By Andreas Cremer

BERLIN (Reuters) - Volkswagen <VOWG_p.DE> reported a 12 percent drop in quarterly profit at its main passenger car division on Thursday, a big improvement on the quarter before but showing the challenges it still faces to overcome its emissions scandal.

Europe's largest automaker is struggling to rebuild its reputation and meet billions of dollars of costs after admitting in September to installing illegal software to mask toxic emissions on about 11 million diesel vehicles worldwide.

The German company published headline first-half numbers last week, saying underlying operating profit of 7.5 billion euros ($8.3 billion) beat analysts' expectations largely due to improvements at its mass-market VW brand.

The brand, Volkswagen's largest by revenues, saw profits plunge 86 percent in the first quarter.

However, some analysts said the drop in the division's second-quarter earnings showed there was still much work to do.

"Some of the details are mediocre, especially the VW brand result," said Commerzbank analyst Sascha Gommel of the company's full first-half earnings release.

"The numbers are slightly disappointing, the brand's earnings quality is still not good," he added, noting higher plant utilization at the brand in the second quarter had not translated into improved profits.

Commerzbank has a "hold" rating on Volkswagen shares, which were down 2 percent at 1020 GMT.

LAGGING MARGINS

The company said operating profit at the VW brand fell to 808 million euros in April-June, down from 914 million a year earlier, as expenses related to the emissions scandal and lower sales outweighed cost cutting.

That gave the brand a quarterly profit margin of 2.9 percent, up from 0.3 percent in the first quarter, but down from 3.3 percent in the same period last year and still well short of the levels achieved by rivals such as Toyota <7203.T>, PSA Peugeot Citroen <PEUP.PA> and Renault <RENA.PA>.

In a bid to catch up, Volkswagen is speeding up model development, slashing costs and ceding more power to regional operations to target markets more effectively.

The company said exchange rate moves and higher sales of cheaper cars compared with the same period last year were also factors behind the fall in VW brand earnings.

At 1.5 billion euros, the brand also bore the brunt of 2.2 billion euros of additional provisions made in January-June to cover the costs of the emissions scandal, VW said.

Analysts have said lasting progress in raising the VW brand's profitability will depend on ongoing talks between management and labor over strategy and the future of Germany's high-cost factories.

VW's powerful unions are seeking fixed targets for production and investment in the talks with brand chief Herbert Diess, a former BMW <BMWG.DE> executive hired a year ago to turn around the business.

"Mass-market carmakers are all very profitable at the moment," said Evercore ISI analyst Arndt Ellinghorst who recommends buying VW stock. "The VW brand margin has to improve considerably."

Volkswagen has pledged greater investment in electric cars and on-demand transport services as it reshapes its business.

The group stuck to its 2016 guidance, predicting revenues would fall by as much as 5 percent amid weak demand in South America and Russia as well as volatile exchange rates.

It forecast a group operating margin of 5 to 6 percent, versus 6 percent in 2015, adjusted for special items.

(Editing by Maria Sheahan and Mark Potter)