(FORTUNE Magazine) – LIKE AMERICANS, Europeans are passionate about their cars -- they just express themselves a little differently. They prefer the intimacy provided by a manual gearbox over the remoteness of an automatic transmission. They drive hyperaggressively, tailgating with abandon and passing on blind curves. As for the cars, they are taut, highly responsive, and very fast -- all the better to cruise the industrial world's only speed-limitless highways. After a disastrous 1993, the cars are selling well again. Unit sales fell 16% last year, but through October of this year they have risen 5%; all eight major manufacturers reported profits for the first half of 1994. With forecasters predicting at least two more years of rising sales, Europe's automakers appear well along to recovery. Yet the prevailing mood at the biennial Paris auto show was, in a word, uneasy. "We really have to hurry to keep up with the marketplace," says Helmut Werner, the jaunty president of Mercedes-Benz. "We have decentralized, cut two layers of hierarchy, and reduced our management positions by 25%, and yet I am quite convinced that we haven't reached the end of the road by far.'' Adds Louis Hughes of General Motors, whose Opel and Vauxhall operations are the most profitable in Europe despite a recent dip in market share: "Anyone who says they have done their restructuring is kidding themselves. The industry is going to displace many, many more jobs, not just in assembly but throughout the whole manufacturing chain." The main reason is that the automakers of Europe -- where Gottlieb Daimler and a co-worker built the first car in 1889 -- continue to trail their U.S. and Japanese counterparts in quality, productivity, and time to market. Unless the European companies can close the gap, several -- Peugeot, Fiat, and possibly Volkswagen -- will be seriously weakened by the end of the decade; / one, Volvo, may not survive in its current form (see box). In the auto business, information travels freely around the globe, borne by industry executives, international consultants, corporate spies, and the products themselves. European automakers are finally paying attention to it, frantically gleaning new techniques in everything from engineering and manufacturing to global integration and cultural change. They radiate impatience with the past, and an almost compulsive urge to drive into the 21st century. Volkswagen CEO Ferdinand Pich is famously single-minded in his pursuit of engineering excellence. Renault's Louis Schweitzer runs his own global fact-finding missions and even drops in on dealers by himself. BMW's Bernd Pischetsrieder is spearheading two historic departures for his company: producing in North America and managing an acquisition, Britain's Rover. As GM's Hughes puts it, "If you stay on the same track, sooner or later you will get run over." To appreciate just how dynamic the industry has become, one need only examine how far some companies have moved from their established public images. Mercedes-Benz, the essence of conservatism and wealth, will soon affix its three-pointed star to a pair of comparatively inexpensive minicars. France's Renault, which once produced lemons like the Dauphine and the Alliance, now builds higher-quality cars than Germany's Volkswagen. Peugeot and Fiat, standard-bearers of French and Italian culture, respectively, have joined to develop an American-style minivan. And General Motors, which remains stereotyped as a lumbering giant in the U.S., reigns as Europe's low-cost producer. But for all their progress, the European auto companies have plenty of catching up to do. The latest evidence comes from still unpublished findings by management specialist John Paul MacDuffie for MIT's International Motor Vehicle Program. That's the group that first alerted the world to the European auto industry's shortcomings with the publication in 1989 of The Machine That Changed the World. MacDuffie, an assistant professor at the Wharton School of the University of Pennsylvania, and his associate, Fritz Pil, have collected data from 75 international assembly plants, including 20 in Europe. They found that while European companies have made "significant improvements" in productivity since 1989, they still lag behind the Americans and Japanese. The average European automaker requires 25.9 hours of labor to assemble a car, vs. 36.9 hours four years ago. By comparison, American manufacturers take 21.7 hours, down from 24.9 in 1989. The Japanese remain the world leaders at 16.2 hours, though they have improved little from the 16.8 hours measured in 1989. The quality of European cars remains deficient as well. Although the number of assembly-plant defects per 100 vehicles has fallen since 1989 from 91 to 63, Americans have improved from 86 to 60. Once again, the Japanese set the standard with just 56 defects per 100 cars, down from 63.

