Volkswagen might be the market leader in Europe, but its profitability is crumbling and experts say its basic strategy is flawed and needs urgent change. As VW is increasingly squeezed in the marketplace, its high cost high price strategy is increasingly being called into question. Neil Winton reports.

VW has too many brands, its traditional policy of using perceived quality to allow it to compensate for high costs in Germany by higher prices is failing, and its move upmarket should have been left to Audi. Things have deteriorated so much that investment banker Goldman Sachs recently called for a Lopez Mark II to slash costs and whip everyone into line.

In the 1990s, VW hired charismatic, Spanish-born Ignacio Lopez de Arriortua, nicknamed “Lopez the Terrible”, away from General Motors, to confront suppliers and take an axe to a bloated internal bureaucracy. Clearly Lopez’s reign, which ended in controversy in 1996 after a flurry of lawsuits and a diplomatic row between the U.S. and Germany, didn’t leave a lasting impression on VW’s operations.

As well as these strategic missteps, VW’s flagship car, the Golf, the latest iteration of which was launched in the autumn of 2003, has been stumbling at dealerships. VW was forced to concede that it had overpriced the car and quickly took measures to put this right by adding free content like air-conditioning. Sales have now risen to a healthier level.

Volkswagen acknowledges that there is a problem. Earlier this year, VW CEO Bernd Pischetsrieder announced a restructuring programme called “ForMotion”, which aimed to cut 2 billion euros from budgets by the end of 2005. This was roundly criticised by investment bankers and other experts as being too timid.

“VW’s ForMotion plan is clearly not as far reaching as the restructuring at Nissan or Chrysler recently,” said investment banker Lehman Brothers.

The Financial Times of London’s Lex column wasn’t impressed either.
“Bernd Pischetsrieder provided plenty of sound bites, but rather less in the way of structural change to deal with the problem. Describing 2 billion euros as a “giant step forward” sounds good, but stops short of the Cultural Revolution needed to deal with the group’s ill-conceived forays into the luxury car market,” said Lex.

Less workers make more cars at Toyota
By way of background, the FT also tellingly pointed out that VW has 335,000 workers which make 5 million cars a year. Toyota, the Japanese powerhouse, made 6.8 million cars last year with only 264,000 employees.

Stephen Cheetham, European auto analyst at Sanford C Bernstein in London, hopes that VW eschews a Lopez II plan. “The Lopez approach, fundamentally a knee to the groin to the suppliers, doesn’t really work. You need to work with suppliers in a partnership which is tough, but throughout the value chain. You also need fairness and then it will work,” Cheetham told Just-Auto in an interview.

Volkswagen must take a fresh look at its brands, which include VW, Skoda, and Seat at the mass-market level, more upmarket Audi, and the stratospheric Bentley, Bugatti, and Lamborghini.

Too many brands
“The brand strategy looks odd. There are too many and it’s all a bit like GM. It’s easy to see what Audi, Seat and Skoda mean, but I’m increasingly asking what VW stands for. It doesn’t have the cost base to compete in the mass market, and doesn’t have the brand strength and it’s too big to move upmarket,” Cheetham said.
“I’d prune the product line and make the brands more focussed. I wouldn’t sell the (bottom of the range) Lupo, and make it just three (VW) products – Polo, Golf, Passat – and ditch anything bigger than a Passat. I’d turn the VW Touareg into an Audi and stop the brands overlapping. Seat and Skoda should be commonised – so you’d only sell one brand in each country. You’d have to decide on the countries – for instance Skoda would cover eastern Europe, and this would save a bunch of R&D,” Cheetham said.

Mark Fulthorpe, director of European forecasting at auto-industry consultants CSM Worldwide, agrees that VW has lost its ability to charge premium prices, and is unimpressed by the scale of the “ForMotion” recovery plan.

“It (ForMotion) seems to be a nibble here, a nibble there, that kind of thing,” Fulthorpe said.

Inefficient capacity use
Fulthorpe is worried by VW’s inefficient use of capacity – the company is said to have at least 20 per cent more capacity than it needs – but is heartened by some VW moves to embrace more niches, like the Touran compact MPV version of the Golf, and the soon to be launched “High roof” version. An SUV Golf is expected in 2007 or 2008.

“This will be the key to fighting back BMW and Mercedes from above, the Koreans from below, and Toyota head on. VW is charging a premium now (versus Toyota) but for how much longer will that be valid? Not for much longer; Toyota won’t be seen as inferior to VW,” Fulthorpe told Just-Auto.

Look out; here comes the 1-Series
The new small BMW 1-series, set to be launched this autumn, is particularly dangerous for VW. Fulthorpe expects 1-series sales to eventually reach about 200,000 a year.

“Where will those sales come from? The natural competitors are higher end Golfs and the Audi A3. It would be a huge, huge, negative for VW if it continued to just build 3 and 5 door hatchbacks, but initiatives like the Touran will give it some breathing space,” Fulthorpe said.

VW’s attempt to move the VW brand upmarket with the Phaeton, an attempt to compete with the likes of the BMW 7-series and Mercedes S-class, has baffled and disappointed investors. VW was also rumoured to be planning a BMW 5-series competitor.

This blind-alley has cost VW a huge amount of money which is likely to be wasted.

How much did they lose in this upmarket foray? “I shudder to think, but it was a lot,” said Sanford C Bernstein’s Cheetham. CSM’s Fulthorpe agrees that the VW luxury plan was a big misstep.

Audi should chase upmarket
“It would seem more sensible to deploy Audi to go chasing BMW and Mercedes, not VW. The market for VW goes up to the Passat, but above that how much mileage is there? The W8 (bigger engined Passat) and Phaeton (sales) are well under target; but the Touareg has performed well ahead of expectations,” Fulthorpe said.

Some experts are impressed with VW’s strong product pipeline. “VW will have renewed nearly 60 per cent of its offering between Q4 2003 and Q2 2005. We believe many investors are now overlooking the positive impact these launches will have on demand, marketing costs and earnings,” said Lehman Brothers.

Not Goldman Sachs.
Goldman Sachs, in its report which called for a Lopez Mark II, said VW’s problems were 30 years in the making, with problems in every area except Audi. Structural overcapacity remained and the “ForMotion” plan failed to provide the obvious solution – restructuring and capacity cuts. The company’s long-standing strategy of using premium prices to protect an uncompetitive cost base was coming apart.
Goldman Sachs was making its comments after VW reported sharply lower first quarter earnings in April. Net profit tumbled to 26 million euros, from 202 million in the same period last year. VW had promised investors that its results would be “lousy” and it duly delivered.

Stunning earnings collapse
“The extent of collapsing earnings in almost every business was still stunning. This is not a simple cyclical blip. In our view VW is facing serious structural issues that are fundamental and potentially permanent,” Goldman Sachs said.

Some experts reckon that VW was deliberately understating its performance so that it could force change internally and look good later in the year.

“We believe management is currently keen to paint a bleak picture in order to mobilise the company internally rather than fighting what potentially may be a lost battle to reverse investors’ sentiment,” said Lehman Brothers.

Goldman Sachs doesn’t buy this.

“We see little evidence in the accounts to suggest that VW ‘sandbagged’ results in order to deliver better earnings in subsequent quarters. Management stated (to analysts after Q1 results) that results reflect the real situation. The real situation is rather grave in our view,” Goldman Sachs said.