The Investment Case for Volkswagen via Porsche, by Booth-Laird Investment Partnership

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Booth-Laird Investment Partnership presentation on Volkswagen via Porsche
Presented at 2013 Booth-Laird Equity Conference
Hosted by LSU’s E.J. Ourso College of Business & Department of Finance

Jonathan BoothWe recently held the inaugural Booth-Laird Equity Conference hosted by LSU’s E.J. Ourso College of Business and Department of Finance on April 12, 2013. We closed out the conference by presenting one of our best ideas at the time – Volkswagen via Porsche. Since then, the stock has continued to drop despite no change in the fundamentals of our analysis, offering an even more compelling opportunity. We took the opportunity to add to our investment. Below is a rough approximation of the presentation I gave at the conference.

We focus on “out-of-favor” stocks, which we define as stocks that are mispriced due to uncertainty or fear, misunderstanding, or obscurity. The higher the market has risen, the more difficult finding such stocks has become. Even the European stock markets have had a strong run despite the major issues faced over there. Yet even in a fairly-to-overly valued market, there exist pockets of negativity. We strive to find those pockets of negativity and then determine which companies represent the best potential upside while still limiting the potential downside. After all, preservation of capital is our top priority.

Searching for pockets of negativity brought Volkswagen to our attention. Europe has had six straight quarters of recession and the auto industry has been particularly hard hit. Furthermore, the Chinese state-run media recently criticized Volkswagen. China is Volkswagen’s single largest market and 60% of Volkswagen’s reported revenue comes from Europe. As a result, the market has become highly uncertain of Volkswagen’s near-term prospects. The stock is down 24% since its peek on February 1, 2013 and down 18% on the year while the S&P 500 is up 9% over the same time period. Volkswagen is also clearly out-of-favor when compared to its non-European global competitors. Using normalized earnings for Volkswagen, it is selling for under 5 times earnings while its six largest non-European peers are trading for 16 times earnings. Furthermore, despite generating returns on invested capital well in excess of its weighted average cost of capital, Volkswagen is selling for less than book value while its peers trade for nearly twice book value.

Because of the market’s focus on the near-term uncertainty, Volkswagen represents a time arbitrage opportunity. Time arbitrage means there is no clear-cut near-term catalyst but long-term minded investors should be rewarded for their patience and conviction as the company outperforms lowered expectations over time. Even more enticing, we can buy Volkswagen shares at a 25% discount to the current stock price simply by investing in Porsche, which is comprised of just two assets after selling its operating subsidiary to Volkswagen: €2B in net cash and 32.2% ownership stake in Volkswagen. Porsche is selling at a 25+% discount to its net asset value.

Volkswagen’s Recent History

Volkswagen is one of the three largest automotive manufacturers in the world with 12 distinct brands (including the recently acquired Porsche) and 100 factories worldwide. The company recently underwent a transformation beginning in 2007 when the new CEO, Dr. Martin Winterkorn, took the helm. After years of reputation and quality issues, poor culture, limited growth and low operating margins, Dr. Winterkorn set about changing the way things were done at Volkswagen. He established the “Volkswagen Way” to change the culture of limited risk-taking, even getting the unions to sign off on it. He also formalized Strategy 2018, the roots of which had begun before he took over. Strategy 2018 is an ambitious plan for the company affecting every major aspect of the company, ranging from concrete targets of global vehicles sales and profitability to more abstract goals such as customer satisfaction, product quality, and employee morale.

Nearly every CEO coming into a difficult situation has grand plans for turning the company around. What matters are results. In the five years since Dr. Winterkorn took over, Volkswagen has delivered results in spades. Global market share for passenger cars increased from 9.6% in 2007 to 12.8% in 2012, increasing every single year. Worldwide deliveries have increased 8.4% on average as the company has almost reached its 2018 goal of 10 million annual vehicle deliveries a mere 6 years ahead of schedule. Over the same time period, revenue has increased 12.1% on average, indicating a steady increase in product pricing. Finally, Volkswagen’s operating margins have exceeded the average of its six largest non-European peers each of the last three years. In fact, Volkswagen’s operating margins have nearly doubled its peer group each year.