BECAUSE protectionist barriers guard big markets like France and Italy from better-made foreign cars, Europeans pay dearly to indulge their automotive passions. A fully loaded Renault Espace minivan sells for $36,000, vs. $28,000 for a comparable U.S. van, the Ford Windstar. And a Renault Safrane luxury sedan powered by a V-6 engine is stickered at nearly $57,000; a comparable Lincoln Continental or Chrysler LHS goes for $20,000 less in the U.S. London- based consultant Karl Ludvigsen says Europeans routinely pay as much as 30% more for their cars than customers in the U.S. or Japan. Because of protectionism -- and because customer ties to local companies are strong -- Europe's manufacturers can thrive in their home markets even while they flounder elsewhere. Volkswagens, for example, account for 21% of the cars sold in Germany so far this year but only 5% of French sales. Similarly, Fiats are the choice of 34% of Italian buyers, but only 3% of Britons. Unlike North America and Japan, where GM and Toyota, respectively, dominate their markets, Europe has no paramount producer. Less than four percentage points of market share separate the top four companies: The VW group has 15.1%, GM 13%, Ford 12.1%, and Peugeot 12%. Close behind are Fiat with 10.4% and Renault with 10.1%. Nine Japanese producers collectively account for 11.2% of 1994 sales, down from 12.6% a year ago. Altogether these companies will sell about 12 million cars and 1.2 million light trucks this year (vs. about ten million cars and five million trucks in the U.S.). Competition in Europe seems certain to increase if protectionist barriers fall as scheduled on December 31, 1999. The drive toward a single European Union means that regulations and taxes will become more uniform, making it easier to sell Fiats in France, for example. At the same time, increasingly less parochial residents of Spain or Britain who watch MTV say they are more willing to buy a car aimed at the entire continent, not just a specific country. Says John Lawson, London automotive analyst for DRI/McGraw-Hill: "In the future, the most successful manufacturers will be those that are the most thoroughly Europeanized." Adds Randall Miller, an automotive consultant for Deloitte & Touche: "If 1999 were today, European automakers would be in trouble." To get ready for the millennium, they have devised a variety of strategies to attack their joint problems of productivity, organizational structure, and market penetration. A sampling: -- PRODUCING LEAN. Like second marriages, new auto plants in Europe can be called triumphs of hope over experience. Even though Europe has too much assembly capacity, its automakers are building new facilities because they provide clean-sheet opportunities to improve layout, logistics, and labor usage. In the former East Germany, GM has built an homage to lean production that is seeding new manufacturing ideas throughout the company the way Saturn was intended to but never did. During the past year more than 2,000 GM managers visited the plant in Eisenach, which builds 150,000 Corsas and Astras annually in 60% of the time required at the average European auto plant. At Eisenach, white-shirted, gray-trousered workers receive intensive training to stimulate creativity and problem solving because their duties go beyond assembly work to include quality, maintenance, and materials management. Each team of six to 12 workers organizes its own work processes and fixes problems on the spot, reflecting what is known as the zero-defect principle. If the buzzword at Eisenach is "lean," it is "integrated" at Fiat's new southern Italy plant in Melfi. Fiat purposely built the plant far from its base in northern Italy in order to attract a young work force more accustomed to farm fields than factory floors; the average age at Melfi is 26, vs. 45 for other plants. Fiat wants to integrate the unspoiled young workers with the plant supervisors in a team-based organization that relies on new technologies. All operations requiring unusual physical effort, such as painting and body welding, have been fully automated. And Fiat has located 17 suppliers around the Melfi plant so that materials, which account for 42% of costs, can be delivered just in time. Twice as large as a typical U.S. plant, Melfi is designed to crank out two cars a minute -- 450,000 a year on three shifts, six days a week. Fiat says that when Melfi is running at full capacity, each assembly worker will produce 79 cars per year, vs. 45 at the average Fiat plant. -- ELIMINATING JOBS. Aided by the recession and creative management, European automakers have made surprising progress reducing head count, despite strict job-protection laws. Peugeot cut 5% of its jobs last year and will chop another 4% this year. Renault started downsizing early, in 1989, and its payroll at the end of last year was 140,000 -- 17% less than five years ago. It plans to continue shedding about 2,000 jobs a year. Says Hans Joerg Hafner, a Gemini consultant in Munich: "Renault is one of the leanest companies in Europe." Volkswagen, which lost $1 billion last year, started late and may not have cut deeply enough. After trimming its payroll at six German plants by 12,000, to 102,000, it negotiated to put all its employees on a four-day week. The workers got the better deal: They reduced their hours by 20% but took only a 16% cut in pay. When the agreement expires at the end of next year, VW may have to consider eliminating 30,000 more jobs. Germany's auto workers are the highest paid in the world. Their average hourly wage in 1993 was $25.80, vs. $21.64 in Japan and $16.64 in the U.S. -- CREATING NEW VEHICLES. For additional evidence that Europe is becoming more international, consider this: The minivan, developed by Chrysler in the U.S., is catching on. Five new models were introduced at the Paris show, including the products of Ford-Volkswagen and Peugeot-Fiat joint ventures. The European vans typically seat only six passengers, vs. seven or eight in U.S. vans. The potential market is smaller too, because gasoline can cost nearly $4 a gallon. Still, sales are expected to be 500,000 in 1999, up from 176,000 this year.

