VW's Electric Redemption

Success will hinge on cutting costs and defending prices.
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Volkswagen's plan is both bold and commendable. In an attempt to put the diesel scandal behind it, the company plans to sell as many as 3 million electric cars a year by 2025, about a quarter of the total.

But the electric target also risks blowing a hole in the German carmaker's profits -- unless it can find big costs savings elsewhere. Those look tricky.

Electric Angst

VW investors don't have much confidence in the company's future earnings capacity

Source: Bloomberg

At stake is the future profitability of VW's carmaking operation. Before the diesel emissions scandal, it generated 11 billion euros of annual operating profit, almost all VW's earnings.

Down in the Diesel Dumps

The VW scandal has catalyzed a shift away from diesel vehicles

Source: CAR Universitaet Duisburg-Essen

VW expects its strategy will lift its operating return on sales as much as a third over the next eight years. But will it? Morgan Stanley analyst Harald Hendrikse fears selling lots of electric vehicles could instead cause VW's carmaking unit to become lossmaking by 2025. It would return to profit at the end of that decade.

Long-term profit predictions are always imprecise, as Hendrikse acknowledges. They're particularly difficult for electric vehicles because of the uncertainty around technology costs, regulation, competition and demand.

Tesla still loses money. Fiat Chrysler CEO Sergio Marchionne begged customers not to buy Fiat's 500e electric car because it was so heavily loss-making. While most carmakers don’t disclose financial data for their electric programs, it's reasonable to assume nobody has yet made money from them.

Investors are nervous about the near-term transition to electric vehicles, hence why carmakers trade at such low multiples of future earnings. They're right to be especially nervous about VW because its plans are so ambitious -- most rivals haven't set a long-term sales target for battery vehicles.

The shift to electric will involve big expenditures. VW's plants and workforce are still almost entirely focused on producing combustion engines. The company will need to restructure, as well as boost spending on R&D, employee retraining and factory retooling to meet its electric vehicle target.

Worryingly, VW plans to use a new vehicle architecture specifically for electric vehicles. This suggests the huge amounts it invested in a parts-sharing platform for both petrol and electric motors wasn't entirely well spent. It's conceivable VW will one day have to write down the value of its production plants.

Big Spenders

German carmakers' R&D spending dwarves Tesla

Source: Bloomberg

VW has some room for maneuver. It spends more on R&D than any company in the world. It should be possible to redirect more of that to developing electric vehicles without compromising its target of spending less than 6 percent of sales on R&D compared with more than 7 percent last year.

Employee Heavy

VW has more employees than Toyota and GM combined, but each makes a similar number of cars

Source: Bloomberg

VW also has a big truck-making operation and builds lots of components in-house.

Tackling labor costs looks harder. VW has too many workers relative to the number of cars it sells. That could get worse: electric motors have fewer parts and are therefore likely to be less labor-intensive than petrol engines. There's talk of about 2,000 jobs disappearing each year as baby boomers retire. Compulsory redundancies are pretty much impossible at VW thanks to the unions so don't expect headcount to fall in a hurry.

But costs are only part of the equation. Pricing will be important too. There's a risk VW will cannibalize earnings as customers switch from a high-margin petrol vehicle to a low-margin electric one. Similarly, the price of gasoline and diesel vehicles could drop if customers decide the future's electric and worry the resale value of their car will deteriorate.

VW won't be able to achieve its electric target without a big sales push in China, which accounts for more than a third of its vehicle sales. But local competitors such as BYD have grand plans for their own cheap electric models.

Still, it's not all bad news. By speeding up the leap to fully electric vehicles, VW won't have to invest so much in expensive hybrid technology or making combustion engines more efficient to meet emissions regulations. So it's possible gasoline and diesel cars will generate more cash in the short term. And, over time, electric vehicle gross margins should improve as battery costs fall and economies of scale increase.

VW promises its ID electric car won't cost more than a regular Golf diesel when it goes on sale in 2020. Getting there will be a bumpier ride for investors than drivers.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Chris Bryant in Frankfurt at cbryant32@bloomberg.net

    To contact the editor responsible for this story:
    Edward Evans at eevans3@bloomberg.net

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