Finding cost cutting has its limits, behemoths like NEC Electronics and Hitachi look to buyouts, joint ventures, and other ways to raise capital
It's not often you hear analysts say cost cutting has gone far enough, but that's what a research report from Macquarie said about NEC Electronics' restructuring plans for the next 12 months.
"Accelerated cost reductions are a positive but not a sustainable driver for recovery...it is difficult to sustain because it demands heavy sacrifices from employees in the form of large cuts to wages and bonuses and other severe economies. We believe NEC Electronics cannot maintain the annual cuts (in wages) without jeopardising long-term competitiveness and employee morale," it said. The Macquarie report, published in May, followed the management's proposal to cut ¥90 billion ($950 million) of fixed costs in the current financial year, up from an original plan to trim costs by ¥60 billion.
Both NEC Electronics and Hitachi have been prominent in announcing turn-around plans. The two Japanese companies, along with Mitsubishi Electric, are working together on a multi-way merger with Renesas Technology, which is set to create the third largest semiconductor company in the world. However, a one-month delay to the integration was announced on July 28—testimony to the problem of making mergers among Japanese companies work.
The Macquarie report sums up the greatest concern about Japanese technology companies, once the glory of the Japanese economy: they have little idea of how to escape the fix they are in, other than to slash costs.
NEC's ambitious cost-saving target makes it clear that the formerly sacred contract between companies and employees in Japan, even among the corporate aristocracy, is now a thing of the past. Actual redundancies may look low by Western standards, but pay and benefits are being slashed. However, it won't be enough. Indeed, in the long run, pay cuts worsen the situation of over-capacity in Japan since lower incomes discourage domestic consumption.
All these companies desperately need to raise capital, preferably equity, to compensate for their losses. In July, a rumour swept the market that NEC was preparing to raise up to $2 billion in equity, but the company has refused to comment on the rumour. None of the leading companies in Japan's tech sector (NEC, Hitachi, Mitsubishi Electric, Fujitsu and Toshiba) has raised funds in the past year. Toshiba will be grateful that it raised $3.5 billion in a massive follow-on in January 2008.
Despite its weak balance sheet, Hitachi, which announced a ¥91 billion net loss for the first quarter of the current fiscal year last week, is planning to spend $2.9 billion to buyout its five listed units in a bid to better coordinate its operations, reduce listing costs, and benefit from 100% of the units' earnings. Rather than a long-term and innovative business strategy, however, this mostly looks like financial engineering.
Like NEC, Hitachi has IT, semiconductor and electronics divisions. But it stands out on account of its power and industrial systems division, which builds elevators, thermal power plants and automotive systems. In the first quarter (April-June), this was the biggest unit of the group in terms of revenue (IT was the second-biggest). Hitachi is also engaged in financial services, logistics and specialised materials. The only units making a profit in the first quarter were the IT, logistics, and finance divisions. TVs, PCs and mobile phones all lost money. The ¥17 billion operating loss in the power division and the 86% decrease in operating income in the IT division had an especially large impact on the bottom line. Both are clearly suffering from the exceptional contraction of the Japanese economy, which is the worst-affected among developed economies by the financial crisis.
Hitachi's plan to buy out its subsidiaries, which was also announced last week, comes as the company forecasts losses of ¥230 billion for the current fiscal year (which ends March 31, 2010). And an analyst at Mizuho Securities told Reuters that "losses in the second quarter, along with the tender offer (for the subsidiaries), could deplete Hitachi's cash by ¥300 billion to ¥400 billion".
Hitachi also reported a net loss of ¥787 billion for the past fiscal year (ending March 2009). And in May, the company announced the equivalent of an individual raiding the piggy bank when it told its shareholders it wanted to reduce its capital reserves and earned surplus reserves—amounting to ¥340 billion—and redeploy the capital.
NEC's results are no more encouraging. The company reported a net loss of ¥297 billion for the year to March 2009 versus a gain of ¥23 billion in the previous fiscal year. Almost ¥180 billion of those losses were due to restructuring costs (¥72 billion) and losses on its equity stakes in other companies (¥75 billion). The latter shows the cost of Japan's answer to the threat of foreign takeovers.
NEC has three basic businesses: semiconductors; personal computers and mobile phones; and IT and network solutions. The first two categories are loss-making, while IT is a bright spot—it is profitable and accounts for over half of net sales. NEC has also carried out some overseas acquisitions, such as the takeover of NetCracker in the US and the acquisition of the rights to an undersea optical cable manufacturer.
For the first quarter this fiscal year (April-June), the company posted a net loss of ¥20.7 billion ($216 million) on revenues of ¥102 billion. Even so, NEC forecasts, quite bullishly in contrast to Hitachi, that it will post positive net profits and $1 billion in operating profits for the current fiscal year. Not everyone is convinced, however.
"The main problem with NEC remains low profitability. Its operating margins are too low. We would like to see them reduce their semiconductor business in particular. Their IT/network solution business profitability is rather better, but not enough to support NEC's total profits," Hiroki Shibata, a Standard and Poor's analyst, told FinanceAsia.
One potentially exciting area is that of lithium ion batteries for electric cars. NEC has set up a joint venture with Nissan for their development. Another area NEC is exploring is cloud computing, whereby users rent IT resources over the internet.
Shibata adds that he would welcome capital-raising by NEC in order to keep down its debt-to-equity ratio, which has worsened in the wake of the company's huge losses.
The May Macquarie report points out that the problem of generating growth is "more intractable" than cutting costs and requires a sustained effort "to expand and globalise the revenue base". The point about globalising the revenue base is well made. Despite its internationally famous brand name, NEC's export market is surprisingly small: the ratio of domestic sales to overseas sales is under 30%. And given the Japanese consumer's increasing poverty, it's not surprising that NEC is finding it difficult to sell personal computers and mobile phones domestically. Hitachi's revenue mix is more balanced, with around 40% coming from outside Japan.
Both companies must be praying for the debt-fuelled Chinese recovery to continue, since Asia is their largest revenue source outside Japan. But the problem in Japan at the moment for companies like Hitachi and NEC is not necessarily that they are badly managed, they are simply producing far too many goods which nobody can or wants to buy. They must either switch to producing new goods and services which people want, or downsize their existing operations. So far, for the most part, it looks as if they are being forced to choose the latter option.