R&I Rating Methodology by Sector

R&I Rating Methodology by Sector Passenger Vehicles April 5, 2016 R&I applies this rating methodology to manufacturers of passenger vehicles in a broad sense, including light trucks and motorcycles. This category does not include so-called commercial vehicles such as trucks. R&I utilizes the same rating methodology for foreign manufacturers. I. Evaluation of Business Risk 1. View of industry risk Passenger vehicles are durable consumer goods, and the majority of purchasers are individuals who use their cars as a means of personal transportation for commuting and leisure. The market is extremely large in size, and a certain level of growth in vehicle demand can be anticipated. Under the impact of vehicle downsizing and price reductions, there is a possibility the market s growth rate on a total value basis will be less than growth measured by number of vehicles sold. In order to operate globally, passenger vehicle manufacturers must make huge investments in capital equipment and development, and employ tens of thousands of workers. Barriers to entry are high. Nevertheless, there exist many strong manufacturers worldwide, and they are competing with each other in terms of development and sales. Until now the industry has not plunged into excessive competition, and selling prices have enabled manufacturers to sufficiently ensure profits. Research and development costs, however, are trending upward against the backdrop of stricter environmental and safety regulations and development of vehicles for emerging countries. With manufacturers from emerging countries appearing, and new players from different industries entering the market, competition has intensified. Based on these considerations, R&I judges the passenger vehicle industry to have a medium degree of industry risk. Compared with the past, the industry risk is on the increase, and among industries classified with the same category of risk, R&I recognizes the industry risk to be on the relatively high side. 1/9

(1) Market size, market growth potential and market volatility With a market size well in excess of 100 trillion yen, the passenger vehicle industry is substantially larger than most industries. As a highly convenient means of transportation, passenger vehicles have spread broadly throughout the world. Because they are manufactured by elaborately assembling approximately 30,000 components, and the safety standards demanded are high, passenger vehicles have become one of the more expensive durable consumer goods. Viewed over the long term, the passenger vehicle market is enjoying an expansion trend, and a certain amount of growth is expected for some years into the future. Worldwide automobile demand, the majority of which is for passenger vehicles, appears likely to reach 100 million units in the near future. Looking at Japan, the U.S., and the advanced countries of Europe, ownership ratios are already at a high level, and the markets are mature. Demand is centered on replacement purchases. In the emerging markets of China, India, and Southeast Asia, on the other hand, high demand growth can be expected. Throughout the motorization phase, as passenger vehicles spread in tandem with expansion of the middle income and high-net-worth brackets, purchases of new vehicles will likely drive demand. Worldwide there appears to be room for the number of vehicles demanded to grow at an annual pace of about 3% over the medium to long-term. Total net sales growth probably will be more gradual, because the average unit prices of vehicles will decline along with the shift of demand to emerging countries. With fully autonomous driving and car sharing likely to broadly enjoy full-scale acceptance in the future, some customers will move from the format of ownership to the format of use of a passenger vehicle as a transport service only when needed, and there is a concern this will lead to a drop in new car demand as well. Care must be taken because should such risk be actualized R&I s view of industry risk will be influenced. Market volatility is relatively high. Passenger vehicles are durable consumer goods, and demand is strongly susceptible to economic trends. In North America and Southeast Asia, a high percentage of customers use loans or leases when purchasing a passenger vehicle, and they are influenced by circumstances in the financial market as well. In the past, demand has sometimes plummeted sharply because of an exogenous shock, such as the oil crisis or the financial crisis. With emerging countries now accounting for the majority of world demand, the risk of the political or economic climate in emerging countries causing short-term fluctuations in demand has increased. (2) Industry structure (competitive environment) Barriers to entry in the passenger vehicle industry are high. Developing and producing 2/9

