DBRS Downgrades Volkswagen to A (low) from A

Dominion Bond Rating Service (“DBRS”) is today downgrading the Issuer Rating of Volkswagen AG (“VW” or the “Company”); the Senior Unsecured Debt of VW Credit Canada, Inc.; and the Issuer Rating of Volkswagen Canada Inc. from A to A (low) with the trends changed to Stable from Negative. DBRS is also confirming the Commercial Paper rating of VW Credit Canada, Inc. and Volkswagen Canada Inc. at R-1 (low) with the trends remaining Stable.

DBRS put VW’s long-term ratings on a Negative trend on February 18, 2004, to reflect its challenge in recovering from continued losses in market share and earnings (approximately €900 million in 2004) in its North American operations due to an aging product line-up, an unfavourable exchange rate, and competitive market conditions. Additionally, DBRS noted that the Company’s aging product line-up and its lack of new products in key segments impacted negatively on VW’s competitiveness and performance.

Also factored into the Negative trend was the fact that a high proportion of VW’s manufacturing base is located in Germany. The high-cost manufacturing base, combined with the sharp appreciation of the euro against the U.S. dollar since 2002, had sharply eroded the competitiveness of VW’s manufacturing operations as well as the high capital expenditures associated with the new models, resulting in a weakened balance sheet despite favourable internal cash generation.

The downgrade reflects that VW’s resultant weakened credit metrics, due to the deterioration in profitability, are no longer compatible with the Company’s prevailing “A” rating. The rating action also considers that, despite DBRS’s expectations that operating results in North America are expected to improve due to the new models in early 2005, a near-term return to profitability remains uncertain and that China as a significant profit contributor to the Company has stalled.

Market conditions in North America are expected to remain very challenging, characterized by a proliferation of new competing models, increasing use of sales incentives, and the expanded presence of Asian producers. The Stable trend reflects that VW has implemented a number of initiatives and profits have begun to stabilize, primarily due to the introduction of the cost saving measures under the Company’s ForMotion program. In addition, VW’s introduction of new models has addressed DBRS’s prior concern over the uncertainty of the product-led recovery, with the new model introductions gaining traction and market share increases recorded in the western European market through the first half of 2005. VW has announced a further cost savings program for VW automotive – ForMotion Plus – targeting €4 billion net improvement in pre-tax profit in 2008 versus 2004, which is expected to aid in the turnaround in profitability. DBRS expects the new model launches and the cost-saving programs to stabilize the credit profile and, over the longer term, improve operating margins.

Two years of increased spending to support product renewals capex declined in 2004 has provided for a reversal in free cash flow and for limited strengthening in the Company’s liquidity position. (The prior deficit in free cash flow had weakened the balance sheet and all associated coverage ratios.) A strong liquidity position provides VW the financial flexibility to execute its turnaround strategy. Going forward, DBRS expects capex to increase to normalized levels and to limit available free cash flow for debt reduction. The balance sheet is expected to remain stable.

DBRS notes that two potential developments that could provide for further stress to the rating: (1) a further deterioration in profitability and market share in the U.S. despite the new model introductions, and (2) a lack of progress in stabilizing the operating results in China.

Notes: The ratings of Volkswagen Canada Inc. and VW Credit Canada, Inc. are guaranteed by Volkswagen AG.
Issuer ratings apply to all general senior unsecured obligations of the issuer in question.

The full report providing additional analytical detail is available by clicking on the link under Related Research at the right of the screen or by contacting us at info@dbrs.com.

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