Volkswagen Still on Shaky Ground

The German auto maker has been touting big turnaround plans, but it still loses money on each car exported to the U.S.

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Europe's largest auto maker, Volkswagen (VLKAY), has tantalized investors since 2004 with its bold restructuring plans and robust profit targets for 2008. In anticipation of a vigorous VW revival, the company's stock has doubled over the past two years, to around €61 ($77) a share.

But at headquarters in Wolfsburg, progress toward the company's ambitious goals seemed to be bogging down. Product mistakes, boardroom battles, and labor resistance to job cuts have conspired to undermine the turnaround.

Then suddenly this spring, VW's overhaul ignited. Second-quarter sales took off—even in the tough U.S. market—driving the VW brand group's anemic operating profit up 168.5% from a year earlier, to $763 million. New models helped Volkswagen boost its European market share for the first half of 2006 to 19.2%, up from 18% a year ago and near historic highs.


  So, is the much anticipated turnaround at hand? Not quite. With first-half revenues up 14.2%, the $122 billion auto maker is steering in the right direction, but it still faces big challenges. The second-quarter sales vroom isn't sustainable, analysts say, because Volkswagen is at the peak of its yearly product cycle. Worse, the turbocharged profits mask problems that haven't gone away.

The big one: VW is bedeviled by production costs that are twice the level of its competitors. In fact, its costs are so high that the German auto maker still loses money on every car it exports. Last year VW's U.S. losses totaled $1.1 billion. That's roughly $3,500 per car, nearly 33% more than the losses GM suffers per vehicle.

VW's ongoing restructuring will help Volkswagen bring its U.S. losses down to $832 million in 2006, Morgan Stanley analyst Adam Jonas forecasts. But top management concedes that it won't be able to turn a profit in the world's largest auto market for several years. "The problem is not European sales, it's a European cost base applied to North American revenues," says Jonas.


  To fix what ails VW, Chief Executive Bernd Pischetsrieder must deliver on a plan to cut 20,000 employees from the company's bloated 100,000-strong German workforce and clinch a vital pact with labor to boost VW's workweek to 35 hours, up from the current 28-hour week, without a pay increase.

As part of a plan to bring VW's pretax profit up to $6.5 billion by 2008 (more than quadruple the $1.4 billion earned in 2004), Pischetsrieder has targeted some $2.6 billion in annual labor cost savings. In addition to shrinking the workforce and lengthening the workweek, his plan also calls for paying lower wages to new hires.

So far, 9,700 VW employees have agreed to an early retirement package and another 2,500 have accepted a voluntary severance package. Pischetsrieder, who is eager to book the 20,000 job cuts by the end of 2006, is now offering workers an "early booking bonus" of $69,000 for agreeing to depart by Sept. 30.


  That's on top of severance packages running from $50,000 to $250,000. The company also is introducing a pay scheme for new hires that eliminates the 20% premium VW's existing workers currently are paid above the average German auto worker wage.

Volkswagen's labor problems have proven intractable to date, since the state of Lower Saxony still owns 18% of the company's shares and has long sought to protect jobs in the region. But the cuts are essential if VW is to regain competitiveness. Its German factories run at a loss of several hundred million dollars a year.

As Japanese and Korean auto makers ratchet up their drive to sell cars in Europe, VW's traditional 18% to 20% market share will come under heavy assault and is likely to ebb, European auto industry experts warn. "In 15 years, VW's market share in Europe will look dramatically different," says Jonas.


  If Volkswagen starts to cede market share to Asian rivals without getting its costs down sharply, it will end up in the same vicious spiral of red ink, excess capacity, and job cuts that plagues General Motors (GM) and Ford (F). Already, VW's six German factories run at only 60% of capacity—way below a level that ensures profitability, analysts estimate.

"The stock market has recurring visions of a super-competitive Volkswagen. But management is working hard just to maintain its existing position," says Stephen B. Cheetham, an analyst at Sanford C. Bernstein in London.

To restore real competitive muscle, Volkswagen has to prove it can sustain operating margins of 4% to 5% over the long term. It hit 3.3% in 2005, and analysts forecast a 3.6% operating margin this year. But the figures are misleading, since the company has slashed capital expenditure and must invest far more annually to sustain competitive products and factories. "VW's spending level is unsustainably low," says Jonas.


  Much is riding on a revamp of VW's flagship compact, the Golf, which is due out in 2008. The fifth-generation version, unveiled in late 2003, was roundly criticized as overengineered, overpriced, and "boring." Analysts believe VW makes no money on the current version of its largest-selling car because it was forced to pack it with extras or reduce the price in order to drive sales.

Production chief Wolfgang Bernhard is now speeding a revamp of the sixth-generation Golf to market, which market researchers say will be priced as much as €1,000 ($1,280) lower than the existing model.

At the same time, Bernhard has warned labor leaders that the next Golf may not even be built in Germany if labor costs cannot be lowered sufficiently. "It's ridiculous not using expensive machinery three days a week," says Patrick Juchemich, analyst at brokerage Oppenheim in Frankfurt. "Bernhard needs to bring the cost level down enough to export profitably to the U.S."


  Volkswagen also desperately needs to polish its product lineup for the U.S. market, where it has been outmaneuvered by rivals such as BMW, with its hot niche models like the X3 baby SUV and stylish Mini. U.S. sales of the VW brand group fell 11.9% in 2005 to 224,000 cars, after declining 8.5% in 2004. BMW has now overtaken VW in U.S. sales volume, even though VW is a mass-market auto maker and BMW sells premium cars.

One reason for VW's slide: Its misguided effort to go upmarket and introduce a $67,000 sedan called the Phaeton. By striving to challenge Mercedes with innovative engineering and classier brand image, Volkswagen lost touch with its core "people's car" customers who associated the brand with good value. It also lost touch with U.S. customers' changing tastes.

But Bernhard is also working to fill the pipeline with some 20 new vehicles over the next five years that will uphold VW's traditional cars-for-the-people values, including a baby SUV based on the Golf platform.


  "Just shipping the Golf and the Passat to the U.S. is not a successful strategy," says Ferdinand Dudenhoefer, director of the Center for Automotive Research in Gelsenkirchen. "In the long run they have to think about whether it makes sense to export or to build in North America together with Audi."

In the meantime, analysts warn, VW could see its fortunes dip again next year as volumes slide. Lower labor costs from employee departures will not help the bottom line until late in 2007. And an increase in Germany's value-added tax scheduled to take effect in 2007 could also dampen auto sales in VW's home market.

"VW will have a tough 2007—they will struggle just to have earnings equal 2006 levels," says Cheetham. Despite VW's progress, Pischetsrieder's promise of pretax profit of $6.5 billion in 2008 is still a wager many analysts aren't taking.

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