Commentary: VW May Pay Dearly for Its Detour into Luxury

As the carmaker rolls out pricey new models, it's neglecting the mid-market

By Christine Tierney

With a starting price of $150,000, it's not exactly a "people's car." The Bentley Continental GT coupe, the first Bentley developed by Volkswagen (VLKAY ) since it bought the British marque in 1998, captures the elegance and sportiness of the brand's racing heritage. Behind the exquisite radiator grille, is a 12-cylinder engine that takes the car from 0 to 60 mph in less than five seconds. VW will start delivering these cars in Europe next year and expects to sell more than 2,000 in 2004.

The new Bentley is but the latest volley in VW's luxury offensive. In June, the German auto maker introduced the Phaeton, the most expensive car ever to sport the VW badge. Car magazines rate the $62,000-plus Phaeton on a par with pricier, top-line Mercedes-Benz and BMW models. In November, VW is rolling out another premium product: the latest generation of the Audi A8 sedan, priced at upwards of $68,000. It's packed with gadgets, such as a tiny pad that verifies the fingerprint of the owner and up to three more drivers and adjusts the seat, steering wheel, and temperature to their preferences. "If we compare it with the BMW 7 Series, we're better," says Falko Schling, group quality director.

But as it grabs for the brass ring--make that gold--Volkswagen seems to be loosening its grip on its core business. The new dream-mobiles will account for less than 5% of the company's $87 billion a year in revenues. The bulk of sales and profits come from small and midsize cars, led by the $15,265 VW Golf compact. These models are now struggling. "Walking through the Paris motor show, one sees all the money and engineering time tied up in the Bentley, the Phaeton, and the Lamborghinis. They're suffering for that," says Stephen Reitman, auto analyst at Merrill Lynch & Co. in London.

Volkswagen had better watch out. Europe's market for midprice cars is a punishing arena, where it's easy for an auto maker to lose its footing. VW is profitable and has a history of engineering excellence. But its performance this year is discouraging: VW sales in Europe are down 7%, more than any major auto maker except Fiat Auto (FIA ) and General Motors Corp.'s (GM ) Opel. In the U.S., VW's sales are off less than 1%. But the company is piling on incentives faster than its European competitors. According to researcher Autodata in Woodcliff Lake, N.J., incentives on VWs were up 61% in September from year-earlier levels, to an average of $1,115 per model.

Slack sales and discounts are taking a toll. In July, Volkswagen CEO Bernd Pischetsrieder warned investors to brace themselves for a 10% drop in earnings from last year's pretax profit of $4.3 billion. Of course times are tough. But not everyone is paring back forecasts. France's PSA Peugeot Citroen expects to end the year with higher sales and profits, bolstered by a fresh crop of eye-catching compacts and minivans. VW remains the leader in Europe, with 18.5% of the market, but it has lost half a point of share over the past year. Peugeot is closing in, with 15%, up from 12% in 1999.

Some of VW's troubles this year were inevitable. The Golf, accounting for almost a quarter of group sales and profits, is showing its age: the latest model is five years old. Indeed, the Golf recently surrendered the title of best-seller to Peugeot's 206. And the Polo subcompact, sold in Europe, has disappointed. Just 11 months after its launch, VW is offering deals, such as 0.9% financing.

Meanwhile, the German auto maker has been slow to develop cars for fast-growing segments. It is only now introducing a sport-utility vehicle, the Touareg. And it has missed out on a sales surge in Europe's compact minivan market, a segment pioneered by Renault with its Megane Scenic. VW's equivalent, the Touran, will enter a crowded race when it debuts next year.

It's a dilemma for Pischetsrieder, who has been in the driver's seat at VW only since April. Picked by former VW CEO Ferdinand Piech, the onetime BMW chairman has embraced his predecessor's strategy of enhancing the group's image by developing premium cars. While the Phaeton isn't expected to earn much money, VW claims it will cast a halo of luxury over other VW models, enabling the company to command higher prices across its lineup. Many investors like the strategy and appreciate Pischetsrieder's vow to winnow out overlapping models and loss-makers like the Audi A2 compact. But it takes years to move a brand upmarket, while VW's pricing power seems to be weakening now. The Bentley and the rest of VW's supercars may yet prove a luxury Volkswagen can ill afford.

Tierney covers the European auto industry from Frankfurt.

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