Toyota Motor

Toyota’s fiscal first-quarter consolidated revenue was up 10% year on year with automobile revenue edging up 9% thanks to an increase in vehicle sales volume in Japan and Asia. With continued sales and profitability pressure in China, profit for China joint ventures slumped 31% year on year.

Why it matters: Automobile revenue and margin were in line with our expectations thanks to decent hybrid demand. Operating income declined 9% year on year as material costs, volume, labor and other expenses contributed JPY 350 billion of profit reduction despite currency tailwind. Profitability declined in Japan, indicating an urge for cost optimization, but improved in North America and Europe. Operating margin for Japan slid to 9.2% from 12.3% last year, while North America margin returned to 2.1% from negative 1.2% due to price revisions and decrease in tariffs. Toyota approved JPY 1 trillion share repurchase program, showing management’s willingness to reward shareholders even amid sluggish profitability.

The bottom line: We maintain our fair value estimate at JPY 3,550 (USD 237). With shares down over 20% in the past six months, the stock is undervalued in 4-star territory. However, we think uncertainty from headwinds to US consumer affordability may continue to pressure share price.

Between the lines: Toyota raised fiscal 2027 operating income guidance by 13% to JPY 3.4 trillion on weaker yen forecast, less Iran war impact and cost reductions. Nevertheless, full-year dividend payout was maintained at JPY 100 per share. JPY 480 billion exchange tailwind and JPY 145 billion volume and mix gains drive the higher profit forecast, despite a higher raw material cost of JPY 135 billion. Global retail volume was kept at 11.2 million, 1% drop from last year, including a 3% growth in North America. As the revised guidance assumes an exchange rate of JPY 160/dollar from previous JPY 150/dollar, we are not surprised by the guidance increase led by currency benefits this quarter.

Toyota's fiscal first-quarter consolidated operating income slumped 9% year over year to JPY 1.1 trillion, with operating margin narrowing 170 basis points to 7.9%. The fiscal quarter saw JPY 345 billion foreign exchange tailwind and JPY 55 billion from cost reduction efforts, which were offset by JPY 60 billion operating profit deduction from volume and model mix, JPY 115 billion expenses to compensate suppliers and secure materials prices, and JPY 75 billion negative impact from Iran war. The decline in operating income for Japan operation was mainly attributable to increased expenses, while US market returned to a positive profit thanks to price revisions, foreign exchange fluctuations and decrease in tariffs. Having said that, we remain cautious about further upward price revision potential in US market given headwinds to consumer affordability.

The company's consolidated vehicles sales dropped 1% year over year to 2.4 million units, with decline in North America and other regions more than offset the growth in Japan and Asia. The company's plan to emphasize hybrids is paying off. Fiscal-quarter hybrid powertrain retail sales grew by 7% year over year to 1.2 million units, accounting for 49% of Toyota and Lexus retail volume. Plug-in hybrid volume grew 24% to 58,000 vehicles, while all-electric volume more than tripled year over year to 114,000 units. As a result, we expect profitability to gradually improve from next fiscal year as tariff impact stabilizes and hybrid powertrain further gains strength in the North America market.

Our fair value estimate for Toyota's US-traded ADRs is USD 237, implying a fiscal 2027 price/earnings ratio of 15 times. For fiscal 2027 guidance, management forecast 7% consolidated revenue growth to JPY 54.0 trillion, a 10% consolidated operating profit decline to JPY 3.4 trillion, and a 110-basis-point margin decline to 6.3%, due to tariff impacts, higher expected material costs, and labor expenses, despite offsets from currency tailwind, price revisions and cost-reduction efforts. Global retail volume was guided to reach 11.2 million from 11.3 million last fiscal year.

In our Stage I forecast, we project revenue, excluding the captive finance arm, to increase at a 2% compound annual growth rate over our five-year forecast period. We model the firm's operating margin, excluding the finance arm and equity method investments, to average 6.9% during our Stage I forecast. Although we think higher volume will continue to enable the company to sufficiently leverage its operating expenses, currency devaluations in emerging markets, inflation, a much more competitive auto industry than in the past, and ever-rising research and development expenses for electric and autonomous vehicles pose margin expansion challenges ahead for Toyota. Our midcycle operating margin is 7.5% to reflect these harsher industry dynamics. During the past decade, Toyota's operating margin has had a high of 13.5% (2024), a low of 5.2% (2013), and a mean of 9.0%.

