(FORTUNE Magazine) – EVEN THOUGH it makes high-speed tires for BMWs, Mercedes, and Porsches, Continental should by all reckoning be stuck in the slow lane. The global tire market is plagued with overcapacity and ruinous price competition. At home it faces Germany's worst recession since World War II. And like other German manufacturers, including the country's celebrated auto producers, the company is handicapped by the highest labor costs in Europe -- perhaps in the world. But Conti, as Germans affectionately call it, earned $38.1 million on sales of $5.5 billion in 1993, making it the only profitable major tiremaker in Europe. The company also announced a dividend of $2.35 a share, its first since 1990. It is a prime example of German industry's response to its most severe postwar test. It is moving low-tech production abroad, working with unions at home to reduce overgenerous social benefits, and adopting such American and Japanese management techniques as lean production, teams, and total quality management. Says CEO Hubertus von Grunberg: ''Germans have suffered a shock. But we are going to come back leaner, meaner, and hungrier.''

Von Grunberg took over three years ago while the company was fighting off a takeover by Pirelli, the Italian tire company. Since then he has cut the work force by 20%, or some 10,000 employees. Research, administrative, and distribution functions are being centralized at the headquarters in the northern German city of Hannover, but about a quarter of the company's tires are now made in the Czech Republic, Slovenia, Poland, and Portugal. In London the investment banks Morgan Stanley and Kleinwort Benson have begun to recommend the company's stock, partly in anticipation of an upturn in the European auto market. Michael Barsch at Hamburg's Berenberg Bank thinks Continental, along with some other German companies, is now a buy. Says he: ''Investors realize that companies such as Conti have gone through an earthquake.'' Still, the seismic shifts in the German economy are far from over. The government is forecasting an anemic 1.5% growth rate this year, and unemployment is expected to reach 10.5%, meaning that more than four million Germans will be out of work. Also, Continental's 1993 earnings are meager for the world's fourth-largest tiremaker (and Europe's second largest, after France's Michelin, the world's biggest). They are especially meager when compared with Goodyear's. The American company, No. 2 in the world, earned $388 million last year on sales of $11.6 billion. Increasingly, tires are purchased on the basis of price instead of technology. Yet producing them requires large investments and giant economies of scale. Robert Steinmetz, manager of Continental's giant plant in Stocken, Germany, walks past giant vats of bubbling processed rubber and huge multimillion-dollar rubber stamping machines. ''For a so-called low-tech business, tires demand high-tech investment,'' he says. Over the past decade, the industry has consolidated from dozens of producers to six global giants that control 80% of a $55-billion-a-year world market. Moreover, when consumers do shop for tires by name, they tend to recognize Michelin, Continental's French archrival, rather than the German brand. Michelin is still riding the last major innovation in tires -- the radial it introduced four decades ago. Although Michelin lost some $600 million in 1993, it has trimmed 15,000 jobs in the past two years and completed a $500 million cost-cutting program. Until 1979, Continental was almost entirely German. Then in quick succession it bought Uniroyal's European operations, the Austrian producer Semperit, and, finally, America's General Tire. The acquisitions gave it nine brands made in 13 plants in Europe and four plants in the U.S. Says Wilhelm Schafer, a member of the executive board: ''We were like a greengrocer picking up bargains. Our biggest problem has been coping with this sprawl.'' Despite its acquisitions, the company seemed too small to survive when Pirelli launched its 1990 takeover bid. The deal would have joined Pirelli's strength in Southern Europe with Continental's dominant position in Northern Europe. But Continental Chairman Horst Urban refused to sell out. Shareholders, including Germany's major banks, ousted Urban for being inflexible and stubborn, then banded together to fight off the Italian challenge. The banks strong-armed BMW, Daimler Benz, and Volkswagen into taking stakes, and in 1993 they joined institutional investors and the Lower Saxony government to buy Pirelli's remaining shares. ''Our shareholders assure us stability, and that's a big advantage over the U.S. system,'' insists von Grunberg, ''but the Pirelli episode made us realize that no alliance is strong enough to keep you safe unless you are a strong earner.'' THE LANKY, ENERGETIC von Grunberg was a breath of fresh air for Continental. Though born in rural Pomerania and a graduate of the University of Cologne with a doctorate in physics, he had mostly worked abroad, first in Brazil and later in the U.S. In 1989 he became CEO of ITT's automotive parts unit in Auburn Hills, Michigan. ''We were happy campers in America,'' he says. ''My wife didn't want to leave and I was set on retiring with ITT.'' But the opportunity to transform Continental proved too appealing. When he arrived in Hannover, his aggressive, take-charge American manner stood out in the more sedate German corporate