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Toyota & Tesla, Comparing Apples to Lemons




What Does Toyota Fundamentally Do?

The Toyota Motor Company (TM) exists to produce passenger vehicles for the retail and commercial markets. These vehicles are both produced and sold globally, with R&D and a large part of manufacturing concentrated in Japan.

Individuals and companies purchase TM vehicles for their high quality and relatively reasonable price. The company is able to differentiate itself on quality, and generate a leading ROA of >3% and profit margins of ~5%. TM is able to do this at its price point due to the manufacturing and management processes that have been developed since the company’s founding, commonly known as The Toyota Way or Toyota Production System.

For a sense of scale, the number of vehicles produced per year by TM for the last 5 years are below:




Background

TM was the pioneer of a lean approach to complex manufacturing. It is still the leader in this regard. A lean approach is low in excess; WIP, raw materials and inventory, all of which are reported in the universe of financial statements as assets.


This lean asset base allows TM to produce a consistently strong ROA and net income margin relative to other vehicle manufacturers.


Thesis

TM is a well-run, consistently profitable company, that produces cars of exceptional quality and reliability. Some see it as boring for this reason, but this is the kind of boring I like. Due to its past success with hybrid vehicles, and the low levels of car ownership in the developing world, where TM is already competitive, the company has ample growth opportunities. TM, however, appears to be currently under-priced in regard to these stated characteristics. The company also has significant cash reserves ($USD 40 billion).

Whilst electric vehicles are most likely a disruptive technology, large automakers have contributed significant resources to the development of electric models. What separates TM from just large R&D spend is the fact that TM has been involved in the mass production, and marketing, of hybrid vehicles that share common components and systems with EV vehicles for the past two decades. As a result, TM has developed a significant value network that is currently being utilized for its imminent entry into the EV market. This is not to sell TM’s EV vehicles as just a growth driver, but also as robust downside protection from the market's perceived source of risk.


Contrarian Perspective

I beleive that the market is currently overweighting the downside risk posed by alternative fuel and autonomous,vehicles to existing car manufacturers, and under weighting the degree of difficulty involved in replicating the Toyota Production System (TPS) that allows TM to produce high quality vehicles, profitably, at scale.


Target Price

$185-$231 per TM:NYSE share


Catalysts

Price appreciation will be driven by the slow rationalisation of the market regarding autonomous driving, alternative fuel vehicles, the growth potential offered by emerging markets, and TM’s relative strengths in regard to the latter two.

In addition, TM are in the beginning stage of rolling out an electrified version of all models by 2025. I believe this continuous introduction of new electrified model variants will reset the markets perception regarding TM’s EV capabilities.

Key Financials Breakdown

A common feature of vehicle manufacturers is that they have financial services divisions. The assets of the financial business unit that are recorded on the company’s balance sheet can be categorised into the following three categories:

  • Retail

  • Leasing

  • Wholesale

Retail finance receivables relate to agreements with retail customers. They are primarily brokered by dealers who receive a commission, with TM, the vehicle manufacturer and wholesaler to dealers, holding the final contract with the customer. The retail finance agreements are also secured, with the car purchased with the loan acting as collateral.

Wholesale finance receivables differ significantly from retail finance receivables. Wholesale finance receivables are extended by vehicle manufacturers to their dealers to allow the dealers to purchase inventory from the manufacturer. With dealers on thin margins this is a standard feature of the manufacturer and dealer distribution model.

As the assets and liabilities of the financial services division are reported under the group, the true financial health and characteristics of the more important core vehicle manufacturing businesses is skewed when simply looking at the financial metrics of the vehicle manufacturing companies on the whole.

With dealers lacking the cash reserves to fund the acquisition and storage of automobile inventory prior to sale, it forces manufacturers to extend artificiality cheap financing to their dealer networks. This low-cost financing is more of an inherent cost for the manufacturer of running a dealer distribution network, than a source of income for the financial services division.

