Volkswagen’s credit rating has been downgraded by Fitch Ratings to BBB+, from A. Fitch has also given the car maker a negative outlook. The downgrade comes as VW Group struggles under the weight of its diesel emissions crisis and its associated costs.

Fitch said the downgrade “reflects the corporate governance, management and internal control issues highlighted by the ongoing emission test crisis related to up to 11 million diesel-powered vehicles”. Fitch said that the “emergence of a fraud of this magnitude, going either unnoticed or uncorrected by top management for so long is not consistent with a rating in the 'A' category.” Volkswagen's recent admission that it understated carbon dioxide emissions on 800,000 vehicles reinforces this view , it said.

The downgrade also reflects the expected direct and indirect financial effects from this crisis including recall costs, fines, lawsuits and legal claims worldwide as well as lost sales and revenue and “probable discounts on vehicle sales”.

Fitch also said that it is too early to quantify precisely the magnitude and timeframe of the costs of the crisis and its consequences on the group's revenue, income, cash generation and key credit ratios.

It added that the latest findings unveiled by the company's ongoing internal investigation are increasing the damage to Volkswagen's image and reputation and could potentially lead to further legal claims from regulators and customers, further impacting the group's revenue and earnings.

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Fitch Downgrades Volkswagen to 'BBB+'; Outlook Negative

Fitch Ratings-London-09 November 2015: Fitch Ratings has downgraded Volkswagen AG's Long-term Issuer Default Rating (IDR) to 'BBB+' from 'A' and Short-term IDR to 'F2' from 'F1'. The Outlook on the Long-term IDR is Negative. A full list of rating actions is at the end of this commentary. 

The downgrade reflects the corporate governance, management and internal control issues highlighted by the ongoing emission test crisis related to up to 11 million diesel-powered vehicles. Fitch already incorporated the group's relatively weak corporate governance in its ratings but we believe that the emergence of a fraud of this magnitude, going either unnoticed or uncorrected by top management for so long is not consistent with a rating in the 'A' category. Volkswagen's recent admission that it understated carbon dioxide emissions on 800,000 vehicles reinforces this view and highlights the fundamental issue of internal control failure within the group. 

The downgrade also reflects the expected direct and indirect financial effects from this crisis including recall costs, fines, lawsuits and legal claims worldwide as well as lost sales and revenue and probable discounts on vehicle sales. We believe that Volkswagen's credit metrics are solid for the ratings and can absorb several billions euros of extraordinary cash outflow, particularly as we expect fines and legal claims to be spread over a few years. 

However, we expect the final cost to be substantial, although it is too early to quantify precisely the magnitude and timeframe of its consequences on the group's revenue, income, cash generation and key credit ratios. The latest findings unveiled by the company's ongoing internal investigation are increasing the damage to Volkswagen's image and reputation and could potentially lead to further legal claims from regulators and customers, further impacting the group's revenue and earnings. 

We believe that changes at the supervisory and management boards since the start of this crisis have been limited and do not seem to reflect a fundamental determination by the company to overhaul its corporate governance and culture. Furthermore, while the recent disclosure of understated carbon dioxide emissions emphasises the new management's apparent diligence to conduct a thorough investigation of their powertrain and emission issues, it also reiterates the possibility of further problems still to be uncovered as well as the substantial uncertainty about the final overall consequences on the group's business and financial profiles. This is reflected in the Negative Outlook. 

We also expect the reputational damage on the group to affect its funding ability. Refinancing of the group's financial services business could remain more difficult and expensive in the foreseeable future and could hinder both its liquidity and its capacity to offer attractive financing offers to its customers thanks to cheap funding. A potential recapitalisation of the financial services division could also affect the industrial business's credit metrics. 

KEY RATING DRIVERS 
Corporate Governance Below Peers 
The downgrade to 'BBB+' reflects the corporate governance, management and organisational issues highlighted by the ongoing emission test crisis. Fitch considers VW's corporate governance as weaker than that of its main peers. Key areas of weakness include a 20% blocking minority in voting resolutions, potential conflicts of interest on the part of some board members, 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. 

Limited Management Changes 
Martin Winterkorn has resigned from his role as CEO of Volkswagen but he has been replaced by a long-time insider of the group, Matthias Mueller, who was lately CEO of the Porsche brand. Although the latter, together with the management and supervisory boards, has pledged repeatedly to uncover and resolve all irregularities, he will not bring outside views and we also consider that he will face a hard time changing the group's decision-making process and culture. In addition, the inclusion of Porsche vehicles in a new investigation by the US Environmental Protection Agency casts doubts about Mr Muller's independence in reviewing the overall internal investigation results. The supervisory board has also elected Hans Dieter Poetsch, Volkswagen's CFO and member of the board of management since 2003, to act as their Chairman, potentially raising conflict of interest issues and doubts about the group's motivation to fundamentally reform its management culture. 

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 Volkswagen's ambitious investment plans to support growth and increased dividends. The free cash flow (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. We will also review our projections for cash generation in the near future to assess the effect of this crisis on FFO. Nonetheless, we expect capex to be cut to limit the impact on FCF. 

Strong Business Profile 
The ratings reflect the group's unparalleled product portfolio in the auto and heavy-truck segments. They also reflect Volkswagen's broad diversification, leading market shares and an unrivalled potential for cost savings and economies of scale. However, the group's business profile is likely to be damaged by reputation issues stemming from the ongoing emission crisis. 

KEY ASSUMPTIONS: 
-Declining profitability and multi-billion euros cash outflows from lost sales, probable discounts on vehicles, recall costs, fines, lawsuit and legal claims worldwide, and potential R&D increases. 
-Acceleration and intensification of Volkswagen's efficiency programme to try and mitigate the impact of this crisis. 

RATING SENSITIVITIES 
Negative: Future developments that could lead to negative rating action include: 
-Further material reputational damage to the group and its brands. 
-Further substantial negative findings as a result of ongoing investigations. 
-Operating margins remaining below 3% (for industrial operations) and 4% (at group level). 
-Significant deterioration in key credit metrics, including FFO adjusted gross and net leverage above 2x and 1.5x, respectively, and cash from operations on adjusted debt below 50%. 

Positive: Future developments that could lead to positive rating action include: 
-Ability to absorb upcoming cash outflows from the emission test crisis without triggering Fitch's negative rating sensitivities. 
-Tighter corporate governance practices. 
-Evidence that core brands have not been impaired by the emission test crisis. 

LIQUIDITY 
The group maintains a solid net cash position, backed by ample liquidity although persistent difficulty in accessing capital markets to refinance could hinder the group's liquidity profile. 

Gross cash and equivalents and marketable securities for the industrial business were EUR20.6bn at end-2014 after adjustments for restricted and semi-liquid cash and securities. In addition, the group issued EUR2bn of preferred shares in 2014 to refinance the purchase of Scania shares and also issued hybrid notes of EUR2bn in 2013, EUR3bn in 2014 and EUR2.5bn in 1Q15. 

FULL LIST OF RATING ACTIONS 
Volkswagen 
- Long-term IDR downgraded to 'BBB+' from 'A'; Outlook Negative 
- Senior unsecured notes downgraded to 'BBB+' from 'A' 
- Short-term IDR downgraded to 'F2' from 'F1' 

Volkswagen International Finance NV 
-senior unsecured notes downgraded to to 'BBB+' from 'A' 
- subordinated notes downgraded to 'BBB-' from 'BBB+' 

Original source: Fitch Ratings