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Dark Days at Daimler


When employees arrived at Chrysler's Auburn Hills (Mich.) headquarters on July 28, they were greeted with astounding news: Dieter Zetsche, the affable, 52-year-old CEO who had led the auto maker's resurrection, was headed back to Germany to head the ailing parent company. A wave of excitement swept through the headquarters as employees realized that an executive who really values the American carmaker would run the transatlantic auto giant. And if anything, the buzz back in Stuttgart, where DaimlerChrysler (DCX) is based, was even better, as shareholders and executives breathed a collective sigh of relief. Finally CEO J?rgen E. Schrempp was on his way out, and the company would get someone with the wherewithal to repair Daimler's tarnished crown jewel: Mercedes-Benz (DCX). "Zetsche is well respected on both sides of the Atlantic," says Joseph S. Philippi, principal of auto consultant AutoTrends in Short Hills, N.J. "The board obviously thought he was the right guy to get the whole company back on track."

Maybe so, but he faces formidable challenges. In the past seven years, DaimlerChrysler has experienced a reversal rife with irony. Who would have predicted that in 2005, Chrysler would be the healthy part of the empire -- and Mercedes the laggard? But it's true. Beset with humbling quality problems, a money-losing small car business, and high production costs, Mercedes has gone from being the global benchmark for quality and one of the most profitable auto makers in the world to a money-losing shambles. For the first half of 2005, the premium carmaker lost $1.1 billion. Clearly, Zetsche will have his work cut out turning Mercedes around.

But fixing the luxury brand is only one part of his challenge. Nearly seven years after Schrempp brought together Daimler and Chrysler, with the promise of building an auto maker with sufficient size to compete globally, the question that has dogged the merger from the beginning remains: Does this marriage make sense? Schrempp sold investors on the idea of an historic merger of mass with class. Together, Mercedes and Chrysler would have the money, clout, and knowhow needed to produce next-generation engine technologies. They would produce a series of small cars for the world's emerging middle classes. Chrysler would tap into Mercedes technology, and Chrysler would give Mercedes the ideal hedge in case the luxury car market plateaued. Synergies and cost savings would proliferate. Later, Schrempp spent $2.1 billion adding a stake in Mitsubishi Motors to his visionary empire, hoping to get needed exposure in Asia as well as help Chrysler with small and medium-size cars. And he encouraged the growth of the Smart division at Mercedes as a way into the market for small, affordable cars in Europe.

Nothing worked out as planned. Far from being the perfect hedge, Chrysler proved to be a massive rescue job that sucked up billions and absorbed German management for years. Mercedes has lost share, reputation, and now is losing money. Synergies have been few and far between. Mitsubishi Motors? Daimler ditched the alliance after the deal proved the lemon of all lemons. The Smart car? It's looking anything but. And the merger certainly hasn't helped the stock: Before the announcement sent the share price soaring 10%, DaimlerChrysler's market cap hovered around $38 billion -- just $2 billion more than Daimler paid to acquire Chrysler in 1998. Marrying mass and class has been far tougher than anyone ever imagined.

With Schrempp leaving, Zetsche has the unenviable task of proving the wisdom of the original vision. That will not be easy. Even though Chrysler has made a remarkable comeback under Zetsche -- it produced a third of the group's operating earnings during the first half -- merger critics fret that the turnaround is not sustainable. They point to the continuing onslaught from Asian carmakers and Chrysler's history of rebounding, only to stumble anew. Most important, the Germans have not proved they can manage a steadily profitable, mass-market carmaker while recapturing and maintaining the 7%-plus margins that a premium brand like Mercedes should produce year in and year out. That's the kind of profit posted by rival BMW -- and one that Mercedes, too, might be sporting, given more astute management.

The upshot: Even before he starts work in Stuttgart, Zetsche is facing mounting pressure to prove that the merger makes sense. The new CEO has two basic choices. He must either make a much more successful go of Schrempp's strategy by ramping up the technical and manufacturing collaboration between Mercedes and Chrysler -- and producing much better financial returns in the process. Or he must run the two companies as separate entities, laying the foundation for a possible sale of Chrysler in the future.

Having just turned Chrysler around, Zetsche would be loath to unload the auto maker now, analysts and company insiders suggest. Still, in Germany, bankers and private-equity players are already talking about the possibility of buying DaimlerChrysler outright or at least taking a stake and pressuring management to sell off pieces. Dumping Chrysler and the Smart minicar unit, say proponents, would allow Zetsche to focus on restoring Mercedes to the high-margin premium auto maker it once was.

