Volkswagen (VOWG.F) Germany: Automobiles
\" \" November 6, 2003 Stock rating: In-Line Coverage view: Neutral Large-Cap Growth Price: EUR44.45 This report is based on our morning note of November 4, 2003. Weaker Chinese margins a risk for ’04 earnings. China is likely to contribute 70%-80% of VW’s EPS this year, but 3Q results show worrying signs of falling earnings in this market. If Chinese profits decline in 2004, the impact could offset some of the gains expected from the new Golf/other models in Europe. IL/N.Chinese profits are the main driver of 2003 earnings VW's strong exposure to the Chinese auto market is often cited as a positive for the stock. China will likely be the key driver of earnings in 2003, contributing c.70%-80% of reported EPS thanks to equity income from the JVs and operating profits from selling parts. One quarter does not make a trend, but 3Q results show worrying signs We see worrying signs in VW's 3Q results that Chinese profits may already be slipping. Pro-forma EBIT from the Chinese JVs fell 35% yoy, despite much higher volumes, suggesting much lower margins. Profits from selling parts to the Chinese JVs also appeared to fall. We also see some evidence that inventories of Polo, Gol and Audi A6 are rising in China. A weak Chinese result in 2004 could reduce EPS by EUR1.00 or more We estimate that China will contribute over EUR2.00 of EPS in 2003, and our current 2004E forecast assumes EUR2.50 of EPS derives from China. But if Chinese profits in 2004 run at 3Q’s weak level, the Chinese contribution could easily fall to only EUR1.60 next year. Gains from Golf and Germany may not be enough for VW to hit consensus 2004 is likely to see VW’s US profitability fall further, probably into loss. If China also declines, it places even more pressure on Europe to deliver an improvement. Our estimates already assume that the new Golf and other models can deliver a EUR500 mn+ improvement in EBIT in Europe, yet we expect EPS of only EUR3.90. Consensus is still between EUR4.50 and EUR5.00 for 2004. We are concerned that expectations for an earnings improvement at VW remain too optimistic. Stock data 52-week range EUR46.30-28.65Yield 2.9%FTSE Europe 260 Keith Hayes keith.hayes@gs.com London: 44-20-7774-1142 Max Warburton max.warburton@gs.com London: 44-20-7774-5905 Manning Doherty manning.doherty@gs.com Hong Kong: 852-2978-1024 Shane McKenna shane.mckenna@gs.com London: 44-20-7552-2919 Avaneesh Acquilla avaneesh.acquilla@gs.com London: 44-20-7552-9372 Price performance AbsoluteRel to FTSE Europe1M10%7%3M17%10%12M 11% 5% Price performance chart Absolute Price Performance (Left Axis)Relative to Index (Right Axis)460.100.050.00-0.05-0.10-0.15-0.20DJFMAMJJASON 44424038Capitalisation Forecasts/valuation P/EEV/EBITDA12/2003E12/2004E 15.3x5.0x11.4x 4.0x 3634323028Market cap EUR17,384 mnEPSLatest net debt/(cash) EUR7,826 mnFree float Derivatives 80%–EUR2.90EUR3.90 FOR REG AC CERTIFICATION, SEE PAGE 18. FOR OTHER IMPORTANT DISCLOSURES, SEE PAGE 21, GO TO http://www.gs.com/research/hedge.html, OR CONTACT YOUR INVESTMENT REPRESENTATIVE.
Goldman Sachs Global Equity Research Shares outstanding 425.5 mn Volkswagen
Automobiles
Table of contents
1 Overview: Weaker Chinese margins a risk for 2004 earnings 3 Chinese profitability under pressure as pricing falls 7 A weaker China result could prevent 2004 earnings growth 10 Cost base may be ‘sticky’ and difficult to cut fast enough 12 Some indications of inventory build in China 14 Financials: 2004 consensus estimates may be too high 19 Disclosures
The prices in this report are based on the market close of November 5, 2003.
Goldman Sachs Global Equity Research - November 6, 2003
Automobiles
Volkswagen
Overview: Weaker Chinese margins a risk for 2004 earnings
Exhibit 1: Forecasts and valuation
Year to RevenuesDecember (EUR mn)2001 88,5402002 86,9482003E 85,9502004E 87,948
EBITDA(EUR mn)
8,0207,1595,0506,300
Pre-tax profit
(EUR mn)
4,4093,9861,9132,513
EPS(EUR)7.666.722.903.90
EV/EBITDA
(x)2.73.45.04.0
P/E(x)6.27.015.311.4
Source: Company data, Goldman Sachs Research estimates.
VW enjoys market leadership in China
VW has enjoyed first mover advantage in China. Its early investments and decision to persevere through difficult times in the 1980s and 1990s have been rewarded with leadership in the world’s fastest growing and most coveted market. While other OEMs are still formulating China strategies, VW is already well underway to selling almost 1 mn units a year, at very satisfactory margins.
VW is more reliant on China profits than previously realised
The high level of profitability enjoyed so far in China has been driven by high, tariff-protected prices, rather than low costs. A booming market has played into VW’s hands as its market share strength, installed capacity and more advanced distribution have allowed it to supply soaring demand. Higher sales have not been matched as closely as hoped by rising profits (Chinese EBIT in 2002 was little higher than in 2001, despite volumes up over 40%), but the level of earnings has still risen and US profits have fallen to a level that has made China a key contributor to the Group’s bottom line.
We believe the importance of Chinese profitability to VW remains poorly recognised. As US and UK profits collapsed with the move in the euro, and European margins fell further as pricing weakened for VW, China has been left standing as the only real
remaining profit centre (other than spare parts in Europe). We estimate China contributed over 70% of 1H earnings at VW and could contribute c.70%-80% of full year EPS.
Chinese earnings derive from two sources
VW reports profits from China in two areas. Neither are that transparent, but together we estimate they contributed up to EUR542 mn of net earnings in the first nine months of 2003, out of a total of EUR813 mn of net earnings for the Group. These two sources are:
·
Equity income from the Chinese JVs. VW has joint ventures with SAIC (50%
stake) and FAW (40% stake). Both are profitable and VW books its share of profits as equity income. VW only publishes quarterly proportional EBIT for the JVs, but this figure correlates closely to equity income.
