Volkswagen Stock: Value Play Emerging As A Structural EV Winner (OTCMKTS:VLKAF)

While semiconductor chip shortages and the invasion of Ukraine by Russia have taken over the headlines, Volkswagen AG (OTCPK:VWAGY, OTCPK:VWAPY, OTCPK:VLKAF) is actually weathering all these difficulties well. Here, I look deeper into how Volkswagen is currently doing and how it is managing these challenges.

Investment thesis

I have written an initial article on why I believe that Volkswagen will be a structural winner in the EV transition race (found here) and the investment thesis for Volkswagen remains intact and as follows:

1. Volkswagen’s commitment to the transition is the highest. It has the largest investment spend in EV and software, both high-growth areas of the future, among global automotive manufacturers over the next 5 years.
2. In addition, Volkswagen has a clear, ambitious battery strategy to support this. VW has a unified, in-house battery strategy and it will be building 6 new gigafactories by 2030. All these ensure adequate battery supply for its EV rollout.
3. Volkswagen takes the vertical integration strategy with its upstream investments. I believe that this is key for incumbents in order to have control over their EV transition and lower their overall costs.

Solid 1Q22 results

In its 1Q22 results, the company generated EUR8.5 billion in operating profits, with the lower volume being offset by better mix and higher selling prices. The total clean free cash flows that were generated that exclude diesel and M&A came in at EUR2.2 billion, which was negatively impacted by a EUR2.1bn build-up of inventory but the full year target of EUR13 billion to EUR15 billion was confirmed. The results in 1Q22 were also supported by slightly higher at equity contributions from Volkswagen’s Chinese JV.

At the division level, the outperformer was the premium brands, which achieved 15% margins, outperforming expectations, and Porsche (OTCPK:POAHY) also delivered solid margins at 18.6%. The volume brands performed in line while operating profit margins were relatively soft at 3.6%.

Volkswagen management has confirmed the guidance initially given for 2022. This includes revenue growth range of between 8% to 13% year on year, adjusted operating profit margins of 7% to 8.5%. Furthermore, the company continues to guide for improvement in the supply of chips in the second half of 2022 as the tight chip situation in the early months of 2022 are expected to ease. Lastly, the company continues to guide for a BEV share of 7% to 8% in 2022 as compared to the 5.2% it achieved in the first quarter of 2022 as it continues to have a record high order backlog for its BEVs.

In my view, the reiteration of guidance is definitely a positive and shows how management has been very prudent as well as proactive in being able to manage the very difficult operating environment today, with the supply chain challenges derailing many vehicle manufacturers and logistics challenges worsened by the Russia and Ukraine conflict.

Confidence in improving supply chain situation

Several of Volkswagen’s management has echoed similar confident tones of easing of chip shortage in the second half of 2022. Specifically, CEO Herbert Diess said that Volkswagen expects a strong second half of 2022. The company expects that Volkswagen will be able to continue on its path to taking over its competitor Tesla (TSLA) as the chip shortages ease in the second half.

In terms of the easing of semiconductor supply, Volkswagen has control over its own supply chain through better transparency. With specific semiconductors going into specific models and brands, Volkswagen has mapped out the chips that go into its vehicles and also established direct relationships with the suppliers of these chips. Also, Volkswagen has full transparency into the chip supply situation as well as dedicated capacity allocations that significantly improve visibility for Volkswagen. While the situation for semiconductors may continue to be relatively tight through 2023, Volkswagen will leverage on its pricing power to manage these uncertainties.

Improving business in China and EVs

Volkswagen Group CFO Mr. Antlitz claimed that the underlying improvement in the first quarter in the China business, especially for the JV with SAIC, was due to reductions in fixed costs as well as better pricing ability. Without the impact of lockdowns in China at the end of the month of March, the JV would have achieved double-digit margins. Although there remain to be uncertainties about the direction the Chinese government will take with the covid-19 situation, Mr. Antlitz believes that the Chinese business remains fundamentally strong and continues to target year-on-year growth in profits. The management continues to have confidence that these JVs have the flexibility to catch up lost volumes when the semiconductor supply improves as lockdowns ease.

