(FORTUNE Magazine) – The night before the Frankfurt auto show last month, Volkswagen CEO Bernd Pischetsrieder seemed anxious. Two weeks earlier, VW had unveiled its latest redesign of the Golf, the company's biggest-selling car, and the next day it would be on display for hordes of international auto writers. Good Golf reviews are essential to VW's future financial health. Asked how he was doing, Pischetsrieder replied, "I'd prefer to answer that question after the show is over."

How well the new Golf sells remains to be seen, but Pischetsrieder has good reason to be nervous. The world's fifth-largest car company is losing market share to Japanese and other European manufacturers, its profits are deteriorating, and it's suffering from a multiplicity of brands and models, including several at the high-end of the car chain, where the "people's automaker" has never gone before. And the new CEO has to fix all that with his predecessor looking over his shoulder.

On the job just 18 months, Pischetsrieder succeeded a legend, Ferdinand Piech, the Porsche scion who pulled VW out of a tailspin in the early 1990s. At VW's annual meeting in April 2002, Piech was honored with a standing ovation on his departure, but he made it clear that Pischetsrieder was his handpicked successor. Piech met Pischetsrieder when the latter ran BMW and the two fought over which company would get Rolls-Royce and its Bentley brand. VW took Bentley, BMW took Rolls, and Piech was taken with Pischetsrieder. "He was able to favorably guide negotiations and get that piece of the cake he wanted," Piech said before turning over the reins. "At the the end, I got both things I wanted. I got Bentley--and I got Pischetsrieder."

But while Piech reinvigorated VW with the new Beetle, quality improvements for its Seat and Skoda brands, and a system of platform engineering that helped it make more cars with fewer parts, he didn't meet his financial goal of a 6.5% return on sales. And he left Pischetsrieder with the legacy of his $1 billion rush toward luxury. Not only did Piech buy Bentley, he bought Bugatti and Lamborghini, and he built a $200 million glass-walled factory in Dresden that last year began making the $75,000 Phaeton, a luxury car that's supposed to put VW in the same league as BMW and Mercedes.

All that spending now is viewed as the self-indulgence of a man with gasoline in his veins. It diverted engineering talent from bread-and-butter models such as the Golf and Passat and from hot new product niches such as SUVs and multipurpose vehicles that VW is getting into only now. While Golf sales are declining, that model alone accounts for 15% of the five million cars and trucks that VW makes. Yet it wasn't until this fall that the company came out with a new version, seven years after the last one went into production. (The new Golf is longer, wider, and taller, but it doesn't look much different from the old one.) VW won't update the existing Passat, its second-biggest seller, until 2005.

To get VW back on track, Pischetsrieder must undo some of the legacy of the man who put him in the job--and who is still chairman. That's a tall order, because even though Piech voices his support publicly, he clearly expects Pischetsrieder to carry on where he left off.

So far Pischetsrieder is saying the right things. His first priority, he says over dinner in Frankfurt, is cost. He wants VW to achieve returns on investment greater than the cost of raising capital, something it failed to do last year. "We have so many fantastic plans, but we can't pursue them all if we continue to spend so much money," says Pischetsrieder. "I don't know if this is a vision, but I want the company to earn more money." Indeed, last year's results were a damper on the record results Piech achieved in 2001. Sales fell 1.8% to $82 billion, and operating profit fell 12% to $4.5 billion. Results this year will be worse, VW warns. "They've got a cost problem," says Stephen Reitman, an auto analyst at Merrill Lynch in London, who says he doesn't expect VW to meet its cost of capital until 2006.

VW also has a market-share problem. Last year it lost ground in its four biggest markets: Germany, China, the U.S., and Brazil. The American market has been particularly tricky. The new Beetle made a big splash when it arrived five years ago, but sales are tapering off. And the car market has been flooded with cheap financing. VW has refused to match the sales incentives of the American automakers. The resulting drop in volume has meant that VW's operating profit in North America fell to $65 million, from $769 million, in the first half of 2003. "I don't think it's the right thing to buy the market," Pischetsrieder says. "We'd rather keep our margins."

