Toyota’s forecast provides some light in a murky earnings season

An earnings season with no earnings forecasts is pretty dull, to say the least. So kudos to Akio Toyoda for his decision to provide earnings guidance - at a time when most Japanese industrials are neglecting to even hazard a guess at what the pandemic will do to their P&L. Toyota Motor expects a 22% fall in unit sales, 20% in revenue terms, and an 80% fall in OP for FY3/21 to Y500bn. That will probably prove conservative, as it often has before: coming out of the financial crisis, Toyota forecast a loss of Y850bn at the start of FY3/10, then went on to make a profit of Y148bn. Admittedly it was reeling from the shock of a Y460bn loss the previous year, on the back of a 22% revenue decline, so that forecast was given under some duress.

This new forecast may also be wrong. But what is interesting is Mr Toyoda’s assertion (in the Nikkei JP | EN) that the ability to remain profitable is the outcome of “strengthening the corporate structure,” which is Japanese-manager code for cutting costs. As it turns out, apart from the GFC and the recovery from it, Toyota’s gross margin and SG&A/sales have been highly consistent; it is spending the same SG&A to sales today as it did in 3/08, before the crisis hit, while gross margin is slightly lower (mainly due to currency):

blue: gross margin, red: SG&A/salesSource: S&P CapitalIQ — **blue**: gross margin, **red**: SG&A/sales
*Source: S&P CapitalIQ*

Cost cuts in a crisis predict better performance beyond it

But wait a minute - look at that SG&A/sales line after FY3/09: having spiked to 12% with the fall in sales, Toyota had it down below 10% even before the top line and gross margin recovered - in fact it took some Y700bn out of SG&A by FY3/12. Perhaps what Mr Toyoda is really telling us is that the company will be even better at cutting overhead this time than it was post-Lehman?

If so, does that mean Toyota is a particular standout in its ability to cut costs in a crisis? Or will other companies be just as successful at doing so? If so, that might also be an indicator of likely operating performance coming out of the crisis. McKinsey reckons so - in a recent, excellent piece here. This is the killer quote:

“...resilient companies—those that most successfully weathered the 2008 downturn ... achieved three times the improvement in operating expenses as a percentage of revenue than their “nonresilient” peers, and did so substantially earlier, “saving their powder” and preserving capacity to invest in growth, while keeping SG&A in line with sales as revenue fell. Additionally, most companies classified as resilient stand apart from peers on multiple financial and operational metrics through both downturns and recovery…”

The article covers a number of stages of downturn and recovery, and provides a roadmap for CFOs to deploy SG&A in a sensible way both on the way down, and back up again as the business recovers. We believe this is particularly important for Japan - where managements are not known for nimbleness; fast reactions now might well enable a competitive advantage later.

the financial crisis SG&A “Crash diet”— and abenomics rebound

With that in mind, let’s investigate in relation to other listed companies: if a management has historically been adept at cutting SG&A, that might well mean we can count on the same in the coming couple of years. Time to run a screening. We looked at more liquid names in Japan to see who cut SG&A the most in FY3/12 vs FY3/08 - the “crash diet” phase - and while we are at it, we’ll check to see if any of them managed to keep the weight off, by maintaining or reducing SG&A/sales further. Our suspicion is 10 years of up-cycle plus labour and other cost inflation during the Abenomics era mean avoiding a rebound has been quite an achievement.

We’ll compare within broad industry groups, because of the difference in cost structures and also because like companies will generally have similar accounting treatments (i.e. comparable SG&A).

autos and parts - who was asleep at the wheel?

And the winner is… Mazda Motor. Carlos Ghosn might have been known as le cost-cutter at Nissan, but perhaps he was asleep at the wheel post Lehman? Nissan’s 33% SG&A cut pales in comparison with Mazda, which not only brought SG&A down by 56% from FY3/08 to FY3/12, but also reduced the ratio to sales further, even as the top line recovered after that. Toyota Industries wins the prize for the worst rebound since FY3/12; and the mothership Toyota Motor itself has been… nothing if not consistent.

Machinery - the McKinsey analysis plays out

Here, McKinsey’s analysis seems to play out: higher growth and higher margin names generally outdid their peers post GFC (Fanuc and SMC beating Yaskawa and CKD; Komatsu outdoing HCM). The story post FY3/12 is rather different, however, and Fanuc and Komatsu, along with Nabtesco and Kurita, look like having the most rebound fat to cut from here. Meanwhile the Heavy Industry names are looking a little heavy round the SG&A waistline, which may prove to be a burden in view of massive production cuts at their customer Boeing, and engine-making partner GE (WSJ here).

