Toyota parts price cut requests: normality asserts itself

by SR on March 19, 2012

An article in the Nagoya-based Chubu Keizai newspaper reported that Toyota is asking its parts suppliers to accept a 3% cut in prices for the first half of FY3/13 compared to the second half of FY3/12. The article comments that despite this request, auto parts suppliers are also struggling and that negotations are likely to be “difficult”. My take: this signals a return to “normal” pricing and strongly suggests that rumours of massive cuts that were put about in late 2011 are overblown. (Related stocks: Toyota and its entire supply chain – think Denso, Aisin Seiki or in the US companies like JCI.)

There’s no need to make a meal out of this so I’m going to keep it brief. Note that I still prefer auto parts to machinery-related plays and I like tyre stocks such as Bridgestone also due to lower natural rubber prices.

  • Actual cuts in first half of FY3/13 to be smaller than 3% YoY. The article suggests a cut of 3% relative to the second half of FY3/12. This initial figure is a negotiating gambit and the parts companies are not going to accept it lying down (the widespread perception that Toyota can order its core suppliers to do whatever it wants is unrealistic and inaccurate). I would expect a decline of 1.5% to 2% on average for major suppliers like Denso. For the full year, I would think a figure of between 2% and 3% is reasonable. That’s a little more than usual.
  • But prices to fall more than in FY3/13 than in ‘easy’ FY3/12. Typically a tier-1 Toyota supplier in Japan would see its average selling price fall by between 1% and 2% annually. Moreover, the core rate is pretty stable (essentially determined well in advance) and the fluctuations tend to be superficial. We should still pay attention because changes in pricing can have a significant impact on the P&L statement, but the auto industry does not operate like the tech industry, where short-term mismatches between supply and demand can result in dramatic fluctuations in pricing. You can’t operate like that in an industry where new products take 5 years to develop and have a manufacturing life of 5-6 years; your suppliers will not make the necessary investments to support you if you crush them during the downturns. Nevertheless, after the Tohoku earthquake (as during the global financial crisis of 2008-2009) Toyota deliberately eased off a little on the price pressure to give its suppliers some breathing room as they struggled to reconnect their supply chains. So in FY3/13, I’m expecting Toyota’s parts suppliers to return the favour and give up a little more than they would in a “normal” year. However, averaged over the two years of FY3/12 and FY3/13 those price cuts will probably be in the 1.5% to 2% p.a. range.
  • Surging volumes should drive parts supplier profits. Pricing is going to have an impact, but the real driver of auto parts supplier profits is going to be a sharp increase of volumes compared to FY3/12. That is to some extent an issue of there being a low base for comparison. The earthquake had a pretty dramatic impact on output in the spring and the Thai floods in the autumn stole another month or so of output from a major manufacturing base. With those factors out of the way – and with new Toyota models being rolled out – we should see a pretty substantial increase in volumes. Suppose Denso sees its volumes grow by 10% YoY in FY3/13 (a figure that is unlikely to make its way into initial management guidance). With marginal profitability of about 35%, the Y311bn increase in revenue from Y3,110bn in FY3/12 (guidance) to Y3,421bn would likely generate additional operating profit in the region of Y109bn on top of the Y135bn expected by the company in FY3/12. Plus you can add back one-off costs in FY3/12 of Y16bn related to the quake and Y12bn related to the floods so call it Y28bn. Y135bn + Y109bn + Y28bn = Y272bn in OP for FY3/13, at least in theory. In practise I feel that could be a bit ambitious – depreciation and price cuts will shave some of that off – but there are cost reductions to be had as well as potentially weaker forex, so it could well be in the Y250-Y300bn range.
  • Despite alarmist reporting, no change in basic dynamics. An article on Bloomberg in early October 2011 gave the impression that Toyota had herded its suppliers into a room and told them to cut prices by 50%. This was a seriously misleading piece of “journalism” although there was effectively no concrete information and thus nothing to disprove. We talked to the right-hand man of one of the committee members that organised this supplier event and it was a far more nuanced outing, basically consisting of Toyota saying to the smaller, more timid Japanese suppliers, “come on guys, let’s shift production overseas as quickly as possible, where it makes sense”. I think that 50% figure came from Toyota showing suppliers the price at which it needs to sell an entry-level car in developing markets like India and Brazil and extrapolating from that the necessary cost of parts. For a new part, developed specifically for a low-cost car in a low-cost market, a bill of materials 50% lower than a typical part for a Corolla in Japan or the US is easily possible. But 50% cuts on existing parts? Laughable. So, by all means let’s explore scenarios such as whether price cuts in FY3/13 will be 2.1% or 1.5% or 3.2%, but the mere fact that figures of this familiar magnitude are being put out there suggests that Toyota’s business model is not being jettisoned, though it may be tweaked. And that’s reassuring for the parts suppliers.

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