In Europe, where competition is brutal, VW has seen a drop in both market share and unit sales. It is being hammered by Japanese, French, and even American automakers. GM Opel's new Astra, for instance, has been favorably reviewed against the new Golf. In China, VW faces a different problem: Sales were up 43% last year, but market share was down. In order to regain its position, Pischetsrieder says, the company will have to invest $6 billion over the next four to five years.

The key to reviving VW, of course, is to make more cars that more buyers want to buy. To do that, Pischetsrieder has put some discipline into product planning, creating a central product-strategy committee that decides which brands attack which niches rather than allow VW, Skoda, Seat, and Audi to compete with one another. "I want every brand in its own segment and niche, and everywhere excellent design," he says. Executing a Piech idea never put into practice, Pischetsrieder has created two brand families within the company, the traditional VW family and the sporty Audi group.

He has also put new emphasis on design and marketing and pushed responsibility for creating a global image down to the individual brands. That, as well as making each brand responsible for its own sales, resulted in the high-profile departure last spring of Robert Buchelhoffer, a former BMW board member who was Piech's top marketing man and who, some say, didn't get along with Pischetsrieder. "It wasn't necessary to have one board member coordinate sales and marketing," says Pischetsrieder, who denies any personal friction. "It made it more difficult to give more responsibility to the brands."

Most car mavens believe Pischetsrieder, 55, is up to the job. An engineer by training, he calls himself a "petrol head" like Piech. Unlike his predecessor, he is more affable and approachable. And he cares about the financial markets. Analysts say VW has become more communicative, holding regular conference calls, and its financial statements are less opaque. Because VW is 18% owned by the state of Lower Saxony, which is more concerned with jobs than profits, Piech never took shareholder interests to heart. He just wanted to build great cars.

The one black mark on Pischetsrieder's resume--his ouster from BMW in 1999 for the failure of its 1994 Rover acquisition--doesn't seem to have hurt his reputation. Pischetsrieder spent 26 years at BMW, the last six as CEO, and his record there was otherwise impressive. BMW's initial strategy to diversify into mass-market cars looked better on paper than in reality, says John Lawson, auto analyst at Citigroup in London. After the purchase, the rise of the pound against the deutsche mark hurt Rover sales by making them more expensive relative to German luxury cars. "You could simply blame Pischetsrieder, but it would be a gross oversimplification," says Lawson. "BMW bought something they didn't understand." Of the Rover debacle, Pischetsrieder says, "I still think strategically it was the right choice."

One of BMW's problems with Rover was that the two brands didn't share a common culture or even similar parts. That's not true at VW. In fact, sharing common parts and technologies is a key element of both Piech's and Pischetsrieder's strategy to keep costs down. Parts of the Phaeton air-conditioning system are shared with the new Bentley Continental GT and the Audi A8. Pischetsrieder is also driving a common culture by moving managers around to run different brands. The former head of Audi now runs Bentley as well as global R&D, while the former head of Skoda sales and marketing is now in charge of VW brand marketing and distribution. Every top manager is being paid according to how well the entire group meets return-on-investment objectives.

Pischetsrieder says his strategy in branding and marketing, as well as production, is a "refinement and execution" of many of the ideas that Piech had. "I wouldn't have joined the company if I didn't agree with his strategy," he says. Indeed Piech first revealed the idea of forming two brand groups in a FORTUNE interview in 1999, when he sketched an X with Seat leading up to Audi, Bentley, and Lamborghini from the lower left to upper right and Skoda leading up to Volkswagen and Bugatti from the lower right to the upper left. Under Pischetsrieder, the Audi, or sporty, group consists of Seat, Audi, and Lamborghini, while the traditional VW family consists of Skoda, VW, Bentley, and Bugatti.

So far, there is little to show for the work of Pischetsrieder's product-strategy committee, which has been operating for about a year, mainly because it takes several years to develop new products in the car industry. "They're still dealing with a lot of decisions which were set in concrete some time back," says Reitman of Merrill Lynch. But executives say the committee has determined that certain brands will stay out of certain niches. Pischetsrieder is making all the final decisions. "If Audi wants to do a sports car in a specific price range," says Franz-Josef Paefgen, the Bentley CEO, "they take it to the committee, and Pischetsrieder may say 'No' because Bentley is doing it." In the past, if Audi could show that the new model would make money, Piech would have given it the green light.