To gain a better understanding of the real-world characteristics of the vehicle manufacturing business unit I have made what I believe to be necessary adjustments to the financial data I have pulled from S&P Capital IQ. The result is that the revenue, operating costs and assets associated with the financial business units of TM and the selected comparable companies have been removed. I still believe the effects of the financial business units will be apparent in the below comparisons, though just to a significantly lesser extent.

A comparison of TM’, VW’s, and Daimler’s adjusted net income margins is below[1]:



Also, a comparison of TM’, VW’s and Daimler’s adjusted, and non-adjusted return on assets[2]:



It is evident from the above data that TM is more competent in the core business function of manufacturing vehicles. I’ve highlighted this because after all manufacturing and selling cars is why large auto makers exist in the first place, and their performance in this regard will drive their long-term success.




Industry Analysis, Porter's Five forces Analysis


Threat of New Entrants


  • The consensus view is that the threat of new entrants is low. This view is based upon the fact that the production of vehicles requires billions of dollars of investment in property plant and equipment, and in the hiring and training of manufacturing and research staff. This large asset base also requires significant sales volumes to produce an adequate ROA, more simply understood as economies of scale.

  • For context, TM reported the value of their PPE at $102 billion USD (March 2020), whilst a manufacturer of similar scale, VW, reported the value of their PPE at $74 billion USD.

  • More so than the capital outlay required to enter the automotive industry is the knowledge gap between incumbent manufactures and new entrants. With leading incumbents having the skill and ability to annually produce millions of high-quality vehicles, at an affordable, yet profitable, price.

  • Access to supplier networks is also initially difficult without scale.

  • Traditionally automakers have utilized dealer networks to distribute vehicles for sale. Building an extensive dealer network distribution channel would be both time consuming and costly, with dealers often relying on cheap financing from vehicle manufacturers to fund the purchase of dealer inventory. However, new entrants to the automotive market, such as Tesla, have opted for a direct distribution channel of online selling without any dealer network. Whilst this method of distribution results in the manufacturer capturing the full retail price it is still too early to tell whether it will be a feasible long-term model. The main reason it is unknown is the fact that dealership networks offer valuable ancillary services to owners of that particular networks brand of vehicle, such as maintenance support, sourcing of parts, financing and general guidance in the somewhat complicated purchasing process of a vehicle, which for the vast majority of people is the second largest purchase they make in their lifetimes.



Threat of Substitute Products or Services


  • A developing substitute to owning a vehicle is the autonomous vehicle fleet, as stated by McKinsey & Company here. There has been much fanfare and speculation surrounding the development of autonomous vehicles with many observers and members of the investment community believing that the advent of autonomous mobility will precipitate a decline in the demand for personal vehicles. Whilst there have been significant advances in assisted driving, with full autonomous driving within reach, I believe that the perceived risk relating to the threat of shared mobility is not deserved. While shared mobility will improve, it still does not offer the level of personal ownership and control that owning a vehicle does. Shared mobility is also an old service, with the first taxi being invented in 1897 and the rikshaw in 1879. Whilst shared mobility has improved dramatically since the rikshaw, individuals in urban areas have always had the option to utilise shared mobility services in the place of owning a vehicle. Shared mobility services will certainly continue to improve in convenience and cost with the introduction of autonomous driving, though they will still be unable to offer the equivalent level of personalisation, independence and feeling of control that owning a personal vehicle provides. Being a mature service, one could reasonably assume that the impacts of shared mobility on the sale of personal vehicles have played out. Ironically, I think the most probable outcome of fully autonomous vehicles will be the fact that everyone will want to own one.



Bargaining Power of Customers


  • The buying power of customers is extraordinarily strong.

  • Vehicle manufacturers are the price takers in the relationship with end customers.

  • There are immaterial switching costs between brands, if any.

  • Toyota highlights this in its 20-F report with the following disclosure "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".

