Volkswegan AG (VLKAY) Half Year 2018 Earnings Conference Call August 1, 2018 8:00 PM ET
Oliver Larkin – Group Head of Investor Relations
Herbert Diess – Chairman of the Board of Management
Fred Kappler – Head of Group Sales
Frank Witter – Member of the Board of Management
Arndt Ellinghorst – Evercore ISI
Dominic O’Brien – Exane
Horst Schneider – HSBC
Georges Dieng – ODDO BHF
Jose Asumendi – JPMorgan
Daniel Schwarz – Credit Suisse
Harald Hendrikse – Morgan Stanley
Michael Punzet – DZ bank
Frank Biller – LBW Bank
Mike Dean – Bloomberg
Hello, and good afternoon, ladies and gentlemen. Welcome to Volkswagen’s conference call for investors and analysts on the results for the period January to June 2018 based on the half yearly financial report we published this morning. For today’s conference call, I’m delighted to be joined by Dr. Herbert Diess, Chairman of the Board of Management, Volkswagen AG; as well as and Frank Witter, Member of the Board of Management, Volkswagen AG, responsible for finance and IT; and Fred Kappler, Head of Group Sales, Volkswagen AG.
You can as usual follow today’s webcast via our website, where you will also find the charts available for you to download. Most of you will have followed the webcast from this morning’s press conference, and we will try to avoid a repetition of content.
So let me now hand you over to Herbert for some opening remarks.
Okay. Thank you, Oliver, and good afternoon, ladies and gentlemen. I truly welcome this opportunity to talk to you today. For me, certainly, U.S. investors and analysts are key players who deserve to see real results. And you really also, I think, you should be glad to, let’s say, get our direct comments. And I’m really glad to join today’s conference. Frank has been keeping me regularly up-to-date on your thoughts and concerns, and I’m looking forward to your comments and questions later on. It’s also a good opportunity for me to reflect on what we are doing and our way forward.
Our and my focus in the last three months has been on implementing the changes I see necessary for Volkswagen to become more agile and move the tanker at a much faster pace. As you heard this morning, I’m pleased with our continuous growth, and the good results achieved under demanding conditions in the first half year. Together, over the last few months, we have notched up a number of successes. We are pushing alliances with much greater vigor like Ford, JAC in China or QuantumScape, for instance.
As you have heard this morning, we made good progress in implementing our new decentralized group structure. For instance, in the volume brand group and with greater subsidiary in our decision-making. We are strengthening our leadership base also with top executives from the outside, like Stephan Sommer or Markus Duesmann. The most important task for Volkswagen is and remains cultural change and ensuring a high level of integrity and compliance throughout the group. The monitorship is of great help on this task.
Speaking about culture. My top management team and I have also analyzed the roots of the diesel crisis. We will do everything possible to make sure it cannot happen again, and we agreed on a common vision and understanding of leadership for the new Volkswagen: more open, more honest, more cooperative, more international.
As you can see, there’s a lot going on at Volkswagen. Looking into the next months, however, we are also facing challenges, namely WLTP, which is a real headwind for us. Frank has outlined this to you since November last year, and there’s still a lot to do to get us over the line.
On a broader scale, our industry is changing rapidly. Challenges are growing. Who would have believed five years ago that China and U.S. tech companies would be eating into our space, or that United States would be pushing for such fundamental changes in our trade position. Despite all, for you guys and all our stakeholders, we need to deliver on our planning round in November. We are working hard on that, leaving no stone unturned. We have to free up further resources, especially for R&D particularly, to deliver and to drive digitalization and e-mobility, as we strive to remain a winner in the new era of mobility, too.
Looking ahead, my goal is unchanged: I want to make the whole group and all brands significantly more efficient, productive and profitable. And there still is a whole lot of potential. We will reduce the complexity of our product portfolio and the number of variants without incurring tangible disadvantages for our customer. Another priority, we must transition from a sole product focus to a much higher concentration on production and processes. Working together with our brands, we want to improve efficiency at all plants by approximately 17% by 2025, factory costs, productivity and investments.
As I stated this morning, we will push ourselves to bring us up to competitive levels in terms of productivity and efficiency. That is the board’s and my personal commitment. Of course, at the same time, we will never give up on what made us successful: developing and building the best vehicle. To get to where we want to be, further significant efforts will have to happen, especially post 2020, and brand Volkswagen is a huge part on the effort required. I’m convinced that Strategy 2025 is the right foundation for driving the change. My overarching goal is that Volkswagen will still be here in 20 years, efficient and profitable, innovative and customer-oriented, responsible and respected.
To this end, we must get closer to the company valuation levels of Uber, Apple and Emerson. Ladies and gentlemen, we have a whole lot to do, but I assure you that I’m convinced that we will prevail in the tech world, too.
Thank you, Herbert. And let’s now pass over to Fred.
Ladies and gentlemen, I would also like to extend a warm welcome to this conference call and will present the first half-year sales results for 2018. The following overview shows the development of the world by passenger car market, and Volkswagen Group deliveries to customers of our passenger car brands in comparison with the previous year. The global car market continued to grow at a moderate pace in the second quarter, where, once again, the Asia-Pacific region and especially China, was a key driver. And nearly all regions and core markets contributed to the total growth in the first half year.
It was dampened by the decline of market, such as Japan, Mexico, the Middle East and the UK, which, however, returned to growth in the second quarter. The Volkswagen Group pursued on its growth path with a strong second quarter result and recorded the best-ever first half year in its history, delivering 5.1 million passenger cars to customers worldwide, a growth of 7% versus the same period of the prior year. Among others, this growth was driven by the ongoing success of our group-wide SUV offensive. Every fourth customer worldwide was opting for an SUV of our group brands. Group deliveries increased in all core market, especially in China.
Let’s now take a closer look at the deliveries of passenger cars compared to the car market developments on a regional basis. The North American market continued to grow slightly versus the prior year period. While the U.S. market was still growing on a high level, the Mexican market declined further, and demand in Canada stagnated. These results presented a mixed picture. We increased deliveries in the U.S. by more than 6% and in Canada by nearly 14%, thanks to our new product portfolio.
On the other hand, this increase was partly offset by a decline of sales in Mexico, that is in part attributable to the total market decline. In Western Europe, total demand returned to growth in the second quarter. This was partly influenced by an upturn of the British market in the second quarter. Key growth drivers in the first half of the year were again Germany, Spain and France. We increased sales by 5.9%, with strong momentum in the second quarter and, therefore, continued to gain market share. This performance was especially favorable in Germany, Italy, Spain and the UK.
Our newly introduced compact SUVs were key drivers of this growth, which was also supported by positive effects of the environmental bonus as well as the good economic situation in many markets. The total market in Central and Eastern Europe lost some momentum during the first half year, but still maintained a high rate of growth. Almost all main markets recorded an increase in demand, with Russia as a key driver. We benefited from this positive development and increase sales of our brands in nearly all markets, again particularly in Russia.
