Europe's Auto Makers: An S&P Scorecard.

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S&P RATINGS NEWS

Premium manufacturers should be able to hang onto their margins while volume producers scramble to stave off fierce competition

European auto manufacturers face an uphill chug for profits through 2006. Stalling new car registrations in most national markets and encroaching Asian competitors are intensifying the fierce competition for market share. Continuing high raw material prices will increase profit pressures, and the relative weakness of the U.S. dollar against the euro will have a negative impact on some manufacturers exporting to the U.S.

New model launches, which can stimulate a manufacturer's sales volumes, will not feature highly in 2006, so auto makers will rely on facelifts and derivatives of existing models to win consumer favor.

Although high gasoline prices have so far not influenced European consumers' auto-buying choices, as they have in the U.S., customer preferences for environmentally friendlier and fuel-saving options are forcing auto makers to spend on researching alternative technologies.

EFFICIENCY VS. VOLUME. Standard & Poor's Ratings Services expects these tough industry conditions to widen the performance gap between broadline and premium auto manufacturers that has started to emerge in recent years.

Players in the premium segment, despite seeing a certain softening of demand and pressure from competitors' attempts to enter this market segment, should remain relatively protected and be able to maintain their above-industry-average margins.

The profitability of volume manufacturers, on the other hand, is increasingly coming under pressure despite continuous introduction of new models. Enhancing operating efficiency and improving cost structures has become a common theme for all manufacturers. For example, the operating margins of Renault, Peugeot, and Fiat converged at a low range between about 2% and 3% during 2005.

PUEGEOT'S SHIFT. Nevertheless, the ratings on European auto manufacturers in the past five years have generally held up well to industry pressures. In April, 2005, the long-term corporate credit rating on Renault was raised by one notch, reflecting improvements in financial measures that bucked the industry trend. In August, 2005, the outlook on Fiat was revised to stable from negative, reflecting improvements in its financial flexibility.

However, the outlook on Peugeot was revised to stable from positive in July, 2005, reflecting the deterioration of the group's operating margin as a result of tough trading conditions in Europe. In addition, in 2005, a long-term corporate credit rating of A+ was published on premium manufacturer BMW.

Where do the rating outlooks for individual auto makers stand? Here's our list, as of Feb. 21:

BMW Rating: A+; Outlook: Stable

Although the automotive industry will remain challenging, we expect BMW to be able to sustain above-average margins and benefit from its premium positioning, despite increasing competitive pressure and a certain softening of demand in the premium segment. To maintain the current ratings, the group is expected to keep its conservative financial policy, robust cash flow generation, and strong financial flexibility.

The potential for a ratings upgrade is limited by the group's niche positioning and competitive pressure in the automotive industry. On the other hand, downward pressure on the rating could result from a significant deterioration of the group's financial figures, owing, for example, to a large acquisition.

DaimlerChrysler Rating: BBB; Outlook: Stable

We expect DaimlerChrysler (DCX) to maintain satisfactory profitability and cash flow on a consolidated level in 2005 and beyond, which, in combination with its moderate financial leverage, mitigates downside risk on the rating. To achieve a higher rating, we expect the low profitability and quality issues [leading to product recalls in some cases] at Mercedes Car Group to be addressed successfully and sustainably, Financial Services to maintain its stable performance, and Commercial Vehicles to continue to perform in line with the global truck industry cycle.

We view Chrysler's position as challenging in the long run, but do not consider it a significant credit risk in the near term. On the other hand, the rating could come under pressure if there were setbacks in Mercedes Car Group's route to recovery, or if Chrysler's profitability deteriorated.

Fiat SpA Rating: BBâˆ'; Outlook, Stable

The group's three main business units are expected to disclose an enhanced trading profit in 2006. Fiat Auto figures it should turn black, and the introduction of new models is expected to halt the group's commercial decline. In particular, the new B-segment Punto, launched in October, 2005, could be the large-volume model that the group has been lacking for the past several years by exceeding the group's sales target of 350,000 in 2006. The Punto's performance will be critical for the group.

We remain concerned about Fiat Auto's competitiveness given the challenging market trends prevailing in Europe and the relative strength of the division's main rivals. Fiat's agricultural and construction equipment brand CNH and its truck brand Iveco are expected to show solid performance again in 2006 through continuing pricing improvement.

Peugeot S.A. Rating: Aâˆ'; Outlook, Stable

Amid ongoing challenging conditions in the automotive market, the operating margin of the group's automotive division is likely to remain constrained by raw-material price hikes, soft demand, and stiff competition in Western Europe. The company is, however, poised to benefit from its rejuvenated and diversified product range which, combined with steady improvements in operating efficiency, should compensate for tough trading conditions.

We also expect an improvement in working capital in 2006 and a related increase of the net cash balance at the industrial level, which at year-end 2005 reached its lowest point since 2001. Should Peugeot's operating margins and market shares erode further in 2006, the outlook could be revised to negative.

Renault S.A. Rating, BBB+; Outlook, Stable

We expect tough pricing conditions in Western Europe and additional rises in raw material prices in 2006 to continue to weigh on Renault's operating margin. Nevertheless, we expect the group to continue to generate free cash flow and to improve its net debt position at the industrial level at year-end 2006.

Cash flow generation will be supported by the group's solid product range, continued cost cutting, and increased dividends paid by 44.4%-owned Nissan Motor Co. [BBB+], which are likely to be a substantial source of cash for Renault in the coming years.

The group's limited product diversity and worsening market conditions in Western Europe currently prevent any rating upside, even if Renault's financial profile were to improve further. As long as the group generates a decent level of free cash flows, downward pressure on the ratings remains unlikely. However, the group's sales contraction in Western Europe and its dependence on the Mgane model family -- which accounts for a substantial portion of profits and now suffers from competition from more recent models -- are a source of concern.

The group's recently unveiled ambitious strategy relies primarily on launching a series of new models. Although this could alleviate dependence on Renault's two model families, it might also entail increased development costs and will expose the company to the risk of limited commercial success of some new models, particularly in the premium segment, where Renault lacks a successful track record.

Volkswagen AG Rating: Aâˆ'; Outlook, Negative

In line with our expectations, VW showed a certain improvement in operating profits in its automotive operations in 2005 as a result of revenue and profitability enhancement and cost-saving programs. In view of the group's difficult competitive situation in North America, and the increasing competitive pressures in Europe and China, we believe that profitability will remain modest in the medium term. We expect automotive net liquidity to continue to improve, and operating cash flows to exceed investments in the automotive division.