DaimlerChrysler: Stalled

Was the merger between Daimler and Chrysler a mistake? Many say yes -- and call for Schrempp's head

On a brisk September evening, DaimlerChrysler executives gather for a party at a sprawling Mercedes-Benz dealership in Frankfurt. As guests sip champagne and nibble crudités, the auditorium lights dim, music swells, and a huge video screen displays a young Formula One driver filmed that morning in Brescia, Italy. He slips the 626-horsepower engine of the new Mercedes-Benz $416,000 SLR McLaren sports car into gear and tears into the Alps, retracing part of the historic Mille Miglia (1,000 mile) road race through Italy.

Milling about in the crowd is Chrysler Group Chief Executive Dieter Zetsche, the German boss dispatched three years ago to turn around the company's troubled U.S. unit. The breathless celebration of Mercedes' muscular engines, prestigious sedans, and leading-edge technology is a far cry from Zetsche's daily struggle in Auburn Hills, Mich. For if Mercedes is the profit engine behind DaimlerChrysler's $166 billion globe-spanning business, Chrysler remains its dragging muffler. Its unpopular models, inefficient factories, and weak brand image have defied the efforts for a quick turnaround. Says Zetsche: "We have to deal with the hand we have, and turn it into a winning hand."

Still, there's no masking the stark reality behind the biggest industrial merger in history. Five years after Daimler Benz CEO Jürgen E. Schrempp carried out a $36 billion fusion with Chrysler Corp., his promise of creating the world's most profitable carmaker is a financial blowout. After an unexpected $1 billion loss in the second quarter, Chrysler may end 2003 in the red, despite Schrempp's boast a year ago that the unit would earn $2 billion this year. That wipes out the gains of 2002 and follows on the heels of the $5.8 billion loss in 2001.

Chrysler is not the only thing Schrempp, 59, is worrying about these days. In July, a J.D. Power & Associates Inc. survey revealed embarrassing quality deficiencies at Mercedes itself, raising questions about whether the drain on management from Chrysler was affecting the classiest of German marques. Mitsubishi Motor Corp., another troubled imperial possession that was supposed to boost profits through cost savings from shared engineering and purchasing, has warned of a $683 million first-half loss and has slashed its full-year earnings forecast by 75%, as U.S. sales plunge. In July, Daimler's $30 billion truck business embarked on a reorganization to reap savings from sharing parts and pooling purchasing for its various units after losing $960 million in two years. And in August, Daimler agreed to pay $300 million to settle a lawsuit by institutional investors and still faces a $2 billion claim by shareholder Kirk Kerkorian.

Was the merger a colossal mistake? A growing chorus of voices are saying it was. Many auto industry experts believe that Chrysler, whose competitiveness Schrempp badly overestimated in 1998, might have gone bankrupt by now without its German parent. Schrempp promised a world-spanning company that would dominate the industry. But five years into the merger, new products have failed to pull Chrysler out of a rut. And DaimlerChrysler dominates only where it did before -- in luxury cars. It now owns or controls struggling players in both the U.S. and Asia. While Schrempp refuses to admit defeat, some European analysts suggest that DaimlerChrysler might jettison Chrysler altogether. "There are one or two things we didn't do right [at Chrysler] in the beginning. But we will get it right," a subdued Schrempp told journalists at the Frankfurt Motor Show.

Schrempp, once one of the most garrulous of CEOs, portrayed himself as a champion of shareholder value at the time of the merger. But he's giving few interviews these days, especially to members of the U.S. press. And why would he want to? The market capitalization of DaimlerChrysler, at $38 billion, is sharply lower than the German auto maker's $47 billion market cap before its marriage to Chrysler. BMW has seen its market value rise by 27%, to $25 billion, since the end of 1998.

Many institutional investors and small shareholders are fed up. They want to see Schrempp replaced and the deal unwound. But the most stinging criticism comes from those within the vaunted 119-year-old auto maker, who point to top management error for the company's dismal performance. "The entire management board is too removed from the business. Things have been going in the wrong direction for a long period of time," says one senior DaimlerChrysler manager.

Poor execution isn't the only problem. The logic behind Schrempp's vision of Welt AG, a world auto company with integrated parts, looks increasingly flawed. Sure, Chrysler and Mitsubishi may be able to cut their costs by sharing parts and engineering. But many auto-industry experts and top executives agree Schrempp erred fundamentally in merging a luxury auto maker with a mass-market brand -- an unnatural combination that offers limited benefits and requires twice the expertise and effort to manage. Moreover, luxury has proved a better source of growth and profits than mass-market cars.