  • According to a Statista survey conducted in 2018 the most important factors when deciding which car to purchase, in descending order, were the following:

  • Toyota's focus, evident from its disclosure, is in-line with the results of the survey. Given that these are the primary points of value for the average car buyers, if these features are provided uniformly across all car manufacturers then the bargaining power of the customer is immense.

  • Nearly all car manufacturers produce models that can deliver fuel efficiency, suitability for daily use, driving comfort and design. Meaning that the only real differentiator between car manufacturers is quality and price. Given this, it would be prudent, and I believe correct, to assume, that car manufacturers are ultimately price takers with minimal pricing power.



Bargaining Power of Suppliers


  • Suppliers do not pose a threat of downwards vertical integration.

  • Vehicle manufacturers enjoy a negative working capital balance due to their favourable negotiated contracts with suppliers. Cash is paid upfront by dealers when they purchase cars, though parts are paid for about a month after they are received from suppliers.

  • Due to the numerous amounts of suppliers producing similar components they have traditionally had minimal bargaining power with auto manufacturers.

  • Suppliers are, however, critical to TM's production system which is built primarily on the idea of one-piece flow. With any supplier delays ultimately causing delays in TM's production schedule. TM is actively engaged with its top suppliers to ensure that it can share any of its leading lean production systems and manufacturing knowledge to assist the supplier more efficiently produce components for TM. Whilst this hand holding is beneficial for TM it is fundamentally an extra cost of doing business. Though, given TM's industry leading lead times in developing new models and manufacturing vehicles the benefits of this hand holding appear to outweigh the costs.

  • A tiered supplier category system is used by TM to reward suppliers that consistently meet and exceed targets set by TM. The effect is that suppliers of similar components compete amongst each other to reduce costs, increase quality, improve efficiency, and meet schedules[1]. It is due to this tiered TM supplier system, and the competition it creates, that I am confident in assuming that the bargaining power of TM suppliers is weak. If there was strong bargaining power amongst TM's suppliers there would be no incentive for them to further compete against each other for more favourable contract terms that favour TM’s business.


Intensity of Competitive Rivalry


  • Competition is fierce in the automotive manufacturing industry. Government support programs for local manufacturers also alters competitive forces between manufacturers in certain geographies.

  • The costs of transitioning out of, or exiting, the vehicle manufacturing industry are large. This encourages unprofitable firms to continue manufacturing vehicles at a price point below their break-even point, whilst attempting to develop a strategy that will lead the company profitability. This leads to significant downward pressure being placed on vehicle prices.

  • Whilst there are a large number of vehicle manufacturers focusing on specific vehicle segments, there is nothing stopping a manufacturer targeting a new segment. Customers are constantly offered new options by these manufacturers focusing on new segments, generating significant competitive forces.



The Tesla Obsession



Batteries


  • The easiest way to think of battery technology is to think of Russian Dolls. Battery modules are made up of multiple smaller battery cells that come in the form of either cylindrical, prismatic or pouch cells. Whilst battery packs are made up of battery modules.

  • The key within battery pack systems is the interaction between the software that measures the voltage, amps and temperature of each individual battery cell and the physical design of each component within, and including, the battery pack. Packing all of this together efficiently is where the precision and finesse comes in.

  • It is inherently more difficult to manage these factors the larger that battery packs become, the more power they can store and release, and the more of them you have to manufacture. Tesla appear to currently have the edge with larger battery packs in terms of performance, though TM have gained extensive experience in the two decades they have had in managing battery power within the Prius, and in manufacturing reliable battery packs and procuring electrical components at scale.



Types of Battery Cells

  • Cylindrical:

Cylindrical cells look almost exactly like those in the back of your TV remote and are produced the same way. Tesla use cylindrical cells. They are the cheapest option as well as the easiest to manufacture into battery modules, and then into battery packs.


I am far from an expert in batteries, but I do know that businesses that are yet to be consistently profitable place significant importance on quick cost reductions. It is simply for this reason that I believe Tesla use cylindrical cells largely due to their low cost and ease of manufacture, whilst TM, a manufacturer with a long track record of prioritising safety and quality, opt to use, and invest in, the further development of prismatic cells.


