TSLA - Volkswagen: Reluctant To Adapt Doomed To Decline?

2023-06-12 12:11:15 ET

Summary

• Volkswagen's reluctance to fully commit to electric vehicles (EVs) and in-house software development may hinder its long-term success in the EV market.
• The company's $200 billion investment in EVs over five years may be too little, too late, as competitors like Tesla, Ford, and GM have already made significant progress in the EV market.
• Volkswagen's massive debt load of $225 billion could further jeopardize its future performance and potentially lead to bankruptcy.

Background - Why VW was Called Upon to Clean Up its Act

In recent years, and since at least the 2010s , environmental concerns and the dangers of climate change have been top of mind for many regulators and investors , especially in Europe. Carmakers have subsequently been taken to task over their role in these climate phenomena, since they create products that directly contribute to climate change by burning carbon-based fuels and putting that carbon into the atmosphere.

As a result, vehicle emissions standards were tightened by much of Europe as part of the plan to minimize the damage from climate change, and vehicle electrification was soon encouraged to accelerate these efforts.

The recent history of Volkswagen AG (VLKAF) (VWAGY), or VW, illustrates these increasing concerns fairly well. After being exposed for cheating on its emissions tests for newly released vehicles in the mid-2010s, it was forced to pay fines to many regulators worldwide and settle several hefty lawsuits . Notably, in the United States, one settlement even required VW to fund projects that would accelerate electrification efforts , which in turn birthed its electric vehicle (“EV”) charging subsidiary, Electrify America, LLC. The European Union also took a stronger stance on vehicle emissions regulations after the scandal, as highlighted by a 2020 rule change on emissions conformity .

In effect, the VW emissions scandal and its fallout demonstrated, among other things, how seriously Europe and the US were taking the enforcement of emissions standards.

VW’s CEO Answered the Call; VW’s Management Rejected it, and Him

Ironically, mere months before the scandal broke, VW hired on a CEO, Herbert Diess, who appeared ready and willing to bring VW’s auto business into the EV age. Diess spearheaded proposals for big changes within VW that would likely have made it a top global EV maker by the end of the decade, including ending diesel vehicle sales in the US , electrifying his company’s car fleet and building out significant EV infrastructure , ramping up VW's future EV factories to match Tesla’s ( TSLA ) rate of production , bringing EV software in-house via its software division, Cariad, and allowing this subsidiary to operate with a fast and flexible “software culture” .

Unfortunately, VW’s management, and by extension VW, chose to reject the new wave of changes and mandates Diess laid out for the company. It sidelined , then fired , Diess, and replaced him with a more agreeable CEO, Oliver Blume, who was willing to compromise on the speed at which VW pivots to EVs. And compromise he has: reportedly, the new VW head is reconsidering the company’s planned Wolfsburg EV factory , and is shelving its planned battery factory joint venture with Bosch GmbH. With Blume at the helm, VW has also opted to trim down the management at Cariad , replacing most of the board with a new CEO.

VW and Cariad

While one could interpret the Cariad firings as VW simplifying its management structure, it could also be seen as VW rolling back Diess’ vision to centralize its software production. Indeed, while Diess was in charge, VW was still showing interest in establishing 3rd party software partnerships to address its software woes, in part due to Cariad's software mishaps and missteps. Now that Diess is gone, outsourcing solutions for most of VW’s software needs to other companies may become standard practice, since that would be the easy way out of the Cariad situation.

To be fair, Cariad’s software production issues have been significant, but if VW chooses to abandon the approach of software centralization and reduce Cariad’s role within the company, VW may lose its chance to gain any sort of in-house software advantage that is increasingly important in the modern auto market, reducing VW EVs’ appeal to consumers.

Even if Cariad is maintained and does find its footing, however, VW may still be on track to be an also-ran in EV production. Tesla has a German factory with production rates that unnerved Herbert Diess, who commented on its significantly greater vehicle production efficiencies and rollout time compared to VW’s plants.

VW is also already unable to meet demand for EVs in the United States , and has seemingly been content to sacrifice North American market share to Tesla and other producers while it prepares to ramp up EV production capabilities closer to home. Yet considering Tesla’s soon-to-be highly productive EV factory in Brandenburg, Germany that is already ramping up EV production , I think VW is in for a nasty surprise in Europe as well, as Tesla satisfies demand for EVs in Europe by producing faster than VW there, too.

