Mercedes Gains, But Still Lags Rivals

The carmaker's more reliable and profitable. But CEO Zetsche will have to deliver on his high-margin vows to catch BMWand foil takeover bids

Gone are the dark days at Mercedes Benz (DAI) when poor quality and plunging profits savaged the global reputation of the renowned German automaker. A three-year overhaul has helped restore strong earnings and buff the reliability of Mercedes' pricey models. Its new C class sedan, which starts at $31,000, has launched without a hitch, to glowing reviews. And Chief Executive Dieter Zetsche even has vowed to boost Mercedes' operating margin from a forecasted 7% this year to 10% by 2010—matching that of Toyota (TM).

But the road back to the top will require more than zooming profits and cars that don't break down. Since Mercedes slipped, rivals such as BMW (BMWG.DE) and Audi (VOWG.DE) have become stronger and are wooing the same well-heeled buyers. Despite Mercedes' steadily improving performance, European consumer satisfaction surveys still show it trailing German premium competitors and Japanese automakers. In J.D. Power's German survey of quality and consumer satisfaction, Mercedes ranked No. 8 this year, up from 11 in 2006, but below Honda (HMC), Toyota, BMW, Audi, and Volvo (F).

"What Mercedes needs to do is to prove they can stick to this level of quality and further improve it—that's what Toyota and Honda do so well," says Martin Volk, project manager for quality studies at market researcher J.D. Power in London. "You can lose a reputation in one day, but to recover takes ages." (Like BusinessWeek, J.D. Power is a unit of the McGraw-Hill Cos.)

The Road to No. 1

No one knows that better than Zetsche and his team of top managers. Since 2002 Mercedes has slashed quality problems in its cars by 50%. Warranty costs are down 45% in the same period. And this year, Mercedes actually ranked second only to Honda in problems per 100 cars, in the German J.D. Power survey. It even beat Toyota. (Mercedes came in with 197 problems vs, Toyota with 201.) But image problems still bedevil Mercedes. "There's more work to do. We want to be No. 1," admits Rainer E. Schmückle, chief operating officer at Mercedes Car Group.

Schmückle also vows to keep chiseling away at costs. The three-year restructuring program launched at Mercedes in November, 2004, has slashed $8.5 billion from annual operating costs. The new C class, for example, has a cost base 20% to 30% lower than the previous model thanks to shorter development time, streamlined production processes, lower supplier costs, and better quality.

Two years ago, Mercedes cars cost $2,000 to $3,000 more to build than comparable models produced by BMW, automotive industry experts say. Like BMW, Mercedes is now moving toward greater sharing of modules among various models to lower costs. That plus more streamlined production has probably halved the gap with BMW to date, analysts say. The arrival of a new E class sedan in 2009 will bring even greater savings—and may help push Mercedes' operating profit toward Zetsche's 10% goal, says Ferdinand Dudenhöffer, director of the Center for Automotive Research in Gelsenkirchen.

Performance-Improving Measures

On the shop floor, the change is noticeable. Anti-static flooring covers acres of production space, to ensure no electrical parts are zapped by stray electricity. Workers jump into cars with infrared handheld devices that automatically inspect assembly quality.

And the testing of each model before launch is far more rigorous—with computer programs that bombard the electronic systems with signals to ensure their resilience.

The three-year overhaul, which included 45,000 performance-improving measures, also boosted revenues by $1.4 billion. Some 8% of the $8.5 billion in savings came from a voluntary program to reduce staffing, which cut 9,700 workers and trimmed labor costs. "It was very hard work," says Schmückle.

Now comes the hard part—climbing back to No. 1. BMW overtook Mercedes as the world's largest luxury automaker in sales-volume two years ago, and analysts say Mercedes Car Group, which includes the Smart mini-car, will struggle to match sales with the BMW group and its popular Mini brand. Mercedes will not lead in sales volume for the next two to three years, says Dudenhöffer. "I don't see more than a breakeven performance at Smart. Mercedes needs a story like the Mini."

Critics Remain Skeptical

No one doubts that Mercedes can churn out rich profits, now that its quality problems have been addressed. But some analysts and rival auto executives are skeptical about Mercedes' bid to achieve lofty, Toyota-level earnings by 2010. "That would mean Mercedes' management goes from poor to perfect in short order," says Commerzbank (AZ) analyst Albrecht Denninghoff. "How do they do it? Where is the miracle in margins and productivity? The bet on 10% is still open."

Others believe the forecast for 7% to 8% operating margin in 2007 may also be a stretch. "Daimler used the divorce (with Chrysler) to make a lot of write-offs. That's a classic financial trick," says a rival German auto industry executive. "If you look bad one year then it's easy to look good the next. We don't believe they are operating at 7% margin."

On Sept. 24, shares in DaimlerChrysler rose 0.9% to €68.64 ($95.76) on speculation among traders that Germany's Quandt family, BMW's largest shareholder, might be buying shares of its arch rival. German finance executives say DaimlerChrysler is still vulnerable to an unfriendly takeover by private equity funds—even in the wake of the decision earlier this year to sell Chrysler—since it has no core shareholder.

Zetsche's vow to hit a 10% operating margin has helped buoy the company's share price. But he'll have to drive it even higher to put Daimler out of reach of determined and deep-pocketed buyers.

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