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.
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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 process when nitrogen reacts with oxygen. The higher the temperature of combustion, the more NOx is formed. There are two primary NOx control methods on diesel vehicles: exhaust gas recirculation (EGR) and urea / ammonia inject upstream of a catalytic converter. An EGR system takes exhaust gases and reintroduces them into the combustion chamber. This lowers the resultant exhaust gas temperatures and the amount of NOx formed. Recirculating exhaust gases significantly reduces engine performance and economy. All cars have a computer controlled EGR valve. People looking to get better mileage will turn off (illegally) the EFR valve to prevent it from working. I’m assuming Volkswagen limited the amount of exhaust gas recirculated or completely disabled it during normal operation and engaged it during emissions testing ‘mode.” Messing around with the urea / ammonia injection will affect the NOx removal of the catalyst, but there is no performance or mileage degradation associated with the injection rate.”
Simple logic would dictate that if the companies most at risk of using a device which turns off diesel filtration to achieve better fuel economy performance would be showing performance metrics that show the best of both worlds: great power and great fuel economy. European regulators have placed a much more pronounced emphasis on reductions in Carbon Dioxide emissions, and this is directly linked to fuel economy. However, as we now realize, the EGR process which reduces NOx emissions, leads to worse fuel economy.
We took the two engines Volkswagen has cheated on, and have compared these engines to those of their European competitors. We’ve normalized for nearly all relevant comparable factors: engine displacement and speed, transmissions, vehicle weight, stop / start or other hybrid technologies. These side-by-side comparisons suggest Fiat and Renault are the least likely to have used any cheating devices, as their cars advertise worse fuel economy given very similar performance factors.
Exhibit 1: Comparable 2.0L Diesel Engine Performance
While Fiat’s 500X pictured in exhibit 1 has all-wheel-drive, which took off 10% in the fuel economy of the similar Ford model which offer both 2-wheel and 4-wheel drive, the 500X also has a 9-speed transmission, which typically increases fuel efficiency by 10%. Thus these two metrics which skew the comparison offset each other. Renault doesn’t currently offer 2.0L diesel engines, but we can see its performance in the 1.6L range show in exhibit 2.
Exhibit 2: Comparable 1.6L Diesel Engine Performance
Opel (GM’s European subsidiary) and Peugeot look most likely to cheat, with the Ford Focus throwing up a worrying red flag. We note that Opel and Peugeot were also called out by the research organization related to the Volkswagen investigation as having the worst performance mismatches between stated emissions and actual emissions. We aren’t aware of these companies making similar assurances as FCA and BMW have recently made that they don’t use any related device used to trick emissions tests. Thank goodness GM’s management has been so coy to talk with FCA about a potential merger, as there looks like a potential skeleton in that management team’s closet – the second in just a couple years.
Exhibit 3: Actual Emissions Performance, Measured by Transport & Environment
One of the Best “Special” Situations We’ve Ever Seen
Even with FCA having made the assurance, and the cars being obviously less at risk of “gaming,” fuel economy and performance numbers, the stock has declined more than its peers.
We believe this has created an outstanding opportunity. Those contrarians who are attracted to Volkswagen’s current valuation can express their contrarian bet with a far safer management team in FCA, with multiple catalysts over the coming months that we believe will propel shares of FCA significantly higher. With an investment in FCA, one receives (what is increasingly undisputed) the best management team in the industry, with a near-term IPO carve-out of one of the most powerful brands in the world, bearish consensus, and the same valuation as a distressed company that is suffering its worst reputation crisis since Hitler was associated with Volkswagen. Furthermore, none of Fiat-Chrysler’s brands have staked their entire brand image on false claims such as clean diesel. The company has a lower mix of diesel sales in Europe than peers, in large part, thanks to its heavier concentration of sales of small cars, which more frequently carry gasoline engines (or even natural gas engines in Italy).
We think it offers one of the most interesting “special situations,” we’ve ever seen. The informed reader will know we’ve long been supportive of Fiat-Chrysler, but we won’t have to wait much longer until Sergio Marchionne pulls the value-creating levers that will show FCA is a healthily expanding company, even without the irreplaceable Ferrari.
Exhibit 4: FCA’s Current & Pro Forma Ferrari Valuation
Exhibit 5: Ferrari’s Share of FCA’s current EV (per FCA share, using 80% of the company)
*We use adjusted EV, which we define as Market Capitalization + Net Automotive Debt + Pensions – Finco Book Value.