Soon after he took over, Pischetsrieder said that Piech's approach created too many "hatchbacks, notchbacks, and long-backs," and too few SUVs, minivans, roadsters, and other profitable lifestyle niches that VW missed. "Rather than everyone chasing the hatchback market, some brands will chase certain segments," says Adrian Hallmark, director of sales and marketing at Bentley. For instance, Audi plans to use the platform of the new VW Touareg SUV, which has a six-month waiting list, to build an SUV of its own called Pikes Peak beginning in 2006. But Skoda and Seat will not be selling SUVs, at least not in that size, says Pischetsrieder. Meanwhile, to attack the roadster segment, VW and Audi each showed two-seaters at the Frankfurt auto show. Both may be built. "For Audi, Seat, and VW it would be fine to be in that segment," says Pischetsrieder--"just not in the same price, size, and performance category."

That all makes sense. What doesn't is VW's drive toward luxury, a strategy Piech believed would enable VW to get more pricing power. Bugatti has launched a $1 million, handbuilt Veyron sports car with a 1001 horsepower engine that can accelerate from zero to 62.1 miles per hour in just three seconds. Critics say the Veyron won't generate enough sales to make all that muscle worth the cost of developing it. But VW insists it will break even. "This is a product for car fanatics," says Pischetsrieder. "The next model will have to make money." Pischetsrieder says VW plans to build between 200 and 300 Veyrons, although he's not yet happy with the way the car handles.

Meanwhile, the Phaeton, the VW-branded car that's supposed to compete with Mercedes, looks suspiciously like an upgraded Passat. It hasn't sold as well as expected. This year, VW will make just 7,841 Phaetons, although the factory has capacity to make 20,000. VW had hoped the Phaeton would be profitable next year; now it says the Dresden factory won't break even until late 2004 or 2005. "You can't get people to pay a very high price for a VW, however good the car," says Merrill Lynch's Reitman. Pischetsrieder calls the Dresden Phaeton plant "a beautiful factory that's not utilized enough. The car is excellent. But we need to convince customers that VW can do this."

Piech's most promising purchase is Bentley. The first new Bentley under VW, the $150,000 Continental GT, is sold out until April 2005. "I am very confident that Bentley will make money," says Pischetsrieder--at least in 2005. Yet VW knows that making Bentley a mass luxury brand, selling up to 9,000 a year, won't be easy.

As he tries to develop a more coherent brand strategy, Pischetsrieder is also tinkering with Piech's platform strategy, which had several cars built on one platform. Now VW is breaking that down further into "modules," smaller parts such as air conditioning systems or engines, so it can make more cars with fewer parts. The trick, of course, is to keep the cost of parts down while maintaining product differentiation. To do that, Pischetsrieder is putting more emphasis on design.

There are signs this is working. Analysts who talk to car buyers say they perceive Seats, Skodas, VWs, and Audis differently, even if many of the cars share the same engines, suspensions, or floorplans. JD Power, which measures what car buyers think about cars, says buyers perceive Seat as a sassy young brand, Audi as high-tech and stylish, VW as dependable and straightforward, and Skoda as delivering good value for money. "I hear all this talk that all these cars from VW are similar, but I don't think customers perceive that," says David Sargent, a partner at JD Power. "We know that what is under the skin of a Seat Leon is somewhat similar to what is under the skin of a Skoda Octavia or a VW Golf or an Audi A3. But customers don't see these things."

If that continues to be the case, Pischetsrieder has a good chance of fulfilling Piech's ultimate dream. "It's my personal conviction that I have to complete his vision," he says. Piech wanted to make VW into one of the globe's top three auto companies, with different brands offering different products to every potential customer. "If someone asks me what is the best car company today, I say 'Toyota,' " Pischetsrieder says, "because no one does their job better. In two or three years, if people say we are among the best three car companies--not just in terms of figures, but also in terms of strategy--we will be proud of that."