Volkswagen (VLKAY) has been in the news again recently, both for some positive reasons and for one very negative lingering reason. The carmaker with a portfolio of over 10 brands, including Audi, Porsche, Bentley and its namesake VW line, is currently vying with Toyota for the position of largest global automaker and it has exhibited strong 1H 2016 sales. VW has also made strategic acquisitions of heavy duty truck assets (Navistar International) and, most notably, it is making an ambitious pivot to electric vehicles, including its bold long range I.D. concept that is currently making waves at the Paris AutoShow. 

Positive news no doubt, but VW has a dark cloud obscuring its future results in the form of the emissions scandal and admissions of environmental cheating that shook the automaker (and its stock price) to its core last September. The announcement of the “Defeat Device” scandal shaved $20 billion off of the company’s market cap and the stock dropped nearly 30% virtually overnight.  In fact, VW is down more than 40% from May 2015 highs. 

(VLKAY – Volkswagen US ADR)

And while the stock has recovered from the late September 2015 doldrums, the global legal ramifications, including the $15 billion civil settlement and recall plan with US Regulators, will not be resolved any time soon.  What actually happened and what is the outlook for VW and its stock price in the long wake of its admissions of fraud?  Lets recap:

In May 2014, the California Air Resources Board conducted on-road testing of emissions for VW models equipped with 4-cylinder turbocharged diesel engines.  The researchers found that actual road testing of these engines showed emissions almost 40 times the permitted levels. This led to a broad internal investigation and inquiries from various U.S. regulatory bodies, including the U.S. Environmental Protection Agency, the U.S. Federal Trade Commission and numerous State Regulators. In the face of this pressure, the CEO was forced to step down and VW officially announced that some of its diesel cars were outfitted with “Defeat Devices” – software that detected testing and allowed the vehicles to game or cheat U.S. air pollution tests.  Specifically, engineers deployed software to sense when emissions testing was being conducted based on inputs such as position of the steering wheel, vehicle speed, and barometric pressure. In these situations, diesel engines went into a type of "test mode."  This allowed emissions controls to run during testing periods, but while on actual road conditions emissions rose to as much as 40 times legal levels.

This has led to a raft of recalls and mandated repurchases and/or repairs of vehicles in the U.S., Europe and throughout the world.  In June of this year, VW agreed to pay up to $14.7 billion to settle civil allegations of cheating admissions tests with the U.S. FTC and the State of California. This huge fine is only a part of the potential future legal problems.The U.S. Department of Justice is currently in discussions to resolve a criminal investigation that will carry with it a heavy fine.This is in addition to a potential settlement with U.S. attorneys general in 42 states. And this is just in the U.S.

Volkswagen has acknowledged that it installed illegal software in 11 million cars worldwide, making capable of defeating pollution tests. VW is also under investigation for breaking consumer protection laws in 20 European countries, including its home market of Germany, and faces inquiries in South Korea and Australia, among other countries.  Seemingly generous settlements with U.S. Regulators are also drawing scrutiny from counterparts in Europe and other countries where remediation efforts are less comprehensive.

In their totality, these cases could take more than a decade to resolve and the final costs to the company could surpass $50 billion dollars. The scope of the problem could also broaden and threaten VW’s prized brands, Audi and Porsche, whose divisions constitute the majority of its operating profit.  And much of the $20 billion that VW has already set aside or reserved to settle claims has already been spoken for by U.S. settlements. VW will likely endure this crisis, and although the final tally will not be known for some time, it is almost a certainty that this scandal will present a drag on VW’s earnings and stock price for some time to come.  

Add to this VW’s strategy pivot.  While electric and battery operated vehicles may very well be the way of the future, diesel is the company’s foundation and still its core product.  The company’s VW line has an operating margin that is already quite thin - 1.7% in Q2 ‘16 (2.13 Overall) - and existing manufacturing plants will need to be refitted and operations restructured in response to this new strategy.  This will likely add significant capital costs to the company in the coming years.

There is a significant amount of uncertainty surrounding the company as its seeks to exorcise its past misdeeds and make a strategic shift under the direction of new management.

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Commentary is provided for educational and informational purposes only and should not be considered as investment advice. Investing involves risk including the risk of loss. Before investing, consider your investment objectives, financial resources and risk factors.