Our assumed cost of equity is 10.1%, including 0.5% country risk premium. This reflects Toyota’s sensitivity to the economic cycle, plus relatively low financial leverage, offset by the company's favorable operating leverage relative to other automakers. Our pretax cost of debt assumption is 4.6%, reflecting the spread creditors are likely to demand given Toyota's credit quality. We assume a long-run effective tax rate at 27% based on Japan's statutory corporate tax rate and Toyota's historical results. For fiscal 2027, we estimate total debt/equity for the automotive operations of 8%. Consequently, our weighted average aftertax cost of capital used to discount Toyota’s future cash flows is 8.2%. We value Toyota’s financial services business at book value.

Most vehicle manufacturers do not have a moat, due in large part to the competitive landscape of the industry as well as its cyclical nature. The cyclicality of the business makes it difficult to maintain any excess returns above cost of capital over an economic cycle. While Toyota reported higher ROICs than WACC for the past 10 years, we have less conviction that the firm can earn excess returns relative to its WACC for at least the next 10 years. As such, we expect the excess returns to diminish over our five-year explicit forecast period. In addition, Toyota is not immune to value destruction in a recession. Generally, we see two moat sources in the auto sector from intangible assets such as brand equity, best exemplified by Ferrari, and from cost advantage. At this stage we do not yet see either moat sources to be retained by Toyota in anticipation of intensifying competition within the next 10 years from electric vehicles and from the intense internal combustion engines, or ICE, competition, where consumers have no switching costs.

Toyota operates in a capital-intensive industry that suffers from stiff competition. It is very challenging to build a brand image that warrants a moat, and it takes decades of industry awards and technological innovation to gain a maintainable economic advantage over competitors. There are no switching costs for customers who are looking to change vehicles. Even the longest-lasting mass-market brands are rarely able to create significant pricing power compared with peers. Relying on mass market appeal decreases the value of a company’s intangible assets, which has proven to be a moat source for select luxury brands like BMW, Porsche, and Ferrari. Moreover, barriers to entry are not as high as in the past. Competitors in emerging economies like China and India pose a real threat to take market share in Europe and the US. In addition, electric vehicle companies like Tesla and BYD are crowding the space in an effort to capture a meaningful share of the EV market.

Even though it has generated returns on invested capital above its cost of capital in fiscal 2015-24, we see a high degree of difficulty for a mass-market automobile manufacturer like Toyota to have anything more than a moderate and temporary competitive advantage. Competitive pressure has worsened in recent years, with Tesla now at scale plus many BEV entrants beyond Tesla, making it a very difficult landscape for companies to build an economic moat. While annual global wholesale averaged around 9.7 million units for Toyota and Lexus light vehicles in the past 10 years, we don't think the company is able to permanently garner significant pricing power relative to competitors, especially in anticipation of increasing competition from electric vehicles.

Toyota targets to produce 1.5 million units of BEVs in 2026 and 3.5 million by 2030. It established battery electric vehicle, or BEV, dedicated business unit, BEV Factory, in May 2023. The company plans to release 10 new BEV models by 2026, including cars built on next generation electric platform with greater battery efficiency.

We believe capital requirements necessary for the company’s electrification transition, battery capacity expansion, modular assembly and vehicle intelligence technology are high. Toyota hopes to reduce the vehicle development costs by 30% and plant investment by half by 2026, through a new modular structure and gigacasting, which will allow greater degree of component integration. While cost-cutting, such as production capacity optimization, is an effective strategy to mitigate the financial impact of a poor economic environment, it is not enough to completely safeguard returns. The ease with which customers can switch to a competitor's product further adds to the company's challenges in carving out an economic moat.

Toyota's popular vehicles usually allow Toyota to use fewer incentives than its US counterparts, boosting the firm's profits and improving the resale value of vehicles.

Toyota plans to accelerate its transition to electric vehicles and targets to increase global production of battery electric vehicles to 1.5 million units in 2026 and 3.5 million by 2030.

Significantly lower pension and retiree healthcare costs give Toyota a cost advantage over the Detroit Three, although this advantage is less than it used to be.

Toyota’s use of Japan as an export base for its vehicles puts the company at disadvantage to withstand tariff risk and a strong yen relative to the dollar.

Toyota sells around 1.8 to 2.0 million vehicles per year in China, primarily through its joint venture. China is a market with intense competition and Toyota seems have lost steam for four consecutive years.

Environmental laws are becoming stricter, which will make cars more expensive to produce and more expensive for consumers to buy. Toyota, for now, is lagging in battery electric vehicle offerings relative to other firms.