(FORTUNE Magazine) – Spend $25,000 on a car that doesn't run the way you expect it to, and you get pretty angry. Spend $50,000 or $100,000, and you get really angry. Just listen to the anguished howls of Mercedes-Benz owners on websites like troublebenz.com, lemonmb.com, and mercedesproblems.com, as they vent about the latest mishap to afflict their Benzes. Depending on the model, the complaints range from faulty key fobs and leaky sunroofs to balky electronics that leave drivers and their passengers stranded. Regardless of the severity, a single sentiment runs through the gripes: This shouldn't be happening to a Mercedes.

No auto manufacturer wants to hear customers whine, but the sensitivity is magnified at Mercedes, which commands a steep premium for its products because of the belief that they are engineered to higher standards, are assembled more carefully, and feature more advanced technology than more pedestrian brands. So it's not good news when customer surveys by J.D. Power & Associates rank Mercedes quality as much worse than average--in 26th place, behind Oldsmobile, in one survey. Other industry researchers see slipping consumer sentiment and declining resale values. The bad vibes have resonated all the way to Stuttgart, Germany, where Mercedes has made its home for more than 100 years. Longtime boss Jurgen Hubbert is devoting a good deal of energy these days to unraveling the problems that have led to the customer complaints. "Quality is part of our heritage, one of our core values," Hubbert says. "That's why we are working like hell to solve the problems we've seen."

Life would be relatively simple if quality were the only issue on Hubbert's plate. But as he gets ready to retire in 2005, after nearly 40 years with the company, he faces lots of other unfinished business. Besides fending off competition from the likes of Lexus in the U.S. and BMW everywhere, Hubbert is preparing Mercedes to launch its first big product offensive of the 21st century. The new models will propel the company into new niche markets--for multipurpose vehicles, specialty four-doors, and others--where it hasn't competed before. What's more, Hubbert is laying the groundwork for the introduction in the U.S. of two dramatically different automobiles: a sport-utility version of its Smart city car and a crossover vehicle based on the compact A-class. Significantly smaller and less expensive than any of the company's traditional models, those models will sharply alter customers' perceptions about the kinds of cars made by the company behind the famous three-pointed star.

If the new cars are successful, they have the potential to expand Mercedes' U.S. sales faster than would be possible with its traditional product line of sedans, coupes, convertibles, station wagons, and SUVs, and to introduce the brand to younger buyers. Should they fail, they could embarrass the company, erode Mercedes' historic price premium, and drive away customers who perceive the star as tarnished. "If there is a false step, they are in difficulty," says Garel Rhys, director of the Center for Automotive Industry Research at the University of Cardiff Business School in Wales. "The market is less and less forgiving. People don't have to wait for Mercedes to sort itself out. They're going to buy a BMW or Lexus."

The crosscurrents buffeting Mercedes are beginning to weaken sales. With fragile economies in Europe and Japan, Mercedes sold 1.1 million cars in 2002, fewer than the year before, and sales fell another 2% during the first eight months of 2003. One bright spot: the U.S., where sales through September were a record 159,447 vehicles, up 3.7%. But for the rest of this year and next, Mercedes sees worldwide sales remaining flat.

DaimlerChrysler, Mercedes' parent company, can't afford to let its most valuable division stall. Mercedes is the profit engine driving the company. Last year it contributed more than half of DaimlerChrysler's adjusted operating profit. This year it is producing 75% of it. That's helped offset bad news from Chrysler and allowed the stock to rise to $35 from a low of $26.27 in March.

Any sign of weakness at Mercedes is like blood in the water. As recently as 1998, Mercedes outsold archrival BMW in the U.S., 170,245 to 131,559. But BMW passed Mercedes in 2001, and this year J.D. Power forecasts that it will sell 234,072 vehicles, compared with 209,612 for Mercedes. (Buyers still pay more for a Mercedes, though--about $5,500 a car on average, and up to $125,620 for a CL600 sedan.)

Meanwhile, Toyota's Lexus has capitalized on the boom in luxury sport-utility vehicles to carve out its own parking space at the upper end of the U.S. market; like BMW, it appears to be gaining momentum. In a study of buyer intentions by AutoPacific, an automotive market research firm in California, the number of car shoppers who would like to buy a Lexus or a BMW is growing twice as fast as those who would like to buy a Mercedes. "We see future consideration for Mercedes deteriorating year after year," says AutoPacific president George Peterson. "When we first began looking, Mercedes was neck and neck with BMW and Lexus. Now it has fallen behind and is barely in the top ten brands considered." Peterson blames the decline on distractions from Chrysler, weakness in sport-utility vehicles, and inconsistent advertising, as well as quality problems.

