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Friday Five: Sizing Up Volkswagen's 'Diesel-Gate' Damage

We dropped our value estimate in the wake of the automaker's emissions scandal. Plus, Caterpillar and ConAgra under pressure, and more.

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Jason Stipp: I'm Jason Stipp for Morningstar. Welcome to The Friday Five, Morningstar's take on five stories in the market this week. Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: Up first this week, Jeremy, Volkswagen was in the news because of some issues with software they had that was deceiving emissions regulations. What's the latest there?

Glaser: It was revealed late last week that Volkswagen had installed some software in their diesel cars that allowed them to bypass emissions testing in the United States. This scandal has just continued to grow as the week has gone on. It's already taken out the CEO, who had to step down because of it, and the probe is widening. It seems like this could be more of a widespread problem instead of just being in the United States.

This is going to be quite damaging for Volkswagen on a couple of different levels. First, you have the fines that they're going to face from this sort of deception. That's going to be a pretty big number. But even more than that, they're going to suffer a pretty bad reputational hit because of this, and also they're probably going to see some pretty big lawsuits from people who bought these cars, because this is a pretty clear-cut case. They went out of their way to install the software in order to brazenly get around some of these regulations that were in place. I think that's something that is easy for people to understand and easy for people to get somewhat upset about. So this could weigh on Volkswagen for quite some time, no matter how many times they apologize.

We did bring down our fair value estimate because of this. We took a nine billion euro cut out of the enterprise value of the firm to try to capture some of these costs that they're going to see. The shares have sold off quite considerably and are trading for below our fair value estimate, but our analyst still thinks that investors should exercise caution when it comes to this name. There's a ton of uncertainty here; this hangover could go on for quite some time. Only investors who have an incredible tolerance for risk should be looking at Volkswagen right now.

Stipp: Caterpillar was also under pressure this week. They cut their revenue outlook, and they also announced that they're cutting 10,000 jobs. What's the latest there?

Glaser: This potential of 10,000 job cuts is part of a cost-savings measure, as Caterpillar is feeling a lot of pressure from a slowing global economy. They brought down their 2015 and 2016 revenue guidance and will likely cut earnings guidance in a little bit here.

Caterpillar is feeling the effects of low commodity prices from a slowing China. Their end customers who want this big, heavy machinery just aren't demanding it right now. They're trying to get their cost structure in line with that lower demand, and it's going to be challenging for them to do, and you could see cash flow really get pinched here.

Stipp: In economic data, we got global PMI. This gives you a timely snapshot of how different parts of the world are doing. What did that tell us?

Glaser: This is the flash purchasing managers' data that's compiled by Markit, and it's become somewhat popular recently because it's one of the first looks that we have on what's happening in the global economy, as this is September data.

I don't think we learned a whole lot new from it, but it does show that the entire world isn't falling apart, even though China continues to slow. China did, in fact, slow down, as was expected, and it was even worse than expected. That index is now at a six-and-a-half year low. But Europe only fell a little bit, and it's still in expansion territory. The United States was steady.

Bob Johnson, our director of economic analysis, thinks this is a sign that the Europe and U.S. at least now are resilient to what's happening in China. Things could deteriorate from here, but there's no signs, at least at the moment, that things are getting much worse.

Stipp: Restaurant operator Darden reported results this week. They're in the midst of a big turnaround. What did the results say about how it's going?

Glaser: After a high-profile proxy battle--you may remember the discussions over if they salt the water or not before they make the pasta in order to keep their pots longer--Olive Garden really is showing signs of turning around.

They had a 2.7% increase in same-store sales at Olive Garden; that was better than expected. Overall sales were better than expected, and management raised earnings guidance for the rest of the year.

One interesting thing happening is that management is planning on spinning off the real estate into a real estate investment trust by the end of this year, and there were some maybe concerns about this after the IRS said recently that they have concerns about these types of transactions. They think that some of them might be tax dodges and might not be quite above-board.

Management says that even with those concerns and what the IRS has said, they're still confident that their transaction can go through and they're confident they'll get the tax advantages that they want here. So look for that later in 2015.

Stipp: Lastly, packaged food firm ConAgra reported. Some of the issues that we're seeing there may be emblematic of some of the broader issues that the whole sector is facing.

Glaser: ConAgra is under a lot of pressure, and as you mentioned, packaged foods is under a lot of pressure.

They didn't have a great quarter, they had to take a big charge on this private-label business they bought just in 2012, and they're now planning on selling it. It just didn't work out the way that they anticipated.

The rest of their sales are also under pressure, as consumers shift away from traditional packaged goods. The company really hasn't invested a lot in any of its brands, like Healthy Choice. They're probably going to need to come up with a turnaround plan, but we haven't seen it yet. The new management team has been in place now for six months, but we haven't seen any grand strategy as to how things are going to start to look better, and the market is somewhat concerned that they haven't seen that yet.

Also, when you look at the landscape, you see Kraft Heinz has been executing very well, particularly the Heinz group. And that's set a new bar for profitability and for what consumer packaged good firms should do. I think that's also weighing on ConAgra.

They're going to have some work in front of them to turn around. Erin Lash, our analyst, thinks that the shares are richly valued right now, which means that you're not even getting a discount to take on some of that uncertainty.

Stipp: Great insights as always on the news of the week, Jeremy. Thanks for joining me.

Glaser: Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

Jason Stipp does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.