In September 2015, Volkswagen AG revealed that several of its diesel powered car models not only failed U.S. and other nations emissions tests, but had (for years) been fitted with engine management software configured to detect emissions tests and operate differently if a test was detected. The “cheating” software was effective, as VW diesel engines passed emission tests but emitted pollutants in volumes of some 10-40x the legal limits in real world use. The systematic cheating was uncovered not by the EPA or other government officials but by an academic study. Volkswagen in fact continued to dispute and deny any culpability until the EPA threatened to withhold certification of its 2016 MY diesel cars, at which point the scandal was revealed.
Even relative to some of the other high-profile business scandals of the 21st century, this is a saucy one!
Subsequent tests of VW cars have unsurprisingly revealed that real-world performance is not as good as advertised when the cheating software is in operation, with horsepower, acceleration, and gas mileage all suffering by 15% or so versus “normal” operation. In legal terms this is a very basic consumer fraud issue (making false claims to induce sales of a product), plus lying to government officials (in many countries), plus damaging the environment.
Some sensible questions and our current answers:
Q - How large is the scandal?
A - In the USA, diesel vehicles are about 3% of total unit sales and are only 0.5% of the auto fleet. VW has sold over 500k diesels in the USA since 2008 when the cheating first started, or about $12.5 bn worth of cars assuming a $25,000 average selling price. In Europe, it is a very different story where about ~50% of unit sales are diesels and, depending on where you live can be up to 70% of the fleet in some cases. Diesel engines are more fuel efficient (in MPG terms) and high fuel taxes outside the USA therefore favor diesels. Volkswagen may have sold up to 11 mm cars globally with the cheating software in place, although standards outside the USA are not as stringent. The cars affected are any VW-brand diesels from 2008 onwards, along with Audi and Porsche brand diesels in the USA (VW owns these auto brands and others).
Between environmental fines, the cost to replace or refund the defective cars (more on this below), punitive damages, government fines, the loss of equity value for the VW brand and its dealerships, and sharp declines in the salvage-value of financed cars, we would estimate a meaningful double-figure $ billion liability in the USA alone. Outside the USA, the legal systems are not as apt to generate gigantic court judgements, but VW-brand cars may become more difficult to sell.
Q – Is this a lot like the BP oil spill? Was that stock a good buy after the initial panic?
A – Not really x2. It might look a bit like BP but we think this is a very different set of issues. BP stock fell over 50% in the first half of 2010 when the oil spill occurred, falling from just over $60 to just under $30. It did trade into the high $20s for about 10 days in June 2010 and bounced back to the $40s quickly - so if you were a clever/quick trader there was some money to be made. But after an initial oversold bounce BP stock did not make much of a return, even before the 2014 oil price crash. The legal costs did serious damage to their business capabilities. VW stock shed over 45% in September and also bounced a little recently, losing over $30 bn in market value (and therefore implying a $40+ bn pretax loss from the above liabilities).
At BP, we assume nobody was actively trying to cause an oil spill, it was a combination of ineptitude by their drilling team and some bad luck on top. At VW, some engineers and managers (and the company has yet to disclose who exactly) set out to write software to deliberately fool emissions inspections globally, and they were highly successful at this for years. This is going to be very difficult to defend. Secondly, and this is an important thought, the loss of brand equity for a car company can be damaging if not fatal, whereas that is a non-issue for a commodity producer. Car companies require high factory utilization rates to be profitable. A decline of 10-20% in volumes can be enough to eradicate any profitability. We have yet to see definitive statistics on the impact to the VW brand but would broadly guess the market share losses will be in that range. Last, the issue of salvage value for VW’s diesel cars already sold represents a potentially large liability tail. A large percentage of cars sold around the world are leased or bought on credit. If VW’s diesel cars cannot be remediated easily (we think this is unlikely) they may need to be pulled from the road or are worth only a small fraction of their book value. This would mean trouble for the value of VW’s own finance receivables (worth over $150 bn) and any securitized lease or auto loan receivables containing VW diesel cars may require remediation.
Q – So is VW something Cambiar would buy?
A - Not currently, no. In short, putting a reliable number on the true size of VW’s liabilities and the damage to the business is difficult and not likely to come into clear view for some time. It’s one thing to buy cheap stocks with few liabilities but another thing entirely to buy cheap stocks with gigantic and unquantifiable liabilities. We have bought stocks with large liabilities priced into them that appear grossly overstated, but usually it takes several years for the liabilities to ripen and then be discharged. We are very far from this now. Cambiar did own Volkswagen and sister-company Porsche in the past and exited several months ago (we were concerned that global luxury car sales were getting close to the saturation point in key markets). This scandal is… beyond our wildest dreams.
Q - Why would this have happened?
A – Obviously they thought they could get away with it and nobody would notice or care. It should not be a big secret that the real-world performance of cars does not equal their “test world” performance in terms of fuel efficiency and other metrics, though not by a factor of 10-40x! Few people ever generate the mpg on the car window sticker. Reports suggest the cheating may have started 9 years ago, so indeed nobody did notice for a long time. VW has held aggressive corporate goals to exceed 10 million cars produced annually and to become the world’s largest car company. These aggressive goals likely provided the motivation to sell astonishingly non-compliant cars.
Q - Are all diesel cars really dirty polluters?
A – That may be the unavoidable conclusion. Diesel fuel by definition contains a lot of pollutants. The combustion cycle does not burn diesel fuel as completely as gasoline is burned. Other manufacturers (notably BMW and Mercedes) sell a lot of diesels globally but could not meet current emission standards without adding a costly secondary system that injects liquid urea into the diesel exhaust stream. Urea reacts with NOx particles and becomes ammonia, which is then burned off in the exhaust system. This system of a secondary tank, fluid pump, and complex exhaust system is costly to produce. As we understand it, competitors’ engineers could not figure out how VW had managed to generate good engine performance and meet the emission requirements without using urea injection. As it turned out, they could not.
This calls into question the feasibility of any cheap solution to the offending cars. A software “tweak” likely causes them to perform poorly creating a clear consumer fraud issue. Remediating with a urea tank is not possible; that would mean re-manufacturing the cars!
Beyond VW’s customer relations nightmare, there is a basic question of whether the real-world pollutants caused by diesel are worth it. In major European capitals, black soot from diesels coats buildings and sidewalks much as the soot from coal powerplants once did, and an increasingly visible brown cloud surrounds larger cities when the air is still, much as a brown cloud once enveloped Denver and Los Angeles in the 1970s and 80s before emission standards were raised. Diesel fuel and clean air don’t really go together.
Brian M. Barish, CFA - President