·
Operating profits from selling parts to China. VW also sells parts to its Chinese
JV partners to use in the assembly of new cars. These are included in the Asia-Pacific region EBIT, but are not split out. VW indicated that such profits amounted to EUR300 mn in full year 2002 out of EUR460 mn for the region as a whole.
Goldman Sachs Global Equity Research - November 6, 2003
1
Volkswagen
3Q result suggests Chinese profits could be under pressure
Automobiles
We caution that it is possible there could have been some special factors at work in the 3Q Chinese result, and currency has also had a negative impact year on year (although not quarter on quarter). But we are concerned that 3Q may indicate a genuine downward trend for Chinese margins. It appears to us that the stated figures for both Chinese equity income and profits from selling parts to the JVs fell significantly in 3Q, raising concerns about the ongoing level of VW’s Chinese profitability.
·
Margins in the Asia Pacific region fell from 13.6% in 3Q2002 and 8.9% in 1H to 6.0% in 3Q2003. We assume that most of this is due to lower parts prices paid by the Chinese JVs, rather than falling profits from selling cars in Australia and other countries in this region.
Proportional EBIT in the JVs fell from EUR163 mn in 3Q2002, EUR168 mn in
1Q2003 and EUR193 mn in 2Q2003 to just EUR105 mn in 3Q. VW does not publish a revenue figure but we estimate JV margins fell from c.16% in 3Q2002 to c.8%-9%.
·
2004 earnings could disappoint
We will be very interested to see what the 4Q result looks like. Profits reported in the Asia-Pacific segment could look better, as we expect VW to book the one-off gain from selling the tooling for the Golf Mark 4 to a Chinese JV partner. But the reported
proportional result at the Chinese JVs should not be affected by any unusual items. A margin as low as that of 3Q – or lower – would suggest that estimates for Chinese earnings in 2004 are too high.
If China profitability is on a downward trend, we fear that VW’s 2004 earnings could disappoint, despite the likelihood that Chinese volumes will climb again. We expect the US to be loss-making in 2004, as volumes will likely fall further (due to ageing models) and the effective currency rates will also be worse than in 2003 according to
management. China is likely to generate over EUR2.00 of EPS in 2003, but we believe there is a risk this could fall in 2004, a risk that would be exacerbated by any appreciation of the Chinese renminbi. That leaves Europe to deliver the earnings improvement that the market expects.
The question is whether the new Golf and other models and/or higher German volumes can deliver a sufficient earnings uplift. We already forecast a EUR500 mn uplift from new models in Europe, but our 2004 estimate is only EUR3.90, at least 15% below consensus.
The stock may not be as inexpensive as it looks
VW’s valuation looks inexpensive on some measures. We calculate that the stock is trading on 2004E EV/Sales of 29%, EV/EBITDA of 4.0x and 11.4x earnings. But if China profits were to disappoint, an earnings multiple could suddenly look rather less attractive.
2
Goldman Sachs Global Equity Research - November 6, 2003
Automobiles
Volkswagen
Chinese profitability under pressure as pricing falls
VW’s Q3 results contain some strong indications that Chinese profitability could already be under pressure, despite rising volumes. If the trend continues in 4Q and 2004, the impact on Group earnings could be serious. We believe price pressure from new entrants could be forcing VW to cut prices faster than it can cut costs.
One quarter does not make a trend
We believe it is important to state that one quarter does not make a trend. Chinese
margins in the first half of 2003 actually appear to have increased slightly versus 2002, based on our calculations. 3Q could have been an anomaly, due to several factors:
· ·
Currency has had some effect as the Chinese renminbi is pegged to the US dollar. However, this is unlikely to have been a one-off effect.
3Q may have been impacted by one-off exceptional costs for increasing production or introducing new models. We understand that Santana production was cut as VW prepares to move this car to another JV partner.
Accounting at the Chinese JVs may not be sufficiently advanced for quarterly results to give a genuine indication of business developments.
·
However, the fact that VW’s Chinese margins have been running at what must be considered unsustainable levels, the evidence of new competition and pricing cuts in China, and the guidance from the company lead us to believe that Chinese profitability is under increasing pressure. Profit per unit has effectively more than halved.
Price pressure from new entrants may be to blame
VW’s apparent falling profitability is likely due to new price competition. Having previously dominated the market, VW is now seeing credible new global competitors (Honda, Toyota, GM, Kia) and local producers launch new products and cut prices. VW has already had to cope with falling prices for some time (see Exhibit 2) but we believe that the speed of pricing erosion – especially on vehicles more expensive than the Santana – may have accelerated.
Too many bulls in a China shop
We warned in our February 21, 2003 report ‘Too many bulls in a China Shop’ that over-ambitious investments by other global OEMs could result in pricing erosion as too much capacity chased an uncertain number of buyers. We questioned whether the high costs in China – largely due to an inefficient supply base and costly operating overheads – could be reduced quickly enough to offset falling pricing. If VW’s 3Q is indicative of falling margins, then this impact has happened faster than we expected.
