Volkswagen Brakes For Epic Change

Scandal may free Bernhard to make a life-saving new deal with labor-for starters

Volkswagen's new Mr. Fix-it, Wolfgang Bernhard, didn't mince words in his first public diagnosis of what ails Europe's largest auto maker. Its costs are too high, its quality subpar, and its products too expensive. "Volkswagen is facing a cold wind ahead," he said, speaking to financial analysts on July 13. To restore VW's declining competitiveness, Bernhard is aiming for $8.4 billion in cost savings by 2010, and 5 to 10 new low-cost models. "There will be no sacred cows," says Bernhard, 44, who took over as chairman of the flagship Volkswagen brand group last November. (Bernd Pischetsrieder is chief of the entire company.)

It's now or never. Volkswagen has suddenly realized that its efforts to cut costs and compete in a global market have fallen short. Sales in the U.S. are in free fall, new models are sputtering in Europe, and it's losing ground rapidly in China to General Motors Corp. (GM ). The $107 billion German giant eked out a net profit of just $859 million in 2004, a profit margin of less than 1%, and its core VW brand lost money on every car sold. By contrast, Nissan Motor Co. (NSANY ) earned $2,019 per car and Toyota Motor Corp. (TM ) made $2,328. "If we cannot export cars out of Europe [profitably], Europe has a very, very dark future," warned Bernhard.

That kind of candor from VW's Wolfsburg home is refreshing after years of denial by top brass that the company was veering off course. Bernhard -- who helped shut six factories while at Chrysler (DCX ) in Detroit and cut that workforce by 26,000 -- is quick to insist VW can turn around. But he's setting the stage for an epic overhaul, one that may become a beacon for change for Germany. At VW and most German companies, the co-determination model, which gives labor half the seats on a company's supervisory board, cripples management's ability to adapt to fast-moving global economy. "It's looking more and more like a turning point for Volkswagen," says JPMorgan Chase & Co. (JPM ) analyst Philippe Houchois.

Bernhard has to attack VW's high fixed costs, from wages a fifth above the industry average to excess plant capacity of at least 20% to 30%. "To be profitable they need to be operating at 90% of capacity," says Ferdinand Dudenhöffer, head of the Center for Automotive Research in Gelsenkirchen. That could mean plant closings, layoffs, and rollbacks of wage and labor rule deals -- taboos that VW had not dared broach until now. "Bernhard has to do more than just cutting 10% here and there," says Michael Schwarz, a Booz Allen Hamilton principal in Düsseldorf. "The onslaught of low-cost competition is not stopping."

Until now, the chief obstacles to change at VW have been the interwoven ties between top management, labor leaders, and VW's controlling shareholder, the state of Lower Saxony. But those ties may be less binding in the wake of a scandal at the auto maker involving alleged kickbacks, front companies, and extravagant sex escapades that were expensed to the company, toppling several senior managers and a labor representative. One of the fallen is Peter Hartz, head of personnel and a close adviser to Chancellor Gerhard Schröder. "It shows Pischetsrieder and Bernhard are stronger than we thought," says one insider.

The shakeup helps clear out a management cadre linked to Supervisory Board Chairman Ferdinand Piech that was blocking change. Piech, too, is under pressure to go, though his contract runs two more years. The scandal could also provoke a national rethink about the role of labor representation on German boards. "With the workers' council discredited, there may be room for maneuvering," says Booz Allen's Schwarz.

Restoring luster to the VW logo won't be easy. Some analysts warn the turnaround could be more difficult than Bernhard envisions. But coming clean on its problems is the first step on the road back.

By Gail Edmondson in Frankfurt

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