S&P Cuts Long-Term Credit Rating on Volkswagen AG (VLKAY) to 'BBB+'

Standard & Poor's Ratings Services said that it has lowered to 'BBB+' from 'A-' its long-term corporate credit rating on Volkswagen AG (OTC: VLKAY)(VW or the parent). The outlook is negative. We affirmed our short-term corporate credit rating on VW at 'A-2'. We also lowered our long-term ratings on VW's debt instruments.

In addition, we lowered to 'BBB+' from 'A-' our long-term ratings on certain core subsidiaries of Volkswagen, including captive finance entity Volkswagen Financial Services AG (VW FS). We affirmed the 'A-' long-term ratings on Volkswagen Bank GmbH (VW Bank). (See "Volkswagen Financial Services Ratings Lowered To 'BBB+'; Ratings on VW Bank Affirmed; Outlooks Negative," published today on RatingsDirect.) We also lowered to 'BBB+' from 'A-' our long-term issuer credit and financial strength ratings on captive insurer Volkswagen Insurance Co. Ltd.

We have removed the remaining CreditWatch placements on the ratings. We initially placed the VW ratings on CreditWatch with negative implications on Sept. 24, 2015, and we removed some of these placements when we lowered the long- and short-term ratings on VW to 'A-/A-2' from 'A/A-1' on Oct. 12, 2015.

The downgrade reflects our view that VW's manipulation of engine emissions exposes the group to material, wide-ranging adverse credit impacts. These risks and related costs continue to expand and deepen, particularly following the recent disclosures regarding the misrepresentation of CO2 emissions and fuel consumption levels, beyond the original issues that related only to nitrogen oxide emissions.

In our view, these events have tarnished VW's reputation and brand perception, and will negatively affect the group's market position and competitive advantage. We also see weaker business prospects for the group, as VW experiences reduced profits and cash flows from lower volumes and prices, as well as substantial costs and potential fines and litigation damages. In addition, we consider that VW's cost structure may not be sufficiently flexible to enable it to fully adjust its expenses in a timely manner.

It is too early to draw clear conclusions about how VW's volumes, pricing, and underlying profitability will be affected by these events, but there are early signs that VW's market position is eroding. During October 2015, VW's volumes in the EU declined slightly by 0.5% year-on-year compared to market growth of 2.9%, according to the European Automobile Manufacturers Assn. Data from VW and Ward's AutoInfoBank also suggest that, while VW's October volumes held up in the U.S. with growth of 5.2%, this lagged well behind the market's much stronger growth of 13.6%. We see a risk that this trend could accelerate in coming months, as VW loses new sales volumes and has to reduce prices and incur additional expenses to support its market position.

Our updated base-case scenario for VW envisages:

• GDP growth of 3.6% globally in 2016, 1.9% in Western Europe, 5.5% in Asia-Pacific, and 2.8% in the U.S. We forecast global auto volume growth of about 2% in 2015 and about 3% in 2016, supported by broadly favorable macroeconomic trends. However, slowing demand growth in China is leading to a more competitive and challenging market environment--particularly for premium carmakers, which have benefited from strong growth in the past.
• Stable volumes for VW in 2015 (excluding joint ventures in China), followed by a single-digit decline in 2016. Revenues slightly higher in 2015 year-on-year, with a moderate decline in 2016. We forecast reported consolidated operating margins (before emissions-related provisions of €8.7 billion in 2015) of about 6% in 2015, declining moderately in 2016. We recognize that VW will seek to accelerate cost-cutting and take other measures to partly mitigate the negative effects on its operating performance. We also see lower equity-accounted profits and dividends from joint ventures in China due to weaker market conditions.
• Cash outflows related to the emissions provisions taken in 2015 will be fully expensed in 2016. Reflecting slightly lower spending levels as publicly guided by the company, we forecast annual capital expenditure (including capitalized development costs) of €16 billion-€17 billion. We expect no change in the level of annual dividend payments of about €2.0 billion-€2.5 billion, as in 2014.
• We do not expect any material acquisitions beyond VW's announced purchase of a stake of about €0.8 billion in Nokia's HERE digital mapping business. The announced sale of VW's 50% stake in LeasePlan Corp. N.V. for about €2.2 billion is due to occur within the next few months.
• We include emissions-related provisions in our calculations for Standard & Poor's-adjusted EBITDA, funds from operations (FFO) and adjusted debt.
• There are a number of uncertainties facing VW, notably the amounts and timing of potential costs for fines and litigation damages, and the possible mitigating steps which VW may take, such as asset or business disposals to cover emissions-related costs and support liquidity. These will only fully emerge over the coming months and years. Accordingly, we do not currently have sufficient visibility to confidently factor these items into our base-case forecasts. Nevertheless, we assume that VW will offset the costs of potential fines and damages by broadly equivalent mitigating actions, including disposal proceeds.