Goldman Sachs Global Equity Research - November 6, 2003
3
Volkswagen
Automobiles
Exhibit 2: VW has seen prices fall for years, but the pace may have increased VW Santana pricing since 1993
Price
(Rmb’000)250199320019941995150World market price 2001 US$8,000 + 17% VAT Rmb78,0001997199619982000 = Rmb120,0002001 = Rmb100,0002003 Source: Roland Berger. 3Q: Profits from selling parts to Chinese JVs falls as prices cut VW does not disclose the exact profit made from selling parts to the Chinese JVs, but indicated that this contributed something in the region of EUR300 mn of EBIT in 2002. This appears now to be falling. It seems that while the number of components being shipped is climbing fast, margins are not keeping pace. Revenues in the Asia-Pacific region were up 50% in 3Q, which is explained by the 73% increase in Chinese volumes (i.e., VW had to ship more parts for higher production). However, the Asia-Pacific margin fell from 14% to 6% in 3Q, which we attribute to: a margin squeeze in the Asia-Pacific car business (ex-China), and lower pricing on VW components sold to Chinese JV companies. We assume that the reason for the lower pricing is because SAIC and/or FAW (VW’s two JV partners) have demanded that VW reduces the prices of supplied components, a demand being made on all suppliers as automakers attempt to cope with falling prices. We also believe that currency played only a minor role in explaining the decline in profitability between 1H and 3Q. Margins at Chinese JVs appear to have halved year on year An even greater concern is that reported pro-forma profits at the Chinese JVs appeared to slump in 3Q. VW stated at the 2Q point that the Chinese JVs had a proportional operating profit of EUR361 mn in 1H. This is just under 50% of the total profit of the JVs (VW has 50% of the SAIC JV and 40% of the FAW venture), so we multiply the disclosed amount by 2.2 to calculate estimated Chinese EBIT. We then estimate revenues to arrive at a margin for China. 4 Goldman Sachs Global Equity Research - November 6, 2003 Automobiles How we estimate JV margins Volkswagen VW does not disclose the revenues of the JVs but we have attempted to model the likely revenues in order to calculate margins. Our assumptions include the following: · · We use quarterly production and estimate a revenue/per unit figure for each unit sold in Chinese renminbi. Given the very strong improvement in mix at VW’s Chinese operations – with Passat, Bora and Audi A6 increasingly supplanting the cheap Santana in the mix – we assume rising revenue per unit for the range each quarter. However, while mix is improving the average revenue/unit, we believe the pricing of each model is slipping, due to new competition. So revenue per unit on a mix-adjusted basis is falling. Therefore the stated overall increases in revenue/unit are modest. We use the average spot rates for EUR/Rmb for each quarter, to calculate a revenue figure in euros. We assume minimal parts and servicing revenues. The currency has moved 5% so far this year but almost 15% since 3Q2002. We use our estimated quarterly euro revenue figure, the pro-forma quarterly EBIT figure (grossed up to account for the JV holding structure) and calculate a margin. · · · This process indicates that margins tumbled in 3Q2003. VW produced 173,511 cars in 3Q. If we assume revenue/unit of Rmb139,000 (we base this on the figure for Chinese JV revenues supplied by VW of EUR8.6 bn in 2002 and assume an improvement in mix), and apply the average spot exchange rate, that implies 3Q Chinese revenues of EUR2.59 bn. With EBIT of EUR231 mn (stated EUR105 mn grossed up), we estimate a 3Q margin in the Chinese JVs of 8.9%. That is still a very high level by the standards of the global auto industry, but a big fall on our estimate of margins in 1H2003 and FY2002. We show our analysis in details in Exhibit 3. Goldman Sachs Global Equity Research - November 6, 2003 5 6 Exhibit 3: VW derived over 70% of its earnings from China in 1H, but Chinese JV margins and profits on parts sales appeared to fall in 3Q Analysis of VW Group earnings from parts sales to China and equity earnings from JVs. Estimates also made for EBIT margins at Chinese JVs. 20022003EVW GROUPQ1AQ2AQ3AQ4AFYAQ1AQ2AQ3AQ4EFYEGroup sales21,26622,79421,20921,67986,94820,69822,13321,28121,83885,950Group Operating Profit1,1301,4021,1821,0474,7616046166304762,326Net income6277764397552,5972023942173231,136Reported Asia-Pacific EPS1.612.021.141.956.720.511.020.550.822.90margin fell from 13.6% to 6% in Q3 2003 despite 50% growth in VW CHINA PROFITABILITYAsia-Pacifc revenues(1) Parts Sales to JVs:Chinese proportionalAsia-Pacific sales1,2141,1141,1461,6745,1481,4091,5541,7132,1766,852share of JV operatingAsia-Pacific EBIT10487156122469160104103113480profit also fell Asia-Pacific Margin8.6%7.8%13.6%7.3%9.1%11.4%6.7%6.0%5.2%7.0%dramatically in the Asia-Pacific EBIT includes:same quarterChinese part sales EBIT (est.)675610078300102676672307Despite lower earnings (2) Equity earnings from China JVs:from China. Chinese China EBIT, VW proportional90136163161550168193105190656contribution as a % of China equity income (in P&L)9314116916757114516690299700total group earnings was 70% in Q3 2003Total China earnings (parts profits tax @40%)133175229214751206206130342884EPS from China (est)0.350.460.600.561.960.540.540.340.892.30We have left our FY% of total22%23%52%29%29%105%53%62%109%79%estimate for Chineseequity income unchangedNB: estimated margins at China JVsalthough given Q3 it is, Est. sales (Rmb mn)9,92915,01617,91924,46167,32521,94325,69124,11825,91397,665along with estimated JV margins in Q4, almost Est. rev/unit (Rmb)128,000130,000132,000133,142131,353135,000137,000139,000139,000137,556certainly too highEUR/Rmb ave. exchange rate7.267.618.148.297.838.889.419.339.529.28Goldman Sachs Global Equity Research -Est. sales (EURmn)1,3931,9972,2342,9758,6002,4702,7312,5902,72710,519We estimate theEst. rev/unit17,95317,29316,45916,19516,77915,19514,56414,92914,62914,815operating margin atChina unit sales77,568115,506135,751183,723512,548162,540187,522173,511186,427710,000Chinese