Value Investors Club / VOLKSWAGEN AG (VOW3)

Description

Overview:

Volkswagen appears cheap on a SOTP and a FCF basis when compared with European peers and the

shares could fetch anywhere from 210-260 euros over the next 12-24 months, resulting in

approximately 40-70% upside. VW is the largest auto-maker in the world, and it has a wide moat owing

to great brand equity across its portfolio and an industry leading R&D franchise. This has resulted in

some of the most iconic cars ever made and strong customer loyalty that has lasted for decades even

through various crises.

Unfortunately due to years of misguided M&A and the well-known emission-testing scandal under prior

management, the company’s stock has languished. These two issues combined with the huge size of the

company has made the investment case for VW shares tough, and as a result it gets a fairly low

multiple. Investors are effectively putting a very low FCF multiple on the whole company, including the

portion of revenues that come from premium cars (35%) and commercial trucks/buses (14%) – which

represent nearly half the company’s top line. Some argue VW actually gets almost no credit for its

commercial truck and bus business, despite the fact it’s a leading global player. Notably, the stand-

alone valuation premium that carmakers and commercial truck makers get is 60-70% higher than what

the market is effectively giving to similar assets at VW today.

Furthermore, with a new CEO who was widely lauded during his time at BMW and a younger generation

of controlling shareholders gaining influence, it appears there’s a new willingness from many

stakeholders to explore options to unlock value at VW. The new managers believe partially separating

some non-core units or at least breaking out subsidiary profitability is the first step in addressing the

valuation mismatch between VW’s assets and peers. While it’s clear management wants to move more

quickly than certain stakeholders, shareholders will likely benefit from this new leadership team, as they

seem focused on increasing the stock price sooner than later.

A Relatively New Structure:

The current VW brand portfolio is relatively new. Porsche was folded into Volkswagen in 2012, the Man

SE (trucks/buses) was acquired in 2012, Scania (trucks/buses) was originally bought in 2007, but full

control was not taken until late 2014. While Lamborghini and Bentley are the oldest VW subs after Audi,

having been acquired in 1998, they were arguably neglected until 2011. Notably, the Porsche acquisition

was in effect a bail-out of Porsche by VW after Porsche’s failed take-over of VW in 2008, which left the

company in a precarious financial position for years. With the support of a Qatari sovereign wealth fund,

Porsche was able to engineer a sale of its car business to Volkswagen in 2012, leaving Porsche

shareholders with a majority voting stake in Volkswagen. These Porsche constituents now control 52.2%

of the voting rights of VW and 30.8% of the economic interest. Not all Porsche family members are

happy with the sub-par return they have seen on their VW shares over the last 6 years, as Porsche profit

growth has been very solid while core VW has suffered. The level of operational integration between

Porsche, Audi and VW has increased significantly in recent years, and could be a hindrance to full

separation of the units according to management, but VW has not ruled out partial IPOs of these

units. VW has negative net debt of Euros 1.7B and pension liability of Euros 33B. Finally, the separately

managed diesel-gate liability has become a moving target but the company believes on-going

cash uses related to this will be less than 1B by 2021 (or sooner).

Cheap vs European Peers:

VW is very cheap when compared with peers. Analysts estimate FCF at Renault, Peugeot, Daimler and

BMW in total will be 10B in 2019. While these companies have a total market cap of approximately

+120B, this means they collectively trade at a +12x FCF multiple. While VW is expected to generate 8.9B

in FCF in 2019 (before backing out +1B in diesel-gate payments) and has a market cap of 72.2B -- which

means it’s trading at an 8x 2019 adj FCF multiple. More importantly on 11/20/2019 management

announced its confidence that the company will hit its target of 10B in adj FCF for 2020. So the

company is now trading at 7.2x 2020 adj FCF. While BMW and Daimler get higher multiples due to their

premium brands and higher unit profit margins, it doesn’t appear that Audi, Porsche, Lamborghini or

Bentley are benefitting from this higher valuation. Based on analyst estimates, BMW is trading at above

13x 2019 FCF and Daimler is trading at +16x 2020 FCF; Daimler tends to get a higher multiple than BMW

due to its commercial truck and bus business (which VW has too).

 Renault trades at 12.8x 2020 FCF

 Peugeot trades at 8.8x 2020 FCF (DB estimate)

 BMW trades for 13x 2019 FCF

 Daimler trades for 16.25x 2020 FCF

 Ferrari trades for 38x 2020 adj FCF

 VW trades for 7.2x 2020 adj FCF

o This includes Audi, Porsche, Lamborghini, Commercial Trucks and VW volume brands

o The best public comp for Porsche, Lamborghini, Bentley Bugatti and Ducatti is Ferrrari.

