BMW Hits a Speed Bump

German automaker BMW (BMW) has a problem most rival auto bosses would love to have. Its new models are so successful that factories are running at nearly 100% capacity and orders are backlogged for three to six months. It invested early in new technologies to boost fuel efficiency and those innovations are now hitting the market, helping new models sip less gas. Yet despite surging sales, BMW's profit margin fell to 7.3% in the first half of 2007, down from 9.3% in same period a year ago, hit by rising raw material costs, a strong euro, and higher investments in research and development.

BMW's $2.6 billion pretax profit is hardly a disaster and its profit margin, despite getting nicked, is still one of the best in the auto industry. But investors are the nevertheless gloomy about BMW's first half results, released Aug. 1, because they have long believed BMW's finely tuned machine should be driving margins even higher -- to 10% and beyond. Rival Mercedes recently upped its profit forecast for 2007 to "above 7%" and Chief Executive Officer Dieter Zetsche is vowing to hit 10% by 2010. Fast-moving Audi is also closing a historic profit gap with BMW. "BMW is delivering quite strong sales growth and diddly-squat in earnings," says Stephen Cheetham, analyst at Bernstein Research in London.

Powered by surging sales of the second-generation Mini, a new X5 sport-utility vehicle, and the 3 Series coupe, BMW's revenues rose 7.3% in the first six months of 2007, to $35 billion. Yet as BMW invests heavily to make its cars more fuel efficient, pretax profit fell 13.6% to $1.46 billion. Management insists BMW's earnings will rebound in the second half of the year and that the company is on track to exceed last year's pre-tax profit, excluding a one-time gain of $509 million on a convertible Rolls Royce bond.

Efficiency vs. Profits

"We are very confident we will achieve our target. Most of the exchange-rate hit has been taken in the first half of the year," said Chief Financial Officer Stefan Krause in a conference call with analysts.

But the worry is that BMW is trapped in a 21st century Catch-22 -- how to make its high-performance cars more efficient and boost profits at the same time. Caught off guard by the rising popularity of Toyota (TM) and Lexus hybrid models, BMW is now trying to catch up with its own fuel-saving innovations tailored to combustion engines. Research and development spending rose 14% in the second quarter to $645 million. Installing the innovations across its entire model range is not cheap.

And so far consumers are not willing to pay a premium for a fuel-efficient BMW, analysts note. As a result, BMW's costs are going up, but the price of its cars do not recapture the investment in fuel-efficiency innovations. "Our first experience with [new technologies to boost efficiency] is that it gives us competitive advantage, but pricing remains a challenge," admits Krause. "Over time we will solve it."

Catching Up with Lexus' Hybrid

BMW Chief Executive Norbert Reithofer, who took control 11 months ago, is all too aware of the profit conundrum and has been huddling regularly with his top lieutenants on how to fuel earnings growth amid environmental challenges. During mini-retreats at a Bavarian lake called Tegernsee, an hour's drive from headquarters, the 51-year-old former production chief provokes intense debate on everything from engine technology to climate change. This fall Reithofer will present the results of the high-powered confabs: a 10-year strategic plan designed to boost profits and keep up the Bavarian automaker's growth trajectory.

That plan is likely to include a road map for future models that can compete with Toyota's hybrid juggernaut, cost-cutting measures to polish margins, and details on shifting more production to BMW's U.S. plant in Spartanburg, S.C., as a currency hedge. "The Lexus LS600 hybrid is a very sophisticated evolution of a hybrid. It caught BMW flat-footed. BMW will have to spend a lot to catch up," says Thomas Aney, analyst at Dresdner Kleinwort in Frankfurt.

More Stateside Production

Reithofer already has signaled that the next generation of the popular X3 baby-SUV will be made in Spartanburg and that the plant's annual production will rise to 240,000 cars. Analysts believe BMW may also consider building its next plant in the U.S. instead of Germany, and shifting some engine and component production to the U.S. sooner.

Reithofer, who led strong efficiency gains at BMW's factories as production chief, said the company would likely achieve a 7% productivity gain this year. He also pointed to a 20% sales increase in July. "New models will increase our margins. And we have other products in the oven," said Reithofer. The new Mini Clubman, a hotly awaited wagon version of the Mini Cooper, will be unveiled at the Frankfurt Auto show in September.

Krause also dismissed a recent report in Germany's Manager Magazine to the effect that the Mini doesn't make a profit. "The only thing that is not mini about Mini is its profit," he said. Sales of the new Mini launched in the U.S. this spring soared 18% in the second quarter. Analysts expect Mini sales this year to top 200,000 -- more than double BMW's original target. Responding to general criticism about BMW's sliding margins and the better performance of rivals, Krause said, "I assure you over the long term our operating margins are at a very good level compared with premium competitors."