The global market may be becoming increasingly competitive, but Japan's and Korea's top automakers are hitting new production records and expanding outside their domestic markets at a rapid pace. Faced with stagnant demand in their home countries and a need to reduce foreign exchange risks, the big automakers in both countries are rapidly expanding production overseas and shearing off market shares from the foreign incumbents.
So far, the big three Japanese companies -- Toyota Motor Corp. (AAA/Stable/A-1+), Honda Motor Co. Ltd. (A+/Stable/A-1), and Nissan Motor Co. Ltd. (BBB+/Stable/A-2) in Japan -- are enjoying successes as their tight controls on costs and mostly competitive product lineups enable them to take market share from overseas rivals. All three recorded strong sales growth for 2005 and their profits remained robust. In Korea, both Hyundai Motor Co. (BBB-/Stable/--) and Kia Motors Corp. (BBB-/Stable/--) face serious margin pressures due to their mainly Korean-based manufacturing and the impact of the strengthening Korean won.
But as the automakers drive for further gains in overseas markets, challenges are emerging. Success in executing their expansion strategies will depend on how each tackles these, particularly:
-- Geographic concentration, particularly disproportionate reliance on the North American market;
-- Vulnerability to foreign exchange rates; and
-- Controlling expansion costs in the face of rising raw material prices while maintaining or enhancing product quality.
Japanese Carmakers Lead The Way In Global Expansion
Over the past decade, Japanese automakers have been setting up and expanding production facilities overseas. Globally, they have doubled their overseas production to over 10 million units, from just over 5 million in 1998. In the U.S., they now supply 67% of their total sales from their North American plants, compared with less than 12% a decade ago. Toyota remains the most geographically diverse, doubling the number of its overseas plants to 51, and boosting its presence to 26 countries from 18 over the past 10 years. And it's still expanding, with further production capacity under way in Texas, China, Thailand, and Russia. In a new innovation, Toyota has developed and implemented a global supply chain based in Thailand, and the project has started to accelerate the company's rapid business growth in Asia. Honda and Nissan are more focused on the U.S., where both have a significant presence, but Europe and Asia are expected to play a larger role in the future. In comparison, Hyundai and its subsidiary Kia are late starters in their localization plans in the U.S. and Europe. But free of the strictures imposed by the more rigorous corporate governance structures of their peers, the companies are embarking on highly aggressive business expansion strategies no other global auto manufacturer could emulate. Hyundai recently completed construction of its first plant in the U.S., and Kia has commenced construction of a plant in Europe. Even before the U.S. plant finishes its first year of operations, both companies have announced further plans to build second production facilities: Hyundai in Europe, Kia in the U.S. Back home, the Hyundai group is also investing heavily in ambitious steel production schemes and has announced its intention to acquire Mando Corp., an auto parts supplier. All five Japanese and Korean companies have seen their market shares rise in the U.S. and are enjoying a growth spurt since 2002. In the light vehicle segment, Toyota's market share in the U.S. reached 13.3% in 2005 up from 9.3% in 2000, by capturing sales primarily from General Motors and Ford Motor, and it has done so without offering aggressive sales incentives. Honda had 8.6% of the light vehicle market in 2005, up from 6.7% in 2000, and Nissan had 6.4% versus 4.1% in 2001.
For Hyundai, the U.S. is its most important market, accounting for about 23% of unit sales in 2005 (based on production in Korea). The Hyundai and Kia brands command a light-vehicle market share in the U.S. of 4.3% in 2006. Both companies have continued to make impressive progress in improving their position and raising average selling prices in North America, achieving volume and market share gains in an environment of intense pricing pressures and competition. All five automakers' prospects for further expansion in North America look promising. In the current high gasoline price environment, their product mixes look to be in tune with customer shifts, with more fuel-efficient cars becoming popular. In global markets, Toyota appears set to make its 15% market share target ahead of schedule - initially the early 2010s - with the broadest lineup, while Honda and Nissan have more concentrated product mixes, and Hyundai and Kia are even more reliant on a few key models.
What If The U.S. Market Shifts?
