BERLIN (Reuters) - Volkswagen's (VOWG_p.DE) mass-market VW brand returned to profit in the first quarter, in a sign deep cost cutting is starting to revive the business at the heart of the German carmaker's emissions test cheating scandal.
Europe's biggest motor manufacturer said on Tuesday group underlying operating profit fell 5.9 percent to 3.1 billion euros ($3.5 billion) in the quarter.
That was better than analysts' average forecast of 2.8 billion euros, as demand for upmarket Audi and Porsche models offset a drop in sales at the mass-market VW brand.
But Volkswagen said it was still braced for a tough year as it battles to rebuild following the biggest business crisis in its 79 year history.
Volkswagen plunged to a record loss last year after making provisions at a group level to cover the costs of the diesel emissions scandal and ditched its long-standing CEO after it admitted in September to cheating tests in the United States.
It has set aside 16.2 billion euros to cover vehicle refits and a settlement with U.S. authorities, but still faces potential U.S. Justice Department fines and questions over who was responsible for the cheating, with investigations ongoing.
The company has been slashing costs by using more common parts across its range of models, investing in electric vehicles and working on a new business structure aimed at improving accountability and speeding up model development.
The VW brand, the group's largest by revenues, which was struggling with high costs and weak sales even before the emissions scandal, showed some signs of improvement.
It swung to a 73 million euro profit, having made a loss of 127 million euros in the previous quarter. But that was still well down on a profit of 514 million in the first quarter of 2015, with revenues down 4.6 percent and an operating margin of just 0.3 percent.
This compares with a 9.3 percent margin at Volkswagen's Czech division Skoda and 2.6 percent at Spanish brand Seat, which has long been grappling with losses.
Finance chief Frank Witter warned of a long road to recovery, saying that while the VW brand was committed to boosting its margin to 2 percent this year, it was unrealistic to expect to it hit its long-standing 6 percent target by 2018.
"The situation is on our radar and it is among the highest priorities within the organization," Witter said on a call.
Moving the VW brand into sustainable profit is key for the strategic overhaul underway at VW following years of strong volume growth and spiraling costs.
Volkswagen is counting on steps to streamline vehicle development to adapt the VW brand more quickly to market trends, speed up cost cuts and expand modular platforms to boost common parts and production flexibility.
"This is an ongoing complex task," he said.
Volkswagen shares, which hit an 8-month high heading into the results, were down 1.6 percent at 135.70 euros at 1452 GMT (10.52 a.m. ET).
"We continue to view VW as a huge restructuring opportunity and nothing from Q1 changes that view," said Evercore ISI analyst Arndt Ellinghorst who has a "buy" rating on the shares.
Others are more wary, with DZ Bank analysts saying the prospect of further scandal-related costs led them to retain a "skeptical view" on Volkswagen, which did not make any further provisions in the first quarter.
Its turnaround plan has come under close scrutiny recently from activist investor TCI, which has urged it to speed up and extend restructuring efforts.
Group results at the 12-brand company were supported by broadly flat sales at flagship luxury brand Audi and a big rise in both sales and profits at sports car maker Porsche.
Higher demand in western Europe and the Asia-Pacific also helped to offset declines in South America and eastern Europe.
However, Volkswagen reported a 25 percent plunge in operating profit at its two Chinese joint ventures - which are not included in quarterly results.
Analysts have said heightened competition in China has led the company to step up incentives for buyers ahead of the expiry of tax breaks for smaller cars at the end of this year.
Quarterly sales in China, Volkswagen's biggest market, rose 6.4 percent after falling in 2015.
Including one-off items, group operating profit rose 3.4 percent to 3.4 billion euros. That was helped by 300 million euros of "currency-related adjustments" to provisions.
Volkswagen said net liquidity at its automotive division was 26 billion euros at the end of March, around 1.4 billion higher than at the end of 2015, bolstering its finances ahead of an expected bond issue to replace expensive bank loans.
The company reiterated guidance issued in April for sales to fall this year by up to 5 percent and for a group underlying operating margin of 5-6 percent, versus 6 percent in 2015.
Writing by Mark Potter; Editing by Alexander Smith