Mercedes and BMW Hit Hardest by Slump

Daimler's executive board has moved offices within the southwestern German city of Stuttgart a number of times over the years. They first relocated across town from the district of Untertürkheim to the higher-lying district of Möhringen. A few years later, they returned to the valley. Then recently the top executives had to transfer from their high-rise office building there to the former company museum.

But wherever the company's senior management goes, a fog of rumors always follows them. And at the moment it is billowing thicker than ever.

Dieter Zetsche, the company's mustachioed CEO, is even allegedly due to be replaced soon—apparently by the current chairman of the supervisory board, Manfred Bischoff. And the more the managers whisper in backrooms, the more often they meet other colleagues who have already heard the rumor. For some people that even counts as a confirmation that the gossip is true.

Rumors are spreading faster than ever in Stuttgart these days. The giant carmaker Daimler (DAI) is not doing well. Car sales have declined by almost 18 percent, while truck sales have plummeted by around a half. The company reported losses of €2.4 billion ($ 3.5 billion) for the first six months of this year.

Zetsche has introduced a savings plan aimed at reducing costs by €4 billion a year. But he still hasn't been able to come up with conclusive answers to key questions. Can the premium carmaker Mercedes-Benz survive alone, or does it need a partner? And how long can Daimler continue to compensate for the drop in sales by relying on government-sponsored "short time" programs which support workers on reduced hours? If sales don't pick up soon, the company will have a surplus of 25,000 employees on the payroll, according to internal calculations. Will the carmaker have to close plants and lay off thousands of workers?

Hard HitThe global economic crisis has unnerved Daimler, a carmaker which had grown accustomed to success. It is difficult to compare the current downturn with previous sales slumps. One difference is the introduction of a government "cash for clunkers" scheme designed to support the auto industry—but which almost exclusively benefited high-volume carmakers. But that's only part of the story.

Up until now, premium producers like Mercedes-Benz have had an easier time weathering economic storms. This time around, the luxury class is the hardest hit. Sales are also collapsing at brands like Bentley, where sales are down by 50 percent, Rolls-Royce (minus 41 percent), Porsche (minus 25 percent) and BMW (BMWG.DE) (minus 18 percent).

There are multiple reasons why the luxury segment is suffering so badly. Many customers can no longer afford a luxury model, partly because companies have reduced bonus payments for executives, partly because fewer models are being ordered as company cars and also because many managers have lost their jobs.

And there are other consumers who are simply no longer willing to spend so much money on a car. Times are changing and drivers' relationships with their cars are evolving, according to a study conducted by the PricewaterhouseCoopers consulting firm. The automobile is increasingly being seen as a means of transportation—and less as a status symbol.

Downsizing TrendUntil recently, customers always wanted to move up to a larger class when purchasing a new car, but now the opposite is true. Mercedes-Benz purchasers are ordering an E-Class instead of an S-Class luxury sedan, or a compact executive C-Class instead of a larger E-class. A similar development can be observed at BMW, with serious consequences for the carmaker.

Small cars generate only small profits—if that. Consequently, today's downsizing trend has taken a big bite out of manufacturers' earnings.

With a decline of just over 7 percent, Audi is the German upmarket car brand least affected by the current drop in sales. The Volkswagen (VOWG.DE) subsidiary sells a higher proportion of its cars in the compact and lower midsize range. In addition, Audi is profiting from the other two German luxury carmakers' failures by offering what many consumers are looking for during the crisis: premium with a touch of understatement. By contrast, Mercedes-Benz and BMW have been caught unprepared by the new trend in consumer behavior.

Many customers define luxury differently than they did only a short while ago. Cars are still expected to be fast, sexy and safe. But for many people today, prestige now also means that their luxury sedans run in a more environmentally friendly manner or, better yet, act as a trendsetter for green technology. As a result, Daimler and its competitors need to invest billions in electric, hybrid and hydrogen technology.

But it will take some time before they can earn money on these models. In the meantime, their core business has crumbled, leaving them with insufficient profits to finance the necessary investments. Daimler and BMW have fallen into the luxury trap, and they will have a hard time getting out.

Lack of VisionThis development has rattled the company's top executives. For decades their objectives were clear. First, they were supposed to become the world leader in automotive engineering, then a trans-Atlantic powerhouse by merging with Chrysler. Both visions proved to be dismal failures. But Daimler executives have a hard time getting by without any clear mission at all. They are torn between the affirmations of their boss that Daimler can make it alone, and the continuous search for a partner, which appears to contradict those claims.

Following its disappointing experiences with Chrysler and Mitsubishi, Daimler was actually no longer interested in entering into a partnership with a high-volume carmaker. But when then-Porsche CEO Wendelin Wiedeking asked Daimler executives if they wanted to buy a stake in the sports car manufacturer, and thus indirectly become a major shareholder in VW, they started negotiating again.

Zetsche met a number of times with Wiedeking. But the Daimler CEO and supervisory board head Manfred Bischoff agreed right from the start that such a mega-deal was only possible if it was approved by all major VW shareholders. Ultimately, the deal died when the state of Lower Saxony, which owns a blocking minority stake in VW, and Ferdinand Pi&eumlch, the powerful chairman of the VW supervisory board, announced their opposition.