True, when the Mercedes management sets its mind to change, it can be very successful. In the early "90s, when Mercedes was losing ground to the Japanese, they revamped products and brought costs and prices down. But the global auto market these days is brutally competitive. Car sales in Asia, Europe, and the U.S. are all in a long slump. In the U.S., the 1-2-3 punch from Japanese minivans, SUVs, and pickup trucks is perilously eroding Detroit's market share. Japan also leads in the hot new crossover segment.

The toughest challenge may be the relentless downward pressure on pricing in the U.S. In an effort to maintain share and cash flow, General Motors Corp. has continued the incentives war it launched in late 2001, changing the face of American auto retailing. Big Three rebates now average nearly $4,000 per vehicle, more than double 1998 levels. That makes it hard to earn a premium on even the newest, snazziest models. Witness Chrysler's $38,000 2004 Pacifica minivan-SUV crossover. Consumers considered the price tag steep for a Chrysler, especially one sharing showrooms with drastically marked-down alternatives. Little wonder the Pacifica got off to a dismal start and needed a $1,000 rebate to juice sales.

Under German management, Chrysler's U.S. market share has dropped three percentage points, to 13%. And in August, it lost to Toyota its 53-year position as America's No. 3 carmaker. But the Germans in charge of both Mercedes and Chrysler are counseling patience. "In our industry, size, strong brands, and synergies are decisive. You must be big," says Rüdiger Grube, chief of development at DaimlerChrysler. Schrempp's managers insist that the integration of process knowhow and parts sharing is just starting to kick in and that over time productivity gains will reduce costs while quality improvements and new models boost Chrysler. "We have a revenue problem because of competitive pressure, and we have to solve it with further improvement on the cost side," Schrempp told analysts on July 24. "It has no effect on our strategy."

The statement has a dangerously familiar ring. Two years ago, Schrempp vowed that Zetsche, 50, who had been running Daimler's truck division, and Wolfgang Bernhard, the best troubleshooters Stuttgart could find, would rescue Chrysler. They slashed costs by more than $6 billion, eliminated 26,000 jobs, and tackled quality problems. In May, Zetsche vowed to cut costs by a further $1 billion this year, on top of targeted cuts of $2 billion. The four-year labor pact Chrysler reached with the United Auto Workers on Sept. 14 will allow the carmaker to unload seven parts plants. "Dieter has gone into a very tough situation," says Ford Motor Co. CEO William C. Ford Jr. "He won this town over. He's providing very strong leadership."

But Chrysler's problems are overwhelming the gains. The new products vital to a Chrysler rebound have been slow in coming. The first joint Chrysler-Mercedes engineering product -- the sleek Chrysler Crossfire roadster -- only recently hit the market. While the sleek $35,000 roadster offers German engineering finesse and quality at a bargain, thanks to borrowing 40% of its components from Mercedes, the experiment is one of a kind. Future Chrysler cars will share most with Mitsubishi, not Mercedes, in order to avoid diluting the luxury German brand image. The company is pinning high hopes on the launches of at least five new models in 2004. That includes the Chrysler 300C sedan and the Dodge Magnum wagon -- rear-wheel-drive vehicles sporting a Mercedes' state-of-the-art five-speed transmission. Chrysler is also updating its once-vaunted minivans but finds itself simply playing catch-up to standard-setting Toyota and Honda models. Few in the U.S. auto industry expect even Chrysler's newest models to sell without profit-sapping incentives. "Chrysler could prove impossible to fix," says Garel Rhys, professor of automotive economics at Cardiff Business School in Wales.

In Stuttgart, the fear and loathing of Chrysler is palpable as it becomes increasingly clear that shoring up Chrysler will require billions of dollars more. Even Mercedes dealers are fretting: "Chrysler is the downfall of Mercedes-Benz. It is a hole for billions of euros," says one Stuttgart area Mercedes dealer. For the first half, DaimlerChrysler's revenues fell by 11%, to $75 billion, and net profit declined by 81%, to $773 million. Schrempp has revised his 2003 operating profit forecast down to $5.5 billion, but many analysts say that's overly optimistic. They're also dubious that the company can break even in 2004. For now, Jürgen Hubbert, the respected boss of Mercedes Car Group, has kept Mercedes pumping out steady profits. A raft of new models -- from the handsome E-Class sedan launched in 2002 to the sexy SLK roadster and the Maybach super-luxury car -- continue to add luster to the industry's most prestigious luxury brand. Mercedes' operating profit rose 3% in the first half of this year, to $1.62 billion, representing 54% of group profits.

