Excess Capacity and Difficulty of Exit: Evidence from Japan’s Electronics Industry (SpringerBriefs in Economics) 9811648999, 9789811648991

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SPRINGER BRIEFS IN ECONOMICS DE VELOPMENT BANK OF JAPAN RESEARCH SERIES

Sumio Saruyama Peng Xu

Excess Capacity and Difficulty of Exit Evidence from Japan’s Electronics Industry

SpringerBriefs in Economics

Development Bank of Japan Research Series Series Editor Akiyoshi Horiuchi, Tokyo, Japan Editorial Board Shinji Hatta, Tokyo, Japan Kazumi Asako, Tokyo, Japan Toshihiro Ihori, Tokyo, Japan Eiji Ogawa, Tokyo, Japan Masaharu Hanazaki, Tokyo, Japan Makoto Anayama, Tokyo, Japan Keisuke Takegahara, Tokyo, Japan

This series is characterized by the close academic cohesion of financial economics, environmental economics, and accounting, which are the three major fields of research of the Research Institute of Capital Formation (RICF) at the Development Bank of Japan (DBJ). Readers can acquaint themselves with how a financial intermediary efficiently restructuring firms in financial distress can contribute to economic development. The aforementioned three research fields are closely connected with one another in the following ways. DBJ has already developed several corporation-rating methods, including the environmental rating by which DBJ decides whether or not to make concessions to the candidate firm. To evaluate the relevance of this rating, research, which deploys not only financial economics but also environmental economics, is necessary. The accounting section intensively studies the structure of IFRS and Integrated Reporting to predict their effects on Japanese corporate governance. Although the discipline of accounting is usually isolated from financial economics, structural and reliable prediction is never achieved without sufficient and integrated knowledge in both fields. Finally, the environmental economics section is linked to the accounting section in the following manner. To establish green accounting (environmental accounting), it is indispensable to explore what the crucial factors for the preservation of environment (e.g., emission control) are. RICF is well equipped to address the acute necessity for discourse among researchers who belong to these three different fields. Titles in the series are authored not only by researchers at RICF but also by collaborating and contributing researchers from universities and institutions throughout Japan. Each proposal is carefully evaluated by the series editor and editorial board members, who submit written reports that appraise each proposal in terms of academic value and rigor and also provide constructive comments for further improvement. At times, the editorial board appoints external referees to provide additional comments. All prospective authors also present their research findings to the editorial board in face-to-face editorial board meetings, where the series editor and editorial board members provide further detailed comments on the findings, methodology, overall presentation, and advice in preparing the book manuscript in English. Any opinions, findings or conclusions contained in this series are those of the author and do not reflect the views of the Development Bank of Japan Inc.

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Sumio Saruyama · Peng Xu

Excess Capacity and Difficulty of Exit Evidence from Japan’s Electronics Industry

Sumio Saruyama Japan Center for Economic Research Chiyoda, Tokyo, Japan

Peng Xu Department of Economics Hosei University Machidashi, Tokyo, Japan

ISSN 2191-5504 ISSN 2191-5512 (electronic) SpringerBriefs in Economics ISSN 2367-0967 ISSN 2367-0975 (electronic) Development Bank of Japan Research Series ISBN 978-981-16-4899-1 ISBN 978-981-16-4900-4 (eBook) https://doi.org/10.1007/978-981-16-4900-4 © Development Bank of Japan 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publishers, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publishers nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publishers remain neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Singapore Pte Ltd. The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore 189721, Singapore

Acknowledgements

The studies presented in this book are based on our works on corporate governance supported by JSPS KAKENHI Grants. Those presented in Chap. 2 are developed on basis of our book chapter of Hosei International Comparative Economic Study Research Series in Japanese. We would like to remember that the late Professor Masayuki Otaki encouraged us in writing this book. We are also deeply grateful for the editors of Springer Briefs in Economics DBJ Research Series for offering us the opportunity to publish this book as well as the participants of the review conference for their helpful comments. All the remaining errors are our own. Any opinions, findings, or conclusion expressed in this book are those of the authors and do not reflect the views of the Development Bank of Japan and the authors’ affiliations.

v

Contents

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 Technological Changes and Overcapacity in the Electronics Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Difficulty of Exit and Employment Practices . . . . . . . . . . . . . . . . . . . 1.3 Lack of the Market for Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4 Purpose and Outline of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Zombie Businesses in the Electronics Industry: Case Studies . . . . . . . 2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Sony’s Investments in Deficit Segments During 2005–14 . . . . . . . . . 2.2.1 Sony’s Overall Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.2 Sony’s Profit and Investment by Sector . . . . . . . . . . . . . . . . . . 2.2.3 Response of the Stock Market to Sony’s Expansive Actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 NEC: Breakaway from “Deficit Investment” by Separating Semiconductors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Overall Performance of NEC . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.2 Performance of NEC by Sector . . . . . . . . . . . . . . . . . . . . . . . . 2.4 Mitsubishi Electric: Successfully Terminating Investment in Low-Profit Segments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4.1 Overall Performance of Mitsubishi Electric . . . . . . . . . . . . . . 2.4.2 Performance of Mitsubishi Electric by Sector . . . . . . . . . . . . 2.5 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.1 Difficulty of Exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.2 Employment Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Misallocation of Internal Funds to Loss-Making Zombie Businesses in the Electronics Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Research Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1 2 3 5 7 11 13 13 17 17 18 20 22 22 23 25 25 26 29 29 32 34 38 39 39 42 vii

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Contents

3.2.1 Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.2 Hypothesis Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 Segment Investment and Segment Employment . . . . . . . . . . . . . . . . . 3.3.1 Descriptive Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.2 Misallocation of Internal Funds and Segment Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.3 Consequences of Investment in Deficit Segments . . . . . . . . . 3.3.4 Do Single-Segment Firms Invest Efficiently? . . . . . . . . . . . . . 3.4 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Slow Downsizing After Mergers of Individual Loss-Making Parts and Components Divisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 The Case of Renesas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.1 Sales and Profit by Business Line . . . . . . . . . . . . . . . . . . . . . . 4.2.2 Changes in Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.3 Slow Downsizing and Restructuring . . . . . . . . . . . . . . . . . . . . 4.2.4 Restructuring by Business Line . . . . . . . . . . . . . . . . . . . . . . . . 4.2.5 Discussion and Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 The Case of Japan Display . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.1 Overcapacity in the Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.2 Debt Overhang . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.3 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

43 44 47 48 49 55 57 62 68 71 72 75 77 80 82 84 86 88 89 91 92 94 97

5 Final Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 5.1 Lessons Learned from the Two Lost Decades of Japan . . . . . . . . . . . 99 5.2 Policy Implications and Remaining Issues . . . . . . . . . . . . . . . . . . . . . . 103 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

About the Authors

Sumio Saruyama is a lead economist of the Japan Center for Economic Research (JCER). He received his B.A. from The University of Tokyo. He studied at Harvard University in 1985–1986 and received his Ph.D. in economics from Hosei University in 2018 for his research on exit behavior of troubled firms. At JCER, he is involved in analysis and policy recommendations on structural issues in the Japanese economy, such as the declining birthrate and aging population, public finance, and trade policies. Peng Xu is a professor at Hosei University, Tokyo, where he teaches corporate finance and corporate governance. His areas of expertise include hedge fund activism, corporate restructuring, and corporate governance. He is the author of numerous corporate finance and governance articles that have appeared in academic journals in economics, including the Journal of Japanese and International Economies, Japan, and the World Economy, Journal of Restructuring Finance, and Journal of Financial Markets. He received the M&A Forum Award 2016 as a chapter author. He was a faculty fellow of the Research Institute of Economy, Trade, and Industry during 2003–2006. He has served on several journal editorial boards, including as an editor of the Journal of Economic Policy Studies and the Law and Economics Review. He received his Ph.D. in economics from the University of Tokyo and his B.A. in social engineering from the University of Tsukuba.

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Chapter 1

Introduction

Abstract In this book, we argue that excess capacity and difficulty of exit are responsible for the two lost decades. Non-performing loans and zombie lending are the consequences of overcapacity in the banking industry due to financial deregulation in the 1980s. The large-scale bubble burst is a result and a trigger of the first lost decade. In parallel with the bursting of the bubble economy, regulatory, technological, and economic changes have been the main causes of excess capacity in the electronics industry after 1990. However, Japan’s employment practices make it difficult for prompt downsizing and exit to take place. We demonstrate that two major electronics companies generated waste of cash flow for investment in declining core electronics businesses after 1990. Ultimately, it took 20 years or more for major Japanese electronics companies to exit from their slumped PC business. Analysis of segment investment shows that Japanese electronics conglomerates allocated more credit to segments with more employment even if they were making losses. Naturally, segment profitability is negatively related to unnatural segment investment. This evidence is in support of the employment consideration hypothesis. At the same time, the stand-alone electronics companies also continued to invest regardless of poor investment opportunities. The sluggish post-mergers and acquisitions (M&A) employment adjustment in stand-alone Japanese electronics firms suggests that employment considerations also hinder the success of M&A to restructure electronics component businesses. The two lost decades are a result of the slow response to the rise of cheap and high-quality electronics products of Apple, Samsung, and Lenovo. Many well-known Japanese electronics companies globally enjoyed rapid growth, dominant market positions, and high profits till the 1980s; however, we expect to see fast-growing startups that can take their place. Keywords Two lost decades of the Japanese economy · Electronics industry · Zombie firms · Excess capacity · Technological changes · Employment practices · Exit · M&A · Regulation · Startups We are deeply grateful to Prof. Akiyoshi Horiuchi for the insightful comments on employment practice in Japan. Any opinions, findings, or conclusion expressed in this book are those of the authors and do not reflect the views of the Development Bank of Japan or the authors’ affiliations.

© Development Bank of Japan 2021 S. Saruyama and P. Xu, Excess Capacity and Difficulty of Exit, Development Bank of Japan Research Series, https://doi.org/10.1007/978-981-16-4900-4_1

1

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1 Introduction

1.1 Technological Changes and Overcapacity in the Electronics Industry What factors are responsible for the two lost decades in Japan? Is it abnormal or Japan-specific? Previous studies emphasized the misallocation of bank credit to the weakest firms due to the perverse incentives of troubled banks as a main reason for the first lost decade (Peek and Rosengren, 2005; Caballero et al., 2008). Jensen (1993) argues that excess capacity and difficulty of exit are responsible for the failure of the best known U.S. companies. Regulatory, technological, and economic changes are the main causes of excess capacity. Financial deregulation in the 1980 Japan liberalized corporate access to corporate bond markets, and consequently Japanese banks lost regulatory rents. Though they ought to downsize or to exit, the banks expanded loans to the real estate sector and less credit-worthy companies. This was responsible for the asset price inflation in the 1980s, the burst of bubble, and the subsequent bank failures. The burst of bubble yielded zombie firms in the banking, financial, real estate, construction, and retail industries. Due to the difficulty of exit, troubled banks extended credit to zombie firms and to evergreen non-performing loans rather than withdrawing the loans. The zombie firm problem is the consequence of excess capacity and difficulty of exit in the banking industry during the first lost decade. Limited to our knowledge, the failure of real estate investment was mainly occurred to real estate, construction, and retail companies in the 1990s and a majority of zombie firms recovered after the first lost decade (Nakamura, 2016). After the resolution of the non-performing loan problem, however, Japan experienced the second lost decade. Just like the first lost decade, the second lost decade is also consequences of overcapacity and difficulty of exit. The rapid technological changes in 1990s resulted in new entries to the electronics industries. The PC business is a good example (Dedrick & Kraemer, 1998). In the 1980s, a leading PC vendor, NEC, enjoyed rapid growth, dominant market position, and high cash flow and profits in the domestic PC market, because NEC PC-98 was designed to handle Japanese text easily. In the early 1990, however, IBM Japan introduced the DOS/V operating system that enabled displaying Japanese text on standard IBM PC/AT VGA adapters. Soon, NEC’s market share shrunk largely after 1992. Since then, the profit was declining steadily and the company ultimately was suffering huge losses for long time, but most of the internal fund was wasted for investment in loss-making electronics segments including PC business. At long last, NEC moved its PC production to a joint venture with Lenovo in 2011. Sony also sold off its VAIO computer division in 2014, pressured by a U.S. activist fund. Fujitsu outsourced its PC manufacturing and subsequently sold its PC business to Lenovo in 2016. Toshiba was financially distressed in 2018, and its PC business was acquired. It is noteworthy that IBM already sold its PC business to Lenovo in 2005, after Gateway, Dell, and Lenovo newly entered the market. After losing advantage in manufacturing PCs, more and more technological changes have been hitting the Japanese electronics companies. Since 2001, Apple has

1.1 Technological Changes and Overcapacity …

3

been launching iPod, iPad and iPhone. Forty years ago, Sony launched its Walkman line of compact portable music players and totally sold more than 400 million sets of Walkman worldwide. Now, it is standard to buy iPhone or iPad and download music online. iPod and iPhone are more convenient, user friendly, and compact. Before long Sony ran into severe competition with Apple, and it lost the battle. Later, iPhone has been dominating the domestic smartphone market in Japan. Likewise, storied Japanese electronics companies such as Sony, NEC, Toshiba, and Panasonic have been losing markets after 1990 because they could not introduce changes. Ultimately, they had to restructure their business in the 2000s. Consequently, Japan lost one more decade, although the non-performing loan problem was resolved. Thus, the common reasons for the two lost decades are excess capacity and difficulty of exit. More importantly, the extremely sluggish move from low margin hardware business to high margin software and information business has hindered digital transformation in Japan.

1.2 Difficulty of Exit and Employment Practices Since 1990, the rise of cheaper and high-quality PCs in the United Stated and China has contributed to excess capacity in the PC industry worldwide. However, most major PC makers in Japan did not spin off their PC business until the early 2010s. It took them about 20 years to exit. The sluggish exit is the valid reason for the two lost decades. Jensen (1989) predicted that the Japanese economy would produce massive overcapacity as the U.S. companies did in the 1980s. From the view point of Jensen’s free cash flow, Japanese companies’ success in world product markets created rich cash as alternatives to bank loans, whereas Japanese shareholders had no power to force the companies to pay out free cash flow. According to Jensen (1993), many U.S. largest and best-known companies such as Kodak, GM, IBM, and Xerox appear on the list of firms with the worst performance in R&D and investment. This suggests that excess capacity and difficulty of exit are not specific to Japan. The bursting of the bubble is nothing more than a result of overcapacity in the banking industry attributable to financial deregulation in the 1980s. In parallel, Japanese electronics companies spent 20 years to downsize in response to excess capacity after 1990. However, no one recognized that Japanese successful banks had to downsize in response to the financial deregulation soon in the heyday of the Japanese economy. In the late 1980s, it was apparent that there would be massive overcapacity in the banking industry as constraints on corporate bond market were lifted. Even when problems became severe, there were only several bank M&A till 1996. In 1998, the Long-Term Credit Bank of Japan and the Nippon Credit Bank were nationalized after their failures and the Industrial Bank of Japan was merged to Mizuho in 2000. The three banks provided long-term loans by issuing debenture, thus were earning regulatory rents till the 1980s. It is widely recognized that the injection of public funds into under-capitalized banks to pursue withdrawing loans from zombie firms (Hoshi & Kashyap, 2011). The injection of public funds into banks was only a

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1 Introduction

stopgap measure, however. Ultimately, Japan experienced an M&A wave among major banks after 2000.1 Bank failures and bank M&A are true testaments to massive overcapacity in the banking industry. Although Japan spent the first lost decade to pull excess capacity apart from banks, and real estate companies, today it still needs to speed up mergers and consolidation of Japan’s regional banks.2 Overcapacity implies excess employment. The lifetime employment practices in Japan make it extremely difficult for the adjustment of excess employment to take place unless the firm is approaching distress. Along with lifetime employment, it has been widely viewed that the most important purpose of enterprises is to ensure job security in Japan. Facing overcapacity, impaired banks were struggling to maintain employment and this coincided with zombie firms’ perverse incentives to ensure temporary job security. Moreover, because of an underdeveloped labor market for mid-careers and a weak social safety net for unemployment, the government had to insist on banks keeping lending to zombie firms to avoid massive labor turnover (Hoshi & Kashyap, 2011). The labor laws in Japan also strictly regulate layoffs. Roughly speaking, layoffs are allowed if and only if there is a substantial doubt about a firm’s ability to continue as a going concern. In other words, the management must prove that the firm will go bankrupt without personnel reduction. Moreover, the management must devote efforts to avoid dismissal by other means, such as reassignment and recruitment of voluntary retirees. Next, the criteria for determining who should be hired must be objective, rational, and fair. Moreover, the management must explain to the trade union or workers the necessity, timing, scale, and method of dismissal to be convinced. The labor laws also impose constraints on layoffs around M&A that plays important roles to eliminate overlapping capacity. Article 625, paragraph (1) of Civil Code (Act No. 89 in 1896) provides that a company transferring a business must obtain individual consent from each worker whose existing labor contracts will be specially succeeded by the acquiring company. It is important to keep in mind that a worker to be succeeded cannot be dismissed solely because she/he has not accepted the succession of her/his labor contract. In M&A, pre-M&A labor contracts should be comprehensively maintained. Regarding company splits, the Labor Contract Succession Law provides that the labor contracts of workers mainly engaged in a divested business will naturally be succeeded to the newly established company or the absorbing company. Unlike transfer of business, no worker consent is required, but the succession of the labor contracts of the relevant workers should be stipulated in the split plan (contract) as the rights and obligations to be succeeded. If the split contract does not stipulate that the succeeding company shall succeed to the labor contract that a worker mainly engaged in the business has concluded with the split company, the worker may object in writing. When an objection is filed, the labor 1

Japanese Bankers Association provides details on M&A in the banking industry. https://www.zen ginkyo.or.jp/article/tag-h/7454/, 2021/01/2. 2 See Factbox: BOJ tiptoes into industrial reform with regional bank aid by Reuters Staff, November 26, 2020 https://www.reuters.com/article/us-japan-economy-boj-factbox/factbox-boj-tiptoes-intoindustrial-reform-with-regional-bank-aid-idUSKBN2860FI?il=0, 2021/01/27.

