How High Will VW's Share Price Fly?

Volkswagen’s shares enjoyed a turbo-charged ride in 2005, sprinting 34% thanks to market confidence that restructuring would accelerate under VW’s talented new brand chief Wolfgang Bernhard. Then in October, Porsche became Volkswagen’s major shareholder, taking a 18.5% stake and giving the turnaround story even more gas.

But as Bernhard stepped out at the Detroit Motor Show on Sunday, he warned it will take another five years to get VW earning a decent 9% return on capital. Yes, five years. Despite investor eurphoria, there are big road dips ahead. In December, a report by Morgan Stanley slashed its 2006 forecast for VW, warning the group’s pretax profit could actually plunge 41% this year to $1.0 billion, leaving VW with an auto operating margin of a meager 1.8%.

Though a massive cost-cutting program is underway at VW’s Wolfsburg headquarters in Germany, with a target of saving $8.5 billion in costs by 2008, Volkswagen’s global empire is in disarray. As fast as Bernhard can cut costs, the savings are chewed up elsewhere by higher material prices, discounting and bleeding operations. VW is far from turning around its huge losses in the US and it’s fast losing traction in China to General Motors. Morgan Stanley figures VW’s US business will lose $1.3 billion in 2005 and another $912 million in 2006. And its Spanish unit Seat, which lost an estimated $120 million this year, could see losses double in 2006.

Bernhard, who helped turn around Chrysler from 2001 to 2004 together with DaimlerChrysler’s new CEO Dieter Zetsche, also must face down German labor unions. VW needs to slash some 20,000-30,000 workers to streamline production and revamp its labor contracts, which pay factory workers the highest wages in the auto industry — 20% above those who toil for BMW and Mercedes. Cutting jobs and slashing wages will be rough going, since nothing happens at VW without the approval of the state of Lower Saxony — a shareholder with 18.2% stake in VW whose No. 1 priority is job protection.

Sure, turning around most troubled automakers takes years. The worry is that Bernhard is only just beginning to realize how intractable VW’s problems are. Volkswagen’s performance started deteriorating in 2001, but management has been slow to change direction. Why? Former CEO Ferdinand Piech steered Volkswagen off course in the 1990s by trying to take the VW brand upmarket to challenge Mercedes. At the same time, he took his eye off the company’s core business in small cars, and failed to grapple with VW’s growing productivity gap. With a domineering Piech sitting on the supervisory board, successor Bernd Pischetsrieder didn’t dare do a U-turn, and many problems festered. Now, despite a flush of new models hitting the market over the last two years, and VW’s promised rebound keeps receeding further into the future. On Sunday Bernhard promised ten fully new models by 2010. In July, his target was 2008. And while VW needs to reinvent its product lineup, the plan is to cut capital expenditure.

Can Bernhard deliver a restructured VW? Only if Piech vigorously backs him. Now supervisory board chairman, Piech has tightened his control over Volkswagen through Porsche’s $4 billion stake in VW. (Piech and his family control 51% of Porsche.) So a bet on VW is now a bet on Piech’s instincts and interests. Investors have to hope that Piech is more attentive to producing a good return as an investor than he was as CEO.