(FORTUNE Magazine) – The relationship between an auto-parts company and its customer, the automaker, is like the relationship between a masochist and a sadist. Really. The parts maker slashes margins to the bone to get a contract in which the difference between a winning bid and a losing one may be one-thousandth of a cent. Then the real pain begins. The manufacturer demands that the parts maker meet rigorous schedules, adjust to wide fluctuations in production, and cut prices by several percent every year that a contract runs. If a part turns out to be defective, the parts maker may have to share in the manufacturer's added warranty costs--or perhaps pay damages from a class-action lawsuit.

Much as they may abuse parts makers, the auto companies can't live without them. In fact, parts companies are becoming even more important as automakers outsource more research, engineering, and manufacturing. So the question of how this quintessentially old-economy industry can survive and prosper in the 21st century is a critical one. Nobody is struggling harder with the answer than Delphi Automotive Systems, the world's largest auto parts company, with 1999 sales of $29.1 billion. "This is the biggest challenge since the Industrial Revolution," says J.T. Battenberg III, Delphi's chairman, CEO, and president. That statement sounds grandiose, but it reflects the reality of an industry undergoing seismic global change.

You may not have heard of Delphi, which has been an independent company only since General Motors spun it off a year ago. But had it appeared on this year's list of the FORTUNE 500, Delphi would have ranked 40th, ahead of such blue-chip giants as Du Pont and Johnson & Johnson. Under Battenberg, Delphi has begun to improve every aspect of its business, grow its quarterly earnings, and--naturally--embrace the Internet. But its stock price has barely budged. Since it first sold shares to the public in February 1999 at $17, Delphi has traded between $14 and $22. The ratio of its stock price to forecasted earnings this year is stuck in single digits. Delphi is hardly the only old-economy stock languishing, but its P/E is way low for a profitable company that has a strong cash flow and promises to boost profits by 10% a year.

If Delphi's valuation simply reflects a temporary aberration in investor preferences, then the danger to the company is small. "By any measure, the entire supplier universe is downright cheap," writes Paine Webber analyst Joseph Phillippi in a new report. "The group is trading at valuations never before seen, period." Some auto-parts makers were selling at valuations twice as high just two years ago, and a few analysts predict the stocks will bounce back.

But if Delphi's multiple remains where it is, its efforts to prosper and grow will be a lot more difficult. Without a reasonably priced stock, Delphi has to pay more to raise capital and can't use its shares as currency for acquisitions--a major disadvantage in a rapidly consolidating industry. Moreover, it will have a tougher time hiring talented young workers eager to make a killing in the new economy. Lately job seekers have moved lemminglike to faster-growing companies that can reward them with stock options, the mother's milk of the 21st-century economy.

"We are not happy with this," says Delphi's chief financial officer, Alan Dawes. "Over time, it is going to be harder for us if we are viewed as part of the old economy." The dangers of having an old-economy market multiple have become distressingly evident in recent weeks: Two of Delphi's competitors became targets of corporate raiders. Federal-Mogul, a maker of brake, chassis, and heavy industrial parts, is under siege by veteran financier Carl Icahn, who announced that he had bought a 5.2% stake. And Simpson Industries, a small powertrain supplier, just won a proxy fight against John Dyson of Millbrook Capital Management, which still owns 4.7% of the stock.

While the whole auto-parts industry is depressed, Delphi carries additional baggage because of its corporate heritage. Its history goes back more than 80 years. It was originally assembled from some 200 plants of GM's old Automotive Components Group (ACG). Though it was the spawning ground of such auto-industry hall of famers as Alfred P. Sloan and Charles "Boss" Kettering (the inventor of the electric self-starter), the components group had been in decline since the 1960s. As a captive supplier, ACG sold its parts to GM divisions like Buick and Chevrolet on a cost-plus basis. Since it had no incentive to be competitive with outside suppliers, its costs rose as its productivity sank.

In 1992 a boardroom coup at GM elevated a new group of managers to the top of the nearly bankrupt company. They decided that the money-losing parts group was ready for a major overhaul and gave Battenberg, now 57, the job. The son of an Air Force pilot who was killed in a flying accident during the 1961 Berlin crisis, Battenberg turned down an appointment to the Air Force Academy so that he could attend the old General Motors Institute in Flint. Poised, focused, and ambitious, he moved up quickly through GM's engineering ranks; eventually he became a top executive with GM's luxury car group, shepherding the development of such vehicles as the Cadillac Seville and Oldsmobile Aurora.

