Volkswagen: A Structural Winner In The EV Transition Race

Summary

• VW has the largest investment spend, among global automotive manufacturers, into EV and software.
• With plans to build 6 gigafactories by 2030 as well as a unified cell strategy for its EV platform, VW is pushing ahead with high growth in its EV segment.
• VW is ahead of the curve as it is building an in-house battery production capability and investing further upstream, securing battery supply and controlling battery costs.
• Based on my 2025 forecasts, my estimate for VW's target price is EUR313, which implies a solid 75% upside potential.

Chesky_W/iStock via Getty Images

The transition towards Electric Vehicles (EV) is happening today and gaining momentum as EV penetration accelerates globally. Bloomberg estimates that about 5.6 million passenger EVs will be sold this year, which is almost double that sold in 2020. Furthermore, in 2021, 8% of all vehicles sold were EVs and this number is poised to increase as the EV transition continues over the next decade.

I believe that when looking at global automotive manufacturer incumbents, there is a clear winner in the EV transition race and that is, Volkswagen (OTCPK:VWAGY).

Investment thesis

I believe that VW will be a structural winner in the EV transition race due to the following reasons:

• VW's commitment to the transition is the highest. It has the largest investment spend in EV and software, both high growth areas of the future, among global automotive manufacturers over the next 5 years.
• In addition, VW has a clear, ambitious battery strategy to support this. VW has a unified, in-house battery strategy and it will be building 6 new gigafactories by 2030. All these ensure adequate battery supply for its EV rollout.
• VW takes the vertical integration strategy with its upstream investments. I believe that this is key for incumbents in order to have control over their EV transition and lower their overall costs.

Due to their current cheap valuation relative to pure play peers, I believe that this valuation gap will narrow. This will happen as VW proves to the market that their electrification and battery strategy, and in the long term, their software strategy, can be executed well. As such, I am of the opinion that VW is currently a strong buy amongst global automotive manufacturer incumbents. Based on my 2025 forecasts, my estimate for VW's target price is EUR313, which implies a solid 75% upside potential.

Overview

Currently, as the largest automotive manufacturers by volume, VW produced about 10 million cars annually under an umbrella of brands. Its Volkswagen brand, Volkswagen Commercial Vehicle, Skoda, SEAT, and Cupra fall under its volume brand. Audi, Bentley, Lamborghini, and Ducati fall under its premium brands. Lastly, Porsche falls under its sports brand.

Although VW was the largest automotive manufacturer globally, its EV production and deliveries were minuscule compared to its Internal Combustion Engine (ICE) vehicles production and deliveries. In 2019, VW sold 70,000 EVs worldwide, representing less than 1% of VW's total vehicles sold in a year. From 2013 to 2019, VW only sold 250,000 EVs worldwide. This is in contrast to the 367,500 EVs Tesla produced in the year 2019 alone.

However, in my view, this started to change when VW launched its new ID3 model, a fully electric car with a carbon-neutral footprint. With this new launch of ID3, it brought VW into a new era, into large-scale EV production. Since then, VW has been going all out into the EV transition as it seeks to compete and regain market share in the EV space and even take over the top spot in the EV space from Tesla by 2025. In March of 2021, VW also had its Power day where it unveiled plans for the Group's battery strategy, which in my view, is a pivotal shift towards the right EV strategy for VW.

Industry

For the longest time, large global auto players had the mindset of only shifting to EV mass production when majority of customers start buying EVs and when penetration has become fairly healthy for decent margins to be made for each EV. As such Tesla (TSLA), as a pure play EV player, benefited from the lack of any serious threat from global incumbents as it continued to dominate EV market share. In 2019, Tesla's market share was 18%, up from 12% in 2018 as customers started buying more EVs and Tesla started to gain brand reputation. As shown below, the global EV sales grew at a rapid pace from 2015, with further acceleration in EV sales in both 2020 and 2021.

However, today, Tesla is the one being threatened as the competitive environment has changed dramatically. Many global automotive manufacturers are launching new EV models in the year to come, with many EV startups focusing on pure play EVs set to compete with the leader. In fact, about 100 BEV models are set to be launched by 2024.

With the competitive landscape changing, I believe that it is essential for companies to not only grow faster than the industry, but also control costs to ensure higher margins. In my opinion, the best EV players will be the ones with control over battery production, ensuring self-sufficiency in battery supply as the EV penetration continues to tick upwards.

Competitive advantage

Heavy investment spend increases competitive moat in EV

I took a deeper dive into VW's investment spend over the years and where they are focusing investments. This will give us a clear roadmap of where they are heading and whether they are consistent and taking serious actions today for their EV transition.

