The Power of German Lying

Monday 09/28/15

     Last week a scandal at Volkswagen rocked the German financial markets. Volkswagen admitted that it had installed illegal software in the engine control units of their 2009-2015 Volkswagen and Audi diesel vehicles affecting more than 11 million engines. The software detected when a vehicle was undergoing an emissions test and would implement emissions control features in order to pass, but those features would be disabled under normal driving conditions. This resulted in NOx pollution that exceeded federal limits by 40x. The problem was discovered by The Center for Alternative Fuels Engines and Emissions (CAFEE) part of West Virginia University. This week I want to look at the impact that these recalls might have on Volkswagen and Germany.

     Volkswagen was the largest company by total revenue in 2014 as shown in figure 1 it was also the largest by total number of employees. As you can see from the chart, Volkswagen employs a lot more people on a relative basis. This has helped Volkswagen become the fourth largest employer in the world behind Walmart, Hon Hai, and G4S. Volkswagen also just surpassed Toyota in total vehicle sales in the first half of 2015 to become the largest car company in this respect as well. Needless to say, this scandal will have a major impact on their sales overall.

     At this stage it is impossible to know what the exact impact the scandal will have on Volkswagen, but it will clearly be huge. The fine for violations of the U.S. clean air act are $37,500 per vehicle x 482,000 non-compliance vehicles, which comes to just over $18 billion (this is a max fine and the actual could be less). There are about 30 states that are coordinating an investigation into Volkswagen which will result in additional fines. Volkswagen will also have to recall all of these vehicles and give them a tune-down, meaning that the fix will reduce the performance and fuel economy of the vehicles. This article shows the breakdown of preliminary additions that would need to be added. They describe a substantial retrofit estimated to take dozens of hours at about $100 per hour for a Passat (presumably this would be more for a higher end Audi). At a certain point it might even be more economical for Volkswagen to buyback some vehicles. Let's assume a cost of $5,000 per vehicle x 482,000 vehicles, that's another $2.4 billion. It is possible that they could make the upgrade simply by changing the software, but that would likely result in a very large performance hit to the vehicle.

     There will also be many legal challenges for Volkswagen going forward. They are likely to face criminal charges for individuals as well as numerous class action lawsuits. According to the EPA, NOx emissions can cause serious respiratory problems and can especially aggravate symptoms of people with asthma, bronchitis and emphysema. NOx emissions also form ozone when interacting with organic compounds in heat and sunlight, a real public health concern. NOx has been shown to increase trips to the emergency room and premature death. There have already been at least 25 class action suits (seperate from the EPA charges) against Volkswagen and Volkswagen has set aside $7.3 billion for legal charges related to the scandal. All of these charges are just associated with the United States, but Volkswagen was most likely in violation of laws in China, the EU and elsewhere. However, Volkswagen has a strong balance sheet and can likely afford all of these charges in the near term. They have €32 billion of cash and short term investments, which they are going to need. Their credit rating will almost certainly be downgraded by the big three ratings agencies, leading to higher borrowing costs.

     By far the biggest challenge facing Volkswagen is the damage to their brand. Volkswagen and Audi vehicles sold at a premium because it was believed that they had superior engineering. In fact, one of their marketing campaigns was “That's the power of German Engineering”. Many of their fans now feel betrayed. Volkswagen's future will depend a lot on how they handles the recall; if owners have their car down-tuned they are not going to be very happy and will likely not return to Volkswagen, which is why I think they will need to proceed with the more expensive retrofit in order to ensure repeat customers. However, even if they handle this situation as perfectly as possible, sales will take a hit because they are not allowed to sell many of their vehicles. There is a very real possibility that Volkswagen could declare bankruptcy, but it will take quite a bit of time to determine whether it is likely.

     This scandal should be very concerning for Germany and the EU in general. Germany is the largest economy in Europe and Volkswagen is a major part of that economy. This could become a much bigger problem than Greece ever was. Volkswagen has many more employees on a relative basis than other car companies and a cut to their workforce seems extremely likely (they've already cut one employee, the CEO). Volkswagen's stock had already been suffering from concerns about a slowdown in China and has now erased about five years worth of gains for shareholders as shown in figure 2. Although Volkswagen stock may seem cheap now, I believe it should be avoided until there is more clarity.