Why is Abu Dhabi buying into Volkswagen?

Where do automakers turn when they are in serious trouble? To governments, preferably their own.

That's what Chrysler did in the 1980s, when it successfully sought help from the US government. That's what Daimler Motors did, too, when it needed a major infusion of cash - although the state investor was Kuwait, rather than Germany. Now, it's the turn of another German carmaker to look to a Gulf state for an urgently needed capital infusion.

Volkswagen - which has recently seen both profits and its share price fall - has struck a deal with Abu Dhabi and Saudi Arabia's Olayan Group, which have agreed to pump in over $2 billion in a deal that involves the acquisition of FleetPlan, a leading fleet management company in Europe and Asia.

The timing of the deal could not have been better for VW. Despite sales of over 5 million vehicles, worth $105 billion, in 2003, the company is widely viewed as underperforming and proven perhaps vulnerable to a hostile takeover, which is why the $2 billion deal with Abu Dhabi is being met with great relief in Lower Saxony, where VW is headquartered.

Lower Saxony is currently the single largest shareholder in VW, and used its controlling stake to fend off takeover candidates. Germany's VW Act stipulates that no single shareholder is permitted to hold more than 20 percent of the voting rights in the group.

This shield has been the subject of controversy between the German government and the European Commission, which has been asking the government to disband its illegal protection of VW.

The European Commission believes this act impairs the free movement of capital and is now trying to launch legal proceedings. Lower Saxony fears that VW could become a potential takeover candidate if the act is overturned, endangering important manufacturing jobs.

'This is why efforts are being directed towards obtaining a stable capital structure and why Abu Dhabi is therefore a welcome investor,' explains Frederik Westin, an analyst at WestLB, a leading investment bank.

Together Abu Dhabi and Lower Saxony would have about 30 percent of the votes, constituting a blocking minority. The cash-rich emirate could also help finance future VW investments.

'Abu Dhabi would constitute a reliable and long-term-oriented investor who is familiar with and shares the stated goals of the Volkswagen Group, and who, we believe, would also be a stable partner,' argues Bernd Pischetsrieder, chairman of VW's management board.

Through this deal, Volkswagen is now taking the same road as American rivals General Motors and Ford, which have been turning to their financial divisions - including car loans, leasing and insurance - when sales have stagnated.

For VW, too, the financial division is the profit center, at least for now. Operating profits rose by 24 percent in 2003, to 894 million euros, while manufacturing profits were just 886 million euros, down from nearly 4 billion euros a year earlier.

It appears, then, that Volkswagen has killed two birds with one stone. Not only has the company managed to significantly expand its presence in the leasing business, but it has also found an outside investor to pay for the deal.

The acquisition of LeasePlan, Europe's largest fleet management business, has long been a strategic necessity, but VW did not have enough funds in its coffers to pay for the purchase. Neither could it have raised the money in the markets without seriously undermining its credit rating.

Since LeasePlan held 10 percent of VW's stock, the carmaker could offer this 10 percent to the investor without undergoing any major change in its shareholding structure. If VW had tried to offload the 10 percent equity in the market, it would have sent the stock price crashing, hurting the company and its shareholders. The only way for VW to have purchased LeasePlan was by tying up with an investor.

Financial analysts are nearly unanimous in their support for the VW move. 'Strategically, this was not a must-have, but it makes more sense than buying another carmaker,' says HypoVereinsbank analyst Albrecht Denninghoff. 'Loyalty in the leasing businesses is quite high, and this purchase will give Volkswagen the chance to win more customers.'

Another analyst, Patrick Juchemich of Sal. Oppenheim Jr. & Cie, a private bank, said that he expected Volkswagen's financial services unit to report higher profits as a result of the deal with Abu Dhabi. 'Customers who lease cars tend to replace cars more often than buyers, and they go for more expensive models,' he said.

'LeasePlan fits the strategic orientation of the VW Group very well, and VW will therefore be able to extend its strategic position in the value-added chain as planned,' says Westin of WestLB. ÒThis takeover can certainly be regarded as a sensible move. But while bringing a financial investor onboard was an obvious solution, that does not solve the problems the company is facing in its automotive business.'

