For Japan's automakers, things look good for now.

Strong pent-up demand and easing semiconductor shortages in key markets including Japan, Europe, and the U.S. are all positive factors for key Japanese companies. A weak yen also underpins their performance. In addition, the companies will benefit from moderate growth in demand and improving operating efficiency, in our view. S&P Global Ratings therefore expects credit profiles for Japanese automakers to remain stable over the next one to two years.

Growth, however, is set to weaken in 2024. High interest rates and slowing global economic growth are likely to dampen consumer purchasing power for vehicles next year. Meanwhile, price competition and rising penetration of electric vehicles (EVs) in China should weigh on profitability and cash flows.

Impending secular change could add to downside risk. Japanese producers are behind the curve on EV offerings in the global market. In particular, their market share in China continued to decline in 2023, as it has since 2021, as momentum for electrification continues in the country. Domestic players in China will likely maintain price cuts for another year, particularly for EV models. The ability to quickly roll out competitive EV models in China will be increasingly important for Japanese automakers' competitive positions there.

We expect the ratio of free operating cash flow (FOCF) to sales, a measure reflecting the ability of automakers to flexibly raise their investments without eroding their sound financial positions, to remain stable for Japanese automakers over the next one to two years. This is because we foresee their profitability improving in fiscal 2023 (ending March 31, 2024) and remaining stable in fiscal 2024 and we anticipate they will control their research and development (R&D) and capital expenditure burdens at a certain level compared with sales.

Cash Flows And Profitability Stable

We believe Japanese automakers can maintain the flexibility required for elevated levels of investment, as seen through the FOCF-to-sales ratio, although they continue to lag global leading peers over the next one to two years. We hold this view for two key reasons.

Chart 1

Costs are likely to stay under control.   Japanese automakers have a sufficient record of disciplined investment including capital expenditure and R&D. Toyota and Honda have controlled their capital spending and R&D to sales ratios at about 9%-10% for the past five years, except for fiscal 2020, when sales fell due to the Covid-19 pandemic. Nissan also has maintained a certain level of capital spending and R&D in the face of sluggish performance, and as its performance recovered in fiscal 2022 its investment burden eased to roughly 9% of sales, the same level as Toyota and Honda. We expect the carmakers' disciplined investment approaches to continue for the foreseeable future.

Catching up to peers and building advantage in EVs will depend on ability to secure supply of critical materials, develop software, and roll out competitive models.   Japan's automakers lag overseas competitors on EVs and have announced they will allocate a large portion of overall investments to electrification. Capital spending and R&D in EVs will account for 20%-50% of total investment over the next three to five years, or equal to 2%-5% of sales by our estimate. It's a dramatic increase from past years when investment was mainly for gas and hybrid vehicles. We do not expect Japanese automakers' investment burdens to become lighter than those of leading global competitors anytime soon. However, the companies will maintain amounts they invest as a percentage of sales by streamlining or reducing investments in conventional gas and hybrid vehicles to control overall investment, in our view.

Profitability of Japan's major automakers will remain stable.   Their average EBITDA margin will improve in fiscal 2023 thanks to strong pent-up demand in Japan, Europe, and the U.S. and a weak yen offsetting weak sales volume in China. We don't expect the percentage of EV sales among Japanese automakers to increase significantly. Therefore, we believe a modest increase in overall sales volume and ongoing cost reductions will offset pressure on margins from increased EV sales, and margins will remain generally flat in fiscal 2024.

Meanwhile, profitability of Japan automakers will remain below that of similarly rated European peers.   Among higher rated automakers, EBITDA margins at Toyota Motor Corp. (A+/Stable/A-1+) have been 3-5 percentage points (ppts) below those of Germany's BMW AG (A/Stable/A-1)and Mercedes-Benz Group AG (A/Stable/A-1) in the last two fiscal years. Meanwhile, Honda Motor Co. Ltd.'s (A-/Stable/A-2) EBITDA margin has trailed that of Volkswagen AG (BBB+/Stable/A-2), also of Germany.

Chart 2

We think Japan's automakers will continue to lag Germany's for two key reasons.

• Japanese automakers are structurally less profitable than the three German automakers because premium models, which tend to be highly profitable, account for a lower percentage of their overall sales volumes. Toyota's premium brand, Lexus, accounted for about 7% of total sales volume in fiscal 2022. Nissan's and Honda's premium brands account for even smaller shares of sales volume.
• Japanese automakers could face more pressure on earnings than European counterparts after fiscal 2025 because of possible deterioration in their product mixes if they accelerate work on development of EVs.

European and Japanese automakers will both experience pressure as the share of EV sales eats into that for more profitable gas, diesel, and hybrid models. However, Japanese automakers lag the Germans, whose battery electric vehicles (BEVs) and plug-in hybrid vehicles (PHEVs) already account for 10%-20% of their overall sales.

