Volkswagen Aktiengesellschaft, Wolfsburg, Germany
Broad product range with a good brand image and growing market shares underpin current rating Volkswagen (“VW” or “the company”) is Europe’s largest car manufacturer, with a market share of 20.3% in Western Europe in 2008, and ranks number four globally with total annual unit sales of approx. 6.3 million vehicles. Based in Wolfsburg, Germany, Volkswagen manufactures mass-market and premium cars under the VW, Audi, Skoda, SEAT, Bentley, Lamborghini and Bugatti brands, as well as commercial vehicles under the Volkswagen- and SCANIA brands. Through its subsidiaries Volkswagen Financial Services and LeasePlan (50% owned), VW also provides the full range of financing, leasing, fleet and rental services. Volkswagen Bank GmbH (A2/P-1/C+), a 100% indirectly owned subsidiary, holds a banking licence and offers retail banking services.
Aiming to become benchmark in the industry
The CEO of Volkswagen Group, Prof. Winterkorn, set clear and demanding strategic goals to be achieved by 2018. The Group wants to become benchmark in terms of customer satisfaction, quality, returns as well as attractiveness as an employer. With additional new models, VW will intensify its penetration of the SUV-, pick-up- and van segments and expand further in at the lower end with the “New Small Family”. Markets such as China, India, Russia and Brazil are expected to be the key drivers of the ambitious growth target. In addition, the implementation of a new business model in USA with new products more tailored to the needs of the US customers and a local production starting in 2011 should result in significant volume growth and a turnaround in profitability over the medium to longer term.
Furthermore, VW targets continuous productivity improvements of at least 10% annually and scale effects from an intense use of modules across platforms and brands based on a modular matrix (called MQB) enabling the company to become benchmark in profitability in the industry
Uncertainty around a potential combination with Porsche
On May 8, 2009 Moody’s placed Volkswagen’s (“VW”) A3 long term ratings under review for possible downgrade following the announcement of a potential combination between VW and Porsche Automobil Holding SE (“Porsche”). In their communication the companies announced the aim to create an integrated automotive manufacturing group thereby insuring the independence of all brands. Within the next four weeks the final structure should have been agreed on based on result of the negotiations involving VW, Porsche, the State of Lower Saxony and the employee representatives.
The review for possible downgrade reflects the risk that the combination of Volkswagen and Porsche might result in an entity with a financial profile that might not be in line with VW’s current A3 rating given the significant debt of Porsche SE reported as of January 31, 2009 in the company’s six-month report.
But against initial planning an agreement on a possible combination has not been reached yet. Moody’s understands that VW remains highly committed and strive to maintain its single-A credit rating as a key priority which could be one of the reasons why the company has not been willing to enter into a combination with highly leveraged Porsche.
As press report that Porsche is in process of looking for potential investors to reduce its debt also in order to strengthen its position in the negotiations the timing and possible outcome of an integrated automotive manufacturing group remains unclear at that point in time.
Absent further progress within the next few weeks, Moody’s might therefore choose to conclude the rating review taking into account 1) the existing uncertainties around a potential consolidation of the two entities 2) any changes in the operating performance and cash generation compared to our current expectations which were outlined in our latest rating action of March 20, 2009 if appropriate and 3) the commitment of VW’s management to retain a strong credit profile.
The crisis stopped in its track the impressive recovery in earnings and cash generation that the company had achieved over the last couple of years. This recovery had been driven by volume growth based on market share gains, new model launches the recent replacements of the Golf, Polo and Audi A4, cost savings as well as a historically low capex level resulting from the product cycle. Nonetheless as at the third quarter of 2008 the company has undoubtedly built a solid financial flexibility based on accumulated cash reserves as well as a high level of operating profitability, two factors that were preparing VW reasonably well to face the difficult period ahead.
Negative mix impact and cash generation capability in current fiscal year as well as ability to recover financial performance and key credit metrics in 2010 are key rating drivers
Moody’s anticipates a sharp deterioration in Volkswagen’s profitability and key credit metrics in fiscal year 2009 based on the company’s car demand declining by around 10%. This is a far better volume performance than expected by the agency at the end of last year (-20%) before the various scrapping systems have been introduced in Europe’s major car markets. In addition, VW is expected to protect cash consumption in the current year as a result of successfully reducing inventories and cash in the course of the next quarters.
However, the impact and magnitude of a negative price/mix effect resulting from the shift towards small cars as well as Moody’s concern over the inability to recover volumes, profitability and cash flows in 2010 remain key uncertainties regarding future rating positioning of the group in addition to the above described impact resulting from a merger with Porsche.