Cylindrical cells have the highest cell level volumetric efficiency, though this is dramatically reduced when looking at the modular level volumetric efficiency. Modular level volumetric efficiency is ultimately counts.


They are the easiest to manufacture with higher tolerances for inaccuracies in module construction. Given Tesla's lack of experience in complex manufacturing at scale their choice of cylindrical cells for this reason is understandable.


  • Prismatic

Prismatic cells are in casings the size of an old VHS tape, and are harder to manufacture than cylindrical cells.


TM's JV with Panasonic, named Prime Planet Energy & Solutions, focuses on the development and production of prismatic battery cells.


Prismatic batteries are easier to service as there are less battery cells required due to the larger size of each cell. Cells are also able to pack closer and more securely together due to their box like shape, with no need of gluing cells together, unlike the cylindrical cells within Tesla battery modules which are glued/bonded together. This allows for eventually further scale of prismatic cell battery pack sizes, as well as easier servicing.



Comparing TM and Tesla’s Approach


The 2017 TM Prius Prime has a battery pack consisting of 95 prismatic cells, with 19 cells per module, whereas the Tesla Model 3's battery packs contain 4416 battery cells in 4 modules. In the Tesla there are two module sizes with two of each size in the pack.

In the Tesla battery pack design no individual cells are replaced, only the module. In the Prius Prime the larger cells are individually replaceable. The cost of replacing a Tesla Model 3 module was ballparked by Elon Musk at under $7000, while individual TM Prius Prime cells cost roughly $700 to replace. Tesla modules are significantly larger and can store more power than a smaller TM Prius module, so you get more battery for your money with Tesla.


On the flipside though, you aren’t required to replace as much battery if a TM battery pack fails. Evidently TM servicing in this regard is better for both the owner’s wallet and the environment.

While these are the respective costs of replacing battery modules, I have not been successful in determining how often, or likely, it is that a vehicle owner will have to replace a battery module or cell. Given this, I am not confident enough to estimate the cost of servicing the battery for each technology over a vehicle’s lifetime.

The point of this brief explainer on battery technology is not for technical purposes, but to give an idea of the approaches of TM and Tesla towards manufacturing cars. TM will not go to market with what appears to be an inferior technology to ease the burden on manufacturing and costs, they will slowly tinker and develop trusted technologies. This is a core pillar of TM’s lean production framework.

In this case it has manifested with the choice of prismatic cell based battery packs, which appear of a higher suitability for EVs due to their compact packing within battery packs, and more modular and less labour-intensive servicing.



Competitive forces

What Are the Biggest Threats and Weaknesses?

The greatest threat is the probability that a rival car manufacturer can replicate TM’s production and management system, or, develop their own unique systems that allow them to introduce vehicle models that offer superior quality at an equivalent or lower price.

Hyundai Motor Group (HM), the flagship car manufacturer of South Korea, are the greatest threat in this respect. In developed markets, and more predominately in emerging markets, HM are introducing competitive small sized vehicles that are both cheaper than TM vehicles (Hyundai Accent 550 million Viet Dong, Toyota Vios 570 million Viet Dong), whilst maintaining a commendable image of quality, re-enforced by generous manufacturer warranties.

In January 2020, the list of highest selling cars produced by the Vietnamese Automobiles Manufacturing Association (VAMA), listed the HM Ascent as the highest selling single model for the month. This was the first time in since 2014 that TM’s similar sized Vios model did not take the top spot.

Despite the above example I do believe that this threat is low, as one of the key drivers of vehicle sales is the introduction of new vehicles to market. TM are currently the leader in the time it takes for new vehicle development, with design times half that of the average manufacturer such as HM. This allows them to respond to any competitive vehicle models quicker than it takes rivals to develop them, mitigating the threat just described.