With its reputation at stake, Mercedes is bending over backward to keep its American customers happy. U.S. sales executives have pushed dealers to invest nearly $500 million in expanded service facilities and helped train some 1,000 new service technicians. In July, new E-class cars were offered to nearly 2,000 owners who had paid for a navigation system to be installed in their cars after delivery. Mercedes decided the post-sale installation might cause glitches, so it took the cars back and replaced them with new ones that had factory-installed systems--at no charge.

Urbane and diplomatic, Hubbert is well qualified to lead Mercedes over this rough patch. After taking charge of Mercedes passenger cars in 1989, he led the company's response to the original assault by Lexus on the luxury-car market. He developed less expensive models, banished the practice of giving engineers carte blanche, and insisted they design cars to meet a certain price point. Hubbert also drove the expansion of Mercedes' product line into sportier models and SUVs, and he built a plant in Alabama, the company's first in North America. In the past several years, though, his focus on Mercedes may have blurred as his responsibilities expanded. In early 2001 he became co-chair, with DaimlerChrysler chairman Jurgen Schrempp, of the company's top automotive-management committee. That means he also oversees product decisions at Chrysler as well as at Japan's Mitsubishi and Korea's Hyundai, in which Daimler owns minority interests.

At the Frankfurt auto show, held in September, Mercedes put on a spectacular display to demonstrate that it was still the world's most prestigious automaker. The company commandeered a huge hall with a spiral ramp and an atrium that made New York City's Guggenheim Museum look puny, stuffed it with cars, hung thousands of computerized lights, and screened an expensive promotional video.

As another signal that challenges to Mercedes will not go unanswered, Hubbert introduced the SLR McLaren sports car. Not just another fast, expensive two-seater, the long-nosed SLR is a supercar designed to catapult Mercedes into the automotive stratosphere with the likes of Ferrari and Porsche. Made of carbon fiber, the material used in racing cars, the SLR generates 626 horsepower, accelerates to 60 miles per hour in under four seconds, and will sell for more than $435,000. Only 1,000 will be made a year. To introduce it, Mercedes staged a dash across the Italian Alps, videotaped the trip from a helicopter, then played the highlights, scored with music, 24 hours later.

Mercedes also used the show to take the wraps off another new car--a hardtop sedan with a sumptuous interior--whose existence had gone undetected by competitors, as well as by the automotive press. Described as a four-door coupe and named the CLS, the car is designed to sell for about $60,000, placing it just above the most expensive E-class and below the cheapest S-class. Although the CLS was presented as a concept car not yet approved for production, Hubbert spread the news that it would go on sale next year.

The new CLS, like any other Mercedes, will have a thorough going-over before being shipped to the U.S., which has become the home of Mercedes' most vocally demanding customers. Like other luxury manufacturers, Mercedes sells the same car around the world--in its case, more than 190 countries. While international customers have similar expectations about how their cars should look and feel, they have quite different ones about what constitutes a defect. That, says Hubbert, is the source of a split between the perceptions of American buyers about the quality of Mercedes cars and other customers. "It is hard to understand why we have these problems in the States, and we don't have them in other parts of the world," he says.

Mercedes is still searching for the answers. The most widely publicized U.S. surveys of vehicle quality are conducted by J.D. Power. In its initial quality survey, which measures the defects customers find in new cars after three months of ownership, Mercedes has slipped fairly steadily over the past six years. After attaining fifth place in 1997 among brands sold in the U.S., it tumbled to 14th in 2003, finishing behind such makes as Mercury, Buick, and Chevrolet. Mercedes performs even worse in a J.D. Power study of complaints after three years of ownership, known as the vehicle dependability index. Ranked first in 1990, it has fallen sharply since then and found itself tied for 26th place in the latest study, with more than 300 problems reported per 100 vehicles. The top-ranked nameplate was Lexus, whose owners reported only 163 problems per 100 vehicles.

Hubbert is perplexed about the results. "J.D. Power did the same study in Europe and in Germany, and E-class came out of these surveys as the best of all Europeans," he says. "We are in deep discussions with Power to understand what's going on."

Meanwhile, shifting perceptions about Mercedes quality are affecting the projected resale value of its cars. Automakers, especially luxury ones, watch residual values of their cars closely because they affect the price of the car when new as well as the terms of a lease. Over the past year the projected value of a used Mercedes has slipped significantly, according to Automotive Lease Guide, the industry bible. ALG figures a 2003 Mercedes will retain only 52.6% of its value after three years--a drop of 2.4 percentage points from the 2002 model. A 2003 BMW, on the other hand, is expected to retain 52.9% of its value after 36 months, a decline of just 0.1 point. A Lexus actually gained value over the same period. "Mercedes still has its image, but BMW's cool new products have given it momentum," says Raj Sundaram, president of ALG. "This will be the first time in the past five years that BMW has had an advantage over Mercedes."