Cariad is unlikely to make much of a difference for VW’s EV sales if VW is incapable of producing more EVs than its most prominent Western competitor.

Cariad’s Implications Regarding VW’s EV Push

The way VW is rolling back Diess’s vision for centralized EV software, so too I think VW is rolling back Diess’s vision for aggressive EV adoption and production. True, VW has talked a good game in recent months about “doubling down” on future EV investment by pledging $200 billion over the next 5 years, but as the sayings go, talk is cheap, and actions speak louder than words.

Diess took concrete steps to force VW as a company to transition to EV production as quickly as possible; VW’s management replaced him with Blume, who has rolled back Diess’s EV plans and projects. These actions suggest that VW’s leadership is not ready to commit to EVs with the necessary focus. Considering increasingly stringent vehicle emissions standards and electrification pushes by governments worldwide, EVs are the future without a doubt, and disappointingly, it seems VW is not prepared to fully embrace it.

VW’s EV Investment Makes it a Better EV Buy – But Not a Good One

Even if VW is willing to fully commit to EVs with this big 5-year investment, other competitors like Tesla have invested much more money for much longer periods. Tesla’s investments in particular are now bearing significant fruit in the form of EV profitability and mass sales of EVs. Tesla’s success in the EV world appears certain to continue for the foreseeable future, whereas VW’s fate is much less certain, even if it allocates its $200 billion to achieve the biggest payoff possible. In the end, investors waiting to see if VW will succeed in 5 years would be better off parking their capital with the presently successful Tesla, and instead enjoying the comfort and safety of Tesla’s continued growth and prosperity in the EV market.

To be sure, VW’s EV prospects improve quite a bit in my opinion with this $200 billion commitment, but I doubt it will be enough for VW to dethrone Tesla as the West’s most prominent EV producer in 5 years. Honestly, I am uncertain if it will be enough to maintain VW’s position as a prominent carmaker worldwide. EVs will soon become the main type of automobile sold ; Tesla is now ramping up its production capacity to multimillion unit volumes ; Tesla is also selling EVs by the truckload to satisfy the majority of the market’s EV demand ; yet VW is only just starting to invest in EVs in earnest.

Meanwhile, many of VW’s fellow legacy competitors like Ford ( F ) and GM ( GM ) began boosting their EV investments years ago, and are now establishing lucrative EV partnerships of their own. VW’s EV investment is quite substantial, but it may be too little, too late.

Financials

VW’s revenue has stayed mostly stable over the past 5 full fiscal years, hovering in the $270-280 billion range from FY2018-2021. The exception is FY2022, which saw a rise in revenue to about $300 billion.

For the 2018-2022 period, gross profit was $51 billion, $52 billion, $44 billion, $50.6 billion, and $53 billion for each consecutive year, indicating a drop in profitability in 2020 followed by a recovery thereafter. Net income followed a similar trend; VW saw $14 billion in net income in 2018, $15 billion in 2019, $10 billion in 2020, $17.5 billion in 2021, and $16.5 billion in 2022. Considering the severe disruptions the Covid-19 pandemic inflicted on the global economy and many businesses in 2020, VW’s 2020 slump isn’t so bad.

Interestingly, VW’s core car production business fared quite well throughout the whole 5-year period, completely unfazed by the pandemic. Cash flow from operations was ~$8 billion in 2018, $20 billion in 2019, $30 billion in 2020, $43 billion in $2021, and $30 billion in 2022. This indicates that whatever VW’s struggles were in making money, they weren’t due to an inability to get cash for cars, coronavirus or no coronavirus.

Overall, for a behemoth in its industry and one of the top carmakers in the world, VW’s financials are fair. A hiccup in 2020, but nothing to write home about. As it invests in EVs in earnest, however, I expect the financials to begin to trend significantly downward – perhaps not enough to endanger the company, but likely enough for VW’s financials to gradually disappear from analysts’ lists of bull thesis talking points. There is, however, the issue of VW’s debt, which I will address in its own section.