JVs (not China EBIT, VW proportional90136163161550168193105190656disclosed by VW) China EBIT margin, all (est)1982993593541,2103704252314181,443fell to 8.9% from 16.1%Est. China EBIT margin14.2%15.0%16.1%11.9%14.1%15.0%15.5%8.9%15.3%13.7%in Q3 2002Source: Company data, Goldman Sachs Research estimates. November 6, 2003 Volkswagen Automobiles Automobiles Volkswagen A weaker China result could prevent 2004 earnings growth Consensus earnings for VW in 2004 are between EUR4.50 and EUR5.00. The assumptions about earnings growth rest on the hope that the new Golf and other new models can deliver a large improvement in Europe in 2004. While we believe that some degree of improvement in Europe is possible, we believe it is important to recognise that the base from 2003 – Chinese earnings – may not be reliable. The market is expecting earnings growth at VW in 2004. With consensus earnings between EUR4.50 and EUR5.00, the stock is currently trading on c.10x earnings. But consensus estimates make two key assumptions, in our view: · · The new Golf and other models help boost volumes and margins in Europe; and The base level of profitability seen in 2003 – largely reliant on China – will hold up. We remain cautious about both these assumptions. Our estimates do assume an improvement in Europe, as can be seen in Exhibit 4, but we believe many are overestimating the extent to which new models can boost margins, even if the Golf does bring some year-on-year benefits. However, we are growing more concerned about the assumption that Chinese profits can be relied upon in 2004. Exhibit 4: Our 2004 estimates assume higher profits in Europe and China VW reported historical and estimated future earnings by region RevenuesEurope/Rest of the WorldNorth AmericaSouth America/South AfricaAsia-PacificTotalOperating Profit Europe/Rest of the WorldNorth America South America/South AfricaAsia-PacificTotalTotal (before capitalised R&D)Operating Margin Europe/Rest of the WorldNorth America South America/South AfricaAsia-PacificMarginMargin (before capitalised R&D)200160,34617,8325,6264,73688,54020013,3981,664-454075,4244,16120015.6%9.3%-0.8%8.6%6.1%4.7%200260,23917,2774,2845,14886,94820023,3651,287-3594694,7613,28120025.6%7.4%-8.4%9.1%5.5%3.8%2003E61,29814,2003,6006,85285,9502003E2,11630-3004802,3261,0762003E3.5%0.2%-8.3%7.0%2.7%1.3%2004E62,25814,1003,7107,88087,9482004E2,686-20-2005523,0182,1682004E4.3%-0.1%-5.4%7.0%3.4%2.5% Source: Company data, Goldman Sachs Research estimates. Goldman Sachs Global Equity Research - November 6, 2003 7 Volkswagen Automobiles Our current estimates assume that VW will enjoy further growth in China in 2004. We assume: · · · · a 30% increase in unit volumes; Flat unit pricing at our estimate of current levels (aided by better mix); 10% margins in the JVs (below estimated 1H levels but above estimated 3Q’s level; and Higher parts sales to the JVs, recorded in Asia-Pacific EBIT. Together, these assumptions lead us to estimate that China could generate EUR750 mn of equity income (2003E EUR700 mn) and EUR353 mn of EBIT from parts sales (2003 estimate EUR307mn, VW guidance on 2002’s profit, EUR300 mn). This equates to EUR2.51 of EPS from China (2003 estimate EUR2.30). But if Chinese profitability continues to slide beyond 3Q, the contribution could be much lower. If we assume only 20% volume growth, 7.0% margins in the JVs (still a high level by global standards, given there are few spare parts and no financing profits included), and 4.0% margin in Asia Pacific (2003E estimate 7.0%), then China could contribute only EUR495 mn of equity income and EUR190mn of parts sales. This equates to only EUR1.59 of EPS from China, as we show in Exhibit 5. 8 Goldman Sachs Global Equity Research - November 6, 2003 Goldman Sachs Global Equity Research - November 6, 2003 Exhibit 5: If Chinese JV margins fell to 7% and Asia-Pacific margins fell to 4% as parts prices drop, China’s contribution to EPS could fall to EUR1.00 Estimated Chinese profit contribution in 2002 and 2003 and current China estimates plus ‘weak China’; scenario for 2004. FY 2002FY 2003EFY 2004EFY 2004EVW GROUPCurrentWeak ChinaUnder our weak Chinese Group sales86,94885,95087,94887,948scenario, EPS in 2004Group Operating Profit4,7612,3263,0182,854could be little better thanin 2003Net income2,5971,1361,5181,099EPS6.722.903.902.98Further pricing erosionVW CHINA PROFITABILITYon components sold toChinese JVs could result(1) Parts Sales to JVs:+33%+15%+8%in a decline in Asia-PacificAsia-Pacific sales5,1486,8527,8807400profitabilityAsia-Pacific EBIT469480552296Asia-Pacific Margin9.1%7.0%7.0%4.0%Margin pressure in Asia-Pacific EBIT includes:Chinese market could Chinese part sales EBIT (est.)300307353190reduce share of earningsfrom Chinese JVs(2) Equity earnings from China JVs:China EBIT, VW proportional550656628400EPS contribution from China equity income (in P&L)571700750495China already 66% of our 2004 forecast, this could Total China earnings (net - tax parts profits @40%)962609fall to 55% under our EPS from China (est)1.962.302.511.59weak scenario% of total29%79%64%53%NB: estimated margins at China JVs+43%+38%+30%+20%Est. sales (Rmb mn)67,32597,665128,297116,724Est. rev/unit (Rmb)131,353137,556139,000137,000EUR/Rmb ave. exchange rate7.839.289.289.28Est. sales (EURmn)8,60010,51913,82312,577Under our weak scenarioEst. rev/unit16,77914,81514,97614,761we estimate the operating China unit sales512,548710,000923,000852,000margin at Chinese JVs China EBIT, VW proportional550656628400(not disclosed by VW) China EBIT margin, all (est)1,2101,4431,382880could fall to 7% in 2004Est. China EBIT margin14.1%13.7%10.0%7.0% Source: Company accounts and Goldman Sachs Research estimates. 