Moody’s Global Rating Methodology reflects history of strong performance
The application of Moody’s Rating Methodology for the Global Automobile Manufacturer Industry, which identifies key areas of focus for assessing relative credit quality results in a A1 rating for the period 2006-2008, two notches above VW’s current A3 rating with a stable outlook. We expect that the outcome and the difference with the actual rating will in the future narrow due to the anticipated lower performance and metrics over the intermediate term.
RATING FACTOR 1: Market Position and Trend
In 2009 the company has been able to continue its positive share trend in its key markets. In Western Europe VW has gradually grown its market shares over the recent years, holding a 20.6% market share as per Q1 2009.
Going forward Moody’s expects VW to gradually improve market shares especially in Western Europe and Eastern Europe based on (i) the company’s young and broad product range including the new Golf and the launch of the new Polo in H1 2009 as well as (ii) the demand shift to smaller and more fuel-efficient cars. With its strong presence in its domestic market (VW Group market share in Germany was 32.5% per Q1 2009) the incentive scheme (“Abwrackprämie”). In addition, VW pursues an ambitious volume strategy of targeting 10 million unit sales by 2018 driven by penetration new markets like India, Russia and China as well as regaining strength in North America.
Volkswagen’s global market presence, its high brand recognition especially in Europe, South America and China and a product portfolio covering nearly all categories from small cars to luxury and super sports cars and trucks under nine different brands is reflected in the single-A score for sub-factor “Product breadth and strength”.
Overall, the company scores in the mid single-A category for this factor.
Moody’s notes that China has become Volkswagen’s second largest region behind Western Europe over the last years, however units sold in China are mainly produced locally from VW’s two joint-venture company’s FAW Volkswagen Automotive Company and Shanghai-Volkswagen Automotive Company where VW’s stake is 40% and 50% respectively and the companies are accounted for at equity.
Going forward Moody’s expects VW to protect or even gradually improve market shares in its key markets. However, we believe the company’s volume growth target least 10% p.a. to be somewhat ambitious. VW is targeting 10 million unit sales by 2018 driven by penetration new markets, regaining strength in North America but also entering further niche segments with additional model variants in established markets.
Volkswagen’s global market presence, its high brand recognition especially in Europe, South America and China and a product portfolio covering nearly all categories from small cars to luxury and super sports cars under eight different brands (nine brands when including heavy trucks under the Scania brand) is reflected in the single-A score for sub-factor “Product breadth and strength” despite the losses generated from North America over the last years.
RATING FACTOR 2: Leverage and Liquidity
VW’s Aa2-score for this factor benefits from the company’s very strong cash position prior to 2008 and its solid leverage. Against the backdrop of the significant cash absorption over the course of 2008 VW’s liquidity profile started to deteriorate ((Cash & Market. Sec.)/Debt: 60.3% in 2008) while its leverage remained solid (Debt/EBITDA: 1.5x in 2008). Moody’s expects leverage to increase over the intermediate term as a consequence of the weakening profitability. A possible combination with Porsche a highly leveraged company according to its published reports would very negatively impact VW’s leverage and liquidity position if no mitigating measures were taken to strengthen the capital structure. This risk has been reflected by Moody’s recent rating action when placing the A3 ratings under review for possible downgrade.
RATING FACTOR 3: Profitability and Returns
VW’s profitability and returns (EBITA Margin 7% in 2008) have reached their high point and against Moody’s expectation of a significant drop in volumes in 2009 operating profitability is anticipated to weaken considerably. As the market leader in Western Europe with a wide mass market offer, the company is among the main beneficiaries of the scrapping systems that have been introduced over the last months to halt the dramatic fall in car demand in Europe’s key markets. In Germany, the largest market of the region representing around 25% of Western Europe’s new car registrations, the incentives are expected to result in a 15% higher demand in the current year compared to 2008. However, most of the incentive schemes are set to expire at year end or in early 2010 and as Moody’s believes that car demand has only been pushed forward we are concerned that market volumes in 2010 will be well below the current year particularly in Germany but also in Western Europe as a whole. In Q1 2009 VW sold 46% of its vehicles in Western Europe therefore we caution that a further decline in volumes in 2010 is likely. Such a scenario would pressure profitability and delay the anticipated recovery in earnings that should have resulted from progress in reducing fixed costs.
Another negative effect on the profitability is expected from the visible change in the segment mix in most car markets fuelled by the scrapping bonus systems and also tax changes to support low emission cars i.e. smaller cars. The increasing consumer’s preference for smaller cars also burdens car manufacturers profitability and returns as generally smaller cars have smaller margins.
Overall, the company scores in the Aa3 category for this factor a score that Moody’s expects to weaken significantly for the next couple of years.