1.2 Difficulty of Exit and Employment Practices

5

contract that the worker concerned has with the split company shall be succeeded to by the succeeding company on the day when the split pertaining to the split contract becomes effective. In short, it is quite difficult to lay off redundant workers around M&A. There has been no progress in reforming the labor market till now. If a firm has to lay off workers, the CEO needs to devote a great effort to convincing the enterprise union. Additionally, the CEO needs to compensate early retired workers in cash. Even worse, it is possible that the CEO has to resign to take responsibility for breaching job security. It is well known that during the Toyota Motor Corporation labor dispute in 1950, President Kiichiro Toyoda and the two executives resigned, taking the blame for layoffs.3 Thus, the CEO can choose continuing investment to buy labor peace and leave exit to rivals, as argued in Jensen (1993). Even in acquiring a bankrupt Japanese company, job security is still a main concern.4 In particular, a foreign company can be pressured by the Japanese government to retain employment in acquiring a Japanese company. Anecdotally, employment considerations are the top issue even in acquiring a slumped business. Of course, an acquisition conditional on maintaining employment would impede layoffs that are the source of synergy gains of takeovers. In addition, deals would fall through if all parties insist on maintaining employment. Employment protection impedes layoffs around M&A and results in a greater reduction in volume, number, and synergies of M&A. Likewise, insistence on continuing operations in plants which are overlapping and redundant would reduce the activities and gains of M&A. Dessainta et al., (2017) show that the M&A volume scaled by GDP in Japan is the lowest among major Organization for Economic Cooperation and Development (OECD) countries.

1.3 Lack of the Market for Control Faced with excess capacity, most managers failed to downsize promptly, while they continued to invest to maintain employment. Downsizing and exit has been significantly delayed due to the misallocation of credit to businesses with excess capacity for employment considerations, even though the non-performing loan problem was resolved. We have focused on the bursting of bubbles, nonperforming loans, and zombie lending. We also need to face the truth that technological changes have been changing the leading players in the global economy. The two lost decades are also consequences of lack of the market for control. Jensen (1993) and Shleifer and Vishny (1997) emphasize that the roles of capital markets such as mergers, LBOs and proxy fights in eliminating excess capacity. Cross shareholdings among banks 3

Item 6: Labor Disputes and Resignation of President Kiichiro in Sect. 6: Postwar Business Reorganization and Labor Disputes, 75 Years of Toyota History (in Japanese), https://www.toyota. co.jp/jpn/company/history/75years/text/taking_on_the_automotive_business/chapter2/section6/ item6_d.html, 2021/01/28. 4 See details in Chap. 3.

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1 Introduction

and industrial firms have been disempowering capital markets. Large industrial firms were also large shareholders of banks but only large shareholdings by banks were exaggerated. However, the ownership in Japan was not concentrated. Moreover, bank managers and nonfinancial corporate managers had low powered incentives. Cross shareholdings are aimed to isolate bank managers and industrial firm mangers from exposure to the market for control, in particular, from exposure to takeovers by foreign capital. Because of their own agency problems, Japanese banks have incentive to lend more loans to borrowing firms even for excess investment to extract more regulatory rents, unless the firms are near to financial distress. As point out Shleifer and Vishny (1997), there is little evidence that Japanese main bank system was effective enough to force borrowers in decline to downsize or exit promptly, unless the firms are near to default. Of course, there is no good reason that Japanese bank were able to discipline themselves. In hindsight, the burst of bubble is a natural consequence of finance without governance and zombie lending caused by non-performing loans is a natural consequences of banks’ own agency problem and severe overcapacity in banking industry. The conventional Japanese corporate governance system cannot be sustained and it is misapprehension that the Japanese main bank system is an alternative to leveraged buyouts (LBOs). Even if there had not have non-performing loan problem, Japanese banks could not have forced electronics company to restructure earlier. Ironically, US private equity funds contributed to the restructuring of the failed Japanese banks and distressed industrial firms (Hoshi & Kashyap, 2011). In 2001 Japanese banks were required to sell shareholdings to reduce risky assets in response to strengthened bank capital regulation and this in turn substantially reduced cross shareholdings. The changes in cross shareholdings gave chances for foreign and domestic activist funds to challenge the Corporate Japan, as predicted in Jensen (1989). In the early 2000s, Steel Partners, an activist hedge fund based in USA, and a Japanese activist fund led by a former bureaucrat Mr. Murakami, targeted quite a number of Japanese firms with rich cash and poor investment opportunities and demanded substantial increases in dividends, repurchase of shares or buyouts. Such shareholder activism was blamed as the abuse of shareholder rights and green mailers, just as hostile takeovers were criticized in the U.S. In 2009 Steel Partners sold most equities in 2009 after losing a law suit against a target’s launching of poison pill. After running into insider trading trouble, Mr. Murakami left to Singapore and launched a new company Effissimo Capital Management. None of major electronics companies were targeted for several reasons. First, the performance in electronics industry in the early 2000s was not so bad. In the early 2000s, the major electronics companies such as NEC and Sony were going through with only lax restructuring, mainly laying off foreign employees, contract workers, and temporary workers. The second reason is that it is hard for an individual activist investor to challenge a large electronics company alone. Even now, shareholders deemed to collective engagements can be charged with insider trading in Japan if they do not disclose their joint ownership and it has been commented Japan should revise

1.3 Lack of the Market for Control

7

the Stewardship Code to give investors assurance for collaborative engagements without disobeying regulation on inside trading.5 As ever, Japanese companies could not conduct effective restructuring during the second lost decade, because they were still far from financial distresses and there were few non-performing loans to the industry. As sales and profits deteriorating, ultimately NEC, SONY, Toshiba and most major electronics have withdrawn from the business of televisions, PCs, smartphones, and home appliances. US activist investors such as Third Point have been contributing to the restructuring. There is little evidence that banks and institutional investors are tough in corporate governance in regard to eliminating overcapacity. However, the restructuring after losing comparative advantages is too late. After targeting Sony, Third Point has targeting profitable firms such as Seven & i Holdings and the best-known robotic company Fanuc to demand spinoff of declining business and repurchase of shares. Just as even Apple is under pressure from the capital markets once the stock price falls, today profitable Japanese companies are also exposed to pressure from activist investors. If activist investors hindered by cross shareholdings had taken hold in the early 1990s, the electronics companies would have been pressured to restructure earlier and more effectively.

1.4 Purpose and Outline of the Book The two lost decades are a long painful journey of downsizing and exit in response to regulatory, technological, and economic changes. Previous studies mainly investigated dysfunctional bank lending by identifying zombie firms or reputable firms but neglected credit allocation among intra-firm business segments. It is no problem for a zombie firm to borrow a new loan to invest in its profitable business segments. On the contrary, it is a severe problem if a non-zombie firm allocates more credit to the loss-making segments. It is crucial to take a close look at segment investment to examine the difficulty of exit in response to excess capacity. Most importantly, in response to the rise of new entries and major technological changes, investment in profitable companies that have begun to decline is likely to lead to corporate value destruction, employment destruction, and entire economic stagnation. The purpose of this book is to discuss how employment considerations hinder prompt downsizing and exit to eliminate high-cost excess capacity at the segment level. The remainder of the book is organized as follows. In Chap. 2, we focus on the misallocation of credit to loss-making electronics business segments in three major Japanese electronics companies. We show how Sony wasted its internal funds from profitable finance and entertainment businesses to subsidize its loss-making primary electronics business. Similarly, NEC spent most free cash flow on its loss-making

5

See https://jp.reuters.com/article/toshiba-board/japan-government-contacted-toshiba-sharehold ers-before-agm-sources-idUSKBN2680HV by Makiko Yamazaki, Takashi Umekawa.

8

1 Introduction

electronic devices sector. In contrast, Mitsubishi has been promptly cutting off investment in deficit business segments and improving its profitability. It is not surprising that the perverse investment in loss-making segments prolongs poor performance. The direct reason is that free cash flow is in excess of investment opportunities in the electronics industry. However, the outside-dominated board does not prevent Sony from investment in a deficit segment. Moreover, foreign institutional investors neither voice nor vote with their feet against perverse segment investment in Sony and NEC. Exceptionally, Third Point, a U.S. based activist investor fund, exerted pressure on Sony to spin off unrelated businesses and then Sony spun off its loss-making PC business to dodge the requirement. Furthermore, there is no evidence that banks actively intervened in Sony or NEC’s management after 2000. In Chap. 3, we explore the reasons for inefficient investment and slow downsizing despite a significant decline in the operating income margin of core electronic equipment and semiconductor businesses in Sony and NEC. In particular, we link segment investment to segment employment in the electronics industry. As shown in the aforementioned examples, most Japanese electronics companies failed to exit timely from their slumped PC business. Nevertheless, none of them was specialized in PCs. Therefore, we need to exploit segment investment decisions to identify the difficulty of exit. If the management maximizes shareholder interests or his/her own private profits, it is quite natural to cut back on segment investment with no prospect of surplus. At least, segment investment is sensitive to the incidence of operating losses at the segment level or at the firm level. In other words, segment investment is less likely to be negatively related to the incidence of operating losses if job security considerations are the top concern of management. Furthermore, we examine the effects of investment in a deficit segment on subsequent segment performance. For comparison, we examine the investment decisions of specialized firms. Segment investment increases with segment employment irrespective of segment operating profitability. At the same time, however, investment in all segments increases when the whole firm is in deficit. However, such positive employment effect on a segment in deficit decreases with institutional investors’ ownership. We also find evidence that institutional investors’ ownership puts pressure on the management to downsize in a segment with poor investment opportunities. Not surprisingly, investment in a deficit segment exacerbates subsequent segment profitability and segment asset turnover. Likewise, single-segment firms also have excess capacity, whereas they prolong investment. With the rise of global peers, Japanese electronics companies have been losing their supremacy in semiconductor business and display business. In Chap. 4, we show that employment considerations hinder not only prompt adjustment in employment but also the success of M&A in the electronic components industry. In semiconductors other than DRAM, Hitachi and Mitsubishi Electric integrated their operations to launch Renesas Technologies, and later Renesas Technologies and NEC Electronics merged and became Renesas Electronics in response to poor post-M&A performance after the Global Financial Crisis. However, Renesas Electronics failed to revive, and it was acquired by Innovation Network Corporation of Japan, a government-affiliated investment fund. Since then, it closed five plants, sold six plants, and laid off 60%

1.4 Purpose and Outline of the Book

9

of its workforce. With implementing dramatic downsizing, it took an upward turn in its profit margin after 2014. Likewise, the M&A of liquid crystal display (LCD) business were repeated after 2004. Led by the government, in 2012 the loss-making mobile LCD divisions of major Japanese electronics companies were merged to the “national” LCD manufacturer, Japan Display Inc., to prevent foreigners from acquiring “Japan’s advanced technology.” However, the investment left nothing more than overcapacity, heavy debt and poor performance, and JDI laid off 30% of 15,572 employees at the end of March 2016, and the number of employees was expected to decrease to 10,986 at the end of March 2017. At long last, it had to turn to foreign investment funds. Renesas specializes in semiconductor manufacturing, and JDI has a single segment of small-medium LCD. Their slow employment adjustment in response to poor profitability is in support of the employment consideration hypothesis for stand-alone Japanese firms. In sum, it is quite cumbersome for Corporate Japan to downsize or exit, in particular, to lay off workforce, until the problem is unresolvable irrespective of conglomerates or single segment. Inactive M&A and difficulty of downsizing following M&A for unprofitable businesses result in sluggish intra- and inter-industry reallocation of resources. This is another reason for Japan’s second lost decade. Such sluggish post-M&A employment adjustment in stand-alone Japanese electronics firms in response to poor profitability suggests that employment considerations also hinder the success of M&A. Chapter 5 concludes the book by discussing lessons, policy implications, and remaining issues. Facing persistent overcapacity, a company has to downsize sooner or later. Investment in deficit businesses only buys temporary labor peace. Most importantly, the slow reallocation of resources from loss-making electronic devices businesses to profitable ICT services units has contributed to the decline of productivity and digital transformation. Policy makers, managers, and economists should learn lessons from the failure of Japanese electronics companies in response to overcapacity. Following the electronics industry, worldwide technological, political, regulatory, and economic changes and new entries have been emerging in the machinery industry, robotic industry, and automobile industry. If investors’ bet on electric vehicles comes true, there would be severe excess capacity and employment destruction in traditional gas car and diesel car manufacturing. This suggests few investment opportunities in manufacturing traditional gasoline cars. Along with technological changes, business models have been changing. Without transforming innovation architecture, R&D expenditures in the manner of closed innovation would create losses. Therefore, easy investment in plants and equipment and outdated R&D in companies facing new entrants and technological changes would generate waste. This might be the reason for conservative financing and investment decision making in reputable Japanese companies during the second lost decade in Nakamura (2016). Instead, labor market reform, capital market reform advocating shareholder activism, spinoffs, M&A, buyout, open innovation, and corporate venture investment are necessary to regain technological advantages and to acquire the seeds of growth. Though GM and Kodak went bankrupt, Microsoft, Apple, Google, Amazon, Facebook, and Tesla have taken the place of the U.S. storied companies. It is noteworthy that Microsoft and Apple were founded in the 1970s, Google and Amazon are 1990s

10

1 Introduction

startups, Mark Zuckerberg founded Facebook in 2004, and Tesla started its venture in 2003. We expect to see fast-growing startups in Japan that can take the place of declining storied electronics companies. Today, Japan needs more startups to create distinctive technology and business models. The lack of startups is attributable to the regulated bank-centered financial system till the 1980s. Japan already recognized the necessity of developing venture capital in the 1970s. Nevertheless, most Japanese venture capital companies were affiliated with banks and securities firms. Japanese banks were enjoying regulatory rents, and they had discouraged firms from investing in risky, profitable projects (Weinstein & Yafeh, 1998). It is not surprising that bank venture capitalists had neither incentives nor the ability to evaluate new high growth businesses. Rather, they tended to invest in traditional low-risk industries. For example, only 0.04% of the total investments by venture capitalists in Japan went to the high growth software industry, compared to 11% in the United States (Dedrick & Kraemer, 1998). Moreover, with the strict profitability criteria for initial public offering (IPO), venture capitalists were unwilling to make risky investments due to the lack of prospect of a big payoff from an IPO. Moreover, Japanese entrepreneurial companies could not raise enough funds to accelerate growth without the prospect of an IPO, as U.S. venture companies often did. For a very long time, the Japanese government has been eager for deregulation and liberalization. So far, it has made limited progress in some policy areas important to new businesses. Japanese governance system has been changing, however. Even in financial distresses, the influence of banks is no longer apparent. The turnaround of large distressed firms including Nissan, Sharp, Toshiba and JDI have been relying on foreign companies and activist investors. Japan has launched corporate governance reform advocating shareholder activism, and more activist investors are put pressure on profitable companies in decline to repurchase shares. Successful appointments of outside directors by activist investors and successful hostile tender offer bids (TOBs) are emerging. Until recently, we have not seen successful hostile TOBs. Most recently, in March 2021 Murakami backed fund Effissimo Capital Management successfully called an extraordinary shareholder meeting and won approval of its proposal for an independent probe into allegations on voting at the last year’s annual general meeting of Toshiba that is a household name in Japan. The win for Effissimo is the fourth time that an active shareholder has won a corporate vote and the first time against a top major company, according to Reuters report.6 After Toshiba’s accounting scandal, the equity finance for turnaround resulted in 28% of estimated shareholding of activist investors and passive foreign investors sided with activist investors. This suggests that finance without governance or with soft governance in financial distresses has gone away and shareholder activism has emerged as tough governance mechanisms to monitor managers. Also, there are changes in the labor market. During the 2019 economic boom, a considerable number of Japanese companies in surpluses were launching early voluntary retirement programs. In addition, several major electronics and IT companies, such as Sony, are offering much higher 6

See https://jp.reuters.com/article/toshiba-shareholders-int/activist-backed-proposal-for-toshibaprobe-received-58-of-shareholder-votes-idUSKBN2BG0SE by Makiko Yamazaki.

1.4 Purpose and Outline of the Book

11

payrolls than seniority-based wages to attract young AI engineers and data scientists around the world. Moreover, major Japanese firms are attempting to redirect. Toyota, Japan’s automaker giant, has been launching open innovation programs by inviting ventures. In response to the pandemic, Japan has exceptionally lifted regulatory constraints on food-delivery and online healthcare services. These changes will lead to efficient resource allocation, innovation, and startups in response to upcoming technological changes. Finally, it is noteworthy that Japan’s unemployment rate is the lowest among OECD countries. The redundant employment in Japanese firms has been contributing to macroeconomic performance in terms of unemployment rate. Undoubtedly, employees are company’s most important stakeholders as shareholders. In this regard, Japan is agreeable. On the other hand, Japanese economy has been growing much lower than major OECD countries. Japan needs to overcome the dilemma between job security and economic growth via reforming labor markets and corporate governance system.

