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Friday, October 2, 2015

Don’t be caught unprepared by an Extreme Risk Event, like VW Group. Learn how to survive if a unique risk strikes.

Perhaps the Board and Senior Executives of VW Group did not know about the fraudulent use of emission suppressing software. Reports of this nefarious scheme may well have been censored or simply left languishing in an inbox. In a bureaucratic organisation it is common for middle managers to avoid being the messenger bearing bad news.

However it seems reasonable to surmise that the leadership at VW Group did not create a culture with a higher purpose; such as to produce safe, economical, environmentally friendly vehicles at reasonable prices. Instead the purpose and culture instilled seems to have been to make as much money as possible and beat the competition at any cost; even though the website goal statement claims otherwise.

Therefore the leadership definitely bears responsibility for this calamity; the German saying ‘a fish smells from the head down’ comes to mind.

The CEO is said to have done the ‘right thing’ by resigning but what he has really done is strapped on his Golden Parachute and walked off the stage to enjoy a comfortable retirement, leaving others to clean up the mess.

This situation could well result in thousands of hard working honest VW employees losing their jobs and pensions. The Group reported Provisions for Pensions of €29.8 billion on its December 2014 Balance Sheet. It is troubling to note that this Provision does not appear to be matched by ring-fenced assets of the same value. The grim financial prospects of the Group in the light of the current crises are covered more fully later in this article.

The Board and Senior Executives should have realised that an extreme risk event could strike the business at any time. That is assuming that they had read or heard of The Black Swan by N N Taleb. If in fact they were aware of the chameleon in the room that could destroy the business – in the form of an unimaginable risk with devastating potential – they did not prepare to deal with such an event.

Perhaps they thought that since they could not imagine what may happen to overwhelm VW Group they should simply wait for the crises to break and then thrash around, blame each other and fire people, apologise, ‘re-arrange the deckchairs on the Titanic’ and put aside a hopelessly inadequate €6.5 billion.

Unimaginable Risk Drivers must not be overlooked simply because they cannot be imagined, described or counted. They will occur in the future and they are the risks most likely to destroy real businesses.

It is estimated that VW’s fines in the USA alone could amount to €18 billion if imposed in full. On top of fines in the USA will be the cost of reengineering non-conforming vehicles and the cost of settling compensation claims, with attendant legal costs. These costs will be multiplied by the number of other jurisdictions that take action; it is reported that Germany, France, India, Australia, Norway, South Korea, Switzerland and Canada have initiated investigations that could lead to prosecutions.

It is possible that VW will find the €6.5bn in cash ‘set aside’ woefully inadequate. Note in that respect that it closed the 2014 financial year with €18.6bn in cash plus €11.2bn in Marketable Securities and Time Deposits, having generated €10.8bn in Cash Flows from Operating Activities in 2014.

Commentators such as the Financial Times speculate that VW will have to find a great deal more cash than it had or has on hand; even if it has generated as much Cash Flow from Operations this year, as it did last year.

In The Chameleon in the Room – Chapter Two – I suggest that the leaders of every real business, from the smallest to the largest, should regularly anticipate the potential maximum future loss that could result from occurrence of an extreme risk event. They should jointly consider this number regularly and discuss possible defensive measures that could be taken in order to protect the capital and ongoing-concern status of the business.

The aim of such preparation would be to arm executives with an array of possible action steps that could be tailored to any situation that may arise. This would enable the leadership team to react immediately and effectively in any extreme situation to protect jobs and investors.

In the book I describe how Corporate Probable Maximum Loss (CPML) should be calculated in order to provide focus for a discussion as to steps to take in a future crises arising from an unimaginable cause.

In order to illustrate how the CPML should be calculated and used, I go on to work through an example based on the 2013 annual report of VW Group. The detailed work of this example can be studied in the book; of course at the time of writing The Chameleon in the Room there was no indication that VW would in fact face a crisis; this is a rare case when there was ‘such a thing as a coincidence’.

I have examined the 2014 annual report of VW Group and comment as follows on its financial prospects in light of the company-specific Black Swan Event that has occurred:

• Volkswagen AG Credit Ratings will determine its cost of borrowing and the availability of any short term and/or long term loans it may need to borrow in order to meet demands to pay fines, compensation and the cost of reengineering vehicles.

• Currently its credit ratings are listed as: Standard & Poor’s: Short Term: A-1, Long term: A, Outlook: Stable and Moody’s: Short term: Prime-1, Long term: A2, Outlook: Negative

• If VW’s credit ratings are downgraded its cost of debt will rise and obtaining funds via borrowing will become more difficult.

• Volkswagen AG’s share or stock price dropped from 213.45 on July 2nd to 96.50 on October 1, 2015.

• The drop in value of VW’s shares indicates that raising cash by issuing fresh stock is unlikely to be a popular option.

• The Financial Times article of September 30, 2015 titled Seven Reasons Volkswagen is worse than Enron goes further stating: “The stock collapse is only the beginning. Potentially irreparable reputational damage, a crisis of confidence and massive legal liabilities could do the company in.”

• VW’s assets as at December 31, 2014 included Intangible Assets of €59.9bn, which represented 27% of Noncurrent Assets and 17% of Total Assets. Intangible Assets in turn included €23.6bn in Goodwill, which is 39% of the Intangible total.

• Allocation of Goodwill by operating segment is stated as; Porsche €18.8bn, Scania Vehicles €2.9bn and others €1.9bn

• Arguably the serious nature of the transgression admitted by VW, which also touches its other brands, will have seriously diminished the value of this Goodwill. Although the Porsche Brand does not appear to have been involved in the wrongdoing so may hold its value.

• It is usual for conglomerates such as VW that face an urgent need for cash to sell assets. The sale or spin-off of Porsche may be a survival tactic to be employed.

• Current and Noncurrent Financial Liabilities that include Bonds, Commercial paper and notes, and Liabilities to banks amounted to €44.4bn at the end of 2014, which was 20% of Noncurrent Assets and 28% of Noncurrent Assets excluding Goodwill.

• Financial Liabilities of this kind may well be contracted on the basis that a Material Adverse Change in the circumstances of the Debtor (VW) would provide the creditor (bank, investor or bond-holder) grounds to demand immediate repayment or provision of collateral to secure repayment of the debt. Similarly VW may be party to margining agreements that would require increased cash collateral to be provided if its credit rating were to be downgraded.

According to its website Volkswagen Group;

“Operates 119 production plants in 20 European countries and a further 11 countries in the Americas, Asia and Africa. Every weekday, 592,586 employees worldwide produce nearly 41,000 vehicles, and work in vehicle-related services or other fields of business. The Volkswagen Group sells its vehicles in 153 countries.”

The Financial Times article referenced above comments that “Volkswagen’s (fraud) has endangered the health of millions. The high levels of nitrogen oxides and fine particulates that the cars’ on-board software hid from regulators are hazardous and detrimental to health, particularly of children and those suffering from respiratory disease.”

This fraud, which is fundamentally due to poor leadership, has also put at risk tens of thousands of jobs.