Quotes of the Day

Angela Merkel looks set to win her struggle to be Germany's next chancellor. As she and her erstwhile political foes haggle over the final shape of a new coalition government, they should read the letter Dieter Zetsche wrote to the work force of the Mercedes Car Group last month, four weeks to the day after he took the helm at the fabled German automaker. Mercedes has long been the jewel of German industry, an immensely profitable brand that has grown into a colossus with annual sales of more than 1 million cars and revenues exceeding $60 billion. But these days, the reputation of the three-pronged Mercedes star has dimmed. The firm, now part of the DaimlerChrysler conglomerate, has been plagued by uncharacteristic quality problems while its manufacturing efficiency has declined. Rival BMW, once much smaller, now outsells it. Stuttgart-based Mercedes is struggling to make any money at all this year.

Zetsche's Sept. 28 missive — 10 days after the country's inconclusive elections — was the business equivalent of a political "blood, sweat and tears" speech. While saying that some measures the company had taken to get back on track were bearing fruit, he warned: "We should not let ourselves become overconfident. There is still a long and difficult road ahead of us before we can become truly competitive again." The company continues to drag around excess production capacity, he wrote, and its costs remain "significantly higher than those of the best competitors." To redress the situation, he announced, DaimlerChrysler's board was cutting 8,500 Mercedes jobs in Germany, or about 9% of the total. "Our most important task right now is to ensure that our excellent products can be made with less input," he says.

That's a mantra that applies to the whole of Germany these days. For years the nation could justify some of the world's highest costs by making world-beating products. But those days are over, as a host of lower-cost competitors from Asia and elsewhere push their way onto the scene with ever better-quality products. The German response to date has been hesitant; the outgoing government of Chancellor Gerhard Schröder acknowledged that Germany's international competitiveness was slipping, and introduced some labor and other reforms. But its steps were just a start, and not nearly enough to reverse the nation's high unemployment rate or jump-start the stalled economy. Merkel had campaigned on a tougher reform ticket, promising to slash the cost of labor and allow greater flexibility to employers. Saddled with a coalition, she'll likely have to rein back some of that ambition.

But German business isn't waiting. People like Zetsche, 52, are part of a new generation of hard-nosed top German executives carrying out their own sweeping reforms, regardless of the political constellation in Berlin. Klaus Kleinfeld, who took over as chief executive of electronics giant Siemens in Munich at the beginning of this year, recently announced big cutbacks in three of the firm's troubled subsidiaries. At Volkswagen in Wolfsburg, Wolfgang Bernhard, a former Mercedes alumni who took charge of the automaker in May, staged a showdown last month with the company's unions: unless they agreed to massive cost reductions, he would build a new suv in Portugal rather than Germany. The unions chose to work for less rather than not work at all. The signs are that such corporate makeovers are helping to whip Germany back into shape. The latest data from the Paris-based Organization of Economic Cooperation and Development show that German productivity has risen by 3.6% in the past year and by twice that amount since 2002, far outpacing Britain, France, Italy and even the U.S.

In many ways, Mercedes' recent troubles provide a window into Germany's own problems. The prosperity of both company and country has been built on engineering excellence and high-quality manufacturing. Mercedes stumbled, as Germany is stumbling, because of external pressures. In today's fiercely competitive global marketplace, there's little margin for error, especially for high-cost producers. With auto manufacturers worldwide racing to produce ever better cars ever more cheaply, Mercedes slipped because it became too complacent about its technological prowess, took on too big a workload and rushed out new models before they were ready. "They partly got into this mess by resting on their laurels," says Peter Schmidt, a British-based auto consultant.

DaimlerChrysler has also paid the price for its mismanaged global ambition. Two successive chief executives, Edzard Reuter in the 1980s and Jürgen Schrempp in the '90s, aggressively pursued visions of international growth and diversification and financed them by tapping into the cash hoard Mercedes had built up over decades. In the process, the company, which once prided itself on its provincial roots in Baden-Württemberg, acquired a worldwide scale and presence in both cars and trucks. It also bought some absolute dogs, including a near bankrupt household appliance company (AEG), a teetering airplanemaker (Fokker) and a 37% stake in Japan's inept Mitsubishi Motors. Those and other investments drained management's attention and the company's account; Daimler's share of Mitsubishi's 2002-04 losses totaled more than $1 billion.