Overall, however, Europe remains a market of small cars that are getting smaller. GM is said to be considering development of a tiny city car that would cost $9,500 -- 30% less than its subcompact Corsa. And Ford showed off a design concept for a minicar that it hopes to sell in quantities of 100,000 annually. No one has more ambitious small-car plans than, of all companies, Mercedes-Benz. Stung by European rejection of its enormous, gadget-laden S- class cars, the company is radically redirecting its efforts. By 1997 it will begin building a stubby, high-roofed, four-passenger vehicle code-named the A car. Mercedes hopes to sell 200,000 a year; up to 10,000 A cars may find their way to the U.S. Coming next will be an even smaller Mercedes: a two-seat microcompact about eight feet long -- less than half the length of an S320 sedan -- that will sell for between $10,000 and $13,000. Mercedes is designing the car in partnership with Nicholas Hayek, creator of the bargain-priced Swatch watch, and will build it at several plants in which Mercedes will hold a 51% interest. Werner believes that annual sales could reach up to 1.2 million. The notion of mighty Mercedes selling $13,000 cars is cause for glee among its luxury-market rivals. They believe the company will damage its reputation by trying to serve both class and mass. Says one CEO bluntly: "It is a bad idea." Responds Werner: "Our brand will stand for all its historical values, but we must offer products that fit with the lifestyle of the customer."

-- CHANGING THE CULTURE. Werner, who spearheaded development of the two small cars, is determined to shake up Mercedes. Says he: "Our company believed for decades that there was only one way for success: Don't talk to anyone else, just talk to ourselves. Those days are over. We have very competent managers who have to be retrained, reeducated, opened up. We are really in a change process." That's an understatement. Developing a $13,000 car will require a wholly different mindset for engineers accustomed to designing products that cost five or even ten times that much. While the revolution is just beginning at Mercedes, it is already paying off at Renault. Owned by the French government, the company nearly stalled in the mid-1980s. But it has since made such headway in efficiency, speed, empowerment, and reduction of hierarchy that it has been nicknamed the Chrysler of Europe. Says MIT's MacDuffie: "Renault has made big gains by being more flexible with its unions, cutting job classifications, and adjusting work rules. It got the knack of lean production early and tried to understand the principles rather than just slavishly follow the form." -- DEINTEGRATING. Like their comrades in Detroit, European automakers are torn between handing over major design and engineering responsibility to parts suppliers, with the promise of long-term savings -- or squeezing the suppliers now for every last sou. The short-term thinkers are winning. Says a Frankfurt- based management consultant: "It is still 'Screw them or they will screw you.' The manufacturers will not be competitive on a global basis until they become partners with suppliers." Exhibit A is Volkswagen, where GM's former bad boy, Jos Ignacio Lopez de Arriortua, remains in charge of purchasing. Says Gemini's Hafner: "Lopez has reduced costs by putting pressure on suppliers. Suppliers love working with BMW or Mercedes or GM's Opel, but there seems to be much less cooperation with VW." Renault is trimming its supply base from 1,850 companies in 1984 to 800 by 1995 while increasing its dependence on outside parts from 65% of the cost of the car to 75%. Says a Renault executive: "We are trying to give more sales to fewer suppliers, who can invest in our new programs."

-- BREAKING THE MOLD. Since the turn of the century, conventional wisdom has held that success in the auto industry can be reduced to three words: "Spread your overhead." If you spend $2.5 billion to develop a single product, as Volvo did with its 850 model, you become compelled either to sell the car for a very long time or charge a lot of money for it. When automakers join forces, it is almost always to spread the overhead. Yet nearly every manufacturer in Europe has been burned by an acquisition that turned out to be strategically or financially unwise: Ford and Jaguar, GM and Saab, VW and Spain's SEAT, Fiat and Alfa-Romeo. Meshing separate engineering operations and product lines -- especially across national boundaries -- is difficult and often results in the weaker partner being consumed by the stronger one. So why is BMW's purchase of Britain's Rover earlier this year being hailed as a masterstroke? Because BMW is ignoring the conventional wisdom. Oh, it may put an engineer or two on the plane from Munich to Birmingham, and a BMW engine may turn up in the odd Rover. But BMW has vowed not to integrate the two companies. Explains Helmut Panke, formerly BMW's chief strategist and now head of its North American operations: "You don't want to lose the creative independence in either organization or the feeling that each is responsible for what it does." BMW has a novel strategy for Rover. It wants to use Rover's popular-priced cars to open new markets -- particularly in developing nations -- for BMW's high-priced cars. It also gets to sell Rover's much-sought four-wheel-drive vehicles, and it hopes to use some of Rover's historical but dormant brands, such as MG and Austin-Healey, on new limited-production sports cars. Will BMW's strategy embolden other automakers to seek a partner? Aside from Volvo, the likeliest candidate is Fiat, which will lose its protected sanctuary in Italy at the end of the decade and could benefit from outside engineering and design help. Since it scuttled deals with Ford and Chrysler as far back as 1984, its most likely alliance would be with France's Peugeot or Renault. All three companies specialize in small cars that could profit from shared components.

