By Madeline Chambers, European Auto Correspondent
FRANKFURT, July 25 (Reuters) - The problems facing Europe's auto industry were thrown into sharp relief this week as falling demand for cars, a stronger euro and pricing pressure hit profits, and it may take some time for conditions to improve.
In a sector characterised by roughly 30 percent overcapacity and a region where car sales are expected to fall about three percent this year, most of Europe's automakers are battling even to keep earnings stable this year as discounts on cars and currency effects look set to continue.
Former sector darling PSA Peugeot Citroen delivered the harshest blow to investors, missing expectations with a 12 percent fall in first-half net profit and cutting its guidance for the full year in a move that may trigger a shift in investor sentiment towards French rival Renault .
PSA shares dropped sharply and analysts described its comments as a warning signal for the whole sector.
But its peers did not fare much better -- the main difference being that expectations were lower.
Europe's biggest carmaker Volkswagen's operating profit halved in the second quarter while DaimlerChrysler's sank over 60 percent. Renault saw its operating profit sink by over a third in the first half.
Meanwhile manufacturers' attempts to revive their fortunes are hampered by high development and labour costs and pressure from unions and national governments not to cut jobs and close plants to raise efficiency.
European auto stocks have fallen by over 15 percent in the last year, underperforming the wider market , which has fallen by eight percent.
"You have to be prepared to sit it out in this sector and the rewards are not great," said one U.K.-based fund manager.
TOUGH PRICING
While weak economic conditions and subdued consumer sentiment have hit car sales this year, some analysts are also worried the European market may follow the U.S. in resorting to steep discounts to boost unit sales.
Discounts eat into revenue and profits, as DaimlerChrysler has discovered in the U.S. The German automaker blamed a price war in the U.S. for a 948 million-euro operating loss at Chrysler.
Ford Europe, which last week posted a $525-million loss, said net prices in Europe had deteriorated by 2.6 percent in the second quarter from a year ago.
A poor pricing environment is most dangerous when companies are launching new cars, which should command a high price. Analysts say VW could stand to lose since it is launching its top-selling Golf in the autumn into a weak environment.
Renault, which is banking on the new Megane and the Scenic minivan to boost profits, may also suffer, though overall earnings are likely to be boosted by its lucrative stake in Japan's Nissan Motor Co .
CURRENCY BLOW
Another profit-denting factor likely to continue into next year is the strengthening of the euro against the U.S. dollar and British pound, which makes sales in the U.S. and UK currencies worth less in euros.
PSA said the rise in the euro took a 292 million-euro chunk out of operating profit at its auto division.
"Currency is a problem that's not exclusive to PSA and will affect all European producers at some point," said Goldman Sachs in a research note.
VW, less hedged than domestic rivals BMW and Porsche said exchange rates had sliced 400 million euros off its second-quarter profit. Daimler cut its full-year revenue target by seven percent due partly to the stronger euro against the dollar.
"The exchange rates are unfavourable and unfortunately we don't expect that to change," said VW Chief Executive Bernd Pischetsrieder.
Still, some experts say companies with new products may gain momentum in the second half and next year and many think Renault and VW will be the biggest winners.
A predicted gradual market recovery in the U.S. will help German carmakers that sell over a quarter of their cars there. If conditions in western Europe follow suit, the fortunes of automakers may gradually revive.