Monday, May 23, 2005

"Toyota-Sacrificing earnings to sustain market share"

Competition in the US automobile industry continues to be intense as GM and Ford suffer various problems and Toyota Motor Corp (TM) tries to gain pole position. Toyota’s 2004 annual report boasted historical highs in sales (up 9.9%), net revenues (up 11.6%), operating income (up 13.1%), and net income (up 54.8%). However, Toyota seems to be losing momentum as earnings sank 17% by the end of March 2005. One of the reasons for this decline is the boost in sales incentives and rebates offered by Toyota. Incentives range from cash rebates, low financing offers, and leasing deals. According to Edmunds.com, Toyota’s average incentive rose 137% since last year. Analysts are concerned that Toyota has started a cascading effect and predicts that Toyota will have a difficult time putting the breaks on increasing incentives, which will result in the continued erosion of earnings.
The analysts’ rational is as follows – by increasing incentives, the value of used models decrease. Decreased value of used models will mean lower trade-in value for new cars. Thus, to provide incentive for consumers to trade-up to new cars, higher incentives will be needed to compensate for the lower value of the used car.
Our viewpoint is that Toyota’s strategy of now offering increased incentives (Toyota has been playing the incentive game for quite a few years now) to capture market share is driven by compulsion rather than choice. Rising oil prices have reduced demand for gas-guzzling SUV’s and the strengthening of the yen against the dollar has reduced margins of Japanese car manufacturers doing business in the US. Further the dollar weakness has also kept commodity prices high and the cost of raw materials (steel) has adversely impacted margins in the industry.
There are some key factors that are being overlooked by the analysts. Toyota’s move to offer incentives was a strategic move to maintain steady sales of their vehicles in the current economy. With gasoline prices staying above $2.00 a gallon and rising interest rates, cash rebates and low financing options keep the cars affordable. Although, Toyota’s earnings dropped this last quarter, car sales increased by 7%.
Another factor that needs to be weighed into the equation is the fact that Toyota is aggressively moving into the hybrid market. Toyota is convinced that the future is in fuel – efficient cars, due to environmental concerns and with the view that the cost of fuel is likely to keep increasing. In support of this belief, Toyota has invested a significant amount in expanding its hybrid vehicle offerings. The hybrids are priced at a premium, which will offset the incentives offered on the older models. Toyota’s current fuel-efficient models have so far been successful with long waiting lists. A-list celebrities are also in the market for these “it” cars, increasing the appeal of owning a hybrid vehicle. If fuel efficient cars are the wave of the future as Toyota believes, then incentives on the older models will not be as a big of a threat to their profits as analysts predict. Moreover, while this new product mix may be a good hedge against rising oil prices; given the large capital expenditure (Toyota’s capital expenditure is expected to peak in the year 2005) that the development of new technology involves, what happens if oil prices fall?
Further, automakers have raised prices last January, including Toyota. Toyota plans to further increase prices to encourage competitors to continue to raise their prices or cut back on rebates. If Toyota’s strategy works, the cascading effect described by the analysts will not be much of a concern.
Given this background, we believe that the biggest risk for Toyota is the possibility of oil prices falling/stabilizing and the yen continuing to strengthen. This is easily possible - even though oil prices and the USD are negatively correlated (ie. fall is USD value causes oil prices to increase). If China revalues its currency, it will cause the JPY to appreciate against the USD. Oil prices may not rise in the same proportion that the USD appreciates against the JPY. Under this scenario, the hybrid cars may not take off as envisaged and Japanese cars (already at increased prices) will further lose their price competitiveness in the US markets.
While the incentives are having some positive effects on increasing sales - they are eating into earnings - hence if sales do not increase proportionately, and the current trend (March, 2005) continues, Toyota could see its profitability dip further. So Toyota should establish a time frame by which it hopes to see an increase in the rate of growth of Sales, else gradually reduce the currently unprofitable scheme of increased incentives to levels which sustain growth in earnings.
Jenny Hannus, Shilpa Kumar, Ritesh Singhania

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