Leaving the car business for the messy, unglamorous world of parts manufacturing didn't seem like a great career move for Battenberg. But being a loyal company man, he plunged in anyway, with a decisiveness rarely seen around GM. Between 1993 and 1998 he sold, closed, or consolidated 61 noncompetitive plants and reduced the number of product lines from 249 to 184 by selling commodity businesses like coil springs and lighting. In all, he sloughed off $6 billion of business to bring the company down to profitable size.

At the same time, Battenberg set about creating a new public image for the company. He renamed it Delphi, after the Greek oracle, and persuaded GM to erect a new headquarters in the bustling northern Detroit suburb of Troy. With his styled hair, gold collar pins, and media-savvy instincts, Battenberg had always stood out among GM's gray suits. Now he used his visibility to talk up Delphi at international auto shows, at press gatherings, and on Wall Street. After overhauling Delphi for six years, Battenberg led the company in a two-stage split-off from GM that concluded last May 28.

An apple doesn't fall far from the tree, however, and Delphi still looks a lot like its corporate parent. Nearly 90% of its top 600 managers are ex-GMers who, whatever their individual merits, tend to reflect the bureaucratic habits of their former employer. Battenberg is energetically recruiting outsiders by touting Delphi's fresh start and global scope. But while car-loving mechanical engineers are easy to attract, Delphi's cheap stock and Michigan base hurt when it chases electronics specialists and MBAs, who have plentiful opportunities elsewhere. "Everybody has to work harder to find people who want to move to places like Detroit," says Tom Colella, a managing director of Korn/Ferry International. "These are not sexy businesses."

To break entrenched habits and implant new ideas at Delphi, Battenberg has begun an extensive training program, with courses like "A Passion for Excellence," taught by Delphi executives including himself. Some employees are still struggling. Recently a group of 30 white-collar workers tried to perform a simple exercise in teamwork and communication. The employees were instructed to form three teams to build raw-egg carriers using soda straws and then figure out how to market them. Instead the workers merged into one group, forgot about the marketing plan, and built some highly defective products. Their failure was evident when they tested the carriers by dropping them onto a carpeted floor; raw egg oozed all over.

Battenberg had considerably more success assembling a strong board of directors. His first pick was Thomas Wyman, who knew the auto business from the inside after serving for 14 years on GM's board. "I had some clear ideas about how a board should be run," says Wyman, "and we talked to potential directors about how we would do things differently." (Though he's too discreet to say, Wyman is presumably referring to the GM board.) Directors were told they would not have to sit through so many rehearsed presentations and would be given more time to discuss strategic issues. They were also granted unfettered access to senior Delphi managers.

The pitch worked; one headhunter says the Delphi board is among the country's best. Two of the biggest names are General Electric alumni: retiring GE vice chairman John Opie, who chose Delphi for his first outside directorship, and Detroit industrialist and racecar owner Roger Penske, who also sits on the GE board. Penske is famously overscheduled, but he says, "I felt I could help them. It's a local company, I'm interested in its business, and I'm familiar with its products." To give the board a global perspective, Battenberg recruited directors from South America, Germany, and Japan.

Leaving the old economy is hard enough, Battenberg has found, but embracing the new one can be like hugging a porcupine. Delphi is a leader in the use of online auctions to buy commodities like steel and estimates it has saved $90 million in purchasing costs over the past two years. It has also pushed the Big Three automakers to work with suppliers to develop a common network--known as a trade exchange--that would reduce transaction costs. But Delphi and other suppliers have thus far been left out of the planning process for the exchange. So Battenberg decided he needed to hedge his bets. "We're not waiting for them," he says. "We're trying to get as efficient as possible on the other side of the equation." Along with five other large parts makers, Delphi is setting up a separate Web network to communicate with its own suppliers, a venture that could eventually wind up competing with the Big Three's exchange.

