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With Ford's And GM's Valuations, Why Buy Volkswagen?

Volkswagen shares have tumbled over 30% since news broke over the diesel emissions scandal.

Many investors are considering buying Volkswagen as a "blood in the streets" investment.

Volkswagen is not particularly cheap when compared to Ford and GM which are not implicated in the scandal.

The biggest news out of the auto industry in the past month has been the diesel emission scandal from Volkswagen (OTCQX:VLKAY). With shares of the German automaker down over 30%, some investors are looking to pick up shares on the cheap.

But in an auto industry where low valuations are widespread, Volkswagen shares do not appear as attractive by comparison. While I am bullish on the auto industry and expect Volkswagen to survive, I believe there are better value plays in Ford (NYSE:F) and General Motors (NYSE:GM).

Damaged Volkswagen

Most people know Volkswagen as the maker of inexpensive cars such as the Beetle, Jetta, and Passat but the company is far larger. In addition to owning the Volkswagen brand, the company also owns Audi, Porsche, Bentley, Skoda, SEAT, Bugatti, Scania, and Lamborghini. Together this has made Volkswagen one of the close competitors for the title of the world's largest automaker.

The recent recognition of rigging of diesel emissions tests has shaken the company up causing the CEO to resign and the stock to fall over 30%. The first part being highlighted for Volkswagen is the potential for an $18 billion fine. This number is based upon the allowable fine of $37,500 per car that violates the emissions regulations multiplied by the over 400,000 "clean" diesels sold in the U.S. expected to have this problem.

What size of fine Volkswagen pays is still up in the air and the fact that the company appears to be fully cooperating could help reduce the fine.

Additionally, the company is already being probed by European regulators and the investigations will likely continue to surround the company for at least the next year. More fines may come from these regulators and the ongoing procedures are likely to weigh on the stock price until resolved.

But these issues may not be the biggest problems for Volkswagen. The company has also built its reputation upon quality German engineering alongside a "clean" diesel technology that provided higher gas mileage and environmental benefits without the cost of a hybrid system. This scandal has already caused sales of the affected vehicles to be suspended and even when fixed these vehicles will likely be more difficult to sell in the future as their image has already been trashed.

Volkswagen could also face damages from class action lawsuits from existing owners of the affected vehicles. The recall and the higher emissions are likely to negatively impact resale values and customers were sold the vehicles as being much more eco-friendly than they actually are.

How Volkswagen fixes the vehicles is also unknown as are the costs to do so. This number will be eagerly watched by investors and is likely to cost Volkswagen another bundle of cash.

The bull case

Not everyone has given up on Volkswagen and there are valid reasons to invest despite the scandal. Volkswagen is a massive company generating substantial amounts of cash, making the fines and lawsuits payable, especially if spread out over the course of years.

And while Volkswagen's reputation has been damaged, the actual impact on sales is unknown. For a comparison, many bulls look towards the General Motors ignition switch scandal where drivers were actually injured and killed due to a faulty product and management inaction. But while GM look its lumps in the press and reached a $900 million settlement, sales of GM vehicles actually grew after the scandal broke.

While environmental damage should not be taken lightly, the fact that the direct link between GM vehicles and consumer deaths did not crush sales is a positive for Volkswagen's ability to continue selling its vehicles.

Volkswagen bulls currently cite the scandal as a "blood in the streets" opportunity and with shares trading 30% lower than before the scandal, this view is worth considering.

Comparative valuation

To determine whether or not Volkswagen shares are a good option, it's important to consider both valuation to market levels and valuation to peers.

In terms of valuation to market, Volkswagen trades at a discounted 5.3x 2014 earnings. This represents a discount to the 2014 P/E valuations of Ford and GM trading at 16.9x and 17.8x, respectively. However, Ford and GM were both impacted by one-time events in 2014 with Ford sales being hurt as new models were rolled out and GM taking charges for the ignition switch scandal.

Looking at 2015 earnings valuations, GM and Ford clearly have the advantage over Volkswagen. GM trades at 7.8x est. 2015 EPS and Ford trades at 8.0x est. 2016 EPS. In contrast Volkswagen, trades at 6.3x est. 2015 EPS, however, these estimates have yet to incorporate the damage from the scandal which could nearly wipe out 2015 EPS.

If we look at forward 2016 earnings, GM trades at 5.8x est. 2016 EPS and Ford trades at 7.0x est. 2016 EPS. Volkswagen currently trades a 5.3x est. 2016 earnings however these estimates have yet to fully incorporate the problems of the diesel emissions recall. But even if these estimates were correct for Volkswagen, it's still not much cheaper than GM and Ford.

Prior to the diesel emission scandal, Volkswagen traded at a premium to GM and Ford, however, this premium could be difficult to earn back. GM and Ford are being assigned low valuations due to negative investor sentiment and concerns of a cyclical business. With the latest scandal, Volkswagen's image as a strong properly run company has been damaged making it difficult to regain a valuation built because of it.

Capital returns

GM, Ford, and Volkswagen are all decent dividend paying stocks, however, the emissions scandal is likely to negatively impact capital returns at the German automaker. Some investors have speculated that Volkswagen may suspend its dividend, but I believe a cut or slower dividend growth is more likely.

In contrast, Ford and GM are likely to continue boosting their dividends over the next few years alongside rising earnings. GM is also in the process of running a $5 billion share buyback which would be financially and politically difficult for Volkswagen at this point.

Following the drop in Volkswagen's shares, dividend yields on all three stocks are roughly the same. However, Ford and GM are better positioned to raise their dividends.

Other considerations

Volkswagen bulls expect that the company will continue growing despite the scandal and this may well be the case if the world economy can remain on track. However, such growth would also benefit GM and Ford increasing their earnings as well.

Volkswagen shares could also rise if investors turn bullish on the auto industry, however, such bullishness would also likely benefit Ford and GM.

Other investors are still concerned about GM's ignition switch scandal or the possibility that American automakers may get tied up in the emission scandal. With the ignition switch scandal, it appears the worst is over given that the DOJ settlement has already been reached. There are still more costs to come but GM has gone much further through its scandal than Volkswagen is through its own.

With respect to other potential scandals, it's something investors should take into account as a risk. But at this point, investors need to weigh the evidence. While there is strong evidence that Volkswagen rigged emissions tests, there is little if any evidence that other scandals are about to burst at GM and Ford.

Investors should also consider that unless GM and Ford have their own major scandals, these companies could actually benefit at Volkswagen's expense. First off, as long as sales of the affected Volkswagens remain suspended, people looking to buy cars will need to find alternative vehicles. Damage to Volkswagen's reputation could also allow Ford and GM to gain market share and boost total sales.

Volkswagen-GM-Ford takeaway

Volkswagen shares now appear cheap relative to the broader market but GM and Ford trade at similar valuations without the diesel emissions scandal. Additionally, these American automakers have better dividend growth potential and could take market share from Volkswagen depending on how the German automaker handles the scandal.

Since I expect Volkswagen to survive and still have significant earnings power, I may add shares if they fall further from current levels and I will be watching closely. But until then, I prefer GM and Ford over Volkswagen.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.


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