Volkswagen Strains to Keep Foot on the Gas

By William Boston

WOLFSBURG, Germany--Seven years into a decadelong push to outsell rivals Toyota Motor Corp. and General Motors Co., Volkswagen AG Chief Executive Martin Winterkorn appeared to be in the passing lane.

Volkswagen, after all, is on track to sell more than 10 million cars and trucks in 2014--four years ahead of plan. It overtook GM last year and could soon eclipse Toyota to claim the industry's top spot.

But on Tuesday, Mr. Winterkorn surprised investors by announcing he would step down as CEO of the VW brand, the company's namesake marque which has suffered dwindling sales in most markets as well as weak overall profits. He will retain his position as group CEO. His replacement at the VW unit, a top executive from German rival BMW AG, Herbert Diess, will come aboard in October.

The move marks a strategic reversal for Mr. Winterkorn, a Volkswagen lifer, who in July pledged to "take action that is clear, effective and sometimes painful" but gave no hint of handing off the iconic brand. Historically, the CEO of the company, which also includes eight other marques such as Porsche, Audi and Bentley, has always held the reins of the VW brand.

Investors had expressed concern that the CEO was too preoccupied with the company's larger portfolio of brands to focus on the VW unit, which accounts for more than half of group revenue but has skidded amid high costs and falling sales in big markets including the U.S., Russia and Brazil. Some analysts have also questioned the CEO's stomach for profound change at VW.

In a statement Tuesday, Mr. Winterkorn said that the move "puts the executive management of both the Group and the brand on an even broader footing."

The decision to hand control of the VW brand to Mr. Diess may permit faster action, analysts said.

The shift comes at a pivotal time for Volkswagen and the industry. Global car makers are benefiting from the rise of a new middle class in emerging markets that has spawned a generation of first-time car buyers.

But auto makers also face rising costs to cut emissions, improve fuel economy and connect cars to the Internet. The challenge for Volkswagen and its peers is to stay profitable while balancing the potential of global markets against the burden of regulation.

Mr. Winterkorn's response was to spread rising costs over an expanding production base. But world events have been upending those plans.

In Europe, the company is growing slowly in a weak market. In the U.S., VW-brand sales have tumbled until recently and the marque is struggling to break even, according to a person familiar with the situation. Emerging market sales--especially in Russia, Brazil and India--have been battered by political crises and sliding currencies. Growth is slowing in China, a Volkswagen stronghold, and VW brand sales declined for the first time ever in November. The company has yet to penetrate other Asian markets.

Tighter regulations have added to Mr. Winterkorn's headaches. Under current market conditions, meeting European Union limits on carbon emissions will cost Volkswagen up to EUR5 billion ($6.2 billion) in earnings each year to 2020, or the equivalent of adding EUR1,500 to the cost of every car it produces in Europe, according to two people familiar with the situation.

Even before that expense, Volkswagen group's financial performance trails that of rivals who have spent years boosting efficiency. Toyota, for example, generates similar revenue to Volkswagen with roughly half the workforce.

Also interfering is Volkswagen's unusual history and status as a German national institution tightly controlled by one family. The resulting culture complicates boosting efficiency where it is needed most, in its massive German manufacturing operations.

Despite the stalls, Volkswagen group remains profitable. Through September this year, net profit rose 26.7% to EUR8.5 billion and revenue grew 1.4% to EUR147.7 billion.

Weak profits at the VW brand, though, leave the group dependent on its high-end brands Audi and Porsche and big margins in China, where the VW brand has expanded aggressively.

Volkswagen group's ferocious grab for growth--doubling its revenue, vehicle sales and number of factories since 2007--took it into new markets, but left it vulnerable to their economic swings. Since 2012, swooning emerging-market currencies have cost the VW brand EUR2 billion in pretax profit.

"It is not just the world outside that is putting us to the test," Mr. Winterkorn warned his executives at a meeting in July, according to an internal memo and people who attended the gathering. "We are dealing with homemade problems as well."

VW's German factories are too big and complex, he said. Labor costs significantly outpace productivity gains. Executives, steeped in an engineer-driven culture, too often add features with little thought to profit.

German production costs are so high, he said, that building a new derivative of VW's Tiguan sport-utility vehicle "is not economically feasible at a German production site." The current version of the Tiguan is produced in Germany and exported to the U.S. Now, VW is negotiating to build the next model in Mexico, according to two people familiar with the situation.

In July, Mr. Winterkorn ordered his executives to cut EUR10 billion in annual costs by 2017, tasking the VW brand with covering half the tab. That would help the brand meet its target of tripling profit margins by 2018, to 6% of sales.

To achieve those savings, Volkswagen is moving production to low-cost locations, like the Tiguan shift to Puebla, Mexico--its second-largest factory after Wolfsburg. It is investing billions to standardize its factories with a modular production system that allow different brands and models to share up to 60% of their core components, cutting upfront investment.

But Mr. Winterkorn has stressed that the VW brand needs a tuneup, not an overhaul. Significantly, he has ruled out job cuts in Germany--an edict that complicates streamlining costs in Germany.

Volkswagen's roots date to 1937, when Adolf Hitler's Nazi party backed Beetle inventor Ferdinand Porsche's vision of building a Volkswagen, or "people's car." World War II interrupted the plan. Mass production began after the war and the Beetle became a symbol of Germany's economic recovery.

