Daimler Gives Chrysler to Cerberus

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And though the global market for luxury autos is growing at a healthy clip, the world has changed since the simple days when Mercedes reigned supreme in the high-end market. The price premium that automakers such as Mercedes or BMW can charge—compared with mass-market brands like Ford (F) or Toyota (TM)—is shrinking, down by 45% in 14 years, Rhys says, as the gap in technology and quality narrows. And that shrinkage is bound to continue, putting greater pressure on upmarket brands to cut costs.

Daimler also remains vulnerable to a hostile bid by private equity groups. The automaker's $83 billion market capitalization is up 74% from last fall—a daunting sum for a raider. But analysts say the company remains seriously undervalued. "On a sum-of-the-parts basis, we can justify nearly 100% of the Daimler share price with just the commercial vehicle business," says Adam Jonas, analyst at Morgan Stanley (MS) in London, in a May 15 report.

That could be a powerful lure for ambitious private equity groups eager to nab Mercedes for free and unlock its value by spinning off the truck business. "There are players who will start thinking about how to tackle Daimler given the new setup," says one German executive.

"Flawed Hypothesis"

When it comes to new models, many things are going right again at Mercedes. Under Zetsche's leadership, development, costs, and quality at Mercedes have all been overhauled, and new models such as the M-Class SUV and the flagship S-Class sedan are powering profits again. For the first quarter of 2007, Mercedes' revenues rose 1% and operating profit rebounded to $1.1 billion from a loss of $992 billion a year ago, when restructuring charges for the Smart mini punctured earnings.

Zetsche confirmed that Mercedes is on track to exceed its target 7% operating margin this year, and that it should do even better in 2008 and 2009, when a new E-Class is set to hit showrooms. Analysts believe Mercedes' profit margin could reach 10% by 2009. "The margins of all Daimler's industrial businesses will rise sharply over the years to come," says Morgan Stanley analyst Jonas.

Overall, DaimlerChrysler's first-quarter revenues declined slightly, to $47.7 billion, pulled down by lower sales at Chrysler. Mercedes reported a $1.1 billion profit for the quarter, up from a $992 million loss in 2006, thanks to its two-year-old CORE cost reduction, quality improvement, and efficiency program. A new restructuring plan for Chrysler announced in February will cut 13,000 jobs, but the unit is expected to post a $2.2 billion loss this year and not expected to return to profitability until 2009.

One remaining business that could undercut Mercedes' performance is the Smart minicar unit, a long-running, unprofitable investment. The company spent $1.2 billion restructuring it in 2005 and is targeting breakeven this year. Zetsche aims to introduce the 2007 "fortwo" model in the U.S. in 2008. So far, 10,000 potential U.S. buyers have given Mercedes a $99 "down payment" for the 2008 car. Sales of the Smart must hit at least 120,000 to 130,000 a year to make a profit. Last year, Mercedes sold just 82,000 of them, and analysts forecast 2007 sales at only 100,000.

"The whole car was built on a flawed hypothesis," says Rhys. Daimler believed people would pay a premium for an environmentally friendly minicar, but the Smart has now been repositioned as a mainstream supermini. "They need some pretty innovative marketing to make sure people see the value for the money—and they may need to lower the price," Rhys says. Analysts say the Smart's cost base is still too high—and that the car should be built in Eastern Europe or China.

Edmondson is a senior correspondent in BusinessWeek's Frankfurt bureau.