Volkswagen AG: Is The Risk Worth The Reward?

Volkswagen, the German carmaker, dropped a news bomb on September 21 when it confessed to cheating on the pollution tests for its diesel cars in the U.S. 

The Environmental Protection Agency (EPA) has accused Volkswagen AG of cheating during the emissions tests by installing a software which hid the fact that VW's diesel engines exceeded pollution standards by as much as 40 times. The company's TDI clean diesel engines complied with the U.S. standards when the so-called defeat device was switched on. The software then switched off the emissions controls in order to improve performance. The EPA estimated that 482,000 cars sold in the U.S. were affected, and the company may face substantial fines of up to $37,500 per vehicle.

Since then, investors have been dumping the stock, which has fallen to its lowest level in five years and has experienced the biggest intra-day decline since 1999 of 20%. Since the news has hit the headlines, the stock has declined 28% and is now trading at $25.8 a share.

As you can see from the above diagram, Volkswagen vehicles represent a third of the Volkswagen group sales. Obviously, the diesel engine scandal will hit the company's profits, and legal claims can reach billions of dollars. The company has already announced that it plans to take a €6.5 billion charge in the third quarter to cover the necessary services measures and other efforts to win back the trust of its customers. Also, the company says it is actively working to "clarify irregularities" on its 11 million diesel cars worldwide. It is still unclear what will be the final cost, as the company will be investigated by Germany and South Korea, and other countries may join the list. It may also face class-action lawsuits from customers. So, at the moment, there is no end in sight for Volkswagen's penalties. What is known for a fact is that the affected models' sales are suspended in the U.S. and Canada, and the company will have a dismal Q3 earnings.

Diesel cars are rare in the U.S., and the percentage of sales remains in the single digits. At the same time, they are mainstream in Europe, which accounts for three-quarters of the diesel car sales worldwide. In 2014, diesel motors were installed on 40% of passenger cars in Europe, and comprised 53% of all new car sales in the region.

Volkswagen announced that it will cut costs and cancel non-essential investments in order to solidify the income statement. So far, the company's management is not considering any asset or brand sales.

So, the main question for investors right now is what to do with Volkswagen's stock? We think that it is too early to get any exposure to the company as the uncertainty is currently too high. Nevertheless, VW's metrics look undervalued with the P/E standing at 5.3 (peers' average at 9.0) and P/B at 0.57 (peers' average at 1.18). Our take is that the most likely scenario is that the stock will be flat in the medium term at its multi-year minimums around $20-25 a share. Answering the question posed in the title, we think that at the moment the risks are too high and the reward is unclear.