Summary
- Volkswagen has recently spun off Porsche and Bugatti to focus on its core business and expansion into EVs and AVs.
- Our view is that the transition towards EVs is good, but the transition towards AVs is met with skepticism.
- Economic weakness could slow demand, as high interest rates and inflation deter large purchases.
- Volkswagen's financial performance has been poor relative to its competitors, but this is reflected in its valuation.
- Our view is that the business becomes attractive at a 5-6x NTM EBITDA level, but it's currently trading at 7x.
Volkswagen overview:
Volkswagen AG ( VWAGY ) ( VLKAF ) ( VWAPY ) is a leading automobile company with a global presence, with significant operations in the following regions: Europe, North America, South America, and the Asia-Pacific region.
Volkswagen Brands (Volkswagen)
Volkswagen has gone through some significant events in recent years. In 2015, the company was implicated in a vehicle emissions scandal, resulting in billions of euros in fines, which have only been fully resolved in the past three years.
Volkswagen has recently spun off its luxury vehicle brand Porsche , which it was combined with over a decade ago following the famed short squeeze . Further, they have partnered with Rimac to separate Bugatti into a separate business, which will be controlled by Rimac and Porsche.
This has all been part of an effort by Volkswagen to position itself for the future to come, importantly to free up the resources it will need. The business has an incredibly large investment to make, that is to revolutionize its current fleet for the electric vehicle future. The leading EV business in the west, Tesla ( TSLA ), announced record deliveries in Q4'22, which leaves Volkswagen leagues behind.
Markets have rewarded this first movers' advantage, with Tesla's stock outperforming the market by a substantial margin.
We will look to consider what the prospects of the business look like. This will involve an analysis of the financials of the business and its current developments in the EV space. Many people seem to have the opinion "Once the traditional car makers commit fully to the EV space, Tesla is finished". We would like to add a voice to this opinion, as it has been many years and the gap seems to be widening on paper, not closing.
Economic conditions are looking tough:
The global economy has experienced a robust recovery from the pandemic-induced recession of 2020. However, the speed of recovery varies among countries and regions, with some still facing significant challenges. The major issue now is the rise of inflation and the corresponding lifting of interest rates as a means of counteracting it.
Inflation has been a concern globally, with many countries reporting higher-than-expected inflation rates. This is primarily due to relaxed historic monetary policy, supply chain disruptions as businesses struggled to ramp up production, as well as the Russian invasion of Ukraine impacting energy prices. Central banks have generally taken a gradual approach to raising rates, due to fears of triggering a recession and further destabilizing their economies. This is especially the case in the Eurozone, where too high a rate could effectively bankrupt nations such as Italy.
Inflation is problematic in the automotive industry as consumers experience an erosion of their discretionary income and businesses see an increase in their costs of producing vehicles. Thus it leads to a fall in profits on the supply and demand side. Further, high interest rates increase the cost of borrowing. Consumers will find it more expensive to finance the purchase of a new vehicle, thus deterring many, and businesses face a higher cost of capital, increasing their operational costs.
Our outlook for 2023 is that interest rates will remain elevated due to inflation not easily coming down. The ECB is expected to approach monetary policy decisions with extra caution, as European economies are generally quite fragile. Prolonged elevated interest rates and inflation have a good chance of causing a recession, which will only exacerbate what we are seeing now.
Electric vehicles are the future:
The Electric Vehicle (EV) industry has seen rapid growth in the past decade. Growth in new vehicle sales is forecast at a CAGR of 17% in the next 5 years, with millions of cars already being produced.
The increased demand for EVs is driven by several factors such as rising concerns over climate change, a movement toward sustainability, legislation, and advances in technology. The industry is comprised of several key players with Tesla currently leading the pack, boasting a double-digit market share.
Vehicle sales by brand (Statista)
To continue its market-leading position in the automotive industry, Volkswagen has been investing heavily in its EV department. The company has announced plans to launch a range of electric cars and is working to transition its current fleet to electric vehicles. We must remember that the majority of vehicles the business sells are ICE-powered, so Volkswagen must balance its efforts in both areas. Despite these efforts, Volkswagen still lags behind industry leaders such as Tesla. The reason for this is the technological and marketing advantage gained from being the first mover. Tesla's vehicles are perceived to be more developed than other EVs and have fewer EV downsides (ease of charging, battery life, etc).