Firstly, the investment spend into new technologies like BEVs and software have increased from 30% of its total investment spend 4 years ago, to 56% today. This shift in the proportion of investments that VW is putting into new technologies, I believe, signals their intentions to go big into the EV transition and invest into the new technologies of the auto industry.

Specifically, looking into the investment spending into software, it has grown from 5% of the total investment spend 4 years ago, to 19% today. In my opinion, this increasing focus on investment spend into software is crucial for VW in the future as the race to be the best EV does not stop at electrification but rather, to be a winner in the EV race, VW needs to have leadership in software as well.

Source: PR 70.

Second, VW investment spend shows greater conviction and commitment into the EV transition. I have collated some of the commitments made by the top global auto players and found that VW is investing more than double some of its competitors over the next 5-year period in e-mobility and software. Also, its $30 billion investment in software is one of the largest in the industry.

Source: Author collated from various company announcements.

Battery strategy

VW intends to develop battery production capacity in Europe. With its partners, VW plans to have 6 battery factories in Europe by 2030 to "guarantee the security of supply". These 6 factories are expected to produce up to 240 GWh per year when they are complete. The first gigafactory in Sweden is in collaboration with Northvolt and is expected to commence production in 2023, while its second gigafactory is expected to be in Salzgitter.

VW also revealed its new unified cell strategy. This simply means that VW will take a standardised one-size-fits-all approach to its battery strategy, which will reduce battery costs and improve consumer demand. VW stated that its new unified cell strategy should see entry-level EV battery cost reduced by 50% and reduction in battery cost of up to 30% for volume segment models, due to the differences in cell chemistries utilised in these models.

Entry-level EVs will utilise iron phosphate chemistry, volume models will utilise high manganese, and specific solutions will use nickel manganese cobalt. VW is also looking towards solid-state battery packs in the future as well, which could be a game-changer for VW and the industry. VW is known for its $300 million investment into QuantumScape (QS), which could see positive payoffs as early as 2024.

With its new unified cell strategy, fast charging time to add 280 miles can be reduced from 25 mins today to 12 mins after 2025, reducing the barriers to EVs further and improving VW's value proposition to customers.

VW is currently doing a battery recycling pilot in Salzgitter and in the long term, plans to recycle 97% of all raw materials. This battery recycling plan fits into the idea of a closed-loop system for battery materials and helps secure battery materials and reduce battery costs.

All in all, I believe that VW is finally implementing the right strategy to ensure battery supply and lower battery cost with its unified cell strategy and roll out of 6 gigafactories by 2030 to increase its capacity for EVs in the next decade. In my opinion, VW will be the clear winner in the Europe EV market with its huge investment spend and localised supply chain investments in the region.

Heavy upstream investment for development of in-house battery

I believe that to be a winner in the EV race, companies need to have a vertically integrated strategy.

First, VW started a joint venture with Umicore, which is a Belgium cathode materials company that will provide support to VW supply chain in Europe.

Second, VW acquired Gotion High-Tech in China to secure battery supplies in China. In my opinion, localisation will be the next pivotal shift for EV players as each region will need its own domestic production or supply to meet the increasing demands in the region for EVs.

A last example would be VW's investment in 24M Technologies, which is a US-based battery startup that has redesigned the traditional battery cell that could result in smaller production areas, less carbon emissions, and more recycling opportunities.

Peer analysis

VW, as a German auto player, is beating Tesla in Europe. In fact, in 1H21, it was the EV market leader in Europe with 21% market share. Its EV model, ID3, proved to be a popular choice amongst consumers in its first year of launch in 2020.

Source: Jato Dynamics

VW's main edge over Tesla comes from its brand reputation, cheaper pricing, and localised manufacturing facilities.

That said, VW still trails behind Tesla globally as Tesla delivered 627,000 EVs in the first 3 quarters of 2021 and VW sold 293,000 EVs. However, I believe that with the ramping up of new all-electric models by VW, we could start to see VW catch up to Tesla by 2025.

Valuation

VW trades at a significant discount to pure play EV companies with 1 year forward 2022F P/E of 5.6x and Free Cash Flow yield of 21.5%. I believe that the valuation gap between VW and other EV players will narrow in time as VW proves that it is able to execute its electrification strategy well.

After having done extensive research on VW, a financial model was developed to forecast VW's financials to 2025F (key summary below). Based on a conservative P/E assumption of 12x, and discounting back the terminal value by VW's cost of equity of 12%, I derived the Target Price for VW to be EUR313. Based on the current share price, there is an upside potential of 75% to be made from here.

