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A new wave of CFOs is bringing badly needed financial discipline to corporate Japan.

1Jul

In Japan, where courtesy still rules supreme over substance, a growing number of business leaders are starting to get downright rude. Frustrated by 10 straight years of declining shareholder values, these leaders are doing the previously unthinkable--writing off billions of dollars in worthless assets, selling off whole divisions, breaking off business relationships that date back to the postwar era, firing employees, and reorganizing the way they run their businesses.


And despite the growing mistrust of U.S. accounting practices in the wake of Enron, Japanese business leaders are looking to this country for inspiration, particularly in two respects that cut to the heart of Japan's economic malaise: corporate governance and financial management.


"Every company in Japan wants to know what will make them a global competitor," says Shuichi Komori, head of global finance at Japanese securities giant Daiwa Securities Group Inc. With 11 years of experience running Daiwa's business in the United States, Komori thinks the answer lies in a precept of American-style management: "The key is that every board member must consider his top responsibility is the shareholder."


This kind of talk still borders on heresy in Japan, where companies have ruthlessly focused on the top line, not the bottom. The reason for this orientation, says Komori, is that the Japanese board of directors and its executives are typically undivided. Traditionally, directors come from inside the company or from related companies, and therefore have a vested interest in maintaining the status quo.


Not any more--at least at companies like Daiwa, which scrapped its board three years ago in favor of a smaller, so-called executive-style board, with outside directors. What's more, in another nod to U.S. management practice, some Japanese companies have created a new executive position: the CFO.


Most companies in Japan don't have a head of finance. Sony Corp., long considered a maverick in Japan, revamped its board and hired its first CFO only three years ago. Last March, computer giant Fujitsu Ltd., with fiscal 2001 revenues of $37.6 billion (¥ 5 trillion), announced a complete makeover of its board and the hiring of its first CFO, Takashi Takaya. Meanwhile, at Daiwa Securities, Japan's second-largest securities firm with revenues of $3.7 billion, Shuichi Komori became the first-ever head of global finance in 2001.


Why are Japanese companies starting to hire CFOs now? Two forces in particular are at work. 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 companies across Japan into crisis mode. For example, capital spending as a percentage of cash flow 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 first three months of 2002 hit the third-highest quarterly level since World War II. Electronics companies alone wrote off more than $15 billion from their balance sheets this past spring.


Such defensive actions are just the beginning of a real restructuring of Corporate Japan, which could take anywhere from 3 years to 30. But the process is lurching in the right direction. And if managers of 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 those companies off their hands.



Disclosing Daiwa

Facing up to problems means more disclosure--easier said than done, given the penchant for secrecy in Japan's business culture. But it must be done, says Komori. "Transparency helps us," he declares.


Today Daiwa has one of the highest standards of corporate disclosure in Japan. It's also working hard on cleaning up its balance sheet; recently it wrote off more than $1.1 billion through the sale of its property management business and a revaluation of its securities portfolio. Komori 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 result for the fiscal year just ended was a sumo-sized net loss of nearly $1 billion (¥ 130.5 billion). But analysts expect Daiwa to bounce back in the current year, for which they project profits of $345 million on sales of $4.6 billion.


Overseas fund managers have noticed, upping their stake in the company from 17 percent three years ago to 32 percent today. Still, Komori's job is far from finished. His big goal is to raise Daiwa's barely investment-grade rating of BBB/BBB+ and lower the securities group's cost of capital. But that won't happen if risk-averse Japan can't be coaxed back into the capital markets. "To revitalize Corporate Japan, we have to revitalize the Japanese capital markets. To do that, there needs to be an ability to address risk," asserts Komori. That's where the CFO comes in, and why Japan needs more of them, he says.