Many argue that such a divorce would be a boon for investors, because an unshackled Mercedes would sport much higher returns and therefore earn a much better valuation in the market. "A breakup would be the most value-creating route for Zetsche to take," says analyst Stephen Cheetham of Sanford C. Bernstein in London. Based on the multiples for comparable businesses and including a discount for Chrysler's pension and health liabilities, he estimates the breakup value of DaimlerChrysler at $72 billion to $96 billion -- nearly double its current market cap of roughly $51.5 billion.

Such a scenario, unthinkable a week ago, is now a real possibility. For years, Schrempp could afford to fend off angry investors because he had in his corner the company's single largest shareholder, Deutsche Bank (DB). But on July 28, Germany's biggest lender sold down its 10.4% stake to 6.9%. Amid rising international competition, German companies and banks have been unwinding their traditional cross-shareholdings for several years, but the fraying of the Daimler-Deutsche partnership is a powerful signal that Germany's once-cozy business culture is increasingly untenable. Now the path is clear for any investor to take a large stake and push for a restructuring. Even a hostile bid led by Germans close to the establishment would not be stopped, bankers say.

For now, fixing Mercedes has to be Zetsche's top priority, regardless of whether the merged company is destined to stay together or split. That's because Mercedes is beset by a swarm of problems, from poor quality to high labor costs and increasingly competitive rivals. If Zetsche can't turn Mercedes around, no amount of dealmaking is going to secure his legacy as CEO.

How did Mercedes manage to go from one of the world's most-admired premium brands to a quality has-been? One reason was that it rushed out too many new models, say analysts. Under Schrempp, Mercedes expanded up and down the value chain, from small cars such as the A-Class and Smart to luxury limos like the $450,000 Maybach. Not all the models made decent margins -- and some lost money.

BOOM AND BUST

But it was the merger with Chrysler that diverted management attention from controlling costs and quality at Mercedes. Starting in 1998, troops of managers started flocking to Auburn Hills on a corporate jet. Soon the Germans discovered that Chrysler, which has a long history of boom-and-bust cycles, was in much worse shape than they anticipated. It spun deeply into crisis in 2000, racking up $4.7 billion in operating losses the following year alone. Mercedes had to make the ultimate sacrifice, squeezing its own costs to pump out better profits for the group. Analysts say Mercedes demanded lower prices from suppliers and allowed them to cut corners on quality. By July, 2003, Mercedes had fallen to near the bottom of J.D. Power & Associates' reliability survey.

Mercedes is still reeling from a series of embarrassing recalls of its prestige sedan, the E-Class, which starts at $50,000. In May, 2004, the company suffered a spate of problems with its electronic brake control system, and it recalled 680,000 cars for inspections. This year, in late March, Mercedes announced the biggest recall in its history -- 1.3 million cars with faulty fuel pumps made by supplier Robert Bosch. Software bugs and the complex interfaces that allow the myriad electronics systems to talk to each other are to blame for many Mercedes defects. Getting such bugs out is a fiendishly hard job and can often take years. The problems have also pushed up costs and hurt profits. Last year Mercedes spent some $600 million to cover warranty costs, analysts say.

Worse, the quality fiasco has taken a heavy toll both in Europe, which accounts for 76% of sales, and in the U.S., where the auto maker sells 21% of its vehicles. Mercedes' European market share slipped to 4.2% in the first half of 2005, down from 4.5% for the same period in 2004. And last year, BMW (BMW) overtook Mercedes as the world's No. 1 luxury carmaker. The smaller rival -- which took a diametrically opposite strategy from Schrempp's and now builds only premium cars -- continues to make gains.

The question is whether those quality problems are being stamped out. In February, Mercedes boss Eckhard Cordes launched a costly quality offensive designed to cut the number of defects and catch them before cars leave the factory. That involved forging a new quality unit and making sure engineers, designers, and production and assembly managers make no key decision on engineering or purchasing without the approval of quality managers. Long-term, the fix lies in designing cars that are less complex, stripping out excess electronics and bolstering testing before new models go into production. Paul Halata, president and CEO of Mercedes USA, insists the company's efforts to improve quality are finally showing. In the latest J.D. Power initial quality survey, Mercedes moved up from tenth in 2004 with 106 problems per 100 vehicles to fifth with 104. Many analysts are skeptical. "It's really too soon to tell on Mercedes quality," says Albrecht Denninghof, an analyst at HVB Group in Munich. "We need about 12 months to see if there are still problems."

