EUR 850.00 For Business Accounts Only

Morningstar | Volkswagen Reports Solid 2Q Results on Higher Volume; Maintaining EUR 230 FVE

No-moat-rated Volkswagen reported earnings per diluted preferred share before special items of EUR 8.85. The result was strong, obliterating the consensus EPS estimate of EUR 5.56 and well ahead of the EUR 6.06 reported in the second quarter of 2017. Consolidated revenue increased 3% to EUR 61.1 billion from EUR 59.2 billion on a 5% increase in consolidated unit volume, excluding China joint ventures, and a 7% increase in financial-services revenue. Second-quarter group operating income jumped 21% to EUR 5.5 billion from EUR 4.5 billion, while operating margin expanded by a healthy 130 basis points to 9.0% from 7.7%.

Management confirmed 2018 guidance but warned that "growing protectionism" represents a risk to its outlook. The company continues to forecast an increase of as much as 5% in consolidated revenue compared with 2017 and consolidated adjusted operating profit margin (before special items) within a range of 6.5% to 7.5%, despite first-half cost headwinds including heavy launch costs, currency, and a longer, more expensive government approval process for emission certification. Notwithstanding headwinds, this year’s margin guidance represents a 50-basis-point expansion versus last year’s guidance of 6.0% to 7.0%.

In our opinion, 4-star-rated Volkswagen shares offer investors compelling valuation. Even though the worst is over in the U.S., our main concern about Volkswagen stock remains the uncertainty surrounding the ongoing European investigations into the diesel scandal and possible collusion. We also believe the market has discounted the stock on concerns that trade tariffs may escalate and on the higher investment needed in autonomy and powertrain electrification, which our fair value already takes into consideration. The preferred shares (much more liquid than the ordinary) currently trade at a compelling 36% discount to our EUR 230 fair value estimate.

We have maintained a EUR 20 billion reduction to our enterprise value to reflect potential litigation in Europe where criminal investigations persist, and EU consumer agencies are seeking relief similar to remuneration received by U.S. consumers who had the option to have Volkswagen buy back the vehicle or receive $5,100 cash plus free repair. European consumers were only offered free repair. Removing the EUR 20 billion reduction would result in a EUR 271 fair value.

Volkswagen second-quarter 2018 industrial revenue (excludes financial services) rose 3% to EUR 52.0 billion versus EUR 50.6 billion reported last year. The company’s global unit volume (excluding China JVs) rose by 5% mainly due to 16% and 9% increases in South America and Europe regions, respectively. Total Volkswagen Group volume including China joint ventures was 6% higher versus the year-ago second quarter.

While unit volume in Europe and South America increased 9% and 16%, respectively, revenue rose by only 6% in each respective region, due to mix in Europe and currency translation in South America. Despite a decrease in China import duty as July 1 that caused consumers to postpone purchases to the third quarter from the second quarter, China JV volume increased 7% to 959,000 units during the quarter. The VW brand had historically had higher exposure to small passenger cars but new crossover and sport utility products introduced in the region added to the volume increase. Excluding China, Volkswagen brand posted solid gains in global passenger vehicle revenue and volume, increasing 10% and 7%, respectively.

Industrial operating margin, excluding China JV equity income, was 8.2%, expanding 20 basis points compared with 8.0% last year. Improvement in volume and efficiencies from modular tool kit manufacturing were nearly offset by pricing pressure, negative currency, and higher spending on powertrain electrification. Even so, at 7.2% for full-year 2018, our forecast is near the high end of management’s operating profit margin guidance, versus 8.7% reported for full-year 2016.

VW brand operating margin significantly improved to 5.5% versus 4.4% a year ago, primarily due to solid pricing/mix, solid execution, but partially offset by unfavorable currency translation. Audi brand saw a 2% increase in revenue on a 3% increase in unit volume, while operating margin remained flat at 9.2%. Porsche revenue remained relatively flat on an 8% skid in unit volume. Even so, operating margin was flat with the year-ago period at an impressive 19.4%. While mix and operating leverage on higher volume were favorable, launch costs and powertrain electrification offset operating performance. Skoda and SEAT were bright spots for Volkswagen’s quarter, with revenue jumping 5% and 17% on volume increases of 2% and 15%, respectively. Also contributing to the results, VW Commercial, Scania, and MAN revenue from commercial truck and power (MAN diesel engines for marine and stationary applications) increased 11%, 5%, and 11%, respectively. Unit volumes increased 4%, 4%, and 21% for each commercial vehicle maker. VW Commercial’s operating margin was solid, expanding 220 basis points to 10.2% while Scania was off slightly but still healthy at 10.4%. However, owing to continued losses in MAN’s power business, operating margin contracted 30 basis points to 3.9%.

Given the difficulties Volkswagen faces with the diesel scandal as well as higher cost from investment in technologies, the company’s operating performance has been impressive. We estimate that operating margin (excluding financial services, special items, and including China JV equity income) during our Stage I forecast averages 6.5% versus a Volkswagen 10-year historical high, low, and median of 8.7% (2017), 1.3% (2009), and 6.8%, respectively. We assume a normalized sustainable midcycle margin of 5.1%, 170-basis points below the 10-year historical median. Consequently, our EUR 230 fair value estimate already takes into consideration higher spending for industry disruptive technologies including mobility services, autonomy, and powertrain electrification. Even so, the 4-star-rated stock is attractively valued, with the market currently trading shares at a 0.64 P/FVE.