Arguably the greatest manufacturer in the world, with the 9th most valuable brand on the planet according to Business Week, is hiding in plain sight in a 16 year bear market in Japan. Toyota looks on its way to becoming the largest automaker in the world, which of course is not necessarily a good thing. Automaking is an awful business for most of its players. The list of disasters in this industry starts with GM but goes well beyond that. And many Japanese companies have become the biggest in the world at what they do while sacrificing shareholders for market share. Toyota is very different from what one might assume based on its industry and its country.
The more we learn about this company the more we like it. Here’s something from the Wall Street Journal July 14th. They survey the hottest car models in the U.S. defined as the ones that spend the shortest time on the dealers’ lots before being sold. 7 out of the top 8 were Toyota models. And it ranged across all their brands, from the Prius at #1, to Scion, to Toyota and Lexus. We woke up this morning to CNBC reports that GM is cutting sticker prices on its models just as Toyota is raising prices on theirs. We believe Toyota has latent pricing power.
By our analysis it trades at a 10% free cash flow yield after backing out our estimate of net cash on the balance sheet ex the finance sub. We’ll go into a little more detail below. The auto business earns a mid teens return on capital unlevered and it grows.
Why are Toyota ADRs not a core holding in every large cap mutual fund? We have no idea. Toyota is as global a company as any U.S. multinational. They have an excellent IR department in New York who are very helpful, they file financials as clear and useful as any U.S. company, and they translate their quarterly conference calls into English. We suspect American mutual fund managers will increasingly come to realize that their “auto weighting” doesn’t have to be GM or Ford, which increasingly looks like a choice of electric chair or firing squad. They can own Toyota.
Toyota and Lexus are regularly #1 and 2 in quality surveys. Toyota’s Lexus is the leading luxury car brand in the United States, ahead of BMW and Mercedes. The company is the leader in emerging hybrid technology, which they are getting ready to ramp up big. Read their last two annual reports and you might conclude as we did that they are very transparent with disclosure and despite their insular culture they are surprisingly shareholder friendly. They are ultra conservative financially, and they hold a lot of cash, but it would be hard to argue with their capital allocation in any other respect.
Toyota is a growth company, and it grows by investing with returns above a reasonable cost of capital unlike the rest of Japan which seems to be satisfied with a return above the miniscule Japanese bond yield. The growth case we would make by three simple points. 1) look at the history of the company over decades – it grows; 2) Our two favorite numbers on Toyota are 12% and 5%, which is their market share in North America and Europe, respectively. We don’t see any reason why those numbers can’t be 20% and 10% down the road. In other words, they are far from a saturation point; and 3) As we will demonstrate below when we get into the numbers, they grow by reinvesting at high incremental returns.
They have gained share consistently and we have no reason to believe that will stop. If they are doing that at the expense of profitability, you sure don’t see it in the numbers. They strike exactly the right balance between market share gain and profitability.
Let’s talk valuation alongside profitability – the two go hand in hand. The valuation looks cheap on the surface at 1.4x book, 11.4x earnings, with earnings roughly equal to free cash flow. Of course there are a lot of automakers which would be overvalued at such ratios. But dig into the financials and get to know the numbers and it gets better than that.
The key to the numbers is at the back of the annual report – the breakout of the auto company and the finance sub. Management does not highlight these numbers (they don’t hype anything), but the numbers are fully disclosed. You need to work through these numbers, with the goal being to figure out how much of the securities on the balance sheet are what we would call “cash and equivalents” and how much are cross-holdings in suppliers. That is the key to the valuation, because it allows you to back out the right amount of excess cash from the valuation and then allows you to calculate the kind of return on capital this business really earns ex its cash hoard. The annual report gives enough data to get a good estimate of that excess cash number.
You will recognize if you look at the segment disclosure in the 20-F that most of the debt you see on the consolidated balance sheet is the finance sub. The finance sub is earning 170bp on assets and is capitalized with 9% equity so I see no reason not to deconsolidate the finance sub (its cash and securities and its debt) for the very important calculation of what excess cash really is.
It is important to recognize that not all of the “investments” on the balance sheet are cash and equivalents, or you’ll wind up overstating the number. The Liquidity section of the Management Discussion and Analysis gives some clues as to how much of this to include in your calculation, and their footnote on bond investments gives another clue which confirms the range of the number. You don’t want to be including cross shareholdings in suppliers in Cash and Equivalents.
What we came up with and confirmed with the company – it is not at all immediately obvious – is that if you deconsolidated the finance sub you are left with about $2.2 trillion yen of excess cash – that’s about $12 a share on the ADRs.
That leads to adjustments to both the valuation and return on capital calculations (the market cap and the equity need to be adjusted for excess cash to understand the true economics which can be summarized as follows:
1) What we come up with is a 10% free cash flow yield. There is nothing funny about that free cash flow – earnings come through the pipe as cash for this company.
2) We see an auto business which earns 14% on capital UNLEVERED, and a finance sub which earns about 18% on equity, 170 on assets. Those look like pretty good returns for 1.4x a very clean book value.
We’re pretty sure that five years from now Toyota is going to be bigger than it is today with fewer shares outstanding (they buy back a good deal of stock and this is not an options culture to say the least).
In terms of valuation we see no reason why Toyota is not worth 15 or 16x earnings, and adjusting for the balance sheet that gets us to about $110 a share on the ADRs as a reasonably conservative valuation. ($6.50 of trailing earnings x 15 + $13 of excess cash).
We have no idea when it goes up, but we just see a significant mismatch between quality and valuation here that will close at some point.