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Ownership Change, Global Expansion, Turmoil at Top Mark Year for VW

Executive Summary

As 2007 winds down, VW finds itself on the verge of two potentially seminal events: official take over of the auto maker by Porsche and the possibility a sex and payola scandal could reach all the way to management’s top ranks.

Special Report

2007 Year in Review

It’s been anything but a typical year for Volkswagen AG.

Rocked by scandal and management upheaval at the highest levels, pursued as a takeover target by the smaller Porsche AG and locked in the midst of a painful restructuring aimed at shoring up its languid financial results, VW has faced more than its share of challenges in 2007.

But, despite the distractions, growth remains very much on the German auto maker’s mind, as it looks to vault past key marketplace rivals on the strength of a vast new-product assault and extensive investments in critical global markets.

As 2007 winds down, VW finds itself on the verge of two potentially seminal events: official take over of the auto maker by Porsche and the possibility a sex and payola scandal could reach all the way to management’s top ranks.

In late November, Porsche Chairman Wendelin Wiedeking, in what widely was viewed as an early Christmas present to VW’s 324,000 employees, promised his company would not increase its 31% stake in VW before Dec. 25.

“Christmas is the holiday of peace; let’s create a little harmony,” Wiedeking told The New York Times.

But Wiedeking isn’t likely to wait too long beyond that to increase his company’s financial control in Europe’s biggest auto maker, having already acquired tens of thousands of stock options and created a holding company, Porsche Automobil Holding SE, to facilitate such a move.

The path toward outside control of VW was cleared in October, when the European Union’s highest court ruled illegal a German law shielding the auto maker from takeover. The so-called “Volkswagen Law” had capped voting rights for any single shareholder at 20% and required more than 80% approval from stockholders to adopt resolutions, ensuring VW’s home state of Lower Saxony, the auto maker’s second-largest stakeholder, held veto power over all proposals.

“By maintaining in force the provisions of the VW law concerning the capping of voting rights at 20% and the fixing of the blocking minority at 20%…the Federal Republic of Germany has failed to fulfill its (public-trust) obligations,” the European court said in delivering its verdict.

Although a Porsche takeover has the blessings of VW’s upper management – the move largely bears the fingerprints of VW Chairman Ferdinand Piech, who used Porsche’s tightening grip to broom VW’s top executives at the close of 2006, it has proven a tougher sell to the rank and file. Particularly uptight about the power shift are German labor leaders, who have enjoyed added security under the system that has given unions a say in how the company is run and helped protect jobs for plant employees.

Shortly after the court ruling, VW workers at several manufacturing plants – including 40,000 at the main factory in Wolfsburg, Germany – held 1-hour work stoppages in an attempt to exert pressure on Porsche to keep VW intact should it gain control.

“There is great disquiet and insecurity among the staff,” Bernd Wehlauer, deputy head of the VW works council told Reuters in late October.

Porsche responded with full-page ads in 17 newspapers assuring it had no intention of splitting up VW operations or in fully merging the auto maker with Porsche.

“Unlike some hedge funds, Porsche has an existential interest in keeping your company in its current form,” the ads said. “There will be no merger of the two companies. That means Porsche will stay Porsche and Volkswagen will stay Volkswagen.”

But union leaders remained underwhelmed.

“Advertising campaigns will not improve the staff’s mood in regard to major shareholder Porsche,” Bernd Osterloh, head of the VW works council, said in a statement.

The financial machinations are occurring at the same time a scandal, considered one of the worst corruption cases in Germany’s history, is threatening to ensnare Chairman Piech. Already on trial on charges of conspiring to use company funds to pay for perks, including pleasure trips and prostitutes for traveling labor representatives and executives, are former VW works-council head Klaus Volkert and his management liaison, Klaus-Joachim Gebauer. In January, VW’s former personnel director, Peter Hartz, was handed a 2-year suspended sentence and fined €576,000 ($843,000) for masterminding the scheme.