I believe that a 12x P/E multiple is warranted given VW's leadership in EV and strong business fundamentals. This should give it a premium in its valuation compared to global auto manufacturers that are laggards in the EV transition race.

Risk

Chip shortage

One big near-term risk for VW is its semiconductor shortage, which has been costly for VW as it has had to reduce production. For VW, its volume brands like Volkswagen, Skoda, and SEAT suffered the most during this semiconductor shortage.

VW CEO Diess remains optimistic that there will be a pickup in semiconductor supply next quarter, but I think we could still see some supply constraints in 2022. As this is a temporary constraint, I believe that this does not impact the fundamentals of VW in the long run, which is what investors should be looking at. Furthermore, I am encouraged that VW is looking beyond the semiconductor shortage to make sure that in the future, VW will not have any issues in battery shortages due to heavy investment in the upstream EV value chain and the heavy investment spend in EVs in the next 5 years.

Worsening consumer sentiment in China

Given that VW has a relatively large exposure in China, there are risks that there could be a more serious slowdown in China with the current pandemic situation. If consumer sentiment turns sour, consumer demand for EVs in China and thus, VW's leadership in China may be threatened.

R&D and capital expenditure spend

There may be a need for a larger R&D and capital expenditure if competitors increase their commitments to the industry, thereby using a threat to the current runway that VW has plotted for itself. If so, this could lead to larger spending needs for VW to maintain or grow market share in the EV space.

Software risks

VW trails behind in software although I mentioned that they are spending more investment dollars into software as a focus from 2021 to 2026. However, investment spend may not lead to productive software results as key software talent needs to be attracted in order for VW to catch up and succeed peers.

Conclusion

I believe currently, there is a mispricing situation with VW as there are many positives not priced into VW today. I believe this is due to the semiconductor shortage, which is a short-term headwind, in my view, as well as the uncertainty in execution abilities of VW management in its ambitious EV plans. However, as explained earlier, I am of the opinion that VW will be the leader in the EV transition race as other global incumbents are unwilling or unable to match it in terms of having an in-house battery production capability, a unified cell strategy, its huge investment spend on EV and software, its 6 gigafactories to come by 2030, and its huge investment in the EV supply chain. I believe that the target price of EUR313 and thus a 75% upside potential is achievable given its current depressed valuations.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of VWAGY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Tdot]

Unfortunately there remain a lot of lingering negative biases against VW and their attempt to redeem themselves over "dieselgate" with EVs.

Of course the vast majority of those are teslophile cultists in the peanut gallery, who want to poo-poo other heretical automakers who dare to make EVs. For the time being they are happy to laugh and sling their feces around, it is all they have. Rather than praising other automakers for "following in the footsteps" of the Musky Lord of Tesla, they hypocritically heap scorn, showing it is nothing short of a religion to them.

It reminds of the old Emo Philips skit over religion: Are you Northern Conservative Fundamentalist Baptist Great Lakes Region Council of 1879? Or are you Northern Conservative Fundamentalist Baptist Great Lakes Region Council of 1912? 1912. 1912?? DIE HERETIC!!! I CAST YOU OUT, EVIL SPIRIT!!!

But yes, it is actually useful to get an unbiased assessment as to where VW is in their transformation to EVs, seeing as they are the #1 or #2 automaker in the world (the title going back and forth with Toyota), after what some saw as an existential crisis that should have end in bankruptcy over regeneration of diesel exhaust catalyst, to listen to the fanatical hoards of teslophiles.

[Simple Investing]

@Tdot Thank you, appreciate this!

[Georgy Shishkov]

I rarely say it, but this is a very good article. Thank you!

[Simple Investing]

@Georgy Shishkov Hey thank you, appreciate this lots!

[Thistledo]

VW is losing ground so fast in China there’s no way they will catch up. Especially with their batteries.

[Stock Inspection]

@Thistledo false statement that you can lookup in global sales of their presentation.

[Tdot]

While VW sales were down about 14% in China in 2021 due to chip and supply chain shortages, they still sold 3.3 million vehicles there.

Tesla sold just 473k in China in 2021. Even Ford sold more in China than Tesla, at 624k units.

[Seeburto]

@Tdot darn pesky facts

[HiSell]

Your thesis about VW pivoting to EVs seems sound in theory until you look at its balance sheet- EU120b of net debt. It will get a bit of reprieve from the sale of Porsche (Ferrari market cap $40bn). But taking on Tesla is herculean, TSLA's operating system is its USP and it's constantly upgrading, I consider it the iOS of cars. I own a Tesla and an Audi- iPhone vs Nokia, and the Tesla was 30% cheaper after you add Audi's rapacious options.

