Moody's Upgrades Volkswagen AG (VLKAY) to 'Baa1'; Outlook Stable

Moody's Investors Service has upgraded to A2/(P)A2 from A3/(P)A3 the long-term senior unsecured ratings and to Prime-1/(P)Prime-1 from Prime-2/(P)Prime-2 the commercial paper and other short-term ratings assigned to Volkswagen Aktiengesellschaft (Volkswagen)(OTCBB: VLKAY) and its guaranteed rated subsidiaries. Concurrently, Moody's has upgraded to Baa1 from Baa2 the junior subordinate rating assigned to the undated euro-denominated subordinated notes issued by Volkswagen International Finance N.V. and guaranteed by Volkswagen. The outlook on all ratings is stable.

"Today's upgrade reflects our expectation of further improvement in Volkswagen's operational performance in the next 12 to 18 months, despite mixed global economic conditions, owing to the company's robust portfolio of brands, established market positions in Western Europe and China, as well as ongoing efforts to increase operational efficiency, especially within its main brand", says Yasmina Serghini-Douvin, a Moody's Senior Credit Officer and lead analyst for Volkswagen. "We expect that improved profitability will help Volkswagen sustain a positive robust free cash flow, even though investments will remain at a high level in the next few years given the structural need to develop new models, invest in technologies and meet stringent regulatory requirements in major car markets", adds Mrs Serghini-Douvin.

RATINGS RATIONALE

The upgrade to A2 was prompted by Volkswagen's solid operational performance in 2014 when the company delivered more than 10 million vehicles to its customers, outperforming the broader market in Europe and Asia. This supported an increase in sales revenue (including financial services) of 2.8% to EUR202.5 billion and in reported operating profit of 8.8% to EUR12.7 billion. Earnings growth was driven by the continued positive momentum within Volkswagen's premium segment (mostly Audi and Porsche) and at Skoda helped by the better-than-expected demand in Europe last year and the roll out of new models. This, together with Volkswagen's ongoing efficiency measures and Modular Transverse Toolkit (MQB) strategy, more than offset adverse effects from currency depreciation and higher fixed costs.

In addition, the company's Chinese joint ventures, which are a material part of global operations, grew their profit contribution significantly by EUR0.9 billion to EUR5.2 billion. Including the share of income from these joint ventures, Moody's estimates that Volkswagen's adjusted EBITA margin was approximately 8.7% in 2014 compared with 7.4% in the previous year. Whilst Moody's forecasts unit sales growth in China to somewhat slow in 2015 to 6.5% compared with 7.1% in 2014, the rating agency believes that Volkswagen will continue to capitalise on its market leading local position to further grow its sales this year and that the Chinese operations will remain an important component of the company's Moody's-adjusted profit and cash flows.

However, Moody's cautions that the prospects for both the global passenger car and truck industries will be mixed in 2015 and 2016. This is following the rating agency's forecasts of low economic growth in Europe, weak economic conditions and generally low visibility in certain emerging markets such as Brazil and Russia where the company operates, all of which will constrain its sales growth in the next 12 months.

Moreover, Volkswagen's main brand Volkswagen Passenger Cars (around 60% of total volumes) suffered from poorer operating conditions in Latin America and in Russia and underperformed the market in the Americas, which more than offset the improved growth of the brand in Western Europe. The brand posted a decline in its reported operating profit by EUR417 million to EUR2.5 billion, translating into a margin of 2.5%, down from 2.9% in 2013. The brand's operating margin continues to lag significantly behind that of other global rated competitors such as Toyota Motor Corporation (Aa3 stable) and Hyundai Motor Company (Baa1 stable).

Moody's nevertheless recognises Volkswagen's efforts at improving the operational efficiency of its main brand with the aim at delivering EUR5 billion in annual cost savings by 2017. The company also intends to address its issues in the US by launching new models which will better meet customers demand there. This will help VW improve more sustainably the Volkswagen Passenger Cars' margin and bring it closer to the company's long-term margin target of more than 6%. These efforts at cutting costs will be compounded, at the group level, by the continued roll out of the company's MQB strategy with the objective of more than 7 million vehicles per year as of 2018 with an expected 2.7 million in 2015.

