Stalled in the USA: Europe's Small Cars

The strong euro and pricey labor are making it tough for VW, Volvo, and others to show a profit in America

When automakers reported how many cars they moved in the U.S. in May, small fuel-sippers were the clear favorites. Ford Motor (F) sold 53% more Focus compacts than it did a year ago, while Nissan's (NSANY) tiny Versa sold 15% more. And Volvo (F), Volkswagen (VLKAY), and BMW? All sold fewer of their small models.

A head-scratcher, that. European carmakers should be cleaning up. After all, small cars rule the road on the Continent, where gasoline costs twice as much it does in the U.S. But here's the dirty secret: Volvo, VW, BMW, and their peers are limiting the supply of some of their cars in the U.S. because they aren't profitable.

Earl J. Hesterberg, chief executive of Group 1 Automotive (GPI), a Houston megadealer with two Volvo stores, says he could sell 5 to 10 times as many S40 compact sedans if Volvo reinstated a lease deal it dropped in March to suppress sales. But "there isn't a scenario where we can sell cars under $30,000 at a profit," says Volvo Cars of North America President Doug Speck. He acknowledges Ford's Swedish brand could lose U.S. market share.

European carmakers are victims of a punishing exchange rate. Over the past 12 months, the euro has risen 13% against the greenback. The suggested retail price for a Volvo S40 T5 is $32,085, says By contrast, a Ford Focus goes for $16,650. Even VW, which two years ago made a big fuss of selling its Rabbit, Beetle, and Jetta—built in Mexico and Germany—for $17,000 each, is limiting supply of some models because they contain so many profit-killing European parts. And the company has to price a typically equipped version of its new German-made Tiguan small SUV at nearly $30,000, a potentially sales-killing premium over models that Honda (HMC), Toyota (TM), and Ford build in the U.S.

High labor costs are another fact of life in Europe, where unions remain powerful. Although more than 100,000 auto jobs have moved into cheaper Eastern European countries, Volvo builds its cars in Sweden and Belgium while VW and BMW still make many of theirs in Germany and Austria. European automakers also typically load up their brands with goodies popular with drivers at home, including sporty suspensions and more powerful engines. Such add-ons only make the vehicles more expensive, and often less fuel-efficient, than rivals in the U.S.

Why don't the Europeans simply make more of their cars in America? Mercedes (DAI) and BMW are already doing that. But, like the Big Three, they misjudged the U.S. market and invested billions of dollars in factories dedicated to making fuel-sucking SUVs such as BMW's X5 and the Mercedes M-Class.

Only now are the Europeans starting to switch gears. Audi, which was planning to build an SUV plant in the U.S., is mulling building passenger cars there, too. Audi parent VW is close to choosing a location for a factory that will probably build Passat sedans and a small VW and Audi SUV. That move could boost margins on those cars by 30%, depending on how many U.S.-manufactured parts go into them. Volvo has long resisted entreaties from Ford to build more of its vehicles in the States. Volvo wanted to protect jobs in Sweden as well as the brand's European identity. Now the company says its future may depend on building cars alongside Fords on U.S. assembly lines.

One European car continues to sell briskly: BMW's Mini had its best sales month ever in May. Yes, the re-imagined classic is made in Oxford, England, and it suffers the same high costs as Volvo and other European makes. But it's a cult car, and con-sumers seem happy to spend up to $5,000 per vehicle on custom paint and other heavily marked-up extras. Models like the Mini come along only once every decade.

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