What's That Knocking Under Mercedes' Hood?

Big losses at its minicar division--and growing competition

DaimlerChrysler's performance continues to disappoint. The $512 million third-quarter loss generated by Chrysler is a drag on the entire company, slamming the stock and raising new questions about the wisdom of the monster merger that created the $151 billion company two years ago.

The only thing the world's fourth-largest auto group seems to have going for it is the sterling Mercedes-Benz division, which chalked up a 15% sales jump in the third quarter. Mercedes appears within reach of selling more than one million cars and boosting profits by more than 10% in 2000. Affluent Americans and Europeans are snapping up the C-Class sedans, the sports utilities, and the road-hugging SLK convertible. "Mercedes-Benz is doing extremely well by any comparison in the world," DaimlerChrysler's embattled chairman, Jurgen E. Schrempp, told analysts in a teleconference on Oct. 26.

Impressive. But a close look at the numbers shows cause for concern even in Mercedes' performance. It's nothing approaching a Chrysler-level disaster. But margin pressures are building, and DaimlerChrysler will have to spend billions to keep its Mercedes division in mint condition.

Start with the margins. At 7%, Mercedes' margin is better than the industry average of 4% to 5%. But it looks thin next to the 11% that rival BMW has managed since it dumped Rover. And Mercedes' margins have narrowed more than half a percentage point in the past year, due to spending on five new or face-lifted models to be launched next year and persistent losses at the Smart minicar division. "In such a context, the higher expenditures are what you'd expect," says Jurgen Hubbert, head of Mercedes and Smart cars. As a result, operating profit in the third quarter, excluding exceptional items, rose 5%, to $624 million, well behind the 15% sales increase.

But more worrisome was DaimlerChrysler's guarded outlook for next year. Chief Financial Officer Manfred Gentz says Mercedes hopes to maintain margins. "Given the dollar's strength, and the full-year benefit of the C-Class, that was disappointing," says Deutsche Bank analyst Christian Breitsprecher.

The surge in fuel prices hasn't helped Mercedes either. Consumers are switching to models with fuel-efficient diesel engines, from which Mercedes makes less money. Franck Thomas, a Mercedes executive in Paris, says diesel cars now account for 70% of sales on models offering both versions. Making matters worse, Europe's car market has begun to dip, and German car sales are down 11%. Still, Mercedes managed a 5% rise in its home market and a bigger gain in Europe.

Mercedes faces other challenges. Ford, Volkswagen, and Toyota are developing luxury models targeting the segment now dominated by Mercedes. In mid-2001, Ford is launching the X-type "Baby Jaguar," in the same category as the $20,000 C-Class. Volkswagen will produce a D1 sedan next year to rival the S-Class, which starts at $46,000. "It's a sign of the ever-growing competition that all the carmakers face today," says D. Garel Rhys, professor of motor industry economics at Cardiff University in Wales.

COST-SHARING. Mercedes, keenly aware of the threat, has an ambitious product rollout program to fend off competition. "We're working on the Maybach [limousine], we're working on the SLR [sports car], we're working on three new models for next year, and we're working on more which we're not revealing," Schrempp says.

A bigger lineup and higher volumes don't always boost margins, however. The popularity of the C-Class, one of Mercedes' smaller cars, actually hurt profitability.

The product mix may tilt further toward low-margin cars again next year, as two of the three new models are C-Class variants. Meanwhile, analysts expect the Smart minicar division to lose about $340 million this year, fueling investor discontent with Schrempp's expansion into small cars. "We're a long way from seeing the rewards," says Merrill Lynch & Co. analyst Stephen Reitman.

Schrempp insists the strategy will pay off. The Smart unit and Mitsubishi Motors Corp., DaimlerChrysler's partner in Japan, will share the costs of developing the main components of a four-seater Smart to be launched in 2004. And although Schrempp stands firm that Mercedes and Chrysler must never use the same platforms, there's room to lower costs by pooling some technology and components, such as manual transmissions. Schrempp plans to proceed carefully to ensure none of the brands lose their distinction, "and definitely not Mercedes-Benz." It would be a pity to dent the world-renowned brand as the giant company maneuvers down a hazard-filled road.

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