Volkswagen has been taking profit share while increasing prices and maintaining above-average profitability. Yet the market prices Volkswagen at 1/3 its peer group using the P/E ratio and 1/2 its peer group using the P/B ratio. A thorough analysis of Volkswagen reveals no real basis for this extreme disparity in pricing and sentiment.

Properly Analyzing Volkswagen

All major auto manufacturers are hybrid companies that combine a manufacturer and a captive financing company. Just as you would not analyze Proctor & Gamble and Bank of America the same way, you cannot analyze an auto manufacturer uniformly. It is necessary to look at the different pieces separately and then determine a sum-of-the-parts valuation. Most auto manufacturers understand this dichotomy and provide full financial statements, including the cash flow statement, for the manufacturing and for the financing divisions separately.

Auto Manufacturing Division

All global auto manufacturers share common traits and pursue common goals. The key is to determine the areas in which a company can truly differentiate itself versus simply doing what is necessary to keep up with the competition. For Volkswagen, the key areas are distribution and manufacturing efficiency.

Distribution is one of the least appreciated aspects of any business. For a differentiated (non-commodity) manufacturer of any kind, distribution is absolutely vital for maintaining and growing market share. It does not matter if you invent a time machine. No one will buy it if they cannot find it. We have found that most companies with strong market shares boast the strength of their distribution system. An expansive, intelligent distribution system takes a long time to build up and creates a barrier to entry for new competition looking to take market share.

For auto manufacturers, the “distribution” is primarily the dealer network attached to the manufacturer. A typical dealership is independently owned but exclusive to the manufacturer and relies heavily on the manufacturer for parts, support, and financing. Simply put, the more dealerships you own in an area, intelligently distributed, the more likely you are to have a higher market share.

China is a perfect example. Volkswagen was the first to move into China in a big way in 1984 and now has over 2,000 dealerships in the country with plans to expand to 3,000 in the medium term. Volkswagen also has 21% market share and growing. Meanwhile, General Motors has 75 dealerships in China with plans to expand to 150 in 2013. It will be very difficult for General Motors to take market share when it is dealing with 1/25th the number of dealerships. A clustering of dealerships of that magnitude also leads to benefits in shipping costs, regional overhead allocation, etc. Even though General Motors is also one of the three largest auto manufacturers in the world, it cannot expand from 75 dealerships to 2,000 overnight. Some of the issues General Motors would face pursuing such an endeavor include the availability of land, government licenses and approval, cost, building the regional infrastructure to support it, and, if independently owned, finding a sufficient number of entrepreneurs with sufficient access to capital willing to take the risk.

Overall, Volkswagen has 20,000 dealerships worldwide with plans to add 1,500 in the near-term. Volkswagen outlines its plans for growth in every single growth market (basically any part of the world not called Europe). In every region, those growth plans call for significant investment in expanding the local dealer network.

Next to distribution, Volkswagen’s manufacturing efficiency is equally important. The global car market competition is intense and getting more intense each year. Intense competition means pricing pressure, so constantly driving cost out of the manufacturing process is vital for maintaining and growing margins. A major trend among manufacturers is to consolidate multiple models onto fewer platforms, which leads to interchangeable parts, less complexity, bulk discounts from larger order sizes, and reduced design and engineering time for new models.

Volkswagen has been on the leading edge of reducing platforms and expanding the use of modular parts for years. Volkswagen’s “modular toolkit” represents the next in a long line of breakthroughs in manufacturing efficiency achieved by the auto industry as a whole. While Ford and Toyota were previously the pioneers, now it is Volkswagen’s time to shine.

