Volkswagen Earnings Defy Industry Gloom

Despite auto industry pessimism, European small-car makers have reported solid earnings. But VW's future may depend on the resilience of emerging markets

Volkswagen (VOWG.DE) on July 23 provided more confirmation that emerging markets are propping up the European car industry. The German automaker registered sales decreases in Western Europe and North America but racked up solid gains in Latin America and Asia, helping to deliver a 22% increase in second-quarter operating profit, to $3.35 billion. VW joined France's PSA Peugeot Citroën (PEUP.PA) and Italy's Fiat (FIA.MI) in reporting earnings that defied pessimism about the global auto industry. Shares of all three companies surged as investors demonstrated a newfound interest in makers of smaller, fuel-efficient vehicles.

But there may also be hidden peril in Volkswagen's emerging-markets success. Even more than in wealthy nations, people in poorer countries may prove vulnerable to rising fuel prices. In addition, growth in emerging markets is slowing while the cost of financing is rising. "The headwinds may become stronger," says Christian Aust, who follows VW for UniCredit (CRDI) in Munich. Aust says growth in emerging markets is still strong enough to deliver sales gains for VW, but believes company shares are overvalued and is advising clients to sell.

In one worrying sign, sales growth in China—VW's second-largest market after Germany—is already cooling, VW sales and marketing chief Detlef Wittig told analysts on a conference call. In the first half of 2008, Volkswagen sold 532,000 cars in China, a 23% increase over the year-earlier period and more than three times as many cars as the company sold in the U.S. Wittig says he is concerned about the world economy, but "we have the right products."

Hurt by Strong Euro

No doubt VW's stable of smaller, more fuel-efficient cars is a positive. But in emerging markets the crucial issue is whether consumers respond to high fuel prices by shifting to smaller cars or by not buying cars at all. Because many emerging-market buyers are first-time buyers, there's a risk that they will postpone purchases. Volkswagen also suffers from the strong euro, which raises the price of its products not only in the U.S., where sales slipped 0.4%, but also in countries such as China, whose currencies track the dollar.

In the developed markets, Volkswagen is seeing a clear shift to smaller cars, Wittig said. In October, VW will launch the latest edition of its compact Golf, the stalwart of its lineup. But the array of gas-sippers won't necessarily protect VW from economic turmoil even in developed markets. In Spain, the core market for VW's Seat brand, sales have plunged along with that nation's economy.

VW Chief Financial Officer Hans Dieter Pötsch seems to be wishing that the company had not discontinued the Audi A2 and Volkswagen Lupo a few years ago because of poor sales, both of which were designed to consume just 3 liters of gasoline per 100 kilometers, or more than 75 miles per gallon. The two models were "perhaps ahead of their time," Pötsch noted ruefully.

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