April was a busy month for Volkswagen Group (OTCPK:VWAGY) (OTCPK:VLKAF) (OTCPK:VWAPY). On April 24, the company presented a Capital Markets Day in China, and a week later, the Group reported its Q1 numbers. Before commenting on the latest news, since our last update, It Gets Worse Before It Gets Better, we anticipated a challenging and competitive market. Despite that, we have a long-standing buy on the Group that is supported by 1) a lower CAPEX thanks to new collaborations, 2) a cost-saving plan in progress, 3) a tasty dividend yield recently increased to €9 per share, 4) a solid balance sheet and a negative stub value on a sum-of-the-part valuation.

China CMD and Q1 Results

Starting with Chinese Capital Market Day, it is vital to note that the region is Volkswagen’s second home market. In recent years, the company has been racing to catch up with upstart Chinese EV competitors. That said, the company has 40 years of deep roots in the region, with 39 plants and approximately 50 million customers. Volkswagen released its update called “In China, for China.” With the new strategy, we see significantly higher value creation in the region with a critical focus on the wishes of Chinese customers. For the company, the Chinese region remains an attractive profit pool powerhouse, and Volkswagen aims to maintain a domain thanks to the:

In-house development thanks to economies of scale. Volkswagen will use shared software and platforms to reduce development time by 30%;
Local partnerships with equity stake investments. The German company announced a new architecture development called China Electrical Architecture (CEA). This is used for EVs, Chinese electric vehicles, and smart cars. As a reminder, Volkswagen invested €700 million last year in XPeng’s 5% equity stake. This new architecture should help Volkswagen offer cheaper electric vehicles in China, the largest German company market. Four new brand electric cars will be assembled on the new platform starting in 2026. With the new platform, costs could be reduced by 40% compared to the Meb platform developed in Germany by reducing the number of control units. The new China Electrical Architecture uses a central computer and zonal structure to control all electronics to achieve functions such as autonomous driving.

Higher profitability and rapid development are crucial for Volkswagen’s competitiveness in the dynamic environment. The company will likely recover its market share in China, where it is suffering from growing competition from local manufacturers. By 2030, the company aims to set a €3.0 billion operating profit, including the fully consolidated Anhui JV.

Source: Volkswagen Q1 results presentation – Fig 1

Looking at the Q1 results, Volkswagen reported a 21.6% decline in net profit. “Weaker sales volumes,” customers who opted for less profitable models, and “higher costs” affected the group’s results, the main reason. In numbers, Volkswagen’s Q1 profit reached €3.71 billion. That said, the German automotive company performed better results than Wall Street analysts estimated. Q1 net profit expectations were set at €3.34 billion. Sales dropped by 1% to €75.46 billion. Going down to the P&L analysis, the company’s operating profit reached €4.6 billion and missed estimates by 7%. However, adjusting the EBIT on commodity hedge losses aligns with the core operating profit.

Fig 2

Why are we still positive?

Volkswagen’s efficiency program has not yet had a visible impact on core operating profit;
Considering lower volumes, the company was able to increase prices on a yearly basis marginally;
There is a positive impact from R8D capitalization costs;
There was no change in Volkswagen’s 2024 guidance (Fig 3). The company aims to increase top-line sales by 5% revenue and achieved a 7.0-7.5% EBIT margin with an FCF in the €5.5 range. That said, a weak Q1 makes FY targets more ambitious. During the Q&A call, the management reassured the sell-side community on Q2 margin development despite anticipating €900 million provisions due to the redundancy program;
The company has solid automotive cash liquidity, including a €6 billion inventory build-up (Fig 4).

Fig 3

Fig 4

Earnings changes and Valuation

Here at the Lab, after the Q1 results, we are moderately optimistic, and we believe Q2 will be a turning point for consensus estimates. We are confident in better sales and margins in the upcoming quarters and positively view the Volkswagen redundancy provision for Q2 2024. This finally means the company is getting serious about reverting its operating margin decline. We leave our sales unchanged at €338 billion; however, considering a lower Q1 operating profit and including €900 million in one-off cost, we reduce our EBIT margin from 7% to 6.5% to €21.97 billion. This represents an operating profit decrease of approximately 7.6% and lowers our EPS projection of 9% to €30.39. Leaving our P/E target at 6.5x unchanged and consistent with our valuation methodology, we arrived at a buy rating of €197 per share. As a reference, the company now trades at a current P/E of 3.5x with an EV/EBITDA < 1x. This valuation is not justified for a company that sells approximately €1 billion cars per day and has €37.2 billion in net liquidity (and increases its DPS).

Risks

Downside risks include 1) raw material price changes, 2) higher-for-longer interest rates (in detail, Volkswagen is exposed with its Financial Services division to a higher Credit Loss Ratio and lower volume sales – Fig 5), 3) a macroeconomic growth deterioration which might affect consumer sentiment, 4) FX changes given the fact that the company reported in euro terms but 7.7 million cars are sold outside Europe (Fig 6), 5) competitive pressure from new entrants, and 6) execution risks on the company’s redundancy program.

Fig 5

Fig 6

Conclusion

Volkswagen is the second-largest OEM by unit sales globally. The company’s portfolio comprises twelve brands covering all segments, from supercars (Porsche, Bugatti, Bentley, and Lamborghini) and motorcycles (Ducati) to heavy trucks and passenger cars (Audi, Skoda, Seat, and VW). The company confirmed its 2024 guidance. For prudency reasons, we lower our buy rating target; however, we still believe that Volkswagen is a top pick. The company trades at a depressed level. Even if the weak Q1 print makes Volkswagen’s target more ambitious, we are long-value investors, and patience usually pays off.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.