Nissan Motor Co. Ltd.'s (BB+/Stable/B) profitability in the next one to two years is likely to remain weaker than that of other major global automakers rated in the 'BB+' category. Peers include Ford Motor Co.(BB+/Positive/B) of the U.S. and Renault S.A. (BB+/Stable/B) of France. Nissan's sales volume will likely remain lower than its production capacity, impeding its profitability.

China, It's In Your Hands

A rapid shift to EVs in China and increased competitiveness of the nation's local brands in the EV market could pressure Japanese automaker's market positions. Being laggards in internal combustion engine technology, China's domestic carmakers and new entrants pursued an EV-focused strategy, given the huge growth potential under a government decarbonization initiative. This, together with fast development of a local EV supply chain, including for software, enabled local producers to become global frontrunners in EVs.

As demand in China's new vehicle market shifts to electrification, Japanese automakers, which have strength in gas and hybrid vehicles, are struggling with sales there. We believe this is because Japanese automakers lag overseas makers, particularly Chinese ones, on lineups of EVs and price competitiveness.

Chinese automakers are taking a larger chunk of their home market. Their share of new vehicle sales was about 40% before the COVID-19 pandemic; it was about 50% as of August 2023. Meanwhile, Japanese automakers have seen their share of sales in China decline every year since 2021. While Toyota's year-to-date sales in China were down only about 5% as of August 2023, Honda and Nissan sales are down more than 20%.

Chart 3

Japanese players have had more notable declines in market share in China than German automakers, though VW is also struggling there. We think this is because Japanese producers mainly focus on mass market models while German brands have meaningful exposure to the premium segment, which has been more resilient to electrification so far. Local EV makers' products are aimed at the mass market, which is the main market for Japanese cars, so competition with the premium segment has not intensified greatly.

In the face of fierce competition, German automakers are stepping up efforts to catch Chinese competitors, in part through cooperation. In July 2023, Volkswagen acquired a 4.99% stake in Xpeng Inc., a Chinese EV startup. The pair aim to develop two BEV models using Xpeng's EV platform and software capability. Audi AG, under Volkswagen AG group, also announced it will cooperate with SAIC Motor Corp. Ltd. for EV development. Collaboration with local automakers with proven competitiveness could potentially help traditional car companies lower their investment burdens and accelerate the launch of new products in China.

We take the view that Japanese automakers also need to act fast. Toyota has launched a BEV co-developed with BYD Co. Ltd., but its product lineup is very limited at this stage. In fiscal 2022, Chinese sales were about 20% of the total for Toyota and 30% for those of Honda and Nissan. We believe the Japanese automakers will soon rapidly expand competitive product lineups at affordable prices in China, not only for gas and hybrid vehicles but also EVs, to maintain market position in the country. However, if they do not, sales volume will not recover and price competition will intensify, pressuring overall earnings.

Chart 4

We note that emerging Chinese automakers are also increasing sales in Southeast Asia, where Japanese manufacturers have a very high market share and generate solid profits. We believe a rapid increase in Chinese auto makers' market shares in this region, driven by higher demand for EV vehicles, could gradually damage Japanese automakers' overall market share and profitability.

Solid Earnings And Healthy Financial Profiles Will Support Our Ratings

We expect Japanese automakers we rate to maintain solid earnings performance over the next one to two years.   Profitability at Toyota and Honda, in terms of EBITDA margin, has remained stable. They are popular, particularly in the U.S. and Southeast Asia. In our view, the following key strengths support their stable, though not high, EBITDA margins:

• High brand recognition and pricing strategy for their gas or hybrid models;
• Large and competitive broad product lineups, including sedans, SUVs, vans, and luxury and mini vehicles;
• Customer loyalty because of a focus on affordability over luxury; and
• Strong operational and cost control capabilities.

A recovery, albeit gradual, in global vehicle production and sales volumes and a protracted weak yen could underpin their profitability.

Rated Japanese automakers will maintain healthy financial profiles with stable profitability and cash flows, which will support our ratings on them for the time being.   Toyota, Honda, and Nissan are increasing their strategic investments in next-generation technologies for environmentally friendly and autonomous driving to maintain global competitiveness. However, they are trying to rein in their financial burdens using technology originally for hybrid vehicles and reduced development expenses for conventional products. These Japanese automakers have sound financial profiles with large net cash positions, and strong financial buffers have become more important in our evaluations of creditworthiness given growing pressure on cash flows.

Related Research

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• An Impending Electric Shock For Japanese Autos? May 17, 2023
• Glimmers Of Winners Emerge In Asia's EV Push, May 14, 2023