But quality isn't Zetsche's only worry. He also must whack Mercedes' high manufacturing costs in Germany and boost productivity significantly. That means coaxing unions to work longer hours and limiting pay increases -- something to which Germany's combative labor leaders are unlikely to agree. Another obstacle to cutting jobs or wages is the labor pact that Schrempp signed in 2004 guaranteeing the jobs of Mercedes' 160,000 workers through 2012. To find savings, Zetsche will have to focus on high material costs, supplier agreements, and streamlining manufacturing. Pruning the number of models to reduce complexity would help as well. "It is high time for a serious dose of austerity," says Olivier Pouteau, an analyst at Oddo Securities in Paris.

JUST ADD ZING

Some of this, too, Cordes has begun to tackle. In February he launched an overhaul of everything from design and purchasing to production and distribution in a program called CORE (Costs down, Revenues up, Execution). The project's goal is to save $5.6 billion by 2007 and restore a 7% operating margin at Mercedes, up from 3.3% last year. But it now appears likely that Cordes will no longer steer Mercedes to the finish line and is likely to leave Mercedes by yearend.

Fixing all that is a mammoth task, and one that will take time. Progress may come faster as Zetsche tackles the urgent problems facing the Smart minicar unit, launched with great fanfare by Schrempp in 1998. Smart will cost Mercedes $1.4 billion in restructuring costs this year alone. On top of that, it has lost an estimated $3.6 billion since its launch and will not break even before 2007, racking up $600 million in losses this year. The original two-seater Fortwo never hit the company's sales targets, and subsequent derivatives like the unpopular Forfour sold only 40,000 units last year -- well off Mercedes' planned-for production of 150,000. Without a family of models, it will be hard for the Smart to break even. Still, analysts say Zetsche should pull the plug on the Forfour, even though that would generate a huge earnings hit from compensation payments to suppliers for their investments, or seek a partner.

Wooing back customers will also mean putting some zing in the model lineup. New models are in the pipeline, including the vaunted S-Class sedan, which will be unveiled in September, and the new M-Class sport utility vehicle -- and not a moment too soon: Sales of two of the company's key profit engines, the E-Class and C-Class, have plunged 30% to 35% this year, buffeted by reports of quality problems. They are also dowdy compared with hot new models from the competition, such as the Audi A6 and the BMW 3 Series. Another eventual sales engine could be the R-Class crossover, due out in 2006. It will offer the off-road ability of an SUV, the roominess of a minivan, and the interior and handling of a luxury sedan. The B-class, a similar concept in a smaller package, hit German showrooms this spring and has been selling briskly.

Chrysler, in contrast, is firing on all cylinders -- and after years of draining billions of dollars from its parent, it's now helping keep the group in the black. But much of Chrysler's turnaround success rests on a handful of stylish new cars, including the Chrysler 300 sedan and the Dodge Magnum wagon. The question is whether Chrysler can keep the hits coming and can boost its profits and return-on-investment enough to make it worth hanging on to. To quiet critics in Germany, Zetsche must prove that Chrysler fits in the Daimler family -- meaning he will have to do a far better job of proving that the marriage should be saved.

SLIM MARGINS

For now, most analysts think Chrysler has a good enough product plan to stay competitive. But the new cars will have to sell, and there's no guarantee they will, especially the next generation of midsize cars, which arrive next year and were built with the help of Mitsubishi Motors Corp. The midsize segment is crowded, and it's one in which the Japanese are preeminent. Longer term, with Mitsubishi now out of the picture, Chrysler will have to find a new partner to develop small and midsize cars -- or spend more of its own cash.

Boosting profits won't be easy, either. The price war with General Motors Corp. (GM) and Ford Motor Co. (F) is forcing Chrysler to spend more than $5,000 a vehicle in incentives, says Art Spinella, president of CNW Marketing Research Inc. in Bandon, Ore. Even the 300 sedan is carrying rebates. Plus, union contracts give Chrysler higher retiree pension and health-care costs than Asian carmakers, and its plants still are not as productive. The net result: Chrysler's pretax margins are less than 3%. That's more than GM or Ford but much less than major international players like Toyota and Nissan Motor Co. (NSANY) earn, and well below the profitability of a prestige carmaker like BMW -- or of Mercedes, were it running smoothly. Numbers like that fuel the argument that even a robust mass-market company such as Chrysler will always water down the earnings power of a healthy Mercedes.