In South America, the market recovery continued throughout the first six months. While Brazil maintained its double-digit growth, demand in Argentina lost its strong momentum in the second quarter, remaining however on a higher level. The Volkswagen Group recorded a significant sales increase in this region, especially thanks to strong sales growth in Brazil in the second quarter, which was supported by our new product, such as the – or new Polo. Demand in the Asia-Pacific region continue to rise moderately, with above all China as a key driver and India gaining strong momentum. The margin China lost some of its dynamic in the last three months due to a strong first quarter growth impacted by tax effects in 2017, as well as the postponement of purchasing decisions related to lower import tariffs effective from July 1.
While the extraordinary sales growth of the first quarter lost some pace as well, the Volkswagen Group recorded a substantial increase of deliveries of 9% in the region as well as in China. The strong SUV offensive has been very positively received by our customers, alongside a robust performance of all sedans. The portfolio will be further strengthened this year with even more new market-specific SUVs and renewed local sedan models. Last but not least, the gradual resumption of sales in South Korea led to a favorable contribution to growth.
Moving now to the performance of our group brands in the first half year. Since the beginning of the year, the Volkswagen Group delivered a total of 5.5 million passenger and commercial vehicles to customers worldwide, a favorable increase of 7.1% compared to last year. This result is based on the performance of each of our group brands, many of which achieved their best first half year in terms of total sales.
The Volkswagen Brand accelerated its growth and increased its deliveries by 6.3% to over 3.1 million cars to the first half year. The biggest product offensive in its history, with focus on SUVs, was again key to the further upward trend. As before, China was a core driver, as I just mentioned, thanks to new SUVs such as the Teramont, but also the strong performance of various local sedans. The fact that the brand grew 20% in Brazil is worthy of a special mention. Deliveries in Western Europe were very encouraging, with a consistent growth of more than 7% in Germany and a strong dynamic in markets, such as Italy, Sweden, the UK and Spain. This development was supported by our environmental bonus, especially in Germany.
Further core markets, such as the U.S. and Russia, also delivered favorable contributions to the worldwide sales balance. Year-to-date, Audi delivered around 949,000 vehicles to customers, an increase of 4.5% that was largely driven by a very strong first quarter in China. This was however influenced by a weak prior year period due to Audi’s strategic realignment. Moreover, the last month was burdened by the announced reduction of import tariff.
Besides establish models like the top-selling A4L, new SUVs, such as the Q5L and the all-new Q2L make us confident for further growth in China. Sales in North America remained strong, particularly in the U.S., where the brand kept growing at a record level. In Europe, deliveries were down at the midyear point. As part of its model initiative, the brand is replacing various models that account for [indiscernible] of its total sales.
While the changeover of the A6 in Q3 dampened the results, the newly launched models Q5, A7 and A8 as well as the Q2 achieved high growth. SKODA maintained its high sales growth of almost 12% in the second quarter and, thus, concluded the first half year with a record result of 653,000 vehicles. Nearly all markets contributed to that growth. Above all, China followed Russia, Germany and France. Key growth drivers on the product side were once again the new SUVs, Kodiaq and Karoq as well as the new Karoq L that was just launched exclusively in China. The brand is extending the Chinese SUV range further in 2018.
Finally, sales growth was banked by models, such as the Octavia and the Rapid. Also, SEAT maintained growth at a high level and concluded the best first half year ever with deliveries of 290,000 vehicles, an increase of 17.6%. Again, primarily the new SUV Arona boosted these figures. The brand obtained excellent results in Europe, with nearly all countries posting double-digit growth. Algeria also delivered a significant growth contribution, thanks to the local assembly of the new Ibiza.
In September, SEAT will expand its SUV range with the new Tarraco, enabling us to reach new customers. With around 171,000 vehicles delivered worldwide, Porsche continued its positive trend and exceeded the previous half year figure by 3.2%, reaching a new record. Main drivers of this growth were the new-generation Panamera in China and the U.S. as well as the 911 Coupe and also the newly launched Panamera Sport Turismo in Western Europe. While Western Europe gained more momentum in the second quarter, this dynamic was burdened by reduction of sales in China due to the customers pausing their purchase decisions in light of the announced reduction of import tariffs.
After difficult first quarter due to a precautionary delivery hold of T6 models, Volkswagen Commercial Vehicles returned to growth, recording a strong second quarter of double-digit growth. Year-to-date, the brand handed over 259,000 units to customers, a growth of 3.5%. This result was primarily driven by the Transporter series and the new Crafter in Europe as well as the Amarok in South America. The demand for trucks above six tons in our relevant markets increased year-on-year. Where the truck market in Western Europe increased slightly, demand in Brazil and in Russia were significantly higher than the previous year’s level.
During the first half of 2018, both MAN and Scania registered an increase in deliveries in almost all regions. MAN sold around 65,000 vehicles worldwide, an increase of 24%, which was supported by the positive development in South America.
Scania also recorded higher sales and delivered around 47,000 units. Let’s take a look on the next month. After our top performance the first six months, the second half of the year will be significantly more challenging. In Europe, we expect deliveries to be affected by the changeover to the new WLTP standard. The homologation process is very time-consuming and complex, with around 300 engine transmission variants worldwide and a very short time line.
In the next weeks, a further wave of homologations is expected. On the positive side, we have reduced complexity by taking out a high double-digit number of engine transmission combinations and are strictly prioritizing high-volume, high-margin models. However, some model lines will most likely be handed over to customers later than planned.
We can assure you, we have set the highest possible capacity levels to homologate cars as quickly and – as possible to ensure the greatest possible availability for our customers. The further challenges posed by the political discussion around import tariffs in the U.S., we take this very seriously. Nevertheless, the so-far positive development of our brands across all core markets, combined with our ongoing broad product offensive, give us ground for optimism. For the full year 2018, we are, therefore, expecting sales result moderately above last year.
Last but not least, let me now introduce you to a few model highlights, which have been successfully introduced to the market in Q2 for which we have high expectations. The new Volkswagen Touareg marks the milestone in the brand’s largest model and technology campaign. Equipped with the connectivity of a new era and a pioneering fusion of systems, comfort, lighting, infotainment system, the Touareg points the way to the future.
Following on from the Kodiaq – SKODA Kodiaq and Karoq, the SKODA Kamiq extends the brand’s SUV family in China. It combines compact dimensions in a surprisingly spacious interior. The Kamiq is aimed at young urban customers, who wish to maintain their digital lifestyle in their car and desire modern connectivity solutions.
Third-generation Bentley Continental GT combines high performance with handcrafted luxury, cutting-edge technology and muscular exterior design. The spec was an enhanced version of Bentley’s 6-liter W12 engine, delivering 635-horsepower, a dual clutch with 8-speed transmission and the revolutionary Rotating Display.
As the first supersport utility vehicle, the Lamborghini Urus creates a new niche in the luxury segment, with benchmarking power and driving dynamics, and unparalleled design and daily usability. The Urus accelerates from 0 to 100 kilometers in 3.6 seconds. With a top speed of 305 kilometers, this is the fastest SUV available. These, and a lot more new model launches, make us confident for the sales development in the near future.