passenger vehicles based on the internal combustion engine from scratch requires substantial R&D costs and capital expenditure, as well as tens of thousands of workers. A parts procurement network and a sales and maintenance service organization also must be created. In addition to the tangible aspects of infrastructure construction, the accumulation of know-how on component design alignments, thorough process and quality control, etc. is essential in intangible aspects. Benefits of scale easily affect various aspects of the business. Competition among existing passenger vehicle manufacturers is intense. In Japan, the U.S. and Europe alone, there are over ten global enterprises with annual sales in excess of two million units. This has not led to an excessive decline in selling prices because manufacturers have some ability to control prices through their sales companies and dealers. In China and other emerging countries, manufacturers that procure key components such as engines and transmissions from outside suppliers and engage only in vehicle assembly at low costs have come to the fore. Should they scale up their business from low-end products and ratchet up the competition with existing manufacturers, this could put strong downward pressure on selling prices. The popularization of electric vehicles and autonomous driving cars has the potential to vastly alter the industry structure in the future. Compared with internal combustion engine cars, the structure of an electric vehicle s power train (engine and drive train) is simpler and does not require close coordination with parts suppliers, and new market entry is said to be comparatively easy. In the autonomous driving sector, the market entry from different industries such as IT-related firms is noteworthy. This will result in firms, including the mega-suppliers of automobile components, competing through the development of advanced technologies. On the other hand, moves to search for new cooperative relationships both within and outside the industry probably will emerge as well. (3) Customer continuity and stability As durable consumer goods, passenger vehicles do not enjoy strong customer continuity and stability. Market share fluctuates over the medium to long-term. Passenger vehicle manufacturers strive to achieve a firm grip on customers through the opportunity of providing after-sales services such as vehicle inspections and repairs at affiliated dealers. (4) Capital and inventory investment cycles To assimilate the expansion of global demand, building production locations in the markets where customers are located or in adjacent regions where tariffs are low will be critical. In addition 3/9

to new plant construction, production line expansion, and maintenance and upgrades of existing facilities, investment for new models and restyling will also be required. Because passenger vehicle demand characteristics and needs vary by region, manufacturers that wish to operate globally will have to develop multiple models that enable them to respond to customer diversification. Considering the typical three-to-five year model cycle, the investment recovery cycle is comparatively short. The certainty of investment recovery is also relatively low, because vehicle sales depend not only on global economic trends but on the success or failure of new automobile development and model changes as well. R&D investment targets also span a broad range, including technology to meet emissions reduction and fuel efficiency improvement regulations, next-generation environmental technologies typified by electric vehicles and fuel cell vehicles, and advanced safety measures, autonomous driving cars, and network connection functions. Because of the need to develop powertrains for all segments and meet stricter environmental and safety regulations, R&D expenditures are expected to climb. When inventory investment is examined, inventory that will enhance the product lineup is needed in countries such as the U.S., where a large portion of sales are made at dealer shops. In the case of exports, inventory overall increases because ocean transport requires many days. (5) Protection, regulations and public aspects R&I judges the industry risk related to protection, regulations and public aspects to be neutral. Changes to regulations concerning fuel efficiency, emissions, and collision safety have a substantial impact. On the other hand, governments in each country sometimes assist new car sales with subsidies and tax reductions as an economic stimulus measure and environmental initiative. (6) Cost structure The industry requires a substantial amount of capital and development investment, and the burden for depreciation and amortization expense and R&D spending is heavy. It also employs large numbers of workers in divisions such as production, development and sales, and on the whole fixed costs are at a high level. Despite a high variable cost ratio because of the numerous components purchased externally, the industry s cost structure lacks flexibility. When vehicle sales slide and plant capacity utilization rates fall, profitability can quickly deteriorate. Recent years have seen a trend toward cost savings through efforts such as integration of platforms, reduction of parts suppliers, and parts sharing and modularization. On the other hand, this means that when a recall occurs, a broader range of models is affected than in the past, swelling the amount of the loss. 4/9