References Caballero, R. J., Hoshi, T., & Kashyap, A. (2008). Zombie lending and depressed restructuring in Japan. American Economic Review, 98(5), 1943–1977. https://doi.org/10.1257/aer.98.5.1943 Dedrick, J., & Kraemer, K. L. (1998). Asia’s computer challenge: Threat or opportunity for the United States and the world? Oxford University Press. Dessaint, O., Golubov, A., & Volpin, P. (2017). Employment protection and takeovers. Journal of Financial Economics, 125(2), 369–388. Hoshi, T., & Kashyap, A. (2011). Why did Japan stop growing? The National Institute for Research Advancement (NIRA). Research Report https://www.nira.or.jp/pdf/1002english_report.pdf Jensen, M. C. (1989). Eclipse of the public corporation. Harvard Business Review, 67(5), 61–74. Jensen, M. C. (1993). The modern industrial revolution, exit, and the failure of internal control systems. The Journal of Finance, 48(3), 831–880. https://doi.org/10.1111/j.1540-6261.1993.tb0 4022.x Nakamura, J. (2016). Japanese firms during the lost two decades: The recovery of zombie firms and entrenchment of reputable firms. In Springer briefs in economics: Development Bank of Japan research series. Springer. Peek, J., & Rosengren, E. S. (2005). Unnatural selection: Perverse incentives and the misallocation of credit in Japan. American Economic Review, 95(4), 1144–1166. Shleifer, A., & Vishny, R. W. (1997). A survey of corporate governance. The Journal of Finance, 52(2), 737–783. https://doi.org/10.1111/j.1540-6261.1997.tb04820.x Weinstein, D. E., & Yafeh, Y. (1998). On the costs of a bank-centered financial system: Evidence from the changing main bank relations in Japan. The Journal of Finance, 53(2), 635–672. https:// doi.org/10.1111/0022-1082.254893

Chapter 2

Zombie Businesses in the Electronics Industry: Case Studies

Abstract In this section, we focus on the misallocation of credit to loss-making electronics business segments in major Japanese electronics companies. We show that Sony wasted its internal funds from profitable finance and entertainment businesses to subsidize its primary loss-making electronics business. Similarly, NEC spent most free cash flow on its main loss-making electronic devices sector. In contrast, Mitsubishi has been promptly cutting off investment in small underperforming business segments and improving its profitability. It is not surprising that the perverse investment in loss-making segments prolongs poor performance. The direct reason is that free cash flow is in excess of investment opportunities in the electronics industry. However, the outside-dominated board does not prevent Sony from deficit segment investment. In addition, foreign institutional investors neither voice nor vote with their feet against inefficient segment investment in Sony and NEC. Exceptionally, Third Point, a U.S. based activist investor fund, exerted pressure, and then Sony spun off its loss-making PC business. Keywords Electronics · Segment · Profitability · Investment · Employment · Overcapacity · Downsizing

2.1 Introduction In the 1970s, Japan had developed into the world’s most competitive industrial power. Since the best-selling book “Japan as Number One” came out in 1979, the United States has learned from Japan the Japanese management techniques such as total quality management and just-in-time production system. As U.S. companies learned more from Japan, ironically, Japanese companies came to resemble more the U.S. companies in the 1980s, as predicted by Jensen (1989). The U.S. experience since The analyses presented in this chapter are developed on the basis of our works originally written in Japanese as a book chapter of Hosei International Comparative Economic Study Research Series. All remaining errors are our own. Any opinions, findings, or conclusion expressed in this book are those of the authors and do not reflect the views of the Development Bank of Japan or the authors’ affiliations. © Development Bank of Japan 2021 S. Saruyama and P. Xu, Excess Capacity and Difficulty of Exit, Development Bank of Japan Research Series, https://doi.org/10.1007/978-981-16-4900-4_2

13

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2 Zombie Businesses in the Electronics Industry: Case Studies

1970 suggests that the U.S. corporate internal control systems failed to enhance downsizing and exit in response to slow growth and overcapacity (Jensen, 1993). Jensen shows evidence on wasting internally generated funds for value destroying capital expenditure and research and development (R&D) of a considerable number of firms such as General Motors, IBM, Xerox, and Kodak in the period 1980–1990. As Japan’s success in worldwide product markets created free cash flow far in excess of their investment opportunities, without effective internal control, Japanese managers would have wasted internal funds like U.S. managers in the 1980s. Unfortunately, Jensen’s (1989) prediction came true since the early 1990s. Japan’s electronics business is a suitable industry setting to examine how internally generated funds are used as capital expenditures for deficit segments. Jensen (1993) argues that it is difficult to promptly downsize or exit from low profit businesses for companies that enjoyed rapid growth, dominant market presence, rich free cash flow, and high profits for long periods. Indeed, Japanese electronics makers had great historical success in worldwide consumer electronics. We highlight through case studies how investments in loss-making businesses by major electronics manufacturers deteriorate their subsequent performance. Jensen (1993) points out the reason why firms cannot make the decision of efficient exit, focusing on U.S. companies. First, large enterprises that are enjoying the glory of growth tend to leave declining businesses even though they are aware of the necessity of terminating them until they cannot postpone the problems any longer. If one dares to embark on implementing early reforms, the president should expect to be expelled from the post. Securing employment tends to be a good excuse made by the top management to continuously spend abundant cash flow on the deficit segments. From the perspective of Jensen (1993), we pick up Sony, NEC, and Mitsubishi Electric, which are major electronics companies, and clarify the relationship between the profit margin of their electronic devices and investment in their electronic devices sectors. Both Sony and NEC were still profitable in the first half of the 1990s regardless of the burst of bubble. However, the two companies continued to invest in their electronics segments even after a significant decline in the operating profit margin became evident. They did not reinforce high-profit sectors such as finance, music, and films for Sony, or information technology (IT) service and system development for NEC. Sony has injected free cash flow earned in other profitable businesses to maintain employment of its electronics businesses, which account for 70% of the company’s employment. Sony also tends to expand its investment in the deficit sector when its profit is boosted by weak yen. It ends up with prolonged investment in lossmaking businesses. Conversely, Mitsubishi successfully suppressed investment in deficit business when its profit rate was low in the 1990s. Its profit margins are now in the top majors. Over the past 20 years, the landscape of the electronics industry has dramatically changed. Among other things, “horizontal division” has become common, under which the assembly work of electronic machinery is outsourced to Electronic Manufacturing Service (EMS), such as Foxconn Technology Group for electronic equipment, and to “foundries,” such as Taiwan Semiconductor Manufacturing Company

2.1 Introduction

15

(TSMC) for the production of semiconductors. Rather than developing technologies and manufacturing parts themselves, manufacturers of final products procure standardized items from specialized manufacturers. Specialized manufacturers can enjoy economies of scale and supply products and parts at low cost by making large-scale capital investments in advanced technology in short cycles. Moreover, the entry of China into western economies has allowed EMS companies to assemble final products using limitless cheap workforce. The horizontal division in R&D is the so-called open innovation. Companies like Apple are increasing their value added by making themselves a good scout for cutting-edge technology. Apple looks for companies that have the most suitable and attractive technology worldwide. The IT giant even urges suppliers to develop new products when something needed is not available at the moment. If a company has an R&D division, it is difficult to adopt technology from outside. Even in the case of the divestment of poor businesses by M&A, holding its own R&D division and devoted workforce would be an obstacle to flexible M&A. Japanese electronics firms have taken it for granted that they develop technology by themselves, apply it to their products with internally procured parts, and compete with other firms. This is called the vertical integration model. Disruptive changes from vertical integration to horizontal division made many electronics businesses in major Japanese firms move into deficit. They, however, cannot terminate investments in loss-making businesses giving high priority to employment security. That may also be viewed as a curse of the past successes that they enjoyed by applying the vertical integration model. A dominant factor that deterred the recovery of the Japanese economy in the 1990s and brought a “lost decade” was the non-performing loan problem in the banking sector. Many authors point out that virtually bankrupt “zombie firms” survived with assistance from banks (Caballero et al., 2008; Peek & Rosengren, 2005). However, in the 2000s, the Japanese economy remained in low growth even when the banking sector had disposed of most of the non-performing loans in the early 2000s and some of the “zombie firms” became healthy firms (Nakamura & Fukuda, 2013). There should presumably be another fundamental and chronic problem dragging on Japan’s economy. We explore how electronics manufacturers once leading the Japanese economy left their loss-making businesses and invited the decline of the industry. This will help elucidate why the Japanese economy has stayed stagnant in “another lost decade.” What is the cause of another lost decade? Jensen (1989, 1993) gives a hint. The first “lost decade” has its roots in the resistance to downsizing and exit of banks and zombie firms. There did not exist appropriate governance of banks and companies, in particular, the mechanism of the capital markets urging impaired banks and zombie firms to withdraw. It is also the result of cross-shareholding between financial institutions and business corporations. The first lost decade of financing zombie companies was a natural consequence of Japan’s malfunctioning corporate governance. Japanese companies tended to overcome their hardship by expanding business in the past. Kang and Shivdasani (1997) compared Japanese and U.S. firms whose profits were halved during 1986–90. Only 2.6% of U.S. firms responded to the situation by expanding production and facilities, while in Japanese peers the percentage

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reached 27.2%. In addition, assets were sold only in Japan by 4.3% compared with 36.8% in the United States, while staff reductions were only 17.4% in Japan versus 31.6% in the United States. The most outstanding contrast was the ratio exposed to capital market pressures such as acquisitions, which was 0.42% in Japan versus 36.8% in the United States. In other words, even in the days when the main bank was functioning, Japanese companies had expanded production and facilities despite halving operating profit. From the viewpoint of encouraging early withdrawal from low-profit business, the main bank system was not tough enough. Even when the non-performing loan problems were settled, investment in the deficit businesses of major electronics manufacturers that were required to withdraw persisted. Banks did not interfere with the investment in the deficit sector unless the enterprise as a whole was in the red. More seriously, discipline from both internal corporate governance and institutional investors did not work to encourage withdrawal from the deficit business. Sony first moved to a company with committees in 2003 and replaced most of the members of the board with outside directors. It superficially strengthened internal governance by separating business execution and supervision. Moreover, as shown in Sect. 2.2, the period when the company began to increase deficit business investment overlapped with the period when the shareholding ratio of foreigners rose. Therefore, as pointed out by Kang and Shivdasani (1997), the pressure from the capital market is still absent in Japan. We trace the three major companies Sony, NEC, and Mitsubishi Electric to highlight the fact that sluggish performance has been more serious for those who have failed to divest from loss-making businesses. Sony, which has long suffered a slump in profit margin, allocated nearly 80% of its investment to loss-making businesses over 10 years till 2014. NEC made huge investments in the deficit electronic devices business from 2005 to 2009. It managed to recover from 2010 onward by withdrawing from the red semiconductors and by concentrating on system development services. Conversely, Mitsubishi Electric, whose performance was poor in the 1990s, is now gaining the top profit rate among major electronic machinery firms by refraining from putting resources into the deficit sectors. Neither internal corporate governance nor monitoring by banks and investors has kept Sony and NEC from wasting capital. Prompt withdrawal from deficit businesses will lead to new risk-taking. In order to push efficient withdrawal, the role of the capital market including activists should be reevaluated. This chapter is organized as follows. In Sect. 2.2, we focus on Sony and trace its investment in the deficit businesses and its prolonged losses. In Sect. 2.3, we investigate how NEC finally decided to break out of the deficit electronic devices business in 2010 and concentrate on more profitable businesses such as IT services. As a contrasting example, in Sect. 2.4, we examine the case of Mitsubishi Electric, which governs itself with the norm “withdraw when deficit continues three consecutive years.” In Sect. 2.5, we derive the implications for corporate governance and conclude the chapter.

2.2 Sony’s Investments in Deficit Segments During 2005–14

17

2.2 Sony’s Investments in Deficit Segments During 2005–14 In July 2019, Sony opened an exhibit in Ginza, Tokyo with more than 200 models of Walkmans on display. Since the launch of its Walkman line of portable music players 40 years ago, the Japanese electronics maker sold more than 400 million Walkmans worldwide. Sony released the CD Walkman in 1984 and the MiniDisc Walkman in the early 1990s. Before long, Sony went into severe competition with Apple’s iPod and music-playing smartphones, but it lost the battle. iPod and iPhone are more convenient, user-friendly, and compact. Regardless of the requirement for downsizing and exit due to Apple’s entry to the music player market, Sony continued to waste its cash flow on low-profit and even loss-making segments. Apple’s iPod has changed the way we listen to music just as did Sony’s Walkman. Now, downloading and streaming are standard as the way of enjoying music. Internet technological forces are changing the worldwide economy in the same manner as the Industrial Revolution in the nineteenth century. However, Sony failed to make earlier adjustments in response to the technological changes. Rather, it continued to invest internal funds in loss-making electronics segments.

2.2.1 Sony’s Overall Performance First of all, let us look back on Sony’s overall performance (Fig. 2.1). For each financial indicator, we display five-year backward averages considering volatilities due to business cycles. Profitability in terms of earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by the total assets once reached 19% in 1988–92, which included the height of “bubble economy.” It was an era when the home video camera “Handycam” was a big hit and audio appliances such as television, Walkman, and CD players were performing well. Although the profit was falling rapidly to about ROA EBITDA/Asset,t-1 %

20

Percent of Tangible Assets

100

100

80

80

Investment

15 60

I-CF

60

40

10

60

Ownership Ratio of Foreign Investors, %

50 40 30

40

20 5

20

0 -20

0

Debt/Asset, %

0

20 10

0 92 97 02 07 12 15 92 97 02 07 12 15 Fiscal Year, Average of lagged 5 years Note (1) 2015 stands for the average 2013-15. Note (2) I-CF = investment-cashflow. Investment is defined as increase in tangible assets plus depreciation. 92

97

02

07

12

15

92

97

02

07

12

15

Fig. 2.1 Sony’s ROA, investment, debt, and ownership

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2 Zombie Businesses in the Electronics Industry: Case Studies

10%, the company was still profitable. The decline in profit is not attributable to the collapse of the bubble economy. The real reason is that Apple launched iPod in 2001. Consequently, the Return on Assets (ROA) continued to decline in the 2000s and fell to about 5% in 2008–12 and 2013–15. Investment as a difference in tangible fixed assets plus depreciation expenses has been increasing since 2003–07 after being restrained during 1993–97 and 1998–02. Investment during 2003–07 was financed by its internal funds. This resulted in decreasing its debt ratio during this period. Investments have exceeded its cash flow from 2008 onward. The foreign investors’ ownership ratio has been rising to 50% throughout, except 2008–12, even in the face of declining profits. The company’s high debt ratio is due to its insurance and banking businesses. Normally, when the debt ratio is high, the main bank and other lenders monitor the company to make sure it does not squander internal funds, however there was no sign of this. Likewise, institutional investors did not monitor Sony closely enough until Third Point, a U.S. activist fund, raised its voice.

2.2.2 Sony’s Profit and Investment by Sector It is possible that Sony reallocates its resources from loss-making segments to segments with profitable investment opportunities. Thus, we examine the profit and investment by segment (Fig. 2.2). Sony’s business fields are largely divided into four categories: electronics, music/films, finance, and others. For example, in the financial statement of 2015, there are nine segments, of which five (mobile phones, games, cameras, TV sound, and devices) correspond to electronics and the remainder are

20

Percent

35

Operating Profit/Sales 15

Percent of the firm's tangible assets, %

30 25

10

20 15

15

5

Music/Films 10

10 Finance

0

5

5 Electronics 98-02

03-07

08-12

Others Employees Finance Music/Films Electronics

20

Music/Films

-5 93-97

10000

25

Electronics

Finance

30

Investment

13-15

0 93-97

0 98-02

03-07

08-12

13-15

98-02

Note: Others for operating profit and investment are omitted. Amortization of goodwill for Colombia Movies is excluded from Music/Films for 1993-1997.

Fig. 2.2 Sony’s profit margin and investment by sector

03-07

08-12

13-15

Fiscal year, period average

2.2 Sony’s Investments in Deficit Segments During 2005–14

19

finance, music, films, and others. Considering the classification of segments is reshuffled occasionally, we recalculate segments into the above four categories. Notably, the finance segment and music and films segment are not related to the electronics segment. Thus, most assets-at-place in the electronics segment were worthless unless Sony was able to reallocate its resources to profitable segments. Figure 2.2 typically illustrates how Sony’s investment in the deficit sectors expanded since the middle of the 2000s. We can notice the following. (i) In terms of profit margin, during 1993–97, all segments including electronics, finance, and music/films produced surplus. The electronics segment earned profit margin over 5% in the same period. The diversity of profitability was small. Conversely, from 2003 onward, electronics fell from zero to negative, while finance grew rapidly and music/films were steadily improving. Interestingly, the finance segment and music/films segment earned the most cash, as growth opportunities and profitability in the existing primary electronics business were exhausted. In Chap. 3, we show that the average Q ratio of single-segment firms is below one, indicating limited investment opportunities in the electronics industry. The combination of electronics business and unrelated finance and entertainment businesses might reduce overall firm cash flow volatility. Moreover, Lang and Stulz (1994) and Gomes and Livdan (2004) find that firms diversify when growth opportunities in the existing industries are exhausted. Indeed, Sony entered damage insurance and banking businesses around 2000, as its profitability largely declined. (ii) As the diversity of profitability substantially increased after 2002, however, the investment was mostly concentrated on loss-making electronics businesses, while capital expenses for profitable finance and music/films businesses were fairly limited. Particularly in 2003–07, the gap significantly widened. An acceleration in 2013–15 in the electronics segment presumably reflects Sony’s large investment in image sensors, while the firm generally kept compressing its tangible asset. (iii) The electronics segment also has the greatest number of employees, which still accounts for around 70% at the latest. In addition, its total number of employees only moderately dropped. One of Sony’s symbolic deficit businesses was the television set business, which suffered deficits for 10 years in a row during 2004–13 to make its accumulated loss ¥800 billion,1 almost equivalent to its tangible fixed asset.2 Let us compare that magnitude to that of ailing Sharp once created before being acquired by Foxconn. Sharp’s accumulated operating loss amounted to ¥290 billion during 2011–15, which was about a half of its tangible asset for the same period (¥540 billion on average).3 We may say that the slump in Sony’s TV business has been more serious than that of Sharp as a whole. Sharp is a company that is mainly devoted to LCD panels and televisions, in addition to some home appliances and solar panels. It has not been so 1

Toyo Keizai Online, December 24, 2014. The tangible fixed asset of Sony was ¥1.4 trillion in 2003–07, ¥1.0 trillion in 2008–12, and ¥750 billion in 2013, respectively, on a period average basis. 3 Sharp downsized its tangible asset from ¥1.1 trillion in 2007 to ¥350 billion in 2015 as it had to sell its asset in a downturn of business performance. Its accumulated net income loss amounted to ¥1.4 trillion during 2011–15, and it incurred impairment losses from facilities that were no longer expected to achieve recovery. 2

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2 Zombie Businesses in the Electronics Industry: Case Studies

diversified. If Sony’s television business had been set up independently like Sharp, without the support of cross subsidization from non-electronic sectors, it would have been difficult for it to survive due to its huge losses for a long time. Even in the case of the liquid crystal display (LCD) business, it was not until its loss swelled considerably that Sony decided to separate it. Sony, Toshiba and Hitachi integrated their small- and medium-sized LCD business in April 2012 to establish Japan Display, Inc. The Innovation Network Corporation of Japan (INCJ), a government-funded fund, injected ¥200 billion as capital to establish Japan Display.4 Back in 2009, Sony already sustained ¥7.8 billion impairment losses on the fixed assets of small- and medium-sized LCD business and incurred ¥5 billion impairment loss from LCD business in 2010. The net assets of the corresponding businesses of Sony, Toshiba, and Hitachi were ¥+31.6 billion, ¥−103.2 billion, and ¥−22.1 billion, respectively, as of March 2011.5 Accordingly, easily integrating the corresponding businesses without injecting capital would have resulted in a new company with ¥−90 billion net assets. In Chap. 4, we take a close look at the performance and restructuring of Japan Display, the merged loss-making LCD business lines of Hitachi, Toshiba, and Sony. Looking at Fig. 2.2, it is interesting that investment in electronics is growing in pace with the expansion of the surpluses of finance, music, and films, say, during 2003–07, when the Japanese economy enjoyed a long economic expansion. Conversely, during the period from 2008 to 2012, when the Lehman shock and subsequent appreciation of yen up to 80 yen per dollar afflicted Japan, Sony suppressed investment in electronics relative to the previous five years. However, from 2013 onward, the yen has turned to its weak status with the implementation of the Abenomics policies, and the business condition improved. The investment in electronics has become vigorous again. It can be said that the company’s deficit business investment tends to expand during the period of a weaker yen. Nonetheless, its smartphone business moved into deficit for three consecutive years since 2015. It is not surprising that the weak yen is not much helpful for its smartphone business since its smartphone XPERIA is assembled in Thailand and Beijing.

