Island Dispute Plays Havoc in China’s Car Market

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Toyota (NYSE: TM) has recalled 7.4 million vehicles from around the world, about the same number as the total units sold in the previous fiscal year, over defective window switches. This would be the world’s second biggest vehicle recall ever, behind Ford's (NYSE: F) 8 million recall about sixteen years ago.

Although the cost of the recall won’t be available until the next earnings report but a new political dispute threatens its sales in China. The three leading Japanese vehicle manufacturers, Toyota, Honda (NYSE: HMC) and Nissan (NASDAQOTH: NSANY.PK), have reported a drop in monthly sales in China as the territorial dispute over a group of Islands called Senkaku (Japanese) or Diaoyu (Chinese) intensifies; this prompted Chinese consumers to boycott Japanese cars. Nissan generates 26% of its global sales in China, followed by Honda with 20% and Toyota with 10%. Any drop in sales numbers from this region is going to significantly impact the income statement, particularly for Nissan.

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The cause of dispute is the potentially massive reserves of oil reportedly located beneath and around the islands. The Japanese Premier believes that Senkaku is a part of his country’s “inherent territory.” On the other hand, China thinks that its combined oil reserves in the South and the disputed East China Sea are as big as Saudi Arabia’s, which will be enough for the country for about half a century. The dispute has existed for decades, but the current row was instigated by Japan after it purchased the islands from their owners.   Both countries are in desperate need of securing oil and gas reserves for the future.

Interestingly, very little oil and gas exploration work has been carried out over the area in the past decade; therefore, the actual quantity of reserves remains a mystery, with China claiming 160 billion barrels and the US Energy Information Administration (EIA) estimating just 100 million barrels. However, after observing the rift this tiny area has caused, it would be prudent to assume that the actual reserves are somewhere in between. 

Any political dispute between two of the world’s largest economies is bound to have economic repercussions. The Japanese automobile industry is emerging as the biggest victim of the quarrel. According to JPMorgan Chase, Japanese vehicle sales to China can drop by as much as 70% in the fourth quarter of the current fiscal year. They have already lost nearly 0.4 percentage points of the total market share, which fell to 21.2% in August. This has created an opportunity for German and Korean firms, whose combined market share increased by 2.3 percentage points in the same period. Moreover, it can also create opportunities for US based vehicle manufacturers, such as Ford or General Motors (NYSE: GM), which is staking the future of the firm’s growth on China.

Ford has a very small market share in China, around 3%, but GM treats China like one of its primary markets. It has a $1 billion annual investment plan for the country. Last month, GM and its Chinese partner SAIC Motor opened the $250 million state of the art 1,400 acre automobile test track near Shanghai. Until 2010, GM’s market share in China was an impressive 12.7%, which it increased even further to 13.6% in 2011. Last year, it sold 2.5 million vehicles, while this year it has already crossed the 2 million mark. The current Islands crisis has presented a unique opportunity for growth to the company.

On the other hand, the past couple of years have been challenging for the Japanese automobile industry due to the earthquake, tsunami and the global financial crisis. The row comes at a particularly bad time for Toyota and Honda after the manufacturers were putting up strong numbers due to increasing car sales (despite the strengthening yen). Toyota, until August, was expecting record shipments of 9.76 million units, a 23% annual increase with production breaking the 10 million units benchmark, the first time ever for any automobile manufacturer in the world.

Through the first half of the current year, Toyota, Honda and Nissan were up 21.7%, 13.4% and 6.9% respectively. The second half now threatens to wipe out the gains with the three’s shares dropping by 7%, 13.5% and 11% respectively. Overall, since January, Toyota’s stock is up 13.2% while Honda and Nissan’s are down 1.9% and 4.9%.

<table> <tbody> <tr> <td> </td> <td> <p><strong>Toyota</strong></p> </td> <td> <p><strong>Honda</strong></p> </td> <td> <p><strong>Nissan</strong></p> </td> <td> <p><strong>Ford</strong></p> </td> <td> <p><strong>GM</strong></p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>16.1</p> </td> <td> <p>13.6</p> </td> <td> <p>8.4</p> </td> <td> <p>2.3</p> </td> <td> <p>8.8</p> </td> </tr> <tr> <td> <p><strong>EPS</strong></p> </td> <td> <p>4.64</p> </td> <td> <p>2.21</p> </td> <td> <p>2.01</p> </td> <td> <p>4.4</p> </td> <td> <p>2.81</p> </td> </tr> <tr> <td> <p><strong>Div</strong></p> </td> <td> <p>1.4</p> </td> <td> <p>0.97</p> </td> <td> <p>N/A</p> </td> <td> <p>0.2</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p><strong>Yield</strong></p> </td> <td> <p>1.8%</p> </td> <td> <p>3.3%</p> </td> <td> <p>N/A</p> </td> <td> <p>2%</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p><strong>ROA</strong></p> </td> <td> <p>1.7%</p> </td> <td> <p>2.1%</p> </td> <td> <p>3.0%</p> </td> <td> <p>2.4%</p> </td> <td> <p>3.0%</p> </td> </tr> <tr> <td> <p><strong>ROE</strong></p> </td> <td> <p>6.3%</p> </td> <td> <p>7.1%</p> </td> <td> <p>10.8%</p> </td> <td> <p>157.8%</p> </td> <td> <p>14.6%</p> </td> </tr> </tbody> </table>

As mentioned earlier, Toyota is relatively safe from the dispute as 1) China is not its biggest market and 2) the company has attributed increasing sales units from the US and local market due to the Japanese government’s incentives for fuel efficient vehicles, which has spurred local demand as well as the strength of their brand in the U.S.  GM and Chrysler have years of work to do to rebuild trust with a large number of U.S. consumers. 

Out of the three Japanese firms, Nissan has offered the highest return on assets and equities and has a lower P/E, which means investors won’t pay a premium for it like they will for Toyota. China is the one market where Nissan is stronger than Toyota and Honda and has the most to lose going forward if this situation escalates. Honda’s strength in 2-wheeled vehicles and its geographically diverse production base make it a more defensive play on Asian growth.

Despite Toyota’s climb, it has little to offer in terms of return on assets and equities and gives a smaller yield as compared to its rival, so value investors are likely not interested. Its powerful brand, coupled with the share hike in the first half has pushed the P/E to almost twice as much as GM, which has a higher ROA and ROE. However, the returns of Japanese firms were greatly affected last year. For the previous quarter, Toyota, Honda and Nissan have significantly higher ROE of 11%, 12% and 9.3% respectively.

Toyota is the best growth bet due to strong branding, even in the U.S.  The U.S. manufacturers simply have a lot of work to do to regain trust outside of pickup trucks.  Honda, again, is a defensive option after Toyota due to its diversified portfolio of products and strong 2-wheeler presence in Southeast Asia.  Ford may capitalize on this Chinese-Japanese rift somewhat; its large exposure to Europe poses a challenge amid the debt crisis.  GM is the one who stands to gain the most from this of any foreign manufacturers.

However, both China and Japan have recently decided to hold talks over the dispute, which could resolve the issue, but it has inflamed old passions that will take time to subside.  

PeterPham8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Ford. Motley Fool newsletter services recommend Ford and General Motors Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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