Earnings Preview: A Weak Yen, Rising SUV Sales In North America Could Boost Honda’s Profits

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Honda Motors (NYSE:HMC) is scheduled to announce its Q3 earnings on January 30. During the Q2 earnings release, Honda downgraded its forecasts from 4.83 million vehicle sales for the fiscal year 2015, to 4.62 million, citing challenging business environments in both North America and Asia. [1] It sold 4.3 million vehicles for the fiscal year ended March 2014. The Japanese auto maker saw its volumes decline in the first half of fiscal 2015 amid a challenging market environment. The company had to recall about 5 million cars in the U.S. and Japan due to faulty airbags provided by the Takata Corporation and had a hefty lawsuit filed against it by consumers in the U.S.  As a result of the recalls, Honda’s priority has shifted from new model roll-outs, to the management of recalled vehicles. The handling of the faulty airbags situation by Takata was negative p.r., and Honda was made to look quite bad in comparison to the much swifter handling of a similar airbag problem by U.S. auto maker General Motors. [2] However, the company was still confident that a weak Yen would help it attain its operating profits target.

We have a $41 price estimate for Honda Motors, which is about 30% above the current market price.

Japan Weakness To Dampen Results

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Ever since the introduction of Abenomics, the name given to the monetary and fiscal policies pursued by the Shinzo Abe Government, and the tapering of the quantitative easing program, the yen has devalued in relation to the U.S. dollar. At the beginning of October, the yen to dollar conversation rate was around 109 but by the end of the year the rate had moved to 119. [3] This should benefit the country’s automotive companies since overseas profits now translate back to more yen. Since companies usually hedge against currency fluctuations through forward contracts, the actual price realization might be different from the spot prices. Thus, the magnitude of Honda’s profits will rely on the level of price realization to a great extent. Still, it is likely that Honda will beat its profit guidance simply due to favorable currency fluctuations.

The weaker yen will not, however, spur more domestic sales. Rising sales taxes and falling real wages over the past few months have meant that people are reluctant to splurge on new cars. Salaries have failed to keep pace with the inflation rate and low expectations about future salaries continue to cast a shadow over future domestic sales for Japanese companies. [4] Honda’s domestic rival Toyota Motor Corp also cut its guidance for 2015 on the expectation of declining domestic sales. [5] Combined with the airbag issues, Honda expects to sell about 80,000 fewer vehicles in the fiscal year ending in March.

Sales In Asia and Europe Could Rise

In the previous quarter, volumes in Europe and Asia rose on the back of the introduction of new models. The company saw sales across Asia rise from 1.05 million units to 1.07 million units because of new model introductions. In addition to rising sales, cost-cutting efforts improved the company’s operating profit margin in the region by 170 basis points on a year-on-year basis.  We expect this trend to continue in the third quarter as well. In China, sales had slowed earlier in the year. Japanese car companies have been trying to regain market share after political tensions flared up between China and Japan over claims on the disputed islands (known as Diaoyu in China and Senkaku in Japan), beginning from September 2012. This impacted the sales of Japanese companies negatively and it took a few months before sales normalized.

Honda had stepped up its operations in the country by launching  a new R&D center in Guagnzhou, and launching China specific models such as the Crider and the Jade. Unit sales had grown by 31% in the first two months of last year but growth fell to 2% in March. [6] However, the trend reversed in the next quarter with sales in China rising by 26% on the back of the introduction of Jade and Crider along with an updated version of the popular Accord. That trend continued into the third quarter. Honda missed its target of 800,000 unit sales in China for 2014 by about 12,000 units but the figure was that narrow due to a 41% increase in the number of deliveries in the month of December. [7] China accounts for more than a sixth of Honda’s global deliveries.

North America Still Key For Profits

North America is the biggest market for Honda and accounts for more than 40% of the unit sales. During the previous quarter, overall sales in the U.S. for the Japanese automaker stayed flat but increased by 33% for the Accord sedan, its best-selling vehicle, on the back of incentives such as discounts and no-interest deals, which made the vehicle more attractive to owners of older models. However, the heavy dependence on incentives meant that operating profit in North America declined 14% to ~39 billion yen ($360 million), from 46 billion yen ($420 million) in the previous year.

In the first half of fiscal 2015, sales had fallen by 3% on a year-on-year basis for the company, while it had guided for a 3% increase in overall unit sales for the year.  Despite that, the company did not cut its guidance for North America for the full year when it announced its earnings for the second quarter. The company was banking on several strategies to lift its sales.  One of these strategies was the model refresh of the CR-V. Previously, the CR-V has made up about one-fifth of the total car sales in the U.S.  Through November, Honda had sold about 302,000 CR-Vs, comprising 24% of its total sales in the U.S.  In October and November, CR-V sales grew by 30% and 38%, compared with year-ago levels. Considering that the U.S. auto industry sales are expected to surpass 17 million units in 2015 and the SUV/compact crossover segment is still growing, the CR-V sales momentum could continue well into the next year. Additionally, considering the slightly higher pricing of the CR-V, rising sales could add a significant amount to the company’s bottom line. If we assume the base price of the CR-V LX model is $24,150, the November sales boom alone would add more than $200 million to Honda’s bottom line. As a result, in the third quarter, the operating profits in North America should be a lot higher than in the previous quarter.

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Notes:
  1. Honda cuts sales forecast as recalls delay new model roll-outs, Reuters, October 2014 []
  2. Takata Non Grata: GM Recall Actions Shine By Comparison, Forbes, October 2014 []
  3. JPY to USD quotes, Bloomberg []
  4. Japan real wages fall at faster pace, cast doubt on consumption, Reuters, September 2014 []
  5. Toyota gives first forecast for shrinking sales in at least 15 years, Reuters, January 2015 []
  6. Japanese Car Companies Post Slower Growth in China Sales, April, 2014, Wall Street Journal []
  7. Honda misses China sales goal as Japan carmakers lose traction, Automotive News, January 2015 []