2.2.3 Response of the Stock Market to Sony’s Expansive Actions How did the stock market react to Sony’s deficit business investment? Using the event study methodology, we explored the reaction of the stock market when the company announced the expansion of its business. We used the database offered by Nikkei on various corporate actions. The information therein includes corporate actions such as investment on their own and tie-ups with other companies for major firms including listed companies collected from corporate disclosure and news reports. 4 5

It sustained net income loss of ¥398.3 billion throughout 2012–18. Nikkei Veritas, September 4, 2011.

2.2 Sony’s Investments in Deficit Segments During 2005–14

21

Among them, we used those events that can be regarded as an expansion of business such as “entering into new business” and “strengthening existing business” from 1998 to 2013. A total of 193 events were identified for Sony that fell in the categories. The response of the stock market is measured as excess return around the event publication date. The abnormal return A R it is estimated as the actual rate of return Rit minus the return rate predicted by the market model, where i stands for event and t stands for the business day starting from the publication date (t = 0). 



A R it = Rit − α − β R Mt 



R Mt is the daily return on the market (TOPIX), α is the intercept, and β is the slope (beta) of the market model, respectively. The estimation interval covers 250 days from 270 days before to 21 days before the event. The return rate data are from NPM Japan Equity Daily Return of Financial Data Solutions. It is customary to examine the accumulated value (CAR, cumulative abnormal return) over several days including before and after the event publication date considering that relevant information may be distributed in advance. We use the cumulative values from two days before to two days after the publication date. Table 2.1 shows the estimated result. θ is obtained by assuming a normal distribution to CAR and Table 2.1 Responses of stock market prices to Sony’s expansive actions: comparison between surplus/deficit periods Cumulative abnormal return (CAR), [−2, 2], 1998–2013 Electronics

Finance

Music/Films

−0.1

2.0

0.3

(0.3)

(−0.2)

(1.4)

(0.2)

76

47

8

10

−0.5

−1.8

–

–

(−0.8)

(−2.1)

–

–

36

16

–

–

Whole

Devices

0.1

θ Obs CAR θ obs

During surplus CAR

During deficit

Note Based on events classified as “entering into new business” or “strengthening existing business” in Nikkei’s “Corporate Action Database” θ is obtained by dividing the CAR by the standard error, taking into account the cumulative number of days and assuming normal distribution as the error term of the excess return rate. Obs. stands for the number of observations Surplus period and deficit period are based on the segment’s operating income. The balance of electronic devices is assumed to be the same as that of the whole electronics Categories with events (observations) exceeding 5 are reported. Finance and music/films have few events in deficit periods

22

2 Zombie Businesses in the Electronics Industry: Case Studies

standardizing its average value using standard deviation. We follow the method of MacKinlay (1997). We map each event to its business segment and identify whether it occurred during the surplus or deficit period. The surplus or deficit for each electronics product corresponds to that of the electronics segment as a whole, since it is not possible to identify the gain or loss of individual products. Calculating CAR by segment and by the surplus/deficit period illuminates the followings. (i) The stock price generally responds positively to the expansion of the surplus sectors and negatively to the investment in deficit sectors. (ii) Positive, but insignificant, reactions are observed for finance and music/films, which constantly produce surplus. (iii) Responses to the expansion of electronic devices have been negative even in the surplus period and much larger minus during deficit period, which is statistically significant. Out of 63 events for electronic devices, 24 account for image sensors, 14 for recordable media, and 8 for semiconductors used for game machines.

2.3 NEC: Breakaway from “Deficit Investment” by Separating Semiconductors Similarly, in the 1980s and early 1990s, NEC, a leading PC vendor, enjoyed rapid growth, dominant market position, and high cash flow and profits in the domestic PC market, because NEC PC-98 was designed to handle Japanese text easily. In this section, we will discuss NEC, which has a brilliant history. In the 1980s, NEC dominated the Japanese PC market with the “PC-9800” series and became the world leader in semiconductor sales from 1986 to 1991. Moreover, in 2001, it was the top-ranked company in domestic mobile phone shipment with 27.7% share. The company experienced a steady decline in profits since the late 1990s. In 1990, however, IBM Japan introduced the DOS/V operating system that enabled displaying Japanese text on standard IBM PC/AT VGA adapters for technological changes. Soon, NEC’s market share shrunk from 52% in 1992 to 33% in 1995 (Dedrick & Kraemer, 1998). Facing increasing competition from Fujitsu, Seiko Epson, IBM Japan, U.S. PC vendors, and Lenovo, NEC suffered huge losses for a long time, but internal funds were wasted on investment in loss-making PC businesses. It has been changing for the worse from around 2000, especially in electronic devices business.

2.3.1 Overall Performance of NEC First, let us look back on NEC’s overall performance (Fig. 2.3). The ROA remained at about 10% until around 1997 but fell to about 5% around 2000. Then, the company had repeated ups and downs. Investment was rather restrained during 1998–2002;

2.3 NEC: Breakaway from “Deficit Investment” … 20

15

10

5

ROA EBITDA/Asset,t-1 %

50 40 30

Percent of Tangible Assets

Investment

100 80

I-CF

20

60

10

40

Debt/Asset,%

60

Ownership Ratio of Foreign Investors, %

50 40 30

0 -10

23

20

20 10

0 -20 0 92 97 02 07 12 15 92 97 02 07 12 15 92 97 02 07 12 15 92 97 02 07 12 15 Fiscal Year, Average of lagged 5 years Note (1) 2015 stands for the average 2013-15. Note (2) I-CF = investment-cashflow. Investment is defined as increase in tangible assets plus depreciation. 0

Fig. 2.3 NEC’s ROA, investment, debt, and ownership

however, large-scale investments were made in 2003–07.6 From 2003 onward, NEC has kept its capital expenditures within the limits of its internal funds. Thus its debt ratio has gradually declined. The ownership ratio of foreign investors was constantly rising except around 2012.

2.3.2 Performance of NEC by Sector Now, we turn to NEC’s profits and investments by sector. NEC’s disclosed segments that are traceable since approximately 2000 are classified into two major segments: electronic devices and “IT and Networks.” We see from Fig. 2.4 the following. (i) Electronic devices segment fell into deficit from 2005 onward. The segment operating margin became as low as minus 10% in 2008 and 2009 when the economy got caught in the Lehman Shock. (ii) The electronic devices segment had far larger investments than IT and Networks until the electronic devices segment disappeared in 2009.7 As a result, the electronic devices segment put considerable resources into “deficit business” during 2005–09. Curiously, the 2005–07 period when electronic devices turned into the state of deficit investment was a period when the overall investment was restrained compared with the company’s cash flow, and the operating margin of the other segments, IT and Networks, improved. NEC resembles Sony’s segment investment in deficit.

6

Elpida’s behavior affected NEC only through its profit as an equity-method affiliate, not through its asset and investment since NEC’s stake of Elpida was limited to 50%. NEC Electronics was a consolidated company of NEC until 2009. 7 As stated above, when NEC Electronics was merged with Renesas Electronics in 2010, it was out of the scope of NEC’s consolidation. Renesas Electronics’ profit was included in NEC’s earnings according to NEC’s share as equity-method affiliates, but not for asset or investment in 2011 and 2012.

24 10

2 Zombie Businesses in the Electronics Industry: Case Studies Percent

Percent of the firm's tangible assets

Operating Profit/Sales

Investment

5

25

Others 20

Employees

Electronic devices IT & Networks

IT & Networks 15

0 -5 -10

10000

Electronic devices Electrojnic devices

10 5

& Networks

0 98 00 02 04 06 08 10 12 14 98 00 02 04 06 08 10 12 14 98 00 02 04 06 08 10 12 14 FY) Note: There was only one segment in 2001. Others for profit and investment are omitted.

-15

Fig. 2.4 NEC’s profit margin and investment by sector

Compared to Sony, NEC’s “deficit investment” was modest in its length of time and its magnitude. This is because some loss-making businesses were separated early from NEC’s electronic devices division and merged with the same businesses of other companies. In 1999, NEC separated its dynamic random-access memory (DRAM) business as Elpida Memory, which was established jointly with Hitachi and Mitsubishi Electric. In 2002, the system LSI business was spun off as NEC Electronics. NEC Electronics was merged with Renesas Technology, which was a joint venture between Hitachi and Mitsubishi Electric in 2010 and became Renesas Electronics. In later years, Elpida filed for corporate reorganization law in 2012 and was taken over by Micron of the United States. In 2011, NEC integrated its PC business8 with Lenovo of China and withdrew from smartphone business in 2013. Notably, NEC moved PC production to a joint venture with Lenovo, Lenovo NEC Holdings B.V. (LNH, hereafter), and held 49% of LNH shares till July 2016. Thereafter, LNH was not NEC’s consolidated subsidiary but an equity-method affiliate, and thus the PC business was disconnected from its business segments. In July 2016, NEC sold most LNH’s shares to Lenovo based on a joint venture agreement under which Lenovo could exercise the right to request the transfer of LNH’s shares to Lenovo. However, NEC held LNH’s newly issued subordinated shares and had a veto right to the important matters in terms of voting rights. Merged loss-making segments were only NEC’s equity-method affiliated companies, and such businesses were not disclosed in segment reports. It is very interesting that the spinoffs of lossmaking business segments are extremely difficult, and NEC has been holding major ownership of its merged poor performing business segments. As Elpida eventually collapsed and Renesas also entered under the umbrella of the Innovation Network Corporation of Japan (INCJ), NEC’s ownership of both companies either came to nothing or was fairly diluted, so it suffered greater losses from the semiconductor 8

By contrast, Fujitsu already outsourced its PC production in the 1990s, and IBM sold its PC business to Lenovo in 2005. Pressured by Third Point, a U.S. activist fund, in 2014 Sony sold off its VAIO computer division to a Japanese investment fund, Japan Industrial Partners as will be stated later.

2.3 NEC: Breakaway from “Deficit Investment” …

25

business than what its segment operating profits suggest. From 2012 onward, NEC has become a company that mainly provides communications and computer-related hardware and system development services to corporations and governments. This makes it possible to earn a stable profit. Although there is almost nothing left of its prosperity once established with PCs, cellular phones, and semiconductors, it has somehow secured its way to survive. Sony’s primary business was electronics. However, the electronics business is not related to its entertainment business or finance business. Thus, Sony’s diversity of employment and profitability is much larger than that of NEC. Although the IT and Network services segment employs the largest number of employees in NEC, its electronic devices segment also had considerable employment. In Chap. 3, we show that maintaining employment is the main reason for investment in deficit segments and unnatural segment investment is negatively related to subsequent segment profitability. Due to the rise of products of Apple, Samsung, and Lenovo, most stand-alone electronics companies achieved low growth but continued to invest. As Jensen (1993) points out, securing employment tends to be a good excuse made by the top management to continuously spend abundant cash flow on the deficit segments. In Chap. 4, we show how Renesas and Japan Display collapsed. The difficulty of downsizing in employment also hinders M&A that eliminate overlapping capacity.

2.4 Mitsubishi Electric: Successfully Terminating Investment in Low-Profit Segments 2.4.1 Overall Performance of Mitsubishi Electric Compared to Sony and NEC, there are other electronics companies that are improving their performance. A good example is Mitsubishi Electric (Fig. 2.5). Although its

20

15

ROA EBITDA/Asset,t-1 %

50

Investment

30

I-CF

-10 -20

0

100

Debt/Asset,%

80

-30

60

Ownership Ratio of Foreign Investors, %

50 40

60

10 0

5

Assets

40

20 10

Percent of Tangible

30 40 20 0

20 10

0 92 97 02 07 12 15 92 97 02 07 12 15 92 97 02 07 12 15 92 97 02 07 12 15 Fiscal Year, Average of lagged 5 years Note (1) 2015 stands for the average 2013-15. Note (2) I-CF = investment-cashflow. Investment is defined as increase in tangible assets plus depreciation.

Fig. 2.5 Mitsubishi’s ROA, investment, debt, and ownership

26

2 Zombie Businesses in the Electronics Industry: Case Studies

Percent of the firm's tangible assets Percent 16 12 20 Operating Profit/Sales Investment 14 10 Industrial automation 12 Industrial 15 automation 10 8 8 Energy & Elc Home 6 Home app. 6 10 appliances 4 2 Ene & Elc 4 0 5 Info & -2 2 Electronic Info & Comm. Electronic -4 devices Comm. devices 0 -6 0 03-07 08-12 13-15 98-02 03-07 08-12 13-15 98-02 Note : Others for profit and investment are omiited.

10000 Employees

Others Home appliances Electronic devices Information & Communication Industrial automation Energy & Elc

98-02 03-07 08-12 13-15 FY, period avearage

Fig. 2.6 Mitsubishi’s profit margin and investment by sector

ROA was low during the bubble period, it did not decline further in the subsequent periods. In 2001, it incurred operating loss most recently, and in 2002, it incurred net income loss most recently. Mitsubishi Electric is in good contrast with Sony whose net income was in the red six times throughout eight years from 2008 to 2015 and NEC was in the red three times. Mitsubishi Electric’s ROA has exceeded 12% for three years since 2013 on average. Its investments have almost been kept within the range of cash flow since around 2000. As a result, the debt ratio has gradually declined to almost 50%, which is the lowest among the eight general electric companies.9 Again, this suggests that operating cash flow is in excess of investment opportunities in the electronics industry. It is evident that Mitsubishi has been selected as a major investment target by foreign institutional investors, as foreign shareholding ratio continues to rise consistently.

2.4.2 Performance of Mitsubishi Electric by Sector Figure 2.6 shows that one outstanding feature of Mitsubishi Electric is that it has a structure consisting of five fields with diversified customer classes and required technologies: energy and electric systems, industrial automation, home appliances, information communication, and electronic devices. This structure has not significantly changed, and no particular segments are prominent in terms of employment. Furthermore, a sector with a low profit margin tends to restrain investments. For instance, electronic devices attracted the largest investments during 1998–2002. However, during 2003–07, the least investments were made in the electronic devices sector since it turned into deficit in the preceding 1998–2002 period and the industry had poor investment opportunities due to industrywide overcapacity. In 2003, the firm transferred its DRAM business to Elpida Memory and separated the system LSI 9

The eight companies here include Hitachi, Toshiba, Mitsubishi Electric, NEC, Fujitsu, Panasonic, Sony, and Sharp.

2.4 Mitsubishi Electric: Successfully Terminating Investment …

27

business as Renesas Technology.10 Such downsizing and exit resulted in increase in profitability in the period 2013–2015. There may have been “a good luck” brought by the inferiority of the semiconductor business to other major electronics manufacturers in the early years when Mitsubishi was able to withdraw from the poor performing electronic devices businesses. According to Yunokami (2013), the major Japanese companies (NEC, Toshiba, Hitachi, Fujitsu, and Mitsubishi Electric) were called the semiconductor Big-5 in the 1980s, but Mitsubishi Electric is always ranked at the bottom. Thus, it is easier for Mitsubishi to exit from a loss-making business segment than the remaining semiconductor Big-5. Additionally, different from Sony’s electronics segment, Mitsubishi’s electronic devices segment is minor in terms of employment, and thus it is easier to reallocate employees in a minor segment without any past glory to other related segments. Moreover, in the communication equipment business, Mitsubishi terminated its mobile phone business from Europe in 2002, from China in 2006, and from the domestic market in 2008. The withdrawal from the mobile phones industry was the earliest among its peers. It is said that Mitsubishi has the internal principle “withdraw in the case of loss for the third consecutive year.11 ” It presumably has a corporate culture that does not prolong investment in deficit business segments. In recent years, investment is heavily allocated to profit-generating segments, such as industrial automation. Investment in electronic devices is not uniformly suppressed. Mitsubishi Electric has strengths in “power semiconductors” that are central parts of inverters that facilitate energy saving. We picked up events from Nikkei’s corporate action database corresponding to Mitsubishi’s expansion of its electronic devices to identify 10 cases since 2004, eight of which are focused on power semiconductors. In addition, seven out of them show the plus stock market’s responses to average CAR 2.4% around the day of the announcements of expansion measures. In 2013–15, electronic devices have returned to the second place in profit margin after industrial automation. Figure 2.7 shows the investments of the three companies by surplus business and deficit business. 77% of Sony’s investments during 2005–2014 were made in deficit businesses. NEC’s investments in deficit businesses expanded from 2005 to 2009, but due to the spinoff of semiconductor operations, it cut off investments as it was in the red. Mitsubishi Electric, on the other hand, after investing in deficit businesses from 1998 to the beginning of the 2000s, minimized investments in deficit businesses by spinning off semiconductors earlier and restraining investment in the low-profit sector. Now, we examine the fact that investment in deficit segments results in worse performance. The horizontal axis in Fig. 2.8 represents the scale of net surplus investment (=surplus segment investment minus deficit segment investment) relative to the firm’s tangible fixed assets. The vertical axis stands for operating profit 10

Mitsubishi transferred the related business to Elpida and had no shareholding, which limited its subsequent losses. Conversely, it kept 45% of shares in Renesas Technology and it incurred losses according to its ownership. 11 Nikkei, July 4, 2007.

28

2 Zombie Businesses in the Electronics Industry: Case Studies

40

Percent of the firm's tangible assets

40

Sony

30

40

NEC

30

30

Mitsubishi Electric

20

20

20

10

10

10

0

0

0

-10

-10

-10

-20

-20

-20

Investment in Deficit

-30

-30

-30

Investment in Surplus

-40

-40

-40

98 00 02 04 06 08 10 12 14 98 00 02 04 06 08 10 12 14 98 00 02 04 06 08 10 12 14 Note: Investment in surplus is shown by the positive sign, and investment in deficit is shown by the negative sign. FY

Fig. 2.7 Investment in surplus/deficit businesses of the three firms Operating Profit/Sales (percent, period average) 7 Average for the four sub-periods

Mitsubishi Electric

6

FY 98

5

02 ↓

High Investment in Deficit 4 Low Profitability

High Investment in Surplus High Profitability

FY 03

07 ↓

FY 08

3

12 ↓

FY 13

2

Sony

1

15

NEC

0 -15

-10

-5

0

5

10

15

20

25

30

35

Investment in Surplus - Investment in Deficit (percent of the firm's tangible assets, period average)

Fig. 2.8 Net investment in the surplus sector and profit margin of the three firms

margin. The eighteen years from 1998 to 2015 are divided into four sub-periods, and the average value for each period is plotted. In the upper right corner of the figure, both surplus investment and profit margin are high. On the contrary, in the lower left side, investment is biased to deficit businesses and profit margin is low. For example, Sony had invested in surplus business and secured a margin of 3% in 1998–2002 ➀, but the expansion in the deficit sector in the subsequent 2003–07 period ➁ led to a worsening margin of 0% in 2008–12 ➂. In 2013–15 ➃, thanks to the depreciation of the yen, the economy improved and the profit ratio rose, but still this could not substantially enhance surplus investment and increase profit margin. NEC’s profit

2.4 Mitsubishi Electric: Successfully Terminating Investment …

29

margin was already low in the first period ➀. Although the strong economy in 2003– 07 ➁ helped its margin rise, expansion in the deficit segment investments pushed the point to the left. During 2008–12 ➂, electronic devices turned into deficit. In the next 2013–15 period ➃, its performance improved to the upper right partially by having divested the electronic devices business in 2010. We can see that both Sony and NEC suffered sustained low profit margins after they increased deficit investments unless there came a tailwind of economic recovery. At the time of ➀, Mitsubishi Electric’s performance was the worst among the three companies. Both its profit margin and investment in surplus sectors were low. However, after that, it improved its profit margin while increasing investments in surplus sectors. In the 2013–15 period ➃, investments equivalent to nearly 30% of its tangible fixed assets were put into surplus segments, and the profit margin reached nearly 7%. Mitsubishi Electric’s performance transformed from bad to excellent.

