The Light at the End of Toyota's Tunnel

It was good news and bad news, but at least the bad news wasn't much of a surprise: On Tuesday, Toyota (NYS: TM) reported a quarterly profit of 80.9 billion yen ($1.05 billion), a drop of 14% from the (not all that great) year-ago period.

That drop shouldn't have surprised anyone -- Toyota's production problems in the wake of a series of natural disasters in Asia over the last year have been widely reported, and the sales lost as a result are no secret.

Here's the good news, though: The long-beleaguered Japanese auto giant raised its forecast for next quarter, as production is finally back on track and sales are gathering steam. But there may be some new concerns ahead.

On track to a (hopefully) full recovery
Toyota's strong January U.S. sales numbers suggested that the company's battered supply lines might finally be healthy -- and that its loyal customers had stayed loyal despite months of shortages. That sales strength gave some hope that the company's fourth-quarter numbers (Toyota uses a fiscal year that ends March 31) would come in strong.

Sure enough, Toyota is now predicting full-year net income of 200 billion yen ($2.6 billion), an 11% boost from the dour 180 billion yen forecast it gave in December. That's still a 51% drop from year-ago numbers, and it's a long way from the $8.8 billion number (excluding special items) posted by smaller rival Ford (NYS: F) . But it's an increase that should give some hope to Toyota's long-slammed shareholders, especially in light of the more glum forecasts from Sony (NYS: SNE) and Honda (NYS: HMC) , both of which are still struggling to recover from last year's natural disasters.

And there's even some chance that Toyota is sandbagging it a bit, though it did say that the strength of the yen versus the dollar and euro continues to pressure its margins. Analysts polled by Bloomberg are expecting a full-year net income number more in the range of 285 billion, on average. One analyst interviewed by Bloomberg suggested that Toyota's upward revision was based mostly on its expectations for resurgence in the domestic Japanese market, and didn't allow for the likelihood of increased strength here in the U.S.

An upside surprise would be great for shareholders, of course. But with those rising sales numbers comes a new and unsettling concern: Those sales increases may end up costing Toyota in the long run.

Sales are great, but profits should be the priority
Toyota's margins, as noted above, are already under intense pressure from exchange-rate disadvantages. For a company that makes a big percentage of its sales in dollars, but books profits in yen, exchange-rate movements are a big deal -- and in recent years, those movements haven't favored Toyota.

A Toyota executive said last year that exchange-rate disadvantages were costing it an average of $4,000 in profit for every vehicle sold, a consequence of Toyota's longtime insistence on producing lots of its vehicles in Japan. Now, that's not an insurmountable problem; Toyota can hedge the risk of further unfavorable swings, and it can use the yen's strength to its advantage by building more of its cars outside of Japan. That's already happening to some extent -- company officials said on Tuesday that Toyota would boost production of Corollas at its plant in Mississippi, likely in hopes of reducing or eliminating the need to import Corollas from Japan in the future.

But what might be a bigger problem is the company's avowed determination to recapture lost market share, and its apparent willingness to spend big on incentives to gain sales ground. For instance, the big jump in Camry (and Avalon) sales seen in January was likely helped along by incentives -- specifically, the availability of low-cost (read: subsidized) financing. That's somewhat unusual, as the current Camry was brand new last fall, and it has been well-received. One would think that it would sell well without discounts.

We've heard this story before, and it didn't end well
Toyota would probably respond by saying that it was simply meeting competition -- and in fact, similar financing deals were available on most of the Camry's key competitors in January. But few of Toyota's competitors are facing the acute profitability pressures that the Japanese giant is struggling with.

Toyota Senior Managing Officer Takahiko Ijichi said on Tuesday that "cost reduction activities" would help profitability going forward. But a reliance on incentives to hold market share combined with attempts to cost-cut its way to better margins is a story we've heard before -- it's the tale of the decline and fall of General Motors (NYS: GM) .

At GM, the problem went like this: Cost-cutting resulted in less-competitive products, which in turn meant that discounts -- incentives -- were necessary to keep sales up. Eventually, that became a vicious, margin-eroding circle. Anyone who has cross-shopped a Toyota with something like a Ford or Hyundai recently knows that there are already a few signs that Toyota is heading down that road (for those shopping, look at the materials used in the cars' interiors).

That's a place that Toyota simply can't afford to go, no matter what the cost in near-term market share. Toyota's spending on incentives in coming months will bear close watching -- stay tuned.

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At the time thisarticle was published Fool contributorJohn Rosevearowns shares of Ford and General Motors. You can follow his auto-related musings on Twitter, where he goes by@jrosevear. The Motley Fool owns shares of Ford.Motley Fool newsletter serviceshave recommended buying shares of General Motors, Tesla Motors, and Ford.Motley Fool newsletter serviceshave recommended creating a synthetic long position in Ford. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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