Can Volkswagen Recover From the Diesel Scandal?

The auto scandal that's been brewing since September finally came to its climax last week, as Volkswagen (VWAGY 0.67%) has settled on charges it used defeat devices in its vehicles to cheat emissions testing.

On this industrials edition of Industry Focus, Sean O'Reilly and John Rosevear explain what we know about what Volkswagen was doing -- and why on earth they would do something like this -- how the company is planning to repair the damage it's done, why this is different from other scandals we've seen in the industry before, and what countries around the world are doing in response to the settlement.

They also discuss what investors should take away from the news, and the 29% drop the stock has seen since the news broke.

A full transcript follows the video.

This podcast was recorded on June 30, 2016. 

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Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, June 30th, 2016, so we're talking about energy, materials, and industrials. Joining me on air via Skype is Motley Fool's senior auto specialist, John Rosevear. John, what is the good word?

John Rosevear: The good word today is "settlement" -- as in, Volkswagen's.

O'Reilly: Yeah. We're not talking about energy like we always do, it seems, on this show. We're talking about something that I don't think we did on the energy, materials, and industrial show enough, which was the Volkswagen scandal that came out... was that, what, six months ago?

Rosevear: Yeah. It was in September that the world first learned about it. There'd been an investigation and a back-and-forth going on for a long time. What happened was that the EPA and CARB, the California Air Resources Board, which is a powerful regulatory agency, charged Volkswagen with using what they called "defeat devices" in certain of their diesel engines that they sold in the U.S. "Defeat device" is a technical term under the Clean Air Act. It means, basically, you're skirting emissions controls somehow. What VW was doing was they had programmed the car's software to turn on the emission controls connected to the engine only when the car detected that a government emissions test was happening, and there were certain ways where they could reasonably do that.

This is a huge thing. This affects, in the U.S., about 482,000 VW and Audi vehicles sold from 2009 to 2015. I mean, there are millions of these things worldwide, about 11 million in total. The issue, and the reason it's such a big deal in the U.S., is the specific flavor of emission controls that are relevant to diesel. Diesel engines that don't have clean air systems on them cause smog. They emit nitrogen oxides, and that's what causes smog. This is why California hates it so much. If you're of a certain age, like me, you'll remember when L.A. was a smoggy mess. Now, it's only lightly smoggy. That's because the California Air Resources Board has been so militant about cleaning all this stuff up. They're furious, the EPA is furious, it's a flagrant violation. They went back and forth for months with VW to get to a settlement, and that's apparently what we got this week.

O'Reilly: Yeah. When this came out, I was, like, "You cannot make this stuff up." It's staggering! John, why'd they do it?

Rosevear: Well, think about a top-down hierarchical German company, and almost in some movie stereotypes here, where they came in and told the engineers, "You will design clean diesels, they will hit these performance and fuel economy targets, and it will cost this much." The engineers went round and round and round, and decided they couldn't do it. Somebody -- and it is still, months after all this broke, it's still unclear who exactly authorized this, and how high up the decision went inside VW -- somebody decided, "All right, we'll create a workaround, a cheat."

O'Reilly: No heads have rolled.

Rosevear: Some heads have rolled. The CEO, Martin Winterkorn, left a couple days after this broke. He was replaced by Matthias Mueller, who had been Porsche's CEO, and Mueller has been trying to get his arms around this thing, and it's been quite something. He seems pretty capable, but there's a lot here.

O'Reilly: I don't know if anybody could handle this. Just got the settlement very recently. What is in there? What does Volkswagen have to do to make this right?

Rosevear: First and foremost, it's a ton of money. They're going to make it right with... well, let's back up a second. What they're settling, first of all, are the charges from the EPA, the charges from the California folks, a separate set of charges from the Federal Trade Commission, who said: "Hey, you were advertising clean diesels, now we've got you on false advertising."

O'Reilly: Oh my gosh!

Rosevear: Most of it was a series of class-action suits that were consolidated all together with all of these civil claims from the government in one giant court case in California, suits by the owners basically saying: "Hey, now my car's worthless. What the heck?"

O'Reilly: Yeah!

Rosevear: "I bought it on these premises." First and foremost, VW is setting up a settlement fund that will have a maximum value of just over $10 billion. This is to compensate owners. All owners will get a cash payment of between around $5,000 and around $10,000.

O'Reilly: That almost doesn't seem enough.

Rosevear: Yeah, well, wait, wait... but wait, there's more! In addition, VW will offer to buy back the cars at their book values as of mid-September, the day before the scandal broke, basically.

O'Reilly: Oh, wow!

Rosevear: Whatever they were worth before this news hit the world wires. They will buy back the cars. Alternatively, if customers say: "Well, I want to keep the car!" VW will come up with some way to fix them so that they comply with the Clean Air Act. It is notable that VW and the feds and California have not yet agreed on any sort of fix that will actually fix the cars.

O'Reilly: Hold on... how are they going to... why didn't they just do that in the first place?

Rosevear: Right.

O'Reilly: That doesn't make any sense to me!

Rosevear: Yeah!

