Denso Managing Slow Global Recovery
Analysts don't believe Toyota fallout will be too serious for Denso and other global suppliers.
By Roger Schreffler Ward's AutoWorld, Mar 1, 2010 12:00 PM

It was a defining moment for the new CEO of Japan's largest automotive supplier: Denso Corp., bluest of the blue chips, had a bottom line that turned distinctly red.

Nobuaki Katoh, just three months on the job, was faced with the perfect storm.

For nine consecutive months after the shock of the Lehman Brothers Holdings Inc. bankruptcy ushered in a major global recession in September 2008, Katoh witnessed a steady erosion of Denso's cash holdings as operating losses mounted to more than ¥167 billion ($1.8 billion).

And then, just as quickly as the bleeding started, it stopped.

Three times since April, Denso has revised its earnings forecast upward and now is projecting profits of ¥110 billion ($1.2 billion) for the fiscal year ending March 31, still a long way from fiscal-2007's record levels but moving in the right direction.

In fiscal-2007, the supplier reported earnings of ¥348.7 billion ($3.9 billion) on sales of ¥4.0 trillion ($44.8 billion), delivering an operating margin of 8.7%.

Katoh, one of the architects of Denso's global-expansion plan that put the company in nearly 30 countries with more than 100 plants, now is focused on rebuilding a foundation for long-term growth.

“Yes, we're profitable but only slightly,” he says. “It will take us five years to return to our previous earnings levels.”

The supplier spent much of the past year “just trying to survive,” he says. Our first priority was to lower our profit breakeven point to 70% of fiscal-2007 business levels. Next, we had to devise a plan for sustainable business growth.”

The 60-year-old executive, who became Denso's president in July 2008, insists the supplier won't shutter any plants but will merge and idle lines as needed to raise utilization.

In fact, Denso didn't close any plants last year in Japan, where it faced considerable overcapacity, and only shut down a small starter/alternator facility in West Midlands, U.K., consolidating that operation into Denso Mfg. Italia SpA in San Salvo, Italy. The result: 80 job cuts.

Denso put a hold on at least one big domestic project, a ¥16 billion ($175 million) air-conditioner plant in Fukushima prefecture, although management gave that investment a green light in January. Production startup now is planned for 2011, a year behind schedule.

Tokyo analysts have mixed views on Denso's prospects.

Kohei Takahashi, an analyst at J.P. Morgan Securities Japan Co. Ltd., notes Denso “hedged its bets that Toyota (Motor Corp.) would continue to grow its business indefinitely, and thus overbuilt facilities during the past five to 10 years.” Toyota owns 24.8% of Denso.

That said, Takahashi expects operating margins to recover to 6% in fiscal 2011, not too far below the supplier's fiscal-2007 peak, although profits, because of significantly lower sales, will remain at two-thirds that of previous levels, at about ¥193 billion ($2.1 billion).

Denso, which met its 2010 sales target of ¥4 trillion ($44 billion) in March 2008, now has recalibrated and aims to recover to those levels by 2015. In addition to ¥4 trillion in sales, the supplier has set a 10% return-on-equity target.

Koji Endo, managing director at Advanced Research Japan, fears Denso will not be able to generate the same level of profits in emerging markets such as China and India, as it did in the U.S. before the economic crisis hit.

“Japanese auto makers are not as strong in those markets, although that's where we envision greatest growth in the years to come,” he says. “I don't expect the U.S. to recover to 17 million units until the latter part of the decade.”

Katoh is well aware of the sea-change taking place in the industry and has steered Denso's research organization toward less-costly components for emerging markets, as well as environmentally friendly technologies for hybrids and electric vehicles.

“Everybody talks about the recession and the difficulty of exchange rates,” he says. For me, a bigger problem is the shift in customer attitudes as demand for small cars grows. The era of high-cost components is over.”

That is, except for Toyota's Lexus luxury brand, although it has taken a beating with global sales falling 15% last year. Analysts now fear Toyota's protracted recall crisis could tarnish it as well.

Even before the economic crisis, Denso had taken steps to bifurcate its development activities between traditional and emerging markets. In the air-conditioner business, it cut costs for emerging-market customers about 30% by standardizing production processes and commonizing core components and materials.

A senior research executive says Denso air-conditioners for emerging markets are designed to fit multiple models and grades, mostly for B-segment cars, while core components, including heat exchangers, condensers and evaporators, are standard. More importantly, they are of equal quality to those for North American and European cars.