But in December prosecutors extended their investigation to determine how much then-CEO Piech may have known about the financial and ethical irregularities. Although prosecutors continue to assure Piech officially is not under investigation, that could change. A German TV documentary, quoting an unidentified retired VW executive as its source, drew a line connecting Piech to an internal investigation surrounding the so-called “account 1860” slush fund.

“It is reasonable to assume that Mr. Piech was informed about the results of the investigation he ordered,” a senior state prosecutor later was quoted as saying.

VW has denied any connection between the slush fund and Piech and said it would consider a lawsuit over the allegations. “Neither VW nor its then-chief executive had any knowledge of the misappropriation of funds,” the auto maker said in a statement late last month.

Whatever the outcome, the probe is seen as a potentially major distraction for VW at a time when it is trying to complete a restructuring effort launched in 2005 and trigger a new-product assault and global expansion aimed at overtaking General Motors Corp. and Toyota Motor Corp. at the top of the global auto sales charts.

Signs of progress emerged in 2007, as projections were VW would wind up the year some €6.3 billion ($9.2 billion) in the black. Operating profit jumped 50% over like-2006 results through during 2007’s first three quarters, beating market expectations and putting the company on track to meet its 2008 pretax profit target of €5.1 billion ($7.5 billion) a year earlier than planned.

“We have significantly improved our financial position,” CFO Hans Dieter Potsch noted in July.

Vehicle sales also were on the rise, increasing 8.5% through October to 5.14 million units worldwide and headed past the 6 million mark for the first time. That includes an expected record 3.5 million vehicles for the VW brand.

The Porsche takeover drama notwithstanding, labor tensions brought about by massive cutbacks and increases in workweeks began to ease as the year wore on, and the auto maker predicted a 12.5% improvement in productivity at its keystone assembly plant in Wolfsburg.

“We will likely raise (annual output) to 27 vehicles per worker in the Wolfsburg site in 2007 – last year it was 24,” said Horst Neumann, head of personnel.

Osterloh, the works council chairman, called for further improvements, saying continued gains were “absolutely necessary” to stave off competition from Japanese rival Toyota.

“If the workforce really pushes hard, then there will also be considerable productivity gains in the coming years,” Osterloh said in a midyear statement.

Similarly, productivity was improved at a plant in Brussels, where Audi AG agreed to produce its next A3 model and upcoming smaller A1 in exchange for 20% cost cuts, achieved mainly by adding three hours to the facility’s weekly work schedule, bringing it to 38 hours. The plant’s future had been uncertain prior to the labor deal, which will see A3 output added into production, complementing capacity for that model in Ingolstadt, Germany. In 2009, Brussels will add the A1 into the mix and become the exclusive production site for the new small car.

This year’s record-setting volume is just the beginning for VW, which is setting its sights on a 30% increase in vehicle sales over the next three years and topping the 10 million mark by 2018. That includes a target of 1.5 million vehicles annually for Audi, up from about 900,000 currently. The total would put VW in the ballpark with global leaders GM and Toyota, each on track to sell about 9 million-plus vehicles in 2007.

Rejuvenating its moribund U.S. operations is key to VW’s expansion plans. In September, CEO Martin Winterkorn, who had replaced Bernd Pischetsrieder at the helm on Jan. 1 in the Piech-led purge, outlined a sweeping plan for 12 new vehicles and set a target for U.S. sales of 1 million units annually within 10 years. Through November, VW and Audi combined delivered only about a third of that objective, at 295,032 cars and trucks.

“The U.S. is one of our most significant and important markets,” Winterkorn said. “Expanding our position in the U.S. is a top strategic priority.”

The new vehicles – set for introduction within the next three years – include the A1 small car, A3 cabriolet, A7 coupe and Q5 cross/utility vehicle from Audi; and the Scirocco sports hatchback, Passat Coupe, new minivan and Tiguan CUV from VW. Also on tap is a VW pickup destined for emerging markets and “perhaps” another smaller CUV, the Q3, for Audi. A car slotted between the Jetta and Passat is an additional possibility for the Volkswagen lineup. And in the U.S., VW will get a version of Chrysler Corp.’s Town & Country minivan beginning in mid-2008.

