Last year, Toyota officially eclipsed General Motors as the world’s largest automaker by sales. But the Japanese company’s strength is only relative, according to industry experts: Like its competitors, Toyota is struggling against a sharp drop-off in sales and global overcapacity.

In other words, the company did not surge past GM in global sales; it simply managed not to fall as far. Toyota sold fewer cars in 2008 than it did in 2007, its first yearly sales decline in 10 years. After it closes its fiscal year in March, the new Number One global automaker expects to record its first annual operating loss since it was founded in 1937. In January, Toyota sold nearly 32% fewer cars in the U.S. than it did in the first month of 2008. January was even worse for the major U.S.-based manufacturers: Ford, down 40%; GM, down 49%; and Chrysler, down 55%. Only Subaru and Hyundai reported U.S. sales gains for the month.

“Even at this moment of becoming Number One, it is not a surprise that Toyota is not immune to this global slowdown,” says Wharton management professor John Paul MacDuffie, whose research focuses on the auto industry. After years of conservative growth, Toyota accelerated its expansion over the past decade, making it harder to put on the brakes in the current downturn. “Going from rapid growth to dramatic … shrinkage is a huge challenge to [the company].”

Toyota and other Japanese firms operate on a business model that emphasizes protecting employees’ jobs at all costs, he notes. But the severity of this downturn has forced Toyota to take some steps that erode its management-worker loyalty pact. In Japan, where Toyota employs about 70,000 full-time workers, the company cut part of its temporary workforce. In the United States, it laid off temporary workers at a pickup truck plant in Texas and postponed plans to build its Prius model at a new plant in Mississippi.

“[Toyota] may come out of this stronger,” says MacDuffie. “The question is, how long will the crisis last, and how much will it present them with dilemmas that can’t be resolved without violating their sacred commitments and principles?”

During its expansion, Toyota developed a global roster of independent, more self-sufficient subsidiaries that can offer credit and financing to those customers who venture into showrooms, according to MacDuffie. The company also has enough cash to fuel development of innovative products, and its cars typically maintain their resale value longer than its competitors — which may be another advantage in a cautious economic environment, he notes.

Toyota “can emerge in a better position, but it’s all a relative game,” says MacDuffie, who also predicts that demand for autos is not likely to be substantially displaced by mass transit. “The question is, [which company] is going to be in the best position to take advantage?”

‘The Prince’ Ascends

Toyota is also coming up on another milestone. In June, Akio Toyoda, known in Japan as “the prince” because he is the grandson of the carmaker’s founder, will ascend to president, Toyota’s top job. The American-educated Toyoda, 52, has extensive experience in the company’s global operations.

Wharton management professor John R. Kimberly says the appointment is not a reflection on the current leader, Katsuaki Watanabe, who performed ably given the severity of the economic crisis and is moving to the position of vice chairman. While Toyoda is coming into the job nearly eight years younger than is typical in Japan, Kimberly notes, the incoming heir has been groomed for the position for many years and the appointment comes as no surprise. “He is a very capable guy who is very tough-minded. He’s clearly got his challenges in front of him, but I think he’s well positioned to take Toyota ahead.”

According to Kimberly, the decision to advance Toyoda to the top position at a relatively young age may be a symbolic statement by the company’s board. “The timing could say that the reason he was chosen now was to reassure the company and the rest of the world that Toyota is strong and a resourceful and resilient player.”

“I think there was a desire to announce a leadership change earlier and create an opportunity for him to make some dramatic changes,” MacDuffie says. “He’s often quoted as saying that Toyota’s top management is too conservative. He may want to make some sweeping changes. We’ll see.”

Wharton management professor Lawrence G. Hrebiniak points out that because Toyota grew rapidly, some problems may have crept into its world-class production system. In a number of facilities, older workers with extensive knowledge of their plants and processes are retiring, leaving their jobs to workers who are not as yet in step with their work. As a result, Toyota, which built market share on a reputation for top-quality products, has experienced recalls and quality problems with its vehicles of late. Recently, it announced a recall of 1.3 million vehicles worldwide to fix defects in seatbelts and exhaust systems.

“This suggests that as wonderful as [Toyota’s] model is, they might have to fine-tune it again,” says Hrebiniak. “It might be that they’ve risen to the point where they are so large that their size, and the changeover in workforce, might be suggesting some production-related problems for the future. I think the new president has to worry about those production issues.”

Another problem for Toyota is the rising strength of the yen, as investors around the world pour money into Japanese securities seeking safety in a tumultuous global economy. “The yen is a big headache for the Japanese right now,” MacDuffie says. “Added to everything else, it’s a tremendous burden. It’s one thing to deal with a dramatic shift in exchange rates that made products more expensive for consumers in good times; now it means you have to persuade people to pay more when they are still not buying cars. If you take drastic declines in demand and add on the strong yen, which makes their cars much more expensive, it’s a very tough challenge.”

