David Whiston, CFA, CPA, CFE) The auto manufacturing sector has become increasingly competitive, and Toyota Motor (TM
had been the only automaker we cover that held an economic moat,
because of its brand equity and cost advantage fueled by legendary
operational expertise. However, the time is right to remove Toyota's
moat even Toyota is not immune to these competitive
pressures, and its edge on quality is not what it used to be. The most
concise argument for removing the moat is what we have published for a
long time: There is nothing stopping an emerging original-equipment
manufacturer, such as Hyundai, from doing to Toyota what Toyota did to
the Detroit Three. Barriers to entry have fallen--as the global auto
market grows, a new entrant can obtain a small amount of share yet still
be able to cover the massive fixed costs required to enter. Thus, the
economies of scale the large automakers enjoy are somewhat at risk. This
idea is supported by the entrance of emerging-market firms such as Tata
Motors to the global market, and we think Chinese firms will also
eventually enter developed-world markets in a meaningful way. Existing
players will find moat-building very challenging.
Quality Is No Longer the Differentiator It Once Was
There is little Toyota can do to immunize itself against competitive
pressures, especially in the important U.S. market, since it is much
harder to differentiate on quality than in the past few decades.
Toyota's reputation also took a hit with the recall crisis of 2010 and
the single-largest automotive recall since 1996 in October 2012, which
showed that the company many had long praised had grown too fast and was
not immune to quality problems. Toyota's advantage on quality is not
sufficient to justify a moat anymore. J.D. Power's Initial Quality Study
(problems per 100 vehicles in the first 90 days of ownership) shows
that since 2006, the Toyota brand has not had drastically fewer problems
than the industry, and it actually trailed the industry in 2010 because
of the recalls.
Neither does warranty spending support a moat for Toyota, as the
automaker's outlays are not vastly lower than those of GM and Ford and
have actually exceeded Ford's the past three years.
J.D. Power also issues its APEAL (Automotive Performance, Execution,
and Layout) study, which measures how gratifying a new vehicle is to
drive and surveys owners after 90 days of ownership. APEAL data since
2006 again supports the argument that Toyota does not merit a moat, as
its products are not perceived as superior to the industry.
Conquest and Loyalty Data Offer Conflicting Views on Toyota's Moat Potential
J.D. Power's Customer Retention Study measures the rate at which brands
retain existing customers by surveying buyers and lessees of new
vehicles. The Toyota brand continues to retain customers at nearly
60%--well above the industry average--as shown in Exhibit 4. However,
Edmunds.com issues conquest data (Exhibit 5), which tells a more
negative story for Toyota. A conquest sale is when an owner of a
non-Toyota brand vehicle trades in that vehicle to buy a Toyota brand
vehicle. According to Edmunds.com data cited in October in leading trade
journal Automotive News, conquest sales for all three Toyota
brands combined (Toyota, Lexus, and Scion) have fallen to 46.7% from
60.8% in 2008. Edmunds.com analyst Ivan Drury was quoted as saying that
before 2010, Toyota and Honda "had a number of conquest purchases" but
now "the weight of their sales is heavily dependent on loyalist
consumers." We think Toyota may never be able to conquest as in the
past, as there is only a perception gap in quality today rather than an
actual gap. Edmunds.com attributes the sharp decline in Toyota's
conquest rate in 2010 mostly to the recall crisis, and we agree. The
fact that in 2012 Toyota's conquest rate continued to fall as a result
of the 2010 recalls is more evidence to support removing the moat.
This conquest data is also not surprising to see given the
renaissance of the Detroit Three in vehicles such as the Ford Fiesta,
Focus, and Fusion, Chevrolet Sonic and Cruze, and Buick LaCrosse.
Hyundai-Kia also somewhat explains the decline in Toyota's conquest
rate, with vehicles such as the Elantra and Sonata being worthy
competition to the Corolla and Camry, as opposed to cheap yet
unappealing substitutes as in the past. Hyundai-Kia's combined 2012 U.S.
share was 8.7% compared with 7% in 2009. We believe this new evidence
of stronger competitive threats than in the past supports eliminating
ROIC Is the Best Reason to Keep the Moat, but It Is Not Enough
Toyota's ability to generate economic profit, defined as return on
invested capital above weighted average cost of capital, is the best
argument one could make to retain the company's moat. Our projected ROIC
for Toyota is well above its WACC of 10%.
Despite Toyota's strong ROIC and core loyalist customers, we argue
that the qualitative competitive pressures we've discussed are more
important to Toyota's moat rating than the quantitative ROIC data.
Recent ROIC data shows that even Toyota can post an economic loss in a
severe recession, and its manufacturing excellence is still no
protection against massive supply chain disruptions, as it saw in Japan
and Thailand in 2011. The strong yen against the dollar is another
external force that Toyota cannot control. Every JPY 1 strengthening in
the dollar/yen exchange rate costs Toyota about JPY 35 billion of annual
operating income per previous disclosures by management, or about 30
basis points of ROIC. Cost-cutting efforts can reduce the pain of these
supply shocks and a recession, but they cannot wholly offset the
negative effects. The yen's recent weakening against the dollar
following the election of the Liberal Democratic Party in Japan is
welcome news, but the yen is still nowhere near the weak levels against
the dollar that it was in the early 2000s.
Furthermore, consumers have no switching costs when they decide to
buy a new vehicle, and upstart players such as Hyundai, Volkswagen, or
eventually the Chinese in the United States all are threats to further
usurp Toyota's position as a leading automaker. In addition, the Detroit
Three have re-emerged from decades of underperformance, and we believe
GM and Ford (and Chrysler, to a lesser extent) can now offer competitive
vehicles in all segments against Toyota, as opposed to just the
light-truck segments as had been the case for the past several decades.
Recent models such as the Chevrolet Sonic and Cruze and Ford Fiesta,
Focus, and 2013 Fusion are at least comparable, if not superior, to the
Toyota Yaris, Corolla, and Camry, in our opinion. Toyota has no inherent
defense to keep these competitors at bay and does not deserve a moat.