Vw: Spinning Its Wheels?

Price pressures and other woes threaten a racy turnaround

No doubt about it: Volkswagen CEO Ferdinand Piech engineered one of Europe's greatest turnarounds ever. The autocratic grandson of auto pioneer Ferdinand Porsche inherited a loss of more than $1 billion and declining market share in 1993. With a battery of new models, Piech seized European market share from Ford Motor Co. and General Motors Corp. Including its Audi, Skoda, and Seat brands, VW now has almost 19% of Western European car sales, up from a low of 15% in 1994. Profits last year topped $1.2 billion on sales of $71.4 billion.

But no turnaround is eternal: Europe's largest carmaker is running into problems again. Profits of $799 million for the first nine months of 1999 are unchanged from a year ago, disappointing expectations. But that's not really what's worrying investors, who have bid the stock down 24% this year, making it the worst performer of Germany's big-cap stocks. What gives the market the chills is the prospect of increasingly tough conditions for the next two or three years: Unprecedented pressure on prices in Germany, persistent problems in big foreign markets, and revved-up rivals plotting comebacks. And as a quasi state-owned company, VW has limited room to maneuver. Analysts expect meager growth at best in VW per-share earnings through 2000.

SHARED PLATFORMS. The question is whether Piech has overreached in his drastic reengineering of Volkswagen. Europe, with its eight major auto makers, is a wretchedly difficult place to make money selling cars. To make sure VW is one of those left standing, Piech has greatly expanded VW's model range. The group's 1999 palette includes 51 cars, up from 42 just two years ago. In the meantime, Piech has forced models throughout the range to share parts as much as possible. Eventually, all the company's cars will be built on four basic chassis and parts collections known as platforms.

Cutting platforms has saved billions, and expanding the lineup has scored brilliant market-share gains. But now Volkswagen may end up eating its own lunch. Brand cannibalization is already a problem. No fewer than 11 models ride on VW's so-called A-Platform, ranging from the sporty Audi TT Roadster to the quirky VW New Beetle to the budget Skoda Octavia. Buyers are starting to wonder why they should pay $25,000 for an Audi A6 when it looks suspiciously like a $16,000 Volkswagen Passat. "Consumers have learned that they can get the same technology on lower-priced versions," says Helmut Panke, a member of the management board of rival BMW.

There are early indications that Panke's right: Sales of the Skoda Octavia have soared more than 60% this year while sales of the similar VW Passat and Audi A6 are basically flat. That's not necessarily bad if the Skoda is stealing more buyers from competitors than VW's own brands. But it's bad if Skoda's appeal is eroding the upscale image of its pricier brands and subtly changing consumers' feelings about VW's offerings. "The image of the car is a very emotional, not rational issue," says Harry Gold, sales director at dealer Auto Gehlert in Freiburg, which sells VWs and Audis.

UPSCALE MODEL. VW may aggravate this problem even further. To help shed its middle-class image, for example, the company is developing a luxury model to compete directly with Mercedes-Benz and BMW. Analysts expect it to be in the same price range as the $65,000 Mercedes S-Class. Dusseldorf-based WestLB Research estimates that VW will invest $745 million in the new luxury car, which starts production in 2001. The risk: The car could steal customers from Audi as well as from Mercedes and BMW.

While all of Europe's carmakers face growing pricing pressures, VW is particularly vulnerable. Nearly one-quarter of its unit sales are in Germany, where customer loyalty allows the company to charge almost 10% more for the mainstay Golf than in other countries that use the euro. That spread is sure to narrow as the common currency makes it easier for Germans to shop in neighboring countries.

Meanwhile, European Union competition authorities are expected to revoke rules that give auto makers control over dealers and stymie price competition. The results could be dire for VW. M.M. Warburg estimates that a 1.5% price decline for the VW, Skoda, and Seat brands would slash $880 million from the company's bottom line. And online car shopping, still in its infancy in Europe, could further undermine prices. Analysts say VW is behind Ford and GM in using the Net as a sales and supply-chain tool.

And after years of being VW's prey, competitors are finally striking back. GM's Adam Opel unit's plan to boost its market share in Germany to 17%, from 14.5%, by offering buyers hefty incentives is showing signs of success. In September, Opel's Astra outsold VW's Golf Europewide. Ford of Europe Inc. has a new president, former Jaguar chief Nicholas V. Scheele, who has been given more freedom than predecessors to run his own show.

GOVERNMENT CONTROL. Competition is already squeezing margins, forcing VW to pass gains in manufacturing efficiency on to consumers. Should it become necessary to cut jobs or shift more production abroad, Volkswagen could run into trouble. For practical purposes, it's still a government-controlled company. The state of Lower Saxony, where VW is an economic linchpin, holds an 18% stake. Together, state politicians and worker representatives control VW'S supervisory board. That's sure to limit the company's flexibility.

VW can still point to triumphs. U.S. sales are soaring, rising 40% in the first nine months, to their highest level in 25 years. But the U.S. remains a secondary market. And gains there are offset by losses in economically troubled Brazil, VW's most important overseas market.

The 62-year-old Piech is expected to end nearly a decade at VW's helm in 2002. His product offensive is impressive. But critics fear his dictatorial style has purged management of independent thinkers. "The autocratic approach that serves companies when they're in dire straits can bring negative consequences when it's applied too long," warns J.P. Morgan Securities Ltd. analyst Nick Snee. VW could find out that Piech's turnaround isn't a one-way street.

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