O'Reilly: Now, is it true that these, the diesel engines and everything, is it true that they are actually so good with their fuel efficiency that everybody was so impressed, and that's kind of how this came about? They were, like: "Wow, this is really awesome! How did they do this?"

Rosevear: It's not just the fuel efficiency. Those of us who are old enough to remember the first round of Volkswagen diesels in the 1970s, those cars were really slow. They were way fuel-efficient, but they were really slow, and they were stinky and noisy.

O'Reilly: Got you.

Rosevear: These cars are not slow. They drive like German sedans. My neighbors have a Jetta, a 2015 Jetta, with one of these engines. It's a nice car to drive, actually. It's smooth, it's --

O'Reilly: What have they said? Do they want the buyout? What are they doing, your neighbors?

Rosevear: They have it on a lease. Alternatively, people who have leased the cars can just turn the car back in.

O'Reilly: As they should.

Rosevear: No penalty, nothing done. That's what they're going to do pretty much the moment they get the form in the mail or whatever. That's what they're going to do.

O'Reilly: Got it.

Rosevear: That's the big chunk of it. There are also some other parts. VW has agreed to pay $2.7 billion over the next three years, essentially as a fine, but the fine will go into what they call an environmental trust. What this will do is make grants to clean-air projects that are sponsored by state governments, or something like that. The idea is that that will help offset the impact of all the excess emissions from these 482,000 cars that have been spewing into the U.S. air since 2009.

They also agreed to invest $2 billion over 10 years in zero-emissions vehicle infrastructure access and awareness initiatives. This is interesting. Some people are looking at this and saying: "OK, so VW is being forced to build a competitor to Tesla's supercharger network," which, VW doesn't have much of an electric-car program yet. They've got a lot coming, but it's...

O'Reilly: This is hilarious!

Rosevear: ...it is hilarious. Meanwhile, General Motors (GM 4.37%) is about to roll out the Chevy Volt. Next year, there will be a new Nissan Leaf with -- next year, or the year after -- sometime soon, there will be a new-and-improved Nissan Leaf with similar range to the Volt, like 200 miles. Tesla's Model 3 is coming. They've got to build out this recharging infrastructure, basically in the U.S. -- $2 billion worth.

There are also another set of payments that total around $600 million that settle claims filed by states' attorney generals, as well as Puerto Rico and the District of Columbia -- you know, the usual stuff that the attorney generals hop on when this stuff happens.

If everybody opts for the buyback, it costs $15.3 billion, give or take a few million.

O'Reilly: Wow!

Rosevear: Yeah.

O'Reilly: That is a chunk of change.

Rosevear: That's a big chunk of change.

O'Reilly: That's BP Deepwater Horizon money right there.

Rosevear: Yeah. It's far more than GM had to pay for its recall scandal, it's far more than Toyota (TM 0.05%) paid for the unintended acceleration mess several years ago. The differences here, there are a couple differences between those. One of them, of course, is there was criminal intent here.

O'Reilly: Yeah.

Rosevear: They set out to violate the Clean Air Act, whether that's a crime or not. There was intent to break the law. Whether it's a civil violation or criminal violation has yet to be fully litigated. Whereas at GM, some people blundered; and likewise at Toyota, it seems like some people blundered. That's the difference between a mistake and intent before the act.

It's also simply a fact that they can't fix the cars; they've got to buy them back.

O'Reilly: Got it.

Rosevear: Right?

O'Reilly: Yeah.

Rosevear: You know, if there was an easy way to just recalibrate the software that kept most of the good virtues of the cars and cleaned up the air, first of all, they would have done that before 2009 when they released them. Second of all, they could just do that.

O'Reilly: Got it. All right, listeners. Before we move on, I wanted to take a moment to talk briefly about our sponsor. As you know, this Motley Fool podcast is brought to you by Wunder Capital. Wunder Capital is a Techstars-backed company, with headquarters in Boulder, Colorado.

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John just talked about how Volkswagen's going to be forking over -- across tons of settlements, and investing in infrastructure, and all that good stuff -- over $15 billion. Do they have that money lying around?

Rosevear: In fact, they do. They took a charge, a reserve; they basically wiped out their 2015 earnings, to cover this. That charge is more than enough to cover that $15.3 billion. As of the end of the first quarter, they had about 26 billion euros -- so something like $27 billion in cash and credit lines available to them -- so a reasonable reserve for an automaker. Yeah, they can cover this. They can pay for it. They've planned around it. They're good!

Here's the thing. The question that's being raised now is: What if other governments go back and say, "Whoa! Owners of these cars in the U.S. got these big settlements, they're buying back the vehicles. Owners in Europe got a recall when they installed this little bit of pipe and they say it's fine." Part of that is a function of the different environmental regulations. Our rules in the U.S. around oxides of nitrogen, the relevant emissions that cause smog, are a lot stricter than Europe's. Europe is...

O'Reilly: That's surprising to me, but yeah.

