VW Gains Traction and Gets Ambitious

The German automaker's lesser-known units, Skoda and Audi, delivered strong sales for the first quarter. Now it wants to take on Toyota

Volkswagen's polished first-quarter results were exactly what Porsche Chief Executive Wendelin Wiedeking had in mind when he snapped up a controlling stake in the world's No. 4 automaker last year as it struggled to restructure. VW's operating profit for the first three months of 2007 rose 81%, to $1.48 billion, generating a 4.1% margin. Profit after tax of $1.0 billion was up 127%.

The star performers, however, were VW units Audi and Skoda—not the dominant $24.5 billion VW brand division. Soaring sales of new models at Czech-based Skoda delivered an 8.5% operating margin—outperforming even premium automaker BMW. Skoda's car sales rose 15.5% in the first quarter on a booming Central and Eastern European market and young models, including the Octavia compact and Roomster station wagon.

VW's premium Audi unit also continued to power strong results. Global sales jumped 9.4%, to $11.8 billion, fueled by successful models such as the Q7 SUV and the new Audi TT roadster. First-quarter profit at Audi rose 16%, to $545 million. Together, Audi and Skoda made up 69% of Volkswagen's automotive profit, despite being dwarfed by sales of Volkswagen brand vehicles. The Volkswagen brand unit earned only $525 million, or a 2.1% operating margin, though that was up smartly from a loss of $66 million in the first quarter of 2006.

Still a European Brand

While the first-quarter results under a new management team is cheery news for Wiedeking and Volkswagen's new chief executive, Martin Winterkorn, VW still faces big challenges. As controlling shareholder, Porsche's Wiedeking has given the German giant a breathtaking mission: to outperform global auto Goliath Toyota (TM). That means redoubling cost-cutting efforts, boosting parts sharing and production efficiency, and above all fixing its money-losing operation in the U.S. "The momentum is right, but Volkswagen has a long, long way to go to get where they need to be," says Morgan Stanley analyst Adam Jonas.

As Winterkorn rolls up his sleeves to continue the retooling at VW, his biggest job is building a real export powerhouse. For all its huge $143 billion in revenues, Volkswagen's success remains largely centered on Europe. Together, Western and Eastern Europe account for 62% of VW's sales, while the giant U.S. market with its 17 million in annual car sales makes up only 4%.

"The U.S. is Volkswagen's Achilles' heel," says Thomas Ryard, an analyst with market researcher Global Insight. "VW still has a brand name in the U.S., but they are always coming up with the wrong strategy and taking the wrong model or pricing decisions."

To take on Toyota, analysts say, Volkswagen has to build serious sales muscle in the U.S., where last year it sold only 397,000 cars. To bolster VW's weak U.S. operations, Winterkorn is betting on new models—including a van to be launched in 2008—lower costs, improved quality, and revamped sales and marketing strategies.

Focus on Quality

"We certainly need to enrich our product portfolio [in the U.S.]," said VW finance chief Hans-Dieter Pötsch in a May 2 conference call with financial analysts and the media. "We need models which are more specifically tailored to North America, with a more competitive cost base, and we are doing that."

Winterkorn, a quality-obsessed engineer, aims to transplant to Volkswagen the kind of product planning, components sharing, manufacturing, and quality expertise he instilled at Audi during his tenure as CEO. "There will be a more coherent approach, making platforms as flexible as possible and designing them so they can be built on every conveyor belt," says Global Insight's Ryard. "It's a bit like the manufacturing strategy at Toyota." Poor planning at Volkswagen in the past resulted in new-product pileups, where several key models were introduced in a short span of time and arrived at the end of the model cycle concurrently, puncturing sales.

Volkswagen also must redouble its efforts in China and other Asian markets, where growth is booming. The big U.S. and European markets, by contrast, are stagnant. Though VW ranks No. 2 in China behind General Motors (GM), its sales in the region remain only 27% of VW's total. Last year, the VW group sold 711,186 cars in China, up 24.3%. "There's a long way to go in Asia," says Jonas. "Volkswagen's market share in Europe can't get any better. The company has to look outside the EU for growth."

Since Jan. 2, VW's shares have soared 35.5%, buoyed by Porsche's interest in raising its VW stake. They rose 0.4% on May 2, to €111.75 ($152) on the Frankfurt exchange.

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