9 Automobiles Volkswagen Volkswagen Automobiles Cost base may be 'sticky' and difficult to cut fast enough The current high unit profitability in China is due mainly to high prices, thanks to a market protected by high tariffs and large sales to government organisations. Costs of car production are actually some 15%-20% above world-class (e.g., Japanese, European and US) levels at present. Pricing is declining rapidly, but we fear that producers such as VW are finding it difficult to reduce costs quickly enough to hold margins at previous levels. Most would assume that China, given its emerging market income levels, would be a market where cars are cheap, but labour and production costs are cheaper. In reality, supply base problems, poor quality inputs, management overheads and scale issues mean that production costs are still 15%-20% above European levels, as shown in Exhibit 6. China’s supply base remains poorly developed and, due to its fragmented nature, purchasing costs are high. Inbound parts also need close inspection to ensure they are of an adequate quality. However, the ultimate quality of the cars produced in China is satisfactory. McKinsey has stated that Shanghai VW is among VW’s five highest-quality plants and quotes a German engineer stating that ‘the Passat made in China is even better than the ones made in Germany’. Scale and purchasing reform could drive manufacturing costs below western levels McKinsey believes it is possible for manufacturing costs to fall to world-class levels or below. The consultancy estimates that China could achieve an advantage of 7%-10% per unit, although we question how quickly this can be achieved. To reduce costs below European levels, McKinsey calculates that the following will be needed: · A 33% reduction in component purchasing as scale increases and modern investments are made by the supply base, and a similar fall in in-house powertrain manufacturing; A 50% reduction in body production cost through better steel prices and quality, and increased scale economies due to automated bodyshops; and An 11% reduction in labour cost through to productivity improvements. · · VW’s ability to maintain margins depends on whether it can cut costs to the degree required above at the necessary speed. We fear that VW is finding it difficult to cut costs as quickly as prices are falling. Other OEMs with a different type of local purchasing expertise may have some greater advantages in this regard (e.g., Honda has many years of local sourcing knowledge from building motorbikes). 10 Goldman Sachs Global Equity Research - November 6, 2003 Automobiles Volkswagen Exhibit 6: Manufacturing costs still above European levels, VW must act to cut costs quickly Comparison of component costs in China versus Europe Cost itemsPower trainChassisBody Unit cost, 2001ChinaWorld-class$3,397$2,4501,6991,495 3,047 1,520 Domestic costcompetitiveness 200139% higher in China14% higher in ChinaTwice the world-class cost in China 20% cheaper in ChinaRationale/AssumptionChina has not reached 150k minimum scale of efficiency for the more capital intensive power train and chassis production Chinese steel companies have been slow to introduce cost competitive products with specialised features for the auto industryChinese-made interior systems can be cheaper thanks to:Low labour cost Less frequently updated design Increasing use of local materials, e.g. textilesMinimum scale of efficiency (60-80K) For low end commodity electrical parts, China can be 30-40% cheaper and already exporting to abroadHigher expatriate compensation Utility cost still not competitiveAverage labour wage in China is 1/40 of Japan in 2001Productivity 7-9 x lower than in US (cars/worker/year) Interiors1,8122,265 Electricals Overhead, Running Cost, Management FeeDirect labour36079340010510% cheaper in ChinaAlmost 8 times higher in China2171,06580% cheaper in China Source: McKinsey analysis. Goldman Sachs Global Equity Research - November 6, 2003 11 Volkswagen Automobiles Some indications of inventory build in China China sedan inventories could be on the rise. While hard time series data from the China Association of Automotive Manufacturers (CAAM) is scarce, we believe that auto inventory levels in China could be rising. VW’s production to sales ratio was substantially higher than the industry average in China in September. VW appears to have built up inventories of Polo, Gol and Audi A6. We believe inventory levels could be rising in China, a surprising development given the high level of demand. We assume that: · · · Automakers have accelerated production so rapidly that output may now be exceeding real demand. The new, dynamic nature of the market means demand patterns may shift around between brands. Potential buyers are aware that prices are falling so may in some cases be delaying purchases. Inventory levels still low, but are rising compared to earlier in 2003 CAAM revealed that total vehicle inventories reached 60,000 units in July 2003; based on that data point, we estimate that this number has risen to 91,000 units in September (equal to 23% of September's monthly sales) given a number of strong months with total vehicle production generally outpacing sales. In addition, local steel giant Baoshan Steel, which saw 3Q2003 profits benefit from supplying steel sheets to a number of foreign and local automakers in China, stated that rising auto inventories could impact their profitability in 2004 (Reuters, October 31). Finally, according to CAAM, Chinese 2003 sedan production has exceeded sales in every month since February from 1% (in September) to 13% (in March, prior to SARs). In short, we believe the case for gently rising inventories in China is building. VW, as China’s largest producer, looks to be participating in this inventory build. According to CAAM data on both production and sales, in recent months VW has built more Polos, Golfs, Gols, and Audi A6s than it has sold. The apparent inventory build up looks small, but it is still surprising in a market where demand is supposed to be unquenchable. We highlight the models that we believe may be seeing higher inventories in Exhibit 7. On average, VW built 1.1x as many vehicles as it sold in September. 