The company did not provide a bridge to their 10B of 2020 adjusted FCF guidance at the AGM, but it

would appear to imply 4-6% top-line growth over the next few years, more heavily weighted towards

the Audi and Porsche models. They believe one way they can counter the valuation discount to peers is

to deliver meaningful cost synergies across the group, while boosting volumes and continuing to spend

on R&D. Most analysts are backing out one-time costs related to the diesel scandal and the related legal

expenses when projecting out earnings and cash flows. When speaking with the company late last week,

they suggested the 2020 FCF guidance is not heavily reliant on above trend volume growth; this implies

they see better volumes on higher priced cars over the next few years. VW said they assumed no

adverse impact from tariffs (auto and steel), Brexit and higher interest rates in the 2020 guidance and

would re-visit these assumptions as things change.

New CEO/CFO appear to be moving more quickly:

While the last management team hinted at a potential “trucks IPO sometime in the future”, the new

CEO has said he wants this done in 1H2019 and is interviewing bankers now. They are initially looking at

listing 25% of the unit but would consider selling more depending on how the shares trade. Also, the

CFO of Porsche recently spoke about the strong financials a stand-alone Porsche is exhibiting and said

they are keeping an open-mind about how to highlight the value of the Porsche business. Most people

think a Porsche or Super Premium car IPO is several years away, but just the willingness to provide more

clarity on the unit’s operating profit could likely boost VW stock. Also this week, VW’s CEO mentioned

during the AGM that he may start breaking out the financials of the Super Premium group (ex Porsche)

which would be only Lamborghini, Bentley, Ducatti and Bugatti. These comments not only imply that

the units are showing nice profitability, but help lay the ground work for major structural changes in the

future. According to VW IR, it’s not uncommon for German companies to take a public-discourse

approach when considering corporate restructurings and disposals, as they often need buy-in from

Unions, work-councils, the press, local governments and in some cases the federal government.

As mentioned, the current structure of VW is relatively new and was created by a management team

that has largely left the company. This changing of the guard is opening the door to a more shareholder

friendly approach, with management communicating more frequently with investors via meetings and

update calls. VW is a product of an automotive holding company ethos favored in prior decades but that

is mostly out of step in modern times. With a low valuation, some argue the stock market is signaling to

VW management that the current structure is financially inefficient and may not be ideal for addressing

the various challenges the company is facing. These include disruption by new electric OEMs (like Tesla),

autonomous cars, ride-sharing and emission limits. Most importantly, the new management team

appears keenly aware of this and are taking steps that favor highlighting the company’s hidden value

and to address these competitive challenges, which they believe are related. While VW executives may

make occasional comments to suggest they are happy with the status quo, this is partially to signal a

cautious approach with unions and other non-financial stakeholders, as it’s a delicate balancing act

according to VW IR.

Potential Super Premium IPO after 2020:

Last week when we spoke to VW they confirmed that trying to fully separate the Super Premium group

from VW was not possible due to increasing integration of manufacturing and R&D (despite comments

by the Porsche CFO suggesting otherwise). However, they didn’t rule out a partial IPO similar to what

they’re executing for the truck and bus division. They intimated the success of the truck IPO will be a

factor in shareholder willingness and timing for a Super Premium IPO or IPO of other units. When

pushed on timing they thought best case was early 2021 for a Super Premium IPO, but repeatedly

emphasized no one is working on this yet, due to the complexity and huge amounts of time required.

However IR agreed that any real indication that they would consider this is likely to be good for VW

shares, as some believe Porsche is worth 30B-40B alone. Super Premium includes Lamborghini, Bugatti,

Porsche, Bentley and Ducatti.

Notably, IR said Porsche will be at the forefront of VW’s effort to electrify its whole fleet to meet EU

regulations and would compete directly w Tesla, but using a much broader portfolio of products and

better manufacturing know-how. VW believes it's electronic-vehicle technology will also slowly diffuse

across the entire company and so raising capital via a partial IPO of Porsche or Super Premium may be a

good way to partially fund this and unlock value at the same time. The IR exec wondered out loud: why

an electrified and separated Porsche wouldn't get a similar or better multiple than Tesla? The problem

with this thinking is that Tesla's lofty valuation today is a function of its scarcity value as a disruptive

force; the only automaker to produce high-end 100% electric cars en masse. However, it’s an

interesting point that VW is trying to make.