Valuation

Looking at the valuation of VWAGY (the only non-preferred share class with sufficient data) compared to the consumer discretionary sector, it is trading at a significant discount to sector by any measure at time of writing. VWAGY’s forward P/E ratio is ~3x, and its trailing ratio is ~5x; this compares to the overall sector ratio of ~15x for both. VWAGY’s Price to Sales ratio is 0.21x, compared to the sector average of more than 0.85x. VWAGY’s Price to Book ratio is 0.37x, compared to the sector average of ~2.2x. Lastly, VWAGY’s Price to Cash flow ratio is ~2x, compared to ~9x for the sector.

VWAGY’s valuation is incredibly attractive at these levels, and I can understand why. As a long-standing blue chip car company, its stock is supported by (ostensibly) solid financials compared to other consumer discretionary firms. In fact, despite the issues I have raised regarding VW’s relatively reluctant EV pivot, I would dare to say that VWAGY is underrated and undervalued by the market in the short term on account of its present financial condition (with a caveat that I will address in the next section).

However, I think that the costs of the EV transition will take a toll on VW’s financials, which will worsen VWAGY’s valuation and bring it up to valuation parity with its sector in the medium term. Ultimately, in the long term, I foresee VW’s EV production and sales lagging other major competitors like Tesla even with its costly investment, resulting in even worse financials over time that manage to drive VWAGY into overvalued territory.

Ordinarily, this long term scenario would present as severe undervaluation, as investors in the market generally try to avoid stocks that will underperform in the future; however, I believe that there are many investors who have only ever known VW as a globally leading car company, and will continue to hold this view and invest accordingly, even as VW lags its EV competition in the future. This parallels the conviction many semiconductor investors still have in Intel ( INTC ), despite its underperformance lasting over a decade. These diamond-handed investors would set a floor for VWAGY’s price, effectively ensuring the existence of a long term premium for VWAGY stock as its financials worsen.

While I acknowledge VWAGY’s enticing undervaluation today, I think its valuation metrics do not have the severity of VW’s future financial decline factored in as it transitions to EVs; I also think the metrics will be raised higher long term by the commitment of many die-hard VWAGY buy-and-hold investors who will dismiss VW's worsening financials. For these reasons, I consider VWAGY a long term value trap.

The Debt of VW

Everything I have written about VW so far has been with a certain assumption in mind: that VW’s debt will be a non-issue in the long term. Discarding VW’s debt concerns may seem like a large oversight, but it steel-mans (instead of straw mans) the sell thesis. Even without considering its debt, I can explain why I am not certain about VW’s long term prospects regarding EVs, and why I think its stocks should be avoided.

For those unfamiliar with VW and unaware of what debt concerns I am talking about, VW is regularly among the most indebted companies in the world , with current debt standing at $225 billion .

This may not sound so bad considering its revenues of $300 billion in 2022, but keep in mind that VW’s gross profit hovers in the $50 billion range. Consider also the following facts: VW has just pledged $200 billion over 5 years to invest in EV production, wiping out an amount worth ~80% of its gross profit annually until 2028; VW’s current total cash ($54 billion) and market cap ($78 billion) add up to only 60% of VW’s debt load; and VW would have to spend its entire net income (about $15 billion annually on average) for 15 years just to pay off its current debt load. This is assuming there are no hits to profitability or revenues during that period, and that VW takes out no debt in that time (both of which I am doubtful of).

Even if VW spent all its cash and cut half its market cap paying off its debt, VW’s net income of $15 billion annually, again assumed stable, would take almost 9 years to pay down the remainder. Meanwhile, Tesla will likely spend those years growing its production capacity and improving its financials. Tesla also lacks VW's debt concerns, possessing $22 billion in cash and just $5 billion in debt at time of writing.

Accounting for this massive debt load changes much of the VW analysis. VW's financials are cash flow positive and profitable overall, but the company is terribly debt-ridden, and the profits and cash flow may eventually be insufficient to pay it off in a timely manner, if at all. VW's stocks' valuation looks pretty attractive, but the massive debt load may be causing the discount by keeping investors on the sidelines; that is to say, the market is not undervaluing VW's stocks at all, but is fairly valuing them at a discount to sector, because of the increased likelihood of underperformance for VW and its stocks as the company pays down its huge debt load. In this case, VWAGY would be a clear value trap even in the short term, not undervalued.

When the gravity of VW’s debt burden is combined with the implications of the company’s struggles to compete in the EV market due to a lack of aggression, they paint a picture of a company that is on the verge of insolvency, with no easy way out. Thus, VW’s debt may be the final nail in the coffin if its EV transition does not produce the necessary results. The risk of this debt dooming VW is yet another reason why investors interested in EVs may want to avoid this name.

