Why Volkswagen's Era Might Be Coming To An End

seekingalpha09-11

Volkswagen's stock has declined 17% since my initial "Sell" rating, underperforming the broader market by 38%.VW's falling sales in China, rising competition from Chinese EV automakers, and reduced ...

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Teka77 Today marks a year since I covered Volkswagen AG (OTCPK:VLKAF) for the first time on Seeking Alpha, rating the stock a \"Sell.\" The first coverage has received a good number of commentary from fellow investors, who shared different viewpoints. Perhaps the majority did not agree with my bearish thesis on Germany's largest automaker, which also deviates from the bullish consensus of other SA analysts. Yet, the call has proven to be correct. The stock has been on a downward trajectory, currently down 17% since my coverage, with the broader market (SP500) up 21%.  Altogether, that's a 38% opportunity cost in a span of 12 months.   Previous Coverage (Seeking Alpha) My previous bearish coverage was based on a few key pillars, such as:  Volkswagen's falling sales in China, partially driven by the country's economic challenges and the falling attractiveness of Western automakers.  The hiking monetary cycle in Europe and the US made auto loans less attractive, reducing demand for new vehicles. The growing threat of Chinese EV automakers exports at significantly more competitive pricing.  While most of these adverse events played out as expected, it's time to share updated coverage, particularly as Volkswagen's business faces a new set of threats that should not be taken lightly. Volkswagen's Complex Shareholder Structure Before discussing Volkswagen's threats, the key is to understand that the company's share structure and shareholder diversity are rather complex, certainly not helping the business make streamlined decisions. First of all, the company has two types of shares in its domestic market, Germany:  Voting shares, trading under the ticker VOW Preferred shares, trading under the ticker VOW3  The preferred shares carry non-voting rights yet pay a slightly higher dividend while trading at a lower price. These non-voting rights shares trade as ADRs in the US under the ticker VWAPY and VWAGY. Now, in terms of the shareholder structure:   Porsche Automobil Holding SE (OTCPK:POAHY) is the largest shareholder, with 31.9% of Volkswagen's shares and 53.3% of the voting rights. In theory, you can get exposure to Volkswagen by buying Porsche shares instead. Foreign institution investors own roughly 27% of the total shares. Lower Saxony (a German state) owns 11.8% of the total shares and 20% of the voting rights. Qatar Holding LLC owns 10.5% of total shares and 17% of voting rights. Private Shareholders and German institutional investors own a combined 19.3% of the total shares.  With such a diverse shareholder base, including family owners, governments, private companies, and institutional investors, balancing interests often comes at the cost of the company's performance and future objectives. What's worse, the 20% voting rights of the State of Lower Saxony mean political involvement in some decision-making, particularly when it comes to employment. Volkswagen is the largest domestic industrial employer, with over 300,000 workers in the country, and often ends up at the center of political battles. That's one reason Volkswagen's business is falling behind, with significantly worse profitability per employee compared to peers, as shown below: Net Income Per Employee (Seeking Alpha)   Losing Battle Against Chinese Automakers Following Volkswagen's rich history spanning 87 years, the company is, for the first time, weighing the option of closing domestic factories to deepen cost cuts amidst rising competition from Chinese automakers. Volkswagen's CEO Oliver Blume is not taking the situation lightly, recently saying: The European automotive industry is in a very demanding and serious situation. Likewise, the company's CFO, Arno Antlitz, said just last week that \"it has one, maybe two, years to turn around its namesake brand\" and stabilize its core business. The company is trying to eliminate its employment protection agreement with labor unions, which has been in place since 1994, to slash spending, helping the company survive the shift towards EVs. The economic environment has become tougher, and new competitors, with more attractive technology and pricing, are quickly entering the European market, stealing VW's market share as the company falls behind in competitiveness. VW's brand market share peaked in 2012 when it made up 12.83% of all European car sales. In recent years, however, the market share has contracted to 9.83%, creating issues with idleness in domestic factories. The shortfall in demand for 500,000 vehicles is roughly equal to the output of two factories that the company plans to close. Naturally, VW's brand is not responsible for all the group's car sales; however, VW's passenger and commercial vehicles make up roughly 49% of all car sales, being vitally important to the company. VW's Group Car Sales 2023 (Statista) Altogether, Volkswagen Group sold 4.3M vehicles in H1 2024, below 4.4M in the prior year. The sales in H1 reached €158.8B, up from €156.3B in H1 2023, helped by higher pricing offset by lower volume. While the group's H1 earnings do not spell immediate trouble for the company, the company is under attack in its domestic region, Europe, and the situation is even worse in Asia-Pacific, which makes up 40% of the group's car sales. Particularly in China, in H1 2024, car sales slipped 7% compared to the previous year, weighing on the operating income which came at €10.1B, falling 11% from the prior year. Ultimately, VW's group delivered a negative cash flow of -€0.1B in H1, compared to €2.5B in H1 2023. While the negative cash flow can be attributed to high R&D expenses, preparation for new model launches at Audi and Porsche, and working capital build-up, the trajectory of razor-thin margins spells major trouble, particularly during a period of where the business has to reinvent the wheel (read EV switch), where we can expect elevated technology spending. VW's group