Volkswagen AG; market cap (as of 25/09/15): €55.0bn
Small Software, Big Turmoil
Volkswagen, the second largest carmaker in the world, headquartered in Wolfsburg, Germany, is in the middle of one of the largest automotive scandals to date. The company was discovered cheating on the emission tests by installing software that limits the harmful fumes produced but only while the vehicle is being tested. Once on the road, the company’s vehicles’ emission levels exceed the norm by 10-40 times. The “trick” was supposed to help Volkswagen win the crucial American market and replace Toyota as the number one car manufacturer in the world.
The serious implications for the firm are expected to not only include costs arising from fines, lawsuits and recall costs, but also criminal and civil charges pursued against individuals directly responsible for the incident. In the recent scandal at GE, which caused many fatalities, employees were putting profits before safety. Since then, there has been a movement to put the highest emphasis on pursuing criminal and civil charges against individuals and not just imposing huge fines that merely impact the shareholders. It did not come as a surprise that America’s Department of Justice decided to open a criminal investigation against the company. Moreover, Volkswagen has set aside €6.5bn to prepare for the upcoming costs and fees.
The Desire for Power, the Need for Efficiency
At the core of this scandal are the so-called “defeat devices” installed by Volkswagen on some 11 million cars worldwide. At the moment legal charges have been brought up on roughly 482,000 diesel vehicles operating in the US under VW and Audi badges. The bulk of these appear to be vehicles containing the 2.0-liter TDI diesel engine, with models ranging from 2009 to 2015.
These “defeat devices” consist of integrated software in the engine’s ECU (engine control unit). When the software detected that it was being tested, it would change to an alternate engine configuration, lowering toxic NOx levels in exchange for a drop in performance and fuel economy. Because of the chemical and mechanical process of diesel engines, it is extremely difficult to lower NOx levels without the aid of expensive exhaust treatment components. This is because as the burn process becomes more efficient, higher levels of NOx are produced. By temporarily running a less efficient engine cycle during the tests VW was able to reduce toxic emissions, while regaining the power and mileage when back on the road and in normal use.
To resolve the current breach of emissions standards VW has two solutions. They could either update the ECU software, reducing consumer’s vehicles power and fuel efficiency, or they could install exhaust treatment components that would cost thousands per vehicle and reduce trunk space. Ironically, as the result of over-engineering on the part of VW, consumers will have to suffer with soon to be inferior products than they were promised.
The Market did not Forgive VW’s misstep
Under the threat of a €18bn potential fine, the negative reaction of the market has been rapid with VW losing c. 38% of its market capitalization in two days. Indeed, the stock went down by 18% on Monday and by another 20% on Tuesday as investors moved quickly to price in the worst-case scenario regarding fines. Only the news regarding Mr. Winterkorn stepping down brought a little break in what seemed to be an unstoppable decline.
In less than 48 hours, VW lost roughly a third of its market capitalization as the market struggled to quantify the near term cost of recalls, potential fines and the longer term impact on the VW brand. The wider automotive sector has also underperformed the market in recent days, with the main worries relating to the spillover into the European market, the future of diesel for the industry and the outlook for car sales in general.
With roughly $430bn of sales in 2014, accounting for 18% of national GDP in Germany, the automotive sector represents one of the main pillars of the whole economy with 1 in 7 jobs directly or indirectly related to the sector. The VW scandal has had important consequences on the whole industry: firstly the STOXX Europe 600 Automobiles & Parts Index, the main European index for the automotive industry, went down by approximately 8% during the week. On top of that all the producers involved in the supply chain have also seen important declines (especially those companies with exclusivity contracts, whose results are highly linked to VW’s volumes); examples are BorgWarner and Delphi Automotive, two producers of cars’ components. Moreover, VW’s peers, BMW and Mercedes lost 6% and 8% respectively during the last week. It is easy to understand that the market is already pricing in the potential fines coming from the stricter and more severe controls the European regulator will enact.
New CEO, New Philosophy, New Era
A breath of fresh air has arrived with the CEO’s resignation. After spending more than eight years at the helm of VW, on Wednesday night Martin Winterkorn stepped down as chief executive of the group saying he was doing so “in the interests of the company”, although he claimed he was unaware of any wrongdoing.
Frontrunner in the succession race, Porsche’s CEO Matthias Müller was chosen to replace Martin Winterkorn by the supervisory board meeting on September 25. Mr. Müller began his career at the group’s Audi subsidiary in the 1970s and has headed Porsche since 2010. His tenure has allowed him to develop an intimate knowledge of the group and its brands as well as develop a reputation for speaking his mind. In addition to this, Mr. Müller is close to both the Porsche and Piech families, who together control a majority of VW’s voting shares via the Porsche SE holding company.
Although a change at the top is not all Volkswagen needs right now, it is a signal that the firm is willing to change. The Group should now focus on taking this opportunity to upgrade its whole corporate structure, try to restructure VW’s image and repair the automaker’s reputation in order to regain the consumer trust it lost.
The Future of the Industry
The reputational damage will probably set back the expansion of diesel vehicles in the US significantly, as they were being marketed as more efficient and eco-friendly alternative to gasoline powered vehicles.
Even if other producers of diesel vehicles have not resorted to the same level of deception as VW, the scandal could mean that these cars struggle to meet forthcoming regulation on the types of emissions allowed. Some fear that this may be the “death of diesel”. There is still scope to improve the venerable petrol engine and to switch to cleaner cars that run on methane, hydrogen and electricity or are hybrids. A multi-billion-dollar race is already under way between these various technologies, with producers often betting on several of them as the way to meet emission targets. Porsche’s all electric rival to Tesla, the electric “Mission E” concept car, seems rather well timed. If VW’s behavior hastens diesel’s death, it may lead at last, after so many false starts, to the beginning of the electric-car age.
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