With Volkswagen Group’s electric vehicle (“EV”) push, there is an order backlog in Europe through 2023. While China currently does not have an EV order backlog, management expects their China EVs to be more competitive after a series of local software upgrades. While commodities prices have resulted in higher battery and thus EV prices, Volkswagen takes the view that price hikes can solve this and maintain the margin profile of the company given the strong order backlog and solid demand from consumers.

Outlook for 2Q22

For 2Q22, I think that we will continue to see a sequential improvement in volumes and revenues, with 2 million unit sales, EUR65 billion in total group revenues, and EBIT of EUR5.2 billion.

I think we will also see EUR28 billion in net industrial cash this quarter due to several reasons. First, there will likely be EUR1.2 billion in dividend payments from China. Second, there will be EUR5.6 billion cash outflow from the Europcar acquisition and payment of dividends, and lastly due to outflows of working capital.

In terms of the commentary from the company, I think we could see weakness in Europe in terms of order intake except for the premium and luxury brands in the region. Also, management should also provide commentary that the product mix continues to remain solid in the group and that the company continues to have pricing power to ride through the current challenges that it is facing.

In addition, Volkswagen is also the beneficiary of tax incentives in the Chinese market, and likely one of the largest winners within the space, leading to further sequential improvement in the second half of 2022. As such, my earnings forecasts for Volkswagen remain the same and unchanged, as I continue to take the view that the company is able to meet the guidance range and deliver the results it guided for earlier in the year.

Valuation

My target price for Volkswagen is EUR240 per share, which implies an upside of 85% from current levels. This target price is based on a 7x 2023F P/E on my 2023F EPS forecast. I think that this multiple is warranted given that it is the historical average P/E for Volkswagen in the past 5 years.

Risk: Shortage in semiconductors

The shortage of and tightness of supply of semiconductors remain the one big near-term risk and bottleneck for Volkswagen. While management has arguably navigated a very challenging situation well so far in 1Q22, moving into the second half of 2022, I think that if the semiconductor situation worsens, this could impact the recovery story for Volkswagen. That said, management has continuously improved transparency of the semiconductor supply for its brands and models and this is likely to add value if shortage persists. With management’s view that the second half of 2022 should see improving semiconductor supply, I take the view that the baseline scenario should be one of improving supply situation. I continue to track the risk of semiconductor shortage and the downside risk it has for Volkswagen.

So, one big near-term risk for VW is its semiconductor shortage, which has been costly for VW as it has had to reduce production. For VW, its volume brands like Volkswagen, Skoda, and SEAT suffered the most during this semiconductor shortage.

China consumer weakness

With the current covid-19 situation in China, there are many uncertainties about the policies the government will likely take if the covid-19 situation persists. Prolonged lockdowns will definitely hurt the economy and dampen demand for Volkswagen’s products given that customers are unable to test drive their potential purchases. China is a relatively large exposure for Volkswagen Group and, as such, any serious slowdown in demand could have a detrimental impact on consumer sentiment and thus, bring downside risks to Volkswagen. In addition, there are also risks that Chinese EV brands may outperform Volkswagen’s EV brands given the highly competitive market in China. This could also bring competitive pressures on Volkswagen’s margins in the region and potentially may slow its progress to rival Tesla in the region.

Large capital expenditures

As a result of increased competition, there may be a need for Volkswagen to increase the size of its capital expenditures. This may be needed to maintain Volkswagen’s share in the market and provides some downside risks in terms of the need for heavy investments in the near term.

Software risks

While Volkswagen is behind peers in software and is spending large amounts of investments into it from now until 2026, there is the risk that these investments into software do not reap benefits as Volkswagen may lack the necessary resources like the talent needed to compete with peers.

Conclusion

There are many reasons to like Volkswagen despite the challenges we see today. It is executing well based on its 1Q22 results, with pricing and mix offsetting the weakness in volume. Management continues to be optimistic about the future as they expect the semiconductor shortage to ease as it continues on its progress to rival Tesla in the EV space. Furthermore, Volkswagen is also doing well in the EV space, with record levels of backlog in Europe.

I look forward to 2Q22 and, based on my preview, I think that its results should show sequential improvement in fundamentals. I think that Volkswagen is currently rather attractive from a valuation perspective and as a value play, it will likely be a structural winner in the VE space in the time to come. My target price for Volkswagen is EUR240 per share, which implies an upside of 85% from current levels.