As Friday afternoon bombshells go, this one wasn't much of a surprise: Toyota (NYSE: TM) released its official forecast for the coming year in which it predicted that its profit would drop 31%, despite the company's surprisingly strong recovery in the wake of the Japanese earthquake.
Toyota management had declined to give an earnings forecast when it released earnings last month, saying (quite reasonably) that the ongoing effects of the March 11 disaster on the company's suppliers were still not fully clear. But the company's forecasted profit -- 280 billion yen ($3.5 billion) -- represents a big drop from the 408 billion yen the company booked in fiscal 2011, and a much bigger drop than Wall Street expected.
That's a surprise, given how well Toyota and its supply chain has been recovering. But it turns out that the earthquake is only one of Toyota's problems.
Bad news despite the good news
There was good news, too, and it seemed pretty good indeed: Toyota now predicts that its domestic Japanese production will be fully recovered in July, although ongoing parts shortages will limit production at some overseas plants for a while longer. That's a significant improvement over earlier predictions, in which the Japanese giant anticipated that it could take as long as a year for some production lines to recover.
Even better, Toyota expects to make up much of its lost ground on the sales front as well. For the full year, the company now forecasts its global vehicle sales to be off less than 1% year over year -- a number that will represent an impressive recovery if it bears out.
So why the big drop in profits?
Problems beyond the earthquake
Production may be recovering, but the bigger picture isn't so simple. Toyota CFO Satoshi Ozawa said on Friday that currency pressures and something he referred to only as "marketing activities" would be responsible for driving profits sharply lower, despite the company's expectation that sales volumes would be roughly flat.
The currency pressures are real and have two main effects. First, they erode the value of the company's overseas profits. Like Sony (NYSE: SNE), Panasonic (NYSE: PC), Honda (NYSE: HMC), and other Japan-based global companies, Toyota sells in a broad range of currencies in local markets, but its financial statements are in yen. When those overseas currencies, especially the significant ones like the dollar and the euro, lose value against the yen, Toyota's profits in those markets are worth less at home.
Likewise, a strong yen puts Japan's exports at a disadvantage in foreign markets. For a company like Toyota, which still has a major manufacturing presence in Japan, this means that the vehicles it exports end up costing more to produce when priced in a local currency, reducing quantities demanded of those now more expensive products.
Is an incentives war brewing?
That, in turn, puts Toyota at a cost and pricing disadvantage against its chief global rivals: General Motors (NYSE: GM), Ford (NYSE: F), Volkswagen, and Hyundai, each of which produces most of its cars and books its profits in countries with currencies that have fallen against the yen in recent years. Last year's quality scandals and the strength of these rivals' products have probably limited Toyota's ability to raise prices significantly, and that means the company's margins will probably be squeezed.
It sounds to me as if Toyota is preparing to trade profits for market share, at least in the near term. Ozawa's reference to "marketing activities" suggest that the company, which fell to third place behind GM and VW in global sales in the first quarter, plans to be aggressive with pricing and incentives to get sales back up to somewhere close to last year's numbers.
That may not be a bad short-term strategy as part of the company's earthquake-recovery effort. But given Toyota's other problems -- products that aren't as competitive as they used to be, lingering quality concerns from last year's recall scandals, and trouble competing with low-cost producers such as Tata Motors (NYSE: TTM) in places such as India and China -- shareholders should be asking: Is this recovery really going to be so simple?
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