Audi:

As it relates to Audi, the company is aware that it’s effectively trading at a 50% discount to BMW despite

having better margins and a more highly rated product portfolio. Notably, the current VW CEO was a top

BMW executive until late 2014 and was in charge of manufacturing, parts-sourcing and supplier

relationships at BMW for over seven years. VW IR suggested they may break out more of Audi's

financial details so it will be easier for investors to give them credit for this great asset, but it sounded

like a partial IPO was unlikely due to its tight integration with the VW volume brand. IR reiterated that

management is very aware the current market cap of VW is less than the value of Audi and Porsche if

peer group FCF multiples were applied, and they are working within their limits to address this.

MAN SE and Scania (Truck and Bus):

On the commercial truck side (“Truck and Bus” or “T&B”) there appears to be considerable upside that

could accrue to VW shareholders via an IPO, as the market would likely back out this unit’s value when

looking at the remaining car businesses. This would highlight how cheaply investors are able to create

the main car brands at VW. Right now VW Commercial Truck and Bus is generating approximately 300-

400mm in FCF due to elevated R&D spend, restructuring actions and removal of the power engineering

unit which is slated for disposal in discontinued items. Bankers and analyst estimate equity value for

VW’s T&B business is expected to be 9B-13B. So if we back out 10B of equity value from the current 72B

equity market cap, then the core car business is trading for 62B, or 6.2x 2020 FCF per management's

most recent guidance. If we assume the discount to peers persists and apply 8x to +10B in 2020 FCF,

then the stock is worth 155-160 per share today versus the current price of 145 euros.

We believe the commercial truck and bus IPO will be a catalyst for VW shares to begin re-rating higher.

Also, funding an acquisition of the rest of Navistar with some of the commercial truck IPO proceeds

could potentially create another 3B-6B of value, according to analysts. VW owns 16.8% of Navistar and a

full buy-out would be highly synergistic on costs, revenues and R&D. This is not included in the analysis

below but is considered a fairly high probability based on Navistar’s willingness to keep an open mind on

M&A.

Parts Division:

Another source of value that’s not often discussed is the internal parts division at VW. This unit is akin to

what Delphi, American Axle and Visteon were to GM and Ford before they spun these divisions off. VW

doesn’t disclose the amount of content per car that is made with internal VW parts, but IR said it could

be up to 20-30% of the cheaper and premium brands. While the super-premium brands tend to lean on

external suppliers more heavily. Nevertheless, creating an internal parts unit to handle “arms-length”

sales to the different brands has been discussed by management. This would allow the various divisions

to more easily report COGS separately in anticipation of brand spin-offs or IPOs and would also allow the

parts division to sell goods to other OEMs. Eventually the parts division could also be separated via a

partial IPO, freeing VW to go elsewhere and negotiate better deals on components. Auto execs believe

VW’s parts divisions would be the largest auto-parts supplier in Europe if it were separated from the

company all at once, although it’s more likely to be sold off or listed in parts (if at all).

SOTP HIGH CASE: Euros 260 per share

SOTP BASE CASE: Euros 210 per share

Shareholders:

While the Porsche family owns 31% of the company, they control it via 52% of the voting rights. Until

recently, the main members of the Porsche SE supervisory board were the ones who engineered the

sale of Porsche to VW starting in 2011. This is generally considered a failed endeavor by current

Porsche family members, as they have seen the value of their holdings stay flat despite unprecedented

profit growth at Porsche over the last seven years. We spoke to Porsche SE representatives who

suggested they are very open-minded to major structural changes in order to unlock value. Notably, in

the press some Porsche SE family members have suggested the retirement of the older generation of

Porsche SE board members will eventually pave the way for some shifts at VW but they generally avoid

making more aggressive comments.

Also, Porsche SE by-laws indicate that a majority of the older members should have vacated their seats

already due to age restrictions. However, the younger generation is reluctant to force them out before

they are ready in order to avoid public acrimony. In recent months though, several older members have

indicated a willingness to leave which would allow new members to take control. These younger

Porsche family members seem to have far less interest in the auto business and many are dentists,

lawyers, pianists and artists among other things. Finally, the state of Lower Saxony has the right to veto

any major decision submitted by management with their 20% voting interest, as VW allows a blocking-

minority of 20% on resolutions. This is further complicated by 10 labor union members that sit on the

VW board and typically direct the voting decisions of Lower Saxony. However, in recent months key VW

labor leaders have shown a willingness to restructure the group if it leads to a stronger and more

competitive VW.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Traton IPO

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			2019	2020
Price:	140.00	EPS	0	0
Shares Out. (in M):	501	P/E	0	0
Market Cap (in $M):	73,000	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0