In May 2019, Volkswagen (FRA:VOW, Financial) announced that it was looking for potential buyers for its ship engine and power generator business, MAN energy solutions. As of Dec. 19, the large engines unit has attracted bids from Cummins (CMI, Financial), Mitsubishi Heavy (TSE:7011, Financial) and Innio.
The bids offered a tentative valuation of 1.5 billion to 2 billion euros (about $1.67 billion to $2.22 billion), falling short of the 3 billion euros Volkswagen expects to fetch from the deal. The carmaker has not yet begun an official auction process, but sources close to the matter expect to see a call for final bids around February 2020.
VW slimming down
Volkswagen’s upper management has been seeking to slim down the company’s assets for quite a while, but the automobile company’s works council vetoed efforts to sell off motorbike producer Ducati and transmissions maker Renk.
“We don’t need more brands. With very few exceptions, we can tap the world’s large profit segments with our existing brands,” CEO Herbert Diess said in an interview with Reuters.
Turning from its decades-old strategy of sparing no expenses to engineer and acquire an autos and engines empire, the company is shifting gears toward something more similar to the business plan for its famous Volkswagen Beetle. According to Diess, the company plans to develop and mass-produce electric cars, and in order to do that, it needs to free up resources by divesting itself of some of its less car-related segments.
In terms of Volkswagen’s profits, slimming down will most likely have minimal impact. The company generates the vast majority of its profits through automobile sales. MAN, for example, accounted for only 3 billion euros of the company’s 235 billion euros in revenue in fiscal 2019 (calendar 2018), while Ducati accounted for less than 1 billion euros.
This past September, the European Union announced that automakers would need to cut carbon dioxide emissions by 37.5% between 2021 and 2030. Higher emissions standards are making the cost of developing electric vehicles lower and lower in comparison to finding new ways to further slash the CO2 output of gas-burning cars.
According to Diess, the company will be emphasizing cost going forward. Instead of pushing innovation ahead of earnings, Volkswagen will do the opposite, aiming to produce cheaper electric vehicles that meet standards without breaking the bank for producer or consumer.
Low investment and decline
"MAN Energy Solution's value has been in decline following years of underinvestment," a Volkswagen representative said on the subject of the large engine unit in 2018. Originally part of the company’s trucks brand, MAN later began to specialize in larger engines for power generators and marine vessels. The unit suffered from underinvestment relative to the rest of the company as Volkswagen poured most of its research money into cars.
Despite prior setbacks, MAN’s sales have been increasing in 2019, according to the company’s interim report for the half-year ended on Sept. 30. According to the report, MAN’s diesel engines performed positively, and the unit also saw an increase in interest in retrofitting solutions and long-term maintenance contracts. Increasing sales may up MAN’s valuation and potentially raise the bidding price for potential buyers.
IMO 2020 valuation
One significant driving force behind the increase in interest in new engines, maintenance and retrofitting solutions comes from IMO 2020, which will go into effect on Jan. 1 of 2020.
IMO 2020 is the nickname given to the International Maritime Organization’s mandate that all marine ships and tankers that sail through international waters must switch to using scrubbers or low-sulfur diesel fuels beginning in 2020.
As a producer of ship engines, MAN is close to the heart of this change and has expanded its emissions control division accordingly. MAN Eco Control is the company’s portfolio of emissions control technologies, which optimizes the performance of ships and reduces their negative impact on the environment in terms of emissions, economy and operations.
In addition to exhaust gas treatment products to minimize emissions from fuel burning, MAN also offers marine battery-hybrid systems, which use batteries to capture and store excess energy from combustion engines that otherwise would have burnt off.
Thus, as IMO 2020 goes into effect, it will drive up the profitability and thus the valuation of MAN Energy Solutions right before final bid offers for the unit are sent in.
Potential value opportunity?
As Volkswagen moves to sell off MAN Energy Solutions and other units that aren’t related to its primary automobile business and use the funds to invest in its electric cars, it stands poised to gain top dollar (or top euro, in this case) for the marine engine manufacturer.
Volkswagen is in a good place financially, especially when compared to the rest of the automobile sector. It has a price-earnings ratio of 6.64, a cash-debt ratio of 0.24 (beating 100% of industry competitors) and an operating margin of 6.89% (also better than 100% of industry competitors). According to the Peter Lynch chart, the stock is currently undervalued.
One major reason for the company’s undervaluation is the 2015 dieselgate scandal, in which the company admitted to having rigged millions of diesel cars worldwide to cheat on emissions tests. The scandal hit the company and shareholders hard, causing stock prices to drop 40%. The CEO at the time of the scandal's revelation was Martin Winterkorn, who later apologized for breaking the trust of Volkswagen's customers and the public.
Another shockwave from this event came in September, when Diess and Volkswagen Chairman Hans Dieter Potsch were accused of stock market manipulation by not informing investors of the diesel emissions scandal quickly enough, causing them to lose money on the decline in stock prices. As of the writing of this article, no convictions have been made regarding the trial, and the company holds that the allegations are unfounded.
"The company has meticulously investigated this matter with the help of internal and external legal experts for almost four years. The result is clear: the allegations are groundless," said senior legal executive Hiltrud Dorothea Werner.
In addition to narrowing Volkswagen’s focus to increase profitability, the dieselgate scandal serves as another reason for upper management’s decision to focus on electric cars. Going electric is potentially the only way for the company to completely rid itself of the suspicion of violating emissions standards.
A future headwind for share price is the strong potential of a worldwide decline in car sales. According to Fitch Ratings and Germany’s Center for Automotive Research, global car sales will drop by approximately 3.1 billion to 4 billion in full fiscal 2019 and stay at that level for the next four or so years. This would mark the largest decline in car sales since the 2008 financial crisis.
In light of an industry-wide decline, Volkswagen may not be a buy at the moment, even if it is undervalued in terms of its current earnings. Moreover, in such a heavily cyclical industry, the lower the price-earnings ratio is, the more investors should be cautious; Volkswagen’s price-earnings ratio of 6.64 is on the lower end of the spectrum, which may serve as a red flag. However, the company is definitely worth keeping an eye on to see where its strategy of slimming down and focusing on electric can take it.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful analysis or consult registered investment advisors before taking action in the stock market.
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