carmaker, and suffered from high rates of uneconomic so-called vertical integration.

Most big carmakers seek to avoid “vertical integration” by using suppliers to produce components like seats and steering wheels which are considered peripheral to the basic task of making cars. These outside suppliers are likely to be more efficient as it is their core business.

“Compare poor productivity with VW’s heavy exposure to the small car focused, 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.

The “modular” strategy means using more and more common components and engines across an increasing range of models

But Peter Schmidt, Editor of European newsletter Automotive Industry Data, believes that VW is definitely on the right track, and even its high cost position in Germany is not as bad as conventional wisdom dictates. The upmarket Audi operation is highly profitable and will get more so, he says.

A1 city car
Audi is about to launch its little A1 city car, which should generate big profits too. Unlike BMW and Mercedes, which find it very difficult to make money from small cars, Audi can use the massive production runs of its parent VW to cut costs. The little Audi is based on the engineering of the VW Polo, which will also spawn Skoda Fabias, SEAT Ibizas and Brazilian VW Gols.

Schmidt concedes that costs in German are very high, but says they are more than offset by VW’s relentless program of automation.

“Certainly VW’s labor costs and social costs are the highest in the industry, but this bears little relation to cost in Germany. With VW’s high rate of automation, plant efficiency is among the most productive in Europe,” Schmidt said.

“It looks like an unfavorable location in financial terms, but if you analyze in detail it looks totally different. There is a very high rate of automation, and it’s actually cheaper than like for like VW products made in China,” Schmidt said.

Clever engineering
“Yes it looks like VW has given in to the union, but it is more than compensated by a higher rate of automation and clever engineering. Sure, profits would be even higher if VW moved out of Germany, but it decided to make a compromise, cooperate with the unions and keep as many jobs in Germany as possible,” Schmidt said.

Schmidt believes that VW can be a five per cent plus profit margin company, and that Audi can crack 10 per cent.

“VW has been undervalued (on stock markets) for years. Now it is starting to live up to its potential,” he said.

One European-mainland based analyst who declined to be named also believes VW is on the right track, and has performed better than its European competitors because of its impressive global diversification. This analyst agrees with Schmidt that VW’s long-term profits are likely to be impressive.

Is VW in danger of pursuing too many sales, when it should be concentrating on perhaps slower growth and higher profits?

“There is always an element of this risk with ambitious growth targets, but it (VW) has the geographical and product spread to succeed. But this is something we will be keeping an eye on to see how it translates into profitability. Size for size’s sake is never a good idea, you have to be large for the right reasons,” he said.

He was unwilling to comment on prospects for VW’s 2018 global sales target, or its plans for rapid expansion in the U.S.

No such inhibitions for AID’s Schmidt, at least concerning VW’s U.S. sales target.

“That’s definitely achievable. The problem in the past has been that VW was not a dollar area producer and it needed a product to compete against the market leaders like the Toyota Camry and Honda Accord. The old European Passat couldn’t compete on costs, but now with the new plant (in Tennessee) and the new medium sized sedan being made there VW should be able to compete with the Accord and Camry. And I think there’s a chance the engines might be made there too,” Schmidt said.

“I feel their products will be competitive in the U.S. and with their image they can achieve the volumes they are gunning for, and profitably too,” Schmidt said.

Neil Winton – April 15, 2010

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