2023-12-11 17:36:07 ET
Summary
- Toyota's stock has risen by around 36% this year, driven by a rebound in revenue and operating margins and an improved technology outlook.
- The company's new battery technology could give it a substantial competitive edge in the EV market, potentially making EVs a no-brainer against legacy vehicles.
- Toyota's valuation is lower than its historical range, but caution is advised due to competitive and macroeconomic risks.
- Growing auto loan delinquencies in the US and slow global sales point toward potential vehicle sales recession risks from 2024 to 2025.
- While immediate risks are high, TM appears undervalued if we project trends into the late 2020s.
After a series of volatile years, many auto stocks have performed well this year, particularly non-US firms such as Toyota ( TM ). TM has risen by around 36% this year, driven by a sharp rebound in its revenue and operating margins. Interest in the stock is high due to its growing potential as an EV market competitor. Unlike most US peers, Toyota has prevented the UAW union from gaining traction in its supply chain, giving it a competitive advantage in a turbulent labor market.
One primary driver has been the general rebound in vehicle manufacturing activity and the normalization of many input cost factors (semiconductors, etc.) that inflated in 2020-2021. Further, immense market growth for electric vehicles added a strong growth outlook to Toyota's future premium . That said, as with many EV producers, there has been a reversal in EV sales metrics in recent months as price competition grows . Toyota's sales in China also appear to have weakened as that country's economy sours and it struggles to compete in an increasingly saturated EV market.
TM is trading back near its peak price around the end of 2021 and is valued at a forward "P/E" of 9.1X. This valuation metric is slightly lower than its historical range, particularly when we account for its decent EPS growth. That said, the vehicle market is highly cyclical, and although US vehicle sales remain decent, the overall global market appears to be turning over. Given issues in the US auto consumer credit market, I believe we can expect weakness in auto demand next year. Fundamentally, although Toyota does not appear expensive today, I believe investors should exercise heightened caution regarding the stock due to competitive and macroeconomic risk factors.
Solid State Batteries May Change Everything
Vehicle companies can be challenging to value due to their cyclical and competitive natures. Immense innovation does not guarantee significant profit growth if that innovation is being seen across other manufacturers. Without a doubt, still being a market leader, such as seen over a decade ago with Toyota's Prius, certainly gives a temporary edge. Even then, fabulous technology in a poor economy does not necessarily boost performance, at least on the immediate horizon. Further, the capital investments required to create new technologies can be a net negative if heightened profits are not made from such investments.
In my view, the overwhelming positive factor behind Toyota's long-term outlook is the battery technology it unveiled over the summer. The stock has risen by around 30% since it announced a new battery technology that pushes the EV range to 620 to 930 miles . These new " solid-state " batteries are also expected to result in ~10 to 30-minute charging, cost significantly less, and have lower fire and maintenance risks. Further, the company expects this technology to be implemented from 2026 to 2028, making it a horizon that potentially warrants a stock price premium.
If all of these expectations pan out, then Toyota's next era of vehicles will likely have a massive edge over conventional gas-powered cars and other electric vehicles. Tesla ( TSLA ) and others are also working on improved battery technology, but Toyota is likely leading the way in creating a profitably scalable production supply chain for solid-state batteries. These batteries will initially cost more due to their lithium density . Still, they may be more economical to produce at scale with a more extensive manufacturing base in the long run. Further, I do not believe the lithium problem is a significant issue because lithium production is rising faster than demand (which is also growing very quickly), and lithium is incredibly abundant. Indeed, due to the glut of lithium, I expect EV prices to continue to converge to or below gas-powered cars.
Given Toyota appears to be at the front of the pack regarding this game-changing technology; it may have 1-3 years of much higher sales and brand development that could cause its EV market share to rise dramatically. Toyota now owns more patents on solid-state battery patents than all of its competitors, even those not in the auto space. Toyota's EV market share was extremely low until recently, as it focused primarily on the long-term capital and research investments strategy. Although some see Toyota's slower EV transition as a negative, I believe it is a positive because the company has built this long-term technology edge. While potentially a gamble, this technology could push Toyota into a new competitive tier, potentially making it more valuable than Tesla, which is already falling behind technologically .
