Great Cars , But Volkswagen Profit Going in the Wrong Ditrection

August 3, 2004; Business Week Online reported that it has been a rough ride for Bernd Pischetsrieder since the former BMW boss took over as chief executive at Volkswagen in April, 2002. VW's share price has fallen nearly 50% since then, wiping out $11 billion in market capitalization as profits plummeted at the $150 billion company.

On July 23, Pischetsrieder delivered more bad news -- a 36% net profit drop in the first half of 2004. Profits for all of 2003 were already down by more than half, and just to take even more air out of VW's tires, the boss issued a grim earnings warning for this year. In three years -- just half a model life cycle in the auto biz -- the world's fourth-largest carmaker has gone from Europe's showcase turnaround to major-league laggard.

What's wrong? Volkswagen's vaunted brand premium -- the implicit guarantee of quality and innovation that long allowed it to charge as much as 8% more than the competition for mass-market cars -- is eroding fast. French, Asian, and even U.S. rivals are improving quality, bolstering manufacturing efficiency, and besting VW at design. Case in point: The Golf compact lost out in 2003 to the Peugeot 206 as Europe's best-selling car for the second year in a row. The all-new, richly priced Golf is running neck-and-neck with its aging French rival this year. To counter slow sales of its Golf in Europe, VW was forced in January to offer a $1,500 air-conditioning system for free and hefty dealer rebates on used-car trade-ins. In the U.S., meanwhile, VW has slapped a $3,000 rebate on its aging Passat and joined the 0% financing game. U.S. losses are expected to reach $1.4 billion this year, due to dropping sales and the weak dollar's impact on reported earnings.

Another nasty surprise is in China, which until recently accounted for up to 24% of VW's operating profit. In late May, General Motors Corp. , keen to dethrone VW as China's market leader, cut prices by 11%. VW matched the move. GM's sales doubled in the first half of 2004, while VW's fell 4.2%. VW commanded half the mainland market in 1999; now it controls just over a quarter. Pischetsrieder now expects China sales to grow only 5% to 7% in 2004, down from over 30% in recent years. "Our prime objective is profitability, not maintaining market share," he said in a July 23 conference call with financial analysts and journalists.

What's the way out? Pischetsrieder has launched a cost-savings program called ForMotion aimed at trimming $2.6 billion over two years, on top of the company's existing effort to squeeze costs by $1.1 billion a year. The plan seeks to cut $970 million in purchasing costs, $600 million in reduced staffing, and $360 million in restructured sales activities. VW is also beefing up its lucrative auto-finance business by buying a leading Dutch car-leasing company.

More models are coming, too: A souped-up Golf is due later this year, and Passat and Jetta remakes debut in 2005. In China, Pischetsrieder is investing $6 billion over the next four years and aims to double VW's production capacity, to 1.6 million cars, by 2008. VW is also introducing fresher models to Chinese market -- the Touareg sport utility, the Phaeton luxury sedan, the Audi A6, and a car that will be expressly designed for China. Pischetsrieder is shifting decision-making from VW's Wolfsburg headquarters to Beijing and sending experienced managers.

Pischetsrieder also has a winner in Audi, VW's $28 billion-in-revenue premium brand. Strong sales of Audi's luxury A8, the new A6 midsize sedan, and the hot A3 compact helped drive a 10% increase in operating profit, to $666 million, in the first half of 2004. Audi will introduce the rugged Pike's Peak SUV in 2005.

Cost cuts, new models, new focus, a strong luxury brand: sounds good. So why aren't investors impressed? Analysts who once expected 2004 to be a comeback year now say earnings will remain anemic through 2006. "VW is a huge ship. You can't turn it for miles and miles," says George C. Peterson, president of AutoPacific Inc. in Tustin, Calif.

One problem is that achieving big efficiencies is like shooting at a moving target. Pischetsrieder's cuts will help, but analysts say the effort pales in comparison with the thorough streamlining already achieved at Renault, Peugeot, and Chrysler. Besides, "VW has never faced up to its fundamental cost problem. It has never faced up to the unions," says John Wormald, a partner at London-based consultant Autopolis.

While rivals retooled, VW dallied. Labor costs at VW's factories are 17.4% of revenues, vs. a European average of 15%, according to a July 27 report by Dresdner Kleinwort Wasserstein. Since closing a plant in Germany is politically impossible, analysts say, Pischetsrieder needs to accelerate cost-cutting dramatically and boost sales while improving plant flexibility. "The group is far from being on a sound recovery path," says Bruno Lapierre, an Exane BNP Paribas analyst, in a July 23 report.

VW has also blundered by neglecting to develop a stable of minivans and SUVs, which make up over 54% of industry sales in the U.S. So far, VW's only offering is the Touareg SUV. "In the U.S., it's playing with one hand behind its back. It has no lineup to match Honda and Toyota ," says Peterson. "How did that escape them?"

Slow-Moving Managers Pischetsrieder, who has a consensus-driven management style, is making little headway against a bureaucracy that is resistant to change. Insiders say VW's chronically weak management and poor execution were aggravated by the nine-year tenure of former CEO Ferdinand K. Piech, a brilliant but autocratic engineer. "Of the top 100 managers, 50 are not used to making their own decisions or thinking on their own. They wait for the phone to ring to get their orders. They are used to being told what to do," says an auto-industry expert who is close to the company. Pischetsrieder has sought to set up more democratic decision-making structures, but many say the pace of change is glacial. "What Pischetsrieder wants to do is right -- to transform the organization, processes, and behavior," says one consultant. "The question is whether there is enough time to survive the tough period ahead." Looks like it's time for a radical shift of gears.