Volkswagen: Getting the Bugs Out

After four years of restructuring, the German automaker is optimistic about challenging Toyota using brand accountability and centralization

Volkswagen (VLKAY) Chief Executive Martin Winterkorn presented an upbeat forecast for Europe's largest automaker Mar. 9 that departed sharply from the black mood and dire warnings of lost competitiveness a year ago by former CEO Bernd Pischetsrieder.

As sunlight streamed though the glass and steel customer center at VW's headquarters in Wolfsburg, Germany, former Audi chief Winterkorn and his new team exuded optimism about transforming the German automaker into a world-leading car company that can deliver strong profits and challenge market leader Toyota (TM) on quality and innovation. "We will bring the Volkswagen group to a new and higher level," said Winterkorn, who replaced Pischetsrieder as CEO on Jan. 1.

Four years of restructuring efforts by VW's previous management helped kick-start a solid turnaround in performance last year, boosting net profit to $3.7 billion from a meager $1.4 billion in 2005. VW's group revenues rose 11.6% last year to $137 billion, powered by a 9.4% jump in global sales. In Western Europe, VW's market sales gained nearly a full point to 20.3% and global market share edged up to 9.7% from 9.1% a year earlier.

Losses in U.S. Market

The world's fourth-largest automaker will meet its targeted $6.72 billion pretax profit in 2008, Chief Financial Officer Hans Dieter Pötsch said, despite a punishing dollar-euro exchange rate and rising material costs.

But high labor costs, lagging productivity, and losses in the U.S. market still weigh on profits. Despite a 6.5% increase in North American revenues, VW lost $795 million in the region last year, down from $1.1 billion in 2005. Volkswagen is likely to lose money through 2008, Morgan Stanley (MS) analyst Adam Jonas noted in recent report. "Fixing the U.S. is our No. 1 priority," said one Volkswagen board member. The operating margin for VW's automotive division in 2006 was a scant 1.2%, compared with the 5.2% it earned in 2002.

Volkswagen's product strategy also has become blurred following a bid to move upmarket in the late 1990s and to challenge Mercedes with the approximately $80,000 Phaeton luxury sedan. The Phaeton has sold poorly and contributed to VW's losses. Last year management pulled the model from the U.S. market.

Better Best Practices

Over the last 18 months Volkswagen has refocused on smaller mass-market vehicles such as the Fox mini, but the company's market strategy remains fuzzy and its mass market brands such as Skoda and SEAT overlap with the VW brand. Winterkorn said he aims to hone the Volkswagen brand image as a midmarket innovator that delivers solid value for the money and top quality. These cornerstones of VW's image allowed it in the past to command a handy price premium over comparable models from rivals.

Restoring stronger pricing to VW's models will be one of Winterkorn's toughest challenges. Quality has been rising at all automakers over the past decade as best-practice manufacturing techniques and processes become standardized around the world. Jumping to the top of the reliability charts now requires not only cutting-edge practices but flawless management execution. Porsche now places at the top of J.D. Power & Associate's rankings, but only after a decade of implementing Toyota's total quality management principles and investing in extensive training.

VW, on the other hand, has a long way to travel. In J.D. Power's 2006 U.S. initial quality survey, the German automaker ranked third from the bottom, with 171 problems per 100 vehicles, far worse than the industry average. In the reliability study, which tests cars that are three years old, VW hardly fared better, ranking sixth from the bottom and, again, sharply below the industry average.

No More Free Rides

VW board member and Porsche CEO Wendelin Wiedeking says a Toyota-like approach to continual improvement in processes and manufacturing will be introduced at VW, but the German automaker is one of the last to introduce such change. Porsche took a controlling 27.4% stake in Volkswagen last year.

Trimming costs won't be easy. Former CEO Pischetsrieder and former VW brand manager Wolfgang Bernhard—both of whom stepped down Jan. 1—already had whacked away at much of the excess staffing and rooted out obvious inefficiencies. Last year Pischetsrieder won an agreement with labor to cut 20,000 jobs through voluntary buyouts and to extend VW's easygoing 28-hour workweek to 35 hours.

Last year, 7,000 workers took the voluntary package. And VW already sources some $1 billion a year in parts from China. To find additional gains, Winterkorn and his team will have to transform VW into a high-performance machine.

One way to accomplish that is to boost accountability. To that end, Winterkorn said Volkswagen will become more transparent by breaking out the performance of each of its individual brands starting in 2007. Until now, the seven brands were reported as part of two groups, the VW group and the Audi group. That structure already has been dissolved. The aim is to achieve a return on investment in the automotive business of at least 9% in the medium term, up from 5.8% last year.

Centralizing R&D

In research and development, VW used to duplicate efforts across its two brand groups. Now, Winterkorn's handpicked team of former Audi managers is overhauling VW's approach and centralizing R&D. One team will create a basket of components and modules that VW's different brand chiefs can then choose from in designing new models—eliminating costly redundancy.

Winterkorn also must make sure Volkswagen's future models have more design pizzazz, since rivals such as Opel (GM), Ford (F), and Toyota have boosted their brand image and market share with eye-catching design. Hyundai hired former Audi designer Peter Schreyer to make sure the Korean automaker's European models turn heads and lure buyers. By contrast, the fifth-generation Golf, launched in 2004, was roundly criticized as boring.

To solve the problem, Winterkorn has taken former Audi chief designer Walter Maria de'Silva with him to Wolfsburg as chief designer for the VW group. Winterkorn also has tweaked upcoming 2007 models to make them more attractive. And de'Silva is toiling intensively on the next-generation Golf scheduled for 2008. "We want [Volkswagen] to become more glamorous and have a sharper profile," says Winterkorn. And maybe put the difficult past a few years behind it.