SHOCK VALUE
Japanese finance managers will be writing off more than US$20 billion worth of assets this spring. Could this lead to better times for the world's second-largest economy?
By Carla Rapoport

The coffee at Japan's largest computer company still tastes like mud. The white stuff to go in it could hold up a spoon on its own. Fujitsu officials still meet their guests in anonymous, gray rooms where the venetian blinds are the only decoration. It smacks of the corporate Japan of yore, of 1980s industrial might, as colorless as a salary-man's suit. Yet within this temple of bland conformity, Takashi Takaya, Fujitsu's chain-smoking CFO, has just launched some of the biggest changes the company has ever seen.

Change in Japan may sound about as meaningless as the deserving rich. After more than ten years of destroying value, however, Japanese companies, aided by a new cadre of CFOs, seem to be making the moves necessary to compete once again on a global stage. Will it be enough? Or is it a case of too little too late? For an answer, stick with coffee for a moment.

A few miles from that cup of Fujitsu brew, on the 35th floor of a slick new skyscraper, an ice-cold Starbucks frappuccino sits on the pod-shaped desk of a CFO with impossibly bushy eyebrows. A New Yorker who speaks flawless Japanese, John Durkin works for J-Phone, Japan's second-largest mobile phone operator, with revenues of about US$11 billion. Oh, and the company's owners are British.

Two forces are at work here. First, a series of incremental changes in Japanese corporate law have made it tougher for Japanese companies to fudge their figures. Coupled with the global downturn and razor-sharp competition in overseas markets, profits have nose-dived sending venerable companies across Japan into crisis mode. For example, capital spending as a percent of cashflow is expected to slip to 63 percent at manufacturers this year, its lowest level since 1981.

Second, Japan's ailing banks simply can't afford to carry their customers through today's fires, whether they are members of the same keiretsu (corporate group) or not. These forces are starting to take a toll - the number of failed companies in Japan in the year to March hit the third-highest level since World War II.

Still, the defensive actions being taken in Japan this spring - electronics companies alone wrote off more than US$15 billion from their balance sheets - are just a beginning. Real restructuring could take anywhere from three years to 30. But the process is lurching in the right direction. And if troubled Japanese companies don't face up to their problems, their banks, rapacious foreigners and, in some cases, their own shareholders are starting to scare up ways to take them off their hands.

Chief Fix-it Officer

These changes are being closely tracked by a world hungry to see Japan lumber off its economic sickbed. But curiously, one the most significant agents for corporate change has gone largely unnoticed. With unexpected frequency, Japan's corporate giants are announcing cuts to their leviathan boards, putting in what's called an "executive-style board", and appointing a post that's largely new to the Japanese, a CFO. Sony, always the maverick, did this a few years ago. US$40 billion-a-year Fujitsu announced a complete makeover of its board, including its first CFO, just two months ago. Daiwa Securities, Japan's second-largest securities group, with annual revenues of US$4 billion, appointed its head of global finance last year. It's no tidal wave, but it's happening. And as a fomenter of change, Daiwa's Shuichi Komori stands out as a man with a mission.

"Every company in Japan wants to know what will make them a global competitor," says Komori. With 11 years of experience running Daiwa's business in the US, he has a ready answer. "The key is that every board member must consider his top responsibility is the shareholder," he says. This kind of talk is close to heresy in Japan, where the focus has been ruthlessly aimed at the top line, not the bottom. And he knows the reason. "Traditionally, the Japanese board and its executives were undivided," says Komori.

Daiwa parted with this system three years ago and has been transforming its company ever since. The other tradition Komori wants to smash - the Japanese penchant for secrecy. "Transparency helps us - the Japanese shareholder is becoming more active," he says.

Komori is serious. Today Daiwa has one of the highest standards of corporate disclosure in Japan. It's also working hard on cleaning up its balance sheet. It just wrote off more than US$1.1 billion in the fiscal year to March through the sale of its property management business and a revaluation of its securities portfolio. The CFO has centralized the group's cash management, upgraded its IT, and put a rigorous risk management system in place that monitors Daiwa's risks on a daily basis. The results for the fiscal year just ended will be a sumo-sized net loss of about 128 billion yen (US$977 million). But this year analysts expect Daiwa to bounce back, turning in profits of 45 billion yen (US$345 million) on sales of 600 billion yen (US$4.6 billion).