And now I now would like to turn over to Frank for the financials.
Yes. Thank you, Fred. And a warm welcome from another guy with a heavy German accent. As anticipated, this year is really developing into a year with two very distinct halves. The underlying operating business was very strong in H1, leading to an operating margin of 8.2% before special items. As in Q1, volume and product cost improvements supported the result.
Furthermore, the Volkswagen brand recovery continued and contributed positively. The operating results came in at €9.8 billion before special items, up almost 10% from the prior year. In Q2, special items of €1.6 billion were booked. After special items, the result came in at €8.2 billion.
Our unit sales came in at a strong 5.6 million. And sales revenue at €119.4 billion was 3.5% above the prior year. Debt equity result, which is mainly driven by the Chinese joint ventures, came in at €1.7 billion. Profit before tax came in slightly above the prior year at €9 billion and equaled 7.5% return on sales. The profit after tax at €6.6 billion came in on a similar level to the prior year. Automotive net cash flow before diesel outflows came in at €5.9 billion versus €6.8 billion in the comparable prior year period.
Diesel outflows amounted year-to-date to €2.6 billion, substantially below the previous year outflows of €11.6 billion. Automotive net liquidity ended the quarter robustly at €26.3 billion. As confirmed this morning, from where we are now, the margin guidance for the full year before special items of between 6.5% and 7.5% is still valid. After special items, we expect the margin to be slightly below this corridor.
Following up on the headline figures, let’s take a deeper dive into the details. Exchange rates had a negative impact on – of €3.3 billion on our sales revenue, and as the result of the strong euro against most currencies. The Q1 trend continued, in particular for the U.S. dollar, Argentinean peso, Brazilian real, Chinese renminbi, Russian ruble and the British pound.
Looking closer at the special items. €1 billion of these related to the payment to the Braunschweig public prosecutor for the breach of monitoring in the powertrain development department. A further €0.6 billion was necessary to top up for other diesel-related legal defense risks. The financial result improved to €0.8 billion. Our Chinese joint ventures, which make up for the majority of the equity accounted investments, reported a proportionate operating profit of €2.3 billion, up around 8.6% on the prior year.
Please remember the low one-off base from H1 2017 due to the Audi dispute with a dealer.
H1 2018 was quite strong, mainly driven by volume; positive mix, for example, from the Teramont and the Kodiaq; and material cost saving.
On the back of a highly competitive environment and FX deterioration, this was a sturdy achievement. In Q2, we also took fixed cost increases due to new factories, like the Foshan extension, Tianjin, Qingdao, where the sales volume benefits will come later as production ramps up. Yet equity impact in the P& L was more or less flat year-on-year, again, dampened by the currency exchange effects. The other financial result was significantly less negative in H1 due to a mix of factors.
There was a positive currency impact from the valuation of loans and receivables, a positive impact from the fair value of derivatives and lower expenses for the discounting of provision. Please also note that an effect of minus €4.4 billion is included for the increase of liabilities relating to the MAN minority shareholders. This increase was necessary as a result of the recent decision made by the higher regional court in Munich regarding guaranteed dividend. Moving on to look at the group operating result performance for the first half in more detail.
The position volume/mix/prices in the passenger car segment reported a plus of €1.1 billion. Stronger volume and positive pricing were, as in Q1, the main drivers. Exchange rate effects had a positive impact of around €0.2 billion so far this year. We have been very successful with our hedging. However, as is always the case, currencies are quite volatile. So let’s see how the rest of the year pans out. The currency translation of cost positions into euros also contributed positively.
Even though the challenge of rising material prices for the whole industry continued, we achieved product cost savings of €0.3 billion. Fixed costs and startup costs rose by around €0.9 billion in the first six months, partially as a result of higher volumes. We can see that the majority – and this is around 2/3, of the increase can be attributed to the Volkswagen brand, Audi, SEAT and Porsche, which all, on the other hand, show substantial turnover growth. Last, capitalization and higher amortization of R&D impacted the P&L negatively by around €0.6 billion.
Costs for and as a result of the monitorship as well as the strengthening of our control function also had an impact. As the year progresses, fixed costs are expected to continue to grow. Of course, as the Board of Management has made clear, we will continue to work hard to improve our operational efficiencies. Nevertheless, we have to and we will continue to invest into our future. And to wrap up this chart, we had to book diesel-related special items totaling €1.6 billion. Turning to our brands in more detail.
Volkswagen Passenger Cars had a stronger H1, with an operating margin of 5% before special items. The operating profit came in at €2.1 billion compared to the prior year figure of €1.8 billion. This increase was mainly driven by volume and improved product costs. Moving on to Audi. The operating profit came in a touch above the comparable period at €2.8 billion. SKODA again reported an operating profit of €0.8 billion, somewhat below the prior year, minus 0.5%. The result was burdened by exchange rate effects and ramp-up costs for new products, while volume and cost optimization contributed positively.
SEAT result improved strongly by over 60% to €0.2 billion, with notable volume, price and mix effect overcompensating negative exchange rate impact and ramp-up costs. Bentley reported an operating loss of €18 million. Delays in the ramp up of the new Continental and negative FX impact were the key drivers here. Porsche on the Automotive business delivered an operating profit of €2.1 billion , flat year-on-year. At 18.4%, the Porsche margin continued at a high level.
Mainly as a result of volume, mix effects and reduced material costs, the operating result for Volkswagen Commercial Vehicles came in at around €0.6 billion, a substantial improvement of nearly 30% above the prior year. Scania increased volumes, achieved a stronger performance in the service business and had positive FX impact. This altogether contributed to the operating profit of around €0.7 billion. MAN Commercial Vehicles earnings increased by around €0.3 billion, mainly due to higher volume. MAN Power Engineering came in lower at €68 million due to lower volumes.
Volkswagen Financial Services had a strong quarter with earnings of €1.2 billion, up a touch. This is fully in line with the full Financial Services Division, which also reported slightly higher earnings of €1.3 billion. At a negative €921 million, the famous volatile Other line came in lower than in H1 of 2017. This position consists of the elimination of inter-company profit as well as the earnings from non-brand companies, such as Porsche Salzburg and PPA cost allocation. Let’s now take a closer look at the underlying Automotive net cash flow development for H1.
Cash remains king, and H1 showed solid cash generation €5.9 billion outflows, compared to x diesel €6.8 billion in the prior year. One reason for the decrease was a lower proportion of China dividends received of €1.7 billion versus €2.3 billion in the comparable period last year. Just to refresh, the expected full year Chinese dividend of €3.4 billion is more or less flat in comparison to last year. Please be aware that the renminbi value has substantially deteriorated by around 3.5% in H1.
Furthermore, working capital was also negatively affected by the deterioration due to the seasonal build up of stock and a certain amount of vehicles that are being banked to cover the WLTP channel. The WLTP effect from the banking of cars, until the new homologations comes through, is expected to hit the balance sheet and the P&L starting in Q3 this year. WLTP is still critical to our full year performance, and the deadline of September first is very near. To sum up on WLTP.
