VW's Big Gamble

Like high rollers at a Las Vegas casino, Volkswagen AG's outgoing Chairman Ferdinand Piech and incoming CEO Bernd Pischetsrieder are gambling the auto maker's future on a strategy that has some onlookers worried. As the new leadership team begins to take the wheel at the world's No.5 auto maker, the plan is to continue on with Piech's controversial strategy to transform the VW and Audi brands into marques that can compete head-on with Mercedes-Benz and BMW AG.

The metamorphosis will be a monumental task for the VW brand, which has become synonymous with small and mass-market vehicles. The same can be said for Audi, a brand that still seems to be searching for its place in the automotive world.

The strategy initially is based on two cards: the ultra-luxury Phaeton sedan and the Touareg SUV.

While Piech has handed over day-to-day control of VW to Pischetsrieder, a leader who has been criticized for the failed strategies he put in place while at the helm of BMW AG, he's not fading into the background. The domineering Piech will continue to look over Pischetsrieder's shoulder thanks to his new perch as chairman of VW's supervisory board. This power-sharing arrangement could spell doom for VW's new CEO even before he gets a chance to clean out Piech's belongings from his office.

Pischetsrieder also will have to navigate a minefield on the German political front as the European Commission looks at eliminating share rules that prevent VW from becoming a takeover target. While the German government opposes any move to change the laws that will make it easier for European companies like VW to be acquired, other European nations are demanding a more level playing field on the corporate front.

Like a good gambler, Pischetsrieder will have to maintain his best poker face to keep VW afloat in the high-stakes global automotive game while at the same time appeasing Piech. It's a seemingly impossible task, although Pischetsrieder seems ready for the challenge, thanks to a stint as chairman of the board of management at Spain's SEAT SA, a VW subsidiary.

But Pischetsrieder hasn't been dealt a great hand. While Piech's management style has been criticized as being too brash, he deserves credit for turning the once fledgling VW brand into a force to be reckoned with. In his nine years at the helm, Piech managed to revamp VW's product lineup and helped revive the Audi brand in the aftermath of its public relations debacle over sudden acceleration in the late 1980s. The controversy captured the attention of U.S. regulators and left Audi nearly lifeless after the U.S. media declared open season on the Audi brand.

“If you would have made a bet in 1993 that VW would be turned around, you would have had pretty good odds against it,” says Phillip Rosengarten, analyst with DRI-WEFA in Germany.

VW's U.S. market share stood at 0.45% in 1993, as the company began the process of building a recovery plan that would instill trust in its brands with products that were engineered to be the best in the world. Piech brought together top European engineering talent to develop critically acclaimed products such as the Golf, Passat, Audi TT and others.

Those efforts helped to boost VW's market share in the U.S. to 2.6% by the end of 2001. In the U.S., Piech took VW brand sales from their low point of 49,533 units in 1993 to their current pace of 355,648 units. Similar results were seen at Audi, where U.S. sales accelerated from 12,528 units in 1993 to 83,283 units in 2001 (see chart below).

While the vehicles were garnering praise, some of Piech's growth strategies were raising the eyebrows of industry watchers. In 1998, VW acquired Rolls-Royce Motor Cars Ltd. and Bentley Motor Cars Ltd. in a convoluted transaction that later was undermined by BMW, which receives the rights to the Rolls-Royce name next year. The Bentley range joined Bugatti and Lamborghini brands in the VW Group lineup. Their additions caused many to wonder if Piech had taken his eyes off the real profit generator: the high-volume VW and Audi brands.

But with the new luxury marques in the plan Piech had the foundation for his ultimate scheme of taking the VW brand, itself, up-market. That plan finally came to fruition in March, when VW took the wraps off its Phaeton luxury sedan. The Phaeton is what many call the last piece of the Piech reign. Now, it's up to Pischetsrieder to handle the dirty work.

After having such an animated and domineering figure at the helm, VW needed someone who was equally as strong and recognizable. Pischetsrieder became a candidate when he resigned from his post of chairman of BMW AG in 1998 amid criticism of his business acumen.

His leadership abilities came under the microscope when, at his direction, BMW paid $1.3 billion for Rover in 1994 in an attempt to expand beyond its luxury car roots and add SUVs to its lineup. Rover Group Ltd., however, continued to bleed red ink through 1998, when it lost $1 billion and pulled BMW's profits lower. The board lost confidence in Pischetsrieder's strategy, and he quickly found himself in the doghouse.

Shortly after Pischetsrieder's forced resignation from BMW, Piech moved quickly to bring the former BMW chief into the VW family and gave him carte blanch control over the SEAT brand. It was Piech's way of testing Pischetsrieder's leadership for his eventual ascension to the VW Group helm.