Nearly certain is a small car based on the rear-engine Up! concept unveiled at the Frankfurt auto show in September. Although officially not confirmed for production, it is expected to reach the market in about two years.

Four new vehicle architectures reportedly will support many of the new projects, including one volume platform dubbed MQB that would serve as the basis for small and medium vehicles with transversely mounted engines. Another, called MHB, will support rear-engine models such as the Up! car and its derivatives – potentially including a production version of the fuel cell-powered Space Up! Blue CUV, unveiled in November at the Los Angeles auto show. A third architecture, known as MLB, would underpin front- and all-wheel-drive models with longitudinal engines. A fourth platform reportedly would spawn mid-engine vehicles.

VW’s effort to boost its U.S. presence gained traction in September, when the auto maker announced it would move its VW and Audi North American headquarters from Auburn Hills, MI, to Herndon, VA, with its Bentley-brand operations shifting from the Michigan locale to Boston.

Stefan Jacoby, who took over as VWA CEO in July, said the move was “a logical step” to getting the auto maker closer to its customer base, but the migration to the East Coast also was seen as a potential prelude to adding vehicle assembly capacity in North America, with the southeastern U.S. among prime candidates to land a new plant. VW will need more capacity if it is to hit its long-range global and U.S. sales targets, and setting up an additional facility in North America – it already operates an assembly plant in Puebla, Mexico – would help it counter the negative impact of unfavorable euro-dollar exchange rates. The new plant potentially could build VW and/or Audi models.

“There are a number of factors that we need to consider in this decision, and we will make an announcement in the next six months on whether or not we will proceed with this initiative,” Jacoby said in mid-November.

The U.S. isn’t the only beneficiary of VW’s international expansion initiatives. The auto maker also is making moves on Russia, where it opened its first factory this year. Located in Kaluga, about 100 miles (161 km) southwest of Moscow, it will have capacity for 150,000 vehicles annually in 2009.

Initially, it will build 66,000 Skoda Octavia and VW Passat models from knocked-down kits, but it gradually will shift to full production. Output of the VW Polo and Skoda Fabia is expected to come later, and the auto maker also is considering adding capacity to produce transmissions, seats, interior panels and other components in Russia.

Audi continued to get more out of its Hungarian operations, launching a convertible version of its A3 there in November and adding output of a new 170-hp diesel a month earlier. Audi Hungaria Motor Kft. production was expected to total 50,000 units in 2007.

In November, Audi broke ground on a new Australian headquarters in Sydney. Due to open in early 2009, the A$50 million ($44 million), 8-story brain center is part of a bigger A$140 million ($123 million) investment planned in the country over the next few years, where sales have been growing at double-digit rates and are targeted to reach 15,000 units annually in 2015.

In India, Volkswagen is pouring $530 million into a new plant in Pune to produce up to 110,000 vehicles annually beginning in second-half 2009, and in July it established its first sales office for the VW brand in Mumbai.

Not so productive were VW’s talks to take a stake in Malaysia’s Proton Holdings Bhd, which came to an end in late November and put the finishing touches to an ultimately unrequited 2-year-plus courtship. The sticking points remain unclear, but analysts say the Malaysian government may have gotten cold feet over ceding control of Proton to VW, which reportedly was pushing for a 50% share of the Malaysian auto maker.

“Volkswagen will now independently examine other possibilities to enter the ASEAN (Association of Southeast Asian Nations trading bloc) market and further strengthen its sales operations in the region including Malaysia,” the auto maker said in a statement.

Dealership expansion also was on the horizon, with Audi reportedly looking to hike showrooms to 3,000 worldwide in 2011, up from 2,700 today.

“We need this density in order to achieve our targeted sales of 1.5 million vehicles (annually),” sales chief Ralph Weyler told a German magazine last month.


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