Volkswagen: Alpine Twins In Valuation Only by Greenwood Investors
Summary: We’ve had a lot of back & forth with our friends and investors about the Volkswagen diesel scandal and the implications for the auto industry. As it happens, we have an engineer that specializes in cooling and controlling NOx emissions at power plants, and have done head-to-head comparisons that suggest Fiat-Chrysler is indeed telling the truth and doesn’t use devices to deceive regulators. The sell-off, which ironically has punished FCA the most (aside from VW of course), has led to an outstanding opportunity to invest in shares of FCA ahead of the important Ferrari IPO in less than a month. We believe the value of Ferrari could eclipse the total current value of FCA shares in the next year or two. Backing out the value of Ferrari, shares of FCA are just as cheap as distressed Volkswagen, yet the company sports the best CEO in the industry, is scandal-free and is catalyst-rich.
Volkswagen Cheap – For A Reason?
While it does seem shocking that the largest automaker in the world, Volkswagen, has been cheating on emissions tests for years, and quickly admitted it, we’re not surprised. The company has lied to investors in the past about assuring no capital raises, which it subsequently and quickly broke. The surprising thing to us is that it’s the middle of a gigantic spending binge of €84.2 billion on new models and technology, yet hasn’t gotten around to fixing this key four cylinder engine. We have consistently doubted Volkswagen’s management’s ability to earn any incremental return from this program, which has kept us neutral to negative on shares of the company and its management team. As it turns out, failing to invest in one of the main engines in its lineup will likely generate a negative return on a portion of this €84.2 billion. Volkswagen’s adjusted enterprise value (take-out valuation) is now just over €50 billion, and if the returns on its capital spending end up being negative, the shares are not a bargain, no matter that the EV/EBITDA is 2.1x. The EV/Capex is 3.1x, which means if management is unable to generate a positive return on this capital spending, the mismanagement will have a severely negative impact on the value of Volkswagen shares.
Thankfully, for investors, a portion of management team has already left the company, but Volkswagen will still be set back by at least five years by this scandal. Navistar (NAV) provides a useful example of what happens to an OEM that fails to meet the emissions requirements of environmental regulators. In 2012, the company’s gamble on keeping EGR technology (instead of the more costly SCR technology embraced by its peers) failed to meet EPA standards. The company was unable to get its engine certified. It bought market share through artificially low selling prices, which it has still been unable to recoup. NAV had to use Cummins engines as a temporary fix and is still dealing with significant warranty issues.
Three years later, the company is still struggling to take back the market share it has lost, even though commercial buyers are more forgiving and focus on total cost of ownership – a statistic on which Navistar claims it’s competitive. Now take that snafu and multiply it by several times – add in a healthy dose of deceit, and some destruction of brand and emotional value to the company, and you likely have a company still struggling to come back from this scandal in 2020. Management’s ambition to become the world’s largest automaker will require even more acquisitions or will not happen in this decade.
Ok, all of that is known now, but seriously, Volkswagen shares trade at 2.1x EBITDA as of today’s close!*
Guess what? Fiat-Chrysler trades at the exact same valuation if we back out the value of Ferrari, which is making its initial public offering in about a month. Backing out 80% of Ferrari at 12x this year’s EBITDA (FCA will distribute its 80% ownership to shareholders in early 2016), the current €11.14 stock price becomes €6.71, which leaves the Ferrari-free company trading at 2.1x 2015 EBITDA (see exhibit 4). And FCA has already confirmed it doesn’t use defeat devices. The key risk that has clearly emerged has been a collapse of Volkswagen.
It sounds surreal, but should the automaker have to halt production on non-compliant vehicles, and its automotive finance company incurs staggering losses on residual values of its cars (the current resale value of an infringing vehicle in California is $0 given they are prohibited to be resold), its fortress balance sheet could look vulnerable. Then add up tens of billions of fines already threatened just by the U.S. (the EU problem is far larger), and all of a sudden Volkswagen is in dire straights.
Thankfully, the German state of Lower Saxony owns 12.4% of the capital (20% of the ordinary voting shares) and will likely backstop the group which employs 593k people. While this won’t necessarily protect shareholders, it will hopefully protect the group from a bankruptcy, which would cause havoc in the supply base and start to affect the other OEMs.
Above and beyond whether or not companies have been using software to trick regulators, there are further implications for the industry. Because the former management of Volkswagen has a penchant for capital spending, they’ve overspent on the development of their lineup. Accordingly, many vehicles are priced higher than peers, a lot of which Volkswagen justified based on better fuel efficiency, which therefore lowers the cost of ownership despite these higher selling prices. Now that this performance has been inflated, these selling prices are no longer justified. Either Volkswagen will lose substantial market share, or it will lower price. It isn’t immediately clear that lowering price will help it keep its market share, but these developments will need to be watched.
Another rational reason for the automotive companies to sell off (though we would argue the market has irrationally punished cleaner companies) is that the costs of small diesel cars will likely be going up, as multiple researchers have shown these cars are far dirtier on the roads than in the labs. We don’t dispute these results, but we dispute the argument that this will drive massive share shifts towards electric or hybrid vehicles.
We don’t believe any reduction in sales of diesel cars will necessarily steer consumers to electric vehicles. Consumers’ purchase intent is dominated by both brand and total costs of ownership. Sure, there are other purchase consideration factors based on technology and environmental concerns, but the mass market is largely a cost of ownership and brand market. Even if we take Elon Musk’s leap of faith with the giga factory for granted, it will be incredibly difficult to get this electric vehicle in 2020 to a selling price of less than $30k and earn a respectable margin (we are quoting this in US dollars, without VAT implications that Europeans should consider). Electric vehicles are not likely to penetrate the mass-market price points for a long time.
Who Else Cheated?
We talked with our engineering friend that works on controlling emissions and cooling processes at a power plant, and his speculation matched the Economist’s from this past weekend. Technically speaking, “NOx forms during the combustion