2.5 Discussion In sum, our case studies show that irrespective of making losses, both Sony and NEC allocated internal credit to segments with considerable employment. Moreover, employment adjustment in segments with more employment was not promptly sensitive to segment profitability. Consequently, segment investment irrespective of losses led to prolonged poor segment profitability and segment job destruction in the long run. The market reaction to investment in loss-making segments strongly suggests that such investment is not only value destroying but also surplus destroying. At long last, total employment decreased. In contrast, Mitsubishi cut back on investment and employment in relatively small loss-making electronic segments. As a consequence, Mitsubishi’s profitability improved and its total employment increased.

2.5.1 Difficulty of Exit What is responsible for investment in loss-making segments? Probably, this can be explained by perverse allocative inefficiency in the internal capital market. Rajan et al. (2000) provided a theory and empirical evidence that expropriation among divisions may lead to defensive but inefficient investments to protect the division benefit and thus the CEO may transfer resources to the most inefficient division to motivate division managers to invest efficiently when diversity in resources and opportunities increases. Scharfstein and Stein (2000) theoretically demonstrate, using a rent-seeking model, that the CEO of a diversified firm could allow the manager of a low-profit division to enjoy private benefits by providing him/her with larger resources compared to the firm’s profitability to make him/her work hard. However, large-scale consecutive expenses in loss-making divisions, which are our focus here, far surpass “internal subsidy” illustrated by Rajan et al. (2000) and Scharfstein and

30

2 Zombie Businesses in the Electronics Industry: Case Studies

Stein (2000), because such investment destroys surplus that the CEO and the division manager want to share. In the internal capital market theories, the CEO wants more surplus, and thus it seems reasonable that they will want to eliminate loss-making business segments. Next, segment investment in deficit cannot be explained by the empire building hypothesis. As argued by Scharfstein and Stein (2000), the CEO would build a profitable, growing empire rather than a loss-making, declining one. CEOs would acquire and/or increase the number of profitable, growing business segments. According to Graham et al. (2002), the market reaction is non-negative to diversified investments. Indeed, Sony has entered the profitable entertainment and finance businesses. Allocating resources towards a loss-making division with no investment opportunities result in not only destroying firm value but also ruining empire. Investment in loss-making segments is related to exit decisions, and it is beyond allocative inefficiency in internal capital markets and empire building. Jensen (1993) documents the difficulty of exit of U.S. firms in the 1980s. Japan is no exception. Is there a mechanism to prevent investment in deficit sectors? One may argue that Japanese companies have no effective internal control over their boards dominated by insiders. Ironically, Sony has 13 outside directors out of 15, and its board is modeled as that of U.S. companies. In the era of Howard Stringer as the Chairman and President (April 2009–March 2012), he was never accused of managerial responsibility for not being able to cut deficit and for continuing to invest in loss-making businesses. However, the prolonged poor performance of the electronics segment suggests that there was an increasing competition from product markets and Japan’s electronic products were not dominant anymore. Foreign institutional investors who hold high ownership of major electronics manufacturers, including Sony, rarely demand their owned Japanese electronics firms to improve their management and performance. At least, those investors could have been able to express their dissatisfaction by simply selling shares of poor performing companies. Selling shares of companies with unsatisfied performance is known as voting by feet. Institutional stakes in Sony have not decreased, however. Hence, passive foreign institutional investors neither voice their dissatisfaction nor vote with their feet to sell the shares of loss-making Japanese electronics companies. The only exception is the case of Third Point, a U.S. based activist and a shareholder of Sony, which issued a managerial reform demand to Sony, such as the separation of movie and entertainment divisions. In July 2014, Sony, under pressure from the Third Point, sold its PC business, which led to an operating loss of ¥91.7 billion (including business downsizing expenses) among the accompanying sales of ¥418.2 billion, to Japan Industrial Partners, an investment fund. This is consistent with evidence in previous studies on remarkably powerless institutional investors in U.S. corporate governance. It is believed that Japanese companies were disciplined and monitored by their main banks, which worked as an alternative to leveraged buyout (LBO) partnerships (Jensen, 1989). However, the question of who monitored banks remains unanswered. Financial deregulation allowed direct access to corporate bond markets, and this in turn resulted in overcapacity in the banking industry. Poorly governed

2.5 Discussion

31

Japanese banks did not recognize required downsizing and exit, and they turned to the riskier real estate sector and small corporate borrowers without adequate portfolio management. One may expect that post-retirement officials from the regulatory authorities as bank executives monitor and guide banks well. However, Horiuchi and Shimizu (2001) show that those banks accepting post-retirement officials have reduced capital adequacy levels and increased non-performing loans. Like electronics companies, Japanese banks did not promptly downsize or exit in response to overcapacity in the banking industry and generated a waste of deposits at the expense of taxpayers. Indeed, in the 1990s, to window-dress non-performing loans, Japanese banks continued to extend additional loans to virtually bankrupt “zombie firms.” Notably, zombie firms heavily relied on zombie lending because they neither had enough internal funds nor were able to access corporate bond markets. Moreover, even when the banking sector had disposed of most of its non-performing loans in the early 2000s, main banks did not come back. In sum, main banks do not act like the U.S. LBO partnerships. Interestingly, troubled Japanese banks were bought by U.S. private equity funds,12 and cross border investment of capital market played an important role in turnaround. In addition, U.S. activist investors, like Steel Partners, entered Japan and hosted several hostile takeovers as the Japanese economy had been sluggish for many years. Unfortunately, this ended up with takeover defense measures taken by Japanese firms under cross-shareholding (Xu & Tanaka, 2009). Moreover, Japan criticized Steel Partners as an example of abusive acquisitions. Japan lost an opportunity to activate its capital market to pressure underperforming electronics companies to downsize and exit. As stated by Kang and Shivdasani (1997), capital market pressures, such as acquisition attempts, were rare for Japanese companies whose operating profit halved in the late 1980s. As mentioned above, the stock market straightforwardly responded to Sony’s investments in the deficit sector. Eventually, Third Point came to pressure the management to redirect in response to overcapacity in the electronics industry. In order to escape from another lost decade, the role of an “abusive acquirer” should be reevaluated now. If shareholder activism spreads, collaboration between institutional investors and activists is expected as in the United States and the UK. As can be seen from the case of Third Point, the existence of foreign activists rather than foreign institutional investors is indispensable in order to encourage early departure from the deficit sector. However, until recently it was unacceptable for any activist funds to challenge a highly profitable Japanese company when the stock price sharply drops. In U.S., as Apple’s stock lost about 30% of its value from its highest in early 2013, David Einhorn, a famous hedge fund manager, Greenlight Capital’s manager, and the largest U.S. activist investor Carl Icahn exerted pressure to distribute huge cash to shareholders. It is only in recent years that Third Point is targeting profitable firms such as Seven & i Holdings and the best-known robotic company Fanuc to demand spinoff of declining business and repurchase of shares. 12

The Wall Street Journal, How a U.S.-Led Group Won Control of a Japanese Bank, Updated March 23, 2000, https://www.wsj.com/articles/SB953768417721976160, September 16.

32

2 Zombie Businesses in the Electronics Industry: Case Studies

Conventionally, withdrawing from a business that has been suffering losses for three consecutive years is a rather quick exit in Japan. During the two lost decades, Japanese companies have continued to waste internal funds on investment in unprofitable businesses far longer than three years, because of lack of active capital market. This may be the truth behind the two lost decades. In addition, this strongly suggests the difficulty of exit as Jensen (1993) points out. Among the frameworks that could give discipline to corporate management, internal control systems, the legal system, government policies, product market, and the main bank are hardly effective for early exit. To encourage exit, the capital market and the market for control are more effective. During the era of hostile takeovers in the 1980 USA, more than half of the major publicly traded companies experienced a tender offer. In particular, an LBO method was developed to raise funds with junk bonds using the assets of the target company as collateral, contributing to improvements in business performance and shareholder value.

2.5.2 Employment Considerations Neither banks, institutional investors, nor internal controls could stop Sony from wasting its internal funds from non-electronics segments in excess of investment opportunities. Now, we show that the main reason for difficulty of exit is employment considerations, as our case studies illustrate. As can be seen above, Sony and Mitsubishi Electric present a sharp contrast: Sony has maintained a low profit margin without letting go of the deficit businesses shining in the past, while Mitsubishi has enhanced its profit margin by promptly cutting off the deficit business. Even when faced with declining profitability, Sony and NEC were slow in reducing segment employment. This suggests that Japanese managers spend free cash flow to buy short time labor peace and postpone exit from a deficit sector as pointed out by Jensen (1993). In other words, managers avoid risks to redirect their business models. However, it is not beneficial for employees to continue investing in deficit business in the long term. In 2005, IBM sold its PC division to Lenovo with $1.7 billion, and 10,000 employees moved to Lenovo. NEC, on the other hand, after continuing the electronic devices business that had fallen into deficit in 2005, announced plans to reduce personnel by 20,000 people and 10,000 people in 2009 and 2011, respectively. After all, in 2011, NEC finally transferred the operation of the PC business to Lenovo and in July 2016 sold the remaining shares of the joint venture with Lenovo for ¥20 billion. NEC could have transformed itself into an IT service company if it had divested the business earlier and invested internal funds for increased retirement allowance and investments in IT and network business. There is a possibility for employees and shareholders to have minimized their disadvantages. This is consistent with Caballero et al. (2008) who state that zombie-dominated industries exhibit more depressed job creation.

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In addition, zombie investment crowded out the entry and investment of healthy peer firms as pointed out by Caballero et al. (2008). The problem is that most electronics businesses are underperforming and intra-industry reallocation of resources, in particular, reallocation of employment, is lacking. If the major electronics companies had terminated investment in PC and other underperforming businesses earlier and instead reallocated their resources to IT services, they may have urged the development of the IT services market. As a consequence, productivity stagnation due to lack of investment in IT by Japanese companies may have been avoided. Fukao et al. (2016) point out that the immaturity of the business process outsourcing (BPO) market and the lack of IT experts make IT input prices relatively high to small companies. It can be seen from Fig. 2.4 that the investment in NEC’s deficit device division hindered the growth of its IT and network solution sector. It is too late to consider exit after falling into deficit, so a strategy of withdrawal is necessary even in the case of low profitability and low growth with surplus. In particular, investment in the electronics sector, which turned into surplus helped by the weak yen, would increase the deficit during the subsequent period of strong yen, as demonstrated by the example of Sony. Shifting employees and resources rapidly from underperforming or loss-making sectors to growing industries could create new employment. It is also important for Japanese companies to acquire profitable and high-growth businesses. However, Kang and Shivdasani (1997) find that only 9.8% of Japanese firms attempted an acquisition when their operating profit halved while that ratio amounted to 32.5% in the U.S. According to the cross-country analysis made by John et al. (2008),13 Japan is ranked low in terms of corporate risk taking among countries investigated in the analysis. Japanese managers hesitate to promptly redirect resources in response to the declining profitability of segments for fear of risking their careers. Figure 2.1 indicates that once Sony’s profitability dropped, it stayed in a low level for a long time. In Fig. 2.3, NEC’s profitability remained in a low and narrow level for more than 20 years. In contrast, Fig. 2.5 shows that Mitsubishi had ROA of 5% during 1988-1992, but it exceeded 10% during 2013-2015. Similarly, Mitsubishi’s operating margin is much higher and more volatile than that of Sony or NEC, as shown in Fig. 2.8. Investment in loss-making segments is responsible for prolonging the low profitability of Sony and NEC. If bold risk taking is spread to Japan with the pressure of capital markets, Japanese companies are expected to improve profitability and increase their growth rate. From the viewpoint of corporate governance, risk taking, such as early withdrawal from unprofitable or loss-making sectors, not only contributes to the interests of shareholders, but also serves as a benefit for workers by creating jobs. If corporate governance, in particular, the discipline of capital markets works, excessively low risk taking such as continuously spending free cash flow on the deficit sector to postpone a problem and secure temporary peace between labor and management would be relieved. The first step in proactive risk taking is early withdrawal from the deficit sector. Capital market pressure is essential to encourage early withdrawal from the deficit sector. 13

Standard deviation of ROA is a proxy for risk taking.

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2.6 Conclusions Previous studies were conducted on inefficient investment in Japan in the late 1990s and early 2000 at the firm level. In this section, we focus on the misallocation of credit to loss-making electronics business segments in major Japanese electronics companies. We show that Sony wasted its internal funds from profitable finance and entertainment businesses to subsidize its primary loss-making electronics business. Similarly, NEC spent most free cash flow on its loss-making electronic devices sector. In contrast, Mitsubishi has been promptly cutting off investment in deficit business segments and improving its profitability. It is not surprising that the investment in loss-making segments prolongs poor performance. The direct reason is that free cash flow is in excess of investment opportunities in the electronics industry. However, the outside-dominated board does not prevent Sony from investment in deficit segments. Moreover, foreign institutional investors neither voice nor vote with their feet against perverse segment investment in Sony and NEC. Exceptionally, Third Point, a U.S. based activist investor fund, exerted pressure and then Sony spun off its loss-making PC business. Focusing on asymmetric segment employment, in Chap. 3, we examined the misallocation of internal funds to business segments for employment considerations. We investigated whether a segment that contributes more to employment is able to extract more credit for investment. We found that a segment with more employment invests more irrespective of internal operating losses. Surprisingly, all segments in a loss-making diversified electronics corporation invest more. Consequently, investment in a deficit segment exacerbates subsequent segment profitability and segment asset turnover. Moreover, we found no evidence that specialized electrical firms cut back on investment in deficit and that firm performance improves as sales shrink. An efficient internal capital market should cut back on investment in loss-making segments that have poor investment opportunities. In addition, exit from loss-making businesses would increase cash flow, and this in turn increases private benefits for the CEO. Thus, the internal misallocation of credit to loss-making divisions cannot be rationalized by either simple empire building of the CEO or the internal cross subsidies in a conglomerate. The most plausible answer is that job security is a matter of the highest priority in Japan. To grant job security to employees, the CEO continues to misallocate fund to loss-making divisions until the problem is unresolvable. Most importantly, we shed new light on internal capital markets where employment can be a source of bargaining power for division investments. The diversity of employment and profitability can lead to the most inefficient segment investment. Our evidence suggests that shareholder-employee conflicts could affect a firm’s internal capital market. When faced with excess capacity, all managers failed to downsize, while they continued to invest to maintain employment. Consequently, downsizing and exit were significantly delayed due to the misallocation of credit to businesses with excess capacity for employment considerations, even though the non-performing loan problem was resolved. Rather, zombie lending itself was in part due to the

2.6 Conclusions

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employment considerations of banks. Furthermore, employment considerations in impaired banks coincided with the need for investment in the weakest industrial firms to achieve job security. In Japan, it is difficult to fire employees for poor company performance, as long as the company is far from default. The difficulty of withdrawal is rooted in the difficulty of dismissal. The linkage between segment investment and segment employment supports the employment consideration hypothesis. In previous studies, single-segment firms are used as a benchmark for investment opportunities and distorted investment in the segments of diversified firms as demonstrated by Shin and Stulz (1998) and Ozbas and Scharfstein (2010). However, we found that single-segment electronics firms have poor investment opportunities in terms of the average Q ratio or sales growth. Moreover, 15% of the single-segment firms were suffering losses. This is not surprising as we have shown that the PC business, TV manufacturing, DRAM business, and LSI business are all underperforming due to worldwide technological changes. Regardless of the poor investment opportunities, investment in single-segment firms is only sensitive to cash flow, and neither investment opportunities nor sales growth has any impacts on investment. Moreover, the performance of single-segment firms is positively related to investment opportunities but is negatively related to sales growth. In short, most single-segment firms also ought to divest rather than invest, but they continued to waste free cash flow. In Chap. 4, we provide evidence on the difficulty of eliminating overlapping inefficient operations in horizontal M&A due to employment protection legislation.14 Merging respective loss-making divisions in the same segment with excess capacity might prevent each concerned company from continuing the misallocation of internal funds to the loss-making business. However, aggressive labor restructuring is necessary for the associated horizontal M&A synergy gains, and thus just merging without enough downsizing is far from the ultimate solution to excess capacity. We illustrate cases where merging respective loss-making divisions in the same business incur losses, and we show that post-merger downsizing is required. Renesas Electronics is 14

In M&A, the succession of rights and obligations is comprehensively inherited by the company. Therefore, the pre-merger labor contracts must be maintained as they are. In transfer of business, the succession of rights and obligations of the acquired business is the so-called specific succession that requires the consent of individual creditors. In transfer of business, Article 625, paragraph (1) of Civil Code (Act No. 89 in 1896) provides that a company that transfers its business must obtain individual consent from the prospective worker whose existing labor contracts will be specially succeeded by the company that receives the business. For details, see the guidelines on matters to be noted by companies when conducting business transfer or M&A (https://www.mhlw.go.jp/ stf/seisakunitsuite/bunya/0000136056.html, in Japanese). It is important to keep in mind that a worker to be succeeded cannot be dismissed solely because he/she has not accepted the succession of his/her labor contracts. According to the Labor Contract Succession Law (https://www.mhlw. go.jp/general/seido/toukatsu/roushi/01a.html, in Japanese), the labor contracts of workers mainly engaged in the business succeeded by the company split will naturally be succeeded to the newly established (absorbing) company by the company split. Unlike transfer of business, no worker consent is required. The succession of the labor contract of the relevant worker should be stated in the split plan (contract) as the rights and obligations to be succeeded, and if it is not stated, if the objection is stated, the contract will be transferred to the new (absorbing) company.