Batteries remain the primary area of weakness for Volkswagen. Despite the company's recent announcement of a $20BN investment in battery factories, the technology still lags behind Tesla's. In terms of vehicle range, Volkswagen's best offering falls short of Tesla's Model S (and X) with 340 miles per charge compared to 405 . While the gap in battery life has decreased, Tesla still holds an advantage with 50% more expected miles. Despite this, Volkswagen has the advantage of industry expertise, brand value, and large-scale production.
Volkswagen predicts they will surpass Tesla in EV sales by 2025, but this may not be a true success as the company's technological superiority will not be the driving force behind this achievement, rather it will be due to its scale advantage.
Volkswagen's current financial profile is based on having several leading brands / models in the market. If Volkswagen were to become relegated to a second-rate scale producer, it could result in long-term margin contraction and a decline in brand image. This potential threat is compounded by Tesla's recent price cuts, which will test Volkswagen's ability to remain competitive and avoid having to discount its vehicles. As the below shows, they are already operating on thin margins relative to Tesla.
Margins (Reuters / Visual Capitalist)
Autonomous vehicles are also the future:
The development of autonomous vehicles is also a growing trend in the European automotive industry. Automakers are investing in these new technologies as a means of making vehicles safer, more efficient (particularly for transportation), and better connected to the Internet. Volkswagen believes that AVs will be mainstream as early as 2030 .
The AV industry is expected to drive significant changes in the supply chain and logistics of many industries. With AVs, vehicles will be able to travel and make deliveries autonomously, reducing the need for human drivers and thus increasing efficiency. The market will disrupt not just the personal vehicle market but the commercial one also. The real value of AVs initially will be in this regard in our view. Long-term, there is the possibility that we have AV taxis, AV buses, AV rental services etc, thus reducing the need for personal vehicles.
The AV industry is also changing the competitive landscape of the automotive sector. New players, such as technology companies (Microsoft (MSFT), Alphabet (GOOG) (GOOGL), and Baidu (BIDU)) and ride-sharing companies, are entering the market and competing with established automakers. This is creating pressure on the automakers to innovate their AV technology to remain competitive. This has been difficult as AV technology is essentially software, which is not in their area of expertise. Our concern here is that the technology businesses have greater resources to invest in this space, importantly having the technological superiority to entice customers away.
Volkswagen is having some teething issues in this area, with a self-driving start-up it i nvested $2.6BN into shutting down. Volkswagen has claimed to be driving around Hamburg and Munich autonomously, but details are not forthcoming. There are even rumors that the release of their first AV , scheduled for delivery in several years, could be completely canceled. This is following more rumors that Audi's project will also be canceled . Unsurprisingly, Volkswagen is struggling with the technology side of the development process, seemingly delaying its ability to come to market. Expertise and resources alone should mean Volkswagen bring something to consumers in the coming years, however, we are currently concerned as to how competitive this will be.
Deliveries are up:
Although market conditions suggest economic weakness, deliveries are still up in December 2022 compared to the prior year. This is still down when comparing the whole year, but early 2021 was heavily impacted by post-lockdown demand which slightly distorts the numbers.
Of these deliveries, All-electric vehicles reached a 6.9% share of total deliveries. 572,100 BEVs were delivered to customers in FY22, which is 26.3% up from the prior-year period. This suggests the EV segment is still a small part of the overall business but is growing healthily as the business ramps up its suite of vehicles.
Volkswagen's rebound in China continues to pick up the pace, with a 22.8% rise in December 2022 deliveries compared to the year prior. The improvement is attributed to the lifting of lockdowns and the resolution of disruptions caused by COVID. This presents a potential opportunity as China's "Zero-Covid" policy has come to an end in recent months. While the immediate impact may cause difficulties due to the ongoing spread of the virus, the long-term outlook is bullish due to the end of lockdowns.
Historical financial performance:
P&L (CapIQ)
Volkswagen has faced a challenging period as its revenue only recently surpassed its FY19 figures.