2. View of individual firm risk In contrast to industry risk, which highlights the standard risks of the industry of which the subject firms are a part, the business risk of each company will differ depending on the individual firm risk as explained below. (1) Product competitiveness For passenger vehicle manufacturers, product competitiveness is the most important factor as a source of cash flow. Even if a company creates a global production and sales organization, this will not be linked to profits and cash flow unless its products, an essential element for product competitiveness, are attractive. With many products including competitors' being introduced to the market, consumers cautiously select the products they purchase because cars are high priced. If a company has a large number of products that are chosen by many customers, this will lead to a stronger earnings base. R&I evaluates passenger vehicle manufacturers based on factors such as the number of their leading models, the breadth of their models and segments, and degree of difficulty in breaching their differentiation factors. (2) Production system Building an efficient production system in regions with large demand, including not only advanced countries but emerging countries as well, is critical for improving the stability and level of earning and cash flow generating capacities. Another key point, in addition to cost competitiveness achieved against a backdrop of local production and high capacity utilization rates, is ensuring the flexibility to respond to changes in demand and exchange rate fluctuations in various regions. Local procurement of materials is crucial for ensuring competitiveness especially in emerging countries where production costs are low, and can reduce transportation costs as well. Provided it has prepared a bridge production system that enables it to manufacture its leading models in multiple regions, a company will find it easier to improve its plant capacity utilization rates as a whole. Local production also has the aspect of helping avoid political and economic friction with the countries hosting the plants. There is a possibility optimal production locales will shift as the number of economic partnership agreements (EPA) and free trade agreements (FTA) expands. (3) Sales capability A high degree of geographical diversification of revenue sources and a high market position in each region lead to stability of an earnings base and cash flow. The leading passenger vehicle 5/9

manufacturers are developing their businesses globally, and in each region the demand trends vary according to factors such as the economic climate, tax reform, and environmental regulations. Moreover, customer preferences exhibit strong local characteristics. In contrast with North America, where large-sized vehicles such as SUVs and pickup trucks are hot sellers because of the long distances, compact cars are highly popular in France and Italy, where older streets still form the core of many built-up urban centers. In Germany, where the autobahn is well-developed, customers demand superior high-speed stable running performance. Markets vary among emerging countries as well. Even within a single country, needs are diversifying because of rising income levels and an expanding customer base. In China, sedans and SUVs ranging in size from mid- to large-size models account for a high percentage of demand, while in India, low-priced compact cars account for the bulk of vehicle sales. It is therefore vital for companies to achieve earnings diversification and boost market share by expanding their sales and service networks in each region. The sales finance business serves as an effective promotional tool for selling passenger vehicles, and if it develops this operation through a consolidated subsidiary, a manufacturer can keep the profits from its sales finance business within its group. While this makes it necessary to have the funding capacity and service development capabilities to offer the most attractive financial products to their customers, it simultaneously exposes companies to financial asset quality and capital management-related risks. (4) Technological and development capabilities To maintain and strengthen the earnings base from a long-term point of view, it is vital for a company to ensure the dominance of its technological capabilities and development prowess. Environmental regulations and safety regulations are expected to continue to tighten around the world. To boost fuel efficiency and reduce emissions, manufacturers must develop electric power trains while also improving the efficiency of gasoline and diesel internal combustion engines. Because of problems in terms of the lack of charging stations and fueling infrastructure and high vehicle cost, the acceptance of electric vehicles and fuel-cell automobiles in the market appears to be quite distant in the future, but falling behind in the development race could deliver a fatal blow to a company s future earnings base. Honing technologies for downsizing and improved combustion efficiency will be essential as well, simply because internal combustion engines will remain the core technology for some time to come. Even in the advanced safety sector, technology development will be increasingly more important than in the past not only for collision safety, but also in terms of preventive safety and autonomous driving. 6/9