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a good example. Back to the 1990s, Japanese manufacturers lost their supremacy in the semiconductor business with the rise of Asian peers. In addition, in semiconductors other than DRAM, Hitachi and Mitsubishi Electric integrated their operations in April 2003 to launch Renesas Technology. However, post-M&A performance was poor, and this resulted in prolonging losses since the Global Financial Crisis. Moreover, the launched company was merged with NEC Electronics (NEC’s semiconductor subsidiary) in 2010. The name of the merged company is Renesas Electronics (hereinafter, Renesas). During the accounting period 2004–2009, the two pre-merger companies were constantly making losses. Obviously, aggressive post-merger restructuring was lacking. To regain viability, Renesas laid off 8.5% (4000) of its employees. The easy restructuring was a little helpful and prolonged losses. Three years later, Renesas got deeply distressed, and it was acquired in April 2013 by the Innovation Network Corporation of Japan (INCJ), a government-affiliated investment fund and a coalition of major customers including Toyota, Honda, and Panasonic. Since then, it closed five plants, sold six plants, and laid off 60% of its redundant workforce. It will also close two plants in the future and only keep six operating. For dramatic downsizing, it took an upward turn in its profit margin after 2014. In 2019, it announced the layoff of an additional 1000 employees and a plan to shut down operations at its nine domestic plants for up to two months by the end of September 2019. Like semiconductor manufacturing, most Japanese LCD divisions were suffering losses. In 2004, Epson and distressed Sanyo combined their LCD divisions as Sanyo-Epson Imaging Devices Corporation. Thereafter, M&A of LCD business were repeated. In 2012, led by the government, the loss-making mobile LCD divisions of major Japanese electronics companies were combined to the “national” LCD manufacturer, Japan Display Inc. (hereinafter, JDI), to prevent foreigners from acquiring “Japan’s advanced technology.” Merely combining loss-making small- and mediumsized LCD divisions of major electronics companies did not result in a profitable company, however. At the start point, JDI was suffering losses and facing international competition from Chinese and South Korean makers. As the main customer, Apple, was losing market share, JDI has been suffering prolonged losses. In response, JDI laid off 30% of its employees in 2016, and the number of employees was expected to decrease from 15,722 at the end of March 2016 to 10,986 at the end of March 2017. Of the 4736 job cuts, only 636 were domestic. It is notable that it seems much more difficult to lay off domestic employees than to reduce overseas employees. Five consecutive annual losses drained JDI’s equity capital, and its liabilities are now exceeding assets. At long last, it had to turn to foreign investment funds. In July 2019, the company announced that it finally secured the 80 billion yen bailout plan from the Greater China-based Harvest Group, activist investor Oasis Management, and an unnamed JDI customer—it was likely to be Apple. Two months later, unfortunately, the Harvest Group canceled its plans to invest in Japan Display.15 In December 2019, the company announced a new bailout plan from Ichigo Asset Management to invest up to $830 million in Japan Display. Several days later, it 15

https://www.oled-info.com/japan-display.

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turned out that the company was suspected of having capitalized an excessive inventory of about 10 billion yen due to inappropriate accounting allegations by a former accounting executive, according to the Special Investigation Committee. However, it was criticized that the Special Investigation Committee included JDI’s executive officers and independence was lacking. The details will be investigated by a third-party committee consisting only of external experts. Renesas and JDI have been required to frequently and promptly restructure or redirect themselves in response to economic shocks such as economic slowdown, technological changes, and the entry of South Korea, Greater China, and India into worldwide product markets. Renesas is specialized in semiconductor manufacturing, and JDI has a single segment of small-medium LCD. Their slow employment adjustment in response to poor profitability supports the employment consideration hypothesis for stand-alone Japanese firms. In sum, it is quite cumbersome for Corporate Japan to downsize or exit, in particular, to lay off workforce, until the problem is unresolvable irrespective of conglomerates or single segments. Recently, 66% of listed Japanese companies answered in the 2018 Ministry of Economy, Trade and Industry (METI) survey on corporate governance that they need the agreement of labor unions or labor-management councils when laying off workers. Moreover, job security is also a main concern in M&A. Of course, an M&A conditional on maintaining employment would impede layoffs that are the sources of synergy gains from takeovers. In addition, deals would fall through if all parties insist on maintaining employment. Indeed, when Toshiba, Fujitsu, and VAIO, the former PC division of Sony and now under the umbrella of Japan Industry Partners, negotiated the conditions for the integration of their respective PC business in 2016, the deal fell through in part due to the insistence on no plant closings of Toshiba and Fujitsu regardless of their slump in the PC business. Even when a bankrupt Japanese company is acquired, job security is still a main concern. At the press conference on the completion of acquisition of all shares of Elpida Memory on July 31, 2013, the former President Sakamoto said, “The common understanding of Micron and Elpida is to maintain employment ….” Difficulty of laying off overlapping redundant labor force reduces activities and gains from M&A. Dessaint et al. (2017) provide evidence that increase in employment protection impedes layoffs, resulting in wage costs that reduce synergy gains from takeovers. They show that the M&A volume scaled by gross domestic product in Japan is the lowest among major OECD countries, although Japan’s OECD Employment Protection Legislation (EPL) index is moderate. This suggests that Corporate Japan pays attention to employment protection more than required by the employment protection legislation, as shown in the above anecdotal example. Using crosscountry data, recently, Arikawa et al. (2019) found that Japan dummy in addition to the Japanese employment protection significantly explains the poor performance of Japanese firms compared to their global peer firms. The fragile employment system hinders flexible divestments and employment adjustments, which are necessary in response to worldwide overcapacity that is attributable to regulatory, technological, and economic changes.

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References Arikawa, Y., Inoue, K., & Saito, T. (2019). Corporate governance, employment, and financial performance of Japanese firms: A cross-country analysis. Available at SSRN https://papers.ssrn. com/sol3/papers.cfm?abstract_id=3312515. Caballero, R. J., Hoshi, T., & Kashyap, A. K. (2008). Zombie lending and depressed restructuring in Japan. American Economic Review, 98(5), 1943–1977. https://doi.org/10.1257/aer.98.5.1943 Dedrick, J., & Kraemer, K. L. (1998). Asia’s computer challenge: Threat or opportunity for the United States and the world? Oxford University Press. Dessaint, O., Golubov, A., & Volpin, P. (2017). Employment protection and takeovers. Journal of Financial Economics, 125(2), 369–388. https://doi.org/10.1016/j.jfineco.2017.05.005 Fukao, K., Ikeuchi, K., Kim, Y. G., & Kwon, H. U. (2016). Why was Japan left behind in the ICT revolution? Telecommunications Policy, 40(5), 432–449. https://doi.org/10.1016/j.telpol.2016. 01.008 Horiuchi, A., & Shimizu, K. (2001). Did amakudari undermine the effectiveness of regulator monitoring in Japan? Journal of Banking & Finance, 25(3), 573–596. https://doi.org/10.1016/S03784266(00)00089-3 Jensen, M. C. (1989). The eclipse of the public corporation. Harvard Business Review, 67, 61–75. Jensen, M. C. (1993). The modern industrial revolution, exit, and the failure of internal control systems. Journal of Finance, 48, 831–880. John, K., Litov, L., & Yeung, B. (2008). Corporate governance and risk-taking. Journal of Finance, 63, 1679–1728. MacKinlay, A. C. (1997). Event studies in economics and finance. Journal of Economic Literature, 35(1), 13–39. Nakamura, J., & Fukuda, S. (2013). What happened to ‘zombie’ firms in Japan?: Reexamination for the lost two decades. Global Journal of Economics, 2(2), 1–18. Gomes, J., & Livdan, D. (2004). Optimal diversification: Reconciling theory and evidence. Journal of Finance, 59(2), 507–535. Graham, J. R., Lemmon, M. L., & Wolf, J. G. (2002). Does corporate diversification destroy value? Journal of Finance, 57(2), 695–720. Kang, J. K., & Shivdasani, A. (1997). Corporate restructuring during performance declines in Japan. Journal of Financial Economics, 46, 29–65. Lang, L., & Stulz, R. M. (1994). Tobin’s q, corporate diversification, and firm performance. Journal of Political Economy, 102(6), 1248–1280. Ozbas, O., & Scharfstein, D. S. (2010). Evidence on the dark side of internal capital markets. Review of Financial Studies, 23(2), 581–599. Peek, J., & Rosengren, E. S. (2005). Unnatural selection: Perverse incentives and the misallocation of credit in Japan. American Economic Review, 95(4), 1144–1166. Rajan, R., Servaes, H., & Zingales, L. (2000). The cost of diversity: Diversification discount and inefficient investment. Journal of Finance, 55, 35–80. Saruyama, S., & Xu, P. (2017). The rise and fall of major electronics manufacturers from the perspective of investment in loss-making businesses. In A. Tamura (Ed.), Corporate direct investment strategies and trade to enhance international competitiveness. Research Series 31 of Hosei Institute of Comparative Economic Studies. Nippon Hyoron Sha. (in Japanese). Scharfstein, D. C., & Stein, J. C. (2000). The dark side of internal capital markets: Divisional rent-seeking and inefficient investment. Journal of Finance, 55(6), 2537–2564. Shin, H. H., & Stulz, R. (1998). Are internal capital markets efficient? Quarterly Journal of Economics, 113, 531–552. Xu, P., & Tanaka, W. (2009). Takeover defense measures in the shadow of share cross-holdings: Case studies. Commercial Law (No.1885, pp 4–18). (in Japanese). Yunokami, T. (2013). Defeat of Japanese style manufacturing. Bunshun Bunko. (in Japanese).

Chapter 3

Misallocation of Internal Funds to Loss-Making Zombie Businesses in the Electronics Industry

Abstract Linking segment employment to segment investment in Japanese electronics firms, we find that segment investment increases with segment employment irrespective of segment operating profitability. We show that the internal capital market equalizes the impacts of cash flow across segments. However, the internal capital market does not cut back on investments in loss-making segments. Moreover, investments in all segments increase even when the whole firm is in deficit. Nevertheless, segments with better investment opportunities do not invest more. Not surprisingly, investment in a deficit segment exacerbates subsequent segment profitability and segment asset turnover. Likewise, single-segment firms also have excess capacity, whereas they prolong unnatural investment. Keywords Segment profitability · Segment investment · Segment employment · Cash flow · Employment consideration

3.1 Introduction What is responsible for the two lost decades in Japan? Previous studies focused on the misallocation of bank credit to the weakest firms due to the perverse incentives of troubled banks (Peek & Rosengren, 2005; Caballero et al., 2008). However, the following questions remain unanswered. Why did not troubled banks dispose of bad loans? Why and how did healthy firms turn into zombies? The burst of bubble probably yielded zombie firms in banking, financial, real estate, construction, and retail industries. However, this does not necessarily mean the decay of the best-known Japanese electronics companies that were reputable for access to the corporate bond market and thus less vulnerable to the banking crisis. Limited to our knowledge, the failure of land speculation is mainly limited to real estate, construction, and retail companies. Most manufacturing companies, including electronics companies, were This work was supported by JSPS KAKENHI Grant Number JP17H02471. All remaining errors are our own. Any opinions, findings, or conclusion expressed in this book are those of the authors and do not reflect the views of the Development Bank of Japan or the authors’ affiliations.

© Development Bank of Japan 2021 S. Saruyama and P. Xu, Excess Capacity and Difficulty of Exit, Development Bank of Japan Research Series, https://doi.org/10.1007/978-981-16-4900-4_3

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profitable in the early 1990s. If we had to use the word “zombie,” we would say that many electronics companies were gradually falling into zombies in the first lost decade. So far, it has been viewed that a striking aspect of the Japanese main bank system is to provide a flexible, more effective discipline for downsizing. However, many of Japan’s large public companies were high-growth and cash-starved companies; thus, the conflict between owners and managers over free cash flow was not a main issue till the late 1980s. Ironically, the 1980 financial deregulation liberalized corporate access to corporate bond markets, and consequently Japanese banks lost regulatory rents. Although they ought to downsize or exit, banks expanded loans to the real estate sector and less credit-worthy companies. This is the valid reason why Japanese banks got troubled. Japan experienced the second lost decade after resolving the non-performing loan problem, although Nakamura and Fukuda (2013) point out that constructive reforms, such as more transparent accounting rules and stricter bank supervision policies, accelerated the recovery of alleged zombie firms at the firm level by downsizing in the 2000s. During the second lost decade, however, the misallocation of credit to loss-making segments prevailed. The PC business is an example (Dedrick & Kraemer, 1998), as shown in Chap. 2. In the 1980s and early 1990s, NEC, a leading PC vendor, enjoyed rapid growth, dominant market position, and high cash flow and profits in the Japanese domestic PC market, because NEC PC-98 was designed to handle Japanese text easily. In 1990, however, IBM Japan introduced the DOS/V operating system that enabled displaying Japanese text on standard IBM PC/AT VGA adapters. Soon, NEC’s market share shrunk from 52% in 1992 to 33% in 1995. Facing increasing competition from Fujitsu, Seiko Epson, IBM Japan, U.S. PC vendors, and Lenovo, NEC was suffering huge losses for a long time, but most of the internal funds were wasted on investments in loss-making PC businesses. At long last, NEC moved its PC production to a joint venture with Lenovo in 2011. By contrast, Fujitsu already outsourced its PCs in the 1990s, and IBM sold its PC business to Lenovo in 2005. In 2014, Sony also sold off its VAIO computer division to a Japanese investment fund, Japan Industrial Partners, pressured by Third Point, a U.S. activist fund. Subsequently, Fujitsu sold its PC business to Lenovo in 2016, and Sharp acquired Toshiba’s PC business in 2018. In this chapter, we perform data analyses of investment in segments with excess capacity in the electronics industry. Focusing on asymmetric segment employment, we examine the misallocation of internal funds to loss-making businesses. Previous studies mainly focus on the effects of unionization or changes in employment protection legislation on corporate financing decisions such as leverage at the firm level. In this chapter, we investigate whether a segment that contributes more to employment is able to extract more internal funds for investment irrespective of loss. An efficient internal capital market should cut back on investments in loss-making segments that have poor investment opportunities. In addition, exit from loss-making businesses would increase cash flow and thus private benefits for the CEO. Thus, the internal misallocation of credit to loss-making divisions cannot be rationalized by either the empire building hypothesis or the diversification discount theory.

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Our evidence supports the employment consideration hypothesis. Along with lifetime employment, it has been widely viewed that the most important purpose of enterprises is to ensure job security in Japan. It is relatively easy to allocate redundant employees from a small segment to other segments or newly hire fewer employees. However, it is quite difficult to lay off large-scale employees when the core business or a segment with considerable employment is distressed. If a firm has to lay off workers, the CEO needs to devote a great effort to convincing the enterprise union. Additionally, the CEO needs to compensate early retired workers in cash. Even worse, it is possible that the CEO has to resign to take responsibility for the breach of job security. Thus, the CEO can choose continuing investment to buy labor peace and leave exit to rivals, as discussed by Jensen (1993). The following news story truly tells us that job security is still a main concern even when a bankrupt single-segment Japanese company is acquired. At the press conference on the completion of acquisition of all shares of Elpida Memory on July 31, 2013, the former President Sakamoto said, “The common understanding of Micron and Elpida is to maintain employment ….”1 Of course, an acquisition conditional on maintaining employment would impede layoffs that are the source of synergy gains from takeovers. In addition, deals would fall through if all parties insist on maintaining employment. Indeed, when Toshiba and Fujitsu, VAIO owned by Japan Industry Partners, negotiated the conditions for the integration of their respective PC business in 2016, the deal fell through in part due to the insistence on no plant closings of Toshiba and Fujitsu regardless of their slump in the PC business. Eventually, Lenovo acquired a 51% stake in Fujitsu Client Computing (FCCL), the wholly owned subsidiary in charge of Fujitsu’s PC business. Fujitsu still held 44% of shares and thus was able to exercises the power of veto regarding significant asset sales after integration. The Development Bank of Japan (DBJ) acquired the remaining 5%. Notably, the integration is conditional on maintaining employment in FCCL’s existing plants and continuing the production of Fujitsu’s brand PC. Anecdotally, employment considerations are the top issue even in takeovers and mergers of slumped business. The difficulty of laying off overlapping labor force also decreases M&A activities and the gains from M&A, though Japan has been required to downsize and exit since the 1990s. Faced with excess capacity, all managers failed to downsize, while they continued to invest to maintain employment and left exit to rivals. Consequently, downsizing and exit were significantly delayed due to the misallocation of credit to businesses with excess capacity for employment considerations, even though the nonperforming loan problem was resolved. Rather, zombie lending itself was in part due to the employment considerations of banks. In addition, employment considerations in impaired banks coincided with the need for investment in the weakest industrial firms to achieve job security. Previous studies focus on firm level investment and zombie lending. However, it is not efficient to invest in a loss-making business to maintain employment even if 1

Elpida Holds Micron Acquisition Completion Conference (in Japanese) https://pc.watch.impress. co.jp/docs/news/609906.html, last visited on December 4, 2019.

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a firm as a whole looks healthy, as noted in Chap. 2. Indeed, the best-known electronics companies were still making some profits in the first half of the 1990s. Thus the overcapacity problem is not attributable to the burst of bubble economy, it is the consequence of the rise of IBM DOS/V PC, iPod, and iPhone. More importantly, it is too late to begin to withhold loans until a borrowing firm wholly turns into a zombie. We need to take a closer look at investments in companies that still make some profits wholly but with core segments beginning to fade. In this paper, using segment data in diversified electronics firms, we find that segment investment increases with employment. However, segment investment opportunities and sales growth are not relevant to segment investment. Moreover, segment investment equally depends on own segment cash flow and cash flow of other segments. When the whole firm is in deficit, however, investments in all segments increase. In relation to corporate governance, we find that the positive effects of employment on investment in deficit segments decrease with institutional investors’ ownership. This suggests that institutional investors put pressure on the management to downsize in a segment with poor investment opportunities. Not surprisingly, investment in a deficit segment exacerbates subsequent segment profitability and segment asset turnover. Likewise, singlesegment firms also prolong unnatural investment while facing excess capacity. The performance of single-segment firms is positively related to investment opportunities but is negatively related to sales growth. Existing studies on segment investment have focused on how division managers bargain with the CEO over internal funds in a diversified firm. However, the influence of employment protection and shareholders on the internal capital market attracts far less attention in the literature. Our paper contributes to the literature as follows. First, our study shows that segment employment is a source of bargaining power related to internal credit allocation. While recent papers focus on the effects of employee rights on profitability, leverage, and takeovers, our paper examines how the shareholderemployee conflicts could affect the internal capital market. Different from previous studies on segment investment, in Japan, segment investment is neither sensitive to segment investment opportunities nor segment growth. Rather, a segment with higher employment attracts more internal funds for investment irrespective of operating losses. This is the first study that links segment level investment to segment level employment. Moreover, we provide evidence that declining single-segment firms prolong unnatural investment, and thus the difficulty of downsizing is due to job security considerations regardless of diversity. The rest of the chapter is organized as follows. In Sect. 3.2, we review the literature and describe our research design. In Sect. 3.3, we report data description and empirical results. In Sect. 3.4, we provide a conclusion.