Success in the U.S. carries some risks. All of the big car companies, but Honda in particular, have a disproportionate reliance on this market. Toyota generates about 30% of its profits from the U.S., and Nissan and Honda about 50%. Reported revenues and associated expenses, however, are attributed to regions based on the location of the parent company or the subsidiary that transacted the sale with the external customer, rather than point of sale. For example, earnings in Japan include export earnings to foreign markets. Based on location of sales to end customers, some revenues and profits from outside Japan are larger than those reported by the companies. The impact of a sudden change in purchasing habits by American auto buyers on these companies' earnings and cash flow could be amplified because of this heavy dependence. The cool down in the large SUV market is a good example of how market shifts can have severe impacts on manufacturers that focus products too narrowly. Currently, consumer demand is growing for smaller, compact cars, which carry lower profit margins, weakening the product mixes of the big automakers. Toyota is least affected by these risks, though, as its strengthening market position shows. Although improvement in industry volume in the North American vehicle market will probably be limited in the near term, Toyota is expected to outperform its competitors through the breadth of its product range, from sport utility vehicles and pick-up trucks to passenger cars, including hybrid vehicles. For fiscal 2005, the company projects unit sales of 2.57 million in North America, or a 13.2% increase from the 2.27 million units sold during fiscal 2004. Honda, which has a narrower lineup, is more exposed to adverse market trends in the U.S. It has been able to maintain a low level of sales incentives, but a possible acceleration of industry-wide price erosion could be a concern. Nissan has maintained disciplined pricing and incentive strategies that have also helped restore its brand image to some extent, and allowed it to maintain high operating margins in the U.S.: 11.2% in fiscal 2004, 12.2% in fiscal 2003, and 10.6% in fiscal 2002. However, Nissan's operating profit during the nine months ended in December 2005 declined 10% from the same period a year earlier, due largely to Nissan's lack of new model launches in the U.S. in fiscal 2005 (ending March 31, 2006).
For Hyundai And Kia Strong Brands Are Key
Of course brand image is critical in the current hyper-competitive operating environment. More so in Hyundai's and Kia's cases, because their ability to sell more cars in the U.S. is vital to support their aggressive expansion plans. In Hyundai's case, respect for its brand has improved significantly. On the J.D. Power & Associate's Vehicle Dependability Study (VDS), which measures car reliability and dependability, Hyundai improved significantly, experiencing the largest reduction in problems reported by owners among all automakers surveyed. Its models are presently positioned as the low-price alternatives, but if the quality improvement continues, Hyundai should be able to move away from its low-price strategy. Kia, on the other hand, still lacks a strong brand image in overseas markets, and it essentially competes with attractive pricing. Unlike the progress made by its parent, Kia is still plagued by problems. This is expected to improve with Kia's and Hyundai's strategy to share platforms and parts suppliers, and increasingly develop platforms jointly in the future. But with a low score on J.D. Power's Initial Quality Study of 110, Kia still remains below the industry average of 118. In addition, Kia scored the lowest of all the main automakers on the VDS survey. Despite some improvement, the lower recognition of its brands raises a key question for the Hyundai group. Will its appetite for risk leave it too vulnerable to adverse market shifts? As the experiences of Ford Motors and GM have shown, falls from grace can be swift and unexpected. If Hyundai and Kia fail to generate the sales and revenues in the U.S. and elsewhere as they expect, they could end up over leveraged and with a capacity glut. In comparison, Toyota and Honda continue to enjoy very good JD Powers' VDS scores of 194 and 210 (lower scores are better), respectively, remaining in the top ten globally and well above the industry average of 237. Nissan has some work to do to catch up, with a score of 275, leaving it vulnerable to similar risks as the Korean automakers, although its stronger brand name in Japan, where it's the second-largest automaker, should provide a buffer.
