BMW gets plugged in

February 28, 2013, 2:05 PM UTC

Among the new models that BMW will introduce in 2013, two stand out. The first, a sports coupe named the 4 Series, is instantly recognizable as a BMW. A bit lower and wider than the 3 Series coupe it replaces, it will be built at BMW’s Spartanburg, S.C., manufacturing complex and sell for prices starting at about $45,000.

The second vehicle, an all-electric city car called the i3, is unlike anything BMW — or anyone else, for that matter — has ever made. Its weight-saving carbon-fiber body is wrapped in layers of electronic services and smartphone apps designed to make life simpler and save time for the owner. Searching for a parking space? The i3 will help you find one at your destination — as well as arrange to rent out your space at home while you are gone. Need a charge for the lithium-ion batteries? Another feature locates the nearest charging station and arranges for an emergency boost if you can’t find it. Should you be planning a trip out of town, BMW will help you swap your electric car for a gasoline-powered one with a longer range.

Engineering cars that make driving pleasure a top priority has made BMW the bestselling luxury brand in the world. Its cars are renowned for innovative design, high-performing engines, and exceptional handling. The i3 has none of those things. It is designed for utility and fuel economy, and when it goes on sale this fall, it will be expensive — about $40,000 — and probably appeal to a small number of people. So why is the Munich automaker risking its reputation by venturing into unproven new technologies where sales will be tiny and profits a challenge?

The answer goes to the heart of BMW’s long-running success. It wants to be seen as a manufacturer of cars that serve a real purpose. In pursuit of that goal, it has made this detour. While BMW believes that the luxury-car market will remain robust, it also thinks buyers are becoming more interested in two qualities that it has largely ignored: sustainability and interconnectedness. In its new mission statement it aspires to become the “world’s leading provider of premium products and premium services for individual mobility.” In other words, BMW wants to make cars that are plugged-in and eco-conscious.

What the initiative means for BMW is uncertain. Six months after the i3’s introduction, it will launch the second car in its i Series, a $125,000 grand touring car with a plug-in hybrid drivetrain. Other electric models are expected to follow. In all, they will require an investment of several billion euros, with little prospect of a quick payoff — a tremendous risk for a company that, in its entirety, is smaller than GM’s Chevrolet division. Rumors have appeared in the automotive press that BMW has canceled or postponed some models because of weak electric-vehicle sales, or is adding gasoline-assisted versions as a hedge against buyer resistance. But BMW’s top executives appear committed. “There is no doubt in my mind,” chairman and chief executive Norbert Reithofer told Fortune, “that sustainable thinking and action is an essential condition for long-term growth, higher profitability, and the development of new customer segments and pioneering technologies.”

BMW embarks on its new direction from a rock-solid financial base. BMW Group’s brands — BMW, Mini, and Rolls-Royce — all set sales records in 2012. Sales of BMW cars alone rose 12%, to 1.54 million, besting Mercedes-Benz and Audi for the title of the world’s most popular premium brand. In the U.S., 281,460 BMWs were sold, leaving Cadillac, Buick, and Acura in the dust. BMW’s market capitalization has surged to 45 billion euros, twice the value of Mercedes. The stock is up 30% in the past six months and hit an all-time high in January.

At BMW the car has always been the star. The company’s heart and soul is the Forschungs- und Innovationszentrum, the research and innovation center known as the FIZ. A short drive from corporate headquarters in Munich, the FIZ is home to some 8,900 engineers and others who bring together the three essential functions of the car business — product development, procurement, and marketing.

In 2007, though, BMW was faced with problems that could not be solved at the FIZ and that threatened BMW’s survival as an independent company. Rising commodity prices and the expensive euro were driving up the costs of manufacturing at the same time that automakers were investing large sums to meet EU regulations for CO2 emissions. Traffic congestion in cities and an aging customer base were depressing demand for high-performance cars. Chairman and chief executive Helmut Panke had sold off the money-losing Rover Group and led BMW’s expansion in North America and China, but the supervisory board declined to extend his contract when he reached the mandatory retirement age. In his place it installed a dark-horse candidate, a manufacturing specialist named Norbert Reithofer. Reithofer, then 50, had spent most of his career in production, making his reputation by halving the time required to ramp up production of a new 3 Series car.

Reithofer set out to understand the threats to the company and the factors that were braking its profitability. He identified some 200 economic, technological, and social trends likely to shape BMW’s future. “It became obvious that our competitive position was at stake,” Reithofer explained at the time. “We realized that we couldn’t carry on as we had before.”

The project was controversial. “Many people didn’t understand back then why the company needed to make changes after being successful for so many years,” he told Fortune recently. “But things are different now. The results have shown that we are on the right track.”

With his study in hand, Reithofer set in motion what he called Strategy No. 1: BMW would become the leading provider of premium products and services for individual mobility by 2020. BMW watchers understood that it was a radical plan. Reithofer’s focus on “premium” was a clear refutation of BMW’s foray into mid-price cars with the Rover acquisition. And his declaration that BMW would provide “premium services” as well as “premium products” signaled that BMW would be venturing beyond the FIZ. Reithofer also set ambitious financial targets. By 2012 he wanted BMW to sell 1.8 million vehicles, earn operating margins of 8% to 10%, and achieve a return on capital of 26%.

The next step was figuring out how to meet the targets. In the spring of 2008 he assembled some of the company’s most innovative thinkers at a secret location in Munich and gave them instructions to redefine personal transportation for the 21st century. A team traveled around the world, visiting big cities, interviewing urban planners and architects, and talking to residents. After nine months the thinkers came up with a new direction. BMW would follow two different paths: one evolutionary, with efficient combustion engines and the technologies that surround them — its traditional car business, in other words — and the other revolutionary, with electric powertrains, recyclable materials, and software-driven mobility services.