3.2 Research Design In the literature of corporate finance, the main reason of overinvestment is that the manager of a firm tends to pursue private benefits rather than firm value because of

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asymmetric information and the separation of ownership and control. In relation to this, Jensen and Meckling (1976) define the concept of agency costs due to information asymmetry and provide a new definition of the firm. Thereafter, several theories have been developed according to the agency theory. In this section, we review the literature on inefficient investment and develop our hypothesis.

3.2.1 Literature Review According to Jensen (1986), managers tend to derive private benefits from empirebuilding investment. This problem becomes more severe in declining stage for excess capacity caused by regulatory changes, massive changes in technology, new entries in globalization (Jensen, 1993). In this connection, our study is also related to studies on the difficulty of exit, zombie lending, employment protection, and diversification discount.

3.2.1.1

The Difficulty of Exit

Jensen (1993) provides evidence on overinvestment in losing operations as U.S. managers’ resistance to shut down plants or to liquidate the firm as long as they have cash flow. This is because redirection is painful for uncertainty, and it would interrupt the CEO’s career. Rather than confronting this pain, a large company that is immersed in the glory of growth continues to invest until the problem of excess capacity cannot be postponed while knowing that it must exit. In particular, the management hesitates to downsize or exit to buy temporary peace between labor and management. In sum, regardless of excess capacity the management tends to choose easy investment and easy employment security that are not in shareholders’ interests. Also, Jensen (1989) has predicted that the Japanese economy would produce massive overcapacity that the U.S. capital markets spent 10 years trying to eliminate. Peek and Rosengren (2005) and Caballero et al. (2008) provide evidence on inefficient investment supported by lending from impaired banks in the late 1990s. The 1980 financial deregulation liberalized corporate access to corporate bond markets, and consequently Japanese banks lost regulatory rents. Although they ought to downsize or exit in response to excess capacity, banks expanded loans to the real estate sector and less credit-worthy companies. This is the valid reason why Japanese banks got troubled. Consequently, non-performing loan problem can be viewed as evidence of the difficulty of exit in the banking industry, and ever-greening bad loans resulted at zombie lending. In sum, the difficulty of exit of banks due to regulatory changes overlapped with the difficulty of exit of industrial firms. Difficulty of exit and zombie lending are the consequences of slow employment adjustment in response to industrial overcapacity. Recently, many studies discussed the relationship between employment and corporate financing (Giroud & Mueller, 2017; Tate & Yang, 2016; Tian & Wang, 2020). Maksimovic et al. (2011) report

44

3 Misallocation of Internal Funds to Loss-Making Zombie …

aggressive closings and plant sales of acquired plants following a merger. Combined with plant sales and closings, redundant workers are laid off around M&A. Dessaint et al., (2017) show evidence that increase in employment protection impedes layoffs, resulting in wage costs that reduce synergy gains from takeovers. Therefore, the M&A volume scaled by gross domestic product (GDP) is negatively related to employment protection across countries.

3.2.1.2

Diversification Discount

Our study is also related to studies on diversification and division investment. Rajan et al. (2000) provided a theory and empirical evidence that expropriation among divisions may lead to defensive but inefficient investments to protect the division benefit and thus the CEO may transfer resources to the most inefficient division to motivate division managers to invest efficiently when diversity in resources and opportunities increases. Scharfstein and Stein (2000) developed a two-tiered agency model in which weaker divisions get subsidized by stronger ones due to the rent-seeking behavior of division managers. According to the diversification discount hypothesis, the internal capital market misallocates cash flow to inefficient segments. If the internal capital market is efficient, segment level investment should depend on segment investment opportunities such as the industrial average market to book ratio of stand-alone firms, segment growth, segment cash flow, or segment profitability. Particularly, the internal market might misallocate credit to segments irrespective of investment opportunities, whereas single-segment firms invest properly. However, it is not necessary to allocate internal funds to loss-making segments, because such investment destroys surplus that the CEO and division managers want to share. According to the internal capital market theories, the CEO wants more surplus; thus, it seems reasonable to cut back on investment and employment in loss-making segments.

3.2.2 Hypothesis Development During the late 1990s, the difficulty of exit of impaired banks resulted in zombie lending and overinvestment in zombie firms. The non-performing loan problem was resolved in early 2000, and zombie lending seems to not be a main reason for the second lost decade. Recently, there is a survey in support of the difficulty of exit. In 2018, the Ministry of Economy, Trade and Industry (METI) surveyed 941 industrial corporations. The METI survey comprises of three questions about the decisionmaking process of layoffs and downsizing/exit from segments. The first question is about issues concerning the divestments of some businesses. Divestments include sales of segments, downsizing segments, or exit from segments. The METI survey shows the problems faced by firms to make decisions on divestments. Second, the survey asks whether corporations use criteria to determine divestments. The criteria

3.2 Research Design

45

include quantitative criteria, such as three consecutive annual deficits and/or indicators like ROE, and qualitative criteria. The third question is about the existence of the process of evaluating divestments. Surprisingly, most respondents selected no specific formal criteria established. 79% of corporations have neither quantitative nor qualitative criteria to evaluate the divestments of some existing businesses. Only 16% of corporations have quantitative criteria, and 6% of corporations have qualitative criteria for deciding which business divestments to pursue. In sum, most Japanese corporations do not have criteria to determine divestments, although quite a number of firms ought to divest since the 1990s. Likewise, 65% of corporations have no procedures for divestments. Consequently, only 35% of respondents answered that they have no problems of divestments, while 55% selected the difficulty of downsizing or exit from existing business lines. This strongly suggests the difficulty of making decisions on downsizing or exit. Downsizing or exit is combined with layoffs. Labor law in Japan strictly regulates layoffs. Roughly speaking, layoffs are allowed if and only if there is a substantial doubt about the firm being a going concern. In other words, the management must prove that the firm will go bankrupt without personnel reduction. In addition, the management must devote efforts to avoid dismissal by other means, such as reassignment and recruitment of voluntary retirees. Next, the criteria for determining who should be hired should be objective, rational, and fair. Moreover, the management must explain to the trade union or workers the necessity, timing, scale, and method of dismissal to be convinced. Indeed, 66% of listed Japanese companies answered that they need the agreement of labor unions or labor-management councils to lay off workers, according to the 2018 METI survey on corporate governance. In conglomerates, it is more difficult to lay off considerable redundant workforce in loss-making segments unless the whole company is deeply distressed. In Chap. 2, we have shown that there was inefficient investment and slow downsizing despite a significant decline in the operating income margin of core electronic equipment and semiconductor businesses in Sony and NEC. For a loss-making segment, there is neither surplus to protect nor prospects for the CEO to share private benefits with the division manager. The main cause of investments in deficit segments is the difficulty of layoffs due to strong employment protection and employment considerations. In sum, segment employment considerations could lead to the misallocation of internal funds to segments irrespective of segment profitability and investment opportunities. Different from previous studies on diversification discount, the CEO prefers labor peace to profit. Since 2000, there is no evidence that healthy banks actively intervened in distressed borrowing firms’ management (Saruyama & Xu, 2019). According to Kang and Shivdasani (1997), among the Japanese and U.S. companies whose operating profit was halved between 1986 and 1990, only 2.6% of the U.S. companies responded by expanding production and existing facilities, compared to the expansions made by 27.2% of the Japanese companies. In addition, assets were sold only in Japan by 4.3% compared with 36.8% in the United States. Importantly, layoffs were conducted only in 17.4% of Japanese companies versus 31.6% of U.S. companies.

46

3 Misallocation of Internal Funds to Loss-Making Zombie …

This suggests that it is quite late for the main bank to discipline underperforming firms even if the main bank works. Moreover, the banking industry also has been facing redundancies since 2000 as the declining loan-deposit ratio indicates.2 To survive, banks turned to risky lending, such as loans to rental house businesses by individuals, irrespective of the increase in the vacancy rate and decrease in rent.3 In sum, it is hard to expect the disciplining role of debt in Japan. In this chapter, we focus on segment investment in the context of employment protection and employment considerations. Moreover, we examine the mechanisms for mitigating investment in deficit segments. Troubled banks increased evergreen lending to the weakest borrowers to window-dress their non-performing loans. Thus, previous studies define zombie firms as those whose interest payments are lower than risk-free interest payments or firms with earnings before interest and taxes (EBIT) lower than risk-free interest payments. In our study, we focus on the difficulty of downsizing at the segment level. Even if the banking industry is healthy, it is still difficult for the industrial management to lay off labor force in the core loss-making segment. In particular, we link segment investment to segment employment in the declining electronics industry. As shown in the aforementioned examples, NEC, Fujitsu, Sony, and Toshiba all failed to exit timely from their slumped PC business. However, none of them was specialized in the PC business. Therefore, we need to exploit segment investment decisions to identify the difficulty of exit. If the management maximizes shareholders’ interests or their own private profits, it is quite natural to cut back on segment investment with no prospects of surplus. At least, segment investment is sensitive to the incidence of operating losses at the segment level or at the firm level. In other words, segment investment is less likely to be negatively related to the incidence of operating losses if job security considerations are the top concern of the management. Furthermore, we examine the effects of investment in deficit segments on subsequent segment performance to examine the consequences of investment in deficit segments. For comparison, we examine investment decisions in specialized firms. To identify the causal impact of employment on segment investment, we link segment investment to segment employment. As shown in Chap. 2, losing firms tend to continue investment in their core loss-making businesses. Accordingly, we expect that a relatively large segment in terms of employment is able to extract more internal funds for investment irrespective of investment opportunities and profitability. Along with lifetime employment, it has been widely viewed that the most important purpose of enterprises is to ensure job security in Japan. If a small segment has poor performance, it is relatively easy to allocate a small number of redundant employees to other segments or newly hire fewer employees. Nevertheless, it is quite difficult to lay off a large number of employees when the core business is declining. If a firm 2

The aggregated loan-deposit ratio declined from more than 80% in 2000 to 66.9% at the end of 2016. For details, see http://www.boj.or.jp/statistics/dl/depo/dcl/index.htm/. 3 For details, see the results of the questionnaire survey on loans for investment properties by the Financial Services Agency (https://www.fsa.go.jp/news/30/20190328.PDF, in Japanese).

3.2 Research Design

47

has to lay off workers, the CEO needs to devote a great effort to convincing the enterprise union. Additionally, the CEO needs to compensate early retired workers in cash. Even worse, it is possible that the CEO needs to resign to take responsibility for breaching job security. Thus, the CEO can choose to continue investment to buy labor peace and leave exit to rivals, as pointed out by Jensen (1993). According to Rajan et al. (2000) and Scharfstein and Stein (2000), to prevent division managers from practicing rent seeking or choosing defensive investment, there can be distortions in the allocation of resources between the divisions of a diversified firm. In our study, we can also interpret that a segment that contributes more to employment has more considerable bargaining power in the firm. If employees in a segment share the private benefits of investment, intuitively it is more likely that a large segment is more influential than a small segment in terms of employment. If employees engage in rent-seeking behavior, a division with more employees can raise their bargaining power and extract greater extra benefits that may take the form of preferential capital budgeting allocations. Regarding the difficulty of exit, we exploit the impact of the incidence of segment operating losses on segment investment. If job security is the top issue, the management can continue to allocate more credit to a segment with higher employment irrespective of segment operating losses. In particular, employees prefer job security over cash wages. If a large segment is in deficit, the resistance to layoff may distort internal credit allocation. For comparison, we also examine whether single-segment firms cut back on investment in deficit segments. Previous studies on internal capital markets focus on the difficulty of allocating credit to segments with ample investment opportunities to mitigate the rent-seeking behavior or resource protection of division managers. In this paper, we look into the difficulty of the efficient reallocation of labor force in an industry setting with overcapacity.

3.3 Segment Investment and Segment Employment In this chapter, we will focus on diversified companies in the electronics industry. Japan’s electronics business is a suitable industry setting to examine how internally generated funds are used as capital expenditures for deficit segments. Indeed, Japanese electronics makers achieved great historical success in worldwide consumer electronics. We highlight how segment investments in loss-making businesses in major electronics manufacturers deteriorate their subsequent performance. Jensen (1993) points out the reason why firms cannot decide to make efficient exit, focusing on U.S. companies. First, large enterprises that enjoyed the glory of growth tend to leave declining businesses, even though they are aware of the necessity to terminate them until they cannot postpone problems any longer. If one dares to embark on implementing early reforms, the president should expect to be expelled from the post. Securing employment tends to be a good excuse made by the top management to continuously spend abundant cash flow on deficit segments.

48

3 Misallocation of Internal Funds to Loss-Making Zombie …

Table 3.1 Segment summary statistics in the diversified electronics companies Variables

Median

S.D.

Observations

Investment

0.0415

25th percentile 0.0166

75th percentile 0.0935

Mean 0.0753

0.1152

1745

Sales Growth

0.0196

−0.0848

0.0968

−0.0010

0.2081

1745

q

0.9236

0.8032

1.0959

0.9704

0.2684

1745

Cash Flow

0.1097

0.0368

0.2462

0.1772

0.3743

1745

Other Cash Flow

0.1725

0.0402

0.3130

0.1742

0.4278

1745

Deficit

0.0000

0.0000

0.0000

0.1868

0.3899

1745

Labor

0.3138

0.1352

0.6113

0.3881

0.2915

1745

Firm Deficit

0.0000

0.0000

0.0000

0.1266

0.3327

1745

Institutional Ownership

0.1188

0.0296

0.2448

0.1529

0.1427

1745

Debt

0.1729

0.1056

0.2571

0.1825

0.0997

1745

3.3.1 Descriptive Statistics Using the Nikkei Financial QUEST (FQ) database, we employ business segments released by companies as they are. What is difficult in using these data is that firms reorganize their segments over time. Following Shin and Stulz (1998), to prevent such reorganizations from affecting our conclusions, we identify a segment by examining the continuity of activities. The period of data used for the analysis is from 1999 to 2015. The disclosure of segment information was mandated together with the disclosure of consolidated financial statements at the end of the accounting year on March 31, 2000 (accounting year 1999). To focus on delayed downsizing in the electronics business, we exclude non-electronics segments. For comparison, we utilize data of firms specialized in the electronics industry. Our sample consists of 345 segments and 1745 segment * years. As the descriptive statistics in Table 3.1 show, on average, electronics segments have limited investment opportunities and low growth rate. The average q of the corresponding single-segment electronics firms is below one. It is quite similar to the average and median q ratios for single-segment U.S. firms during the 1970s downturn of the U.S. economy, as reported by Servaes (2000). In comparison, Rajan et al. (2000) show that from 1980 to 1993, the mean and median of segment q4 for diversified U.S. firms are 1.264 and 1.202, respectively. Ozbas and Scharfstein (2010) demonstrate that the average segment q of unrelated U.S. conglomerates during 1980–2006 is 1.31. This suggests that the electronics industry in Japan has been declining, and there are few investment opportunities for Japanese electronics 4

It is calculated as the equally averaged q of single-segment firms that operate in the same threedigit SIC code. It remains the same for segment q defined as the asset-weighted average q of single-segment firms.

3.3 Segment Investment and Segment Employment

49

corporations after 2000. In addition, the average segment sales growth rate is negative. About 18.7% of segments were making losses. Thus, electronics corporations ought to downsize or exit at the segment level. Likewise, single-segment firms ought to downsize or exit due to increasing global competition. In sum, this industry setting is suitable for our research purpose to study inefficiency due to overcapacity.

3.3.2 Misallocation of Internal Funds and Segment Employment To investigate whether segment level investment depends on segment employment, we add segment labor to regressions. Following Shin and Stulz (1998), we estimate the following: I nvestment = a + b1q + b2 Segment Sales Gr owth + b3 Segment Cash Flow + b4 Other Cash Flow + b5 Segment Labor + ηi, j + i, j,t where the variables are defined as follows: Ii,j,t /FAj,t−1 = I nvestment; The average q for specialized firms in the segment’s industry at the two-digit standard industrial classification (SIC) level in year t – 1 = q; (SLSi,j,t − 1 − SLSi,j,t − 2 )/SLSi,j,t − 2 CFi,j,t − 1 /FAj,t − 2 CFnot i,j,t − 1 /FAj,t − 2 Li,j,t − 1 /Lj,t − 1 Ii,j,t FAj,t SLSi,j,t CFi,j,t CFnoti,j,t

Li,j,t Lj,t

Segment Sales Growth; Segment Cash Flow; Other Cash Flow; Segment Labor; the gross investment of the ith segment of firm j during year t; the book value of the total assets of firm j at the end of year t; the sales of segment i of firm j during year t; the cash flow of the ith segment of firm j during year t; the sum of the cash flows of the segments of firm j except for the cash flow of the ith segment in year t; the number of employees of the ith segment of firm j at the end of year t; the total number of employees of firm j at the end of year t.

50

3 Misallocation of Internal Funds to Loss-Making Zombie …

We normalize Investment and Cash Flow and Other Cash Flow (cash flow from other segments) by the book value of the total assets of the firm. We include q as the proxy for segment investment opportunities by estimating the average q for specialized firms in the segment’s industry at the two-digit standard industrial classification (SIC) level, taking the ratio of the market value of equity plus the book value of total assets minus the book value of equity to assets. Moreover, Sales Growth is lagged segment sales growth. Finally, Labor is the fraction of the number of segment employees normalized by the total number of firm employees. We used the fixedeffects model to control for the segment-specific component ηi, j . Moreover, we add to the regression a dummy variable for each year except for 2015. We do not report these dummy variables in the tables. i, j,t is the error term, and all our regressions use robust heteroscedasticity. Table 3.2 reports the estimates of segment investment equations. In column 1, the coefficient on q shows that the internal capital market in Japan pays no attention to investment opportunities. Rather, segment level investment decreases in segments with more investment opportunities. This result is totally different from that in previous studies on diversification discount. Shin and Stulz (1998) show that segment investment is sensitive to the segment’s q.5 Ozbas and Scharfstein (2010) find a less powerful but positive effect of segment q on unrelated segment investment. In sum, the insensitivity of segment investment to investment opportunities in an industry with overcapacity might be extremely severe. Indeed, according to Servaes (2000), diversification discount declined to zero during the 1970s6 in comparison with a large discount among the 1960s U.S. firms, probably because most industries had few investment opportunities during the 1970s economic downturn. The coefficient of Sales Growth is positive but is not significant at the 10% level. These findings are quite different from the results presented by Shin and Stulz (1998). In short, Japanese electronics firms made inefficient segment investment when all singlesegment firms and conglomerates ought to divest. In the first place, it is impossible for the internal capital market to allocate credit from segments with overcapacity to growing segments that did not exist. A segment investment is equally sensitive to both the segment cash flow and the cash flow from other segments. The difference between the two coefficients is not statistically significant. Our evidence shows that the internal capital market equally allocates firms’ cash flow to segments regardless of investment opportunities. Shin and Stulz (1998) show that the sensitivity of a segment’s investment to the segment cash flow is more than six times of the sensitivity to the cash flow generated from other segments in highly diversified USA firm. Compared to the significant but limited role of the internal capital market in the United States, the internal capital market In Japan plays a significant and primary role. One interpretation is that the management makes an easy allocation of cash flow to maintain employment because 5

However, they found no evidence that the internal capital market protects the investment budgets of a segment with better investment opportunities when the segment or the firm experiences an adverse cash flow shock. 6 In comparison, there is a large discount among U.S. firms in the 1960s.