As communicated already, we expect that WLTP will have a substantial impact on both working capital and cash from Q3 onward. Rest assured, we will do what we can to normalize the situation by year-end. Let’s now move on to this chart to take a deeper dive into CapEx and R&D. I’m well aware that this is also highly critical to maintaining solid cash flow generation. As a starting point in the bridge, the cash flow from operating activities came in at €10.2 billion. In relation to CapEx, at €4.4 billion, this was slightly above the first half of last year. Investments in product launches and the push toward electrification were in the focus.
As I have been saying since November, this slight bump was expected with the aim of avoiding emissions fines down the road. The CapEx ratio also came in slightly above H1 2017 at
4.3% versus 4.2% for last year. From where we are today, we can confirm our full year guidance for a range of 6.5% to 7%. Just to sum up the overall cash story. At this point of time, we remain on track for the full year x diesel net cash flow of at least €9 billion.
In relation to R&D, total research and development costs or cash spend was more or less flat year-on-year at €6.8 billion. At €2.5 billion, capitalized development costs came in below the prior year in absolute terms. This shows our ongoing trend of less capitalization in the balance sheet and corresponds to higher P&L impact of around €0.5 billion. From a ratio point of view, we again saw a decrease from around 43% in H1 2017 with a current ratio of about 37% of total cash R&D. For the full year, we expect the capitalization ratio to remain somewhat below the 2017 level of 40%.
Moving to the bigger picture. For the full year cash flow generation, we will do everything possible to try to come near the level of the exceptional performance of 2017. Nevertheless, with WLTP on our shoulders, it is not an easy task. Net liquidity in the Automotive Division stood at a robust €26.3 billion at the end of June. Our successful capital market issuance of hybrid bonds contributed positively with €2.7 billion to our liquidity. As always – as already communicated, we expect diesel-related cash outflows to come in at around €5 billion for the full year compared with around about €16 billion in the prior year.
Our minimum target for the Automotive net liquidity of at least €20 billion still holds up. And from where I sit today, I’m quite confident that we will stay above this level for the full year. So let’s now turn to the last slide, is our outlook for the full calendar year 2018. We still expect deliveries to customers of the Volkswagen Group in 2018 to be moderately above the level of the previous year amid continuing challenging market conditions. We still expect the full year 2018 sales revenue for the Volkswagen Group to be up by as much as 5% from the prior year figure.
As mentioned earlier, in terms of group’s operating return on sales before special items, from where we are now, our guidance of 6.5% to 7.5% is still valid. In terms of the group’s operating return on sales after special items, we anticipate that we will come in moderately short of the expected range. Believe me that next two quarters are going to be just as tense for the whole Board of Management as for you guys. WLTP, combined with a volatile worldwide market conditions, will keep us busy. Thank you.
Thank you, Frank. And operator, we will now take questions from investors and analysts.
Thank you. [Operator Instructions] Perfect. We will take our first question from Arndt Ellinghorst. Please go ahead your line open.
Yes, thanks very much and good afternoon. It’s Arndt Ellinghorst from Evercore. I’ve got two questions, please. First one, for Dr. Diess. You mentioned to use the upcoming budget process, to fine-tune VW’s financial targets this morning. So the question really from us is, what can we expect from you this November? Can we expect higher or sooner-to-be-achieved financial targets? Will you be hosting a Capital Markets Day? I think that’s a very important trigger date for yourself and the company really and for shareholders certainly.
And in this context, you referred to Toyota’s market cap and earnings power this morning. Staying in Europe, you have an exceptional example of execution at Peugeot. So what lesson do you think VW should learn from how Carlos Tavares is delivering really outstanding results at Peugeot and really at Opel as well these days?
And secondly, a question on cash flow for Frank, as you might expect from me. Now you delivered clean free cash flow pre-diesel of €5.9 billion so far this year. There’s another €1.7 billion coming in dividends from China in the second half. So you have effectively €7.6 billion in the bag for the year. So how do you think about the €9 billion pre-diesel free cash flow target?
You mentioned before it’s a stretch. And especially in that context, we need to talk about working capital. You got a huge cash outflow of €5.2 billion in the second quarter alone. So is this target a stretch? Or do you think you’d get above the €9 billion? Thank you very much.
Okay. So let me start. I think we had this basic question already a few times on the table, and let me just try to explain again. So our budget and planning round process will be very difficult this year because we are really now getting into that turmoiled water where we will face what I call a singularity in with our business model, which applies to basically all our competitors as well. Starting in 2020, we have to deliver on our 95-gram CO2 target in Europe, and the targets in China and in the rest of the world are very, very similar. We still are probably 20 to 25 grams away from reaching this target, which means that by 2020 – and this also applies to most of our competitors.
If you are even further away like Fiat group, like Hyundai, also like the French, a few are a bit closer like Toyota. But let’s say delivering – or closing a 20-plus grams target on CO2 means a huge burden to any of the companies which goes into the billions. So the question also comparing ourselves to the others is probably difficult to only – if you’re only referring to the margin levels there. A good margin level helps you to cope with the situation for sure. But the big question is, how effectively and how efficient can you cope with such singularity, which is coming 2021 to the whole industry?
We think that we are well-prepared. We think we are coming with the right product. We are coping with that situation in a very efficient way with – coming with a very aggressive electric vehicle product launches. We think that how we’re going to cope, which is might be more efficient than some of our competitors. And I would say, to judge the right strategy who is doing better, the French, the Japanese or us will only be possible looking back from 2022 probably into that kind of period of time.
The budget process or the, let’s say, the budget planning process planning round 67 has to cope with that situation. So we will have reduced margins because of the electric vehicles hitting in. We will bake in a lot of improvement on the fixed cost side and on the margins side. We will try to improve the product mix. We will get complexity out, which is the task we have to do over the next couple of weeks and months. And I think if we succeed and if every brand is delivering, we can stick to our, let’s say, profits target, which we announced. I don’t see any chance as to, let’s say, improve our long-term commitment from today’s perspective. Frank, will you?
Yes. I mean we posted very precise and detailed targets for 2020 and for 2025 for the consolidated group. We gave you guys milestones also on a brand level. We talked very openly in March 2017 at our last Capital Markets Day about what is going to happen in the industry. I have referred to it, and that environment hasn’t changed. What also hasn’t changed is our commitment to push our entire organization as much as possible. We have talked in great lengths about Volkswagen Passenger Cars.
I think Herbert Diess and his team and his whole responsibility as brand Volkswagen CEO made – came quite a long way. We started at a very poor 1.6% in 2016. We’re at 5%. We all agree without any doubt that we need to do better. We have obviously potential, but we came a long way, and we need to push. And what’s we posted for the brand. Capital Markets Day, certainly, we are thinking about it. We haven’t made yet the decision regarding timing, but to meet with you folks in person and give you guys access to the top management of the company is always a good idea. So we certainly know that we have to make decisions on that.