culture. He roared to work on a BMW motorcycle and drove the autobahns not in a Porsche but in a Corvette. Eventually, though, his sound scientific background calmed the fears of his managers, many of whom were engineers. Because of strong ties to the producers of German luxury cars, Continental has long been a leader in high-performance tires. It has 18% of the overall passenger car market in Europe and about 21% of the high-performance segment. Even so, von Grunberg refused to concentrate on being a niche player. Says he: ''Leica, the maker of camera lenses, went upscale and left 95% of the volume to the Japanese. We could not do a Leica strategy. We needed to hit our problems head-on.'' Attacking the mass market meant getting Continental's costs under control. Von Grunberg began a massive -- and very painful -- wave of layoffs in the German heartland. ''Unlike in the U.S.,'' he says, ''we couldn't just get rid of workers. The process was long and costly -- a five-digit figure for each employee -- and we always had to think of social stability.'' In three years 10,000 of the company's 50,000 employees were gone, their jobs largely replaced by workers in lower-wage countries in Southern and Eastern Europe. SURPRISINGLY, Continental's moves seem to have strengthened its relations with unions. Says Richard Kohler, the employee representative on the company's supervisory board: ''We must produce in the Czech Republic in order to save the company.'' Kohler also accepts the need for austerity at home. His IG Chemie union agreed this past January to a pay increase that figured out to 1.6%, well below the projected inflation rate of about 3%. That settlement has become a model for the rest of Germany. In early March, metalworkers and unions representing public employees backed down from strike calls and accepted similar agreements. But the Germans still have a long way to go. According to government figures, hourly wages in Germany rose by 23% between 1985 and 1993, after adjustments for inflation, compared with 6.1% in France and a decline of 8.5% in the U.S. A typical unskilled factory worker at Continental makes more than $14 an hour -- and the company must add another 80% in social security costs. Says union leader Wilfred Hilverkus: ''We can't dream of turning Germany into a low-cost country, but we must be more flexible to become more competitive.'' This new flexibility is visible at the company's flagship Stocken plant, built originally to supply the Volkswagen Beetle. Since 1990, almost 1,000 of the factory's 3,800 production workers have been laid off, while production has held steady at more than three million passenger tires a year. Improved work habits explain the increased productivity. Because workers are reimbursed less for illness, the factory's absentee rate has plunged from 11.5% in 1992 to 7.5% last year. This year's target is 5%. On the job, a team approach has replaced the old piecework system. Workers are encouraged to post suggestions on clipboards that call, in English, for ''Total Quality.'' The plant benchmarks with others in the Continental system. This is quite a switch for German managers, who once dismissed such practices as useless American fads. Continental officials believe Germany will prove the best place to produce high-value-added car parts. Instead of just producing tires, they ask, Why not make the entire wheel? Or the wheel and axle? ''In the past, car companies produced 80% of their parts,'' says Peter Haverbeck, managing director of the company's ContiTech parts division. ''Now it's fifty-fifty, and in the not- too-distant future it will be thirty-seventy. Car companies will subcontract complete systems instead of individual parts.'' ContiTech already produces 25% of total sales, and Haverbeck predicts the figure will grow to 30% within five years. The long-term outlook is less rosy in the U.S. After having spent more than $1.3 billion acquiring and restructuring General Tire, Continental expected the unit to break even in 1993. Instead, the brand continues to be weak and lost about $21 million. A frustrated von Grunberg responded at the end of last year by replacing several leading General Tire executives with a German manager. ''Because of my love affair with America,'' he says, ''I was too optimistic. The question we are asking now is how we can prosper in the U.S. with a company only 10% the size of Goodyear.'' The question holds for Continental as a whole. Even with its strong position in Europe, the company is less than half the size of Goodyear or Japan's Bridgestone and less than a third the size of Michelin. Von Grunberg says that unless the company's return on capital improves, ''we may need more bloodshed.'' That could mean an increase in layoffs -- 2,000 more workers will leave this year through a mixture of attrition and cutbacks -- or disposing of General Tire. Von Grunberg could even mean the previously unthinkable -- he could sell the whole company. Says he: ''We want to stay independent, but if we don't do better, all options of new alliances are open.'' The stakes are large. What if, despite all its impressive efforts, Continental remains unable to keep up in world markets? That would mean that no matter what big German companies do, they can't be globally competitive. Since Europe needs a strong Germany to lead it out of recession, Continental's failure would be a disaster not only for Germany but also for the entire continent.