FITCH, an international credit rating agency, sent shock waves through the Japanese stock market in November by cutting the ratings of Sony and Panasonic, two of the country’s bedrock electronics manufacturing companies, to junk for the first time. This came after Fitch reduced Sharp’s credit rating to junk earlier that month.

While we’ve been seeing massive amounts of red ink from these companies over the past few years, the junk ratings are a bad milestone – and a sign of growing concern about the companies and the Japanese economy among investors and the government. There is reason for the concern. As Fitch said in its announcement on Panasonic: “Meaningful recovery will be slow, given the company’s loss of technology leadership in key products, high competition, weak economic conditions in developed markets and the strong yen.”

While Fitch is right in saying that the major challenges for Panasonic, Sharp and Sony are a lack of innovation, competition with lowcost Chinese labor and the slow international economy, we think the real cause of decline isn’t just the changing business environment (which has been evolving ever since the Industrial Revolution). We think the problem is that Japanese senior management isn’t able to adapt to the ground shifts taking place in their international markets. What is more, the buffer provided by domestic sales has disappeared since the collapse of U.S. investment bank Lehman Brothers in 2008. The result: these companies are flailing while their more flexible competitors are busy making hay. Take Hon Hai, Samsung and Apple as examples. They hail from countries where costs are higher than in China, and yet they are making record profits. Why? Besides having mastered the complexity of running a major corporation, these winners have adjusted their business models to fit new market paradigms instead of expecting the markets to follow their preferences. Listening to the market had been a forte of the Japanese when they were lean and hungry. But the competition has caught up technically and have become better listeners.

People Costs

Hon Hai went to China early on, way back in 1988. And the Taiwanese company has kept itself mean (if not lean) since then in a relentless pursuit of low costs. For example, when China’s coastal salaries and labor discontent started to rise five years ago, Hon Hai decided to spend US$3.5 billion in opening factories further inland, thus preserving its status as the lowest-cost manufacturer. The company today has one million employees churning out all manner of global-class products at low margins, which along with its large size and well-thought out operational structure allows it to eke out a meaningful JPY250 billion a year on revenues of JPY10 trillion. The “humans-as-cogs-in-a-manufacturing-colossus” business model is a familiar one for Japan’s ailing giants because it’s how they grew to dominance after World War II. But given Japan’s now-higher costs and confining labor laws, Panasonic, Sharp and Sony now face no option but to significantly move offshore and find another (probably ex-China) workforce to brutalize in order to compete with Hon Hai. Myanmar comes to mind, and sure enough an increasing number of Japanese manufacturers are making early moves there. But for a meaningful reappearance on the global stage, Panasonic would have to invest billions of dollars in Myanmar, something probably beyond its current capacity without making painful cuts in Japan first.

Japanese employees are a huge stumbling block. Yes, Panasonic and the others are firing thousands or busily hiving off parts of their businesses to buyout funds. But with 330,000 employees, most of whom are in Japan, the downsizing efforts are just a drop in the bucket. Our guess is that to pursue this strategy Panasonic would have to “double down” and continue posting its current losses for another three years while at the same time putting an additional JPY300 billion a year into its offshore facilities. We just don’t see the stock market willing to accept that kind of economics, quite apart from the fact that Panasonic would also need an iron-fisted leader and government backing to shed tens of thousands of workers. So if cutting people costs is not a major strategy, what about simply returning to being the very best in certain technologies?

Technology Refocusing

Samsung’s strategy has been to attack the Japanese position of technical superiority in certain sectors, chipping away over the past 20 years or so in disciplines such as DRAM memory and LCD displays while also taking advantage of the lower won. In addition, the Koreans make better international traders than the Japanese at this stage in their development cycle. They are happy to make loss-leader sales to snare major international accounts or flood the market. This is in stark contrast to the Japanese, who are more fiscally conservative and want to make a profit from every deal. They will scrap a sale if it could lose money.

