Toyota Sacrifices Market Share In Favor Of Margins

Aug. 5.13 | About: Toyota Motor (TM)

Toyota (NYSE:TM) has been battling with its own demons for a while. The Japanese earthquake in 2011 followed by a huge tsunami hurt the company's production capacity, floods in the Southeastern Asia hurt the company's supply chain, Chinese boycott along with strong yen hurt the demand for the company's products and finally, as American car companies started to make a comeback, they stole some market share from it. Lately, the investors of Toyota are celebrating the resilience of the company despite all the hardships it went through over the last few years.

Last week, Toyota announced its quarterly earnings and the results were nothing short of impressive. The company's revenues were up by 14%, net profit was up by 88% and its guidance for the rest of the year was being upped by 8%. While Toyota sold far fewer cars than General Motors (NYSE:GM) did in the quarter, it made far more money than GM did.

Toyota has always been known for its high efficiency. When Ford's CEO Alan Mulally was with Boeing, he once visited the company's production plants in Japan and he was highly impressed with how effective Toyota was (in fact, another visit occurred after he became the CEO of Ford and he describe Toyota as the "finest production system in the world"). It took American car companies many years to replicate what Toyota was doing at the time. Toyota's success in automating and standardizing production process and high quality standards earned the company strong margins and a high reputation over the years.

In the last fiscal year that ended in March 2013, Toyota achieved a gross margin of 18.37%, up from the 11.81% achieved in 2012, and the 12.52% achieved in 2011. For the last quarter, the company's gross margin was as high as 21.36%. The company is enjoying a strong American car market and this is the first time in a long time it can sell a large number of cars without having to offer incentives or cash-backs. This is evidenced by the fact that Toyota's revenues were up by 16% even though its sale volume decreased from 2.27 million units to 2.23 million units.

Even though the company's turnaround has been very successful, we can't deny the fact that it was greatly helped by a weakening yen in the last several months. In fact, Toyota estimated that of the $2.75 billion growth in net income, $2.62 billion was attributable to the currency fluctuations caused by heavy yen printing in order to reduce the price of yen in comparison to other currencies. Without the weakening of the yen, the company's profit would have grown by only $130 million in the last quarter. Then again, we can't blame Toyota for taking advantage of weak yen when the company had to suffer from strong yen for years.

The car companies are also benefiting from low interest rates in the western countries at the moment. Low interest rates allow more people to be able to afford new cars as the average age of the cars in traffic (in the U.S.) has passed 10 years and many people feel the need to replace their cars. Also, keep in mind that the newer cars are a lot more fuel efficient than the older cars and many people find out that the money they save on monthly gas bills will be able to cover at least part of their car payments.

In the last couple months, Toyota's stock price has appreciated greatly and the company's investors have been pretty happy. Then again, some other car companies also saw similar price appreciations. For example, Ford's share price nearly doubled between last summer and this summer. Toyota enjoys a higher P/E ratio than most carmakers, which may mean that the investors have higher expectations from Toyota than other car companies. For example, Toyota's current P/E ratio is 20; whereas, Ford's P/E is nearing 12, GM's P/E is 13, BMW's P/E is 9, Volkswagen's P/E is a ridiculous 5 and Daimler's P/E is 9. Interestingly enough, another Japanese carmaker, Honda (NYSE:HMC) also enjoys a relatively high P/E ratio of 18 but Nissan's P/E is closer to those of American and European carmakers at 13.

In the next few quarters, Japan's yen-printing efforts will probably continue at the same rate, if not even accelerate. This is good for Toyota, which has shown no intention of passing the lower production costs to consumers by lowering its prices or offering incentives. It looks like gaining market share is not a big priority for Toyota; rather, increasing its profit margin is. It appears that Toyota's management is growing comfortable with high margins and it will not be very aggressive about cutting prices or offering incentives anytime soon.

In the last quarter, the company generated plenty of cash flow, which increased its cash holdings from $27 billion to roughly $33 billion. The company's cash position is pretty healthy and the company should be ok with sacrificing some margins for the sake of gaining market share; even though management will not agree with me in the short term. Management will probably try to rake-in as much cash as possible while yen is weak.

Is Toyota a good investment? If you believe that the Japanese government will continue to be aggressive about weakening yen over the next few quarters, Toyota is a good bet. If the yen gets too weak, other countries might start pressuring the Japanese government to cut back on its aggressive policy, but I don't see it happening yet. Perhaps, this is another reason for Toyota's reluctance about cutting its vehicle prices. If the company were to cut its prices in a way to steal significant market share from other companies, there might be some complaints from different countries about how the artificial weakness of the yen hurts other companies. For the time being, Toyota seems like a good bet on the Japanese recovery though.

For those who have been asking: I will be covering the auto industry more often from now on. Also, I will be covering a larger variety of companies in the industry. So far, I mainly covered Ford but I like the idea of covering other companies too.

Disclosure: I am long F. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.