Elec components/elec machinery - habitual cost-controllers

A seriously hardcore bunch: six companies who cut SG&A/sales from 3/08 to 3/12, and then carried on to do more from 3/12 to 3/19, though the size of cut needed was not as great as for the autos. Arguably Keyence should be in the previous table (we relied on S&P CapitalIQ’s taxonomy), where it would have been a close second to SMC. Congratulations to the other five champions at cost control, among which Kyocera is a conspicuous laggard since the March 2020 lows…

Hopefully this analysis provides some clues as to which manufacturers will be best at managing the COVID-19 crisis, when it comes to cutting costs. Assessing them fully also requires an understanding of the end markets and, perhaps now more than ever, the quality of management. We are here to help - please get in touch.

Parent-child listings are up for negotiation

As we discussed in our first post, when markets are in crisis, corporate Japan tends to err on the side of caution when it comes to deploying capital. However, the longer term trend of corporate governance reform remains in play - and one of the highlights of that for us is the government’s encouragement of reform in companies with a group structure. As longtime observers of Japan’s most diverse, complex and often challenged companies (a thankless task, but someone has to do it), we are very interested in how those groups address the thorny issue of listed subsidiaries.

Why think about this now? We believe managements are not stupid, and at this time of market dislocation it may be that a subsidiary previously deemed expensive to buy in, becomes substantially cheaper because of greater exposure to the ravages of coronavirus; in some cases it is possible the subs become distressed (some are already at distressed valuations). Alternatively, it may be the parent struggling - and the sub thriving, at least in terms of its valuation, making it a source of funds.

Better group governance is a government policy

The background to this thinking is nearly a year old - that’s how long we have waited, in vain, for METI to translate its Group Governance System Guidelines released in June 2019 (here - a mere 142 pages, 20 in summary form), but there is no sign; thankfully, Nagashima, Ohno and Tsunematsu have provided a very helpful English précis (here). The guidelines emphasise how Groups are expected to manage their businesses as a portfolio, and to consider who is the “right” owner of a given business: therefore there should sometimes be a need for disposals as well as additions to optimise the Group’s structure.

In relation to listed subsidiaries, the guidelines identify the many conflicts of interest between majority and minority shareholders, as came to the fore in Z Holdings’ (then Yahoo! Japan) spat with Askul. Historically, a listed parent could dominate the subsidiary at will, and without penalty, apart from potential reputational damage; but this state of affairs is no longer to be tolerated. There will also be times when a subsidiary - ostensibly independently managed - takes actions (large M&A for instance) which substantially impact its balance sheet, and therefore that of the parent too, through consolidation; especially if the sub takes a rather different view on the use of leverage.

Leading groups are already walking the walk

Managements who read and fully digest these guidelines will reach the conclusion that in many cases, their Group’s governance structure does not really allow for majority-owned (or deemed-controlled) subs to be both listed and independently managed, as the guidelines require. As it turns out, the managers who helped write them took them to heart: it’s no coincidence that Mitsubishi Chemical Holdings’ Chairman, Mr Kobayashi, who was heavily involved, soon after saw fit to buy-in drug-making subsidiary Mitsubishi Tanabe Pharma. Hitachi (also represented on the committee) is also committed to tidying up its listed subs, a process that has been ongoing for years, but accelerated recently. Also involved were representatives of Toshiba, Mitsubishi Heavy, and Shiseido; not coincidentally Toshiba has also been hard at work buying up its subs. We expect far more listed subsidiaries to be rolled up, or sold down, in the coming year or two, and the recent price action may accelerate the process where it has created a disparity in valuations.

We have screened for Japan-listed names with 40%+ ownership by another Japanese listed entity, and include the indebtedness of the parent and the size of the outstanding unowned stake in relation to market cap to give some idea of “affordability” at today’s prices - this list is just the subs who have underperformed their parents and therefore increased the likelihood of being bought in. Please contact us to learn more and to receive the rest of the list - names that have outperformed, and might be sold down by a parent needing cash, for instance.

Cash crunches and weak end markets could prompt reforms

We also wonder whether the current crisis might bring about some long-anticipated changes: is it too far-fetched to think Toyota Motor might finally begin reforms of its convoluted group structure and governance? This network of holdings of course stretches far beyond just the listed subs in the table above. As the Nikkei writes here (JP lang only), the cash crunch from production and sales stoppages (not to mention damage from falling residuals of leasing fleets) is going to put greater pressure on auto OEM and parts maker balance sheets at a time when CASE (connected, autonomous, shared, electric)-related R&D and investment still need to be ramped up; but that’s a story for another post.

Speak softly, but carry a large “brick”

Investors in Japan may, in many cases, be unfamiliar with the Group Governance System Guidelines (METI, please translate them). This is a shame, given both Japanese companies' propensity to own large numbers of unrelated businesses with no synergy, and also the sheer volume of listed subs where either the listing, or the capital relationship itself have outlived their usefulness. At least minority investors are now encouraged to engage with company management on this topic; our suggested approach is to speak softly, but carry a large “brick” - in the form of a hardcopy of the GGS guidelines.

Cost cuts in a crisis: will Toyota be the car in front?