Slipping into Overdrive

At a futuristic, glass-walled factory in the eastern city of Dresden, Germany’s latest luxury car is starting to roll off the production line. The 5 m-long machine has all the performance amenities that customers associate with finely calibrated German engineering, including an optional 12-cylinder engine and a special pneumatic suspension system to guarantee a smooth ride. The price tag is breathtaking too: between $46,000 and $92,000, depending on extras. But this car is not the latest Mercedes or even a top-of-the-line BMW. It’s a Volkswagen.

Are they kidding? Not a bit. Volkswagen has spent nearly $900 million developing the new car, which is called the Phaeton and will be officially unveiled at the Geneva motor show next month. The brainchild of VW CEO Ferdinand Piëch, the Phaeton represents the company’s latest attempt to move the brand up-market away from commodity car-making and into the profit zone long dominated by Mercedes and BMW. But it’s a huge gamble for a company whose very name means People’s Car. “The question is, will a customer want to pay that amount of money for a Volkswagen when you can have cars that already have a brand image such as BMW, Mercedes, Jaguar and Lexus?” says Garel Rhys, an automotive expert at the University of Wales. “If they offer the same sort of car at the same sort of price, then they’re in trouble.”

Maybe, but it’s the kind of risk that Piëch has relished since taking over as VW’s top executive in 1993. Piëch has motor fuel in his blood as the grandson of Ferdinand Porsche, who founded the legendary sports-car company. Under Piëch’s command, VW has become Europe’s biggest carmaker and fourth-largest in the world in terms of autos sold. He has expanded its car business by successfully integrating new brands such as SEAT and Skoda. And Piëch has added some boutique carmakers like Lamborghini and Bugatti to give the company, which also includes Audi, some additional cachet. Under Piëch, Volkswagen commands 51% of the car market in China and 25% of sales in Brazil. Perhaps most important is what Piëch hasn’t done: made expensive mistakes, as BMW did in buying British car-maker Rover and as Mercedes committed by acquiring U.S. giant Chrysler.

Now Piëch is slated to move up to the company’s supervisory board this April. He will be succeeded as CEO by Bernd Pischetsrieder, who joined VW in 2000 after being forced out of rival BMW in the wake of the company’s calamitous investment in Rover. With his insider knowledge of BMW’s successful effort to create a high-end image, Pischetsrieder is expected to concentrate on brand building at VW, while trying to get the company’s costs down. Some shareholders hope that he will also show more attention to the stock price than Piëch did. His comments on that score so far are hard to read. “Naturally it is our goal to increase the long-term share price,” he told the newspaper Handelsblatt last month. “But in our sector the money returns six or eight years after the investment. That’s why the auto industry isn’t in fashion on stock markets these days.” Is that clear?

The real problem with Volkswagen as an investment is that its largest shareholder is the state of Lower Saxony, which holds 18.2% of the shares and is more interested in preserving jobs than enhancing shareholder return. There is also a law on VW’s books preventing any other investor from holding more than 20% of the company, an effective bar to a takeover bid. For these reasons VW’s share price languishes at 1997 levels. “The feeling is that the management in place has tended to give low priorities to investors, having several other constituencies that come higher up the attention screen,” says John Lawson, who follows the auto business at Schroder Salomon Smith Barney in London. Adds Ekkehard Wenger, an economist at the University of Würzburg and a vocal corporate gadfly in Germany: “Volkswagen doesn’t exist to serve shareholder value, it exists as part of the patronage structure of Lower Saxony.”

In an effort to address some of these concerns, the company decided to reorganize into two groups. SEAT and Lamborghini will be part of the new, sporty Audi group. The more traditional Skoda, Bentley and Bugatti will fall under the Volkswagen brand. “This will support corporate transparency and our customers’ and shareholders’ interest in the company,” VW said when the restructuring was announced last year. In fact, for a high-volume manufacturer, VW had a pretty good year in 2001. Return on sales was a robust 5%, about the same as Peugeot, but behind BMW’s 7% and Porsche’s double digits. Pischetsrieder says he wants to boost the company’s return on investment from the current 7-8% to a figure above 9%.

One clear imperative is for Volkswagen to raise productivity at its German factories while maintaining its reputation for producing well-made cars. According to a study by World Markets Research in London, VW’s factories turn out only 46 cars per employee, while Renault averages 71-73 per worker and Nissan gets 101 at its British assembly plant. Volkswagen has a been a pioneer in using so-called platforms — mainly common engines and drive trains — on a wide number of models, thus saving money on research and development. But many analysts have warned that the company may be taking the process too far, so that the cars are starting to look alike. “With the Volkswagen Passat and Audi A4 in some European markets, people know they can get a cheaper car that’s bigger by buying the Passat,” says Gregory Melich, auto-industry analyst at Morgan Stanley in London.

Volkswagen, with 19% of the European car market, has its work cut out for it in trying to increase its market share against low-end competitors like Fiat, Ford and Japanese imports. Now luxury competitors are pushing their marques into the compact-car market too, including the Mercedes’ A-Class and BMW’s One-series, further encroaching on Volkswagen’s territory. It’s no wonder the People’s Car-maker decided to fight back by launching a challenge in the luxury sector. But as beautiful as it looks, does the Phaeton stand a chance against the established luxury champs? The people will decide.