Pischetsrieder immediately moved to upgrade the SEAT image, transforming it into a performance-oriented brand. As part of that he developed the SEAT Sport unit, which helped to translate the vision into sheet metal. While it sounded like a good strategy, some dealers balked.

“Pischetsrieder had his chance to show what he could do at SEAT and you can see a very clear strategy there to make the brand more sporty and more expensive,” DRI-WEFA's Rosengarten says. “It's a nice idea, and it's good for profits, but dealers were not very amused. They said ‘It's not our traditional customers, and it's very hard to get the luxury/performance customer to buy a SEAT.’” Piech endorsed the strategy, and appeared confident of Pischetsrieder's ability to lead the brand through its transformation.

Now, with Piech's blessing, the new chairman-elect is quickly making his mark on the parent company.

Shortly after Pischetsrieder's appointment was announced in November 2001, VW's supervisory board restructured the group's brand and marketing organization into two distinct units. The first brought together SEAT and Lamborghini under the auspices of the Audi Brand Group, while Skoda, Bentley and Bugatti fell under the direction of the Volkswagen Brand Group.

The purpose of the division is expected to help give VW and Audi further differentiation among their products and brand strategies. Industry watchers expect Audi to take on BMW, while VW will focus its efforts on Mercedes, which is moving aggressively down market at the same time VW is pushing upward.

The challenge is a daunting one, because VW has yet to firmly entrench itself as a luxury marque and Audi has yet to fully establish its reputation in the U.S. market as a performance luxury manufacturer.

Len Hunt, vice president of Audi of America Inc., says he's ready to take on BMW, although he acknowledges Audi needs a wider range of products.

“It's a formidable task,” he says. “If you are going to take on BMW, you've got to look at the vehicles they have. We must have a better product portfolio so that we can match them.”

Hunt expects Audi's transformation to BMW status to take “realistically five to seven years.” While Audi's product portfolio will expand into crossover vehicles and more sports performance cars, it also must transform its sales and service experience to be on par with BMW.

“I've got to make sure my dealers, customer experience and my image development in North America matches BMW. We are closing the gap,” he adds.

While Audi may have a foundation on which to build, the VW brand faces a much bigger challenge taking on Mercedes.

The first salvo in the battle will come in the form of the Phaeton sedan. Introduced in March at the Geneva Motor Show with great fanfare, the Phaeton has been one of the worst-kept secrets inside VW. Available with either a V-6 or the much-anticipated W-12, the car is one of the most ambitious projects undertaken during Piech's regime.

VW spent $163.1 million (E186.6 million) on a lavish 893,405-sq.-ft. (83,000-sq.-m) assembly plant dedicated to building the luxury sedan. Dubbed the “glass factory” because its huge windows allow outsiders to see the cars being built, it has the capacity to produce 150 units per day with 800 employees. The plant features 296,334 sq. ft. (27,500 sq. m) of window area on three levels and 258,334 sq. ft. (24,000 sq. m) of parquet floors, which also are found in the general assembly area.

VW plans to sell upwards of 40,000 Phaetons annually, a lofty goal considering it sells only 15,000 to 20,000 Audi A8s worldwide.

“It's very hard to see how successful they will be with the Phaeton,” says Rosengarten.

“Audi has a much better heritage and a better standing in the market place (than VW) and can only sell 15,000 units.”

While many European consumers (Germans in particular) may embrace the Phaeton, convincing Americans to think of VW as a luxury brand on par with Mercedes will be a tougher sell.

“In the U.S., Audi's challenged to sell Audis against BMW and Mercedes; I think Volkswagen will be an even harder sell,” says Merrill Lynch auto analyst John Casesa.

Another major problem is whether the introduction of the Phaeton will cannibalize A8 and A6 sales. Audi executives insist there's a huge difference between their target buyers.

“We know our friends at VW are going after a different group of people than us,” says Audi's Hunt. “These are very, very different vehicles, even though they are both all-wheel-drive and luxury sedans. I think you get a far more sporty and performance feel with the A8 and a more classic feel with the Phaeton.”

Luxury car owners tend to be very loyal to their brands, but VW says that's not a problem because it plans to capture new buyers who are moving into the luxury segment and want something new.

Meanwhile, the leading players don't seem concerned.

“In today's market one should take everybody seriously who is entering into the upper segment of the market,” says incoming BMW Chairman Helmut Panke. “On the other hand, luxury brands still need a clear heritage-oriented position. Whether you look at our company or at other European (car makers), only those who do have a credible heritage are successful. We will have to see what Volkswagen will do… I would not worry about it.”

