FRANKFURT (Reuters) - Blinded by the runaway success of the Prius, Toyota Motor Corp (7203.T) mothballed the costly development of new diesel engines and bet the farm on hybrids taking off in Europe, a mistake that has since come back to haunt it.
Bitter rival Nissan Motor Co (7201.T) is on course to leapfrog Toyota as the best-selling Asian brand in Europe come March, should this year's sales trend continue, with Hyundai Motor Co (005380.KS) not far behind.
Faced with the risk of slipping into obscurity in a crowded European market, Toyota reached out for a life raft on Thursday, striking a deal to procure diesel engines from BMW's (BMWG.DE) range of combustion engines from 2014 and handing over access to precious battery technology in exchange.
Credit Suisse auto analyst Arndt Ellinghorst said the deal appeared to clearly favour BMW, since a carmaker with the size and profitability of Toyota does not normally need an ally.
"What I find revolutionary is that Toyota is effectively sharing with BMW battery technology that was jointly developed with Panasonic and Sanyo, which is the greatest electric vehicle and battery know-how in the industry," said Ellinghorst.
Christoph Stuermer, Director for Automotive Analysis and Forecasting at IHS in Frankfurt, said: "I think someone in the European headquarters just didn't want to go down without a fight and took matters into their own hands."
Partly due to last year's recall scandal that made headlines across the globe, Toyota's market share has crumbled to just 4.0 percent in Europe this year from a peak of 5.8 percent in 2007, according to data from the European auto industry body ACEA.
"This looks very much like an initiative from Brussels, since the Japanese executives are frustrated with results in Europe and didn't want to commit any more money there -- especially not for a high-tech diesel engine you can only sell on one continent," Stuermer said.
Toyota invested in Europe over 7 billion euros (6 billion pounds) in its operations, developed a whole line up of cars just for Europe like the Auris and Avensis, built four major vehicle manufacturing plants and directly created jobs for 20,000 people.
It was the envy of car makers worldwide, with a top-notch triple-A credit rating and undisputed leadership in lean production. Up until 2007, everything ran smoothly in Europe, with 11 straight years of record sales.
The Prius even won the prestigious European Car of the Year award for 2005, prompting European automakers to launch plans for "me-too" hybrids in a bid to catch up and lending credence to the idea that the technology was on the cusp of a market breakthrough, aided by tightening EU emissions rules.
Two years ago the company scrapped plans to offer in 2012 a new family of 1.6 litre diesels for passenger cars in the midst of development with Japanese truck maker Isuzu (7202.T), shifting Europe focus to hybrid technology instead.
Years later, annual sales of Toyota's petrol-electric cars in Europe across all nameplates are far short of the 100,000 mark, while diesel cars enjoy ever rising popularity on the continent thanks to affordability and solid fuel savings.
In the German car market, the region's largest, diesel engines account for about 47 percent of all new cars sold, for example -- and even that is below the western European average.
Of the 1.24 million new diesel-powered vehicles registered in Germany in the ten months through October, Toyota accounted for a measly 1 percent. Even those 13,400 vehicles represented near eight times the volume of its Prius hybrid in Germany.
Nissan, by comparison, can make use of alliance partner Renault's (RENA.PA) extensive range of diesel-powered cars and recently agreed with BMW archrival Mercedes-Benz to source large diesel engines for its Infiniti luxury brand in Europe.
WRONG MODELS, TOO
"Toyota put too much management attention on hybrids and are losing out in combustion engines right now," said Charles McKay, a business professor at the University of Applied Sciences in Gelsenkirchen.
Exacerbating the problem, the bulk of its hybrids including all Prius models have been imported from Japan as the yen has appreciated almost 40 percent in value against the euro since the end of 2007, when the company's sales in Europe peaked.
Even as recently as March, Toyota dedicated its stand at the Geneva auto show -- its most important European platform for generating marketing buzz -- solely to displaying the company's prowess in petrol-electric cars.
But Barclays Capital auto analyst Michael Tyndall argues hybrids are struggling now that innovations like turbocharging engines, or down-sizing to four cylinders from six, mean cheaper conventional engines are making efficiency leaps.
"It's fairly simple and straightforward economics -- look at the cost of fuel and the likely fuel saving, forecast average miles driven and you can calculate the payback period for the added investment for a hybrid," he said.
"For some models we're talking seven years or more depending on the price of petrol."
Even though the Auris hybrid is built in Britain, importing key parts from Japan means the vehicle retails from 20,095 pounds -- a marked premium over the conventionally powered Auris that starts at just 13,500 pounds.
This same problem could also affect the market competitiveness of its smaller Yaris hybrid when production begins in France in the second quarter.
Along with addressing its diesel weakness, Toyota is finally starting to fix some of its other problems in Europe.
This includes a 265 million euro investment that creates 1,900 new jobs and better utilises its UK factory near Derby, where production capacity was halved in August 2010. Meanwhile its French plant will have a third shift starting next year.
McKay warned Toyota would need a very attractive product pipeline for the next two years to regain lost market share.
"The problems are not only the engine side, he said.
"They also got it wrong with a model range policy that is too conservative. Toyota missed out on the trend to urban crossovers, where Nissan has done a great job with products like the Qashqai and smaller Juke."
(Writing by Christiaan Hetzner; Editing by Helen Massy-Beresford)