A Pitch to the Rich

By Daren Fonda

Remember Fahrvergnugen, the German tongue twister that Volkswagen adopted for ad campaigns in the early 1990s to express the thrill of driving its cheap, dependable, even lovable cars? For VW owner Ann Jones of Corona, Calif., the experience has been more like far from groovin'. Jones was lured to the Jetta by its stylish looks, elegant interior and solid road handling, which made it seem worth the $18,900 price. But a few months after bringing her new sedan home in 2000, she returned it to the dealer because of an oil leak.

Then a door lock broke. Then a spring popped out of a seat. By the time she had put 50,000 miles on her Jetta, it already felt sluggish, says Jones, 28. And what especially disturbed her were the grim faces of fellow VW owners whom she encountered at her dealership. "The majority of them weren't there for basic service" of their cars, she says, "but because of some defect."

Ordinarily, Volkswagen might be able to argue that Jones received a rare lemon. But in the latest survey of three-year depend-ability by J.D. Power & Associates, American consumers ranked VW-brand cars 34th, ahead of only Suzuki, Daewoo, Land Rover and Kia. Consumer Reports, which recommended three VW models in the late 1990s, keeps only the pricey Passat on its list of recommended cars. That's quite a tumble for the Volkswagen Group, Europe's largest automaker, which turns out 5 million units a year under brands including Audi, Bugatti, Seat and Skoda.

These quality issues are raising concerns about VW's hold on the North American market--the largest and most vibrant in the world, and a critical one for VW's profit growth. While VW is puttering along in Europe's anemic market--the firm has an 18% share in Western Europe and has sold almost 2 million cars in the first nine months of 2003--it is struggling on this continent. The VW brand's U.S. sales fell 14.6% over that same period, to 221,177, and operating profits in North America shrank to $68 million in the first six months of the year, down from $944 million during the same period in 2002. While North American sales accounted for just 20% of Volkswagen's $101 billion in global revenues in 2002, they delivered 27% of its $5.4 billion in operating profits. And VW clearly aims higher: around a third of its $1.6 billion global ad budget is spent in the U.S.

The man in charge of revving up Volkswagen is CEO Bernd Pischetsrieder, who took over from the domineering Ferdinand Piech in April 2002. A personable, goateed man who ran BMW from 1993 to 1999, Pischetsrieder, 55, is pursuing a risky sales strategy inherited from Piech: pushing his flagship brand into the U.S. luxury arena, where vehicle profit margins are higher than in the mid-priced segment in which VW typically competes. At the same time, he is wringing costs out of manufacturing through design changes and by getting relief from VW's expensive German work force. The firm recently announced that net profit was down 51% in the third quarter compared with a year earlier, and CFO Hans Dieter Potsch warned that the firm would take a charge of "a couple hundred million" euros this quarter to offset R.-and-D. costs.

The company known for the inexpensive Beetle is now launching its most expensive cars ever. Its first SUV, the Touareg, tops $42,000 with an eight-cylinder engine, putting it in league with hot models from BMW, Cadillac and Infiniti. And a loaded Phaeton, a sedan that cost more than $900 million to develop, will have a sticker price north of $85,000 when it hits U.S. dealerships in December. VW plans to launch dozens of new models over the next two years, including a new Microbus, smaller SUVs and crossover vehicles, and is considering a sexy convertible, the Concept R, which Pischetsrieder unveiled at the Frankfurt Auto Show in September. VW's new Golf, expected to hit North America in 2005, has received early positive reviews in Europe and should bolster profitability thanks to lower manufacturing costs.

Pischetsrieder insists the strategy will pay off once the new cars take hold with consumers. Investors seem to think so. VW's share price rallied 34% from the start of the year to early November, outperforming the Dow Jones auto index by 14 percentage points. The Touareg is off to a strong sales start, both here and in Europe. The Phaeton is not. Available in Europe for more than a year, it has been no threat to the Mercedes S Class and the BMW 7 Series, selling less than 8,000 units (in 2002 BMW sold 14,670 7 Series cars in Europe). Equity analysts cite the Touareg and the Touran multipurpose vehicle (MPV) as signs that VW is broadening its mix in Europe, enabling it to profit in hot segments such as SUVs and MPVs and to hedge against downturns in other segments. Some are skeptical. Christopher Will, an analyst at Lehman Brothers in London, describes the Phaeton as a "mistake" and an "irrelevancy." Says Will: "The VW brand could become muddled if the quality issues persist or if VW launches more products that don't fit its core image." Certainly it's difficult to move upmarket when the perception is that quality is heading down, so fixing that issue must be Pischetsrieder's first task. Next he has to ensure that VW's move into luxury doesn't come at the expense of sales in its higher-volume, mid-priced segments. "We know the premium segment is different from the mass market, and we need to make certain that Volkswagen lives up to its new image," he said in September.

The VW boss also needs to take a grinding wheel to costs, which are among the highest in the industry because of expensive labor in Germany, where it runs 10 plants. VW has moved production to eastern Germany--to qualify for government aid and take advantage of lower wages--and to lower-cost countries like Slovakia. Pischetsrieder, known as a gearhead with a good grasp of finance and marketing, hopes to save $3.4 billion over the next five years. Some of the savings will come from sharing more components, like engines, transmissions and ventilation systems, across VW's models and brands. To instill a sense of entrepreneurship and accountability, he has also set profit targets and production goals for project managers.

