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Oh Volkswagen, What Have You Done!

Forbes logo Forbes 23-09-2015 Trefis Team, Contributor

In what continues to be a year to forget for the German automaker Volkswagen AG, the company, which passed Toyota to become the world’s highest-selling auto company this year, recently admitted to cheating the U.S. emission-control standards. According to the federal regulators, Volkswagen admitted to fitting its diesel vehicles with a defeat device that made it possible for the cars to emit less when tested, compared to the real-world conditions. The intensity of this scandal is high and the scale is massive. Volkswagen now faces large fines, loss in customer trust, disenchantment, and possible backlash from its investors, and maybe even criminal charges.

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guilty: The stock which was already on a downtrend this year, has further declined by over 20% since last Thursday, wiping out approximately $20 billion in market value. Volkswagen has faced headwinds all through this year, hurt by the weaker economic conditions in its single largest market China, and continually low sales in the U.S., and this news, frankly, could spell doom. The carmaker has issued a public apology, with both the CEO Martin Winterkorn and CEO of Volkswagen Group of America, Michael Horn, apologizing for the dishonesty and breach of trust, and vowing to ‘make it right’ in due time, but could this be too little too late?© Provided by Forbes The stock which was already on a downtrend this year, has further declined by over 20% since last Thursday, wiping out approximately $20 billion in market value. Volkswagen has faced headwinds all through this year, hurt by the weaker economic conditions in its single largest market China, and continually low sales in the U.S., and this news, frankly, could spell doom. The carmaker has issued a public apology, with both the CEO Martin Winterkorn and CEO of Volkswagen Group of America, Michael Horn, apologizing for the dishonesty and breach of trust, and vowing to ‘make it right’ in due time, but could this be too little too late?

The stock which was already on a downtrend this year, has further declined by over 20% since last Thursday, wiping out approximately $20 billion in market value. Volkswagen has faced headwinds all through this year, hurt by the weaker economic conditions in its single largest market China, and continually low sales in the U.S., and this news, frankly, could spell doom. The carmaker has issued a public apology, with both the CEO Martin Winterkorn and CEO of Volkswagen Group of America, Michael Horn, apologizing for the dishonesty and breach of trust, and vowing to ‘make it right’ in due time, but could this be too little too late?

We have recently revised our price estimate for Volkswagen. We now have a $36 price estimate for the company, which is above the current market price.

See Our Complete Analysis For Volkswagen AG

Let’s take a deeper look at the situation.

The Crime

Volkswagen fitted its diesel models of the Jetta, Beetle, Golf, Passat, and the Audi A3 with a sophisticated software that recognizes when the car is being tested and immediately cuts emissions to a permissible level. However, in normal driving conditions, these cars fitted with the ‘defeat device’ would pollute 10-40 times the legal limit, according to The US Environmental Protection Agency. So not only does this translate into cheating the regulatory body, but also the customers, who bought these affected cars and thought they were driving a cleaner car all this while.

Diesel cars aren’t a rage in the U.S., where low petrol prices and stricter emission standards for the diesel vehicles make it tough to sell these variants. Automakers have to comply with 31mg NOx (nitrogen oxide) emissions per kilometer in the country, compared to 80mg in Europe. While approximately half of the new passenger cars sold in Europe run on diesel, less than 1% in the U.S. use diesel. These tougher standards made it difficult to develop a high performance diesel-run automobile.

The defeat device is thought to work by injecting more urea (an exhaust fluid) into the vehicle during the test, limiting nitrogen oxide emissions. The car detects that it is being tested because while in the laboratory, devices such as the anti-collision systems have to be turned off. But the extra urea is not injected when the car is on the road because it would quickly run out, thus polluting more than it is permissible. Switching off the emission control system during normal use apparently helped in improving driving performance.

The Punishment

Volkswagen has sold 482,000 cars in the U.S. since 2008 involved in these allegations, and apart from covering the cost of recalling these vehicles, the German company will have to face severe fines. According to the EPA, the fine for each vehicle that did not comply with federal clean air rules would be up to $37,500 (£24,000), which means that Volkswagen could be facing fines of up to $18 billion. That’s steep? It could get even worse…

Volkswagen recently announced that 11 million vehicles worldwide are affected by the ‘dieselgate’ scandal. The company said that it was setting aside €6.5 billion ($7.25 billion) to cover costs of the scandal, and a provision for the scandal would be made in the upcoming Q3 income statement. In fact, the amounts could be reevaluated given the investigation is still ongoing.

The Aftermath

Aside from the truckload of fines that Volkswagen is facing, there may also be criminal charges for the Volkswagen executives, given the severity of the scandal. South Korea will also test up to 5,000 Jetta and Golf models, along with Audi A3 models made in 2014 and 2015, and the probe could spread to Europe, too – although it is premature to say so.

But apart from the one-time fines and damages that Volkswagen will pay, what is bound to hurt the automaker more, is the loss in customer perception and trust. The highest-selling automaker in the world was already underperforming in the U.S. The Volkswagen Passenger Cars division (including cars, light commercial vehicles, and SEAT), which forms approximately 18% of the company’s valuation, and was a massive 46% contributor to the net revenues last year, has sold 2.8% fewer vehicles in the U.S. through August, including a large 8% fall in volumes last month alone. The problem for Volkswagen remained the low number of SUV/Crossover options in the country, and to counter this, the company is working on a lineup of five new SUVs, aimed directly at the U.S. market. However, one would think that with so much growth potential on offer in the SUV segment in the U.S., Volkswagen’s game has not been on point so far.

VIDEO: Will the Volkswagen controversy be worse than GM's?

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Volkswagen is investing $7 billion in North America between 2014-2018 for the purpose of adding capacity and accelerating growth in the U.S., and previously aimed to sell around one million vehicles in the country alone by 2018. This estimate was already overly ambitious, with Volkswagen delivering less than 600,000 units in 2014 in the country, and 405,400 units (2.7% year-over-year growth) through August this year. Volkswagen hasn’t been doing well in the U.S., maybe because of the higher model prices of imported units, better perceived performance of the Japanese automakers, or maybe due to customer loyalty towards the American GMs and Fords. But the German company has always prided itself on superior engineering and technology. However, now, with the breach in customers’ trust and loss in perception, Volkswagen will, in all probability, face tougher times ahead.

Volkswagen has gone through a tough time this year, and that is an understatement. From troubles in raising volume sales in the top two automotive markets – U.S. and China, to the uncertainty at the helm of the management. Martin Winterkorn survived an effort to oust him earlier in the year, which later led to the resignation of the Chairman and grandson of the inventor of the Volkswagen Beetle, Ferdinand Piech. The Wolfsburg-based German group has had its troubles in improving efficiency and managing 12 separate brands under one umbrella. Pressure is building on the present CEO in the face of this dieselgate scandal, and this could catalyze further changes at the top executive level at Volkswagen.

Nonetheless, it’s an affair to forget for Volkswagen.

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