12 Goldman Sachs Global Equity Research - November 6, 2003 Automobiles Volkswagen Exhibit 7: Reported sales and production suggests VW is building inventory faster than other producers in China Production to sales ratio for VW models in China, based on CAAM data Production to sales ratio by model (X)Jan-03VolkswagenSantana 0.98Santana 2000 0.70Passat B5 0.79POLO 1.24POLO - 2POLO - 3GOLNew Jetta 2V 0.86Bora 1.6L 0.73Bora 1.8L 0.88Bora 1.8T 0.78Audi A6 1.8L 0.51Audi A6 1.8T 0.88Audi A6 2.4L 0.75Audi A6 2.8L 0.81Audi A6 1.8T 0.88Audi A6 3.0TGolf 1.6Golf 1.8VW China Average (volume weighted)Chinese auto industry total averageFeb-03 0.92 0.90 1.45 1.40Mar-03 1.01 1.00 1.66 1.03Apr-03 1.03 1.07 1.04 1.22May-03 1.29 1.35 0.85 0.94Jun-03 1.25 1.06 0.90 1.37 0.91 0.01 1.63 1.01 1.52 1.93 1.01 1.02 0.86 0.91 1.02 0.48Jul-03 0.46 0.23 0.95 2.28 2.93 0.01 1.46 1.03 1.20 1.56 1.04 1.11 1.04 1.09 1.11 0.62 0.70 14.87 0.93 1.11Aug-03 1.02 0.93 0.96 1.50 6.02 2.13 0.84 0.81 0.91 0.77 0.99 0.78 0.84 0.88 0.78 0.55 8.92 2.78 1.07 1.06Sep-03 0.97 0.82 0.89 1.33 6.31 5.29 0.78 1.00 1.11 0.29 0.60 1.04 0.98 1.13 1.04 1.46 10.07 7.45 1.11 1.04 1.34 1.07 0.97 0.92 1.02 1.32 0.99 1.10 1.11 0.99 1.07 1.12 1.01 1.31 1.31 0.52 0.97 1.10 1.06 0.97 3.18 1.09 1.06 1.26 1.72 0.15 1.03 0.98 1.06 1.03 1.52 0.57 1.31 1.16 1.07 1.25 1.00 1.04 1.02 0.91 1.04 1.13 1.01 1.04 1.04 1.04 0.98 1.08 Source: China Association of Automotive Manufacturers, Goldman Sachs Research. Goldman Sachs Global Equity Research - November 6, 2003 13 Volkswagen Automobiles Financials: 2004 consensus estimates may be too high Any fall in Chinese profitability would have material impact on group EPS If it does emerge that VW’s Chinese earnings are falling – and could be lower in 2004 than in 2003 – then the overall impact on the Group could be material. China appeared to generate c.EUR1.08 of EPS in 1H – over 70% of the 1H total. The Chinese contribution fell in 3Q, to only about EUR0.34 EPS. If the trend into 2004 is downward for Chinese profitability, it provides yet another reason to be cautious about the outlook for VW’s earnings next year. This once again emphasises that VW is highly dependent on a recovery in the European market to boost earnings in 2004. Chinese profitability appears to be falling. US profits may be down year on year (VW is now c.65% hedged, but with an inferior rate to the one used this year). An improvement in Europe should happen; we forecast an improvement in European EBIT of over EUR500 mn. But should Europe, and specifically Germany, remain subdued, then the prospect of earnings disappointments remains high, in our view. We currently forecast 2004E EPS of EUR3.90 compared with an approximate consensus number of EUR4.50. 14 Goldman Sachs Global Equity Research - November 6, 2003 Automobiles Volkswagen Exhibit 8: Profit and loss 2001-2004E: Earnings growth in 2004E relies on better Europe and stable China profits (EUR mn) 2001 Total SalesCost of sales% Sales R&D charged to P&L% Sales Raw materials, purchased goods and services % Other costs %Labour% Gross profits from financial servicesGross profits% SalesSelling and distribution% General administration% Depreciation%Operating Profit (reported)% SalesEBITDAC (adjusted for R&D capitalisation)% Sales Net other operating incomeEBIT (forecast adj. for pension provs)% SalesEBIT pre-R&D capitalisationEquity & investment income of which is Share of Profits from JV's (i.e. China)Other financial Net interest Exceptionals Write down of financial assetsPre tax income (post exceptional)% SalesTaxesTax rateNet earnings% SalesNet IncomeTotal Number of shares (mn) Weighted ave. no of shares (excl Treasury Stock)Published EPS (excludes treasury stock)88,540-75,586-85.4%-2,660-3.0%-51,095-57.7%-4,229-4.8%-13,213-14.9%1,32814,28216.1%-7,554-8.5%-2,154-2.4%-4,389-5.0%5,4246.1%8,0209.1%484,6225.2%3,3593.8%3513800-481-8304,4095.0%1,48333.6%2,9263.3%2,915424.7379.37.67200286,948-74,188-85.3%-2,891-3.3%-49,225-56.6%-4,312-5.0%-13,313-15.3%1,23813,99816.1%-7,560-8.7%-2,155-2.5%-4,447-5.1%4,7615.5%7,1598.2%-3653,9184.5%2,4382.8%5465710-478003,9864.6%1,38934.8%2,5973.0%2,584425.5383.36.722003E85,950-75,944-88.4%-3,350-3.9%-49,664-57.8%-5,000-5.8%-13,450-15.6%1,30011,30613.2%-7,380-8.6%-2,150-2.5%-4,480-5.2%2,3262.7%5,0505.9%-2301,5461.8%2960.3%7507000-220-120-431,9132.2%77740.6%1,1361.3%1,123425.5383.82.902004E87,948-77,047-87.6%-3,300-3.8%-50,332-57.2%-5,136-5.8%-13,621-15.5%1,40012,30114.0%-7,600-8.6%-2,233-2.5%-4,658-5.3%3,0183.4%6,3007.2%-2502,2182.5%1,3681.6%8007500-505002,5132.9%99539.6%1,5181.7%1,505425.5383.83.90 Source: Company data, Goldman Sachs Research estimates. Goldman Sachs Global Equity Research - November 6, 2003 15 Volkswagen Automobiles Exhibit 9: Balance sheet 2001-2004E: VW now has minimal net cash, even excluding pensions (EUR mn) 2001 Assets Fixed assetsIntangible assetsTangible assetsFinancial assets Leasing and rental assetsTotalOther assets (finco receivables)Current assetsInventories Trade receivablesOther receivablesSecuritiesCashTotalPre-paid and deferred chargesDeferred tax assetsTotal assetsStockholders' equity and liabilitiesStockholders' equity Subscribed capitalCapital reserveRevenue reserve Net earnings available for distribution Minority interests in consolidated subsidiariesTotalDeferred tax liabilitiesPension provisionsTax provisionsOther provisionsTotalCurrent liabilitiesTrade payablesOther payablesPayments on accts receivedDebt Bonds Bank loans Notes payableTotalLong term liabilitiesDebt Bonds Bank loans Increase in debt due to fin co Notes payableOther liabilitiesTotalDeferred incomeTotal liabilities and equity2002 2003E 2004E 6,59621,7353,9997,28439,61436,0877,73622,8423,9858,44543,00837,5129,22424,0884,2449,70047,25641,34710,31225,1564,50310,95550,92645,1829,9455,1413,9383,6104,28526,9193781,426104,42410,6775,7474,0553,1922,98726,6582731,445108,89611,0885,8454,0553,1922,98727,1662731,445117,48711,3455,9804,0553,1922,98727,5602731,445125,3851,0874,41514,5463,9475324,0482,2999,9841,41810,38024,0817,05511,35576624,8501,1608,26615,42443,26012,2904,3173,41104,56246012,750285104,4241,0894,45113,9055,1895724,6912,55810,3011,47410,57424,9077,23612,97076919,2713,4685,28310,52039,47718,8699,5272,93106,41161919,488333108,8961,0894,45113,9055,7655725,2672,55810,3011,47411,07425,4077,47813,32276921,6113,4687,62310,52042,41123,4509,5272,9314,5816,41161924,069333117,4871,0894,45113,9056,7235726,2252,55810,3011,47411,57425,9077,65113,63276922,9873,4688,99910,52044,27028,0319,5277,5124,5816,41161928,650333125,385 Source: Company data, Goldman Sachs Research estimates. 