But there are signs that could portend eroding competitiveness. The C-Class compact sedan is straining under competition from BMW's older 3 Series model, while less expensive cars developed to spur growth, including the A-Class, are unprofitable. "The A-Class, the Smart, and the M-Class don't earn money. If you compete in the mass market, you have to be cost-competitive with Toyota," says one Daimler Benz executive. Arndt Ellinghorst, an auto analyst at WestLB in Düsseldorf, figures Mercedes' margins will slip from 6% to 5.7% in 2004 as models pass their selling peak and start to age. BMW margins still run above 7%.

Worse, Mercedes recently suffered a spate of quality problems, including faulty transmissions. Insiders say that in order to cut costs, Mercedes has resorted to buying cheaper parts, including leather from Bulgaria. If quality problems persist, Mercedes could see its stellar brand tarnished. Hubbert vows quality is the top priority at Mercedes. "We are not where we should be, but we are working hard to be back in the top range [of the surveys]," he told analysts recently.

How much more bad news can Schrempp survive? His fate -- and DaimlerChrysler's -- depend on Deutsche Bank (DB ), DaimlerChrysler's largest shareholder, which has seen the value of its 12% stake plunge by more than $15 billion since the merger. "The key question is: What does Deutsche Bank think? Do you throw good money after bad, or cut your losses," says David E. Cole, president of the Center for Automotive Studies in Ann Arbor, Mich. As Deutsche reworks its own strategy and seeks to unwind its portfolio of industrial holdings, it has begun to distance itself from DaimlerChrysler. Deutsche Chairman Josef Ackermann says he wants to sell the bank's stake, but not at today's price. The bank still backs Schrempp, partly because of his ties with DaimlerChrysler Supervisory Board Chairman Hilmar Kopper, the former Deutsche Bank chairman who chose Schrempp as CEO and supported the merger.

But if Chrysler posts huge losses in the quarters ahead that push the mother company into the red, Ackermann could lean on Kopper to force Schrempp out. Dissatisfaction with the merger is growing within Daimler Benz, especially among Mercedes executives. In addition, says one insider, "the race is on to be [Schrempp's] successor." The front-runners: Zetsche and Eckhard Cordes, head of commercial vehicles who edged the struggling division into the black in the second quarter, though its margins are still way below target.

Getting rid of Chrysler could be tougher than firing Schrempp. A parent company can put a subsidiary into Chapter 11 bankruptcy and shrug off its pension and health-care obligations. But that works in this case only if Chrysler's obligations aren't guaranteed by parent DaimlerChrysler. Otherwise, creditors and unions would simply take their demands to the parent.

More plausible, Daimler could spin off Chrysler to its own shareholders. That would surely increase the value of the remaining Daimler Benz business, and U.S. bargain-hunters might even snap up the new Chrysler shares on the cheap. The question is whether Chrysler's research and development, product development, engineering, and leadership could be disentangled from Daimler's. Daimler might also sell Chrysler in pieces, as BMW did with its money-losing Rover unit. BMW's fortunes have since rebounded smartly. Daimler, the theory goes, could sell off Chrysler's profitable Jeep SUV and Dodge truck units for a tidy profit and hand off the money-losing passenger-car business to diehard Chrysler loyalists for $1. That, however, would surely trigger massive political and labor reactions as thousands of car-unit jobs were destroyed, and pension and health-care obligations jeopardized. Short of that, DaimlerChrysler could merge Chrysler and Mitsubishi's car operations into a single unit.

Deutsche Bank is likely to keep Schrempp at the helm for now, barring another dramatic setback at Chrysler. But DaimlerChrysler executives concede that a real turnaround will take three to five years and billions in investment. In short: a full fresh generation of new cars built in updated plants. Zetsche and Schrempp are confident they can pull that off. But many argue that Schrempp, who quadrupled his salary after the merger and ranks in compensation reviews as Germany's top-paid CEO with an estimated $12.1 million pay package in 2002, does not deserve a third chance. If he fails again, Chrysler's problems will implode on its German parent in less than five years, warns an insider. "It will be the biggest industrial cleanup job Germany has ever seen." Given Schrempp's checkered track record, that's a high-stakes gamble.

By Gail Edmondson in Stuttgart and Kathleen Kerwin in Auburn Hills, Mich., with bureau reports

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