Volkswagen AG (VWAGY)

[Enterprising Investor]

It’s Too Early in the Crisis to Bet on VW Shares (9/26/15)

An emissions-falsification scandal that clobbered the stock could pave the way for the auto company to overhaul management and implement reforms.

By Jonathan Buck

Cheaters never prosper, as the adage goes. Just ask Volkswagen, the German auto maker, and its suddenly poorer shareholders, who could become even poorer in the short term if the scope of the company’s diesel scandal widens. And that’s precisely what seemed to be happening at week’s end.

On Friday, German Transport Minister Alexander Dobrindt said that VW, currently the world’s largest car manufacturer, had rigged emission tests on about 2.8 million diesel vehicles in Germany—nearly six times the approximately 500,000 it has admitted to rigging in the U.S. He added that, in addition to the 2.0-liter and 1.6-liter four-cylinder diesel engines already implicated, 1.2-liter engines might be affected, too.

VW has admitted that engine-control software that could rig emissions tests exists in 11 million of its cars worldwide. In the U.S., the affected vehicles are VWs and Audis; in all, Volkswagen has 12 brands, including Porsche. The software is designed to automatically turn on during tests, curbing emissions, but turn off on the road, letting vehicles spew much higher amounts of pollutants, but apparently boosting acceleration and fuel economy.

By Friday, officials in virtually every nation in which diesel VWs have been sold had pledged to begin stringent real-world tests aimed at determining whether the vehicles’ pollution-control systems were performing properly.

On the week, VW’s shares (ticker: VOW.Germany) tanked 28%, closing at 115.55 euros ($129.50), erasing €23 billion ($26 billion) from Volkswagen’s market value.

While the selling may be overdone, venturing into the shares before the potential toll of the scandal becomes clear is dangerous. VW could be fined about $18 billion in the U.S. alone (although that’s unlikely), and it could face billions of dollars in fines in Germany and other countries that find that tests have been rigged. In addition, the cost of bringing the cars into compliance and dealing with lawsuits linked to the mess could easily surpass the €6.5 billion that the company is setting aside “to cover the necessary service measures and other efforts to win back the trust of our customers.”

If the problem can be addressed with a software fix, that might be relatively inexpensive. But it’s probable that the reason VW put the test-cheating program into its cars in the first place is because no software could make them meet the emission standards without subtracting fuel efficiency, acceleration, and maybe driveability.

If a mechanical fix is necessary, it could cost hundreds of dollars a car, which would add up to a hefty sum for the 3.3 million affected vehicles in the U.S. and Germany alone.

VW had a net liquidity position of €21 billion at the end of June, according to Société Générale. But the potential costs of the diesel problem present a massive challenge to VW’s new CEO, Matthias Müller, Porsche’s chief, who is replacing Martin Winterkorn, who resigned on Wednesday.

The crisis isn’t the only challenge Müller faces. By many measures, VW is inefficiently managed. Almost all of its cost ratios are high, compared with rivals’, says Arndt Ellinghorst, head of global automotive research at Evercore ISI in London. “These shortcomings can be turned into opportunities if there’s a management team in place that focuses on lifting value,” says Ellinghorst.

Telling numbers: VW sold 10.14 million cars last year and has about 600,000 employees around the globe, many in high-wage Germany. Toyota (TM), which sold 10.23 million vehicles, has about 344,000 employees. (So far this year, VW is No. 1 in global sales.)

Volkswagen’s shares trade for 5.1 times estimated 2016 earnings, and 0.6 times book value, though analysts’ earnings forecasts are falling to account for potential charges. The price/earnings ratio and a recent intraday low of €102 are reminiscent of the situation four years ago, when Barron’s Vito J. Racanelli wrote a positive cover story about Volkswagen (“World Beater,” Sept. 26, 2011), calling the stock a bargain. It was a good call; VW hit a high of €254.50 six months ago, up almost 174%.

Is the current situation similar?

“If you have the luxury of patient capital and aren’t marking to market, it is an opportunity to buy,” says Bernd Ondruch, founder of Astellon Capital Partners in London.

But we’d suggest keeping your foot on the brake until the scandal’s ultimate potential toll becomes clearer.

http://www.barrons.com/articles/its-too-early-in-the-crisis-to-bet-on-vw-shares-1443247256?mod=BOL_hp_we_columns