Explaining the modular toolkit can get fairly technical, so I will keep it simple. At a high level, it increases the percentage of the car that is interchangeable between models while keeping the visible part of the car differentiated. It sounds simple in theory but the implementation is fairly complex, with significant up-front costs. The PowerPoint presentation I prepared provides some quotes from competitors that give an idea of Volkswagen’s leadership in this area. I’ll repeat the most important quote, the one from a Toyota executive just last year. Toyota is Volkswagen’s largest competitor for global dominance and was lauded for its own manufacturing efficiency (“The Toyota Way”) for years. The executive said, “There’s no doubt we have fallen behind. We have not even begun to make the fundamental structural changes that VW has” in designing and applying flexible vehicle platforms. That quote was pulled from the Newsday article printed on February 12, 2013 titled “Volkswagen’s MQB could vault automaker past Toyota.” MQB is the name for the next phase of Volkswagen’s modular toolkit.

Clearly Volkswagen is doing something right. In 2012, it grew market share in every single major market in which it competed, including North America where vehicle delivery growth more than doubled the growth in the overall regional market. Further, the auto manufacturing division is well capitalized with over €8B in net cash excluding the pension liability. Including the pension liability, net debt to total capital was only 18.3%, which is low for a manufacturer in most industries.

Regardless of what happens in Europe in the near-term, the auto manufacturing division should continue to grow. Volkswagen should benefit from worldwide industry tailwinds, especially in the emerging markets in which it is well established. Further, Volkswagen can continue to take market share with its distribution advantage in key markets, strong capital position allowing for brand promotion, and increasingly more local factories, an effective way to boost local demand. Finally, Volkswagen is interested in acquiring another valuable brand to add to its diverse arsenal.

Financing Division

In automotive financing, there are three areas to focus on: penetration rate, riskiness of loan portfolio, and the sources of funds used to finance loans. Volkswagen measures up well in all three areas.

Penetration rate measures the percentage of auto sales that the company finances internally. Volkswagen has a penetration rate of roughly 30%, which is line with the industry. A high penetration rate leads to the ability to close more transactions, increased customer loyalty, and reduced customer turnover. Volkswagen has an above average penetration rate in established markets but well below average in emerging markets. The company is focused on financing a higher percentage of sales in places such as China, which should act as an additional source of growth for the company.

The loan portfolio is risk adverse. With average interest rates of 7.5% and little interest in lending to sub-prime borrowers, Volkswagen is unlikely to get itself into trouble. While some companies can do very well lending to sub-prime borrowers, it takes a specialized knowledge and a certain touch. Volkswagen’s unwillingness to extend to this uncharted territory is a good sign.

The third piece – the source of funds – is yet another strength for Volkswagen. Like its peers, Volkswagen accesses the capital markets to finance its loans. Rated investment grade with positive outlook by both S&P and Moody’s, Volkswagen is able to enjoy low interest rates and low risk of capital suddenly being cut off. Unlike its peers, Volkswagen also draws funds from its own bank. Volkswagen has over 1 million customers in its German bank, one of the largest banks in Germany. Roughly 22% of its funding comes from its banking operations, and depositors are traditionally the cheapest form of financing available. The Volkswagen Bank is also well capitalized with capital retention ratios easily exceeding minimum European Union requirements.

Addressing Market Fear #1 – European Debt Crisis

The primary reason the stock is down and trading at multiples well below its peers is fears over the near-term future of Europe. Based in Germany with 60% of its revenue coming from Europe, the market naturally fears the worst regarding Volkswagen. If the market were to dig a little deeper, I believe it would find some moderating factors.

First, China is not even included in the top revenue line. While China is Volkswagen’s largest market, Volkswagen operates via two 50%-owned, unconsolidated joint ventures. So while Europe may represent 60% of reported revenue, it represents less than 60% of net income.

Second, 1/3 of European revenue comes from Germany, which is the most stable European country and in even better shape than the U.S. with only 5.4% unemployment rate. While Germany would inevitably be impacted by further declines in Europe, Germany is likely to be hurt less and to rebound more quickly than its peer countries.