Comments posted on the Internet by disgruntled Mercedes owners reveal a variety of complaints--many that dealers are ineffective in fixing. One driver crushed the front end of his 2002 C240 in a collision and discovered that the airbags failed to inflate. The owner of a 2000 S500 returned the car for servicing five times to fix the navigation system, phone, and radio. A college student, frustrated by what he says were more than 60 mechanical problems with his C-class car, parked it in front of his dealer with a sign saying MERCEDES IS UNFAIR TO CONSUMERS.

Mercedes' problems with American buyers get some sympathy from an unlikely source--BMW CEO Helmut Panke. "All European premium brands still have to catch up with the leading Asian manufacturers," Panke says. "At first the Europeans said, 'Our customers are more discerning, so the expectations are higher, and we get lower scores in J.D. Power.' But when you look at it objectively, you can't overcome a lack of perceived and real quality, even if you have an authentic and emotionally appealing product."

Panke pins some of the problems on eager engineers who stuff the latest technology in their high-end cars without thoroughly debugging it first. Hubbert agrees, and he has reorganized the electronics engineering at Mercedes into one department to centralize responsibility for the functioning of entire systems. He has also gone to outside companies like Microsoft to figure out how to integrate the car's various systems (although he jokes that when it comes to reliability, "actually they are worse than we are.").

Judging from the complaints, the Mercedes M-class sport-utility vehicle, introduced as a 1998 model and its first to be made in the U.S., has been a particularly sore spot. "We had teething pains," concedes a Mercedes executive. Practically every part of the car has been subject to malfunctions. Dealers have been unable to address many of the problems, and Hubbert admits that Mercedes' service operations need to keep pace with its sales growth.

The number of M-class defects has been declining since the cars were introduced, and when the next generation arrives in 2005 it will have been completely reengineered. It is moving from a trucklike body-on-frame assembly to a more carlike unibody structure. But such total makeovers are expensive, and they illustrate a recurring Mercedes problem: an inability to design a car right the first time. Another example is the A-class, a short-wheelbase, high-roof car that is the smallest in the lineup. Mercedes was forced to reengineer the suspension at considerable expense following the car's debut in 1997 because it flunked a handling test conducted by a Swedish auto magazine. The radical Smart car is also undergoing an extensive makeover. Originally introduced in 1998 as a tiny two-seater with a rear engine, it will emerge next year as a front-engine car with a much longer wheelbase built on a different platform designed by Mitsubishi.

In a move likely to jolt old-line Mercedes owners, both of the cars are heading to the U.S. A variant of the A-class arrives first, in 2005. Code-named CST for Compact Sports Tourer, it will be a high-roof crossover vehicle. Smart, which gets to the U.S. in 2006, is morphing into a four-wheel-drive, sport-utility model that Smart president Andreas Renschler says will compete with Toyota's popular RAV 4. It will be sold through its own network of 50 to 60 dealers to keep it separate from the Mercedes brand. Expectations for both cars are modest: Mercedes says it will sell only about 25,000 units of each annually.

It all sounds a bit like Tiffany going into the costume-jewelry business and selling the baubles at Wal-Mart. BMW managed the trick by introducing the tiny, lower-priced Mini Cooper, but it was working with a historic brand that had existing ties with consumers. The CST and the Smart sport-utility vehicle will likely cost much less than the $24,900 Sport Coupe, currently the lowest-priced car in Mercedes' U.S. lineup. That will make it difficult to give the new models the imposing heft, jewel-like finishes, or gee-whiz gadgets of mainstream Mercedes. It will also attract more price-conscious customers.

Aside from the risk that the cars will tarnish the rest of the Mercedes lineup, there's a potential financial downside. Smart has never been profitable--Renschler says he expects to turn the corner in 2004--and Hubbert concedes that with the A-class still in its first generation and its capital expenditures still fresh on the balance sheet, it is marginally profitable at best. So why jeopardize a solid business whose operating profit of 6.5% to 7% is among the highest in the auto industry?

Market expansion is the answer. Paul Halata, the energetic Czech who runs Mercedes' U.S. operations, is excited about the opportunities for growth. "This is a very healthy exercise for the company," he says. "Smart gives the company a chance to serve a new segment of the population that is younger, hipper, more fashionable. It fits their lifestyle as a second or third vehicle." Hubbert is also bullish on Smart: "We will present the brand as something quite special. Maybe it will take a little time before it achieves full status." He says he expects the A-class to be a tough sell "because I learned in the last few months there are some traditional American buyers who say a Mercedes has to start with a $40,000 car."

If Mercedes succeeds with either vehicle, it will be a fitting bookend for Hubbert's efforts to make the company more price-sensitive. But Hubbert will not be around to celebrate. His contract expires in April 2005, and he plans to retire then. He doesn't give any hints about who his successor will be, except to say that he will come from inside the company. Hubbert will leave Mercedes bigger and stronger. But in an ever more complicated world, its once unquestioned position at the top of the automotive pecking order is under threat as never before.

FEEDBACK ataylor@fortunemail.com