Commodities

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

Anyone who thought Japan Inc.'s quality-control problems were coming to an end with the pending takeover of Takata Corp. just got a rude awakening.

Kobe Steel Ltd., the country's distant third-largest steelmaker, said Sunday that it had falsified quality data for an array of aluminum and copper products shipped over the past year.

That's not just an obscure testing issue in a business-to-business company: Kobe Steel is one of Japan's biggest producers of aluminum automotive panels and supplies parts to Toyota Motor Corp., Nissan Motor Co. and Subaru Corp. It's also sold faulty products to Mitsubishi Heavy Industries Ltd.'s under-development regional jet, the country's attempt to break into the market for smaller airliners where Boeing Co. and Airbus SE don't seriously compete.

What's in a Name?
Kobe Steel tends to derive a small or negative share of its earnings from ferrous metal
Source: Bloomberg

Just as failure of a structural metal part can cause cascading problems that endanger a car or aircraft, so Kobe Steel risks undermining the integrity of Japan's manufacturing industry as a whole.

At this stage it's too early to know what caused this lapse, but it's hard not to trace at least some of Kobe Steel's predicament to the way consolidation of Japan's steel industry has squeezed smaller players.

With the 2002 creation of JFE Holdings Inc. from Kawasaki Steel Corp. and NKK Corp. and the merger a decade later of Nippon Steel Corp. and Sumitomo Metal Industries Ltd. to form Nippon Steel & Sumitomo Metal Corp., Kobe Steel's market share in its namesake product has dwindled to little more than a footnote, even as the industry's output has declined.

Squeezed Middle
Kobe Steel has gone from a small player to a vanishing player in Japan's steel market
Sources: Bloomberg, company reports, Japan Iron & Steel Federation, Gadfly calculations

Its advantage has been a far more diversified business model, encompassing sales of construction machinery, power generation, and non-ferrous metals alongside the legacy steel division. Margins tend to be thin everywhere in metals manufacturing, but unlike in steel, those in aluminum and copper have at least been consistently positive.

The trouble with diversification, of course, is that it's hard for management to dedicate sufficient time to all the different business units. Returning the steel business to profit and collecting unpaid bills from Chinese buyers of construction machinery have been major tasks in recent years. With those squeaky wheels getting the grease, it's easy to see how the more reliable aluminum and copper business might have been starved of attention.

If they trade at all today, Kobe Steel shares are likely to hit limits before being halted. That sense of fear in the market raises the prospect that the steelmaker is heading into the desperate straits occupied by Takata and Toshiba Corp., or even toward a break-up that might make more sense of its sprawling business model.

That's probably an overreaction at this stage. Japan's metal industry lives and dies on its relationships with major consumers, in particular the auto industry, and Kobe Steel has some significant advantages on that front. At a time when automakers are increasingly switching from making body parts with conventional steel toward lighter-weight aluminum and tougher high-strength steel, this is a company with the rare ability to produce all three. Without it, Nippon Steel & Sumitomo Metal and JFE would become an almost complete steel duopoly, while UACJ Corp. would have the automotive aluminum market more or less to itself.

Takata's experience suggests that Japanese manufacturers can be remarkably forgiving of partners if that means keeping supply-chain disruptions to a minimum. Moreover, the amounts of metal improperly sold -- about 38,700 metric tons of aluminum, and 2,200 tons of copper, according to the company -- are fairly small next to sales of 359,000 tons of aluminum and 143,000 tons of copper in the most recent fiscal year. Kobe Steel's financial position is reasonably strong, too, with interest in the June quarter covered more than 10 times by Ebit.

Posit as a worst-case scenario that the costs run to 100 billion yen ($887 million), or around a third of annual revenue from the aluminum and copper division. Subtract that amount from the 61 billion yen group net income that analysts forecast for the year through March and you're still looking at a very bad year, rather than an existential crisis. If cash was really tight, a share placement on that scale to Toyota, the indulgent uncle of Japan's manufacturing sector, would eat up less than three weeks' worth of the carmaker's profit.

Taking the Hit
Kobe Steel's forecast net income this year is large enough to sustain a significant blow
Source: Bloomberg

That's not a reason to regard Kobe Steel as a screaming buy, even after any selloff. There's a reason why it traded at a consistent discount to the bigger steelmakers even before this crisis. Diversification is all very well, but this collection of jetsam makes a tough investment case.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net