Within Volkswagen's commercial vehicle division, Moody's considers that operational performance has been somewhat uneven as MAN has posted weaker earnings since 2013 with a low reported operating margin of 2.7% in 2014 (2.0% in 2013) whilst Scania has displayed a fairly resilient profitability through the cycle, reaching 9.2% in 2014. Increased cooperation between the company's three brands MAN, Scania and Volkswagen Commercial Vehicles (following Scania's minorities buy out by Volkswagen's last year), is expected to generate added synergies over the long term. In the meantime, Moody's anticipates that the commercial vehicle division will continue to weigh on Volkswagen's broader profitability in 2015.

Despite the significant increase in operating profits last year, Moody's-adjusted leverage ratio for Volkswagen (defined as gross debt/EBITDA) was stable year-on-year at 2.2x owing to a sizeable rise in the company's pension deficit, Moody's single largest adjustment to Volkswagen's debt, resulting from a reduction in the company's discount rate. VW's cash flow coverage ratios were similarly affected which, added to the increase in capital expenditure, led to a weaker retained cash flow/debt ratio of approximately 27% (33% in 2013) and free cash flow/debt ratio of 7% (8% in 2013).

However, Moody's acknowledges that the company's free cash flow remained robust last year at nearly EUR4.0 billion (EUR3.8 billion in 2013) helped by a positive working capital flow. Moody's expects free cash flow will remain solid and underpin the company's liquidity position. Overall, Moody's considers that Volkswagen has sufficient internal and external liquidity resources in place to cover its day-to-day business needs, working capital and capital expenditure requirements in the next 9 months, under our scenario of no access to the debt capital markets and taking into account the funding requirements of the company's financial services business.

RATIONALE FOR THE STABLE OUTLOOK

The stable outlook reflects Moody's expectation that Volkswagen's earnings will moderately improve in the next 12-18 months, despite an expected slowdown in global volume growth for passenger cars, mixed prospects for the truck business and challenging operating conditions in certain emerging markets where the company is present such as Brazil and Russia. This reflects Moody's view that Volkswagen's broad product portfolio, together with the international roll out of it modular strategy, as well as its ongoing initiatives to enhance the efficiency of its operations, especially within its main brand, will more than offset these negative market developments.

In addition to that, Moody's expects Volkswagen to at least maintain its current liquidity profile in order to remain adequately positioned in its rating category.

WHAT COULD CHANGE THE RATINGS UP/DOWN

An upgrade of the rating is not likely in the near term in light of today's upgrade. Upward pressure on the ratings could occur if Volkswagen (1) continues to at least protect its market share in the major markets where it operates, especially in Western Europe and in China, regardless of potential changes in global macro-economic conditions; and (2) significantly grows its competitive position in its key US market. Volkswagen would also need to deliver a more consistent earnings pattern across its commercial vehicle brands as a result of the successful execution of its long-term plan for the division.

Quantitatively, an upgrade of the ratings would require sustained robust cash flow generation, despite elevated capital expenditure, supported by improved Moody's-adjusted EBITA margins sustainably above 10%. This means a (1) free cash flow/debt ratio in the low 10s in percentage terms; and (2) EBITA/interest expense above 10.0x (all ratios including Moody's adjustments).

The ratings could come under pressure if Moody's notes (1) an erosion in Volkswagen's market shares in its core markets; (2) deterioration in the company's operational performance as a result, for example, of weaker earnings of its premium brands or of its commercial vehicle division; or (3) inability to enhance the Volkswagen Passenger Cars' profitability to a level sustainably more competitive.

Quantitatively, a downgrade could occur if (1) Volkswagen's Moody's-adjusted EBITA margin drops below 7%; (2) its free cash flow/debt ratio deteriorates below the mid-single digit range in percentage terms for a prolonged period of time as a result of an operational weakness or more aggressive financial policies; and (3) EBITA/Interest Expense decreases below 7x (all ratios as adjusted by Moody's).