To this end, Katoh believes Denso must bolster its overseas technical operations. At present, the supplier has small R&D centers in Thailand and China, near Bangkok and Shanghai, neither of which is on a scale of its research, testing and engineering complexes in Southfield, MI, and near Munich, Germany.

“We need to focus on low-cost components produced locally and not exported from Japan, in fact not even developed in Japan,” he says. “Those centers should determine the needs of the market and decide which systems and components best fit those needs. Our immediate goal is to boost our R&D capability in markets like China and India to a comparable scale to that of the U.S. and Europe.”

An example of future moves: At last autumn's Tokyo motor show, Katoh announced development of a new “single arm” wiper system for Tata Motors Ltd.'s Nano that had been proposed by Indian engineers and produced using locally procured materials.

Denso already has more than 30 plants in BRIC countries (the world's top four emerging markets of Brazil, Russia, India and China) including 22 in China and four in India. Moreover, Asia, which accounts for 17% of global sales, is projected to pass the Americas next year to become Denso's largest overseas market.

And it is profitable. According to J.P. Morgan, the region will report an operating profit margin of 12.8% when Denso closes its books in March, which compares with 1% for Japan and Europe and 2% for the Americas.

Meanwhile, Katoh is bullish on hybrids, less so on electric vehicles, although he expects the two segments to account for 15%-20% of global vehicle sales in 2020. That comes to 13 million to 18 million units out of a global total of 90 million, according to Denso forecasts. Counting cars equipped with stop/start systems, the executive estimates a global share of 30%, or about 25 million units.

Denso's CEO hedges on which technology, EVs or hybrids, will lead the way in the future. “But at least for Denso,” he says, “we believe the future of automobiles lies in hybrids first, then EVs.”

The supplier is mum about the Prius hybrid recall, which Toyota says is only a software problem involving the car's antilock brake system. The auto maker has notified some 400,000 customers to bring in their cars for reprogramming.

A potentially bigger problem is the accelerator assembly on eight Toyota models produced mainly in North America. So far, Denso assemblies haven't been involved, as the recall has been limited to parts made by CTS Corp. of the U.S.

Denso makes accelerator assemblies for Toyota in Japan and several U.S. models. Denso's assembly is different than CTS's.

Japan-based analysts so far don't believe the Toyota fallout will be too harmful for Denso and other Toyota suppliers, as the Toyota recalls largely have been centered in the U.S. and it is business as usual in most other markets.

They expect the recall crisis in the U.S. to blow over in three to six months, although this could be an overly optimistic view given the mounting political and media pressure on the auto maker to recall even more vehicles.

The Toyota Corolla, the world's largest-selling car, now is under investigation in the U.S. for possible steering problems.

Kota Yuzawa, vice president of global investment research at Goldman Sachs Japan Co., Ltd., has lowered his Toyota sales forecast for this fiscal year ending March 31 by 100,000 units to 7.25 million and his fiscal-2010 forecast (ending March 31, 2011) from 7.7 million vehicles globally to 7.5 million.

In other words, even with the hit being taken on U.S. sales, Yuzawa is projecting growth in fiscal 2010. Toyota's breakeven point after last year's restructuring is estimated at about 7 million units.

J.P. Morgan Japan analyst Takahashi says Toyota might lose a point or two of U.S. market share in 2010, going from 17% to 16% or 15%. He expects the auto maker to retain its share (not counting the January-February period when plants were shut down) by increasing sales incentives.

Therefore, the impact on Denso will be minimal. At present, about 50% of Denso's business is with Toyota, including in the U.S. Its second-largest customer globally is Honda Motor Co. Ltd. In the U.S., General Motors Co. is one of its biggest customers. That business won't be affected by the recall.

Both analysts claim that on a global basis, Denso content per Toyota vehicle is worth between $2,000 and $3,000. In the U.S., it's slightly less.

But all bets are off if more recalls involve electronics (a core Denso product), athough Toyota says it has not found a single case where electronics were to blame for accidents.

For the Prius, which is being recalled globally, Denso supplies the car's heating, ventilation and air-conditioning systems, along with body, engine and inverter electronic control units.

For other hybrids, Denso's growing product portfolio includes, battery-monitoring systems, battery-cooling fans, DC-DC converters and electric air-conditioning compressors.

For the Lexus LS 600h and RX 450h, it also supplies the power control unit. Denso shares the electric compressor and DC-DC converter contracts with Toyota Industries Corp.

In January, Denso announced development of its first battery-monitoring unit for EVs running on lithium-ion batteries. The device was adopted for the Toyota's Prius Plug-In HEV.