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RPT-Fitch Upgrades Volkswagen to 'A'; Stable Outlook

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May 28 (Reuters) - (The following statement was released by the rating agency)

Fitch Ratings has upgraded Germany-based Volkswagen AG's Long-term Issuer Default Ratings (IDR) and senior unsecured notes to 'A' from 'A-' and Short-term IDR to 'F1' from 'F2'. The Outlook on the Long-term IDR is Stable. Fitch has also upgraded Volkswagen International Finance NV's guaranteed notes to 'A' from 'A-'.

The upgrade reflects the group's resilient performance in a currently highly adverse and competitive automotive environment and comfortable financial headroom in its ratings. Earnings declined slightly in 2013 and are likely to erode further in 2014 but we expect a recovery in 2015 as benefits from the group's new platform increase and the product portfolio strengthens further. In addition, profitability and key financial ratios remain strong for the rating category. The group's business profile is also well in line with the 'A' rating category.

Recent acquisitions have moderately weakened some of Volkswagen's key credit metrics but the financial profile remains strong, including a substantial cash position and conservative financial policy, as well as a significant cash generation ability. We believe that the group's ratings can accommodate some further moderate ad-hoc cash outflows, but our rating case does not include numerous and substantial acquisitions or cash expenses.

KEY RATING DRIVERS

Declining but Resilient Margins

Operating margin declined to 5.9% in 2013 from 6% in 2012 and 7.1% in 2011, excluding the robust double-digit margins from its Chinese joint ventures. However, these margins remain solid considering the adverse environment and significant investments the group has made during the same period. Fitch expects profitability to erode further in 2014 from weak pricing in Europe and weakening sales in other regions, but we expect operating margins to rebound to more than 6.5% by 2016.

Modular Toolkit Strategy

Fitch expects the new modular transverse toolkit (MQB) platform strategy to generate substantial time and cost savings in development, purchases and production. However, it poses the risk of a flaw or quality issue with that platform, which could have major repercussions. In addition, brand management will be key to maintain a clear differentiation between the group's various brands in spite of common parts.

Above-Average Business Profile

Volkswagen's ratings are supported by its unparalleled product portfolio in the auto and heavy-truck segments. They also reflect its broad geographical diversification, leading market shares and an unrivalled potential for cost savings and economies of scale.

M&A Risk

M&A risk remains present given the group's acquisitive strategy and history. The recent acquisition of Scania's minorities for EUR6.7bn has been completed while an offer on MAN's remaining shares is still pending and could cost up to EUR3.5bn. We believe that other acquisitions are probable to support Volkswagen's growth strategy, potentially in the truck sector and to purchase another stake in its JV with FAW in China.

High Cash Outflows

Volkswagen has ambitious investment plans of EUR84bn through to 2018 to support growth. This should materially affect operating margins through increasing depreciation in coming years. However, higher investments should ultimately benefit its product offering and industrial footprint.

Robust Liquidity

The group maintains a solid net cash position, backed by ample liquidity. At end-1Q14, it reported gross cash and equivalents of EUR25.7bn at group level, plus EUR8.6bn of short-term securities (including EUR22.7bn and EUR7bn, respectively, for the industrial business). This is compared with EUR13.6bn of financial debt from the group's industrial activities. Recent market transactions include the hybrid debt issuance of EUR2bn in 2013 and of EUR3bn in 1Q14. We also expect up to EUR2bn of preferred shares to be issued to partly refinance the Scania deal.

Below-Peers Corporate Governance

Fitch considers Volkswagen's corporate governance as weaker than at its main peers, although this does not have a direct and immediate impact on the ratings. Key areas of weakness include a 20% blocking minority in voting resolutions, conflicts of interest between some board members including between Porsche and Volkswagen, and lack of independence and diversity at the supervisory board level.

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) (5.6% and 5.9% at end-2013, respectively; 5.4% and 5.7%, expected at end-2014, respectively)

-Significant deterioration in key credit metrics including adjusted gross leverage above 1.5x (1.3x at end-2013; 1.0x expected at end-2014)

-Cash from operations on debt below 60% (89% at end-2013; 80% expected at end-2014, recovering to more than 100% at end-2015). This could result, in particular, from aggressive M&A or accelerated capex without a parallel improvement in earnings.

An upgrade is unlikely as Volkswagen has already reached a natural ceiling for the industry.