Japanese Auto Industry Faces Somber Market

Special Coverage

State of Industry: International

Woe is Japan these days, slowly recovering from triple disasters last spring and depressed by two decades of economic stagnation, with no signs of better times ahead.

Additionally, Chairman Toshiyuki Shiga of the Japan Automobile Manufacturers Assn. warned in September that “the extraordinary high value of the yen has created an uneven international playing field which very seriously affects production activity here, raising the risk of nothing less than the hollowing-out of the industry.”

The situation is forcing some auto makers to shift more vehicle production overseas.

Reconstruction in the northeast coastal region, hard-hit by an earthquake, tsunami and nuclear meltdown, will cost at least ¥19.2 trillion ($250 billion) or more, money that’s not handy with government debt already twice the size of the economy and rated more risky than that of Italy and Spain.

Economic growth, minus 1.2% in 2008, minus 6.3% in 2009 and 4% in 2010, is forecast by the World Bank at 0.1% in 2011 and 2.5% in 2012.

Even reminders of past glories cannot lighten Japan’s heavy burdens today, ranging from an aging population and shrinking workforce to power shortages and foreign currency problems.

A new prime minister, Yoshihiko Noda, who took office in August, is the seventh in five years and not regarded as the strong, decisive leader the nation badly needs. Government is considered by many Japanese to be part of the problem, not the source of solution, and the political paralysis is expected to continue.

Today, the outlook for the nation and its people seldom has been so somber, and the automotive industry, the direct and indirect source of 5.32 million invaluable jobs, now faces gut-wrenching change.

Honda to build more models overseas, including CR-V.

For several years, a strong yen, which reached a record high Aug. 19 of ¥75.95:$1 and continues to hover around ¥76 and ¥77, has been impeding the global operations of Japanese auto makers.

Yet considering everything that has happened, these vehicle producers probably are doing better than expected, having almost completely recovered from the damage created in March by the earthquake and tsunami.

“Toyota, Nissan and Honda are currently operating at 90% to 100% of capacity, hiring people and running their lines faster than normal to recapture lost production, sales and profits,” reports Koji Endo, managing director-Advanced Research Japan. “The question is whether their strong recovery will continue next year.”

Says Chris Richter, deputy head, Japan Research, CLSA Asia-Pacific Markets: “The auto industry is back in full operation again. Toyota and Honda could effectively have seven months of sales in the last six months of this fiscal year. Restocking is under way and exports should go up, but there are big, negative headwinds out there in the global economy.”

The catching-up is temporary, and what’s worrisome is what will happen next.

“Japanese auto makers are really struggling, trying to make profits,” says Kota Yuzawa, a Goldman Sachs Japan senior analyst. “Their operating margins will only be around 3% to 4% in the second half of fiscal 2011, compared to over 10% for some foreign auto makers.”

Japan’s Big Three auto makers all will be profitable in the current fiscal year ending March 31, 2012, but appearances are a bit deceiving.

Toyota is forecasting operating profits of ¥450 billion ($584 million), but that’s less than 20% of its peak in 2007 of ¥2.3 trillion ($29.9 billion). Honda is calling for operating profits of ¥270 billion ($350 million), only one-third of its 2007 high. And Nissan is expected to earn operating profits of ¥520 billion ($681 million), down one third from 2007.

All reflect the bite taken out by every ¥1 gain in the exchange rate against the dollar.

“The losses are quite meaningful, around ¥30 billion ($390 million) for Toyota and ¥18 billion ($234 million) each for Nissan and Honda, raising the specter that they may not want to make as many cars in Japan,” Richter says.

“Among global auto makers, they already have some of the lowest returns on equity. This means they are making less money and ultimately will have less to invest.”

Competitive sharpness is another loss influencing management calculations and business planning.

Says Endo: “Japanese makers are losing market share in Europe to South Korean competitors and in the U.S. to the Europeans. If the yen stays around ¥77 to ¥75:$1, their competitive edge will be badly damaged and they may not be able to sell all the cars they produce. They are already losing money on exports to the U.S.”

Profit centers are changing as well. “All Big Three auto makers are showing massive losses in their Japanese market segment because of the strong yen, so it’s impossible to export cars from Japan at a profit,” Richter says.

“Most are making profits from sales in emerging markets and auto financing. None are making any money selling cars in developed markets. Most profits in North America are from their finance business.”

Auto makers’ countermeasures to minimize the impact of the strong yen are having mixed success.

“Japanese auto makers are doing a great job of cost-cutting, but in the short term, what else they can do is very, very limited, other than squeeze money from parts suppliers and increase sales prices wherever possible,” Yuzawa says.