Rosevear: ...Europe is worried more about CO2. That's why they favor diesels. Diesels get better fuel economy than gasoline engines, so they burn less fuel and generate less CO2. That's the greenhouse gas. That's the global warming contribution. We're concerned about that, too, in the U.S., but we're also concerned about the pollutants that cause smog on the local level that make the cities gray.

O'Reilly: Got you. How many...

Rosevear: It's a different set of rules and a different set of priorities, and that's part of what's driving it here. It is possible that... I mean, these cars were sold all over the world, and a lot of governments... I know South Korea is taking a dim eye toward Volkswagen right now. There's some sort of criminal investigation going on there. India has sort of rattled their equivalent of the Department of Justice sabers a little bit. They're getting wound up. There are lots of other countries that are talking about this.

Fortunately for Volkswagen, they didn't sell very many of these in China. While China is concerned about this, there aren't tens of thousands of cars, or hundreds of thousands of cars in China, so Volkswagen has that going for it. If some of these other governments go, "Hey, wait a minute, we want $5,000 for each of our owners" or "Hey, wait a minute, we think you should buy back these defective cars," this is going to get real expensive in a hurry. To be clear, it has yet to be seen if any of that's going to actually crop up or not.

O'Reilly: For investors, it seems like what you're describing isn't just a cloud over Volkswagen's head. It seems like a hurricane over Volkswagen's head.

Rosevear: Yeah, and it has been for a while. While we have some clarity about what it's going to take to settle most of the charges in the U.S., there's still a lot of uncertainty.

Let's back up a little bit. Volkswagen's American Depository Receipts  -- the shares that trade here in the U.S. -- as of yesterday, they were down 29% since the day before the scandal. The thing is, they were trending down anyway, even before this scandal broke, because people were concerned about VW's costs. Their cost structure is kind of crazy. VW is owned, in part, by the German state of Lower Saxony. They have, under German law, they have union representatives. Labor representatives have a lot of seats on their board, and so forth.

O'Reilly: I remember -- Sorry to interject.

Rosevear: Sure!

O'Reilly: I remember when the Berlin Wall came down, there was a hedge fund manager named Julian Robertson, he ran that Tiger Fund.

Rosevear: Mm-hmm.

O'Reilly: He was all excited and he went over to Germany, and he's like: "Oh, they're going to become capitalists and make all this money," or whatever. He toured a Volkswagen plant, and he saw the union reps, the sweet cafeteria that all these employees get, and he's like: "These people just don't get it." He didn't invest in them for the reasons that you just cited.

Anyway, sorry to interrupt!

Rosevear: Yeah. The comparison is -- you take GM, Toyota, and Volkswagen. They all, worldwide, sell about the same number of cars. Toyota's slightly ahead of VW, slightly ahead of GM, but they're all about the same size. Volkswagen has something like twice the employees that Toyota or GM does, maybe a little more. It's full employment for everybody. I believe they are Germany's largest employer, and that's a big part of their thinking. They don't want to cut costs; they don't want to cut back.

What that means is that, while Volkswagen has been very profitable, at least before the costs of this scandal came up, most of that profit was coming from luxury cars. Audi and Porsche have great profit margins, like their competitors, and VW is generating a lot of money off of those. The VW brand itself was making very little money. There were some years where...

O'Reilly: Jettas are not a moneymaker.

Rosevear: Yeah. This is the bulk of their sales volume, and it's kind of breaking even. There was growing investor concern and pressure about that -- like if there's a downturn, if people turn away from luxury cars. Audi has been a huge brand in China. If people step away from that -- and there's been some sign that they might -- what happens to Volkswagen's profit?

There were these concerns coming in even before this scandal blew up; and now, with this uncertainty hanging over it, this sort of shareholder unfriendliness of the company, the sense that it's run for their few big investors, and the workers, the employees, the government, is not so much a concern for the average-guy shareholder. It's tough to make a case to buy it, even though the stock has been beaten up, and even though this settlement seems like a big step forward for them.

O'Reilly: Got it. All right. Bottom line, stay away from the shares, even though they could be a bargain.

Rosevear: Yeah. Right now, I'm still on stay away. Yeah, it's a big company selling at a good price. There are signs that the new management team is a good one, and that Volkswagen will go in a good direction from here. They're really doubling down on things like electric cars, future technology, so forth, as a way to get past this scandal, but it's also the smart move because that's where the industry is going. They have a lot of clout, and a lot of R&D power, and an opportunity to be a big player there, but the picture is still very unclear. They could get whomped with another huge settlement in some other country.

They're still looking... The settlement in the U.S. doesn't settle the Department of Justice investigation. The possibility is that there's criminal charges still. They may have to accept outside monitoring of their engineering practices for some period of time, and that could add costs, and inhibit innovation, and so forth. It's hard to know yet. I like to recommend companies when I think there's a good story, and maybe the market hasn't seen it yet. The story here is really muddy.

O'Reilly: Got it. All right. Well, thanks for your thoughts, John!

Rosevear: All right, thank you!

O'Reilly: Have a good one! That is it for us, folks. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program.

For John Rosevear, I am Sean O'Reilly. Thanks for listening, and Fool on!