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Morningstar | Toyota's Fiscal Third Quarter Hit by New Accounting Rule but Cash Flow Not Impacted

We are not changing our Toyota fair value estimate despite the company lowering its fiscal-year 2019 guidance in its fiscal third-quarter results. The guidance change is only at the net income level and is mostly due to a noncash charge for unrealized losses under ASU 2016-01 for the firm's many public equity holdings as these securities declined in value at the end of calendar 2018. The company's operating metrics remained healthy in our view for the quarter, and management did not change guidance for revenue or operating income.

Net income is now guided at JPY 1.87 trillion from JPY 2.3 trillion in last quarter's guidance. The other negative impacting net income guidance is a revision in full-year equity income to JPY 370 billion from JPY 460 billion. For many automakers, China is the reason for lower equity income as that market has softened, but Toyota's limited disclosures suggest to us that equity method investments from Japan are the problem. It's also possible that management expects fiscal fourth-quarter weakness from China. For fiscal third quarter and the first nine months of fiscal 2019, total company equity method income declined by 74% and 29%, respectively. Toyota disclosed in Slide 6 of its earnings presentation that China equity method income is up JPY 7.7 billion year over year while contribution from Japan is down JPY 107.5 billion.

The new accounting rules for public equity investments, which Toyota adopted on April 1, 2018, will unfortunately mean investors must expect significant volatility following quarters with large stock price movements for Toyota's investments in public companies that it does not account for under the equity method. For fiscal third quarter, the charge was JPY 503.7 billion. This loss, in our view, can be recouped by Toyota once the stocks move up because GAAP in this case allows unrealized gains to also be recorded. This quarter's noncash loss does not concern us that Toyota's dividend needs to be cut.

Earnings in North America continue to be held back by Toyota's U.S. vehicle mix favoring cars over light truck models. In calendar 2018, Toyota's U.S. light truck mix was 63%, up from 58% in 2017, but this ratio still trails the Detroit Three that have light truck mix of 80% in GM and Ford's case and 90% for FCA. Fiscal third-quarter operating margin in North America held flat year over year at just 1%, but the recent launch of the new RAV4 crossover should help results going forward.

Uncertainty for Toyota in calendar 2019 beyond normal cyclical risk is, in our opinion, around U.S. trade policy around vehicles exported there from Japan. Toyota relies on Japan as an export base more than Honda and the highly profitable Lexus sedans, such as the LS and the large Lexus SUVs, are made in Japan. The RX crossover, however, is made in Canada, so Lexus has some protection in case the U.S. and Japan cannot work out a trade agreement. The RX was Lexus' best-selling vehicle in the U.S. in calendar 2018. We calculate that it made up 37% of Lexus' 2018 U.S. volume mix and that 75% of the RXs sold in the U.S. were made in North America.