Strategy No. 1 gave birth to “Project i” — for intelligent, innovative, and international. In 2009, Project i unveiled its first experimental vehicle, the Mini E. It wasn’t elegant — the back seat of a conventional Mini had been removed to make room for batteries — but the car taught BMW about owner usage and battery life. One Mini E set a record at the time by traveling 147.3 miles on a single charge. Next came the ActiveE, which began U.S. field tests with 700 cars in January 2012. Based on the BMW 1 Series, it was more sophisticated than the Mini E, with seating for four and a thermal management system for improved battery performance.

For the third phase of Project i, BMW unveiled the i3 at the Frankfurt Auto Show in 2011. Developing it sent BMW into uncharted territory. For the carbon-fiber body, it formed a joint venture with an American company, SGL Automotive Carbon Fibers, and built a $100 million manufacturing plant in Moses Lake, Wash., to take advantage of hydropower from the nearby Grand Coulee Dam — sustainable power for a sustainable car. Raw material for the carbon fiber is shipped from Japan to Moses Lake, then sent to component makers in Wackersdorf and Landshut, Germany, and then on to Leipzig for final assembly.

BMW figures the lifetime global-warming impact of the electric i3 is a third less than that of a similar-size diesel hatchback because of the use of carbon fiber for the body, recycled aluminum in the chassis, and interior panels and seats made out of hemp fibers, recycled water bottles, and the like. The Leipzig plant, which was expanded two years ago to accommodate the i3, runs on 100% renewable energy. Although the i3’s electric powertrain weighs about 440 pounds more than a similar combustion setup, the car is 550 pounds lighter, thanks to its aluminum chassis and carbon-fiber body. The car needs eight seconds to get to 62 mph — tortoise time for a BMW — but that didn’t stop Ludwig Willisch, president of BMW North America, from exclaiming after a drive, “It looks great, and it goes like hell. It is a true BMW.”

But the real innovation can be found in the passenger compartment. BMW calls i3 the world’s first fully networked electric vehicle. The driver will be able to summon a mobile charging truck if his battery runs out. He will have smartphone apps to find charging spots, and the ability to swap into a gas-powered car. Operation of the navigation system, as well as the transfer of information among the vehicle, the outside world, and the driver’s smartphone, has been tailored for city driving.

If the i3 is all about practicality and convenience, the i8 grand tourer sits at the opposite end of the mobility spectrum, where glamour and performance rule. Early i8 concepts featured two large pivot doors for access to both the front and rear seats, and laser headlights that are 10 times brighter than standard ones yet somehow don’t blind oncoming drivers. The combined gas and electric motors of its hybrid drivetrain are said to whisk the 3,250-pound car to 62 mph in 4.6 seconds on the way to a top speed of 155 mph. For those with a lighter foot, fuel economy is figured at 104 miles per gallon. Deliveries begin in the first half of 2014.

BMW’s search for services and features to wrap around its i cars has taken it thousands of miles from Munich. For years automakers have used satellite design studios in Southern California to get a window on new trends. BMW has one, of course, but it also uses a technology office in Mountain View, Calif., where 40 professionals seek out, evaluate, and develop high-tech ideas. BMW has a beachhead on the East Coast too; it created its own New York venture capital operation in New York City and funded it with $100 million to invest in mobility services. Among its holdings is London-based Parkatmyhouse, which connects home and business owners who want to rent their parking spaces with drivers looking for a spot. Another is a California company called ChargePoint, the largest network of independently owned charging stations, operating in 14 countries.

There’s more. If you own a BMW in San Francisco, the company offers a service called ParkNow that lets drivers find and book a parking spot in advance at off-street locations, as well as get information on related services, such as finding a car wash and renting a bike. Want to drive a BMW but don’t own one? BMW has established DriveNow, a car-sharing service, in Munich, Berlin, Düsseldorf, and San Francisco. Find a car on its website and pay per use; you’ll be billed by the minute.

All this focus on the future does not mean that BMW is ignoring the present. The company easily met its financial targets for 2012, and propelled by strong sales in China and the U.S., the company expects to hit its target of 2 million in car sales in 2016, four years earlier than planned. Growth is coming from expanded offerings of small and compact cars like the 1 Series, and from BMW’s ability to exploit product niches in existing segments. At the Paris Auto Show last fall it presented a short, chubby hatchback with a hybrid powertrain that it called the Active Tourer. About the same length as the 1 Series, the Active Tourer will share a front-wheel-drive platform with the Mini, making it the first BMW to come to market without the rear-wheel drive that enthusiasts prefer.

Considering the inability of Nissan and others to profit from electric vehicles, BMW’s ability to sell them at premium prices is hardly a given. Fortunately, Reithofer can afford to be patient. Since 47% of its stock is owned by Munich’s Quandt family, BMW essentially operates like a private company. When asked how soon BMW could expect a payoff from its i investments, Reithofer said the project had already been paid for, and “if everything goes according to plan, we will earn a reasonable margin per vehicle and make money on every car.” Just to make sure there was no misunderstanding, he added, “We don’t build vehicles that are not profitable.”

A BMW supplier was overheard one day complaining that the company’s standards make it a very difficult customer. “Every time we get to perfect, they change perfect,” he said. The same might be said of BMW’s long-term strategy. Besides continually refining the ultimate driving machine, BMW has taken on the additional challenge of creating the ultimate sustainable and plugged-in urban vehicle for the 21st century. It is big challenge for a small company, but then that is what makes BMW BMW.

This story is from the March 18, 2013 issue of Fortune.