16 Goldman Sachs Global Equity Research - November 6, 2003 Automobiles Volkswagen Exhibit 10: Cash flow statement 2001-2004E: VW unlikely to generate cash in 2004, in our view (EUR mn) 2001 Net earnings before extraordinaries Depreciation and write-up of tangible assetsNet R&D capitalisation costs Depreciation and write up of financial assets Depreciation and write-up of leasing and rental assetsChange in medium & long term provisionsLoss on disposal of non-current assets Share of retained earnings of Group companiesOther expenses & income not affecting paymentsCashflowCashflow excl financial servicesChange in short-term provisionsChange in inventories and trade receivablesChange in financial receivables (finco)Change in liabilitiesChange in other itemsInflow of funds from current operationsInpayments from disposal of fixed assetsOutpayments for additions to fixed assetsTangibleIntangibleFinancial Leasing and rental assets Change in investments in securitiesAdjustments from consolidation Inflow/outflow on consolidation of acquisitionsOutflow of funds from capital investmentsNet cashflowShare buybackCapital increases + other equity changesDividend payments Capital repayments to retired stockholdersTake-up of bondsRepayment of bondsIncrease in debt due to finance company Change in medium and long-term liabilities to banksOther itemsOutflow of funds from financingCash flow from exchange rate changesIndustrial cash flowChange in cash and cash equivalents3,0474,668-1,263 181,15962060-1703588,4977,3380-766-3,3961274,462540-10,155-6,400-217-110-3,42826629-9,586-4,8580-210-46504,319-3,23206,917-3466,9834-4102,1292002E2,6104,898-1,480 41,418968176-3031068,3976,9790-1,581-3,6491,1844,351384-10,291-6,589-238-259-3,205-23227-9,880-5,761033-50909,285-1,5980-2,7271394,623-160-914-1,2982003E1,1364,754-1,250 01,4505000006,5905,1400-508-3,8355942,841500-9,702-6,000-238-259-3,205-2320-9,202-6,59300-5600004,581 004,0210-1,631-2,5722004E1,5184,932-85001,4505000007,5506,1000-394-3,8354843,805500-9,702-6,000-238-259-3,205-2320-9,202-5,62900-5600004,581 004,0210-667-1,608 Source: Company data, Goldman Sachs Research estimates. Goldman Sachs Global Equity Research - November 6, 2003 17 Volkswagen Automobiles Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Keith Hayes and Max Warburton. 18 Goldman Sachs Global Equity Research - November 6, 2003 Automobiles Volkswagen Disclosures Goldman Sachs Global Equity Research - November 6, 2003 19 Volkswagen Automobiles 20 Goldman Sachs Global Equity Research - November 6, 2003 Automobiles Volkswagen Distribution of ratings/investment banking relationshipsGoldman Sachs Research global coverage universe70%60%53%Percentage of companies covered by the GoldmanSachs Group, Inc, within the specified category50%40%67%Percentage of companies within each category for whichThe Goldman Sachs Group, Inc. has provided investmentbanking services within the previous 12 months30%20%10%0%26%21%77%58%As of 10/1/03 Goldman Sachs Global Investment Research hadinvestment ratings on 1,654 equity securities.OP/BuyIL/HoldU/SellGoldman Sachs uses three ratings - Outperform, In-Line, and Underperform - reflecting expected stock price performance relative to eachanalyst's coverage group, on an unweighted basis with regard to market capitalization and with a 12-month time horizon. Each analyst alsoassigns a coverage view - Attractive, Neutral, or Cautious - representing the analyst's investment outlook on the coverage group.NASD/NYSE rules require a member to disclose the percentage of its rated securities to which the member would assign a buy, hold, or sellrating if such a system were used. Although relative ratings do not correlate to buy, hold, and sell ratings across all rated securities, forpurposes of the NASD/NYSE rules, Goldman Sachs has determined the indicated percentages by assigning buy ratings to securities ratedOutperform, hold ratings to securities rated In-Line, and sell ratings to securities rated Underperform, without regard to the coverage viewsof analysts.Source: Goldman SachsAs of October 1, 2003 Volkswagen (VOWG.F)Goldman Sachs rating and stock price target history7060504030Currency: Euro450400350300250200Nov 4MPILASStock Price20150NDJFMAMJJASONDJFMAMJJASONDJFMAMJJ2000200120022003Source: Goldman Sachs Research for ratings and price targets; Reuters for daily closing prices, as of 10/01/03.RatingPrice targetPrice target removalFTSE Europe; pricing byFactSetCovered by Keith HayesNot covered by current analystNew rating system as of 11/4/02The price targets shown should be considered in the context of all prior published Goldman Sachs research, which may ormay not have included price targets, as well as developments relating to the company, its industry and financial markets.IndexPrice Goldman Sachs Global Equity Research - November 6, 2003 21 Volkswagen Automobiles Company-specific disclosures The Goldman Sachs Group, Inc. and/or its affiliates expect to receive or intend to seek compensation for investment banking services in the next 3 months from these companies, their parents, or wholly owned or majority-owned subsidiaries: Volkswagen. The Goldman Sachs Group, Inc. makes a market in the securities of the following: Volkswagen. 