“Overseas procurement of parts and components is increasing, but this is part of a longer-term action plan,” he adds. “The lead time in the industry is four to five years, and changing parts sourcing takes at least one-and-a-half years.”

Honda imports about 10% of the parts and components needed for production in Japan. And Nissan recently announced plans to import up to 40% of the parts in vehicles made in the Kyushu plant by 2013.

The most critical question is whether the yen will remain in the present range, strengthen further or weaken to a more palatable level, and no one has any answers. Several interventions in foreign currency markets by the Japanese government have been tried at considerable expense and failed every time.

“Even at ¥70:$1, Japanese auto makers can make a profit,” Yuzawa says. “We’re looking at ¥74 for the next 12 months, but this is more dollar and euro weakness than yen strength. And frankly, at ¥75, it is almost impossible to make money from exports.”

Says Endo: “The consensus in Japan is that the yen will probably stay around the current record level and will not likely go to ¥70 or ¥60:$1.However, some people think it will weaken to ¥80 or ¥90. But nobody knows where it will go.

“For exports, the breakeven point is probably around ¥80-¥90, so these shipments are money-losers,” he adds. “This means there is no point to export cars from Japan at current yen levels, and auto makers are now trying to decide whether to transfer more capacity from Japan.”

Output in overseas Japanese plants nearly has doubled in the last decade, to 13,181,000 vehicles in 2010, according to the Japan Automobile Manufacturers Assn. This compares to 9,628,000 vehicles produced domestically in 2010, roughly the same level as 10 years ago, divided between domestic sales of 4.9 million vehicles and exports of 4.8 million.

Honda’s 4.58 million-unit global capacity, for example, currently is spread between 1.3 million in Japan and 3.26 million overseas, but this is about to change.

In a recent interview with the Asahi Shimbun, Honda President Takanobu Ito says that over the next 10 years the company plans to maintain annual production in Japan of about 1 million units, cut exports from Japan in half and build more of its models, such as the CR-V cross/utility vehicle, overseas.

“Honda currently exports 30% to 40% of its domestic production, but it is hard to sell abroad while fretting over currency movements,” Ito says. This follows the move last year by Nissan to shift production of the March to Thailand and satisfy Japanese import requirements.

Capacity in Japan exceeds domestic sales by roughly 5 million units. How much of this production may be shifted offshore, when and by whom, is neither clear nor certain, given the formidable costs in money and manpower.

“The auto industry hasn’t hollowed out much so far,” says Richter. “No company has taken the ultimate step yet of closing an assembly plant in Japan and firing workers, and there will be considerable pressure not to shift more production. A lot of political pressure, cost and lost jobs are involved. It is not a step companies are rushing to take.”

To cushion the blow, Yuzawa believes “any production shifts overseas will be by model, not by factory. Domestic production will definitely decline but gradually. In the next five years or so, a typical assembly plant in Japan may possibly be operating at only 50% of capacity.”

Adds Endo: “If the exchange rate remains high, domestic capacity will drop from around 10 million units to 8 million or 7 million. I wouldn’t be surprised if (annual) domestic capacity went down 20% to 30% within the next few years.

“Although Toyota executives want to keep at least 3 million-(unit) capacity in Japan, it is becoming more and more difficult to do,” he adds. “They will have to change their minds and start shifting more capacity overseas.”

Targets for any capacity transfers will vary by company and country. In the U.S., for example, Honda already builds about 85% of the vehicles it sells there, while Toyota produces two-thirds of its local sales volume.

Analysts agree that emerging markets will be the prime targets.

“Toyota needs more capacity in four regions: India, Brazil, China and possibly Southeast Asia,” Endo says. “Honda wants to continue expanding in China, as well as Southeast Asia, India and Brazil. Nissan will probably expand in China and Southeast Asia and take advantage of its alliance with Renault in Russia and South America.”

Some of the new investments include:

Looking ahead, the future appears more imperfect than usual for Japan, beset by intimidating problems, but it has survived worse. No one should sell the domestic auto makers short, accounting as they do for almost 30% of total global production – 22.8 million vehicles out of 77.6 million in 2010.

“Japanese auto makers are very much in the game, with great leadership in production technology and green technology,” Richter says. “But they must change their production footprint or, ultimately, their strong position globally will be eroded.”

Cautions Endo: “Since more and more cars will be small and hybrid models that are really not that profitable, (auto makers’) earnings will not rise that much in the future as their sales volume.”

Yuzawa predicts the next one or two years will be difficult for Japanese auto makers, “but they will lower their currency dependency, transform their business model, shift more production abroad and remain global leaders.”