The company's biggest acquisition, the $36 billion purchase of Chrysler Corp. in 1998, remains deeply controversial. The market value of DaimlerChrysler, the combined firm, is about one-third less than when the merger was announced. "They frittered away their cash," says Helmut Becker, BMW's former chief economist who now works as an industry consultant. "If they hadn't, the quality problems wouldn't have come about."

Those problems began in earnest after Mercedes launched its E-Class series in 2002 only to face a barrage of complaints about cars that didn't start or kept breaking down. The company quickly realized the model had some serious flaws, and moved aggressively to fix them. More than 200 teams of engineers ripped the car apart to identify and overcome the troubles, which included design and production snafus in complex electronics systems. The firm this year recalled 1.3 million cars, including C-Class and SL-Class as well as E-Class models built between 2002 and '05, took back the lemons, switched engines in some models and started providing two-year full-service warranties to disgruntled owners. In the process, the brand has rebuilt its quality-control management and now says the autos it builds are the best and most reliable it has ever made. Such claims are partly borne out by the latest J.D. Power short-term reliability surveys.

But the cost to the firm's once stellar reputation has been devastating. Mercedes has slid dramatically in consumer rankings over the past two years, especially in the U.S., its biggest foreign market, accounting for 20% of sales. Four models show up in Consumer Reports' list of the worst used cars. And in J.D. Power's influential study of long-term vehicle dependability, which measures problems encountered by owners of three-year-old cars, Mercedes scored far below the industry average in the 2005 survey; Mercedes owners reported more than twice as many problems per 100 cars as top-ranked Lexus. "Mercedes' fall from grace has been especially severe," says Chance Parker, J.D. Power's executive director of product and research analysis.

Fixing the technical problems is just half the battle: Mercedes now has to win back customer loyalty. That's not so quickly fixed as a mechanical problem. In the first nine months of this year, the firm sold 9% fewer E-Class cars worldwide than last year. Sales of its other best-selling model, the C-Class, were down by 12%. The financial outlook is dreadful: even without counting $1.3 billion in losses at its Smart subsidiary (see Small Isn’t Smart), Mercedes managed only a tiny operating profit for the first half of the year after a loss in the first quarter.

And it's going to take a lot of patience and persuasion to bring longtime Mercedes fans like Gary Hurvitz back into the fold. Hurvitz, president of a financial firm in Rockville, Maryland, says reliability is a key issue — and he doesn't believe Mercedes is yet where it should be. "For every time I read of a DaimlerChrysler executive claiming that the problems are resolved, I see two more [online] postings by people whose cars break down within weeks of leaving the showroom," he says. He still owns a '94 Mercedes E320 wagon and a '98 E320 sedan, but last year, after taking a long hard look at the S-Class, he bought a Lexus instead. "European-car aficionados may look down at me when I pull up to them in my supposedly ever-so-boring-to-drive Lexus," Hurvitz says, "but I'll enjoy the last laugh when their transmission fails."

Those problems now belong to Zetsche, who sports a bushy walrus mustache and a big broom. He was once considered a dark-horse candidate for the top job, but his star rose over the past three years. Dispatched to Auburn Hills, Michigan, to sort out Chrysler, he has led a remarkable turnaround at the company, which swung back into the black in 2004 after years of heavy losses. In September, Chrysler reported its 18th consecutive month of sales increases. In the U.S., Zetsche quickly wielded that favorite American management tool: the hatchet. He axed 26,000 jobs and browbeat suppliers to lower costs, but he also introduced what he called "disciplined pizzazz" — a program to bring a focus on efficiency to the company's business operations without sacrificing its character.