On the sales side, VW needs to win back Americans' trust, particularly if it wants to sell those higher-margin luxury cars. VW's late-'90s American renaissance came after nearly two decades of slack sales that led it to consider pulling out of North America. The New Beetle, launched in 1998, saved the decade. Baby boomers with fond (and sometimes pot-hazed) memories of Microbuses and Bugs gravitated to the car, or at least to the dealership, where they saw Jettas and Passats that appealed to their more practical side. Teenage boys and young men turned the Golf GTI into a hit on the "tuner" scene glamorized in the film The Fast and the Furious. The New Beetle and Jetta found an adoring audience in young, college-educated women. VW went from selling just 49,000 cars in the U.S. in 1993 to 352,000 in 2000.

The automaker is now facing the dark side of owning a brand that consumers are passionate about. At the website myvwlemon.com owners gripe about faulty brake lights, knobs that fall off and clutches that blow after just 60,000 miles. VW says many of these problems are minor and that its cars perform solidly over the long haul. Also, the Internet hosts gripe sites about almost all car brands. The problem, says Jamie Vondruska, who runs vwvortex.com is that "VW owners are so attached to their cars, they take it personally when things go wrong." Blame it on all those clever ads that reinforced the notion that VW owners are a breed apart.

VW's reputation for durability hasn't suffered as much in Europe. Its cars stack up well against rivals from GM's European subsidiary Opel and France's Renault and Peugeot, and far better than Italy's Fiat. Compare that with the U.S., where the benchmarks for quality are Japan's Toyota and Honda, famous for their manufacturing standards. But that's changing too. The Golf V and its variants are facing a tougher European marketplace. The Golf will take on a redesigned Opel Astra, which will launch early next year, and faces formidable foes in the Peugeot 307, Renault Megane and Mazda's upcoming Mazda3. The Golf is already losing sales to its VW brethren, such as the Audi A3 and models from Skoda and Seat.

Moreover, Japanese and Korean automakers are cutting into VW's core segment: compacts. In a European market that is down 1.5% this year, Honda's sales are up 7.4%, almost entirely thanks to its new Jazz subcompact. Hyundai, with sales up 10.8%, boasts a European market share of 1.7%, on a par with VW's Skoda. And Toyota's Yaris, packed with features and options for less than $17,000 in most markets, is a bargain compared with VW's $18,000 Golf. The euro's strength against the yen is also bolstering Asian automakers' profit margins, putting pressure on higher-cost manufacturers.

Then there's China, a market once dominated by VW that is attracting newly intense competition. VW's market share in the world's fastest-growing car market has fallen from 60% to under 40% in only two years, as more than 100 local and foreign automakers have entered what amounts to a demolition derby. After industry sales grew 56% last year to about 1.1 million vehicles, they rose another 82% for the first half of 2003, according to the industry publication Automotive News. VW and a partner recently broke ground on a new engine plant in Shanghai, amid plans to expand capacity from 800,000 to 1.6 million vehicles annually at a cost of $7 billion over five years. Other manufacturers are also adding capacity.

All this intensifying global competition makes the U.S. market key for VW. But as the Big Three learned the hard way, you can't build luxury-car sales if the reliability of your basic fleet is perceived to be poor. Among the Big Three, only GM's Cadillac, with a fleet of radically redesigned vehicles, including a new crossover, remains one of the top sellers in the luxury segment. Moreover, luxury-car buyers have come to expect an elite level of service at dealerships, something VW isn't known for. In 1998 only 81 of 600 authorized VW dealers sold the brand exclusively. The vast majority sold other nameplates and were caught short-handed when VW's sales surged, unable to handle the additional repair and maintenance requests. VW's suppliers weren't able to deliver parts fast enough, especially in the wake of several recalls. "In Arizona we had 160 cars down at once, and we couldn't get the parts, so we had to ask people to wait," says Jens Neumann, a VW board member in charge of North American strategy.

VW says such snafus are behind it. The firm has boosted the number of VW-exclusive dealerships to 350 and plans to raise that figure to 450, which will account for 75% of VW's volume in the U.S. within two years. The company says it has opened five parts depots to alleviate shortages and that dealers have added an average of four new service bays in the past four years. "Two years ago, our customer wait time [for a repair] was on average eight days," says Frank Maguire, vice president of sales and marketing at Volkswagen of America. "Now we're down to 2.6 days."

To pump up VW's reliability ratings, Pischetsrieder recently dispatched to the U.S. Stefan Ketter, a recognized expert in quality control. After service technicians found a potentially faulty wiring harness in the Touareg, VW sent technicians to the homes of Touareg owners to fix the harness if necessary and reassure them of the vehicle's quality. The company now has a dozen engineers in the U.S. to monitor the Touareg and other issues.

None of that will fix a basic Touareg glitch: that strange name. After dealers heard it in 2002, some begged VW for a change of name, fearing that U.S. customers wouldn't have a clue about how to pronounce it. VW has tacitly admitted that they were right. Some of the first TV ads for the Touareg parody the pronunciation (which, for the record, is tour-egg). VW says Americans had difficulty pronouncing Passat when it launched. (Never mind fahrvergnugen.) But that doesn't dispel the sense that VW's marketing department is in triage mode. VW named the Touareg for a rugged tribe of African nomads. But it turns out that the tribe held and traded slaves until the 20th century--a poor association for a company that used slave labor during World War II. Last summer Pischetsrieder's worldwide sales and marketing chief Robert Buchelhofer resigned under pressure and was replaced with several executives who each command one brand.

Will such moves be enough to lure back customers like Jetta owner Ann Jones? A few weeks ago, she became fed up with her car and traded it in for a new Honda Accord. It's a testament to VW that she did so grudgingly. "I will miss the Volkswagen style, and I was saddened to leave my Jetta," she says. But her Accord provides her with something her Jetta never did: "I have more peace of mind." --With reporting by Joseph R. Szczesny/Detroit and Steve Zwick/Frankfurt

With reporting by Joseph R. Szczesny/Detroit and Steve Zwick/Frankfurt