Finally, Volkswagen is well established in growth markets outside of Europe, which will go a long way toward abating the expected declines in Europe. The proof is found in 2012 results. While industry-wide European vehicle deliveries declined 8.4% in 2012, Volkswagen global deliveries increased 11.8%. That is a difference of 20 percentage points. Excluding the one-time boost of consolidating newly acquired businesses, the gap is still in excess of 15 percentage points.

To prove my point that Europe is not as significant to Volkswagen’s results as the market fears, I did a simple thought exercise to determine what growth would be required in the rest of the world to overcome a steep decline in European revenue and keep earnings before tax flat year over year. If European revenue were to drop 15% in one year, which is an extreme and unlikely scenario, growth in the rest of the world would have to grow roughly 11-12%, including China. Volkswagen’s revenue growth has been over 12% on average, including Europe, since 2007. While I am not predicting this rapid company-wide pace can continue, I do believe that 11-12% growth outside of Europe is certainly achievable given expected industry growth and likely gains in market share.

Addressing Market Fear #2 – Recent Chinese government criticism of Volkswagen

As noted above, the Chinese state-run media recently criticized the three most successful foreign companies operating in China: Apple, Yum! Brands, and Volkswagen. This criticism has contributed to the decline in stock price for all three companies so far this year. The only conceivable fear leading to this decline in stock price is that the Chinese government will suddenly be against these companies, making it difficult for them to do business in-country. I believe some simple logic should dispel this fear as it regards Volkswagen.

Volkswagen has a longer history in China than the other two companies mentioned, moving into China in the mid 1980’s. Further, it is the only one of the three that operates entirely via 50/50 joint ventures with domestic Chinese companies. Therefore, if the Chinese government were to actively make life more difficult for Volkswagen, it would do so at the expense of its own citizens and business owners. Further, Volkswagen and its JV partners are major employers in China with plans to build more manufacturing facilities and employ even more people.

While governments do not always act logically, they at least, by and large, try to act in their own self-interests. Intentionally hurting a major domestic company with plans to spend significant sums of capital expanding in-country would not be in the best interest of the ruling government. Besides, unlike Toyota when similarly criticized by the U.S. government, Volkswagen acted quickly to placate the Chinese government and would do so again in the future. The risk of permanent damage to Volkswagen’s ability to compete in China is low, in my opinion.

Intrinsic Value

We value the auto manufacturing and financing divisions separately and then sum the two parts to determine the value of Volkswagen as a whole. As with every company we value, we determine a potential upside using conservative assumptions and a potential downside using poor assumptions unlikely to occur. Our upside valuation for Volkswagen came in at €275 versus the stock price at the time of €152. Our downside valuation is €141. Since we first valued and invested into Volkswagen, the stock has dropped to €141, representing an even more compelling opportunity. After the drop, we added to our position since the fundamentals of my analysis remain unchanged. At the current stock price, our calculation of potential upside is 95% versus a potential downside, or permanent loss of capital, approaching 0%.

Preferred versus Common Shares

We purchased the preferred shares (VOW3.DE) on the Frankfurt Stock Exchange instead of common shares and instead of the ADR due to liquidity. The preferred shares are three times as liquid as the common shares due to greater float. Also, the ADR has low liquidity.

Buy Volkswagen at 25+% Discount to Current Stock Price

Porsche SE recently sold the Porsche brand name and its operating subsidiary to Volkswagen. Now Porsche is a holding company with just two assets: €2B in net cash and 32.2% of Volkswagen (with over 50% of the voting rights). Porsche is available at a 25+% discount to net asset value, offering the opportunity to buy Volkswagen at a 25% discount to the current stock price.