Overseas fund managers have noticed. They've upped their stake in the company from 17 percent three years ago to 32 percent today. But Komori's job is far from finished. His big goal remains a significant improvement in the company's rating, which is now BBB/BBB+. For him, it's the Holy Grail of a lower cost of capital. But Daiwa's underlying business - coaxing risk-adverse Japan into the capital markets - remains about as lively as a senior citizen making his way up Mount Fuji. And this brings Komori back to his mission. "To revitalize corporate Japan, we have to revitalize the Japanese capital markets. To do that, there needs to be an ability to address risk," he says. This is where a CFO comes in. Japan needs more of them, he says.

And here - this is Japan after all - Komori is getting some help from above. The move to a US-style board structure is being spearheaded by a government-inspired change to Japan's Commercial Code, expected to take effect next year. Following the revisions of the code, Komori says, corporate board members will be less concerned about their close relationships with banks and associated companies, and more focussed on creating value for their shareholders. Why? "Over-dependence on banks is the reason Japan has such a huge mountain of non-performing loans," says Komori. "Companies who can no longer depend on their banks will have to go to capital markets - these markets can accept all kinds of risks," he says. True, but in a classic case of a cat chasing its own tale, this gets back to ratings. According to Akio Mikuni, president of Japan's highly respected rating agency, Mikuni & Co, of the 733 bond issuing companies in Japan, two-thirds are sub-investment grade.

Gladly Bearing Crosses

Why, you might ask, are all those companies still in business? The answer is simple. While more and more Japanese companies are realizing they have to change to survive, the Japanese stock market remains rigged in favor of incompetence. Anywhere else in the world, bad management is replaced or the company is bought. In Japan, some 35 to 38 percent of the stock market is still held in what's know as cross-shareholding. In other words, shares are held for reasons of long-term relationships and not for yield or appreciation. This figure is slowly unwinding, thanks to government legislation, but not fast enough to force a dramatic pace of change. "The system (of cross-shareholding) corrupts the discipline of the market. It provides carte blanche to management," says Kenya Takizawa, partner at M&A Consulting, a Tokyo-based investment management company.

Not completely. And this is where things are starting to get interesting. M&A Consulting has caused a national sensation in Japan by taking stakes in companies with large piles of cash and making public demands of the boards to provide a better return on their investment. At the same time, ailing companies that are unwinding their cross-shareholdings and restructuring their businesses are putting an unprecedented number of subsidiaries up for sale. And foreigners, for the first time, are being welcomed as a source of cash.

Even unwanted foreigners are making incursions. UK-based Vodaphone's US$11.5 billion unsolicited takeover of J-Phone was completed by patiently collecting stakes in J-Phone's parent that had been sold to other companies. "[Japan] is becoming a good market for M&A," enthuses Taiji Okusu, managing director of UBS Warburg in Japan. Goldman Sachs in Tokyo even publishes a Takeover Recovery Cost Ranking, listing those companies whose cash could cover the costs of a takeover bid according to the time it would take the buyer to recoup its investment. Hostile takeovers, it seems, are coming to Japan.

Be Very Afraid

Few CFOs understand the opportunities better than the New Yorker with the cold frappuccino on his desk. Japanese companies should be scared of people like Durkin. With 11 years experience in Japan under his belt, most recently as CFO of Nike Japan, Durkin has both a deep understanding of finance and a total command of the Japanese language. In a country where even two sentences of Japanese from a foreigner still shocks the average local, this combination equals power. Forget the all-American trappings of his office, the Jimi Hendrix CDs, the blue post-it notes and the Nike paraphernalia. This guy created a finance department for a US$11 billion-a-year Japanese company from scratch in six months.