Domestic Markets Are Flat And Unpromising
The Japanese market remains flat, however, with sales just below 6 million units since 1998. Although the economy is recovering, weak demand is unlikely to be reversed. With a rapidly aging population, long-term growth prospects in Japan are very limited. On top of this, demand is continuing to shift in favor of compact cars and mini-vehicles, which is affecting the model lineups of most of the top automakers. Unit sales of standard-size passenger cars declined by 6.4% in 2005, but small passenger cars and mini-vehicles -- with engines smaller than 0.63 liters -- saw unit sales increase by 2.6% and 1.7%, respectively, over 2004. Toyota remains the undisputed market leader at home. Its cars account for about 44% of all vehicle sales, excluding mini-vehicles. Including mini-vehicles, Toyota and its subsidiaries account for about 41% of total vehicle sales. This leading position is based on the automaker's wide range of competitive products. In 2005, Toyota made six of Japan's 10 best-selling cars (excluding mini-vehicles), reflecting the breadth of the company's product range. In August last year, Toyota launched its Lexus model in Japan, entering the premium brand segment. This could lead to an improved model mix in the domestic market. Smaller Japanese automakers are bearing the brunt of the increasingly fierce competition and challenging market conditions. These pressures could lead to a widening performance gap with Japan's Big Three. Smaller automakers have lower economies of scale, and are more vulnerable to changes in consumer preferences unless they have strong footholds in premium niche markets. The profitability of Fuji Heavy Industries Ltd., the manufacturer of Subaru cars, for example, has been pressured by slow sales and weaker model mix due to its reliance on fewer models. Suzuki Motor Corp. is probably an exception, though. It has a strong market position in mini-vehicles in Japan and some overseas markets such as India, and has maintained solid profitability for the past several years. In Korea, the market is also saturated, but is more volatile than Japan's. In 2005, Koreans bought 1.1 million vehicles, down from 1.6 million in 2002. In the past, the domestic market was the key to Hyundai's overall profitability, accounting for most of its earnings. More recently, the domestic market has accounted for only 33.5% of retail sales (based on vehicles manufactured in Korea). Together, Hyundai and Kia maintain a market share of about 73% in Korea. Domestic competitors have not been able, in aggregate, to increase their market shares substantially: GMDaewoo (9.9% share in 2005), Renault Samsung (10.1%), and SsangYong Motor Co. Ltd. (6.6%). Imported cars maintain a limited aggregate market share of about 2.2%, mostly limited to the luxury segments, and do not pose an immediate threat.
Forex Rates, Rising Costs Threaten Profits
The big five Japanese and Korean automakers are shifting domestic production capacity overseas to become more competitive on the global stage and minimize the impact of foreign exchange fluctuations. But in spite of their efforts to localize production capacity and procurement, exposure to foreign currency fluctuations remains a key issue that may affect these companies' profitability in the future. Riding a weaker currency in 2005, Japanese automakers generated profit windfalls from exports. During the nine months ended in December 2005, Toyota's operating profit was boosted by ?130 billion from favorable foreign exchange rates, Honda benefited by ?75.5 billion at the pre-tax level, and Nissan's operating profit was also boosted by ?62.1 billion in the same period. Earlier in 2003 and 2004, the Japanese automakers had faced an appreciation in the yen against the U.S. dollar, but were able to withstand the 7% appreciation, due to their continuous cost-cutting efforts and localization strategies.
