OREANDA-NEWS. Fitch Ratings has placed Volkswagen AG's (VW) ratings, including its 'A' Long-term Issuer Default Rating (IDR), on Rating Watch Negative. A full rating list follows at the end of this commentary.

The rating action reflects the reputational damage on the group's brands following alleged manipulation of emission tests in the US and the expected multi-billion euros financial impact from potential fines, recall costs, lawsuits and legal claims. This crisis is also another illustration of our assessment of the company's fairly weak corporate governance compared with its peers.

Fitch expects to resolve the Negative Watch when more clarity emerges about the magnitude and timeframe of the cash outflows and when we have more visibility about the impact of this crisis on regulators and consumers worldwide.

We believe that VW's credit metrics are solid for the ratings and that the group could absorb several billions euros of extraordinary cash outflow without jeopardising its credit profile. However, we expect VW's brand image and reputation with regulators and consumers worldwide to be seriously undermined by this crisis although the magnitude and length of the operational and financial effect is difficult to assess. In particular, the extent of the contagion of the crisis in the US on customers in other markets is unclear and therefore it is difficult to quantify the potential loss on revenue and profitability over the next two to three years.

In addition, we expect the fine announced by the US Environmental Protection Agency (EPA) in violation of the Clean Air Act to be followed by class actions typical of such situations in the US as well as several other litigations. While we do not expect the EPA fine to amount to the maximum amount of about USD18bn reported in the press, we expect total cash outflows to be several billions euros over the next two years.

The group has announced that it will set aside a provision of EUR6.5bn in 3Q15 to cover the costs related to this issue, including efforts to win back the trust of its customers. This amount could be revalued as the investigations continue.

However, the group's financial structure is sound and its free cash flow (FCF) generation extremely robust. We expect VW to generate about EUR3.5bn in FCF in 2015 after EUR2.3bn of dividends, and about EUR5bn a year after dividends in 2016 and 2017, excluding any impact from the current crisis. The group should also receive EUR5bn-EUR5.5bn from the sale of its stakes in Lease Plan and Suzuki. We also believe VW could reduce capex in the foreseeable future to bolster FCF.

In addition, the US represent only approximately 6% of total group sales and the group's market share in the US is small compared with that in Europe (just more than 3% compared with more than 25%, respectively). Therefore, a limited contagion from the US to other regions should curb the effect on VW's business and financial profile and could lead to an affirmation of the ratings.

KEY RATING DRIVERS
Reputational Damage
The RWN reflects the reputational damage on the group's brands following alleged manipulation of emission tests in the US and the expected multi-billion euros financial impact from potential fines, recall costs, lawsuits and legal claims.

Strong Business Profile
The ratings reflect the group's unparalleled product portfolio in the auto and heavy-truck segments. They also reflect VW's broad diversification, leading market shares and an unrivalled potential for cost savings and economies of scale.

Corporate Governance Below Peers
Fitch considers VW's corporate governance as weaker than that of its main peers. Key areas of weakness include the 20% blocking minority in voting resolutions, conflicts of interest on the part of some board members including between Porsche and Volkswagen, and lack of independence and diversity at the supervisory board level. The latest emission test crisis is another illustration of inconsistent management control in some areas.

Likely Hit on Profitability
The group's operating margin increased to 6.3% in 2014 from 5.9% in 2013, excluding the robust double-digit margins from its Chinese joint ventures. However, Fitch expects profitability to be hit by the emission test crisis. Fitch previously expected operating margins to rebound to approximately 6.5% in 2016 but we will reassess our assumptions as events unfold.

FCF to Suffer
Solid funds from operations (FFO) are absorbed by VW's ambitious investment plans of EUR86bn through to 2019 to support growth and by increasing dividends. The FCF margin was 2% in 2014 and we project it to remain between 1.5% and 2.5% in the foreseeable future, excluding any impact from the current crisis.

Receding Acquisition Risk
We believe that the recent resignation of the group's long-time chairman Ferdinand Piech will reduce the risk of additional large M&A in the short- to medium-term as Mr Piech has historically pursued an acquisitive strategy. However, we do not expect fundamental changes to the group's strategy.

RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
-Operating margins remaining below 3% (for industrial operations) and 4% (at group level).
Operating margin for industrial - 2014: 6.1%, 2015E: 5.8%, 2016E: 6.3%; operating margin for group 2014: 6.3%, 2015E: 6%, 2016E: 6.5%).
-Significant deterioration in key credit metrics including FFO adjusted gross and net leverage above 1.5x and 1x, respectively (gross 2014: 1.2x, 2015E: 1.0x, 2016E: 0.9x; net 2014: 0.1x, 2015E: 0x, 2016E: -0.1x).
-Cash from operations on debt below 60% (2014: 100%, 2015E: 93%, 2016E: 108%). This could result, in particular, from aggressive M&A or accelerated capex without a parallel improvement in earnings.
-Further evidence of corporate governance weaknesses.

Positive: Future developments that could lead to an affirmation of the ratings include:
-Ability to absorb upcoming cash outflows from the emission test crisis without triggering Fitch's negative rating sensitivities.
]
LIQUIDITY AND DEBT STRUCTURE
The group maintains a solid net cash position, backed by ample liquidity. Gross cash and equivalents and marketable securities for the industrial business were EUR20.6bn at end-2014 after adjustments for restricted and not fully liquid cash and securities. In addition, the group issued EUR2bn of preferred shares in 2014 to refinance the purchase of Scania shares and hybrid notes of EUR2bn in 2013, EUR3bn in 2014 and EUR2.5bn in 1Q15.

Fitch has placed the following ratings on Rating Watch Negative:

VW
- Long-term IDR 'A'
- Senior unsecured notes of 'A'
- Short-term IDR of 'F1'

Volkswagen International Finance NV
-senior unsecured notes of 'A'
- subordinated notes of 'BBB+'