So for the moment, we confirm our targets, but we also confirm our desire to improve wherever possible. I mean, in terms of Peugeot, there’s nothing else other than to congratulate the guys there. They did a tremendous job, tremendous improvements. We didn’t have yet time to analyze the respective details, neither on Peugeot’s level nor on Opel’s level in terms of one-offs or any particular occasion. But nevertheless, they did a good job. But we also with SKODA, for example, have a brand, which is in the volume segment doing extremely well, even exceeding the impressive margin of Peugeot. But in every respect, we can and will push.
And I think Herbert, myself and the entire board counts very much on the volume group of brands and the closer collaboration which should unleash potential. Yes, your favorite, cash flow, and I think it’s a favorite of the entire community. We said equal or greater than €9 billion. And we will not stop counting if we can improve. I mean, we just refer back to the €5.9 billion with a net of diesel outflows. We talked about the €600 million, which are missing from China.
We had around about €200 million higher CapEx. And the big unknown also for the year-end is we assume a normalization in our inventory level. We have an inventory buildup due to WLTP. Most of that stock is in our inventory. And therefore, to normalize it is our intention, as promised, and that certainly which has a positive contribution. But at this very moment, I think it’s solid to confirm our equal or greater than €9 billion, and we will keep pushing and promise that we are not losing focus on net cash flow. Okay?
Okay, let me just Dr. Diess, just to come back to your remarks, just to get this really straight. So none of us should expect an increased effort under your leadership to drive further efficiency beyond what’s been communicated so far under the plan?
For sure. As Frank stated, I think we have an increased potential. We are making good progress though in Volkswagen Brand, which is in the core of the product portfolio. It’s coming on well. We are really on track with our turnaround program in Latin America, slightly ahead of track. I would say, we are basically on track with our turnaround program in the United States.
So we will keep the pace there. Now with bundling the activities in the volume group, there are additional levers where we can look for more synergies also try to be less aggressive between our groups in the markets, so there should be some potential. We are also looking for some additional potential in the aftermarket business. There’s a lot to do. But we have to, let’s say, perform much better than we have been doing so far because the burden which we – and the hit we will receive in the next two to three years. To compensate for that, we just have to speed up our work.
Also, when it comes to the [indiscernible], which is basically on the way we are making good progress in the efficiencies in the plant here, we’re turning around the plants into the new – we are moving the plants towards new technologies, giving up on non-competitive non-core businesses, so that is also underway. We will also, I think, step up our initiatives now coming. Some are joining the board who bring a lot of new knowledge about production components, production and on the purchasing field and we will probably look for more synergies between purchasing and our in-house production for better make or buy decision.
There’s a lot of things being set up which should deliver. Also I would say the new alliances, I’m really optimistic about a joint project with Ford on the light commercial business, because we are – our strategic setup is not competitive at the moment. Our volumes are too small. The amount of technology which is – you basically have to electrify now every other delivery vehicle which you are having in the market. There’s a lot of additional one-off expenditure getting into this segment and alliances for good half of the burden and make us much more profitable.
So what I wanted to say it’s there’s a lot happening, there’s a lot going on. We have now, I think even more potential to rationalize and to optimize. We want to become as – the headquarters should shrink over the next couple of years. We want – we are aiming for a leaner headquarters here in Wolfsburg, which is also an idea which we share with our work counsel. There’s a lot we are pushing, aiming for, but I have to say the challenges we are facing are such that it’s really not the time to promise more margin or more profits than we have in our long-term business plan.
And just to add on that very briefly. I mean you know that we are in the middle of planning ground six to seven which is our five-year planning cycle. Obviously, once we concluded that, we have a better more updated picture about the future. You might go back to your draws, you might remember that originally for 2020, we were quite a bit lower in our assumed profitability levels for brand Volkswagen Passenger Cars. We improved that once we saw the evidence coming in and the progress and that’s the way we review all those numbers. But for the very moment, particularly before we conclude NPR 67, we are not in the position to raise the bar, and we obviously note that the second half is a tough one to manage successfully.
Okay, thank you. let’s move on operator please to the next question.
Thank you. We will now take our next question from Dominic O’Brien from Exane. Please go ahead. Your line is open.
Hi, guys thanks for taking my question. My first one is on production versus wholesales. It looks as though on a consolidated basis, you overproduced by just over 100,000 vehicles or so in Q2. Could you just help us quantify the impact of that on profitability in the quarter itself? And just the reverse of that, what should we expect to be the effect of the underabsorption to be in Q4 – Q3 and possibly Q4?
And my second question follows on from that somewhat. How much – when we look at performance of Q2, how much can we see that as being representative of what the business is able to do in 2019? I know it’s too early to give guidance for 2019 now. But just conceptually, is the underlying performance that we’ve seen so far in the first half something that we could extrapolate into 2019? Thank you.
Maybe let me start with the underlying businesses. Yes, we are quite satisfied that we think the underlying strength and the quality of our P&L has improved, we capitalized significantly less of the R&D spend. We obviously had to absorb higher share of depreciation from the previously capitalized R&D costs. So I think we are quite confident that we are moving in the right direction, but nevertheless, obviously, we have certain unknown level of volatility in key KPIs starting in the second half.
And obviously, it’s something which has to WLTP is the new normal if you want to. Even though, certainly, we are quite confident and positive that the ramifications on the organization and the impact on the organization over time will be less than what we have seen, particularly now in the second half. But it is something which will also impact 2019. But the underlying core business is quite strong.
We talked quite a bit about the areas where we have still room for improvement. But it is certainly something we are building on going forward. Sorry, yes, when we – particular, if you look at the total inventory, we have a build up, also if you look at the balance sheet at the inventory, we have quite a bit of built up for Q3 and Q4, which obviously also had a negative impact on our net cash flow number. If you look at the impact for WLTP, the cars are not labeled.
But just to give you a ballpark number, the number we are talking around about 100,000 cars, just to give you guys a ballpark number, which you could contribute for that particular purpose. The normal seasonality pattern will certainly also kick in. And we assume that by year-end, we hopefully have normalized most of the schedules. But in terms of productions we will have factory closing days, as already communicated. So there’s quite a bit of volatility to an extent which we didn’t have before.
If I may
Okay. Thank you. Let me just – I think your question ties in with a few others here. I think what you’re – I think what your big question, if I may actually as well, how much of the profit of Q2 was influenced by the stock build.
Actually – I think for all practical purposes, no major profit impact because the stock is in – it’s our stock and not dealer stock. So this is business which should positively contribute in Q3 and Q4 when that inventory is moving into dealer land.
Okay, thank you fine. Let’s move on please.
Thank you. We will take our next question from Horst Schneider from HSBC. Please go ahead. Your line is open.
Yes and thanks for taking my question. It’s Horst Schneider from HSBC. First of all, maybe again coming back on to WLTP, sorry. So I just want to know how many percent of your cars are homologated by now across the group? And is it maybe possible to be a little bit more specific on the EBIT impact in H2, just a rough indication where H2 will be versus H1, or at least the range will be helpful. And the other issue that I still have…
Okay. Let’s just take your first question, Horst, while the line improves. Let’s take your question on the number of cars homologated in the earnings H2 versus H1. Frank, for you to jump in the on the earnings? And Herbert? Would – who’s going to take the homologation?