Toyota is developing a global supply chain based in Thailand through its "Innovative International Multi-Purpose Vehicle" (IMV) project, which aims to build a global operating platform for building vehicles and supplying components entirely from outside Japan. This is expected to reduce foreign currency exposure in the future. Production of the IMV series started in Thailand in August 2004. After building the IMV series in Thailand, Indonesia, South Africa, and Argentina, Toyota plans to ship the vehicles to more than 140 countries and regions. Faring less well, the Hyundai group's earnings have been affected by a strengthening won, as the automakers still export a considerable proportion of their vehicles. In 2005, the won gained by about 10.1% against the U.S. dollar and 10.2% against the euro. Combating this risk is clearly a priority for the Hyundai group. If their new production facilities in the U.S. and Europe can dodge the pitfalls often associated with opening new plants, the automakers will be able to reduce their exposure to foreign exchange rate movements. Without a track record of success, though, they cannot assume the new facilities will quickly help offset currency risk. The dependence of Hyundai and Kia on Korea-based production also leaves them exposed to troublesome labor relations and rising labor costs, which are steadily outpacing domestic inflation rates. In fact, while their operating results over the past few years have been robust, the erosion that has occurred stems mostly from foreign exchange and labor cost factors. High raw material costs, particularly the price of steel, which rose 60% in 2004, are yet another drag on the companies' earnings. Although some steel price cuts were seen in 2005, relief from high steel prices is not expected in the short term, but cost-cutting efforts through increased platform integration, reduced number of suppliers, and shared R&D efforts between Hyundai and Kia should help improve the group's cost structure. Hyundai is also aiming to buy steel and parts suppliers to augment its auto businesses. However, any benefits will not be seen for some time, making Hyundai's ability to raise average selling prices and market share increasingly critical for boosting its pressured margins. The 20% rise in steel prices Japanese automakers saw in 2004 was less severe than that experienced by the Koreans, and the Japanese automakers were able to absorb the increased material costs through cost cutting. Another concern for Toyota, Honda, and Nissan is the increased administrative and R&D expenses associated with expanding their overseas operations, which Standard & Poor's believe could put pressure on earnings for the next 1-2 years. In fiscal 2004, Honda's R&D expenses (?467.7 billion) accounted for 5.4% of total sales. This ratio surpassed Toyota (?755.1 billion, 4.1% of sales), and Nissan (?398.1 billion, 4.5% of sales). Honda plans to increase R&D expenses 8.8%, to ?509 billion, through fiscal 2005. Despite the high costs, the Japanese automakers' strong cash generating capabilities should allow them to maintain their strong R&D advantages and pursue new cutting-edge technologies. One example of the big Japanese carmakers' technological leadership is their success with hybrid cars. Toyota launched the world's first commercially viable hybrid car in 1997, followed closely by Honda, which also possesses some of the most advanced technologies in the field. As first adopters, these companies could be well positioned if the shift away from fossil fuels becomes a stronger commercial reality.
Ownerships And Alliances Play A Role
The Hyundai chaebol is tightly controlled by the Chung family, which has in the past put family interests ahead of creditors' and shareholders' interests. The family has disproportionately strong control over the group's management despite having only 5.2% direct ownership in parent company Hyundai. Although the risks of further support being extended to a group credit card company have been reduced, aggressive expansion plans by other group companies, such as INI Steel, raise concerns of future financial burdens if the projects prove to be unprofitable. So far, though, Hyundai's principle of prioritizing support to group companies over investor interests has not compromised its domestic and overseas access to capital markets and lending from financial institutions. But on the other hand, the group's growth goals will likely prevent Hyundai from achieving the balance-sheet strength that characterizes some of its stronger investment-grade peers at least in the short term. And with a dynamic group chairman willing and able to drive an aggressive strategy, it's unclear who would step on the brakes should the expansion costs surpass the group's means. Of the Japanese automakers, Nissan is clearly the most influenced by its ownership ties to a foreign automaker, Renault S.A.. With strong cross-ownership -- Renault owns 44% of Nissan; which owns 15% of Renault -- Renault's management exercises a degree of control over Nissan and has been instrumental in achieving the financial turnaround at Nissan. The two companies are closely coordinated strategically and operationally, and starting in 2005, the companies have a common CEO, Carlos Ghosn. Suffering a failure in a previous alliance attempt several years ago, Honda has since been keen to retain its independence. It has kept to its strategy to grow organically and has not been involved in large alliances, mergers, or acquisitions. Consequently, Honda is likely to maintain its large net cash position over the next few years. Toyota, however, has bought into an alliance with Fuji Heavy, makers of Subaru cars, buying 8.7% of the company's total outstanding shares from General Motors for about ?35 billion in late 2005. But given the size of the investment, it had little impact on Toyota's financial profile. The alliance will likely enable Toyota to utilize excess capacity at Fuji Heavy's U.S. plant to meet the strong demand in the country. Overall, Standard & Poor's expects the risk that support will be needed for Fuji Heavy or other non-strategic group companies will be limited, given that Toyota has mostly resisted participating in bailouts in recent years. The company's close relationships with highly competitive and financially strong suppliers in the Toyota group, including Denso Corp. and Aisin Seiki Co. Ltd., are additional strengths supporting its highly competitive cost position. Clearly, the giant automaker can afford to chart its own destiny. That's a position ailing American giants GM and Ford can only dream about these days.