One way to boost profits is to become an even leaner manufacturer. Incoming Chrysler CEO Tom LaSorda, a manufacturing whiz, plans to take Zetsche's focus on plant flexibility to an even higher level. The company is launching a new program to install new high-tech robots in its U.S. assembly plants that can allow the company to build several different types of vehicles under one roof, the way Toyota and Nissan do. The robots will save more than $1 billion over the next five years, says Frank Ewasyshyn, Chrysler senior vice-president for manufacturing -- savings that will drop straight to the bottom line.

While Chrysler says it is sharing more design and engineering work with Mercedes, the two companies still do not have the kind of money-saving synergies that Nissan and Toyota get within their own global operations. Nissan, for example, has one V-6 engine that goes in its family sedans, pickups, minivans, luxury cars, and SUVs. Chrysler and Mercedes cars don't share big-ticket items like an engine.

Zetsche may push for more collaboration between Chrysler and Mercedes. Thomas T. Stallkamp, a partner with private-equity firm Ripplewood Holdings LLC and former Chrysler Group CEO, says they can go further on sharing parts like suspensions, engine blocks, and cylinder heads. They could also do more platform sharing. In the future, they could share hybrid-electric car systems and fuel cells. "The merger still makes sense," Stallkamp says. "They just need to move faster with integration."

The question is whether investors will give Zetsche time to make it work. Although he himself may not be keen to hive off Chrysler, some bankers in Europe say big investors could force his hand. Deutsche Bank has already signaled it will sell off its remaining 6.9% share in DaimlerChrysler. That would pave the way for an investor to take a major stake. "One could have a Kirk Kerkorian-like situation," says a senior banker at a major investment bank who asked not to be named.

Zetsche may also pare some of DaimlerChrysler's operations to get the company back up to full speed. Chinese auto makers are eyeing a purchase of the Smart business to tap its brand and Western product design, according to one banker. There's talk on Wall Street that some companies and investment firms may also be interested in buying DaimlerChrysler's one-third stake in aerospace giant EADS, which could go for between $5 billion and $6 billion. London buyout firm CVC Capital Partners has been rumored to be in talks to buy a chunk of DaimlerChrysler. CVC declined to comment.

DUBIOUS PROSPECT

But bankers say it's unlikely that private-equity players will swoop in, buy the entire company and break it up -- selling off Chrysler and the commercial truck unit. For one thing, it would be prohibitively expensive and difficult to finance given the company's market cap of $51.5 billion. Even for a corporate buyer, "it would be a huge swallow," says the senior investment banker. After all, the biggest leveraged buyout in history remains Kohlberg Kravis Roberts' $30 billion acquisition of RJR Nabisco Inc. in 1989. The largest since then: the announced $11 billion buyout of SunGard Systems this spring by a consortium of seven private-equity firms.

In fact, it might even be difficult to find a buyer for the one part of the company that is doing well -- Chrysler. As a standalone company, it is a dubious prospect, say some analysts. Without a larger, well-heeled parent company, it could lose its investment-grade credit rating during hard times. Then it would start borrowing money at expensive rates, which would eat away at the profits it makes writing car loans.

What's more, Chrysler's 75,000 retirees have saddled the company with a pension plan that is underfunded by $8 billion. Chrysler also carries $17 billion in unfunded long-term retiree health-care obligations. That means any acquirer would probably want some additional cash injected into Chrysler just to take it over, says one senior banker in London close to the company. The problem: "Daimler needs its cash to fix Mercedes," says the banker. "There's not enough money to go around. You'd be cutting off your nose to spite your face."

But German bankers and private-equity guys are already doing the math. Bernstein's Cheetham estimates Daimler's commercial-truck business, which earned a huge $1.5 billion in the first six months of 2005, is worth $11 billion to $28.7 billion. Mercedes itself could bring $36 billion, assuming the operating margin of 6.5% it has averaged over the last nine years. The price Chrysler could fetch would depend on its performance at the time of sale. Cheetham figures it could bring around $6 billion based on a "normal operating margin" of 3%. "We expect the calls for a breakup to become even louder," he says.

With the pressure mounting, Zetsche will have his hands full fixing all the moving parts at Daimler -- whether or not the marriage between Mercedes and Chrysler is forever. But the monumental task is also sending a ripple of excitement -- and fear -- through Germany, from boardrooms to beer gardens. Retooling DaimlerChrysler is tinkering with Germany's heart and soul. And Dieter Zetsche looks set to give both a jolt.

By Gail Edmondson and David Welch, with Emily Thornton in New York and Ann Therese Palmer in Chicago


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