Perspectives on the VW scandal

The recent Volkswagen (VLKAY) emissions tampering scandal is about the worst thing that can happen to an investor – the kind of idiosyncratic, ‘deus ex machina‘ event that can devastate an investment thesis and yet is both uncontrollable and – for those of us who cannot afford to conduct a road emissions test of a VW – entirely unpredictable. Much like BP post the Macondo oil spill, VW stock has become effectively un-investable: the scale and scope of potential financial consequences are so wide (and so dependent on different variables) as to make valuing the stock next to impossible. If I was a VW investor (and thankfully I’m not), I would likely just dump it, take the pain, and move on – which, judging by the stock’s ~36% obliteration, seems to have been the choice of many. Painful, of course, but at least an exit strategy.

To me, more interesting are the broader consequences for the auto space, which has been crushed alongside VW. The VW-related auto supply chain names are variously down ~15%+, while even well-diversified (and minimally-VW exposed) other suppliers are down 10-15%; Europe-focused OEMs, meanwhile, are down ~15%+ (eg, Fiat Chrysler, Daimler, etc).  The market appears to harbor two main concerns:

  • VW was not alone in manipulating their emissions tests and this could be industry-wide behavior (cf the Auto Bild article accusing BMW of similar behavior, although that article was later recanted);
  • the scandal will force the entire industry to tighten standards (particularly in Europe), increasing costs and lowering profitability

I have a few problems with both of these conclusions. To the first point: the VW attempt was so brazen, and so outlandish, that I have a hard time concluding that this kind of behavior was widespread (especially when most all the other key OEMs have emphatically denied cheating their emissions tests). You could call me naive, but the sheer myopic idiocy of the VW leadership in pursuing such a high-risk, low-reward strategy suggests to me the actions of a deranged few. The uniform condemnation of VW’s behavior from other OEM execs, as well as the shock expressed, also supports this view. I firmly believe that subsequent tests and investigations into the other OEMs – even if they detect emissions over the limit – will demonstrate no purposeful manipulation of emissions tests themselves (this is key for brand and reputation).

The second contention – that tighter emissions standard industry-wide will curb profits due to higher costs – is more defensible, I suppose, but still lacks an internal logic to me, because if costs rise for everyone then either everyone raises prices to compensate, or they push costs down onto their supply chains to compensate; or some combination thereof. Bears may say this is short-sighted, and that some OEMs will look to absorb these increased costs in order to gain share. But how much increased costs are we actually talking about?

VW has already provisioned $7.3bn in costs to recall and upgrade 11mm vehicles, to bring them into line with emissions standards. This equates to about $660 per vehicle – or about ~2% of the average cost of a VW (looking at 2013 stats). I think the new-build cost per vehicle of meeting stricter emissions standards is likely lower than this (as this number should include a number of idiosyncratic recall-related costs). But even if we take the whole number, while clearly significant in the context of industry profitability (VW EBITDA margins, for example, have been in the 13-15% range the last 5yrs), I do not think it is unreasonable to think autos could, say, increase prices uniformly by 1% and push the additional 1% of their costs onto their supply chain. This behavior would only work if a) all the auto OEMs suffer the same new draconian regulations; and b) the OEMs have a mostly captive supply chain. Thankfully, in this case, both of these tenets apply.

So, not only are VW’s troubles likely unique to VW, but the specter of decimated industry profitability, on account of new regulations, is probably overstated too. How about the potential hit to VW’s sales – what could that look like?

We are getting a bit further into the weeds here, as the current scandal is largely without precedent. But other recall scandals may give us some idea of what could happen to VW. The Toyota sudden acceleration recall scandal in 2010-11 is a decent place to start: it involved a similar number of vehicles (10mm++), and involved a large management cover-up (Toyota management lied to investigators and hid the scope of the problem). Of course, Toyota did not purposefully cheat on tests, nor was their brake pad issue a massive environmental problem. On the other hand, over 100 deaths were ultimately tied to the Toyota issue (though the company admitted only a dozen or so directly caused), so the human cost was immeasurably higher. Additionally, from a reputation perspective, you could conceivably argue the Toyota case was more troubling for the company’s go-forward brand as it involved safety.

Taking all these differences into consideration, in FY12 – the first full-year of sales after the scope of Toyota’s issues came to light – saw Toyota North American sales (where the problem lay exclusively) fall 8% in unit terms; but other regions saw minimal declines or even increases. Perhaps more importantly, the following year, Toyota sales in North America rebounded 32% in volume terms, as the company’s full mea culpa found consumer forgiveness (admittedly the market recovery helped a lot too). Toyota’s US sales have been growing ever since.

So, despite a barrage of horrible headlines, and a memorable excoriation before the US senate, the actual sales damage done by the Toyota scandal was, in retrospect, localized, temporary, and very manageable. This has important analogues for the VW case, because – simply put – new car buyers do NOT seem to prioritize environmental considerations highly. Surveys on car buying considerations are a dime a dozen, but in a smattering of recent ones (here, here, here, and here), I could not find one where environmental considerations ranked highly for choosing a brand. Instead, reliability, quality and fuel economy were consistently ranked in the upper factors, while safety is important too (though not as important as it used to be as overall car safety has increased immeasurably); meanwhile more mundane considerations like styling, warranty features, and, of course, price all seem to outrank environmental considerations in this particular survey (from Feb 15):

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This is not to say VW won’t suffer a sales backlash – of course they will. And their reputation for quality will certainly suffer alongside; this too will affect sales. But if VW management can demonstrate – and indeed their survival depends upon this – that the test cheating applied only to emissions and did not affect their safety ratings in any way, it is my contention that you will see a temporary, Toyota-like pullback in sales (-10%?)  followed by a recovery.