Under CEO Carl Hahn in the 1980s, it launched a successor model, the Golf (first called the Rabbit in the U.S.) which remains the world's best-selling car.

Mr. Hahn, who in the 1960s had made VW an American pop icon, expanded globally and transformed VW into Europe's biggest automotive group. He bought Spanish car maker SEAT, set up the first Western manufacturing joint venture in China, and took control of Czech auto maker Skoda after the Berlin Wall fell.

In 1993 Mr. Porsche's grandson, Ferdinand Piech, took over and again transformed the company. He borrowed a page from GM creator Alfred Sloan, who developed a multibrand strategy and pioneered refreshing cars with annual "face-lifts." The strategy propelled GM past Ford in the 1930s and kept GM atop the industry for decades.

Mr. Piech positioned SEAT and Skoda at the bottom of the pricing ladder, the VW brand in the middle and Audi, Porsche, Lamborghini, Bentley and Bugatti at the top. His strategy, which remains in place, was to keep prospering buyers in the Volkswagen family by moving them up the product ladder as they become more affluent.

He also kept Volkswagen in his family after a cousin, Wolfgang Porsche, launched a hostile takeover bid. In 2009, Mr. Piech and his cousin agreed to a complex deal that united Porsche with Volkswagen, giving a family-owned holding a majority of Volkswagen's ordinary voting stock and Volkswagen management control over Porsche's car-making business.

The state of Lower Saxony, where much of VW's workforce lives, works and votes, holds 20% of the voting stock, enough to block decisions that threaten jobs in the state. Volkswagen's publicly traded preferred stock holds no voting rights. Family control insulates Volkswagen from shareholder pressure. In 2007, Mr. Winterkorn took charge and launched the biggest expansion in Volkswagen's history. His growth plan, outlined in 2008 as "Strategy 2018," was to ride surging demand in Brazil, Russia, India and China. The goal was to make VW the biggest, best liked, and most profitable car maker within a decade.

Success came quickly. Chinese demand soared, contributing more than EUR4 billion to group profit last year, up from about EUR108 million in 2006. The company set up a joint venture in Russia, a factory in India and expanded in Brazil. Such global moves helped the company weather a six-year contraction of Europe's car markets amid the euro crisis.

Last year, the trend slowed as currency swings, economic weakness and political crises in emerging markets shrank car demand. Sales growth in China, which topped 30% annually in recent years, could skid to 6% in 2015, according to some industry estimates.

Mr. Winterkorn has said he believes China will keep growing and emerging markets will regain strength.

Today, VW remains the biggest foreign manufacturer in China but Toyota is pushing hard. Elsewhere in the region, VW lacks heft. Of the VW brand's 2.47 million cars sold in Asia-Pacific to the end of October, just 170,000 were outside China.

The VW brand is also struggling in the U.S., reversing several years of progress. Sales fell more than 12% in the first nine months of this year. To eclipse Toyota, VW must get the U.S. right.

Frustrated with slow U.S. progress, Mr. Winterkorn last December fired the head of Volkswagen of America and appointed a Wolfsburg insider, Michael Horn.

Mr. Horn argued for profound change to make VW more American and give its U.S. operation more autonomy from Wolfsburg.

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"We need more U.S. products for the U.S. market and we have to have a louder voice out of the U.S. into this company," he said in an interview. VW, for instance, doesn't offer large and midsize SUVs that are popular with American drivers.

With that goal in mind, Mr. Winterkorn formed a new North America Committee. The group, consisting of U.S. executives and about half of VW's management board, has met at least five times since February.

In July, Mr. Winterkorn announced plans for the CrossBlue, a new midsize SUV, and a new research and development center in Chattanooga, Tenn. The U.S. team is now leading development of new derivatives that could include up to six SUVs for the U.S. market over the next three years.

VW will also update U.S. models within five years, rather than up to seven as in Europe, and will scrap low-selling brands such as the EOS convertible sedan. Last year, the company sold only 7,651 EOS models. More broadly, 19 of its standard models sold fewer than 100,000 cars world-wide.

Part of the problem, critics say, is that VW makes too many components internally--even brake parts and pedals. Extreme integration lowers productivity, drains capital and cuts profits, said the Center for Automotive Research at the University of Duisburg-Essen, in a recent study.

"The problem is that VW simply has far too many employees," says research center director Ferdinand Dudenhöffer. "And the high level of integration adds labor costs and means VW cannot generate as much profit."

VW component-factory employees earn autoworker wages, up to 35% higher than wages at big suppliers. VW's second-largest German plant, in Kassel, employs 16,000 people and doesn't make cars. A similar component plant in Braunschweig employs more than 6,000 people.

Mr. Winterkorn calls integration a strength because it keeps VW in control of key technology.

As for the VW workforce, the CEO has avoided confrontation. Shortly after he announced his savings plan in July, VW's top labor representative, Bernd Osterloh, handed him a 400-page document with savings proposals. It included no job cuts at VW's six German factories.

"The workforce must not be made to bear the brunt of these measures," said Mr. Osterloh. "We won't go along with that."

Mr. Winterkorn, standing next to the labor chief at a workforce assembly in Wolfsburg in August, held the document and swore he wouldn't cut jobs. Workers gave him a standing ovation.

"Our shared task is to create the ability to profitably produce these vehicles in Germany," Mr. Winterkorn told executives in July. To do that, he said, everyone needs to "pull together in one direction."

Write to William Boston at william.boston@wsj.com

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