Volkswagen Has Started Damage Control

September 28th, 2015 by Trefis Team

Volkswagen AG (OTCMKTS:VLKAY) continues to be the focal point of discussion, one week after the largest German automaker admitted to falsifying emission test results in the U.S.  A defeat device helped in cutting emissions considerably when the car was being tested, as compared to during normal driving conditions. This defeat device was first linked with 482,000 diesel variants of the Volkswagen Jetta, Beetle, Golf, Passat, and the Audi A3, which were sold in the U.S. since 2008.  But since, Volkswagen has said that 11 million vehicles worldwide use this software. The group faces billions of dollars in fines, class action suits, possible criminal investigation, and a loss in future sales, and looks like the impact of this is not only limited to the U.S. This could spell doom for the Wolfsburg-based carmaker.

However, Volkswagen has now started damage control, making some structural and operational changes, in view of the recent scandal, and in general, to cope with the falling sales — which were slowing the group’s growth even before the news of the scandal came to the fore. Could this restructuring help in restoring customer and investor faith in Volkswagen?

We have a $36 price estimate for Volkswagen, which is above the current market price.

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See Our Complete Analysis For Volkswagen AG

New CEO, New Vision, But Same Old Problems

After Martin Winterkorn resigned as CEO last week, accepting the blame for all irregularities, but maintaining that he wasn’t aware of the wrongdoings, the Porsche boss Matthias Müller was appointed as the new CEO. Since 2010, Mr. Müller has been Chairman of the Executive Board of Porsche AG and a member of the Executive Board of Porsche Automobil Holding SE, which controls more than 50% of Volkswagen’s voting stock.

Mr. Müller’s top priority is winning back trust for the Volkswagen.  Easier said than done.

Before the scandal surfaced last week, Volkswagen’s stock was already in decline. The stock fell 13% from the start of this year till September 17, as the group struggled to extract higher profits through the first half of the year, hurt by the economic slowdown in its previously dependable Chinese market, and continually weak performances by the Volkswagen brand. Here’s highlighting some of the issues for Volkswagen since before the dieselgate scandal.

  • The group’s operating margins remain a problem. Volkswagen group’s automotive margins are just above 6%, mainly due to the more profitable luxury brands, but this is still much lower than the margins reported by Toyota, which range between 9-10%.  Audi’s 9.7%, and Porsche’s industry-leading 15.7% operating margins, are instrumental in pushing Volkswagen’s profitability up. The 2.6% operating margins for the namesake brand are dragging down Volkswagen’s overall profitability. Lower-than-expected volume sales (volumes fell 4.8% year-over-year through August) for the Volkswagen brand, which contributes ~60% to the group’s net volume sales, and high research and development costs incurred by the group to push for innovation, are hurting profitability at the ailing vehicle division.

  • The highly centralized structure is what could be hurting efficiency, and could also be why the use of the defeat device continued without seemingly much scrutiny.  The group, which employs roughly 600,000 people and has 119 factories around the world, comprises 12 separate brands ranging from mass market cars to luxury vehicles to commercial vehicles. Volkswagen’s chief rival Toyota, on the other hand, employs only around 330,000 people, delivering a comparable number of vehicles worldwide. Large overhead expenses and operational inefficiencies resulting from looking after a highly diversified, yet centralized business, is considered a reason why Volkswagen hasn’t been able to improve its profitability. The group needs a structural upheaval one would think.

  • Volkswagen has let its game somewhat slip in China — its single largest market. The group recorded a 5.8% year-over-year decline in vehicle deliveries in the country through August, while overall passenger vehicle sales were up 2.6% in the country. The German giant’s strongest premium brand, and the highest-selling luxury brand in China — Audi, has also had a weak showing in the country, selling 0.8% fewer vehicles than the year ago period through August.  Amid the normalization of China’s automotive market, Volkswagen has missed out on the growing demand for budget cars and SUVs/Crossovers.

Volkswagen has recently taken steps to make structural changes, which might help kickstart the process of rebuilding. High profile R&D executives of Volkswagen, Audi, and Porsche have been let go. While Michael Horn remains the President and CEO of Volkswagen Group of America, U.S., Mexico, and Canada units are now being grouped to form a North America operating unit, which will be led by Prof. Dr. Winfried Vahland, formerly the Chairman of the Board of Directors at Škoda. Volkswagen has lost out on the high demand for SUVs and Crossovers, and needs more direction to respond better to the shifting market trends — which could happen with more decision making power in the hands of the people working on the floor in North America.

Volkswagen now faces government fines and settlements, private settlements, recall expense, and future loss of sales, related to the dieselgate scandal, which could be up to $34.5 billion, according to our estimates. The interactive model for the same can be viewed on the Trefis Institutional site, and estimates can be altered to show customized scenarios and sensitivity analysis to forecast the total cost of the scandal. But since before this scandal, which will in all probability extract billions of dollars from Volkswagen, the group was facing structural shortcomings that needed to be addressed. This major controversy seems to have shaken the group to the core, stimulating the process of change.

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