Tesla generates a gross margin of $10,000/car, debt-free and a market cap of VW, Merc, BMW, Toyota combined. I don't own Tesla shares, sadly I didn't have the vision to buy early, but I can see why it's so highly valued. Finally, your analysis ignores Hyundai which is already selling well-priced, high-quality EVs globally.

[RJWi]

VW is loaded with debt. All technical / software issues aside, this is important to mention, especially in an environment that might see a hike in rates.

[Nick Cox]

@RJWi
Yes,their debt load is a rather under-appreciated negative for VW.It's about 4 times their market cap.

[Tdot]

Nick, no. Not if that "debt" is mainly in the form of consumer and dealership financing. You have to look at the EQUITY book value, which is the value of the assets minus the liabilities including the debt.

If the "debt" is earning billions on interest rate differentials in financing purchases, then what you have is a Bank.

As of the 3Q21, VW's Balance Sheet showed Shareholder Equity Book Value at $119 billion for the automotive division, plus $42 billion on the financial services side. Over $160 BILLION in Equity Book Value after debts and liabilities. The "debt load" is trivial.

[Zed Asset Management]

@RJWi It is debt in its financial services arm and is non recourse to the auto business

[Bobstert]

Discussion of VW ADR's:

www.jubakpicks.com/...

[Nick Cox]

"Ahead of the curve" ??
Hmmm...even their CEO admits they are 3 years behind Tesla.
And in the world's largest car market, they are being hammered.

[Tdot]

You never did provide any proof that VW's CEO said they were 3 years behind Tesla. What's up with that?

[Nick Cox]

@Tdot
Just search on Google,it's not difficult

[Tdot]

Already did, there are no such results.

[RJMC]

I am going to start a position. Nice article.

[Simple Investing]

@RJMC Thank you! All the best for your portfolio in 2022!

[Seeburto]

I like the thesis, but seems like a long term play. Have been in and out but maybe I will build a core position.

[Simple Investing]

@Seeburto Thank you. Definitely a long term play with great fundamentals today.

[johanvdwerf]

Thank you. I have been looking at VW as well and agree with the general findings. I do have my questions on how the valuation is established though. A P/E of 12 equates to a 0% growth in Earnings in perpetuity based on a discount factor of 10%, which is what is commonly used. What has been the historical P/E of VW and does the author believe that Earnings in 2025-2030 will indeed match current earnings?

[purrpullberra]

@johanvdwerf $200 billion in debt
No joke. And they plan to "invest" $80bil+ into EV's and software development.

[johanvdwerf]

@purrpullberra thanks for the add on. I didn't elaborate further in my comment, but I struggled with the authors approach of using P/E for exactly those reasons. The P/E of 12 is rather grabbed out of thin air in this article, although there might be further details behind it not shown. I think an EV / CF metric would be far more suitable, as it takes into account both the high debt and the CAPEX.

[Tdot]

Most automakers in the industrial manufacturing sector get a valuation of about 8-12x earnings, depending on if they are expected to be growing or not.

P/E is a pretty fundamental metric for a relatively stable business with units of years. It essentially establishes the number of years of current and expected profits that would be required to buy back the shares at current pricing. In that regard, it is a little like a mortgage loan term. A higher P/E also suggests there is a less likelihood of bankruptcy in the time frame.

But many economists prefer not to focus too hard on P/E for discretionary cyclical stocks like automotive, which can be severely impacted by economic swings. Risk of bankruptcy can be high from uncontrollable external factors, like wars and terrorist attacks and such. The COVID shutdown in Spring 2020 put a severe pinch on all automakers, and there was talk of some seeking bankruptcy protection if they were forced to remain shut down in terms of manufacturing and generating revenues.

In any case, some experts prefer P/B - Price to Book (Liquidation Value), aka Price to Equity, as a more stable and dependable measure of how a cyclical company that depends on discretionary spending is valued, and in comparing cyclical peer valuations.

[locum2]

EVs failed in the early 20th Century and they will fail again in the early 21st Century. Anybody who thinks driving a 2-ton compact car is environmentally sound is showing the same ignorance as the Big Three did in the early 1970s—right before the Japanese automakers kicked their butts.

