FOR REG AC CERTIFICATION, SEE PAGE 18. FOR OTHER IMPORTANT DISCLOSURES, SEE PAGE 21, GO TO http://www.gs/research/hedge.html, OR CONTACT YOUR INVESTMENT REPRESENTATIVE. China profit analysis November 6, 2003 Stock rating: In-Line Coverage view: Neutral Large-Cap Growth Price: EUR44.45 Volkswagen (VOWG.F) Germany: Automobiles Weaker Chinese margins a risk for ’04 earnings. China is likely to contribute 70%-80% of VW’s EPS this year, but 3Q results show worrying signs of falling earnings in this market. If Chinese profits decline in 2004, the impact could offset some of the gains expected from the new Golf/other models in Europe. IL/N. Stock dataPrice performance 1M3M12M Price performance chart 52-week range EUR46.30-28.65Absolute10%17%11% Yield 2.9%Rel to FTSE Europe7%10%5% FTSE Europe 260 CapitalisationForecasts/valuation 12/2003E12/2004E Market cap EUR17,384 mnEPSEUR2.90EUR3.90 Latest net debt/(cash) EUR7,826 mnP/E15.3x11.4x Free float 80%EV/EBITDA5.0x4.0x Derivatives – Shares outstanding 425.5 mn DJFMAMJJASON28 30 32 34 36 38 40 42 44 46 -0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10 Absolute Price Performance (Left Axis)Relative to Index (Right Axis) This report is based on our morning note of November 4, 2003. Keith Hayes keith.hayes@gs London: 44-20-7774-1142 Max Warburton max.warburton@gs London: 44-20-7774-5905 Manning Doherty manning.doherty@gs Hong Kong: 852-2978-1024 Shane McKenna shane.mckenna@gs London: 44-20-7552-2919 Avaneesh Acquilla avaneesh.acquilla@gs London: 44-20-7552-9372 Goldman Sachs Global Equity Research Chinese profits are the main driver of 2003 earnings VW's strong exposure to the Chinese auto market is often cited as a positive for the stock. China will likely be the key driver of earnings in 2003, contributing c.70%-80% of reported EPS thanks to equity income from the JVs and operating profits from selling parts. One quarter does not make a trend, but 3Q results show worrying signs We see worrying signs in VW's 3Q results that Chinese profits may already be slipping. Pro- forma EBIT from the Chinese JVs fell 35% yoy, despite much higher volumes, suggesting much lower margins. Profits from selling parts to the Chinese JVs also appeared to fall. We also see some evidence that inventories of Polo, Gol and Audi A6 are rising in China. A weak Chinese result in 2004 could reduce EPS by EUR1.00 or more We estimate that China will contribute over EUR2.00 of EPS in 2003, and our current 2004E forecast assumes EUR2.50 of EPS derives from China. But if Chinese profits in 2004 run at 3Q’s weak level, the Chinese contribution could easily fall to only EUR1.60 next year. Gains from Golf and Germany may not be enough for VW to hit consensus 2004 is likely to see VW’s US profitability fall further, probably into loss. If China also declines, it places even more pressure on Europe to deliver an improvement. Our estimates already assume that the new Golf and other models can deliver a EUR500 mn+ improvement in EBIT in Europe, yet we expect EPS of only EUR3.90. Consensus is still between EUR4.50 and EUR5.00 for 2004. We are concerned that expectations for an earnings improvement at VW remain too optimistic. Volkswagen Automobiles Goldman Sachs Global Equity Research - November 6, 2003 Table of contents 1 Overview: Weaker Chinese margins a risk for 2004 earnings 3 Chinese profitability under pressure as pricing falls 7 A weaker China result could prevent 2004 earnings growth 10 Cost base may be ‘sticky’ and difficult to cut fast enough 12 Some indications of inventory build in China 14 Financials: 2004 consensus estimates may be too high 19 Disclosures The prices in this report are based on the market close of November 5, 2003. Automobiles Volkswagen Goldman Sachs Global Equity Research - November 6, 2003 1 Overview: Weaker Chinese margins a risk for 2004 earnings Exhibit 1: Forecasts and valuation Year to RevenuesEBITDAPre-tax profitEPSEV/EBITDAP/E December (EUR mn)(EUR mn)(EUR mn)(EUR)(x)(x) 2001 88,5408,0204,4097.662.76.2 2002 86,9487,1593,9866.723.47.0 2003E 85,9505,0501,9132.905.015.3 2004E 87,9486,3002,5133.904.011.4 Source: Company data, Goldman Sachs Research estimates. VW enjoys market leadership in China VW has enjoyed first mover advantage in China. Its early investments and decision to persevere through difficult times in the 1980s and 1990s have been rewarded with leadership in the world’s fastest growing and most coveted market. While other OEMs are still formulating China strategies, VW is already well underway to selling almost 1 mn units a year, at very satisfactory margins. VW is more reliant on China profits than previously realised The high level of profitability enjoyed so far in China has been driven by high, tariff- protected prices, rather than low costs. A booming market has played into VW’s hands as its market share strength, installed capacity and more advanced distribution have allowed it to supply soaring demand. Higher sales have not been matched as closely as hoped by rising profits (Chinese EBIT in 2002 was little higher than in 2001, despite volumes up over 40%), but the level of earnings has still risen and US profits have fallen to a level that has made China a key contributor to the Group’s bottom line. We believe the importance of Chinese profitability to VW remains poorly recognised. As US and UK profits collapsed with the move in the euro, and European margins fell further as pricing weakened for VW, China has been left standing as the only real remaining profit centre (other than spare parts in Europe). We estimate China contributed over 70% of 1H earnings at VW and could contribute c.70%-80% of full year EPS. Chinese earnings derive from two sources VW reports profits from China in two areas. Neither are that transparent, but together we estimate they contributed up to EUR542 mn of net earnings in the first nine months of 2003, out of a total of EUR813 mn of net earnings for the Group. These two sources are: · Equity income from the Chinese JVs. VW has joint ventures with SAIC (50% stake) and FAW (40% stake). Both are profitable and VW books its share of profits as equity income. VW only publishes quarterly proportional EBIT for the JVs, but this figure correlates closely to equity income. · Operating profits from selling parts to China. VW also sells parts to its Chinese JV partners to use in the assembly of new cars. These are included in the Asia-Pacific region EBIT, but are not split out. VW indicated that such profits amounted to EUR300 mn in full year 2002 out of EUR460 mn for the region as a whole. Volkswagen Automobiles 2 Goldman Sachs Global Equity Research - November 6, 2003 3Q result suggests Chinese profits could be under pressure We caution that it is possible there could have been some special factors at work in the 3Q Chinese result, and currency has also had a negative impact year on year (although not quarter on quarter). But we are concerned that 3Q may indicate a genuine downward trend for Chinese margins. It appears to us that the stated figures for both Chinese equity income and profits from selling parts to the JVs fell significantly in 3Q, raising concerns about the ongoing level of VW’s Chinese profitability. · Margins in the Asia Pacific region fell from 13.6% in 3Q2002 and 8.9% in 1H to 6.0% in 3Q2003. We assume that most of this is due to lower parts prices paid by the Chinese JVs, rather than falling profits from selling cars in Australia and other countries in this region. · Proportional EBIT in the J