II. Evaluation of Financial Risk In addition to quantitative factors in the form of financial data, R&I also evaluates qualitative factors, such as a firm s financial management policy and liquidity risk, in its analysis of financial risk. For passenger vehicle manufacturers, R&I emphasizes the following financial indicators in consideration of their business characteristics. (1) Earning capacity EBITDA (earnings before interest, taxes, depreciation and amortization) margin EBITDA/average total assets Operating CF/average total assets Operating profit margin R&I evaluates whether a company is able to efficiently generate profits and cash flow from its sales and assets. In addition to variations in accounting standards, each company s depreciation expense burden is unique because of differences in the percentage of engines and transmissions produced in-house. R&I therefore places greater emphasis on the ratio of EBITDA to net sales than on operating income. Because of regulations, in China global manufacturers are developing their business in most cases through joint venture companies, to which the equity method is applied. When confirming earning capacity compared with total assets, R&I will confirm an indicator not only based on EBITDA, but also based on cash flow from operating activities that includes dividends received from the China joint venture company. These indicators emphasize the business segment that is centered on the passenger vehicle manufacturing and sales operations excluding the sales finance business, rather than the consolidated entity. The reason is that the sales finance business is characterized by assets that grow large in size, and the criteria for recognition of revenues can also differ depending on the accounting standard. For sales promotion expenses such as the strategic preferred interest rates for auto loans, each company s reporting method for the expense burden in its passenger vehicle manufacturing and sales operations and its sales finance business varies. To take this aspect into account, R&I confirms the operating profit margin on a consolidated basis. (2) Scale and investment capacity EBITDA Equity capital To maintain and improve competitiveness, and avoid being whiplashed by boom-and-bust 7/9

cycles, vehicle manufacturers must construct a business base in growth markets and undertake up-front investment in new vehicle development for each region. Addressing the rising development cost of next-generation technologies is vital as well. To illuminate such investment capacity, R&I focuses on the size of EBITDA. R&I also verifies the amount of equity capital as a measure of financial resilience for absorbing losses when they are reported. Motorcycle manufacturers have a lighter burden of capital and R&D spending than car manufacturers, and their assets are smaller. With this fact taken into consideration, R&I evaluates their scale and investment capacity. (3) Debt redemption period Net debt/ebitda ratio Net debt/operating CF ratio Amount of net cash Passenger vehicle manufacturers must increase their strategic capital investments and R&D spending to prepare for future changes in the industry s structure. Reserves that enable a company to respond adequately to the occurrence of a large-scale recall are also important. Not holding net debt and having ample net cash is linked to a positive evaluation. R&I evaluates the debt redemption period on a basis that excludes the sales finance business, which requires a substantial amount of funding. (4) Financial profile Equity ratio Net D/E ratio (ratio of net debt to equity capital) Companies must maintain a certain level of debt-equity structure to smoothly procure funds from financial institutions even during economic slowdowns. This can also be viewed as a buffer against risks ranging from profit deterioration to asset impairment. R&I focuses on the equity ratio for the business centered on passenger vehicle manufacturing and sales operations, excluding the sales finance business. R&I also verifies the net D/E ratio in a supplemental manner. In the sales finance business, R&I verifies the equity ratio for the sales finance business to highlight the risk buffer against future credit losses. When sales finance asset quality has deteriorated significantly, this will have a negative impact on R&I s evaluation. 8/9

(5) Liquidity risk A company requires a significant level of funding for its sales finance business, where assets and liabilities increase in tandem with business expansion. Preparing for contingencies such as financial market turmoil by ensuring sufficient liquidity and credit lines is critical. It is also important to diversify financing sources. III. Rating for Passenger Vehicle Industry Issuer Rating Individual Firm Risk Financial Risk Importance Base Indicator Importance Product competitiveness Earning capacity M EBITDA margin Production sy stem M EBITDA/av erage total assets Sales capability M Operating CF/av erage total assets Technological and dev elopment C Operating prof it margin capabilities Scale and C EBITDA investment capacity C Equity capital Debt redemption M Net debt/ebitda ratio period M Net debt/operating CF ratio M Amount of net cash Financial prof ile M Equity ratio M Net D/E ratio F Equity ratio Industry Risk: Medium Note) Importance is indicated by : extremely important, : important, or relatively important. In the Base column, "C" indicates consolidated results, "M" indicates manufacturing and sales operations (sales financing deducted from consolidated results) and "F" indicates sales financing operations. * This report replaces all previous versions that have been released to date. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. 9/9