Rough Terrain for Subaru

Can the Japanese carmaker hold its lead in the crossover category?

American consumers hitting Subaru showrooms since September have gotten something of a shock. Instead of the usual lineup of all-wheel-drive Foresters and Legacy Outbacks--compact sport-utility vehicles for the log-cabin set--they could kick the tires of a hot-looking, retro-styled pickup called the Baja. It's not exactly the kind of car you would expect to see on the back roads of Vermont, the archetypal venue for a Subaru drive.

Instead, the $24,000 Baja is meant for dune-climbing, beach-cruising, and other essential moments of the California experience. The car's hot colors--baja yellow, regatta red--mounted spotlights, and 16-inch alloy wheels make it clear that Subaru wants to grab fresh turf in the car wars. "We are reaching out to a new group of car buyers, well beyond our traditional customer base," says Kyoji Takenaka, CEO of Subaru's parent, Fuji Heavy Industries Ltd.

It's going to be a long haul. Although auto critics like the change of pace, Subaru sold only 415 Bajas in September, far below the targeted monthly sales of 2,000. Subaru top brass point out that car sales weakened across the board in the U.S. in September. The road, meanwhile, is getting more crowded. This year General Motors Corp., which owns 21% of Fuji Heavy, introduced the Pontiac Vibe hatchback, a stylish play on the crossover theme; Toyota Motor Corp. launched the Matrix, a jointly produced twin of the Vibe; and Mitsubishi Motors Corp. is offering the Outlander, a low-riding, compact SUV. Next year, Nissan's Murano, the boxy Honda Element, and Toyota's subcompact Scion bbX will join the race at the low end, while the sporty Nissan Infiniti FX45 and Mercedes Grand Sports Tourer will aim at the top of the market. "I think you're going to see an explosion in crossovers," says Nissan Motor Co. CEO Carlos Ghosn.

As the competition heats up, Subaru is putting on a brave face. "We see all the new arrivals as a plus for the growth of the segment," says Takenaka. He has some reason to be optimistic: Subaru has dominated its market like no other carmaker and pioneered the crossover--vehicles that combine the easy handling of a car with the durability, off-road capability, and space of a sport-ute. That has added up to steady profits: Last year, Fuji Heavy--which gets 90% of its revenues from the carmaker--posted earnings of $252 million on sales of $11.3 billion.

Despite the numbers, investors have their doubts: Shares in Fuji Heavy are trading at their lowest point since 1997 and so far this year have underperformed the beleaguered Nikkei 225 index and nearly every other carmaker in Japan. Some of the damage to the shares comes from Fuji's tendency to lowball earnings estimates, notes UBS Warburg analyst Christopher Redl. But the markets are also holding back until Subaru proves it can hold the lead in the crossover rally.

To win that competition, Takenaka is giving the brand a makeover. Instead of its traditional emphasis on off-road capabilities, Subaru is stressing more-mainstream themes such as smooth ride. That's aimed at helping Subaru expand beyond its strongholds like Alaska and Colorado and into the Sunbelt, where it holds less than 0.5% market share. "We want to shed our off-road, dirt-digger image in favor of messages like safety and driving fun," says Takenaka.

Cars digging in the dirt don't need to be terribly stylish, but those parked at the mall do. So in April, Takenaka hired Andreas Zapatinas, who most recently headed design at Alfa Romeo, to serve as chief designer. Zapatinas' first project: the next generation of the Outback wagon, due out next year in Japan. The current model, now four years old, is the company's chief breadwinner, so success is critical. Next, Zapatinas will get to work on an upscale SUV/minivan crossover, a gas-electric hybrid car, and sporty all-wheel-drive car to be co-developed with GM. In all, Takenaka is promising to nearly double Subaru's current lineup, to seven mainstay models, by 2007.

Problem is, all those new cars will cost a lot to develop--which could create a drag on earnings for the next two years. With more than $100 million a year budgeted for plant upgrades and research and development, Fuji Heavy expects profits to drop 21%, to $200 million, for the year ending March, 2003. And Fuji Heavy says that its operating profit margin will shrink to 3.6% by 2004, down from 6.5% last year. The payoff is supposed to come in 2007, when Fuji Heavy expects to sell 760,000 cars, up 37% from 2001. Some worry that the investment may not play to Subaru's strengths: "A lot more of the funds should be going into Fuji Heavy's [traditional] area of core competence: passenger vehicles that have off-road capability," says HSBC Securities Inc. analyst Christopher Richter.

General Motors might be worrying, too. Although the American giant became Fuji Heavy's biggest shareholder in 1999, the two haven't developed much in the way of synergy so far. Executives in Detroit had hoped to jointly develop an SUV using Subaru's four-wheel-drive technology, but those plans have been put on hold. And Fuji Heavy officials have been dismayed by the poor sales of minivans made in Thailand by GM's Adam Opel unit but marketed as the Subaru Traviq in Japan. The Traviq has sold an average of fewer than 500 per month, far below the 1,000-unit monthly target GM set when sales started a year ago. "Our honeymoon is over," Takenaka says with a smile. "Now we act like spouses." And for Takenaka, a good marriage means cooperating with GM when he can but keeping his sights on the growing crossover market.

By Chester Dawson in Tokyo

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