Porsche is available at a discount because it is being sued. In 2008, Porsche actually tried to buy the much larger Volkswagen, nearly bankrupting itself in the process. Porsche was allegedly less than forthcoming about its intentions, causing a number of hedge funds to lose money. As a result, Porsche is being sued in the U.S., the U.K., and Germany. The lawsuits total roughly €4 – €5B. However, to-date every single court that has made a decision has ruled in Porsche’s favor and, so far, Porsche has not paid a dime. The U.S. court dismissed the case entirely. The German court ruled in Porsche’s favor on one of the small cases totaling a few million euros. That decision is finalized without chance of appeal, setting precedent for and boding well for the far larger cases being tried in the same court. The most likely scenario is that Porsche settles for some small amount to make the lawsuits go away. However, the market is currently pricing in the full potential cost of the lawsuits.

Porsche is essentially the family office for the descendants of Ferdinand Porsche, the founder of Volkswagen and Porsche. The chairman of Volkswagen, Ferdinand Piech, is the grandson of Ferdinand Porsche and on the board of supervisors of Porsche. Further, the CEO of Volkswagen, Dr. Martin Winterkorn, is also the CEO of Porsche. Porsche is the vehicle through which the Porsche and Piech families own sizable stakes in Volkswagen and through which they maintain over 50% voting rights in Volkswagen.

Like any family office, Porsche wants more than one investment. The company is actively looking for a mid-size acquisition in the auto value chain (not another auto manufacturer), likely based in Europe. The board of supervisors and management obviously understand the auto industry well and are apt to make a prudent decision in determining which company is most likely to benefit from future macro- and industry-specific trends. Further, as we have seen with other companies making recent acquisitions in Europe, Porsche should benefit from suppressed prices for private businesses in Europe. As a result, the cash they will eventually use to acquire a company should generate substantially higher returns on capital in the future than it is currently yielding. Therefore, the cash, which is unencumbered, is worth more than what is currently on the balance sheet, equating to a free option on whatever business Porsche acquires in the near future.

Because Volkswagen’s stock is substantially undervalued by our estimation and Porsche allows us to purchase at a 25+% discount to the current stock price, Porsche offers a compelling and unique opportunity. Taking 32.2% of our upside valuation of Volkswagen and assuming Porsche ultimately settles the lawsuits for €500M, the value of Porsche is €141 versus the current stock price of €54, or a potential upside 160%. Taking 32.2% of our downside valuation of Volkswagen and assuming Porsche ultimately pays the full cost of the lawsuit of €5B, the value of Porsche is €59, which is still 9% higher than the current stock price. In other words, the risk of permanent loss of capital, in our opinion, is very low.

Only the preferred shares are publicly traded for Porsche. The common shares are owned entirely by the Porsche and Piech families and the country of Qatar. We purchased Porsche preferred shares on the Frankfurt Stock Exchange (PAH3.DE) rather than via an ADR again due to liquidity differences.

Timing/Catalysts

While I expect the fears of Volkswagen’s future in China to abate in the near-term, I do not think fears over Europe will go away any time soon. Obviously some permanent solution to the sovereign debt crisis would catapult all European stocks. More realistically, shareholders will be rewarded only as Volkswagen outperforms lowered expectations over time. Management has a history of under-promising and over-delivering in recent years, and we expect that trend to continue. The stock market for Volkswagen and, by extension, Porsche might get uglier before it gets better. We will continue buying if the stock continues dropping and expect to be well rewarded for our patience and conviction over the next few years. We are not expecting or looking for a quick, short-term gain on the investment.

Summary

Volkswagen is undervalued due to an over-reaction to the European debt crisis and Chinese government commentary and currently represents a time arbitrage opportunity for long-term minded investors. The turnaround that began in 2007 has been highly successful to date yet under-appreciated by the market as the stock is trading at a significant discount to its peer group and to intrinsic value (even using modest assumptions) with limited downside.

Volkswagen is a well-run company generating returns on capital well in excess of cost of capital, which is precisely the type of company we are content to own for many years. Further, you can purchase Volkswagen stock at a 25% discount to its current stock price via Porsche preferred shares, which comes with a free option on whatever company Porsche acquires in the near future.