Growth between FY20 and FY21 was quite impressive, continuing into the LTM period. Demand bounced back from the lack of vehicle use in FY20 quickly, driven by fiscal support provided by Governments. The boost in demand for vehicles post-lockdown has been hindered by a chip shortage, leading to price increases across the board by manufacturers and dealers. Unfortunately, they were unable to fully capitalize on it. This is likely the reason for demand spilling into FY22, even though economic conditions have slowed.
Although operating and net profit growth appears promising, it is important to note that profits from FY18 to FY20 were impacted by the resolution of legal cases.
Balance sheet (CapIQ)
Despite its recent performance, Volkswagen's financial position remains solid. The company has refrained from taking on excessive debt to compete with Tesla. Volkswagen's debt-to-EBITDA ratio has remained relatively stable at around 5x since 2012.
The automaker's current debt rating is favorable, indicating that it can secure additional funding at attractive rates if necessary to broaden its electric vehicle and autonomous vehicle offerings.
Comparable performance and relative valuation:
Relative performance:
Volkswagen's relative performance (CapIQ)
The European automotive market is characterized by a general uniformity among the leading brands when assessing financial performance. This is due to the maturity of the industry and the high level of competition.
However, Volkswagen is lagging compared to its peers. The company has a disappointing FCF yield, which has only surpassed 8% twice in the past 10 years. This said many of the automakers listed above have inflated FCFs due to the unusual nature of current trading. Additionally, Volkswagen has a higher level of debt, which only exacerbates its underperformance.
Tesla, on the other hand, is an exception. The company operates in a different league from the rest of the industry when it comes to performance metrics. However, it's important to remember that Tesla is no longer just an automaker, and comparing it to traditional car companies may not be appropriate.
Valuation:
Valuation (Tikr Terminal)
Given the relative underperformance of the business in current trading terms, our expectation would be for a corresponding discount in the valuation to be present. We will exclude Tesla from all discussions to follow, due to the point made above.
Volkswagen looks to be trading at 1x, a discount to the average of these comps on an NTM EBITDA basis. Further, Volkswagen's average historical EBITDA multiple is 7.5x, again suggesting the business is trading at a discount to its "average" position in the market. This looks to us as if markets are pricing in the risks associated with the execution of its full transition to EVs / AVs. The question is, of course, is the discount enough to adequately reflect the risk to investors. This is incredibly difficult to conclude on but what we can say is that the next largest international automaker car company trading at a lower multiple is Volvo, which does not come close to the international footprint of Volkswagen.
For those who have faith in Volkswagen's leadership or the brand, acquiring the company at its current price could be a good opportunity, given its historical average EBITDA multiple suggests it's close to a bottom (5x).
Key risks:
Our analysis of Volkswagen suggests that the primary challenge facing Volkswagen is keeping pace with newer entrants in the market in terms of technology. The supply chain and infrastructure are there to be utilized. The risk arises from potential technological inadequacy, which is not a core competency for Volkswagen. This poses a material risk to the company's ability to execute the transition towards EVs and AVs.
To tackle this weakness, Volkswagen has taken proactive steps, such as investing in various tech companies through its software division Cariad and forming partnerships with technology firms.
Examples include:
- Cariad acquisition / JV relationship of Horizon Robotics.
- Cariad acquisition of the Automotive division of Intenta.
Conclusion:
Volkswagen has recently undergone some significant changes, all of which we agree with, as it allows Management to more greatly focus on its core business areas, and on what fundamentally moves the needle. Importantly, investment is being made into areas of weakness, which should allow the continued transition towards EVs to be a success, although we are more skeptical about the AV transition.
Critics have been tough on Volkswagen and other companies in their shift to EVs, but the reality is that demand for ICE-powered vehicles remains strong and cannot be abandoned overnight.
Volkswagen's current valuation reflects its underperformance. We struggle to see enough evidence that performance will improve, however. Taking into account the current economic challenges and the significant investment required, it is too soon for us to consider the company as a long-term opportunity.
With earnings announced soon, there is the chance the stock pops similar to Mercedes, but our tactic would be to look to pick up shares in the coming months if Volkswagen's valuation falls to the 5-6x NTM EBITDA region.
For further details see:
Volkswagen: Becoming Attractive, Be Patient