I’ll start with homologation. We have just those brands, Audi and Volkswagen, only few models currently on the markets which are now being increased week by week. Most of the models are in process of homologation and we’re really facing a situation now in August and September where we have a very limited product offering in those brands. In some of our, let’s say, sister brands facing the same situation.
That will change from September onwards quite dramatically, and we will then, let’s say, until the end of the year, we will probably or basically coming back to full product offering. Only a few models are still missing. On the other hand, you have to see that we will not really fully disrupt our business because we have two months stock situation. We have built up a continuous work in Europe. We will have the cars with a little bit prolonged delivery times because we are piling up some of the production, which only after homogenization will be released. So the total effect will be much smaller than what you currently can see from our ordering platforms.
Frank here. I mean, we obviously guided with quite a bit of caution regarding H2. We started very early to tell you about the distinct differences we expect. Luckily, we’ve been able to report a strong foundation with H1. But if you look at what we are talking about, I mean WLTP will have an impact in two dimensions. We will possibly see higher incentives, because we have a reduced model offering in order to close the deal, we need to keep up the offer to the customer. That is one dimension.
And the other dimension is that we potentially lose sales, because we might not be able to participate in each and every fleet tender, for example, and also, one or the other retail customer. So there are volume risks. These are the two dimensions. And if I look for a comparison, broadly flat volume mix price, which was quite positive in H1. We certainly know about the fixed cost increases. I think I also mentioned this morning a little bit less worried about a potential relevant negative impact from foreign exchange.
So there is a little more optimism there. But we also, if you look at the overall picture to concede that this country mix weakening because we are growing faster, for example, in South and North America than in Europe, where the profit margins tend to be more favorable. So the normalization which we assume in terms of production and inventory is an assumption. We are working very hard to get our arms around it. Obviously, is a lesser issue with secured transportation capacity. There are couple more variables announced and that’s the reason why we see this distinct difference between H1 and H2, but still before special items, keeping our guidance in terms of margin.
Thanks you, since you have mentioned…
Are you on the line, maybe you’ve got another question for us?
Can you hear me now?
Okay. Since you mentioned that positive effect that we have seen now in Q2 that will be repeated the next two quarters, and is it going to result into a big burden in 2019 then, since the comparison base that you have is pretty high from the item?
If I would know all those answers, I would be probably got them rich. You have to remember that I was very concerned and talked about the very potential, the negative impact for the full year. That has improved a little bit. We have been quite active and effective with our hedging. You might also remember that the IFRS 9 effect in Q1 alone was minus €300 million.
We improved to minus €200 million for H1. But we all know how volatile the FX markets are. And this is really difficult. But from today’s perspective, I think for the year, a little bit more optimistic, but huge volatility regarding 2019 as we refer to the other questions where we guide – where we do 2019 comprehensively and we give guidance on bits and pieces at this point of time.
Okay , thank you.
Thank you Horst. And we will move on to the next question.
Thank you. We will now take our next question from Georges Dieng from ODDO BHF. Please go ahead. Your line is now open.
Yes, good afternoon gentlemen. This is Georges Dieng, ODDO BHF. Several questions, if I may. To follow up on the issue of production, you’ve raised production by 13.5% at group level in Q2. Is it fair to assume that in Europe it’s probably something above the 20% mark, and that this impact should fully reverse in Q3, meaning that production in Q3 could fall by at least 20% in Europe? That’s the first point.
And did I understand correctly that, basically, Q2 earnings were not boosted by this inventory effect, because the inventories are still within the OEM and has not yet been shipped to the dealers, meaning that actually Q3 from an earnings standpoint may not suffer as much as one had expected. That’s the first question.
Second question regarding the balance of fixed cost versus the cost savings. Should we extrapolate the current gap between those two items? And what is really the recipe for reversing the trend for fixed costs? I mean when should we expect those two numbers to kind of match each other?
And very last point, talking about the potential for improvement in terms of regions. Could you give more color on the progress please in North America, LatAm and Russia versus the 2020 target of breakeven? Thank you.
Okay, Georges. Quite a few questions for us there, I accounted four. Starting with reduction, earnings impact in Q2. And then I guess we’ll switch to Dr. Diess perhaps for comments around fixed cost and regions. But Frank, could we start with you perhaps on the production and earnings?
Okay. I certainly don’t know – I don’t have it handy, the exact split up in terms of Europe and other regions. But I think, generally speaking, your logic is right, that since we also announced already some factory closings temporarily in Europe, there’s a balancing taking place for the Europe in factoring .
And I can confirm, there is no P&L – no positive P&L impact in Q2. You correctly picked up on the inventory answer I gave earlier. So – but you need to take in mind that, yes, that there’s profit potential from those inventories we are selling in the second half, but we are also reducing for that. So at the end of the day, the sum of all parts is still basically leading to the guidance, which we have been giving you with the volatility level described.
Product cost savings and I think fixed cost matching, the fixed cost increases matching up on product cost improvements, I think you might remember from a previous call that we explained carefully that in terms of product cost improvement, there’s quite a bit of new products and segments where we haven’t been present, so there is no savings to compare with previous periods. And we obviously are coming from a period of heavy investment, so fixed cost increases at least for the foreseeable future will exceed product cost savings. And we obviously also take the R&D into consideration, yes, the capitalization. Herbert will take the other question related particular to Volkswagen, as he normally drives questions regarding North and South America.
Only one remark to fixed costs issues. We could manage Volkswagen now for the third consecutive year to keep the fixed costs flat, which is an achievement also driven by the so-called part, which we will also further aim for at least for the Volkswagen Brand. We are also preparing a project to scale down our headquarters and redefine our headquarters, but we had adverse trends, which you have to understand.
We have a huge amount now of additional work, which we have to – which is driven by the monitor shift we are facing, though we have to establish additional processes, we have still a bunch of lawyers here, which are helping us through the legal situations. But all in all, I am quite happy with the fixed cost development in the Volkswagen Brand. We will extend that approach for the whole group. The recent situation is in Latin America, also, the market in Argentina is really nasty now and also current situation is not easy.
But we will see probably the first positive months already 2018. We definitely will turnaround in 2019, and we should be profitable from then on. In Russia, we are already profitable, which is due to the product lineup we are selling also positive market trend. So we shouldn’t fall back in Russian either. And North America is underway. It’s not easy to become profitable there. The target is touching breakeven by 2020. And I feel this target is still in sight. It won’t be easy, but the new product is coming along well. It’s bigger SUVs, it’s higher-margin products, so we stick to our promise that by 2020, we will turnaround the American region as well.
Great, thanks very much.
Okay, Georges. Thank you very much. And next question please operator.
We will now take our next question from Jose Asumendi from JPMorgan. Please go ahead. Your line is open.
Thank you very much. Jose, JPMorgan. Just a couple of items. The first one, for North America. Can you please confirm that there has not been any major improvements reducing the losses in the region? Or has there been any major improvement cutting those losses?