This is not to be confused with a recommendation to buy VW stock; as per my initial comment, the regulatory/legal financial penalty will be Sisyphean, such that – again, as per BP – VW equity should be in the penalty box for years. But the corollary for the broader auto parts supply chain is quite favorable. Consider the following:

  • (as per above) VW issues are likely idiosyncratic and not systemic;
  • (as per above) increased costs related to tougher emissions standards – even if they are realized, which is not a given – are likely at least partially funded by OEMs and/or passed on to the consumer;
  • (as per above) VW-related sales will take a hit but this likely proves transitory in all but the most bearish, ‘doomsday’ type outcomes, and meanwhile the broader market is firm;
  • the US auto market is enjoying days of ‘high cotton’, driven by pent-up post-recession demand, and ongoing low interest rates (thank you Janet!), such that August SAAR is likely to post a record 17.8mm units, the highest pace since July 2005;
  • the European auto market (particularly Western Europe) has been recovering since QE began under Draghi, with new vehicle registrations rising 9% in Aug (the eighth consecutive YoY increase);
  • meanwhile valuations – already low pre-VW – took another ~15% beating and now discount a ton of bad news

A final, more speculative bullish argument for the auto supply chain involves the potential for consolidation: while some of the auto OEMs (particularly Fiat Chrysler) have been championing OEM consolidation, a similar argument could be (and has been) made for the suppliers – ie, it is time to get bigger to gain more leverage versus the OEMs, especially in a world of tighter standards and higher specifications.

Within the space, I am long Tower International (TOWR), a supplier of body structures (think the skeleton of a car) to most all the major OEMs in the US and Europe. While – unfortunately – VW is a 15% customer, at this point (-15%) the bad news is mostly priced in, while the company has been consistently winning new business in North America, is in the process of divesting under-earning Chinese assets, should yield 15-20% FCF to equity in the next two years, is not aggressively levered (1.5x net) and would be a prospective acquisition candidate for larger names like Magna (MGA) or Martinrea (MRETF). You can read a more in-depth investment thesis for TOWR here.

Disclosure: long TOWR

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Quicksilver: A Quick Post-Mortem

Quicksilver (ZQK) has been one of my core bearish positions for most of the last year, as I viewed the company’s ~$800mm net debt load as unsustainable in the face of interminable secular trends and poor management. I highlighted some of the problems facing the company in a couple of Seeking Alpha articles here, here, and here.

Without rehashing the entire thesis, the basic premise was that in the short term, ZQK’s financial leverage was both unsupportable – too much leverage for a company seeing EBITDA crater and negative FCF – and also poorly structured – ~85% of the debt being subordinated to a small amount of senior debt outstanding which became the only source of liquidity and yet had nothing to gain by waiving covenants. In the medium term, the viability of ZQK’s three core brands – Quicksilver, Roxy, and DC – was threatened by the myopic decision ~2yrs ago to aggressively curtail athlete sponsorship and other marketing, thereby denuding any hope of meaningful brand recovery in the competitive teen apparel space and effectively condemning ZQK to low-margin, commoditized ‘retail hell’ (my pet term).

Horrid execution and FX headwinds (ZQK has 50% of sales outside the US) only added to the company’s woes, and ZQK filed for bankruptcy in the US today. While the company did not detail the immediate cause, I suspect an imminent covenant breach on its senior lending facility (which had minimum availability covenants threatened by ongoing cash burn, no other liquidity, and a shrinking borrowing base as the asset base shrank) was probably likely, as I had speculated last earnings report that best case, ZQK probably only had enough cash for a couple more quarters; ZQK likely tried to negotiate a waiver but since senior lenders had nothing to gain by extending more credit (given their tiny piece of the outstanding debt), it seems likely they simply refused to waive covenants and effectively tipped the company (super senior bank lenders will be made whole as a result). The various debt pieces reflect this reality: senior secured EUR and USD paper trade at the relatively lofty levels of 70-80c on the dollar, while the second lien USD bonds trade at 5c – a level that all but guarantees equity recovery will be a stone cold zero. Indeed, it is likely as well that unsecured creditors receive nothing in recovery other than a very, very small sliver of the new company’s equity (which Oaktree will control via their provision of DIP financing).

Before moving on to new business, it is worth reiterating what I believe is the main lesson of the ZQK story. Certainly, the company was caught in a maelstrom of secular forces, many of which – declining mall traffic, the rise of fast fashion, and a trough in surf and skate fashion interest among teens – appeared beyond its control. But more important, to me, were the horrible strategic decisions a succession of management teams made in the face of these challenges. Not one but two management teams chose to not pursue debt restructuring for years after it became clear the company was far too levered to effectively invest and market their product; this lesson was almost driven home (via bankruptcy) post Lehman, yet the company chose not to heed the warning the next time the business took another leg lower. Hence even when business – and the stock price – recovered, temporarily, a few years ago, there was no delevering through equity or asset sales when the chance was there. After that, ZQK made the odious choice to cut sponsorships – sacrosanct for a would-be premium athletics label – and also deracinate key staff – fatal to morale in recent years – just to maintain the debt burden, instead of, say, selling one of its core businesses or contemplating an earlier debt-for-equity exchange. This, in turn, only accelerated the vicious brand-destroying cycle, virtually guaranteeing ZQK’s fate.

Thus, if ever there was a poster child for the adage ‘you can’t cut your way to prosperity’, ZQK would be it. Hopefully the savvy new owners at Oaktree will realize this and – freed from the legacy debt burden – will rebuild the brand through investment, thereby righting recent management’s many missteps. Unfortunately, of course, this will come too late to help common shareholders – which was the core equity short thesis all along.

Disclosure: short ZQK (but not for much longer).