The imperious Schrempp, by contrast, continued to lurch from crisis to crisis until the Daimler board showed him the exit, three years before his contract expired. DaimlerChrysler stock soared about 10% on the news. The change of leadership "dramatically alters investor perceptions," said Merrill Lynch's London-based auto analyst Stephen Reitman, who upgraded the stock to neutral. "In the land of the blind, the one-eyed man is king," says Schmidt, the British consultant. "Zetsche is a brilliant choice, but it will be very arduous to get Mercedes back to where it was."

Zetsche isn't waiting until January, when he officially takes control of DaimlerChrysler, which last year had total sales of $192 billion. He immediately parked himself in the top job at Mercedes, replacing Eckhard Cordes, a Schrempp confidant who had been in the post only a year. Zetsche says he plans to stay on as head of Mercedes even when he takes over the whole works. He is quick to caution against comparisons between Mercedes in 2005 and Chrysler in '02, but it didn't take long for Zetsche to strike. The layoffs Mercedes just announced are a stunning reversal: just last year, the company signed a deal with unions that guaranteed jobs until 2011. But Zetsche is circumventing that through voluntary buyouts. They will cost the firm more than $1 billion, or a whopping $135,000 a person.

As for the damage to Mercedes' reputation, he likens the brand to "a kind of savings account" from which the company has had to make a few withdrawals. "We have to strongly start to re-fund it." His timing is good, because Mercedes is in the midst of a product offensive, including the launch of its new top-of-the-range S-Class series and a restyled version of its popular M-Class suv. Even before Zetsche's arrival, Mercedes was putting in place a restructuring program introduced by Cordes that aims to boost the company's return on sales to 7% — it's now close to zero — and Zetsche is widely expected to accelerate those measures.

Even with a smaller German work force, he'll have to continue wrestling with costs at the same time as keeping a focus on quality, innovation — and the competition. Becker, the former BMW economist, contends in a book published last month that the glory years of the German auto industry are history and that as much as 25% of the 800,000 auto-manufacturing jobs in the nation will be cut over the next 10 years as suppliers increasingly shift production abroad. The book, titled Crash Course, has attracted wide attention in Germany, with some reviewers calling it overly bleak. Retorts Becker: "They call it bleak because Germans prefer to hear fairy tales rather than the reality."

At Mercedes headquarters in Stuttgart, the question of what went wrong has been pored over in great detail. Senior managers are eager to move on, to talk about the future rather than to air their dirty linen in public. After several rounds of mutual recriminations in the German press over responsibility for the faulty electronics, management has struck an agreement with key suppliers such as Bosch not to blame each other. In their self-critical moments, executives say they ramped up production of the E-Class too quickly before it was ready, and that they were overstretched by the introduction of a welter of new models.

By this summer, though, Mercedes management felt confident enough to put out the word they'd turned a corner. At a July 10 meeting in Frankfurt with its entire German sales force, almost 6,000 people, the automaker's top executives collectively beat their chests, promised that the nightmare was over — and then fielded hours of tough questions. "We needed to convince our own organization," says one senior Mercedes manager.

Even Mercedes' German rivals, while eager to exploit the sales opportunity, are rooting for a modest recovery. "In the end it's also a German brand," says Ralph Weyler, the board member responsible for sales and marketing at Audi. "Generally, it prompts the discussion, Are the Japanese better than the Germans? We're all thrown into the same pot."

These problems present a unique opportunity for Zetsche. If the quality and reliability issues have truly been dealt with — and the indications are growing that they have been — Mercedes will once again take its place at or near the top of the heap. "It would be foolish to believe Mercedes' weaknesses will exist for very long," says Stuart McCullough, the European director for Lexus. The big question is how quickly those scared off by the quality problems will come back. The goodwill is clearly there. "I personally haven't given up on Mercedes-Benz," says Hurvitz, the financial-company president in Rockville who switched to a Lexus. "I loved the older ones and what I perceived the car stood for. I still hope that [the company] can turn itself around." Germany hopes so, too.

• PETER GUMBEL
• Like the German economy, Mercedes has been buffeted by global competition. But Germany's leaders could learn from the automaker's efforts to get back on track