Bad Bet on Trucks

Gérard P. Cachon, Wharton professor of operations and information management, warns that Toyota, like General Motors and other U.S. competitors, has the wrong product mix for the current market. Despite its roots as a producer of small cars, Toyota now relies heavily on larger vehicles, including trucks that are no longer the sales and profit leaders in the U.S. Toyota’s mix is not as bad as General Motors’, he adds, because it does have some sedans and fuel-efficient vehicles, but it is not as oriented toward popular small cars as Honda. “Right now, it doesn’t look like demand is coming back in trucks soon, so Toyota and General Motors are both in a precarious position.”

On the other hand, Toyota is better positioned to readjust its product mix than its competitors. Cachon notes that General Motors carries inventory for 70 to 75 days, while Toyota, with better management of its supply chain and production system, typically has 35 to 45 days’ worth of inventory. If General Motors could attain the same efficiencies, Cachon says, the company would save about $4 billion.”If GM had been able to reduce inventories in the past, they wouldn’t be caught in the downwind and would have had more working capital … to ride out the storm.”

General Motors is also hampered by a need to feed a large network of dealers that tend to be located in older, slow-growth areas, Cachon adds. Toyota, which built its dealer network decades after General Motors, has fewer dealers, but they are generally in areas with stronger population growth.

Volatility in global energy markets in 2007 and 2008 played well into Toyota’s strategy to move toward more fuel-efficient products, which goes back as far as 2000, says Eric W. Orts, a professor of legal studies and business ethics at Wharton who specializes in environmental issues. Even though energy prices have declined, Orts notes that consumers are now sensitized to the risk of higher gasoline prices and will continue to be interested in autos that conserve fuel. “When consumers are hurt that way, they don’t forget it. They realize there is no guarantee oil prices will stay low.” It’s clear, he adds, that the Obama administration will take steps to increase environmental standards for auto manufacturers.

Toyota may be ahead on the issue of fuel-efficiency because Japanese companies, in general, tend to be more environmentally aware, according to Orts. He also argues that the Japanese corporate model, which puts greater weight on long-term results than U.S. firms, may be another reason Toyota is faring relatively well in the current crisis. “The U.S. car companies completely missed the signals and took a very short-term view.”

In the past, the rise of Toyota and other global automakers riled protectionist urges in the United States, but MacDuffie says that is not likely to be a problem for Toyota now. “It is striking that foreign auto markets have looked very good in comparison to the Detroit three amid this crisis,” he notes. Americans are unlikely to turn against Toyota and other foreign automakers now, he adds, because their products make up a major share of the market and have been endorsed by consumers who shifted away from U.S. automakers over the past several decades. Also, Toyota has made an end-run around the possibility of protectionist import restrictions or tariffs by building new plants in the United States that employ thousands of workers.

“People have seen [Toyota] come here and invest in production and jobs and be a good corporate citizen and promote philanthropic causes,” Orts explains. “They have built that image carefully and have a very strong reputation that’s paying off now in the fact that there isn’t any nationalist or protectionist surge of sentiment against them.”

Not the Acquisitive Type

In many industries, an economic downturn typically becomes an opportunity for strong companies to make opportune merger and acquisition plays at the expense of weaker competitors. While Toyota is a survivor, MacDuffie says there is no reason to expect it will attempt to consolidate the industry. “Toyota has always been very clear in wanting to grow organically, not through acquisition. It has a strong culture and it is not easy to bring in other firms.”

MacDuffie points out that Toyota has even been modest in its use of alliances, such as its agreement with General Motors to import vehicles into Japan. “They cooperate, but I think it’s mostly Toyota’s goal to be seen as a good corporate citizen in the U.S. — to have a cooperative, friendly relationship with GM even as it overtakes it, rather than a highly competitive [attitude].”

According to Kimberly, Toyota faced a similar economic downdraft in the 1950s when it almost went bankrupt. Since then, the company has maintained a relatively conservative financial posture which may be paying off now. “My guess is their fiscally conservative nature will help them weather the storm in ways other companies can’t,” he says. “You’re not going to see Toyota headed to its government looking for bailouts. What you will see is that they will have more staying power than many of their competitors.”

Of course, Toyota’s U.S.-based competitors are running to their own government for taxpayer-financed bailouts. Kimberly notes that Toyota, too, would benefit if GM, Ford and perhaps even Chrysler receive bailouts that allowed them to survive the current crisis. This is because Toyota relies on many of the same supplier networks that feed the Detroit Big Three. If any of the U.S. firms fold, many suppliers would also go under, leaving Toyota with fewer options for partners in its signature production system that encourages supplier participation in innovation, product development and efficient operations.

Beyond that, Kimberly adds, strong competition keeps Toyota sharp. “They’re part of this ecosystem of manufacturers of autos and trucks, and they need the competition to keep them on their game as a premier player…. They derive a lot of strength and a lot of their incredible resiliency from competition. If GM or Ford were to fail, it would take a little of the pressure off, but ultimately given who they are as a company, that might come back to bite Toyota.”