Here, Komori is getting some help from above. The move to a U.S.-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 to the code, Komori says, corporate board members will be less concerned about their close relationships with banks and associated companies, and more focused on creating value for their shareholders. Why? "Overdependence on banks is the reason Japan has such a huge mountain of nonperforming loans," says Komori. "Companies that can no longer depend on their banks will have to go to capital markets--these markets can accept all kinds of risks."


True, but in a classic case of a cat chasing its own tail, this gets back to ratings. According to Akio Mikuni, president of Japanese rating agency Mikuni & Co., two-thirds of the 733 bond-issuing companies in Japan are below investment grade. How do all those companies remain in business? The answer is cross-shareholding. Some 35 to 38 percent of the Japanese stock market is still held in this arrangement, in which companies buy each other's stock to cement long-term relationships. "The system [of cross-shareholding] corrupts the discipline of the market," says Kenya Takizawa, partner at M&A Consulting, a Tokyo-based investment management company. "It provides carte blanche to management."


Not completely. M&A Consulting has caused a national sensation in Japan by taking stakes in a handful of 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. "[Japan] is becoming a good market for M&A," says Taiji Okusu, managing director of UBS Warburg in Japan.



Picking Up J-Phone

Even unwanted foreigners are making incursions. Goldman Sachs in Tokyo 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.


One came in November 2000 to J-Phone, Japan's second-largest mobile-phone operator. U.K.-based Vodafone's unsolicited $11.5 billion bid was completed by patiently collecting stakes in J-Phone's parent that had been sold to other companies. The new owners installed the company's first CFO, John Durkin.


A native New Yorker with 11 years of experience in Japan, Durkin speaks fluent Japanese, an ability that helped him create a finance department from scratch in six months. Before the takeover, J-Phone had no head of finance--just an accounting manager at each of its nine operating companies. Those nine entities were merged into three companies in late 2000, then became one company after the takeover. J-Phone's lack of financial leadership was problem number one, says Durkin: "If no one's running the finance department, what happens? Costs go out of control."


J-Phone's capex budget was a whopping $4.5 billion when Durkin came on board. Cutting it meant taking a groupwide focus. Decisions were being made, he says, on the basis of fairness, a very Japanese ethic and common corporate practice. "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," says Durkin. Equipment was purchased by three separate groups in three different locations on three different sets of terms. "If one was short, the other didn't help them out," says Durkin. Making 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 can be a weapon in Japan; companies use it to start discounting wars. In the mobile-phone market, handsets routinely sell for as little as ¥ 1. The idea, of course, is to hook in new subscribers to the pricey phone services. But Durkin hates the practice, and within days of taking over he decreed that J-Phone's handsets would be bought by just one group in one location, on one set of terms. The company took a $153 million write-off on excess phone inventory. Today, Durkin says proudly, the company's best-selling phone, which takes photos and handles five-second video clips, sells for $226.


These actions came at a cost. J-Phone's EBITDA of just over 20 percent is the lowest among Vodafone's 28 groups worldwide, and far below the 33 percent posted last year by Japan's domestic wireless leader, NTT DoCoMo. Durkin says his goal is to increase EBITDA to 30 percent in three years. Following J-Phone's March presentation in London, the international investment community seems inclined to believe him. Andrew Beale, telecommunications analyst for Deutsche Bank in London, reckons that the turnaround at J-Phone will yield Vodafone $1.4 billion of incremental EBITDA annually. "The message that J-Phone has historically been an undermanaged asset came across very clearly, with many examples of poor controls and overspending," states Beale. "Simple actions have been taken by the CFO to reduce costs and improve margins."



Downsizing Fujitsu

Simple actions, perhaps, for a CFO in a hot business with the latest technology and a lean workforce. Not so for Takaya at Fujitsu. The CFO of the computers-to-chips giant recently helped push through a reduction of its workforce by more than 11 percent--an almost unheard-of action in Japan.