And Herbert, can you maybe explain a little bit in terms of product cycle or product mix in the U.S., do you think it’s going to be more production in Mexico -the shift is more the product mix between sedans and SUVs and maybe a greater more sort of drastic product mix improvement in the region? Same question for Brazil. Have you seen an improvement in terms of the losses? I think we are talking about in both regions maybe a couple of 100 million, a few 100 million of losses in the U.S., a few 100 million losses in Brazil.
Has there been any improvement in the first half, and what are the compact SUVs hitting the market in Brazil. The third topic, WLTP. I think there’s a huge opportunity to reduce the number of variants by vehicle. BMW has been, I think, an excellent example of this over the past years. Herbert, you know very well how this works. Can you maybe quantify or help us a little bit with the opportunity for you across Volkswagen brands ŠKODA, SEAT or even Audi, to reduce a number of variance? I think you have a very good opportunity for you.
Jose, thank you there. When you got a moment, if you check back on the tape, I think we touched the region questions already. But we’ll probably just take the question on Mexico, if that’s okay, and then we’ll switch to WLTP in the interest of time.
Yes, regions, I touched already and I think we are really on the way. Brazil, probably to add, you asked when the compact SUVs are hitting in. This is later this year, early next year really coming to market. The product is well underway, and it’s really perceived naturally already by press people and our dealership, so that will help us a lot to improve profitability. But already before the market introduction of the small SUV, we are very likely to be profitable within the next years.
In America, the new products are coming along well. The Atlas is making a further progress. We already started to export Atlases from the U.S. We’re filling up the plant. And also, the Tiguan, which is produced in Mexico. Tiguan long wheelbase is really making its way, so our product mix in the United States is really hugely improved. The new Jetta being launched now, so we are still present in this segment in the sedan segment, which we think also will help us because it comes with better margin than the predecessor model, and it’s a very modern and up-to-date product, which should help the brand also to achieve some volume targets and market share.
Mexico was, over the past years, always in the negative. It’s a very competitive market. It’s, as you know, pricing is very low and also it’s a zero market. We decided to reduce our market share in Mexico and to focus on profitability, so we took quite many models with very low margins or negative contributions out, which helps Mexico to become profitable. Mexico will be profitable already this year, but we compromise on our market share, which we think is the right decision for Mexico.
Variant has a lot going on and variance WLTP, as you say, it will really give us a chance there. We already decided for the new model, so the new Golf coming to market next year will have a 30% less variance in the existing Golf 7. We are – basically, that exercise we did for the whole Volkswagen brands through the product portfolio.
Audi is just starting, because we notice that they are not able to maintain the full product line up when it comes to drivetrains for the next years to come, but they are also on a reduction level of 30% more or less, which will come into place early next year. And the line up – to clean up the line up between the volume brands, this is a task which I’ve started and it will take us probably another three, four months.
And then starting next year, you should see also the complexity reduction between the volume brands. We think we are on the way. So far also, our salespeople are committed not to lose volume or contribution levels because of the reduced product offerings. You probably – we even took out some model lines, so we don’t furthermore produce the Golf convertible. We stop production for the Phaeton. We will stop production for the Scirocco. It’s just on the runout phase. So we are really cleaning out our product portfolio, which should help us then to gain more efficiency and also ramp up and become better productivity wise, mostly on the volume brand side.
Excellent, thank you.
Okay, operator next one please.
We will now take our next question from Daniel Schwarz from Credit Suisse. Please go ahead. Your line is now open.
Yes, thank you very much for taking my question. First question is on the guidance. After the first half, is the upper end of the guidance, i.e. 5% growth and 7.5% margin, is that still a possibility? It seems not to match with the guidance for reported earning.
And the second question is on the €600 million additional legal costs, just for clarification. Does that include provisions for fines that you think you’re going to pay? Or is it just money that you are going to pay or additional money you’re going to pay for legal advice in – to dedicated to lawyers?
I think the way we described it also in the annual report for the legal defense part, so we didn’t specify any more detail. But the legal community were to a great extent benefit from the money which we are reserving for. Yes, the guidance, 6.5% to 7.5%. If you obviously take what we said this morning, including special items, we are certainly currently not assume the very high end of the corridor to be realistic. This is the perspective.
We obviously keep the guidance for the corridor, but we have to also be very clear that there is a chance that including special items that we are moderately ending up below the corridor. We are working the way we described it on all cylinders to improve and to minimize the potential negative impact from WLTP. But as we have been, this has been our approach for the last three years. We tried to be as upright and transparent as possible, and that’s the current situation.
And the improvement from that basis is certainly to be – certainly being appreciated. I mean, we just had to take into consideration the fixed costs in H2 will be higher. As you know, the seasonality pattern behind those numbers, then in H1. We talked about country mix and the normalization as our base assumption for the implications from WLTP, but we still need to deliver on that. And this is the environment which cautions us based on the particular situation we are in. I mean WLTP, a lot of people this morning asked the question, well have you missed the boat, whether we are too late.
We just need to recognize that the same people who have been in the last three years working feverishly on fixing the unfortunate diesel mess which we created and putting the customers back into cars, which are exactly the way the world designed and promised the software and hardware solutions at a very large scale. The very same group of people is obviously challenged by developing the necessary technical solutions for WLTP, which puts us in this particular situation.
This is our job to work on. In line, certainly with an industry which has a particular challenge because some of the applicable rules and details from the regulations has been posted just recently besides the fact that the capacity constraints for testing facilities is an issue for the industry. This morning, I said if you take the finance used – the finance guys' perspective, there’s not too much positive for WLTP in my plan.
The only tailwind I really see and I referred to it, it improved the pressure on the organization to reduce complexity, even the very last human being in our organization now understands that an optimized product offering, particularly for the volume brands, will be allowed ourselves to have a level of complexity comparable to a luxury brand is a must because WLTP is not a one-off which will go away.
It is, let’s call it, the new normal, and you better set up yourselves to deal with this more challenging chess-like procedure. And this is the way we push, and I think we made good progress. I think the biggest progress we made so far in Volkswagen Passenger Cars, but Audi and the others are doing the same thing.
Okay. Thank you very much. Let’s take the next caller please, operator.
Thank you. We will now take our next question from Harald Hendrikse from Morgan Stanley. Please go ahead your line is open.
Thanks guys, for taking my questions. Slightly boring questions from me, I’m afraid. But firstly, can you give any help at all on the other financial line? That seems to be running about half of the levels of last year, and I know we’ve had this question before, it’s an almost unforecastable number, but I wouldn’t mind if you could just give me a few of the moving parts.
And then the second question, and I’m sorry to be so boring, but on WLTP, can we just go slightly bigger macro? I think a lot of the clients are asking just how much EBIT burden as a sort of total number all in, in 2018, do you think that is having i.e. your full year forecast, maybe it will come down and consensus coming down from 2018 to 2017. Is all of that €1 billion or is there even more than €1 billion accounted for by WLTP? And then do we expect or should we expect any normalization in 2019 relative to that number?