Daimler is also conducting talks with the high-volume carmakers Toyota (TM) and Renault (RENA.PA). These negotiations are focusing on issues like hybrid technology and pooling engineering resources for the miniature Smart car. But the most frustrating negotiations have been with BMW. The two upmarket brands actually constitute the best match, but they have the most difficulty agreeing on joint projects. BMW once sold engines to Opel, but they refuse to sell them to Mercedes because they believe that they currently enjoy a competitive edge.

Primordial FearFrom a technological and business perspective, everything points toward a close cooperation between the two companies. Consumers long ago made a mental leap that engineers still reject—today's drivers have no problem with the fact that the Porsche Cayenne has a VW engine under the hood. It has been slightly modified so that it accelerates like a Porsche—and sounds like a Porsche. That's what counts.

Such a division of labor between BMW and Mercedes-Benz would save hundreds of millions of euros annually. So why shouldn't it work?

It is the vanity of the engineers that have put a stop to this marriage. But it also has to do with the history of the two companies. Daimler tried to take over BMW during the 1950s. Ever since they fended off that attempt, managers and the principal owners, the Quandt family, have suffered from a kind of primordial fear of losing their independence.

Nevertheless, the longer-term threat to that independence could be even greater if BMW doesn't cooperate with Mercedes-Benz. After all, the Munich-based carmaker suffers from the same problems as its arch rival. And like Daimler, it has also been unable to come up with convincing solutions. BMW is currently only doing slightly better because the company introduced a cost-cutting program earlier and invested in fuel-saving technology.

New CompetitorIn a series of laborious negotiations, Zetsche has been trying to convince the competitor of the merits of other projects, such as a joint transmission and engine plant in the US. The pressure to forge a deal is considerable because the real challenge to both brands—on top of plummeting sales and changes in consumer behavior—comes from another German brand: Audi.

The newcomer in the premium class can rely on the platforms and engines of the huge VW conglomerate. Audi has to invest much less in new models and is making life difficult for the leaders on the upscale market.

The A3, for example, is based on VW Golf technology. And the A1, which will be released at the end of the year, uses technology from the VW Polo. What Audi saves in engineering costs can then be spent on extravagant interiors. In fact, some of its models appear more luxurious than those of its competitors BMW and Mercedes-Benz. VW CEO Martin Winterkorn says that he is determined to make Audi the leading premium brand.

The reactions of Mercedes-Benz and BMW to Audi's attack show how seriously they take this threat. They are no longer smiling superiorly at the upstart. Instead, they have started to chip away at Audi's image—for example by trying to associate it with VW's Czech subsidiary Skoda, which makes relatively inexpensive cars. It certainly can't be a long-term successful strategy, says Zetsche, if you take a Skoda body, glue four rings onto the hood, and sell the vehicle as an Audi.

Thin-SkinnedBut VW's strategy of equipping its many brands with essentially the same engineering technology has so far paid off. Consumers are not switching in droves from Audi to Skoda, although such a vehicle would give them similar road performance at a substantially lower price tag. Neither Mercedes-Benz nor BMW have figured out how they intend to compensate for Audi's cost advantages. And that's not the only problem.

The crisis has also hit Daimler's truck business. Sales there have plunged by nearly 50 percent. Within the company, they are already calling it a success that this division suffered losses of "only" €650 million in the first six months of this year.

Not surprisingly, this situation is putting Daimler CEO Zetsche under enormous pressure. A number of Daimler managers accuse him of making important decisions without consulting other people. They say that Zetsche has become thin-skinned, and overreacts to every criticism. But it is precisely at times like these that management needs to openly discuss all options to steer the company out of the crisis.

Another contentious figure adding to the general sense of frustration Rainer Schmückle, chief operating officer of the Mercedes-Benz Cars division. He is an efficiency booster who has already managed to drastically reduce costs at Daimler's US subsidiary Freightliner. Schmückle's management style has earned him enemies at all levels of the company. Assembly line workers laid down their tools because the speeds he wanted were unrealistic. Managers criticize the fact that Schmückle apparently only knows two management principles: Either he makes threats or he shouts—and sometimes he does both simultaneously.

Schmückle has often indicated that he is ready and willing to take on a higher position. But according to sources in the company, it has been clear within the firm for some time that the manager will never become a board member. On the contrary, Schmückle is expected to leave the company soon—either voluntarily or with a helping hand.

No Easy AnswersTwo candidates are already ready to fill his shoes: the erstwhile VW cost-cutter Wolfgang Bernhard, who currently heads the van division for Daimler, and Thomas Weber, who leads research and development at Mercedes. The idea is for them to ease the work load on Zetsche, who is currently performing two jobs. As the head of Daimler, he has to represent the company to investors and supervise the truck and car divisions, while in his role as Mercedes boss, he has to make decisions about such things as the new rear axle for the A-Class and the interior of the Smart.

e as the head of Daimler and Mercedes. A number of members of the supervisory board say that no one there favors replacing Zetsche. They say that it is not the Daimler CEO's fault that no solution can be found to many of the manufacturer's problems. Supervisory board chairman Manfred Bischoff intends to extend Zetsche's contract, according to plan, at the supervisory board's first session in the coming year.

Nobody knows how long the current sales slump will last or how the market for luxury cars will develop. In Germany smaller cars are in high demand. In China, however, consumers want the biggest cars they can buy.

It's a situation in which there can be no easy answers. But answers need to be found quickly.

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