Even after the bloodletting, though, Fujitsu still had 167,000 employees worldwide. By comparison, J-Phone has just 3,000 direct employees and, using the new model of outsourcing for call centers, maintenance, and manufacturing, 9,000 indirect employees. But J-Phone already generates about 25 percent of Fujitsu's sales volume, and this year J-Phone's EBITDA will probably outdistance Fujitsu's by a factor of two.


This comparison may be a bit of a stretch, but it underlines a basic reality about Japanese corporations. While many U.S. companies are moving to an asset-light business model, outsourcing manufacturing and emphasizing the value created by strict supply-chain management and strong financial controls, no such "big think" is going on in Japan (or if it is, Japanese executives aren't saying). Instead, companies like Fujitsu, Hitachi, NEC, and Matsushita are working to pare down their businesses in a race to restore profitability.


Last March, Fujitsu represented its initiatives to the investment community under the rubric "Raising Corporate Value," unveiling a new board structure as well as asset sales and write-offs. The restructuring costs of more than $3 billion (¥ 417 billion) that the company took in fiscal 2001 are not the end of its turnaround efforts, Takaya says, but he won't be more specific. As far as strategy goes, Fujitsu's main change is to adopt an IBM-style customer-oriented structure.


But if Fujitsu is using an EVA- or ROE-based system to evaluate its businesses, Takaya isn't saying. Unlike its global rivals, Fujitsu hasn't adopted a performance-based management system, nor have stock options been spread beyond top executives. The latter is "under consideration," says the CFO. "But options aren't enough to motivate people," he adds, 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," says Takaya.


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, says Takaya, noting that 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 upgraded Fujitsu from "reduce" to "hold." Nomura forecasts big losses for the year ended last March, more losses this year, and net profits of $422 million on sales of $41 billion in 2003. Comments Patrick Furtaw, managing director at the Tokyo office of Stern Stewart: "They're in a lousy business, and they're bailing water."



Rebalancing Sony

Unlike Fujitsu, Sony has never been part of a keiretsu. The electronics and entertainment giant moved to an executive-style board years ago, one that boasts an impressive line-up of outsiders. But in recent years, even Sony has come unstuck. While still profitable, the company is no longer making the money it once did. For the fiscal year ended March 31, sales grew only 3.6 percent, to $57 billion (¥ 7.6 trillion), while net income fell 8.6 percent, to $115 million (¥ 15.3 billion).


One reason is that Sony continues to make a bewildering variety of products that can now be made so much cheaper by contract manufacturers in places like China. CFO Teruhisa Tokunaka defends the company's wide spread of businesses, saying that keeping its hands on manufacturing helps differentiate the Sony product in the marketplace. He admits this hasn't worked in every business, particularly PCs, but he won't go into specifics.


"We have to be more careful of how we invest in particular markets," says Tokunaka. "The basic concept is vertical integration versus optimal size. We need a more careful balance, particularly in capital spending."


To help achieve this balance, Sony has adopted economic value added (EVA), which compares the returns of each business with its cost of capital. Tokunaka says EVA was introduced two years ago and "is beginning to take wide effect." The company is also cleaning up its balance sheet by shrinking inventory, revaluing the property on its books, and shedding noncore assets. Despite its efforts, however, Sony's operating profit margin was just 1.8 percent last year; it expects that number to rise to 3.5 percent this year.


Sony's return to past glories will take time--as will Corporate Japan's. "Japan isn't going to change overnight," says Furtaw. "In the U.S., we're suggesting that companies change their metric for incentive 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."


In the United States, such questions are answered by CFOs. That's not usually the case in Japan. But unless that changes, it will be difficult for Japanese companies to reform their financial management. And unless they embrace the challenge of reforming corporate governance, it's hard to see how they will break out of years of stagnation and decline.


As Harunobu Yamada, chief executive of HSBC Securities (Japan), puts it: "If Japanese companies will promote new finance managers, who manage on the basis of cash flow and value creation rather than accounting profits, then Japan will change." Right now, that's still a big if.



Carla Rapoport is managing editor of CFO Asia.

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