Yes, we’ll start, and this is definitely not a boring question because WLTP is on our agenda day in, day out. Yes, this is substantial EBITDA, obviously, depending on the assumptions. We have a range of the financial impact, which could potentially hit us. And we certainly – and I think we should think of a number in excess of €1 billion to be consistent with the guidance we gave with and without special items. But our job is to work against it, and this is what we are doing. But it is a substantial amount of money, which is obviously having – leaving its mark in our plans because we obviously have the foundation which should and could lead to different results based on the H1 figure.
The other line, I know it’s quite a frustrating line for you, guys. But the volatility is nothing we are able to take away. It is predominantly driven by the elimination on stock movements between the brands and our national sales companies, and also, the PPA and the earnings and profits from non-brand companies. We also – and this is something which we are going to carry with us. Also, group expenses for monitorship and strengthening our internal control functions, risk management, compliance integrity.
This is something which a company like us who has to deal with a three year monitorship is going to spend tremendous amount of resources. These are human beings, consultants and expenses related to those. And this is something which is all reflected there, the improvement over H1 2017 is appreciated. But these are the main drivers there.
There are no other items that are probably more relevant from cost of compliance less monitorship to be absorbed over the foreseeable future. And we do everything possible to put the monitor into the position to certify that we have substantially improved by 2020. And given the opportunity to end the monitorship after three years, but this requires a lot of work, a lot of investments, and this is what we hope for because it is our objective not to have an extension.
We just answered the question on the brand results. Was that what you were looking for, just to be clear?
To be honest with you, yes look, it’s always a difficult question for all of us, so I don’t mind. Just slightly more important. I mean I’d love to understand internally, when Mr. D said that WLTP is the new normal, we’re all looking at WLTP as being a somewhat exceptional cost in 2018. Internally, would you agree with that? Would we – if you say greater than €1 billion, which makes a huge amount of sense, should we add that €1 billion back in 2019? Or do you not internally look at it like that?
No, I wouldn’t go that far. I mean, we will have an impact in the carryover due to the normalization of the inventory levels into the new year, but we – there will – the organization will get used to, we will streamline our offering. There will be learnings, less complexity. We are certainly building the capacity in areas which are critical to get more throughput.
We are certainly also reducing the number of the work we have to perform in terms of cleaning up the diesel situation that will free up capacity which we rightly so invest into today’s business and future technologies. So I think the message I want to send is particular difficult because it’s entering into a new era, the second half 2018, but there will be ripple effects into 2019, but I certainly – and we certainly build on the learning curve, which we want to see being followed.
That’s it. Thank you so much.
Okay, thank you. Operator, please the next question.
Thank you. Our next question is from Michael Punzet from DZ bank. Please go ahead. Your line open.
Yes, Michael Punzet. Good afternoon. I’ll try it again on the legal issues. You have booked additional provisions of €635 million. Could you give us an idea what is the reason for that? Is that the number of claims has increased or is that related to the development of the claims? That would be one question. And the second question, maybe you could explain a bit what is the leading cause of margin drop of SKODA? Because I think margin came in only 8.3%. It’s still a very good figure for volume manufacturer, but that’s clearly below first quarter and last year.
I think obviously SKODA is a very significant part of the deterioration, so to speak. I mean, it’s complaining at high-level, as you rightly state Michael. It will contribute to a great extent to foreign exchange effect, quite negative. That is the main driver. And we also obviously have product ramp up some fixed increases. But generally speaking, the FX volatility was the main challenge on the SKODA side.
The €600 million on the special items, it’s a combination of, to a certain extent, the number of claims and handling is – a lot of product related claims have increased. So this is, in summary, the key driver. And I think, overall, the workload of the particular legal expertise in capacity which we need to buy in order to handle those issues carefully and most of them successfully, so successfully.
Okay. Thank you.
Okay. Thank you very much. Let’s move on that to the next question.
Next question is coming from Frank Biller from LBW Bank. Please go ahead. Your line is open.
Yes. Hello, good afternoon. Thanks for taking my question. It’s a question about the China business. So we noticed that there has been reduced tariffs from exports coming from Europe especially. So it came down from 25% to 10%, which should be a positive effect for you. What is your strategy here? So I noticed the competition already lowered the prices of some products, and Volkswagen is a bit later here. So what’s your strategy here? What are you expecting here from the pricing perspectives? And maybe you could give us a view on the margins, what you’re expecting for China? So giving half away to the customers, taking half in your accounts, or what’s the strategy here?
Okay, so let’s just go to Fred first, and then we’ll come back to Frank for some comments.
What we experienced is during the last one or two months of the second quarter, the customers speculating of any price adjustments. We have a market oriented pricing, especially what the premium brands are concerned. The speculation was around Porsche and Audi. And what we see, what we experienced is that the customers are coming back, we will continue with our consistent pricing strategy we are here in the premium segments. And what we can see here in the order entries already after the 1st of July that the customers are coming back, that we will have a strong third quarter also for the brands Porsche and Audi.
And so from a finance cost perspective, there will be huge market pressure to pass those tariff reductions on to the marketplace, and this is what experience taught us, particularly in extremely competitive market that over a rather short period of time going to happen. So I would not necessarily count on a huge margin boost for those tasks in the long run. I think we continue to be positive about our prospects in China. Fred reported back on the volume side for the financial and the performance specialty result, which are clearly in line with the 2017 numbers. This is what we are building our plan on for the time being for calendar year 2018.
Okay, let’s move on that to the last question, please.
Our last question is from Mike Dean from Bloomberg. Please go ahead. Your line is open.
Good afternoon. It’s Mike Dean from BI. I also had a question on tariffs that’s now been answered. But Frank, could you just update us on where you are with your hedging in the second half and maybe into 2019? Thank you.
Mike, generally speaking, we have a pretty consistent approach to hedging. As it pertains to foreign exchange and interest rates, we have a very conservative approach. For us, it’s good to have a good profitability level in our core business and not to speculate on interest rates or currencies, which means we are also giving opportunity away, but we think that hedging our budget rates is essential. I mean, we hedge in all our main currencies.
For competitive reasons, we are not disclosing the very respective details, particularly in like UK pound sterling, was obviously a critical one for the entire industry, we have been hedged quite well. But obviously, over time, those levels for the pound sterling are deteriorating. But our main currencies, as you would expect, are the U.S. dollar and renminbi, and we have a very high hedging levels on those currencies, more difficult on emerging market currencies.
So where possible, we do, but certainly more difficult on the Russian ruble, for example, and the Mexico peso – Mexican peso. But definitely, want to confirm our overall approach to hedging. And as we referred to earlier in the discussion, that is actually helping us quite a bit also in calendar year 2018, at least from an H1 perspective.
That’s great, thanks.
Thank you very much, Frank. Thank you for the participants today who have joined the call, and you of course, our investors and analysts, who have called. That closes the call for today. Thank you, and goodbye from Volkswagen.
This concludes today’s call. Thank you for your participation. You may now disconnect.