understands this challenge and embarked on €10B cost-cutting efforts last year to stabilize its core operations in factories, supply chain, and labor expenses while prioritizing technology investment. To this end, it established a joint venture with Rivian Automotive (RIVN) to invest up to $5B until 2026, unlocked in milestones, to access Rivian's tech know-how and integrate its software into VW's vehicles. This investment is set to make VW's vehicles once again more attractive, particularly in its single-largest market, China, where the vehicles sales fallen by 1/3 in a span of three years, to 1.34M in H1 2024, losing its title a \"China's best-selling brand\" since 2000 to BYD (OTCPK:BYDDF). Altogether, VW's lackluster car sales performance is a testament to a change in the industry. Chinese automakers are starting to take over both their domestic and international car markets, particularly with the switch to EVs gaining traction, despite the heavy tariffs imposed by the US and European Union on vehicle products in China. It's not only Volkswagen; Ford (F) and General Motors (GM) are also seeing sales and market share vanish as local Chinese consumers embrace the idea of buying domestic brands over foreign brands, a major shift in the narrative compared to the previous generation of Chinese consumers. Shares Of Vehicles in China (CNN) Being an auto-mass producer in China and Europe is particularly difficult. The days of high-growth rates and large profits might be over, and many companies are now losing money in the pricing war and race to the bottom. Altogether, in my perspective, automakers are not the best investment now as we navigate the major shift from combustion engines to electric ones, which is also changing the region's manufacturing dominance. I recommend observing the change in the market share from the sidelines rather than buying some of the automakers, which appear to be dirt cheap. If you think VW's cost-cutting plans will be enough to offset the falling demand, think twice. As I said, VW's position in Germany is political, and the factory-closing plan already faces heavy resistance from labor unions. Unions hold almost half of the seats on the company's supervisory board, the body that elects executive managers. A few previous CEOs have already lost their jobs due to similar proposals. The situation is particularly delicate and compounded by Germany's weak economy, which has a domestic PMI of 42.4 points, indicating manufacturing contractions. Germany PMI (Trading Economics) Chinese Exports It's not only in China that Chinese automakers are conquering. Chinese auto exports, particularly with the switch to EVs, are soaring, increasing 60% compared to last year. At this run rate, in 2024, Chinese exports are expected to top 7.8M vehicles, a significant increase from 4.9M in the previous year. In fact, in 2024, China will become the world's largest car exporter, ahead of Germany and Japan.   Chinese Car Exports (Statista) According to UBS analysts, European automakers are expected to suffer the largest setback and market share loss as Chinese automakers are projected to double their global EV market to roughly a third by 2030. In Europe, Chinese EVs already account for 25% of the market share. To protect local automakers, the European Union has hiked tariffs on Chinese-made EVs to 38.1%, and the US has imposed 100% tariffs. However, as part of the competitive law, tariffs are to be applied only to vehicles made in China, not to all Chinese cars. In fact, BYD is already building its first European production plant in Hungary with an annual production capacity of 200,000 cars to satisfy the demand for its vehicles, a direct threat to Volkswagen. Naturally, tariffs will not apply to vehicles produced within the EU. Yes, VW's stock is cheap, but it can get cheaper If you are buying Volkswagen's shares just because the stock is cheap, that's a risky strategy. Yes, the company's shares are trading at a P/E of 3.3x. However, most European automakers, seeing their P/Es >5, are relatively cheap thanks to the above-mentioned risks. PE Ratio (Seeking Alpha) In fact, Volkswagen's shares are trading at 28% of their book value, which is by no means dirt-cheap valuation territory. However, again, most automakers are trading well below their book value, suggesting a larger problem in the industry. Price/Book Value (Seeking Alpha) We could go in circles discussing VW's cheap valuation and what ROR investors could earn if the valuation would revert towards its normalized valuation of 5.3x P/E. Yes, suppose the industry risks fade and the new winners are declared in the age of electric vehicles rather than combustion engines. In that case, we can discuss the potential ROR VW can earn its shareholders alongside the mouth-watering 9% dividend yield. However, for now, there are too many risks in the industry, and consolidation will most likely occur in the future as some businesses fail, with their outdated business models not being fit for the new area of production efficiency. VW is certainly not at immediate risk of bankruptcy with over €45B cash on the balance sheet; however, currently, I do not see a clear path to valuation reversal and potential capital appreciation. Investor's Takeaway All in all, Volkswagen's business used to be the crown jewel of Germany's economy and the symbol of German engineering superiority. Nevertheless, the business failed to innovate and is plagued by poor decision-making driven by state ownership, which cares only about one thing—employment. Altogether, falling sales, loss of domestic and international market share, failed innovations, and razor-thin margins point to a murky future, mainly as more competitive Chinese automakers take the lead in a new era of EV carmaking. At this stage, with Chinese carmakers capturing domestic and international market share, I view Volkswagen as a risky investment even as the company trades at 30% of its book value, as the future, particularly demand for its vehicles and the success of its cost-cutting initiatives, is far too uncertain.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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