-- CREATING A GLOBAL NETWORK. By far the most daring management feat under way in Europe doesn't originate in Paris, Turin, or Wolfsburg but rather in Detroit. Ford has effectively wiped out its huge vehicle engineering staffs in Europe and the U.S. and will reorganize them on January 1 into five platform teams. The teams will develop new models that can be sold, with minimal alterations, in both the U.S. and Europe. Four of the teams will be based in Detroit, with the fifth, for small cars, in Europe. The strategy, known as Ford 2000, sounds commonsensical. Why not develop, say, a single four-cylinder engine for both markets instead of separate ones for each? But as Daniel Jones of Britain's Cardiff Business School, one of the co-authors of The Machine That Changed the World, observes, "It is a much bigger distraction than Ford anticipated." In part, that's because Ford is preserving one of the least productive features of its old system by maintaining duplicate engineering centers in Britain and Germany, a residue from the early days of the 20th century when Henry Ford set up individual manufacturing facilities in each country. Several Ford airplanes fly engineers back and forth between the two countries every day. Says a competitor's CEO: "Because there are two nations, it makes the inevitable competition between two engineering organizations even worse. Furthermore, I understand that it adds about 10% to the cost of developing a new car." While Ford's reorganization appears unnecessarily complex, GM has chosen an elegantly simple strategy. It has essentially quarantined its high-cost North American operation and placed the responsibility for global integration in the hands of Lou Hughes in Europe. Cooperation will be ad hoc. Says Hughes: "We're learning to take a platform and wrap stuff around it that lets us be very responsive to individual markets without going through all the reengineering of heating systems and body structure." So a midsize Opel Omega will be fitted with a new grille and sold in the U.S. as a Cadillac, while a subcompact Opel Astra could serve as a platform for the Chevy Cavalier and Saturn.

! THE NEXT -- and far bigger -- challenge for the automakers will be to move beyond Europe to become global players. With new factories in South Carolina and Alabama, BMW and Mercedes are on their way. Volkswagen maintains a token presence in the U.S., where its sales are one-fifth what they were in the glory days of the 1960s. But Renault, Peugeot, and Fiat all exited the U.S. because they couldn't compete on cost or quality. "I don't think you can be successful when you are just selling cars in Europe," says BMW's Pischetsrieder. "Research and development costs are too high to limit your volume to one of the three major markets. I have a very strong feeling that ((Renault, Peugeot, and Fiat)) have to get back to North America." Regardless of whether they do, the next ten years in the world's oldest auto market will likely produce as much change as the first 105. But don't look for a shakeout. Just as the U.S. rescued Chrysler in 1980, no European government will allow a major auto manufacturer to fail. The hole left in their economies -- and their national pride -- would be too large. To put it another way: Europeans are just too passionate about their cars.

BOX: MAJOR EUROPEAN CAR MANUFACTURERS

VW 15.1% market share Golf III GL Strength Famous name, engineering, overseas reach.

Weakness High costs, slow to make cuts, executive turmoil.

Outlook Must fix its factories and put pizazz in its car designs.

FIAT 10.4% Punto Strength Attacking factory problems; specialist in small cars.

Weakness Slipping in Italy, neglecting luxury brands like Lancia.

Outlook Must avoid being trapped as Italy-only producer.

BMW 6.5% 316i Strength Darling of analysts, solid product line, effective global strategy.

Weakness Soft luxury market, high-cost German base, shaky quality.

Outlook If cars made in South Carolina fly, so will BMW.

FORD 12.1% Fiesta SI

Strength Europe-wide outlook, strong parent, extensive cost cutting.

Weakness Odd model designs, engineering reorganization.

Outlook Contender for a leading role in the new Europe.

GM 13% Opel Astra

Strength Solid organization, low-cost producer.

Weakness Profits fell in third quarter; more competition coming.

Outlook Eastern European thrust could be key to 1990s success.

RENAULT 10.1% Clio

Strength Well managed; government selling one-third of its stake.

Weakness Strategic direction unclear after failure of Volvo deal.

Outlook Best nonglobal player, to damn with faint praise.

PEUGEOT 12% 106 XTD

Strength Devoted French customers, leader in diesels.

Weakness Politics ultra-protectionist, lacks North American presence.

Outlook Must avoid being trapped as France-only producer.

MERCEDES 3.6% C-Class

Strength Very wealthy, fabulous image, robust engineering.

Weakness Changes unsettle managers and risk core market.

Outlook Is Mercedes like GM under Jack Smith -- or Roger Smith?