Durkin's achievement shows how much work remains ahead of the average company in Japan. At J-Phone, like most Japanese companies, there was no head of finance, just an accounting manager at each of the nine operating companies. These were merged into three companies in late 2000 and then became one, following the takeover, in November of last year. The lack of leadership was problem number one. "If no one's running the finance department, what happens? Costs go out of control," he says. The capital expenditure budget was a whopping 600 billion yen (US$4.5 billion) when Durkin came on board. Cutting it meant taking a group-wide focus.

Decisions were getting made, he says, on the basis of fairness, a principle that cuts to the bone of the way the Japanese like to live their lives. "One division was spending X on developing new phone services, then another division spent the same amount and so on, regardless of the market needs.

There was no CFO, no central control. It was like herding cats," says Durkin. Equipment was bought by three separate groups on three different sets of terms in three different locations. "If one was short, the other didn't help them out," he says. And to make matters worse, the phones weren't being bought by a purchasing department, but by the sales department. Not surprisingly, inventory went the way of costs - out of control.

Excess inventory, according to Durkin, is a kind of drug in Japan. Companies use it to create discounting wars. In the mobile phone market, handsets routinely sell for as little as 1 yen. The idea is to hook in new subscribers to the pricey phone services and thus recoup the value of the phone. Durkin hates the practice with a passion. Within days of taking over, he decreed that J-Phone's handsets would be bought by just one group in one location and on one set of terms. He took a 20 billion yen (US$153 million) write-off on excess phone inventory. Today, he says proudly, the company's best-selling phone, which takes photos and handles five-second video clips, sells for 29,500 yen (US$226).

This activity comes at a cost - a net loss this year of just under 20 billion yen. But Ebitda, he says, will reach just over 20 percent. Durkin's goal is to take that line to 30 percent in three years. And following a March presentation with his American CEO in London, the international investment community seems inclined to believe him.

Andrew Beale, telecoms analyst for Deutsche Bank in London, reckons that the turnaround at J-Phone will yield Vodafone US$1.4 billion of incremental Ebitda annually. "The message that J-Phone has historically been an under-managed asset came across very clearly, with many examples of poor controls and overspending. Simple actions have been taken to reduce costs and improve margins by the CFO," he states.

U-Turns are Us

Simple actions, perhaps, for CFOs in a hot business with the latest technology. It also helps to have a slim-line workforce and a core product made by fiercely competitive suppliers. Durkin not only sells phones that can email photos, he can actually put his company's business in his pocket. Consider in comparison the gargantuan task of Takaya at Fujitsu. The CFO of the computers-to-chips giant recently assisted in pushing through the unprecedented step of cutting its workforce by more than 11 percent, an almost unheard of action in Japan.

But after the bloodletting, Fujitsu still had 167,000 employees worldwide. J-Phone has 3,000 direct employees and, using the new model of outsourcing for call centers, maintenance and manufacturing, just 9,000 indirect employees. Even lumping them together, that's still only 7 percent of Fujitsu's workforce. But J-Phone already generates about 25 percent of Fujitsu's sales volume and, even more telling, this year, J-Phone will probably outdistance Fujitsu's Ebitda by a factor of two.

This comparison is a bit of a stretch but a useful one. Companies all over the world are moving to an asset-light business model (see "Asset Lite," April 2002), outsourcing manufacturing and emphasizing the value created by strict supply-chain management and strong financial controls. In Japan, no such "big think" is going on, or if it is, Japanese executives aren't saying. Instead, companies like Hitachi, NEC, Matsushita and the other multi-billion dollar-a-year companies are working on paring down their businesses in a race to restore profitability. Fujitsu even presented its initiatives to the investment community under the rubric "Raising Corporate Value", unveiling a new board structure as well as asset sales, write-offs and redundancies. Its new CFO, according to Warburg's Okusu, "always fights back."

But when you meet Takaya, it's easy to understand why Japan's U-turn is going to take some time. The 420 billion yen (US$3.2 billion) in restructuring costs that the company will write off in the year to March, he says, is not the end of their efforts, but he won't be more specific. As for having an executive management system, Takaya says: "We know who is responsible for what and that helps us in terms of accountability. Decisions can be faster and we can cope with changes." Okay, but Fujitsu's main strategic change is to an IBM-style customer-oriented structure, a move which is more derivative than bold.