According to Frank Gaube, the financial spokesman for Volkswagen in Wolfsburg, the deal with Abu Dhabi 'will help in different ways. First and most important, VW's goal is to move from being just a carmaker to a mobility provider. We want to be positioned along the whole value chain: over 60 percent of revenue comes after the car is built and sold.

'So we want to participate in that. Fleet management is a growing business and has attractive margins. We want to balance the income from automotive and financial services. Finally, as we already have a business in this sector, LeasePlan now takes our network from five to 26 countries.'

The extra earnings from the financial services division will be desperately needed if Volkswagen is to fulfill its forecast of exceeding last year's profits. Analysts say that short- term improvement is not on the horizon yet and that operating profits for the first half 'would be miserable,' in the words of one analyst, even compared to the previous year.

Although group deliveries rose by 11 percent to 514,000 units in March 2004, deliveries in the first two months of the year were down by six percent.

Westin says the group's automotive business is fighting a volumes and profitability problem. The company's much hyped 'For-Motion' program is intended to be one solution. 'The company's objective is to save 2.2 billion euros in costs, but it is questionable whether this figure will be sufficient for a sustained improvement in profitability.'

Indeed, analysts say that Volkswagen has a competitive product portfolio in Europe, but its cost base is too large. Another problem is that the brand positioning within the group is leading to significant cannibalization, hurting the company even more. Over the last year, VW has seen its Golf replaced by Peugeot's 307 as the bestselling car in the European market.

When the German carmaker finally reacted to this slide, launching a new Golf, its pricing strategy backfired. Although the Golf has always attracted a premium over other brands, analysts believe that the group pitched the new Golf's pricing too high Ð costing it customers in the lower price segment.

'It is a far better car than the last Golf,' argues VW's Gaube. 'It is better in various ways. There is no price problem. Even at the entry level, the new version of the Golf is picking up.' Outside Europe, the deal with Abu Dhabi has special significance for VW's plans for the Middle East.

The company currently generates less than one percent of its sales in the Middle East region, putting it way behind other major carmakers. The company says that this was not part of any strategic plan, and that its resources were simply stretched too thin to cover this market.

'We have been focusing on China in a major way, and we could not have been present in all the markets around the world at the same time,' explains Gaube. 'There are Johnnies come lately in various markets. In the Middle East, unfortunately, VW is one of them.'

Despite owning top brands in the luxury segment, such as Bentley, VW has failed to tap the immense potential of the Middle East market, which generates about 10 percent of global sales in this high-profit segment.

'Until 2000, there were never enough shipments marked for the region - for VW, it was too insignificant to invest in. Things have not improved greatly since then,' says a local car dealer in Dubai. 'Volkswagen is a bit player in the Middle East automobile landscape: you can easily contrast this with the kind of clout that rival brands like Mercedes and BMW have here.'

Volkswagen's Gaube, though, insists that all this is now set to change. 'The Middle East is becoming much more important for us than ever before, and this deal will give us a foothold in the region. First, we will have the chance to offer financial services in the area and, second, with new partners, we will have a chance to access large markets in the region.'

The memorandum of understanding signed in April by Abu Dhabi and VW states that LeasePlan and Volkswagen Financial Services will set up a subsidiary in Abu Dhabi, and then spread the services across the entire region. Another important aspect of the memorandum is that VW has agreed to conduct a feasibility study on assembling trucks in the region.

The facility, which could be located in Abu Dhabi, will be the first such VW plant in the Middle East. VW has also agreed to conduct another feasibility study to see whether the region's suppliers could set up facilities to supply VW with various automobile parts made from polymers, rubber and aluminum.

With these initiatives, VW's presence in the region - and the region's importance to the company - will definitely undergo a sea change. Indeed, the presence of a silent but powerful shareholder like Abu Dhabi will ensure that Volkswagen's regional future is bright.

For now, though, the company's worldwide outlook remains less certain. And while VW appears prepared to sell a 10 per cent stake to Abu Dhabi, no deal is likely to take place before September. For both sides, it promises to be a long, hot summer.