The second and most crucial part of VW's growth strategy in the U.S. is its upcoming entry into the SUV market, which will fall on the oddly named Touareg. Criticized by some for its overly unique name, the Touareg will share its underpinnings with the upcoming Porsche Cayenne and Audi's version of the Magellan SUV concept that debuted at the North American International Auto Show in January.

The Touareg — which takes its name from a nomadic African tribe — goes on sale in the U.S. in 2003. VW expects to build 80,000 units annually (including an Audi sibling) at its Bratislava (Slovakia) assembly plant. It's expected to be offered with a 2.8L V-6 (similar to the engine found in the GTI, Passat and Jetta) or a 3.7L V-6. The revolutionary W-8 and W-12 powerplants also will be available as optional powertrains. VW expects to price the Touareg below its Audi and Porsche siblings.

If the SUV succeeds, it will give VW a foothold in the huge U.S. light-truck segment, where, with the exception of its low-volume EuroVan, it has never really competed.

“There's an 8-million-unit segment out there called light trucks, and Volkswagen literally is not playing in the sand box,” says Volkswagen of America President and CEO Gerd Klauss. “We will start with the Touareg, and we will hopefully go deeper.”

VW's move into the SUV market makes perfect sense, says Rosengarten, who points out that VW must play in the segment or risk losing huge profits that will otherwise go to its competitors.

“They're selling more than half a million cars in the U.S., and they don't have a 4×4, so it's an obvious choice in terms of growth and profitability that they move into this area,” he says. “It's a risk, but I think it's worth it.”

If both the Touareg and the Phateon fail to live up to expectations, especially in the U.S., it could spell doom for both VW and Pischetsrieder.

“The American market is the most important to them, and success or no success in America will be the make or break for them,” Rosengarten says. “If they fail in the American market, it will be a disaster.”

If VW's strategy doesn't pay off in the U.S., the fallout also will send ripples throughout the supplier community. Some of VW's largest North American suppliers are GDX Automotive, Sanden International, Degussa — OM Group, Delphi Corp. and Bethlehem Steel Corp. Already running low on gambling chips, failure of VW's strategy could cause some of these companies to bust.

Another thorn in Pischetsrieder's side could come from the European Commission, which is slated to discuss the possibility of eliminating the so called “VW Law” that protects the auto maker from takeover by another company.

The German state government of Lower Saxony, the region where VW has its headquarters and oldest assembly plant, owns just under 20% of VW's outstanding shares. Those holdings carry with them a special “golden share” rule that allows the Lower Saxony government to single-handedly override any attempts by other German or foreign companies to acquire VW.

In an effort to harmonize corporate takeover laws by 2005, the European Commission is threatening to remove Lower Saxony's special status. The EU wants to have regulations similar to those in the U.S., where a company can initiate a takeover by offering to purchase outstanding shares at a set price. If the company's board votes to reject the bid, the prospective buyer can then offer to purchase stock from shareholders and initiate a hostile bid. Currently, the “golden share” provision blocks any type of takeover without the consent of the government.

German Chancellor Gerhard Schroeder is a former governor of Lower Saxony and has been vocal in his opposition to removal of the “golden share” laws.

The stakes for the German government are high if the EU revokes the share law: In addition to VW's Wolfsburg facility, Lower Saxony also is home to about 89,000 of VW's total workforce of 104,000. One in five of the more than 560,000 jobs in Lower Saxony's manufacturing industries are dependent on VW. There's a common saying among the locals that “when Volkswagen starts to cough, the whole region takes to its bed.”

With uncertainty building on all fronts, Pischetsrieder will have to focus his attention on many more issues than his predecessor. While Piech was successful at getting VW's house in order when it came to small and midsize cars, the company had a history in those segments. These new directions could be much more hazardous.

“These are very exciting times; these are challenging times; but we are really looking forward to them because this is what we have to do to be successful in this largest car market in the world called America,” says VW's Klauss.

How Pischetsrieder and his team play their cards will make the difference. If they convince the oddsmakers and consumers that their strategy is on target, Pischetsrieder and his team will go down in automotive history as geniuses. Failure could leave Pischetsrieder's somewhat tattered leadership credentials in a complete shambles and might get him kicked out of the casino for good.

VW's Largest North American Suppliers
(Ranked in order)

GDX Automotive
Sanden International
Degussa — OM Group
Zua Autoparts
Delphi Corp.
Michelin North America
Bethlehem Steel Corp.
Siemens-VDO North America
Goodyear Tire & Rubber Co.
Showa Aluminum Corp.
Autoliv Inc.
Hella North America, Inc.

Source: Volkswagen of America, Inc.