RATING FACTOR 4: Cash Flow and Debt Service
VW’s strong cash flow and debt service ratios, based on 3-year historical averages, position the company solidly in the low Aa-rating category for this factor. Nonetheless, cash flow generation was negatively impacted by high cash consumption already in 2008, resulting mainly from the €2.7 billion working capital consumption and the dividend payment of €720 million. Consequently, free cash flow in its industrial business turned negative by -€930 million. Moody’s free cash flow metrics do not take into account the €2.5 billion cash outflow for the acquisition of Scania shares. Debt Service ratios (EBIT/Interest expense 6.6x in 2008) deteriorated slightly resulting from lower EBIT, being adjusted for the increase in capitalized development expenses.
The current rating incorporates Moody’s expectation that the company’s initiatives to free-up cash by reducing inventory levels will be effective. Nonetheless, Moody’s notes that cash flow and debt service ratios will come under further pressure throughout 2009 in light of the decline in most of Volkswagen’s key markets and weakening earnings.
RATING FACTOR 5: Captive Finance Company
As the availability of financing support is an important element in an automotive manufacturer’s ability to maintain a competitive position Moody’s assesses the impact of the finance company’s operations. The company provides financial services operations through its subsidiaries Volkswagen Financial Services AG (“VWFS AG”, 100% owned by Volkswagen, LeasePlan (50% owned, operationally and managerially independent from VW) and Volkswagen Bank GmbH, a 100% indirectly owned subsidiary. The ratings of VWFS AG is in line with the parent VW as Moody’s believe that it has a good ability to generate and retain equity capital to fund growth, cover credit losses and contend with market disruption. The A2/P-1 ratings of VW Bank are one notch above the rating of VW as they benefit from regulatory oversight due to its banking license.
Despite an increase in revenues in 2008, all key profitability ratios of VW’s industrial business segments started to weaken as a result of the unprecedented acceleration of decline in demand in the company’s key markets in the second half last year and in the last quarter in particular.
VW claimed to have achieved around €1.0 billion improvements in product costs in 2008 compared to 2007 as well as a slightly positive effect from volume/price and mix (€0.1 billion) and around the same amount from reduced fixed costs and depreciation. Negative effects from exchange rates of €0.8 billion for the consolidated Group results as well as from the full consolidation of Scania (€0.2 billion mainly from purchase price allocation) were mitigating factors. After Moody’s adjustments the EBIT margin for the company’s industrial business declined by 1.4%-points over the last year following the impressive rise in 2007 and still at a historically high level. The 6.7% compares also favourably with all European peers including equally rated Daimler (4.2%) and BMW (1.9%). Going forward, a sustainable EBIT margin above 5.0% would be supportive for a low single-A rating, a level that might not be achievable in each of the next two to three years in Moody’s view.
Compared to profit margins cash flow figures declined to a much larger extent in 2008 in some cases even below 2006 year end levels. FFO as reported was already below 2007. As a consequence of higher capitalized development costs that are adjusted in Moody’s FFO definition and a 45% rise in dividend outflow RCF in 2008 was only around the level of 2006 thus 25% below 2008. The sharp increase in capital expenditures by €2.2 billion compared to 2007 and the cash absorption in working capital of €2.7 billion resulted in a negative free cash flow in last fiscal year.
As Moody’s pointed out in previous publications VW’s capex level of the years 2006 and 2007 was assumed to be rather low and unsustainable. Therefore, the amount spent in 2008 is anticipated to be closer to a sustainable level going forward although the current environment could result in a temporarily lower level. Moody’s believes however, that VW should be able to generate at least break-even free cash follows in the current fiscal year driven by the reversal of a significant amount of working capital absorbed in 2008 and a conservative dividend policy.
Volkswagen’s liquidity profile is good, as it has sufficient liquidity to grow and defend market share, as well as to reinvest and to strengthen brands throughout the cycle. Moody’s assessment of Volkswagen’s liquidity takes into account (i) a significant on-balance sheet cash position; (ii) sizeable headroom under its committed high-quality credit lines; (iii) a balanced debt structure; and (iv) a solid average debt maturity profile. Though not factored into the current rating, Moody’s notes that a potential change in the company’s financial policy initiated by its majority shareholder Porsche could impact Volkswagen’s liquidity profile it were to occur .
Volkswagen has ongoing financing needs related to the funding of its customers while the industrial activities should be largely self funding. In a scenario, where access to debt markets is assumed to be closed for 12 months and maturing finance assets are replaced, the company’s available cash on balance sheet of €16.5 billion, marketable securities of €3.4 billion at the end of the first quarter 2009, the €7.8 billion headroom under its unused committed syndicated line as well as expected lower operating cash flow generation do fully cover the potential needs arising from capital expenditures, working capital, day to day needs as well as short-term debt maturities and dividend payments.