Immediate Macroeconomic Risk Factors
Toyota's valuation today is typical of its historical range, but it is elevated compared to its peer group. From an "EV/EBITDA" standpoint, its premium is about 29% compared to the other major auto producers with similar total revenue. Its price-to-sales is much higher than its peers, pointing toward its higher operating margins. See below:
Of course, while Toyota is slightly expensive compared to its peers, it is exceptionally cheap compared to Tesla, which continues to trade at a price-to-sales of around 8X and an "EV/EBITDA" of ~50X. To me, Tesla's valuation is bafflingly high today, given its vehicles are fundamentally not much better, and potentially inferior to, the newest EV vehicles made by its more established competitors. While opinions will differ, its "brand value" is also questionable in the long run due to many liberal consumers moving away from the brand due to their opinions regarding Elon Musk. I make that statement not as my opinion, but one based on consumer surveys , which is essential given that EV sales are far higher in less conservative demographic areas.
Regardless, in terms of sales growth levels, Toyota is the strongest, while Tesla is toward the bottom of the pack. See below:
Tesla has a substantial first-mover advantage and is still trading on the premium created during that era despite having comparatively lackluster growth. Toyota trades at a slight premium to its peers but has much more robust sales growth, pointing toward potential success in its long-term capital development approach. In my opinion, because Toyota has a vast global manufacturing base, it will likely have the most significant competitive edge for EVs due to its remarkable ability to promote scale and its historical record of being a lower-cost manufacturer. Between TM and TSLA, I believe TM is the obvious choice due to the immense valuation gap and Toyota's potential emerging competitive dominance that is (seemingly) poorly realized by most market participants.
Still, I am somewhat neutral on TM from a short-term standpoint. Total US and global vehicle sales are comparatively weak today and never fully recovered after COVID. Further, auto loan delinquency rates are at a 30-year high today after being very low at the end of 2022. Banks are reducing exposure to the sector, likely contributing to a potentially significant decline in sales in 2024. See below:
As detailed in many of my recent articles, I have very low expectations for US and global consumer demand in 2024. With consumer debt levels being elevated and interest on that debt rising, I expect we will continue to see default rates rise to abnormally high levels. Further, household savings levels remain very low despite a decline in inflation, indicating continued declines in fundamental household financial stability. I do not expect vehicle production costs to fall too quickly, so I expect that Toyota and its peers will continue to face inventory buildup, which should impair the industry's profitability in 2024, likely through 2025, depending on overall recession risk.
The Bottom Line
I believe the auto market is on the verge of a recessionary decline in sales due to growing strains in the auto consumer credit market and household financial stability. While opinions on the matter differ, I believe the data is overwhelmingly clear that auto debt is a critical issue in the US market. Historically, vehicle producers can face tremendous losses during market shocks, usually making their stock prices decline by 30-50% and occasionally more. While TM is not expensive today, I do not believe its valuation accounts for this significant risk factor.
Still, while I expect TM to lose some value over the next year, I am not bearish nor bullish on the stock. To me, its immediate downside risk is comparatively low compared to its upside potential, driven by its theoretically huge impending competitive advantage. The way I see it, the auto market will crash soon, opening the door to a new era where EVs quickly become the more affordable option.
Obviously, I can not guarantee Toyota's game-changing battery promises will all prove accurate. Still, the company is, in my view, historically the best at creating innovation on a large scale and at a low cost. The science behind solid-state batteries is also quite clear, pointing toward the complete domination of a new era of electric vehicles; however, over the next three years, we will see whether or not Toyota can scale its solid-state battery manufacturing base enough to emerge as the best EV competitor. Further, while its leading edge in patents is a sure sign, it is possible its competitors catch up technologically.
I plan to buy TM if it loses over 30% of its value, depending on changes in its fundamentals. Until then, the best play may be a long TM short TSLA pair trade, taking advantage of the huge valuation gap between them, which does not appear to be supported in their fundamentals. Still, long-term-oriented investors may find value in TM today, given it's still relatively cheap compared to its sales growth level.
For further details see:
Toyota: Solid State Batteries Will Create A New Electric Vehicle Era