Question

1. Explain the key drivers of financial risks inherent in the motor vehicle industry where Toyota operates.                                                                      [5 Marks]
2. Critically analyse how Toyota has managed to use financial instruments to hedge against risks and cite specific illustrations of these successes.

Answer 1

1-A) Toyota

To hear American car makers and the United Auto Workers tell it, government assistance is non-negotiable. Cash infusions courtesy of the taxpayer are necessary to protect a vital industry, keep people employed, and maintain Detroit’s place as one of commerce’s "shining beacons." Yet the world’s largest car company manages to not only survive without help but generate $272 billion in revenue for FY2019. Toyota Motor Corp. (TM) generates revenue through three primary operations: automotive, financial services, and other business, including the manufacturing of non-automotive machines and various other activities.

Headquartered in Japan, Toyota began in the 1920s as a loom manufacturer. After developing and selling the patent for an automated loom, founder Sakichi Toyoda entered into the automobile business. The first Toyota vehicles were built in the early 1930s, while the Toyota Motor Company was established in 1937. First focusing on compact cars, Toyota eventually expanded to produce pickups, SUVs, trucks, sports cars, and other vehicles as well. Along the way, the company developed into one of the largest automotive manufacturers in the world; indeed, as of 2017 Toyota is the largest manufacturer globally.

Toyota produces 10 million vehicles annually, 2.8 million of those in North America. And that latter number is expected to grow thanks to economies of scale. The Japanese automaker consolidated its United States operations in Plano, Texas, where it will move the production capacity of 11 manufacturing outlets and three distribution networks, along with the company’s North American sales, marketing, and financing headquarters.

B) Toyota's Business Model

Toyota generates the large majority of its revenue from its automotive business, which can be further divided into separate subsegments based on brand and geographic focus. In total, the company sold just under nine million vehicles in FY2019. The company also earns revenue from its financial services branch and through a third, much smaller wing that focuses on miscellaneous business.

Key Takeaways

• About 90% of Toyota's revenue comes from automotive sales.
• A smaller portion of the company's revenue is generated by its financial services department, as well as other business operations.
• Besides passenger vehicles, Toyota also manufactures forklift trucks and various other machinery as well.

C) Toyota's Automotive Business

Toyota's automotive business has multiple distinct business units, each a paean to streamlined Japanese efficiency. The first and most profitable of those is Lexus, the automaker’s renowned luxury brand. The company feels strongly enough about Lexus that the unit is under the direct supervision of the company president.

Last year, Lexus celebrated its 10 millionth vehicle sold throughout its history, including both coupes and sport-utility vehicles. Despite being a Japanese brand, one that technically sells worldwide, Lexus sells a hugely disproportionate share of its vehicles in the United States, with North American Lexus sales figures typically in the area of 300,000 per year.

The Lexus brand originated in the early 1990s as a competitor to other mass-market Japanese automakers’ new luxury brands, such as Honda’s Acura and Nissan’s Infiniti. A generation later, Lexus has surpassed those brands to compete directly with the heavyweights of the luxury division, including BMW and Mercedes-Benz. So far, success for Lexus at the next level has been less than forthcoming.

D) Toyota's Financial Services Business

Unlike some other major car makers, Toyota derives a relatively small portion of its revenue from its financial operations. While Toyota’s financial services division is growing faster than automotive sales are, the company is still a manufacturer first and a lender second. Automotive activities accounted for almost 90% of worldwide revenue last year, while financial services barely generated 6%.

Toyota Financial Services is the subsidiary that focuses on automotive sales financing, credit cards, and other related services. It operates in roughly 30 countries, covering about 90% of Toyota Motor Corporation markets.

E) Key Challenges

Although Toyota is a dominant automotive company, it nonetheless faces a wide variety of challenges. One of the biggest of these is competition, particularly from other well-established vehicle makers around the globe. Because Toyota now competes in all classes of vehicles, it faces threats to its sales from several rivals.

Adaptation is Key

In order to remain successful, the company must also continue to adapt. Although Toyota enjoys tremendous name recognition and customer loyalty, changing tastes, new technologies, and an invigorated sense of environmental responsibility on the part of customers require that Toyota invest large amounts of money in developing new products and tools. If Toyota does not anticipate how the automotive industry will change and react accordingly, it may lose business.

F) KEY RATING DRIVERS OF FINANCIAL RISK

#Resilient Profitability: The increasing use of platform technology and common components should help Toyota to support its cost reduction plans. Toyota will roll out the new Camry Hybrid to Western Europe on its Toyota New Global Architecture (TNGA) in the first quarter of 2019. The company also plans to use TNGA in half of the models it offers by 2020. Such efficiency measures support improved earnings visibility.

#Leading Scale, Technology, Product Line-Up: Toyota will remain among the top global players in the sector based on its massive scale, the breadth of its product line-up and leadership in hybrids. The recent development of a new continuously variable transmission (CVT) reflects that environmental performance remains a core focus, a key differentiating factor given increasingly stringent regulation worldwide.

#Accelerating Technological Shifts: Fitch takes a positive view of Toyota's strategic approach to new technology, which we regard as careful and balanced. The company has taken decisive steps to address key issues, such as autonomous driving, robotics and the trend towards car-sharing by setting up the Toyota Research Institute headquartered in Silicon Valley.

#Stronger Yen, Intense Competition: A stronger yen and increasing competition, especially in North America, remain among the key risks Toyota faces. Fitch expects a negative forex impact to reduce earnings from the industrial operations in the near term and sees further risks in view of rising US interest rates. Increased local production and a highly competitive product line-up should help Toyota to mitigate these risks.