TM’s ability to develop new vehicles quickly is best described by Jeffrey Liker in his book The Toyota Way:

  • “Toyota engineer new vehicles in Japan in less than one year. Their competitors take over two years. The reason is that Toyota’s engineering work is organized into flow, and efforts are constantly made to reduce waste in the flow. Its engineering work, design decisions, prototype construction, and tool construction, seamlessly flow and ‘communicate’ from the beginning to the end of the vehicle design process. No one produces anything before it is required by the next person or step in the process”

The last sentence is the most telling, as it is this feature that trains the focus of engineering and production teams consistently onto what is needed to be done at a particular point in time.



Does the Company Have a “Moat” Protecting its Business?


TM exists because it produces passenger vehicles for individuals and companies. Why can’t any company, such as Tesla, do this to an equivalent level of scale and quality as TM? If not, then why? I believe due to the following reasons discussed below.

To manufacture vehicles on a global scale, with ROA and net income margins that are amongst the best in the industry, and to do this consistently over the long run, requires an immense asset base, and more importantly manufacturing knowledge.

An asset base can be bought using capital, through debt that leads to increased leverage and increased financial risk, or through equity that leads to further dilution of ownership. It can also be bought using the cashflows generated by the business. TM has been able to build a vehicle manufacturing business using the third option, whilst also accumulating a cash pile of $39 billion USD along the way.

Whilst cashflows reinvested in the company to build, and also maintain, a deprecating asset do not immediately flow to owners, they do allow for further growth as well as the continuation of the current level of production. They allow for this without the financial risk and dilution that either debt or equity capital bring.

This just described is the first moat; TM currently have the asset base to produce approximately 9 million cars per year globally, and can maintain and grow this asset base, with all its plant and equipment, without the need to raise capital.

The other aspect is the fact that to produce vehicles at the scale TM do, whilst maintaining industry leading levels of quality and new model turnout, requires a great deal of manufacturing skill. This skill is in the form of manufacturing and management processes, as well as strategic direction.

They involve TM’s TNGA platform that enjoys immense benefits of economies of scale, with the only other car company enjoying similar benefits from common global car platforms being VW. It involves the TPS that has been imitated but never implemented to the same degree of precision and effectiveness that TM has been able to utilise it within its own processes. (I highly recommend reading The Toyota Way, or at least a summary, to gain a more wholistic understanding of the TPS, which this report does not provide.)

I am backing that it is these qualities, which TM happens to excel at, that are difficult to develop and implement within the vehicle manufacturing industry. TM is able to throw these qualities behind areas offering growth, such as emerging markets and EVs. It is also able to do this in conjunction with the specific vehicle electrification knowledge, and asset base, it has built over the last two decades through its leading position in the hybrid vehicle space.



Valuation

Capital Expenditure and Maintaining the Asset Base

In researching and writing this report I found TM to be more straightforward to understand and pull apart than previous companies I have looked at. Though, in regard to valuation this has not been the case at all, I have found it much more difficult than usual.

The reason for this is surrounding the vast sums of cash spent on capex, and the types of expenditures the company classifies as capex. The below excerpt [4] from the 2020 20-F shows the split of capex spending. The split in 2020 is similar to historical capex spending.



PPE capex is quite straightforward in its treatment, as it should be deducted from FCFE given this spending is required to sustain current levels of operations. Amounts spent on additional PPE are also somewhat straight forward to interpret given depreciation. I have deducted these additional investments in PPE from FCFE in the example valuation method below, though some may determine them as additional discretionary spending and treat them as cash that could flow to equity.