The company has been busy - it turned its 17 business units into three divisions - software platforms, electronic devices and semiconductors. It's shuttering plants in the US and Ireland and amalgamating others. But why is Fujitsu still making chips when Taiwan cornered this market years ago and China is now where the action is? Fujitsu's leading edge technology, he replies. He also believes sales will bounce back. But if Fujitsu's using an EVA or ROE-based system to evaluate its businesses, he's not saying.

Unlike its global rivals, Fujitsu hasn't adopted a performance-based management system, nor have stock options been spread beyond top executives. This is "under consideration," he says. "But options aren't enough to motivate people," he says, insisting that training and public appreciation of employees is enough. As for corporate governance: "We know that the Japanese reporting system is not appreciated by the rest of the world so we have to make some changes soon," he says, but is vague on the details.

Japan's cross-shareholding, Takaya admits, needs to be unwound. Fujitsu now has 18 percent of its shares held by companies that won't sell and holds 20 percent of other family companies, down from 30 percent. But why hold any? The relationships are loosening, he admits. Fujitsu's purchases from its keiretsu companies have dropped from 70 percent five years ago to 30 percent today.

Following the company's restructuring announcement, Nomura Securities rerated Fujitsu from "reduce" to "hold". It forecasts big losses for the year ended last March, more losses this year and net profits of 55 billion yen (US$422 million) on sales of 5.4 trillion yen (US$41 billion) in 2003. That's a net 1 percent return on sales. Comments Patrick Furtaw, managing director of Stern Stewart, the EVA consultants, in Japan: "They're in a lousy business and they're bailing water."

There's more to this, however, than a lousy market for computer systems. Visit Takashi Inoue, deputy manager, Economic Policy Bureau, of Japan's Keidanren, the premier association of corporate Japan, for the real battle Takaya faces. Inoue has all the details of the moves to upgrade Japan's corporate governance regime. After ticking off each initiative, he stops, and says the following through his interpreter: "We are adopting American-style accounting standards. But that doesn't mean we are adopting US-style management." For example, some cross shareholdings, he says, will remain.

And he adds: "Japanese lifetime employment will remain. Japanese management tends to work for the long term rather than for fast profits." It's that long-term view that CFOs like Takaya have to fight. Mikuni, at the rating agency, responds to Inoue's point with real fire in his eyes: "This is what will destroy Japan's manufacturing industry. If you keep lifetime employment, you can't compete in a global market. Shedding jobs is better than bankruptcy." The Nihon Kezai Shimbun, Japan's leading business daily, isn't nearly so clear-eyed but it recently thundered in an editorial: "Even their costly and painful restructuring measures this year will probably not be enough to turn these giants around quickly. The biggest problem with their management models is the rapid fluctuation of IT markets, where prices collapse and new technology becomes stale very rapidly. They cannot raise profits merely by ending outdated corporate practices."

Hollywood and Chips

You would think that few companies understand this better than Japan's best known maverick, US$58 billion-a-year Sony. Never part of a keiretsu, always ready with a knockout innovation, Sony has long stood a cut above the traditional Japanese company. It moved to an executive-style board years back and has an impressive line-up of non-executives on its board. But in recent years, even Sony has come unstuck. While still profitable, the company is no longer making the money it once did. Like Daiwa Securities, however, Sony has a top-notch reputation for good corporate governance and is more receptive to requests for interviews than its more secretive brethren.

Nonetheless, a visit to Sony's headquarters is like stepping into the belly of corporate Japan. Aside from a the cheerful bob of a robotic dog at the reception area, the look and feel of a Sony meeting room is as cold as stone. CFO Teruhisa Tokunaka exudes the impatience of a general called back from the front - he'll do interviews because it's part of his job, but he'd rather get on with running his business. Fair enough. But try to winkle out any sense of whether Sony can regain its former glories and you'll walk away little the wiser. For example, like Fujitsu and other electronics giants, Sony makes a bewildering variety of products that can now be made so much cheaper by contract manufacturers in places like China. What's the added Sony value in computer peripherals? And why hang on to the US movie business that provided a distinctly unsexy operating margin of 0.8 percent last year?

