Moody's Lowers Outlook on Volkswagen AG (VLKAY) to Negative Amid EPA Investigation

Moody's Investors Service has changed the outlook on the ratings of Volkswagen Aktiengesellschaft (Volkswagen)(OTC: VLKAY) and its guaranteed rated subsidiaries to negative from stable. Concurrently Moody's has affirmed the A2/(P)A2 long-term senior unsecured ratings and Prime-1/(P)Prime-1 commercial paper and other short-term ratings assigned to the company and its guaranteed rated subsidiaries. Moody's has also affirmed the Baa1 junior subordinate rating assigned to the undated euro-denominated subordinated notes issued by Volkswagen International Finance N.V. and guaranteed by Volkswagen.

The change in outlook follows Volkswagen's announcement that the US Environmental Protection Agency (EPA) is investigating the company's compliance with the US Clean Air Act (CAA). In its notice of violation, the EPA said that Volkswagen produced and installed 'defeat devices' in certain of its 2.0 litre diesel engine vehicles which render inoperative elements of their emission control system designed to comply with CAA standards.

RATINGS RATIONALE

Today's rating action reflects Moody's belief that Volkswagen has the financial wherewithal to cover the amount of the announced provision (EUR6.5 billion), although fully funding that provision would severely limit flexibility at the A2 rating level. Moody's concern, however, is that Volkswagen's alleged breach of US environment rules and, especially, the process by which that breach occurred, will have an adverse effect on its reputation and credibility within the global passenger car markets. This could be a long lasting image, which would weaken Volkswagen's market position, brand equity and pricing perception by customers. This could ultimately affect Volkswagen's future earnings and cash flow generation.

Moreover, there is an uncertainty regarding the response of authorities outside of the US to the company's alleged violations. Volkswagen said that approximately 11 million vehicles globally were concerned and Moody's expects the vast majority to be in Europe where diesel engines have a higher share of the market than in the US. Volkswagen is a marginal player in the US market with approximately 5% share and the US represented about 6% of its global unit sales in the first half of 2015.

Volkswagen is exposed to a penalty which could reach up to USD18 billion as well as to potential litigation claims. The company will also incur recall campaign costs and other costs such as industry and customer outreach costs which may be sizeable, albeit probably spread out over a long period of time. A provision of EUR6.5 billion will be booked in the company's financial statements for the third quarter ending 30 September 2015. This amount could be revaluated as the investigation progresses.

Volkswagen has a strong liquidity position, reflected by Moody's-adjusted free cash flow amounting to approximately EUR6.1 billion in the 12 months to 30 June 2015 and a reported net liquidity of its automotive division of EUR21.5 billion as of 30 June 2015. Liquidity is expected to grow further in the second half of 2015 reflecting, amongst others, cash inflows related to recent divestments including Volkswagen's 50% stake in LeasePlan Corporation N.V. and its 19.9% stake in Suzuki Motor Corporation (unrated). In light of the substantial cash costs facing the company Moody's would expect Volkswagen to take the necessary steps in order to protect its free cash flow generation and financial flexibility.

Volkswagen's alleged infraction comes at a time when the sales growth outlook for the global automotive growth has somewhat weakened. We forecast that growth in global automotive sales will slow to 1.2% in 2015 then rebound modestly to 2.5% in 2016. Moody's believe that Volkswagen is well positioned, as Europe's leading automotive manufacturer, to benefit from a recovery in the region. This effect would be compounded by the company's ongoing cost efficiency programme.

However, its large exposure to a slowing Chinese market, where we forecast automotive sales growth will slow to 1.9% in 2015 before recovering to 5% in 2016, and to weakened Latin America and Russia creates additional downside risks on the company's growth expectations in the next 12 months.

RATIONALE FOR THE NEGATIVE OUTLOOK

The negative outlook reflects the risks on Volkswagen's reputation and financial flexibility associated with its alleged violations of US environment laws. Volkswagen is under investigation and will be subject to fines estimated to be up to USD18 billion and additional costs for class action lawsuits and recall campaign costs.

Further negative rating action is likely if Moody's reaches a view that fines and legal costs are likely to be well in excess of Volkswagen's EUR6.5 billion provision, or that there will be significant damage to the company's market share or pricing position, with sustained negative impact on revenues or EBITDA, and impact starting to extend to core markets outside the US.

WHAT COULD CHANGE THE RATINGS UP/DOWN

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 and (4) fines and legal costs are likely to be well in excess of Volkswagen's EUR6.5 billion provision.

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.

An upgrade of the rating is not likely in the near term in light of today's rating action. A stabilization of the outlook could occur if there is evidence that the effects of the company's alleged violation of CAA are contained with limited repercussions on its brand image, sales and cash flow generation outside of the US.

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 the 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).

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

Affirmations:

..Issuer: Volkswagen Aktiengesellschaft

.... Issuer Rating, Affirmed A2

....Senior Unsecured Commercial Paper, Affirmed P-1

....Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

..Issuer: MAN SE

.... Issuer Rating, Affirmed A2

.... Issuer Rating, Affirmed P-1

....Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....Senior Unsecured Regular Bond/Debenture, Affirmed A2

..Issuer: Volkswagen Group Canada, Inc.

...BACKED Senior Unsecured Commercial Paper, Affirmed P-1

..Issuer: Volkswagen Group of America Finance, LLC

....BACKED Senior Unsecured Commercial Paper, Affirmed P-1

....BACKED Senior Unsecured Regular Bond/Debenture, Affirmed A2

..Issuer: Volkswagen Group of America, Inc.

....BACKED Senior Unsecured Commercial Paper, Affirmed P-1

..Issuer: Volkswagen Group Services SA

....Senior Unsecured Commercial Paper, Affirmed P-1

....BACKED Senior Unsecured Commercial Paper, Affirmed P-1

..Issuer: Volkswagen International Finance N.V.

....BACKED Junior Subordinated Regular Bond/Debenture, Affirmed Baa1

....BACKED Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....BACKED Senior Unsecured Medium-Term Note Program, Affirmed (P)P-1

....BACKED Senior Unsecured Regular Bond/Debenture, Affirmed A2

..Issuer: VW Credit Canada, Inc.

....BACKED Senior Unsecured Commercial Paper, Affirmed P-1

....BACKED Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....BACKED Senior Unsecured Medium-Term Note Program, Affirmed (P)P-1

....BACKED Senior Unsecured Regular Bond/Debenture, Affirmed A2

..Issuer: VW Credit, Inc.

....BACKED Senior Unsecured Commercial Paper, Affirmed P-1

....BACKED Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....BACKED Senior Unsecured Medium-Term Note Program, Affirmed (P)P-1

....BACKED Senior Unsecured Regular Bond/Debenture, Affirmed A2

Outlook Actions:

..Issuer: Volkswagen Aktiengesellschaft

....Outlook, Changed To Negative From Stable

..Issuer: MAN SE

....Outlook, Changed To Negative From Stable

..Issuer: Volkswagen Group of America Finance, LLC

....Outlook, Changed To Negative From Stable

..Issuer: Volkswagen International Finance N.V.

....Outlook, Changed To Negative From Stable

..Issuer: VW Credit Canada, Inc.

....Outlook, Changed To Negative From Stable

..Issuer: VW Credit, Inc.

....Outlook, Changed To Negative From Stable

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