22 Goldman Sachs Global Equity Research - November 6, 2003 Automobiles Volkswagen Goldman Sachs Global Equity Research - November 6, 2003 23 Volkswagen Automobiles Ratings and other definitions/identifiers Current rating system (effective November 4, 2002) Definitions of ratings OP = Outperform. We expect this stock to outperform the median total return for the analyst's coverage universe over the next 12 months. IL = In-Line. We expect this stock to perform in line with the median total return for the analyst's coverage universe over the next 12 months. U = Underperform. We expect this stock to underperform the median total return for the analyst's coverage universe over the next 12 months. Other definitions Coverage view. The coverage view represents each analyst or analyst team's investment outlook on his/her/their coverage group(s). The coverage view will consist of one of the following designations: Attractive (A). The investment outlook over the following 12 months is favorable relative to the coverage group's historical fundamentals and/or valuation. Neutral (N). The investment outlook over the following 12 months is neutral relative to the coverage group's historical fundamentals and/or valuation. Cautious (C). The investment outlook over the following 12 months is unfavorable relative to the coverage group's historical fundamentals and/or valuation. CIL = Current Investment List. We expect stocks on this list to provide an absolute total return of approximately 15%-20% over the next 12 months. We only assign this designation to stocks rated Outperform. We require a 12-month price target for stocks with this designation. Each stock on the CIL will automatically come off the list after 90 days unless renewed by the covering analyst and the relevant Regional Investment Review Committee. Other ratings/identifiers NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Goldman Sachs policies in circumstances when Goldman Sachs is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances. CS = Coverage Suspended. Goldman Sachs has suspended coverage of this company. NC = Not Covered. Goldman Sachs does not cover this company. RS = Rating Suspended. Goldman Sachs Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon. NA = Not Available or Not Applicable. The information is not available for display or is not applicable. NM = Not Meaningful. 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Goldman Sachs Global Equity Research - November 6, 2003 Volkswagen Automobiles Goldman Sachs European Investment Research Co-Directors of European Research Neil Crowder 44-20-7774-6218 Aerospace & DefenceSash TusaJames Moore*Shane McKenna*Autos & Auto PartsKeith HayesMax WarburtonShane McKenna*Banks Anik Sen Susan LeademRichard RamsdenJames ChappellGregor Lanz* Julian Livingston-BoothChristoffer MalmerAlessandro SantoniBiotechnologyStephen McGarry 44-20-7774-1134 Oil & GasAnthony Ling Matthew LanstoneMark Fletcher*Richard Manley*Peter Mallin-JonesJonathan Waghorn 44-20-7774-677644-20-7774-241944-20-7774-833744-20-7774-635944-20-7774-169544-20-7552-2538 44-20-7774-348844-20-7774-571644-20-7774-127944-20-7552-135944-20-7552-175444-20-7552-283844-20-7552-134544-20-7552-578544-20-7774-114244-20-7774-590544-20-7552-2919 Leisure & HotelsRichard Chamberlain 44-20-7552-1361 44-20-7774-547544-20-7774-151544-20-7552-2919 Luxury GoodsJacques-Franck DossinAaron FischerGemma Seddon* 44-20-7774-138344-20-7552-135144-20-7552-9453 Anthony Ling 44-20-7774-6776 Technology/Software & ServicesRichard LeggettDarren CohenMairiJohnson* Mohammed MoawallaTechnology/StrategyCharles ElliottChris Agnew Telecommunications Services 44-20-7774-572044-20-7552-134644-20-7552-371344-20-7552-3718 James GolobJames SawtellFreyaGuinnessSimon WeedenSergei ArsenyevBelinda Sartori*Matthew BloxhamMike MeloanSonalee Parekh*Transport Hugo Scott-GallChris Logan Stephen Bramley-Jackson*Utilities Jean-Huguesde LamazeDeborah Wilkens*GraemeMoyse*Andrew MeadMatija Gergolet Economics/Developed Markets Engineering & MachineryCharles BurrowsNick PatonJames Moore*Shane McKenna* 44-20-7774-650444-20-7774-698744-20-7774-151544-20-7552-2919 PharmaceuticalsMark TraceyJohn MurphyVikram SahuMick Readey* 44-20-7774-117444-20-7774-525544-20-7774-117544-20-7552-3714 Jim O’Neill44-20-7774-2699David Walton44-20-7774-1169Andy Bevan44-20-7774-1168Ben Broadbent44-20-7552-1347Kevin Edgeley44-20-7774-6122WillemSels 44-20-7774-5562Nicolas Sobczak33-1-4212-1343Francesco Garzarelli44-20-7774-5078Sandra Lawson44-20-7774-8736BinitPatel44-20-7774-1105Javier Perez de Azpillaga44-20-7774-5205Dirk Schumacher49-69-7532-1210Thomas Stolper44-20-7774-5183Economics/Emerging Markets Erik Nielsen44-20-7774-1749Mike Buchanan44-20-7552-2901Carlos Teixeira27-11-303-2729Jens J Nordvig-Rasmussen44-20-7774-1386RoryMacFarquhar 7-09-5785-1816Equity Strategy/Global 44-20-7774-508444-20-7552-1036 Peter OppenheimerAlain Kerneis Equity Strategy/European Technology/SemiconductorsMatthew Gehl 44-20-7774-5536 Peter OppenheimerSharon CoombsCarlos Mejia-Perez 44-20-7522-578244-20-7552-134144-20-7774-572544-20-7522-578244-20-7552-300044-20-7552-594844-20-7552-253944-20-7552-397744-20-7774-573544-20-7552-351944-20-7774-191744-20-7552-283444-20-7552-959144-20-7774-100644-20-7774-131944-20-7552-299344-20-7774-223044-20-7774-605644-20-7774-853544-20-7552-328544-20-7774-616844-20-7552-907244-20-7774-164944-20-7774-324744-20-7774-523044-20-7552-375844-20-7552-294044-20-7774-1726 Media Vighnesh PadiachyMarc SugarmanChris CollettHazel Morgan* Metals & MiningDuncan MacLean 44-20-7774-2477 Business & Employment ServicesBoris BernsteinYves Meyer-Bülow Stephen Bramley-Jackson*ChemicalsJonathan TylerMatt ButlinCarys Jones* 44-20-7774-111544-20-7774-372244-20-7552-015644-20-7774-571544-20-7774-519244-20-7552-9591 Paper & Packaging Denis Christie 44-20-7552-5990 Food Producers, Beverages & TobaccoMark LynchTim PotterMike GibbsLisa Heffernan*Elise BadoyClaire Ross Healthcare (Medical Devices)Hans Bostrom 44-20-7552-599144-20-7552-362944-20-7552-362844-20-7552-340144-20-7552-363044-20-7552-598444-20-7552-9351 Real EstateJeppe de Boer 44-20-7552-3704 Retailing/General/Food & Drug ChainsKeith WillsNick Jones Christian Koefoed-NielsenGemma Seddon*Caroline Tatham 44-20-7774-114444-20-7774-508344-20-7552-594444-20-7552-945344-20-7774-1256 Household, Personal Care & CosmeticsJacques-Franck DossinMark LynchAaron FischerInsurance Stephen DiasRichard BurdenRichardTufft* Lawrence Rosenberg* Marketing Analyst Email: firstname.lastname@gs.com 44-20-7774-111844-20-7774-183344-20-7774-572944-20-7552-285244-20-7774-138344-20-7552-362944-20-7552-1351 Technology/HardwareAlec ShutzeTim Boddy To request a mailing list change, please e-maileuromail@gs.com
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