Toyota Motor Corp's <7203.T> surprise quarterly profit and halving of its annual loss forecast were not enough to convince investors that the world's No.1 carmaker had escaped the worst, as government subsidies peter out and a strong yen takes its toll.

Toyota, the world's biggest carmaker by sales, wrapped up an earnings season dominated by rosier projections from Japanese automakers as they squeeze out savings and boost manufacturing efficiencies to offset the damaging rise in the yen.

The industry has been helped by government-backed incentives from Germany to China and Japan, aimed at igniting demand through the worst economic crisis in generations.

But with the outlook for demand uncertain as such stimulus programs begin to run out, Toyota is looking to eliminate more spending, announcing its exit from Formula One racing on Wednesday to put its annual budget of around $300 million to better use.

The question now is whether Toyota will become profitable in the January-March fourth quarter when output usually increases and domestic auto demand is expected to rise before Japan's tax breaks for low-emission vehicles end, said Koji Endo, a senior analyst at Advanced Research Japan in Tokyo.

The biggest challenge for Toyota now is cutting overheads, which had increased in the past 20 years or so when the company enjoyed growth. The company has not been able to respond to a sudden plunge in revenue with speedy cost reductions.

Toyota, until two years ago the world's most profitable automaker, had been the only top Japanese carmaker expected to post a loss in the latest quarter, weighed down by severe overcapacity after years of building new factories during its boom years before the financial crisis hit.

Toyota now expects an operating loss of 350 billion yen ($3.9 billion) for the year to March 31, still above an average projection of a 293 billion yen loss in a poll of 22 analysts by Thomson Reuters I/B/E/S. It narrowed its net loss forecast to 200 billion yen from 450 billion yen.

Toyota also lifted its annual group-based global vehicle sales forecast by 6.5 percent to 7.03 million units.

For the July-September quarter, the maker of the Prius hybrid car reported an operating profit of 58.0 billion yen, down 66 percent from a year earlier but beating an average estimate of a loss of 63 billion yen from five analysts.

Its net profit fell 84 percent to 21.84 billion yen, while revenue dropped 24 percent to 4.54 trillion yen.

For a graphic on Toyota's earnings click http://r.reuters.com/dut77f

Struggling U.S. rival Ford Motor Co also reported a quarterly profit this week, defying Wall Street estimates as it seized market share from rivals General Motors Co and Chrysler as they emerged from bankruptcy.

But the yen's strength remains Toyota's Achilles heel as it exports more than half of its vehicles built in Japan.

A top executive acknowledged that its U.S. operations remained difficult and that it must cut fixed costs more to battle a strong yen, which is making exports unprofitable.

The overall business in the United States for us is still very severe, Executive Vice President Yukitoshi Funo told reporters.

WORK ON CHINA

The second-quarter earnings mark a huge improvement from the previous quarter's 194.9 billion yen loss, as Toyota gradually ramped up production in Japan, where demand for its Prius and other hybrid cars has shot up thanks to generous tax incentives.

But with sales in the key U.S. market still far below their peak, Toyota is aiming to boost manufacturing efficiencies to be able to break even using just 70 percent of its parent-only output capacity.

Analysts expect capacity utilization to improve regardless, with Toyota exiting a 400,000 units-a-year factory in California that it had held jointly with GM.

On Wednesday, Japanese rival Nissan Motor Co <7201.T> revised its annual outlook to a profit from a loss as soaring sales in China helped it grab a bigger slice of the fast-growing market.

While red-hot demand in China has been a boon for all brands, Toyota's sales growth there has lagged the overall market's due to a dearth of smaller models that qualify for Beijing's tax incentives introduced this year.

To better cater to local demand, Toyota is looking to beef up its research and development functions in China.

The Nikkei business daily reported on Thursday that Toyota planned to spend 30-40 billion yen ($330-$440 million) to build an R&D center in China as early as next year. Toyota said it had not made any decision, although it has been considering various options in view of local consumer and government needs.

Shares of Toyota lost 2.7 percent during its second quarter, underperforming the Nikkei average's <.N225> 1.8 percent rise.

Before the results were announced, Toyota ended down 0.8 percent at 3,580 yen, against the Nikkei's 1.3 percent fall.

($1=90.77 Yen)

(Additional reporting by Taiga Uranaka)

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