Delphi still depends on GM for more than 70% of its business. But that number is shrinking as GM loses market share and shifts business to other suppliers. Delphi is also pitching its size, worldwide reach, and engineering savvy to overseas customers like BMW and Daewoo, as well as to nonautomotive buyers like Boeing and Ericsson. Its major competitors range from Ford Motor's Visteon (which also is about to be spun off) to Bosch and Siemens in Germany and Japan's Nippondenso. To get a lead on them, Delphi is investing heavily in new ideas. It spends 6% of sales on engineering and research and development, vs. an industry average of 5%.

Over the next few years it hopes to double its research output, cut its product development time in half, and reduce costs 40% to 50%. One way to accomplish this is by electronically linking company design centers in Asia, Europe, and North America. Delphi can run its R&D around the clock as technicians on different continents hand off work while the sun moves across the sky. Engineers in countries like Mexico and India cost one-tenth as much as their U.S. counterparts.

Battenberg is upgrading his product mix by moving away from commodity parts, such as climate-control modules and steering sensors, and instead emphasizing electronic devices that command twice as much profit. To get a first-mover advantage, Delphi's labs are cranking out a variety of clever new devices: shock absorbers that use magnetic waves to quickly adjust to bumps in the road; a remote switch that disconnects the battery from the starter to deter car thieves; air conditioning that drivers can activate from afar (without turning on the engine), thus cooling off a hot car before anyone climbs in. New ideas don't stay exclusive for more than a year or two in the auto business, but they can boost margins for as long as they do.

To ensure that investors don't overlook Delphi's high-tech prowess, Battenberg recently said he would begin breaking out financial results for the company's multimedia business; it packages electronic accessories for autos, including Palm handheld devices and backseat video players. Battenberg expects multimedia sales to grow fourfold this year, to $200 million, and he wants to signal to investors that he is focusing extra management attention on an expanding business. Analysts oppose spinning it off or creating a separate tracking stock.

Nothing anchors a company to the old economy more than factories. Delphi has 175 in 39 countries, including a few that were still losing money last year. Battenberg enlisted manufacturing specialist James Womack, co-author of the best-selling MIT study The Machine That Changed the World, to teach Delphi's managers how to eliminate waste by analyzing every step in production and distribution. It is tedious, detailed work, but it can pay off. A six-person Delphi team spent three months following the trail of 41 parts used in assembling heating and air-conditioning units for pickup trucks. The group discovered that the parts were handled 288 times, spent 290 days in inventory, and traveled a total of 80,000 miles before they were finally installed in a GM truck. By redesigning the work flow, they hope to streamline that process by 30%.

As Delphi tries to improve productivity, it is tiptoeing around the elephant in the room: its 38,000 lavishly compensated UAW employees. As a legacy of their days on the GM payroll, they get $45 per hour in wages and benefits, vs. $23 an hour for UAW members at competitors' parts plants. Because the UAW jobs are all but guaranteed for life, Delphi can only eliminate them through retirement, attrition, and divestiture, at the rate of about 3,000 per year. Fortunately for the company, much of its most labor-intensive work, like assembling wiring harnesses, is done in Mexico, where 70,000 Delphi workers earn about $2.40 an hour.

Offshore manufacturing, process improvements, and technological developments--such basic blocking and tackling is probably the best way for Delphi and similarly situated companies to boost their returns. Add all the steps together, and they begin to make a difference. In the quarter that ended March 31, Delphi managed to increase its profit margin to 4.1%--well below its target of 5% by 2002 but an improvement over 1999's 3.8% (and 3.1% in 1998).

But analysts have begun to worry that rising interest rates, higher gas prices, and a volatile stock market could conspire to deflate the auto sales boom--and the parts companies' earnings along with it. When Lehman Brothers ranked 104 industries by their estimated P/E multiples for 2000, auto parts came in 97th, behind laggards like tobacco and managed care.

So Battenberg feels pressure to perform. "There is a lot of tension in the system right now," he says. "A number of companies with very low P/Es are out of favor, and there is a real shakeout going on." If he can't get the pop he needs by improving operations, he may have to return to his playbook from the mid-1990s and slough off additional slow-growth businesses or concentrate on more high-potential opportunities like multimedia. The alternative is to sit back and hope that such homely virtues as consistent profits and predictable growth are eventually rewarded by the stock market. In today's volatile environment, he could wait a long time.