[kraken36]

@locum2 2 ton combustion or 2 ton EV? what's the difference. At least you're not turning building walls black and polluting the air with a EV. The adoption rate is too high, EVs are here whether you like it or not

[Keng Yuan Chang]

@locum2 Please google:

"Factcheck: How electric vehicles help to tackle climate change"

"Electric cars have much lower life cycle emissions, new study confirms
In the US, life cycle emissions for EVs are already 60-68% lower than gasoline."

EVs are integral part of fighting climate change, it has been proven, reviewed, over and over by scientists worldwide.

[Mountain Walker]

@Keng Yuan Chang
Yep and China will continue having to rely on coal to power them

[sr1952]

VW does not make "gigafactories". Only Elon Musk makes gigafactories. Elon has a penchant for giving things names that they are not. We have gigafactories, starships, cybertrucks, plaid models, and full self driving. The guy just watches too many sci fi shows.

[johanvdwerf]

@sr1952 lol indeed. Why we can’t call it a battery factory I don’t know

[Keng Yuan Chang]

@sr1952 Haha, maybe that's based on their initial annual output goal, maybe there are gonna be terrafactories in a few years time.

[William S Preston]

@Keng Yuan Chang the Austin factory is being touted as a terafactory.

[Logical Thought]

It's smarter to buy VWAPY: www.wsj.com/...

[William Frey]

@Logical Thought Behind a paywall. Also what about POAHY?

[Mreiffel]

Short all legacy automakers. I have .
Long Tesla for the last 5 years. I wouldn’t say that they’ll collapse entirely, but their share of the market will be declining year after year.

[johanvdwerf]

@Mreiffel which is already completely embedded in their valuations. VW having a P/E of 5.x implies they will become a lot smaller over time, or seize to exist.

Your strategy was the right one for the last 5 years, but doing the opposite now is likely to work out better based on fundamentals

[brankow]

Excellent article.
Investing a higher amount doesn’t warrant a more successful future necessarily though.
Also worthwhile mentioning, their stake in Rimac gives them a competitive edge on the fast charging 800 Volt technology. Moreover, the licensing of the MEB platform to other manufacturers allows to further reduce the costs.

[Simple Investing]

@brankow Great points and thank you!

[Eric Bradley]

Canceled my order for Tesla MY, due to be delivered in January. Wife liked Audi Q4 etron more. Was supposed to be available in December. Now being told limited production late Q1, maybe Q2, so hoping that I get my Q4 around April.

I get that there is a chip shortage, but Tesla is shopping product and increasing sales MoM. If VW can’t deliver product, they have a problem.

If W4 delayed past April, I’ll get in line for the Fisker Ocean. I like it most of all, but not available until November, also a highly optimistic shipping date. Also another $10k or so higher price point

GLTA

[Sebastian1744]

@Eric Bradley Just as a heads up, as scaling production especially for legacy automakers is proving to be exceptionally hard with many delay’s furthered by battery and chip shortages I would remain optimistic about ordering a Tesla . I assume your from European and the GIGA factory in Berlin will open this year, or if your American the Texas GIGA factory will open. I would personally wait until then as it would be using the new 4680 battery Technology from Tesla manufactured in-house and exclusively by Panasonic. I’d suggest reconsidering your Tesla Model Y, as its a great car, albeit an expensive one. Keep in mind that Tesla has increased the price $10,000 since the beginning of the year due to the Demand.

[Simple Investing]

@Eric Bradley Thanks for sharing Eric, definitely a concern most painfully felt by VW.

[Tdot]

The important point is that is is a concern most painfully felt by Tesla. Every Tesla-order or reservation customer that turns instead to another automaker is negative for the musky Tesla Narrative of Exponential Growth Forever, which is the primary basis for Tesla's share price.

[NZK91G]

It only stands to reason that VW being the largest automaker in the world, they would be the largest EV maker when it all shakes out. They also know how to make a quality automobile. Something that Tesla hasn’t yet learned to do. Just Google ‘Tesla Home Depot parts’. That’s something no other production OEM would do.

[Simple Investing]

@NZK91G Definitely a very competitive market and VW has its advantages, but only time will tell. I will continue to monitor the landscape and update more along the way.

[Dennroe]

@Simple Investing The bet on Tesla includes more than vehicles. The valuation only is reasonable if all the investing thesises around AI, automation, Robotaxis etc. can be fullfilled.

[sr1952]

@NZK91G
Good grief! Those "Home Depot" fixes wouldn't even be done in a second-rate repair shop. Tesla makes crappy cars and they don't test them properly. Once a company has a few million cars on the road for 10 years problems start showing up. The majority of Tesla's are still less than 5 years old. I wonder what other garbage is in them.