Japan's automaking titans have myriad headaches.

In Europe, there are stricter environmental regulations. In China, there's the rapid business expansion of manufacturers promoted by the government. In the U.S., we foresee sizeable battery capacity investments and tax stimulus amid potentially tighter emission rules. Globally, a confluence of factors is driving a rapid shift toward electric vehicles (EVs) in the auto industry. And Japan is lagging behind.

Among Japanese automakers, hybrid vehicles and gas guzzlers have been the focus. Of the approximately 24 million new vehicles sold by Japanese automakers worldwide in 2022, about 300,000 were BEVs. This is little more than 1% of the total, with sales primarily driven by the group led by Nissan Motor Co. Ltd. This compares with 5%-10% BEV mixes for global legacy competitors. In S&P Global Ratings' view, this could portend intensifying competition that might pressure ratings later this decade.

Sales figures show why. Globally, automakers sold approximately 7.7 million BEVs in 2022, up 68% from the previous year. With steadily increasing sales in each key region except for Japan, BEVs accounted for around 10% of global EV sales in 2022. In Europe, the figure was 12%, up from 8% a year earlier; In China, it was 20.2%%, up from 11.4%; in the U.S. 6%, up from 3%; and in Japan, 1.4%, up from 0.5%.

The transition to BEVs is proving more costly than anticipated. Battery technologies that are affordable and improve range and operability are key to determining the competitiveness of BEVs. These require major investment. Regulations can also bring competitive edge, as the acceleration of the transition observed in Europe with the "Fit for 55" emissions reduction program shows. However, these programs can also bring unpredictable challenges.

BEV makers in countries with preferential measures for local manufacturers and infrastructure such as recharging facilities can benefit from favorable regulation. Global automakers in Europe and the U.S. have made it clear that they intend to further strengthen their business bases for BEVs. Japanese makers, meanwhile, have only partially woken up to the threats they face, in our view.

Playing Catch-Up

In their BEV businesses, we forecast that the three major Japanese automakers will prioritize the U.S., China, and Southeast Asia. These are key markets for their hybrid and gas vehicles. In terms of supply chain management, the three automaker's business strategies could vary. Toyota plans to mainly focus on in-house production. Honda plans to mainly partner with global auto parts makers. Nissan, meanwhile, plans a mix of in-house production and partnerships with global parts makers. We think that all three are likely to see their research and development (R&D) and capital spending burdens increase as they expand their BEV businesses.

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In our view, the Japanese automakers are being forced to increase R&D and capital spending on BEVs as they aim to catch up with global BEV frontrunners. Accordingly, their ratios of R&D and capital expenditure against revenue in the next two to three years could gradually increase because of their BEV initiatives.

The Risk Of A Boiling-Frog Situation

For Japan, in addition to dour sales at home, there's little for Japanese automakers to celebrate abroad. In North America and China, their main markets for selling cars, the share of BEVs sold by the companies is 1%-2% each.

We still expect Toyota and Honda to secure stable EBITDA margins above 10% over the next one to two years. Solid car sales volume and profit contributions from gasoline and HV vehicles should support these margins. We also consider Toyota and Honda's ability to maintain conservative financial discipline and healthy net cash positions over the long term to support their creditworthiness. Financial discipline and a net cash position also help Nissan.

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Profitability at Toyota and Honda, in terms of EBITDA, has remained stable due to their strong cost control capabilities and brand recognition mainly in the U.S., China, and South and Southeast Asia. This has been the case even during the volatile business conditions of the past several years. However, they are likely to come under pressure as the EV mix rises as a percentage of global sales. EBITDA has lagged that of some global leading competitors because of the difference in product mix.

Stability of EBITDA, which is no longer guaranteed in the medium term, has been supported by a number of factors. The first is that the two companies' conventional gasoline vehicles and HVs, in particular, are highly competitive, in terms of price, fuel efficiency, and safety performance. Second, their broad product lineups, including sedans, SUVs, vans, and luxury and mini vehicles have many competitive models. And third, the companies look to affordability, which leads to high customer loyalty, over luxury. Given these factors, the companies have built up solid customer bases, especially in North America, China, or South and Southeast Asia. As a case in point, Toyota and Honda have offered lower sales incentives for buyers in the U.S. market than most global rivals.

However, we anticipate that the rapid expansion of the global EV market could end the stability Japanese automakers have enjoyed. The U.S., China, and Europe, which account for about 70% of global vehicle sales, are looking to electrification, in particular BEVs. This is an increasing risk for Japanese automakers, given protectionism and less favorable regulatory environments for the models in which they have records of success in combustion engine and hybrid vehicles.

This has changed the way we think about Japanese automakers. As customer demand rapidly shifts toward BEVs in North America and China, key markets for gasoline and hybrid cars, so has our focus. We are going to give more weight to BEVs--in terms of technological advances, production capacity, brand recognition, and marketing strategies--in our assessments of Japanese automakers' creditworthiness.

Key Questions On BEV Competitiveness At Japanese Automakers

R&D and capital investment burdens for BEVs could be heavy, but they are inevitable for global conventional automakers, including Japanese ones. Fierce competition awaits Japanese automakers, which are not only locked in competition with traditional automakers but also with BEV-specialized manufacturers and new market entrants from other industries such as information technology. Accordingly, we forecast that the increasing amounts of their R&D and capital spending for new BEVs could outweigh the cost reductions made in the combustion engine and hybrid vehicle segments.

Hardware development for longer driving distance, making cost-effective fuel batteries that will replace gasoline engines in cars, and building up charging infrastructure will be costly and take years. For Japanese automakers, we are also closely watching the areas outlined below.

• Can they execute BEV business strategies that meet the demanding and rapidly changing regulatory requirements and market needs that vary region by region?
• Can they steadily expand sales of reasonably priced BEVs and secure market shares by establishing solid business franchises with healthy brand recognition in profitable high-end segments?
• Can they restructure their supply chains away from gasoline vehicles and HVs and toward BEVs, including for auto parts and battery procurement, over the long term?
• Can they promote software-related developments, including after-sales upgrades of key applications for BEVs, as well as hardware replacement?
• Can they build new production and sales bases for BEVs, in particular in North America and China, comparable with their conventional business? Also, can they secure steady market positions comparable with those of global automakers in BEVs?
• Can they maintain overall profitability (EBITDA margin) and financial soundness for elevated levels of investment (FOCF to sales ratio) by reducing production costs and boosting the competitiveness of current vehicles? Will this secure sufficient capacity for the constant R&D and capital investment costs for BEVs?

We believe Japanese automakers inevitably face short-term investment burdens as they look to catch rivals in terms of sales of BEVs globally.

All the leading global automakers are aiming to secure business foundations for future growth areas, including BEVs. This entails a degree of business risk. For Japanese automakers, areas of focus include fuel-cell development, production capacity investment, and marketing activities. In addition, they need to maintain financial soundness and sufficient profit through legacy assets. This would likely make a significant potential impact on their global competitiveness and ratings over the next three to five years, in our view.

Related Research

• Global Auto Sales Forecast: Macro Risks Demand Pricing And Production Discipline, April 18, 2023
• Industry Top Trends 2023: Autos, Jan. 23, 2023
• Glimmers Of Winners Emerge In Asia's EV Push, May 14, 2023