Based on the above assumptions, we arrive at the following credit measures:

• 2015: adjusted debt to EBITDA of around 2.1x, and FFO to adjusted debt of 35%-40%. This compares with our previous expectations of around 1.7x and 45% respectively.
• 2016: adjusted debt to EBITDA of around 1.7x and FFO to adjusted debt of 45%-50%. This compares with our previous expectations of around 1.4x and 50%-55% respectively.

Our business risk profile assessment reflects our view of VW's tarnished reputation and brand perception, as well as weaker business prospects and competitive position, together with a cost structure that may be less flexible than we had expected. Other constraining factors include cost pressures from substantial research and development spending; price competition to meet changing consumer trends and comply with stringent environmental standards; and high capital intensity and cyclical demand. Factors supporting VW's business include broad product diversity across volume, premium, and luxury passenger car segments.

Our financial risk profile assessment reflects our expectations that VW's leverage metrics for 2015 and 2016 will be pressured by the negative impacts of the emissions developments.

As of Sept. 30, 2015, our figure for adjusted debt was €31.5 billion. The main analytical adjustments we make to total reported gross debt of €138.2 billion are: the addition of €21.9 billion for pensions, a €6.7 billion emissions provision charged in the third quarter of 2015, €4.2 billion for operating leases, a €4.0 billion put option in respect of German trucking subsidiary MAN, and €3.7 billion for hybrids. We expect to add a further €2.0 billion to adjusted debt in the fourth quarter of 2015, due to the additional costs announced for the CO2 issue.

We deduct €119.1 billion of captive finance debt and €28.7 billion for surplus cash (after deducting €3.0 billion that we treat as not immediately available). We calculate the captive finance debt amount based on the total of leased assets and finance receivables for the financial services division (about €136 billion), allocated between debt and equity at a ratio of 7 to 1, in accordance with our criteria. On this basis, VW's ratios of FFO to adjusted debt and debt to EBITDA for the 12 months ended Sept. 30, 2015 were 40% and 1.8x respectively.

Our 'BBB+' long-term ratings on VW reflect a combination of a satisfactory business risk profile--an assessment we have revised down one category from strong--and a modest financial risk profile, which is unchanged. This results in an initial analytical assessment (anchor) of VW's creditworthiness of 'bbb+', which we have revised down from 'a'. We continue to regard VW's management and governance and risk management framework as a relative weakness, but, given the lower anchor, we no longer include a one-notch negative adjustment for this factor in arriving at the long-term rating.

We continue to regard VW's captive finance entity VW FS and its subsidiary, VW Bank, as core entities under our criteria, reflecting our view that the parent would support them under any foreseeable circumstances.

The negative outlook indicates the possibility that we may lower the long-term corporate credit rating on VW by one notch within the next one-to-two years.

A downgrade could occur if we expected leverage metrics to remain weakened in 2016 and on a sustainable basis, with adjusted FFO to debt below 45% or adjusted debt to EBITDA above 2x. This could occur it VW incurs substantial fines or litigation damages without taking sufficient offsetting measures, or if operating performance and cash flow generation were more negatively affected by VW's emissions challenges than we expect.

We could revise the outlook back to stable if the negative effects of the emissions challenges were more moderate than expected, and if we expected VW to sustainably demonstrate adjusted FFO to debt above 45% or adjusted debt to EBITDA below 2x.

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