Capex focussed on “vehicles and equipment on operating leases” is where I have encountered the most difficulty. They are defined by TM as:

  • “Vehicles and equipment on operating leases to third parties are originated by dealers and acquired by certain consolidated subsidiaries. Such subsidiaries are also the lessors of certain property that they acquire directly. Vehicles and equipment on operating leases are depreciated primarily on a straight-line method over the lease term, generally from 2 to 5 years, to the estimated residual value. Incremental direct costs incurred in connection with the acquisition of operating lease contracts are capitalized and amortized on a straight-line method over the lease term.”[5]

Simply put they are vehicles TM manufacture, then purchase from themselves, to lease to customers over a 2 to 5-year period. To the customers eye they take the form as seen here, known in Australia as ‘Toyota Access’. Should these amounts be included in FCFE? I really don’t know, there are ways to model intrinsic value for both sides of the argument that I think are strong. The reason I bring this to attention is simply due to the material value of its own vehicles that TM own for leasing, which were booked at a value of $42 billion on the 31st of March 2020.

If the amounts are not deducted from FCFE, then I think the depreciation associated with the leased vehicles should not be added back to FCFE. This is simply due to the fact that the depreciation expense is a good estimate of the cash cost of running the leasing business on an ongoing basis. Or more simply put, to continue running the vehicle leasing business, and reap the rewards flowing through net income, an owner will be required to front up cash to maintain operations at current levels. Given an owner also benefits from the eventual sale of the vehicles concerned at the end of the lease I have added the cash flows from these sales back to FCFE.

The five-year trailing average I calculated is after adding depreciation, the sale of assets held for leasing purposes and subtracting total capex from net income. The amount was calculated as roughly $USD 9 billion per annuum.

Another alternative would be to adjust out all income, depreciation, capex investments and divestments associated with the leasing business. If this was done the value of vehicles being leased could then simply be added to the DCF valuation, with a discount applied to the book value of the vehicles at the analyst’s discretion.

Growth

TM’s sales are largely skewed to Japan and North America, two large economies in the developed world. In the developed world vehicle ownership is prolific, with vehicles owned per 1000 people being 838[6], 730[7] and 649[8], in the U.S., Australia and Japan respectively. In comparison the vehicles owned per 1000 are 117[9], 22[10] and 16[11], in Thailand, India and Vietnam respectively. Evidently the runway for growth in the Indo-Pacific alone is vast.

Given the global nature of the business and the growth runway evident in emerging markets I have used a growth rate of 4%, which is in-line with the long-term average global GDP growth rate.


The Most Subjective Part, Which People Like to Skip to



Brief Closing Remarks on Toyota and EVs

It is reasonable to be disappointed with TM’s movement, or lack of it, in the EV market to date, though that is in the past and the company is moving ahead with its EV roll-out over the next 5 years. The lack of initiative has not eroded the company’s qualities, nor its position as being the leading vehicle manufacturer in the world, and it is the qualities and existing business that you receive when you buy TM, with the disappointment only an influence on the current price.



Footnotes:

[1] S&P Capital IQ, Return on Assets % ex Finance Div = (Net income ex Finance Div) / (Total Assets - Finance Div. Loans and Leases, ST - Finance Div. Other Curr. Assets - Finance Div. Loans and Leases, LT) [2] S&P Capital IQ, Net Income Ex Finance Div MARGIN = (Net Income - Finance Div. Revenue + Finance Div. Operating Exp) / (Revenue from Vehicle Sales)


[3] https://www.ey.com/Publication/vwLUAssets/Cash-on-the-road-working-capital-in-the-automotive-industry/$FILE/cash_on_the_road.pdf


[4]Page 84, Toyota Motor Company Form 20-F March 2020


[5] F-17, Toyota Motor Company Form 20-F March 2020


[6] https://www.fhwa.dot.gov/policyinformation/statistics/2018/pdf/mv1.pdf [7]https://www.abs.gov.au/AUSSTATS/abs@.nsf/Lookup/9309.0Main+Features131%20Jan%202018 [8] https://www.jaspa.or.jp/Portals/0/resources/jaspahp/member/data/pdf/tiiki-hoyuu2019.pdf [9] https://www.statista.com/statistics/596665/passenger-cars-in-use-thailand/ [10] https://www.ceicdata.com/en/indicator/india/motor-vehicle-registered [11] https://www.vietnam-briefing.com/news/overview-automobile-industry-vietnam.html/

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