On Sony's wide spread of businesses, Tokunaka defends the company, saying that by keeping its hands on manufacturing, it helps differentiate the Sony product in the marketplace, ensuring that it's more competitive. He admits this hasn't worked in every business, particularly PCs, but won't go into specifics. "We have to be more careful of how we invest in particular markets. If you invest too much, you can get too much exposure to volatile markets," says Tokunaka. "The basic concept is vertical integration versus optimal size. We need a more careful balance, particularly in capital spending," he says.

To help with this process, Sony has adopted economic value added (EVA), which compares the returns of each business to the cash invested in that business. The CFO says the concept was introduced two years ago and "is beginning to take wide effect." In addition to stamping down on inventory levels, Tokunaka says that the restructuring costs announced so far are just a beginning, with more expected as this magazine went to press. The company is also cleaning up its balance sheet by revaluing the property on its books and shedding non-core assets.

As for movies, he actually goes back to Sony's famed Betamax, reminding his visitor that the movie industry sued Sony at the time to prevent the video cassette recorder from pirating its products. In fact, he says, the VCR created a whole new industry. Now that Sony owns a chunk of the movie industry, Tokunaka sees a whole new distribution channel opening up with widespread broadband Internet access. And there's another benefit. "Without Sony's music business, there would be no Sony Play Station today," he says. Sony's combination of technology and entertainment, he says, pulls the best software developers.

Broadband, however, is still "out there". Despite its efforts, Sony is likely to improve its operating profit margin just 3.5 percent this year. Like the rest of Japan, Sony's return to its past glories will take time. "Japan isn't going to change overnight," says Stern Stewart's Furtaw. "In the US we're suggesting that companies change their metric for inventive compensation. Here, we are explaining what variable pay is. Or asking companies what their compensation plans are. Or even asking if someone is responsible for a particular business unit's performance."

Sony, in fact, is continuing to move to a cross-functional business model, something that US companies adopted more than 20 years ago. Others are following. "It's a dramatic change, dividing up functional fiefdoms. Someone's not just responsible for sales and marketing, but the unit's bottom line," says Furtaw. Until the new, younger, foreign-educated executives move in, however, this force for change may move slowly. Older executives in Japan are like senior creditors, with the most to lose if the compensation or organization structure changes, Furtaw notes. .

Dodging the Bullet

But for ample proof that even older Japanese executives see the writing on the wall and are learning to dodge and weave, meet Yuji Suzawa, age 65, CFO and deputy president of Chugai Pharmaceuticals, one of Japan's most respected drug companies. Over the last ten years, Japan's share of the global drug market droop from 23 percent to about 15 percent today. Through an interpreter, Suzawa says: "If Japanese companies want to be globally competitive, they have to do something." For the US$1.6 billion-a-year company, that something was a friendly agreement to sell 50.1 percent of its shares to Swiss drug giant Roche.

The Japanese company maintains its management, takes in the sales force and products of Roche Japan, and can now promote its drugs through the Roche global network. Chugai is now part of a company that ranks fifth in R&D spending globally, ahead of Astra Zeneca. "We used to rank 32nd in terms of R&D spending," he says with a smile. The deal wasn't done out of duress - Chugai makes a respectable profit. It was done because the top ten drug companies in the world spend more than US$2 billion a year on R&D. Chugai was spending less than US$300 million. "We could no longer stand by ourselves," he says.

Suzawa found a successful, if shocking, way out of his company's problems. Foreign takeovers in Japan are still rare. But over the next few years they'll become more common. As Harunobu Yamada, chief executive, HSBC Securities (Japan) puts it: "If Japanese companies will promote new finance managers, who manage on the basis of cashflow and value creation rather than accounting profits, then Japan will change." It's a big if, but not impossible. After all, five years ago, no one in Japan had even heard of Starbucks.

Carla Rapoport is managing editor of CFO Asia based in Hong Kong.