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Technical problems seem to be increasing for the world's leading automaker Toyota Motors (TM). Even after the nightmare of car problems in 2009, the company is still facing technical problems with "Corolla," "Prius" and other models. TM has decided to call back 2.77 million vehicles worldwide because of these problems. Moreover, the company is also witnessing mounting problems in China because of the territorial dispute in east China. However, we feel that these problems are not significant to make investors stand by a short position. We are optimistic about TM's strategic future and therefore have a buy rating for it.

The first reason behind our buy rating is TM's sound operational performance. A comparison to its performance in Q32011 reveals that the company has been able to increase its revenue by 16%. However, its cost control measures have not been as efficient as those of its competitors and this is one reason why its gross margin is 15% less than the competitor average.

While cost control seems to be an issue, TM has been able to control expenses better than most competitors. TM has been able to reduce expenses by 8% if compared to its performance in Q32011. Its expenses are 22% less than the competitor average which is one reason behind better net profitability of TM. The company's net profitability is 13% higher than most of the competitors and three times more than its own profitability in the same period of the previous year. While TM needs to improve its cost control measures, existing performance surely is an indicator of strong operational strategies.

The second reason behind our buy rating is some potential value in TM's stock. Although TM seems overvalued if compared to competitors, we feel that it somehow deserves such valuation owing to its strong operational performance. TM is trading at a forward P/E of 14 times which is higher than the competitor average of 10x. Similarly, its EV/EBITDA of 8x is also higher than the competitor average of 7x. Based on its historical average P/E of 12x and forward EPS of $8, we set a target price of $98.

A comparison with its key rival General Motors (GM) reveals that TM can generate higher returns than GM. Investors can expect a capital gain of 13% and a total gain of 15% from TM which is higher than a total return of 14% from GM.

A Relative Analysis Based on Multiples (X)

Company

Ticker

Trailing P/E

Forward P/E

PEG

P/S

EV/EBITDA

Ford

(F)

2.60

7.86

1.49

0.32

10.36

General Motors

9.46

6.74

0.66

0.25

1.94

Toyota Motor Corporation

14.26

10.74

0.30

0.50

8.06

Honda Motor Corporation

(HMC)

14.30

9.33

0.38

0.52

9.03

Competitor Average

10.16

8.67

0.71

0.40

7.35

EPS Current TM

$8.02

Historical Average P/E

12.18x

Target Price of TM based on historical average

$97.68

Current Market Price

$86.11

Approximate Capital Gain

13%

Dividend Yield

1.60%

Expected Total Gain

15%

The third reason behind our buy rating is the emergence of a new opportunity for TM. Although TM is now suffering in China, its suffering is not significant as China is not the key market for TM. If compared relatively, TM's market share in the Chinese market has gone down by 45% compared to Honda's 40% and Nissan's (NSANY.OB) 35%. However, this does not seem to matter much to Toyota as its reliance on Chinese markets is 10% - a much less reliance than HMC's 20% and Nissan Motor Co's 27%. We feel that the threat from China should not matter as much to TM as a new opportunity, which has recently emerged in the US.

The opportunity has come as a result of post Sandy rehabilitation needs. As Sandy has rendered many cars useless in the US, a boost in overall auto sales has been reported indicating a change in market trends. While people used to avoid buying new cars before Sandy, they are now heading to showrooms to buy them as their old cars have become useless. Although it is hard to tell which auto company will benefit the most from this new opportunity, we feel that TM can surely be one of the strongest candidates. This mainly is because of the company's strong strategic position in the US.

It has the third biggest market share in US after GM and F. Moreover, TM cars are the most favorite ones in North America with Camry, Corolla and Prius leading the market. Toyota's dominance is also evident from the fact that while industry wide sales were up by 12.8% in October 2012, Toyota reported a rise in sales by 42%. As we anticipate a strong rise in US sales, we feel that TM's strong position in the US will more than offset its loss in China and overall profitability will rise up in the coming quarters.

Our Stance

Although TM is facing a drop in sales in Chinese markets, we feel that its stock is a buy because of strong operational performance, potential value in the stock and a strong post sandy opportunity. We have a buy rating for TM.

Source: Buy Toyota As Opportunities Appear Heavier Than Threats