Moreover, any further weakening of Volkswagen's liquidity coverage could put downward pressure on the ratings.

PRINCIPAL METHODOLOGY

The principal methodology used in these ratings was Global Automobile Manufacturer Industry published in June 2011. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

List of affected ratings

Upgrades:

..Issuer: Volkswagen Aktiengesellschaft

.... Issuer Rating, Upgraded to A2 from A3

....Senior Unsecured Commercial Paper, Upgraded to P-1 from P-2

....Senior Unsecured Medium-Term Note Program, Upgraded to (P)A2 from (P)A3

..Issuer: MAN SE

.... Issuer Rating, Upgraded to A2 from A3

.... Issuer Rating, Upgraded to P-1 from P-2

....Senior Unsecured Medium-Term Note Program, Upgraded to (P)A2 from (P)A3

....Senior Unsecured Regular Bond/Debenture, Upgraded to A2 from A3

..Issuer: Volkswagen Group Canada, Inc.

.... BACKED Senior Unsecured Commercial Paper, Upgraded to P-1 from P-2

..Issuer: Volkswagen Group of America Finance, LLC

.... BACKED Senior Unsecured Regular Bond/Debenture, Upgraded to A2 from A3

..Issuer: Volkswagen Group of America, Inc.

.... BACKED Senior Unsecured Commercial Paper, Upgraded to P-1 from P-2

..Issuer: Volkswagen Group Services SA

.... BACKED Senior Unsecured Commercial Paper, Upgraded to P-1 from P-2

....Senior Unsecured Commercial Paper, Upgraded to P-1 from P-2

..Issuer: Volkswagen International Finance N.V.

....Junior Subordinated Regular Bond/Debenture, Upgraded to Baa1 from Baa2

.... BACKED Junior Subordinated Regular Bond/Debenture, Upgraded to Baa1 from Baa2

.... BACKED Senior Unsecured Medium-Term Note Program, Upgraded to (P)A2 from (P)A3

.... BACKED Senior Unsecured Medium-Term Note Program, Upgraded to (P)P-1 from (P)P-2

....Senior Unsecured Regular Bond/Debenture, Upgraded to A2 from A3

.... BACKED Senior Unsecured Regular Bond/Debenture, Upgraded to A2 from A3

..Issuer: VW Credit Canada, Inc.

.... BACKED Senior Unsecured Commercial Paper, Upgraded to P-1 from P-2

.... BACKED Senior Unsecured Medium-Term Note Program, Upgraded to (P)A2 from (P)A3

.... BACKED Senior Unsecured Medium-Term Note Program, Upgraded to (P)P-1 from (P)P-2

.... BACKED Senior Unsecured Regular Bond/Debenture, Upgraded to A2 from A3

..Issuer: VW Credit, Inc.

.... BACKED Senior Unsecured Commercial Paper, Upgraded to P-1 from P-2

.... BACKED Senior Unsecured Medium-Term Note Program, Upgraded to (P)A2 from (P)A3

.... BACKED Senior Unsecured Medium-Term Note Program, Upgraded to (P)P-1 from (P)P-2

.... BACKED Senior Unsecured Regular Bond/Debenture, Upgraded to A2 from A3

Outlook Actions:

..Issuer: Volkswagen Aktiengesellschaft

....Outlook, Changed To Stable From Positive

..Issuer: MAN SE

....Outlook, Changed To Stable From Positive

..Issuer: Volkswagen Group of America Finance, LLC

....Outlook, Changed To Stable From Positive

..Issuer: Volkswagen International Finance N.V.

....Outlook, Changed To Stable From Positive

..Issuer: VW Credit Canada, Inc.

....Outlook, Changed To Stable From Positive

..Issuer: VW Credit, Inc.

....Outlook, Changed To Stable From Positive

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