Risks to Thesis

One risk to my thesis is the possibility of the new Cariad CEO reforming the subsidiary into a competent software solutions firm, and getting the subsidiary’s act together so as to create compelling software for all of VW’s vehicles.

More broadly, though, a major risk is that VW management wakes up to the fact that it needs to invest more aggressively and quickly into electrifying its fleet and upgrading its software, and subsequently directing large amounts of R&D and CapEx toward these efforts, trading short term profitability for long term resilience. To this end, I do think the commitment of $200 billion (i.e. the past 4 years’ worth of gross profit for VW, or almost a year’s worth of revenue) is a good start, if invested efficiently. Still, I suspect VW would have pledged even more if the company had no reservations about becoming an EV company as soon as possible, which I believe the company must do if it is to survive the EV transition, even with a large pile of debt hanging over it.

Regardless, I’d judge the latter risk to be more likely than the former; in any case, the former risk regarding Cariad’s competence may not be realized quickly enough to save it from VW’s wrath for its many failures, leading VW to disband the subsidiary and go the third-party route for EV software development. It’s also possible that if Cariad does evolve into a solid EV software developer, it may not do so quickly enough to save VW’s EV sales, assuming the carmaker keeps the division intact.

Still, the latter risk, that management is waking up to the need to invest even more aggressively in EVs, is potent. It would be worth watching over the next 5 years to see how well it lives up to its commitments, and see whether it decides to further double down on EV investment, as I suspect it must to achieve EV dominance. Unfortunately, VW’s reluctance aside, the company may literally be unable to invest much more due to the large debt load it has to pay, putting the company between a rock and a hard place, caught between bankruptcy and EV market mediocrity.

On a related note, the final major risk to the thesis is that the German government bails out VW and pays off its debts, as the US bailed out its domestic automakers during the Great Financial Crisis. This is another major risk that I think is worth keeping an eye on. VW is one of the biggest companies in Germany by revenue, and similarly to US automakers in the Financial Crisis, the company has likely been granted “too big to fail” status by the German government, meaning it could be saved from completely going under even if it suffers a technical bankruptcy.

This is even more likely considering the revolving door of German politicians and German auto execs , ensuring that VW's board and the German government will have exceedingly friendly relations - likely friendly enough for the government to forgive much of VW's debt to prevent bankruptcy from occurring.

Still, even if Germany forgives VW's debt in its entirety, VW's apparent preference to pursue a more incremental EV transition increases the likelihood of VW underperforming in the EV market, and the overall global car market, in the long term.

Conclusion

VW appears unwilling to take the necessary actions to pivot to EVs with total commitment. While the company’s announcement of $200 billion in EV investment over 5 years is impressive, it may be too little, too late for the company to turn its gas-guzzling ship around fast enough to become an EV leader worthy of investment in the long term.

Worse yet, it remains to be seen how effective it will be in even transitioning to EVs. VW management has proven time and time again that it is more inclined to take a slow-and-steady approach to its EV transition, seemingly content to sacrifice future EV market share to preserve current profits until only recently.

VW management’s sabotage of its former CEO’s EV and in-house software plans supports the thesis that the company is not as committed to EVs as is necessary to become a future EV leader, or to remain a leader in global auto manufacturing. On the other hand, VW’s prominent competitor, Tesla, is already leading in EV sales, producing large volumes of EVs at a profit and set to continue to do so. VW’s fellow legacy peers Ford and GM have also been making significant EV progress, to say nothing of other competitors entering the space.

Investors would likely be better off buying other EV makers, but especially Tesla due to its profitability and reliable growth prospects in the EV market. VW's future position in the EV market is far riskier and less certain, warranting great caution and scrutiny for any investor willing to bet on the company in the long term.

None of this factors in VW’s huge debt load. When combined with the above negative factors impacting VW’s future performance, VW's debt stands to imperil the company and possibly trigger bankruptcy. As such, for investors with a long time horizon who are considering car companies to buy for the EV transition, I believe that other car companies, especially Tesla, will outperform VW in the long run.

I therefore rate shares of VWAGY and VLKAF, as well as preferred shares VWAPY and VLKPF, a sell.

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