How A Weak Japanese Economy And Weak Yen Can Hurt Toyota

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Toyota Motor

Japanese auto maker Toyota Motors (NYSE:TM) is the leader of the auto industry according to unit sales. The company is also the market leader when it comes to profitability. It has a stellar reputation for the engineering of its cars and its business model is more successful than that of all the other companies in the market segment. As a result of these factors, the company has held the position of market leader by volume for six years in a row now. However, the auto maker cut its forecast for unit sales for the calendar year 2015 from 10.23 million units in 2014 to 10.15 million units on expected weakness in Japan and emerging markets.

2014 Japan Recap

In the first six months of 2014, Toyota car sales experienced rapid growth in Japan. Consumers went on a vehicle shopping spree, pushing sales to more than 783,000 vehicles in March, the highest monthly figure in eight years. Retail sales in Japan grew at the fastest pace in 17 years in March as consumers rushed to purchase heavy-ticket items before a hike in sales tax, known as a  consumption tax, from 5% to 8% that came into effect on April 1st. This was the first hike in sales tax in 17 years. Another hike from 8% to 10% is scheduled for October 2015. [1] Thus, vehicle sales for the first quarter were artificially inflated and data from the latest industry figures shows that vehicle sales following the sales tax hike fell to the lowest level since December 2012. Vehicle sales for the month of April fell 5.5% to 345,226. Toyota delivered the smallest number of vehicles since 2011, according to  industry figures. The slump is expected to deepen in May as deliveries of many orders made before April 1 were delayed due to poor weather conditions. [2]

Economy Slowdown

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Japan is in the process of implementing a three pronged program to revive its flailing economy. The three prongs involve changes in fiscal policy, an expansionary monetary policy, and structural reforms to improve investor sentiment. The economy is going to receive money supply injections through a stimulus package, which the Japanese Government wants to finance with an increase in tax receipts, instead of issuing Government denominated bonds. It is against this background that the sales tax hike came. The worry for Japan is that the incentives offered by the Government to corporations, such as a plan to cut corporate taxes to increase worker wages and pay increases, have been minimal. [3] With households already impacted by rising costs of living, the net effect of the sales tax hike has been a contraction in the economy. [4]

It is clear that the government wants corporations to start increasing investment by giving them access to cheap capital. However, this assumes that the new capital will be able to find profitable opportunities to invest in. If the economy contracts as a result of consumers becoming more cautious in spending as a result of prohibitive taxes, corporations might shy away from investing in the economy, thereby reinforcing the same cycle. The most immediate effect of the sales tax was an increase in the average price of vehicles. This occurred because automakers now have to pay more for the raw materials they buy, including vehicle parts and raw materials. The higher cost of goods will translate into higher prices for new products. This rising price from the sales tax will force companies to reduce supply at existing prices, reflecting the fact that they can now produce less for the same amount of money. Besides altering the price, the sales tax will also impact consumers’ buying power. When sales tax rates are high, consumers spend more money on taxes and have less to spend on additional goods. This drives down demand or will force automakers to reduce prices to keep demand steady. Consequently, unit sales for fiscal 2015 fell by 9% in Japan. The impact has not been limited only to reduced sales numbers in Japan. About 50% of Toyota’s manufacturing happens in Japan, so rising costs of production has affected international sales too.

We have assumed an average unit price per vehicle sold of ~$34,000 from Japanese operations for Toyota. If Toyota decides to pass on the sales tax to the consumer, it will result in a higher average unit price. However, the decline in the yen compared to the dollar is greater than the increase in the sales tax, so the net effect will be a decline in average unit price. This decline, coupled with the expected fall in the total number of vehicles sold in Japan over the next 5 years because of a weak economy, can result in a 6% decline in the overall stock price. That, coupled with the increasing cost of production of vehicles, can contribute another 4% to the decline in stock price. So, the net impact can be a decline in the stock price of close to 10%.

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Notes:
  1. Japanese Consumption Hangover Begins As Car Sales Decline, Bloomberg, May 2014 []
  2. Japan’s Worst Auto Sales In 16 Months Show Hangover Begins, Businessweek, May 2014 []
  3. Why An Extra $26 A Month May Decide Fate Of Abenomics, Financial Times, March 2014 []
  4. Abe Orders Japan’s First Sales-Tax Increase Since ’97, Bloomberg, October 2013 []