On paper, the Japanese model is correct for business. But when you have a fierce competitor with products of almost the same quality, and whose mission is to undercut you at every turn, there isn’t much you can do but join the spiral of price cuts until one or the other bleeds to death. Ironically, this is what the Japanese did to their American and European counterparts in the 1970s and 80s, and the lesson learned is that those with higher costs and/or inferior marketing invariably lose.

Having conceded the DRAM, CPU, and LCD markets to the Koreans, the Japanese majors have to come up with better technologies that are harder to replicate or they must switch to less-competitive sectors, the Nikkei said in a recent editorial. A number of Japanese majors are outshining Panasonic and Sony in making non-entertainment consumer electronics products. The air-conditioner market, for example, is worth more globally than the TV market, according to the Nikkei. So maybe Panasonic and Sony should switch gravy trains. There also is the large demand for refrigerators, microwaves and other white goods in emerging economies. While we agree with the Nikkei that another market segment would be a good idea, the white-goods sector already has China’s Haier as a dominant player that is on track to very well become another Samsung in the coming years.

Instead, we’d recommend diversifying into more technical areas such as medicine and the military, both of which are proving lifesavers for firms like Fujifilm and Mitsubishi.

Global Ecosystem

It’s probably unfair to say that Sony should have invented the iPhone instead of Apple. While it is true that Sony had the wherewithal and experience to make this advanced and workable gadget, it was Steve Jobs’ brilliant insight and Apple’s desperation to let him pursue it that led to the iPhone. This showed that while hardware matters, the way to beat Japan’s technical superiority is through software. When the iPhone came out without a keyboard, it was the first time that a mobile device had broken away from Japan’s traditionally superior PC-making skills. Suddenly any manufacturing nation — not just the Japanese — could provide Apple with the components. Yes, the Japanese did and still do make lots of components for Apple, but now they do it on Apple’s terms, not the other way round.

Another amazing insight from Jobs was when he realized with the initial high-volume orders of his new gadget that he could turn it into a platform for third-party software engineers to build a massive user-entertainment ecosystem. The idea of sharing one’s product with outside developers, such that they could make money out of the platform and do it outside the strict control of your engineers, was and still is so alien to Japanese top-down managers that it would never happen in Japan. A case in point was when a American fan wrote software to make the Aibo robotic dog dance. Sony’s immediate reaction was to sue the fellow, which proved both a public relations disaster and an example of the inflexible thinking crippling Japanese electronics companies.

Our prediction is that these companies will take the slow-grind approach to turning around their operations with the hope that while reducing costs their trusted engineers will come up with hit products to turn things around. Yeah, and maybe Israel will attack Iran and precipitate another oil crisis, or maybe North Korea will attack the south and put Samsung out of business. OK, it’s more likely that the Japanese government will arrange for the Development Bank of Japan or some other entity to jump in and invest a significant sum, semi-nationalizing the firms involved. This isn’t so far fetched given the huge number of jobs at stake: Panasonic and Sony alone employ 1% of all Japanese workers. We think the grind will be a drawn-out affair and if things go well both companies may emerge a lot smaller and leaner in three to five years. The biggest danger, however, is that in the meantime they will become takeover targets by competitors and investment funds drooling over break-up values, copious patents and comprehensive global distribution networks.

It’s a sobering thought that as of late November, with a market valuation of just JPY998 billion, Panasonic is worth roughly the same as Motorola Mobility was when Google bought it last year for US$12.5 billion. A Google senior manager has since said that they made the acquisition primarily for Motorola’s portfolio of 24,500 awarded and pending patents. Given that Panasonic for the eighth year running has registered the most patents -- 6,881 in 2012 alone -- in Japan, it probably has an overall portfolio of more than 100,000. So does that make Panasonic undervalued by this single measure alone?

That’s food for thought... tj

This story appeared in Issue 270 of the Tokyo Journal.

To order Issue 270, click here.