“With three Volkswagen and two Audi dealerships in Las Vegas told to stop the sale order of its four-cylinder diesel vehicles, Volkswagen AG said Tuesday that a scandal over falsified U.S. vehicle emission tests could affect 11 million cars worldwide as investigations of its diesel models multiply.” [LVRJ]
There are some interesting layers to this story. Let’s call layer one the “regulations” layer. We do want to set standards for the emission of nitrous oxide, which accounts for about 5% of greenhouse gas created by human activity. And, the stuff tends to stick around:
“Nitrous oxide molecules stay in the atmosphere for an average of 114 years before being removed by a sink or destroyed through chemical reactions. The impact of 1 pound of N2O on warming the atmosphere is almost 300 times that of 1 pound of carbon dioxide.” [EPA]
Therefore, it sounds like a good idea to set some standards for light duty vehicle emissions. [GPO.gov pdf] Volkswagen, desirous of selling its products – in this case four cylinder diesel powered cars – was subject to those vehicle emission standards, just like other diesel vehicles manufactured by Ford, Mercedes Benz, and BMW. [AutoTrader] So, why would the corporation cheat? One important reason is that the company could not manufacture a car with the three legs of the stool: Performance, Fuel Economy, and Low Pollution – and maintain its profits. [Vox]
As everyone knows by now, the corporation decided to install defeat software which fudged the numbers when the cars were being tested for emissions. In short, they could get the performance levels they wanted, at profitability levels they wanted, and this done by sacrificing the pollution part of the equation. This explains the wide difference between the results of the road tests and the lab tests.
“The Environmental Protection Agency alleges the automaker had designed software to let its diesel cars detect when they were being tested for emissions. The software, known as a “defeat device,” was installed in some 482,000 cars, spanning model years 2009 through 2015, regulators say.” [LVRJ]
Again, as everyone knows by now, this was patently illegal. Patently illegal behavior by a company with sales revenues of $202.46 billion in 2014; gross income of $33.88 billion; and, a net income of $10.85 billion. [MktWtch] Prior to this debacle, VW’s ROE (return on equity) was at 11.84%, Ford reported 14.33%, and BMW’s ROE was 15.61% [YCharts]
Investors like watching the ROE because:
“Return on equity (ROE) measures the rate of return on the money invested by common stock owners and retained by the company thanks to previous profitable years. It demonstrates a company’s ability to generate profits from shareholders’ equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate growth. Return on equity is useful for comparing the profitability of companies within a sector or industry.” [YCharts]
VW’s earnings for 2015 were estimated as about $234 billion. Ford, by contrast, was expected to see about $150 billion for 2015. On June 24, 2015 VW was selling at $218.40/share; things started to go south quickly after VW hit $162.40/share on September 18, 2015, and the stock is reported at $111.50 September 23, 2015. We are now sliding into the second layer of the story. It’s not just that VW stock took a dive after the cheating was reported – nor that the cheating caused investors to sell – it may very well be that the very thing the corporate management feared, which caused the cheating, was the proximate reason for the Big Slide.
The Management Layer. VW’s annual report to investors opens with a general description of board operations, “We also receive a detailed monthly report from the Board of Management on the current business position and the forecast for the current year. Any variance in performance as against the plans and targets previously drawn were explained by the Board of Management in detail, either orally or in writing. We analyzed the reasons for the variances together with the Board of Management so as to enable countermeasures to be derived.” [VW pdf]
What we appear to have at this point is Management Speak for Shareholder Value management. It’s probably safe to assume that the discussions of “current business position” included the old standbys sales, revenues, expenses, liabilities, and analyst expectations. We can base this conjecture on the reference to the “forecast for the current year.” Remove the gilding on “variance,” and “targets,” and we’re most likely talking about share prices predicated on earnings expectations.
So, in order to keep the earnings expectations nice and high, and thereby secure higher share prices – the management decided to roll the dice and hope that no one caught on to the Defeat Device. More simply stated: Shot. Into. Own. Feet.
If there were a better reason to chuck the Share Holder Theory of Management – or at least to modify it such that it doesn’t drive the decision making process into the nearest convenient ditch – this just might be the appropriate occasion.
Note that it is not that Volkswagen wasn’t a profitable company. It had a perfectly acceptable RoE (11.84%) with earnings expected to be in the $230B range for 2015. Nor did the 4 cylinder diesel engine cars constitute a major portion of its sales. While the total number of cars involved isn’t clear yet, VW has shut down sales of the 2015 and 2016 “clean diesel” models, noting that 23% (7,400) of new cars sold in August were diesel. [NYT] Volkswagen Group manufactured some 10.2 million vehicles in 2014. [Stat] The North American production for 2015 was estimated at 0.64 million. [Stat]
It almost defies common sense to perceive how cheating on the emissions testing for a group of products which were not a major part of the American market was really supposed to enhance the bottom line. Unless, we revert to the “every penny counts” mindset in maintaining a certain targeted profit level. Let’s take an educated guess that it was more important for VW management to maintain profit (and thus share value) than it was for them to develop and produce cars with legal levels of emissions, acceptable standards for performance, and reasonable fuel efficiency. They were more interested in making money than in making cars? More interested in short term profits and rolling those dice against long term losses?
It wasn’t that long ago that Volkswagen wanted to be the global leader in unit sales, but as a CNBC commentator put it: “Volkswagen is learning that getting ahead at all costs eventually catches up with you. So much for being the leader on a global basis on auto sales.”
The international layer. Diesel powered cars are much more popular in Europe than in the U.S. Thus, economists are trying to sort out what the impact will be on the Eurozone economy [Express] The company is now facing litigation in Italy over fuel economy related issues. [Telegraph] And, there are reports that the EU is looking at stricter rules to close the gap between laboratory and road test results. [EuObs] Ironically, a company that didn’t want to play by the rules may find itself facing a more rigid regulatory regime in the very part of the planet where it had 25% of the market. As of yesterday, there were calls for greater scrutiny of all automobile manufactures in Europe. [MrktWtch]
Perhaps even more ironically, a company that wanted to increase its value managed to cause a 30 billion Euro drop in market cap in two days. [MrktWtch] The CEO has resigned, the Chancellor of Germany is calling for a prompt investigation, [Telegraph] and the UK is entering the lists for a probe of what went so ridiculously wrong. [Guardian]
What went wrong? What’s been going wrong for a while now – the story sounds entirely too familiar? Financial institutions which sold and then bet on the value of financial products on which they could not place a value (Lehman Brothers et al.) in the U.S. in 2007-2008? Subprime CDOs? Bankers colluded to fiddle with the LIBOR rate? Does it sound like the same motivation as seen in the Worldcom and Enron? It’s founded in the same swamp land all the other egregious examples have inhabited – greed.
Perhaps it’s too easy to forget that money isn’t the root of all evil; it’s the LOVE of money, or that “For the love of money is the root of all evil: which while some coveted after, they have erred from the faith, and pierced themselves through with many sorrows.” [1T 6:10] There will be sorrows aplenty – in the regulation layer, the management layer, and on the international scene. There is a relatively fine line between seeking economic growth and downright avarice, and when it’s crossed the results can be catastrophic. The question becomes: How many more times do we have to see this play before we get the point?