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Skoda, a joke no more, joins Audi in driving Volkswagen profit

Volkswagen AG executives used to consider Skoda cars so dangerous they refused to drive them.

At a meeting 15 years ago, after Volkswagen took control of Skoda Auto AS, top managers sent the Czech carmaker's engineers home to design a better car, recalls Detlef Wittig, a VW executive at the time who now runs Skoda. „We told them this is either the end of the story, or you do your job,” Wittig says. Skoda executives heeded the criticism and returned months later with a better-engineered car. It was the first step in Skoda's decade-long transformation from an object of Communist-era derision into Volkswagen's most profitable unit after the Audi brand. That success is helping boost VW's share price as the parent company trims jobs in Germany. „Skoda used to be seen as a poor car at best and at worst the butt of many cruel jokes,” says Stephen Pope, London-based head of equity research at Cantor Fitzgerald Europe. „This baby has come a long way.” In response to the brand's growing popularity, Skoda will introduce an updated version of the Fabia compact at the Geneva International Car Show, which begins March 8. Skoda forecasts 2007 sales will rise at least 5.5% on demand for the Fabia and Roomster multipurpose vehicle. Wittig says stepped-up production in India and China will help increase sales by 45% to 800,000 vehicles within five years.

Those expansion plans mean that Wittig can have the last laugh, amusing visitors with his collection of old jokes about the brand. His favorite: „What's the best way to double the value of a Skoda car? Fill up the tank.” Skoda, based in Mlada Boleslav, 60 kilometers (37 miles) northeast of Prague, holds an outsized role in the fortunes of both its parent company and homeland. In 2005, Skoda sold 492,111 cars and posted record net income of 7.9 billion Czech koruna ($360 million), making the unit responsible for more than 25% of Wolfsburg, Germany-based VW's profit. In 2001, the first year VW wholly owned the unit, Skoda generated just 2.3% of net income. In addition, Skoda accounts for about 3% of the Czech Republic's GDP, says David Marek, chief economist at Prague-based Patria Finance AS. The unit's newfound prominence has prompted some analysts to ask whether the lower-priced cars made by Skoda and VW's Spanish unit, Seat, are siphoning sales away from the Volkswagen brand. Patrick Juchemich, an auto industry analyst at Sal Oppenheim in Frankfurt, says consumers are increasingly turning to mid-priced Skodas to get features and engine quality usually found in more expensive Volkswagen models. In Germany, a Skoda Octavia costs €14,790 ($19,265), about €4,000 less than a comparable VW Golf, and its larger interior rivals that of the mid-size VW Passat. „I don't believe the company's argument that there is no danger of cannibalization,” says Juchemich, who has a „neutral” rating on Volkswagen shares. „I am not sure there is really a client differentiation between the potential customers for an entry-level Passat and the Octavia.”
Wittig says market research shows that Skoda and Seat cars appeal to different types of drivers. „We don't have this famous question of are we cannibalizing our sales within the Volkswagen group,” Wittig says. „We have family-type buyers with Skoda and singles and mainly yuppies with Seat.” Few predicted that VW, Europe's largest carmaker, would face such a dilemma at the start of its involvement with Skoda. After the Velvet Revolution that ousted Czechoslovakia's communist regime in 1989, the new government started selling state assets. At the time, Skoda made a single model, a family car called the Favorit.

The government's search for a partner led to a venture with Volkswagen in April 1991. Over the next decade, VW increased its stake in exchange for investments, gaining full control in 2000. In total, Volkswagen paid about 2.05 billion deutsche marks ($1.25 billion) to take over Skoda. In 1994, Skoda started making a redesigned small compact named the Felicia, with a sleeker look and a more responsive engine than the Favorit, in an effort to appeal to Western European consumers. A marketing campaign featured the slogan „548 changes” -- boasting the number of improvements made to the old Favorit. Skoda began selling its first all-new model - the Octavia hatchback - in November 1996. The Octavia was the first Skoda to use a VW powertrain and frame, and it offered more interior space than the Golf, its Volkswagen equivalent. Octavia sales rose to 270,274 vehicles last year, from 47,876 in 1997. At the same time, Skoda began pushing workers to pay more attention to detail, offering bonuses for meeting quality standards. „Someone could push a little red button and halt the assembly line if something wasn't according to quality standards and quality levels,” Wittig says. „The awareness that there is a button that I can push and I can stop the assembly line was something that never existed before.” Skoda's profits are boosted by labor costs that are about 20% of those in Western Europe, the company says. Competition for low-wage workers may grow now that Toyota Motor Corp. and PSA Peugeot Citroen have established a joint factory in the Czech Republic, says Marek of Patria Finance.

In some ways, Skoda's renaissance was a return to its roots. Vaclav Laurin and Vaclav Klement made their first car at Mlada Boleslav in 1905, a decade after establishing the company as a maker of bicycles and motorcycles. In 1925, it merged with the Plzen-based engineering firm Skoda and adopted the brand name for the company's sedans. Today, the top-equipped versions of the Octavia family car and Superb luxury model bear a „Laurin & Klement” emblem. In the mid-1990s, Skoda engineers gave the company's own cars a 5 rating for quality, the lowest on their five-point scale. Two years after the Octavia was introduced the grade had risen to 3, or satisfactory. Today, Skoda models get an average rating of 1.1, compared with 1.8 for their competitors. „This is beyond imagination,” says Wittig, a former VW sales executive who joined Skoda in 1995 and became CEO almost three years ago. „In early 1991, there was just one target: surviving.” Today, it's VW that's struggling to control production costs and trim its workforce. Volkswagen-brand plants operate at just 80% of capacity, compared with 97% at Bayerische Motoren Werke AG and 93% at Toyota. VW factories in western Germany lost several hundred million euros in 2005, the company said last February, declining to be more specific.

The company plans to cut 20,000 jobs, or 20% of its workforce in western Germany, and has reached an agreement with employees to lengthen the workweek for no additional pay. VW shares have risen 67% to €84.56 since the job cuts were announced on February 10, 2006. That compares with a 27% gain in the eight-member Bloomberg Europe Autos Index. Martin Winterkorn, VW's new CEO, said in November he aims to beat a target of increasing the group's pretax profit to €5.1 billion in 2008 from €1.1 billion in 2004. Meanwhile, Skoda is expanding in emerging markets. It plans to start making the Octavia at a VW plant in China later this year, and will eventually produce the Fabia and Superb in the world's fastest-growing economy. In Russia, a joint Skoda-VW factory will help the carmaker avoid the 25% tax on imported vehicles. The production push, along with introduction of the Yeti, a sport-utility vehicle to be rolled out in 2009, may help the carmaker meet its sales goals. Skoda's reputation for quality and reasonable prices are luring buyers such as Mihael Stanic, a logistics company worker from Nersingen, Germany, who traded his Golf for a Fabia compact. „At Skoda, you get better service, the electronics are much better,” says Stanic. „At Volkswagen, you pay for the brand.” (Bloomberg)