Invesco: VW scandal has caused valuation anomaly

Uncertainty surrounding the Diesel scandal affecting Volkswagen has caused a valuation anomaly in the automotive sector, argue Invesco Perpetual global equities managers, Stephen Anness (pictured) and Andrew Hall.

We have devoted significant research effort this month to reviewing the global automotive sector in light of the VW emissions scandal. We have reviewed the cyclical and secular trends facing the industry, the competitive dynamics and of course given consideration to the long-term implications of the diesel emissions scandal. We have met several industry analysts and concluded a research trip to Munich where we visited the management of BMW. We also attended a thought provoking presentation by Stanford University lecturer Tony Seba on the potential for ‘disruption’ in the automotive industry. Before coming on to discuss the outlook for VW specifically we would like to share our general findings on the industry.

The car industry has a number of notable characteristics; demand has tended to be quite cyclical over time, competition tends to be fierce, profit margins are low and it is highly capital intensive. This has meant that many companies in the industry have experienced very high operational gearing and generally poor levels of cash generation. Typically car manufacturers earn only a few hundred dollars of profit per vehicle which means that small variations in pricing and demand have a big bearing on their profitability. With this in mind it’s important to have some perspective on where the industry is in its cycle.

Figure 1: 10 year trend in global car sales (seasonally adjusted)

invesco stat

Source: BofA Merrill Lynch Global Research, as at 28 October 2015.
Figure 1 shows the 10 year trend in global car sales (seasonally adjusted). We note the sharp recovery in sales post the global financial crisis. The main driver of this recovery has been the USA (where car sales have almost doubled from their 2009 low – source: BofA Merrill Lynch Global Research, as at 28 October 2015) and China which has now become the largest car market in the world. China now accounts for roughly a quarter of global auto sales (source: BofA Merrill Lynch Global Research, as at 28 October 2015). While we don’t have a clear view on the future, our judgement is that we are probably nearing the peak of the current cycle.

This isn’t where the sector risks end however. Battery technology is evolving quickly, allowing rapid reductions in the costs of manufacturing electric vehicles which in time could make electric vehicles a much more attractive proposition (commercially and environmentally) than the internal combustion engine. Electric vehicles bring the benefit of far superior efficiency, much improved torque and lower maintenance costs than traditional cars. While some incumbent car makers including VW and BMW have made heavy investments in this area, this technology change could have the potential to be a disruptive influence on the sector with new entrants such as Tesla, Google and Apple potentially challenging the current incumbents. The onset of autonomous vehicles and ‘car-pooling’ are also notable potential threats to the status quo with early results from San Francisco suggesting that UBER’s car-pooling service is attracting strong demand. In time these developments could question the requirement for vehicle ownership in urban areas.

With these secular and cyclical risks in mind, we are approaching potential investments in the automotive sector with a degree of caution despite many stocks trading on quite cheap relative headline valuations. However the more we researched VW, the more convinced we became that the uncertainty surrounding the Diesel scandal affecting VW has caused a valuation anomaly. We also think this corporate scandal could catalyse organisational change at a group that has historically demonstrated questionable corporate governance practices. Listening to the new CEO, Matthias Muller, present the Q3 results provided some early indications of potential change. He said:

“Volkswagen must embrace a new culture”

Despite VW’s historic short-comings on governance, the company has had many great commercial successes and has won dominant market positions in many markets and segments. It has invested heavily in a new highly efficient production platform and it is very strongly capitalised, with over 20bn euros of net cash on its balance sheet. Despite the obvious risks posed by the current scandal, VW still boasts an outstanding brand stable; including VW, Audi, Porsche, Scania, Lamborghini, Bentley and Bugatti. We have analysed the business fairly extensively and conclude that even in a cautious macro environment (as discussed above), the balance sheet should be able to withstand a very sizeable litigation cost. Sometimes a crisis can be good for a company. With a new CEO, new CFO and two well-regarded external appointments to the management board, we see some chance of a healthy cultural change occurring. With the shares having fallen almost 60% in euros since April, we judge the current valuation (0.2x enterprise value/sales) to be discounting a very pessimistic scenario indeed even accounting for the cyclical and secular risks discussed above. We introduced a new position in VW in October.

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