* Q2 underlying EBIT up 12 percent, above forecast
* Earnings lifted by new models such as the C-Class
* Daimler affirms 2014 outlook (Recasts, includes new CEO comments from analyst call)
By Edward Taylor
FRANKFURT, July 23 (Reuters) - Daimler produced a forecast-beating 12 percent profit increase in the second quarter as its new Mercedes C-Class and E-Class cars helped to lift profit margins.
But the luxury car company said the increasing popularity of smaller, lower margin vehicles meant it would have to extend cost-cutting efforts to improve profitability on these ranges.
The Stuttgart-based maker of cars and trucks has been trying to bounce back after rival Audi eclipsed Mercedes in 2011 as the world's second biggest luxury car maker behind BMW .
The Mercedes-Benz cars division's core earnings jumped 35 percent in the second quarter, but its return on sales has lagged that of rivals BMW and Audi, which have yet to release second-quarter results. In the first quarter, they posted higher return on sales of 9.5 percent and 10.1 percent, respectively.
Mercedes-Benz's return on sales was 7.9 percent in the second quarter, an improvement over last year's 6.6 percent, but still short of a 10 percent goal for the division which includes the Smart brand.
The improved profit margins are down to Mercedes-Benz's ability to raise prices with the introduction of new models such as a revamped E-Class and the new S-Class limousine as well as compact cars, Daimler said.
The company relaunched its A-Class compact late in 2012, unveiled a new S-Class flagship limousine in July 2013 and launched a new C-Class in Europe in March.
But growth in demand for lower margin cars, including the A-class and B-class vehicles which make up around 30 percent of Daimler's passenger car sales, will increase the need to put a squeeze on costs.
"Growth in the compact segment will be higher than the average, therefore the portion of compact cars plus Smart will go to about 40 percent of the total," Chief Executive Dieter Zetsche told investors on Wednesday.
The profitability of small cars will need to be further improved, Zetsche said, while declining to give a breakdown of vehicle profitability by model or to quantify the extent of further cost cutting measures.
Mercedes-Benz cars currently seeks to save 2 billion euros by end-2014 and late last month said it would share costs to develop its next generation compact cars with Nissan's premium brand Infiniti.
Demand for Mercedes-Benz vehicles remains robust even in Russia, where the company posted a 20 percent rise in sales in the first half, Zetsche said.
Daimler said sales are expected to receive a further boost in the second half of 2014, when the next generation Mercedes-Benz C-Class, the company's best selling model which is already on sale in Europe, hits showrooms in China and North America in September.
Between January and June, global deliveries of Mercedes-Benz luxury cars rose 12.8 percent to 783,520, the highest first-half sales ever, putting it on track to post record full-year sales.
"If all markets perform well and the product is good, Daimler can reach the 10 percent (return on sales) even without a new savings programme," Arndt Ellinghorst, a London-based analyst at investment researchers ISI Group said. "Whether the margin would be sustainable is a different matter."
Ellinghorst has a "buy" rating on Daimler shares, which rose 1 percent earlier on Wednesday, but were down 0.8 percent by 1546 GMT.
"It appears the market needs more positive earnings revisions, for the stock to remain exciting. Reporting "in line" numbers and no change to expectations for 2015, which already reflect strong earnings growth, is apparently not enough," Ellinghorst said.
Profitability at Mercedes-Benz Cars, Daimler Buses and Daimler Trucks all rose, the company said, adding that it was still looking for ways to cut costs against a backdrop of emerging market turmoil and flat sales in Germany.
"We are continually looking at ways to improve our structural efficiency," Zetsche told journalists during a conference call. He declined to put a figure on the extent of potential savings.
Currency volatility, mainly related to emerging markets including Brazil, sliced 260 million euros from earnings during the quarter. Daimler affirmed a forecast for a significant rise in 2014 group core earnings from ongoing operations compared with 2013.
The company said group earnings before interest and tax (EBIT) from ongoing business rose to 2.46 billion euros ($3.3 billion) from 2.19 billion in the three months to the end of June, beating a 2.38 billion average forecast in a Reuters poll.
On a reported basis, second-quarter group EBIT slumped 41 percent to 3.1 billion euros as a year-earlier, one-off gain of 3.2 billion euros from the sale of shares in EADS - now Airbus - was not repeated.
$1 = 0.7426 Euros Additional reporting by Jan Schwartz; editing by Jane Baird and Jane Merriman