#Increased US Auto Tariffs: Higher US tariffs on imported automobiles and parts would negatively impact Toyota's profits and cash flow. Toyota operates 11 manufacturing facilities in North America and in January 2018 announced a joint plant with Mazda Motor Corporation in Alabama due to open in 2021. Production in North America amounted to nearly 2 million units in 2017 and Toyota has heavily invested in its US facilities, but imports of vehicles and parts are significant, leaving the company exposed to the threat of a tariff hike. Fitch believes, however, that Toyota's exceptionally strong financial profile would enable the company to withstand the adverse impact of a tariff increase.

#Strong Financial Profile: Toyota's ratings are supported by an exceptionally strong balance sheet and sustained free cash flow generation. The company maintained a conservative financial profile over FY15-FY18 (fiscal year ends 31 March) despite investments in new technology and regular dividend pay-outs. Fitch expects Toyota to maintain FFO adjusted gross leverage sustainably around 1.0x and a net cash position through the cycle, supported by resilient earnings and cash flows.

#Financial Arm Reliant on Short-Term Debt: Compared to peers, Toyota has higher short-term debt in its financial services operations, which may face refinancing risks during a downturn. For instance, US-based Toyota Motor Credit Corporation's (TMCC; US operations only) short-term debt, mainly commercial paper, made up 51% of total debt at FYE18. This compares to a ratio of short-term debt to total debt of 40% for Honda's American Honda Finance Corporation (US and Canada) at FYE18. However, Toyota's cash balance and free cash flow generation - even before considering committed credit facilities - provide adequate cover to this liability.

G) RISK FACTOR

Operational and other risks faced by Toyota that could significantly influence the decisions of investors are set out below. However, the following does not encompass all risks related to the operations of Toyota. There are risk factors other than those given below. Any such risk factors could influence the decisions of investors. The forward-looking statements included below are based on information available as of June 25, 2012,the filing date of Form 20-F.

Industry and Business Risks

The worldwide automotive market is highlycompetitive. Toyota faces intense competition from automotive manufacturers in the markets in which it operates. Although the global economy is gradually recovering, competition in the automotive industry has further intensified amidst difficult overall market conditions. In addition, competition is likely to further intensify in light of further continuing globalization in the worldwide automotive industry, possiblyresulting in further industry reorganization. Factors affecting competition include product quality and features, safety, reliability, fuel economy, the amount of time required for innovation and development, pricing, customer service and financing terms. Increased competition may lead to lower vehicle unit sales, which may result in a further downward price pressure and adversely affect Toyota’s financial condition and results of operations.

2-A) Analyse how Toyota has managed to use financial instruments to hedge against risks

#Derivative financial instruments:

Toyota employs derivative financial instruments, including foreign exchange forward contracts, foreign currency options, interest rate swaps, interest rate currency swap agreements and interest rate options to manage its exposure to fluctuations in interest rates and foreign currency exchange rates. Toyota does not use derivatives for speculation or trading.

#Fair value hedges:

Toyota enters into interest rate swaps and interest rate currency swap agreements mainly to convert its fixed-rate debt to variable-rate debt. Toyota uses interest rate swap agreements in managing interest rate risk exposure. Interest rate swap agreements are executed as either an integral part of specific debt transactions or on a portfolio basis. Toyota uses interest rate currency swap agreements to hedge exposure to currency exchange rate fluctuations on principal and interest payments for borrowings denominated in foreign currencies. Notes and loans payable issued in foreign currencies are hedged by concurrently executing interest rate currency swap agreements, which involve the exchange of foreign currency principal and interest obligations for each functional currency obligations at agreed-upon currency exchange and interest rates.

For the first nine months and the third quarter ended December 31, 2016 and 2017, the ineffective portion of Toyota's fair value hedge relationships was not material. For fair value hedging relationships, the components of each derivative's gain or loss are included in the assessment of hedge effectiveness.

#Undesignated derivative financial instruments:

Toyota uses foreign exchange forward contracts, foreign currency options, interest rate swaps, interest rate currency swap agreements, and interest rate options, to manage its exposure to foreign currency exchange rate fluctuations and interest rate fluctuations from an economic perspective, and for some of which Toyota is unable to or has elected not to apply hedge accounting.

B) Cite specific illustrations of these successes.

Toyota's success is no accident. It has been cultivated through high quality design, unyielding innovation, and bold moves. They're responsible for some of the most impressive sports cars ever produced. Many people also think of Toyota as the company that brought hybrid technology to the forefront of the market.

Toyota's future success depends on its ability to offer new innovative competitively priced products that meet customer demand on a timely basis. Meeting customer demand by introducing attractive new vehicles and reducing the amount of time required for product development are critical to automotive manufacturers. In particular, it is critical to meet customer demand with respect to quality, safety and reliability.

The timely introduction of new vehicle models, at competitive prices, meeting rapidly changing customer preferences and demand is more fundamental to Toyota’s success than ever, as the automotive market is rapidly transforming in light of the changing globaleconomy. There is no assurance, however, that Toyota will adequately and appropriately respond to changing customer preferences and demand with respect to quality, safety, reliability, styling and other features in a timely manner.

Even if Toyota succeeds in perceiving customer preferences and demand, there is no assurance that Toyota will be capable ofdeveloping and manufacturing new, price competitive products in a timely manner with its available technology, intellectual property, sources of raw materials and parts and components, and production capacity, including cost reduction capacity.