Debt * Firm Deficit

Institutional Ownership * Firm Deficit

Debt * Labor * Deficit

Institutional Ownership * Labor * Deficit

Labor * Deficit

Labor

Other Cash Flow * Deficit

Other Cash Flow

Cash Flow

Sales Growth

Q

(3.120)

(0.005)

0.004

(4.759)

(4.794) (−1.179)

−0.012

0.185***

0.182***

(3.137)

0.144***

(0.049)

(0.049)

(14.291)

0.148*** 0.147*** 0.144***

(0.011)

(14.106)

(−0.946)

(0.010)

(−0.712)

(−1.447) −0.006 0.152***

(0.006)

(4) −0.02

0.150*** 0.149*** 0.153***

(0.006)

−0.004

(−1.435)

(0.014) −0.002

(0.014)

−0.002

−0.022

(3) −0.02

(2) −0.021

(1)

(6)

(5.093)

0.180***

(3.534)

0.152***

(15.002)

0.157***

(0.030)

0

(−1.299)

−0.018

(7)

(5.130)

0.178***

(3.656)

0.156***

(16.164)

0.157***

(0.282)

0.002

(−1.326)

−0.018

(8)

(5.125)

0.178***

(3.661)

0.156***

(16.167)

0.157***

(0.254)

0.002

(−1.222)

−0.017

(9)

(5.208)

0.179***

(3.669)

0.156***

(16.183)

0.158***

(0.343)

0.002

(−1.532)

−0.022

(1.250)

0.056

(−3.164)

0.094***

(1.801)

0.084*

(−2.898)

(−3.460)

(−3.369)

(continued)

(−3.689)

−0.144*** −0.209*** −0.186*** −0.182*** −0.214***

(4.740)

0.180***

(3.102)

0.143***

(13.669)

0.154***

(−0.840)

−0.005

(−1.496)

−0.021

(5)

Table 3.2 Segment investment and segment employment in the diversified electronics companies

3.3 Segment Investment and Segment Employment 51

0.053

0.008

R-squared within

R-squared between

1745

0.007

0.055

0.441

345

(4)

(5)

0.088

0.142

0.453

345

1745

(−2.365)

0.087

0.141

0.453

345

1745

(−2.356)

0.088

0.142

0.455

345

1745

(−2.310)

−0.092** −0.093** −0.091**

(3)

** and *—significant at the 1%, 5% and 10% level respectively. t-values in parentheses

0.441

R-squared overall

*** ,

1745

345

(0.032)

(0.032)

Number of segments

−0.019

(2)

−0.02

(1)

Observations

Constant

Institutional Ownership * q < 1

Debt * q < 1

Firm Deficit

Table 3.2 (continued)

0.076

0.131

0.463

345

1745

(−2.575)

−0.098**

(3.138)

(6)

(4.296)

(−1.799)

−0.037*

(4.262)

0.029***

(9)

0.072

0.128

0.463

345

1745

(−2.684)

0.071

0.127

0.463

345

1745

(−2.688)

0.071

0.128

0.464

345

1745

(−2.388)

−0.100*** −0.101*** −0.092**

(0.473)

0.007

0.030***

(4.293)

(8)

0.030***

(7)

52 3 Misallocation of Internal Funds to Loss-Making Zombie …

3.3 Segment Investment and Segment Employment

53

most segments do not have investment opportunities in the electronics industries facing severe overcapacity problem. To examine the allocation of cash flow to loss-making segments, we add the interaction of Deficit and Other Cash Flow. Deficit is a dummy variable and it takes a value of 1 if its lagged segment operating income OPi,j,t−1 is non-positive and a value of 0 otherwise. If the firm cuts back on investment in a loss-making segment, we expect Deficit * Other Cash Flow to have a negative coefficient. However, the coefficient in column 2 is positive but not significant. We have shown that segment investment is sensitive neither to investment opportunities nor to segment sales growth. Now, we see that the internal capital market equally allocates credit across loss-making and profitable segments. Our main concern is how the segment employment share affects segment investment. The coefficient on Labor is positive with a significance at the 1% level in column 3. It is likely that the CEO allocates more credit to a segment that contributes more to employment. A core segment that contributes to 50% of employment receives a segment investment of 0.0455 more than a segment that contributes to only 25% of employment. This effect of segment employment on segment investment is economically significant, in comparison with the median segment investment of 0.041. To examine the effect of segment employment on loss-making segments, the regression in column 4 shows that the interactive variable of Labor * Deficit has a negative coefficient, but it is not significant. Thus, the positive effect of segment employment on segment investment is not influenced by segment deficit. This is consistent with our case study that Sony was continuing inefficient investment in its core electronics business that had been consecutively making losses for a long time in Chap. 2. .7ptSo far, we have shown the inefficiency of the internal capital market. Now, we turn to factors that may mitigate the misallocation of credit across segments. Ozbas and Shcarfstein (2010) find evidence suggesting that agency problems explain the segment investment of conglomerates. In particular, we examine the mechanisms of corporate governance to mitigate the positive effect of segment employment on investment in deficit segments. To address this issue, we add the interactive variable of Institutional Ownership * Labor * Deficit, and, the interactive variable of Debt * Labor * Deficit to independent variables. Institutional Ownership is institutional investors’ ownership SHIV j,t−1 , and Debt is the lagged firm leverage ratio. In column 6, the negative coefficient on interactive variable involving Institutional Ownership is statistically and economically significant. By contrast, the interactive variable involving Debt in column 5 has an insignificant positive coefficient. These results suggest that institutional investors’ pressure weaken the effect of segment employment on segment investment but debt does not play a role in disciplining misallocation of credit to loss-making segments for employment consideration. In column 6, we drop Debt * Labor * Deficit and add the interactive variable of Institutional Ownership * Firm Deficit and the interactive variable of Debt * Firm Deficit. Firm Deficit is a dummy variable and it takes a value of 1 if the lagged firm operating income OPj,t−1 is non-positive and a value of 0 otherwise. If institutional investors and debt play a role to force a loss-making firm to downsize or exit, we expect a significant negative coefficient on each new interactive variable but the both

54

3 Misallocation of Internal Funds to Loss-Making Zombie …

new interactive variables involving Firm Deficit have a positive coefficient with a significance at the 10% level, at the 1% level respectively. To gauge the impact of a firm’s cash flow shortfall on investment at the segment level, we include Firm Deficit instead the two interactive variables involving Firm Deficit in column 7 and this yields a positive coefficient with a significance at the 1% level. Surprisingly, regardless of operating losses Japanese firms have increased investment in all segments rather than downsize or exit. Our evidence shows that the internal capital market does not cut back on investment in any segments, although the whole firm is making losses. It is noteworthy that this result is not attributable to zombie lending because non-performing loan problem has been resolved. In column 8 and column 9, we examine how the governance mechanisms prevent conglomerates from allocating credit to segments with poor investment opportunities. The dummy variable q < 1 takes a value of 1 if q is blow 1 and a value of 0 otherwise. In column 9, the coefficient on the interactive variable of Debt * q < 1 is positive but not significant at the 10% level. Again, debt does not prevent a diversified firm from allocating credit to segments with poor investment opportunities. As the negative coefficient on Institutional Ownership * Segment q < 1 indicates, institutional investors’ pressure may enhance divestures in segments with poor investment opportunities. One may argue that segment employment is just a proxy for relative segment size, and the company just simply allocates more credit to a relatively large segment. However, we find no effect of the ratio of segment assets to firm assets on segment investment when it is included into the regression instead of segment employment. The result is not reported. In sum, the internal capital market allocates more credit to segments with higher employment irrespective of investment opportunities and sales growth. In particular, a deficit division with higher employment still extracts greater credit for investment from the CEO. We shed new light on the relationship between the internal capital market and employment among diversified Japanese electronics corporations. Different from previous studies on zombie investment at the firm level, our paper gauges the relationship between segment investment and segment employment. Till now, the problem of incentives for zombie investment remain unanswered. Our paper suggests that employment considerations might be the main reason for the zombie problem. Consistently, debt plays no role in preventing management from continuing investment in deficit at the segment level or at the firm level. Due to aging and low economic growth, there is also excess capacity in the banking industry. From the viewpoint of employment protection, it is not surprising that banks continue to lend money to a firm for investment in deficit segments unless the firm is near bankruptcy, although the non-performing loans problem has been resolved. Though institutional investors exert pressure on spending cash in investment in lossmaking segments for employment, we find scant evidence that institutional investors prevent the management from investing in segments with poor opportunities. Indeed, Third Point, a U.S. activist fund, put pressure on Sony’s management to spin off the entertainment business. In July 2014, in response to the pressure exerted by Third Point, Sony sold its PC business to Japan Industrial Partners, Inc. In 2013, Sony’s

3.3 Segment Investment and Segment Employment

55

PC business had an operating deficit of 91.7 billion yen, whereas its sales totaled 418.2 billion yen.

3.3.3 Consequences of Investment in Deficit Segments How does investment in loss-making segments directly affect subsequent segment operating performance? Previous studies mainly focus on diversification discount. Limited to our knowledge, we know little about the impact of investment in a lossmaking segment on the subsequent segment operating performance. We measure segment operating performance as follows. EBITDA/Assetsi,j,t Assets Turnover i,j,t Investment SAj,t DEPi,j,t I i,j,t

(OPi,j,t + DEPi,j,t )/(SAi,j,t + DEPi,j,t − I i,j,t ) SLS i,j,t / (SAi,j,t + DEPi,j,t − I i,j,t ) I i,j,t /(SAi,j,t + DEPi,j,t − I i,j,t ) Assets of segment i of firm j at the end of year t depreciation of segment i of firm j during year t investment of segment i of firm j during year t where DEPi,j,t is the depreciation of segment i of firm j during year t and SAi,j,t is the depreciation of segment i of firm j at the end of year t. For segment information, segment assets can change very large for M&A and spinoffs. For example, (OPi,j,t + DEPi,j,t )/SAi,j,t−1 would be biased as well as SLS i,j,t /(SAi,j,t + DEPi,j,t − I i,j,t ) if quite new assets via acquisition are added to segment j. In particular, such biases are very large when a large amount of acquired assets is added to a small segment or a large amount of assets is deleted from a large segment for spinoff.

We expect a loss-making segment’s investment negatively influences the subsequent segment operating performance. Facing overcapacity in electronics industries, investments in fixed assets increase industrial overcapacity and result in declining profitability. We estimate the following equation:   O perating Per f or mance E B I T D A/Assetsi, j,t , Assets T ur noveri, j,t = α + β1q + β2 Sales Gr owth + β3 I nvestmenti, j,t−1 ∗ De f icit + β4 I nvestmenti, j,t−1 ∗ Pr o f it + β5 I nvestmenti, j,t−2 ∗ lagged De f icit + β6 I nvestmenti, j,t−2 ∗ Pr o f it + μi, j + νi, j,t We use a fixed-effects model to control for the segment-specific component μi, j . Moreover, we add to the regression a dummy variable for each year except for 2015. We do not report these dummy variables in the tables. νi, j,t is the error term and all our regressions use robust heteroscedasticity. The dummy variable Profit is (1 −

56

3 Misallocation of Internal Funds to Loss-Making Zombie …

Deficit) and it takes a value of 1 if the lagged segment operating profits are positive and a value of 0 otherwise. Not surprisingly, our regression results show that investment in a deficit segment has a strong adverse impact on next year segment EBITDA/Assets and segment Assets Turnover, as Table 3.3 shows. These results suggest that the investment in a deficit segment destroys the segment subsequent profitability and lowers segment sales asset turnover. In column 3, the negative effect of a deficit segment’s investment on segment Assets Turnover persists two years ahead. Moreover, investment in a profitable segment has an adverse impact on the segment EBITDA/Assets and segment Assets Turnover two years ahead in column 1 and 3 of Table 3.3. In short, investment in deficit segments hurts subsequent segment profitability, and segment asset turnover deteriorates as investment increases irrespective of profit or deficit. These results are consistent with the requirements of downsizing and exit in the electronics industries and thus it is more likely for investment only to result at overcapacity. Table 3.3 Segment investment and subsequent segment performance in the diversified electronics companies Ebitda/Assets

Assets turnover

(1)

(2)

0.009

0.01

0.014

0.015

(0.703)

(0.739)

(1.043)

(1.153)

Sales Growth

0.031**

0.034***

0.036***

0.041***

(2.426)

(2.757)

(2.778)

(3.118)

Investment * Deficit

−0.234**

−0.268**

−0.314***

−0.385***

(−2.212)

(−2.564)

(−3.212)

(−3.960)

0.002

−0.025

−0.116*

−0.164**

(0.032)

(−0.382)

(−1.697)

(−2.430)

q

Lagged Investment * Deficit

(3)

−0.02

Investment * Profit

0.067 (0.552)

(−0.196)

Lagged Investment * Profit

−0.106*

−0.204***

(−1.821)

(−3.456)

Constant

(4)

0.110***

0.106***

0.076***

(4.140)

(4.030)

(2.968)

(2.607)

Observations

1712

1720

1712

1720

Number of segments

338

340

338

340

R-squared overall

0.145

0.14

0.194

0.183

R-squared within

0.007

0.044

0.015

0.049

R-squared between

0.044

0.073

0.073

0.099

*** ,

0.067***

** and *—significant at the 1%, 5% and 10% level respectively. t-values in parentheses

3.3 Segment Investment and Segment Employment

57

3.3.4 Do Single-Segment Firms Invest Efficiently? Irrespective of investment opportunities and sales growth, the internal capital market equally allocates cash flow to segments. In particular, a segment with a higher employment share attracts more internal funds for segment investment. This is quite different from the pattern of the U.S. internal capital market. In previous studies, single-segment firms are used as a benchmark for investment opportunities and distorted segment level investment in diversified firms. Now, we need to answer the following remaining question: do single-segment firms divest overcapacity promptly in response to low firm value or operating losses? If the management of a stand-alone firm buys labor peace exactly as the management of a diversified firm does, we would observe insensitivity to investment opportunities, growth, or, deficit. According to Ozbas and Scharfstein (2010), the q-sensitivity of investments of stand-alone firms is higher than that of unrelated segments in diversified firms. Shin and Stulz (1998) show that the investment of a single-segment firm is as sensitive to industrial q as a segment’s investment in diversified firms. As Table 3.4 shows, we can see that the most electronics industrial firms have been declining according to descriptive statistics. Both the mean and median sales growth are negative. In addition, single-segment firms have limited investment opportunities, as indicated by the mean industrial q and median industrial q ratio. Moreover, on average, 15% of firms were suffering losses. In short, most single-segment firms ought to divest rather than to invest because most of them were operating in industries with a q ratio below one. This suggests that most comparable single-segment firms cannot be a benchmark for conglomerates because they ought to divest overcapacity. To examine the efficiency of investments in single-segment firms, we estimate the following: I nvestment = c + d1q + d2 Sales Gr owth + d3 Cash Flow + d4De f icit + ωi, j + ξi, j,t Table 3.4 Summary statistics in the specified electronics companies Variables Investment

Mean

Median

25th percentile

75th percentile

S.D.

Observations

0.3363

0.1706

0.0901

0.2822

3.0011

1123

−0.0243

−0.0377

−0.1138

0.0736

0.1900

1123

Cash Flow

0.3102

0.2627

0.1364

0.4512

6.4619

1123

Deficit

0.1523

0.0000

0.0000

0.0000

0.3594

1123

q

0.9660

0.9236

0.8014

1.0769

0.2479

1123

Institutional Ownership

0.1504

0.1063

0.0153

0.2372

0.1564

1123

Debt

0.1228

0.0754

0.0336

0.1684

0.1878

1123

Sales Growth

58

3 Misallocation of Internal Funds to Loss-Making Zombie …

where the variables are defined as follows: Ij,t /FAj,t−1 = I nvestment; The average q for a specialized firm in the firm’s industry at the two-digit standard industrial classification (SIC) level in year t – 1 = q; (SLSj,t − 1 − SLSj,t − 2 )/SLSj,t − 2 CFj,t − 1 /FAj,t − 2 Deficit Ij,t FAj,t SLSj,t OPj,t CFj,t

Sales Growth; Cash Flow; 1 if OPj,t − 1  0; 0 otherwise; the gross investment of firm j during year t; the book value of the total assets of firm j at the end of year t; the sales of firm j during year t; the operating income of firm j during year t; the cash flow of firm j during year t.

All variables are defined as those at segment level for a single-segment firm because the single-segment is equivalent to the firm. We use a fixed-effects model to control for the segment-specific component ωi, j . Moreover, we add to the regression a dummy variable for each year except for 2015. We do not report these dummy variables in the tables. ξi, j,t is the error term, and all our regressions use robust heteroscedasticity. In Table 3.5, we find evidence that investment is only sensitive to cash flow. By contrast, investment opportunities and sales growth have no impacts on investment. This is totally different from the results of Ozbas and Scharfstein (2010) and Shin and Stulz (1998). Accordingly, investment in stand-alone electronics firms is as inefficient as segment investment in diversified firms in terms of the q-sensitivity of investment. Furthermore, we find that loss-making firms do not downsize in column 2. The only difference is that loss-making single-segment firms do not increase investment, whereas diversified firms increase segment investment in response to firm level deficit. In column 4, 5, 6 and 8, neither the interactive variable of Institutional Ownership * Deficit nor the interactive variable of Institutional Ownership * q < 1 has a insignificant negative coefficient. This suggests that institutional investors do not exert pressure on a loss-making firm or a firm with poor investment opportunities for cutback on investment. Likewise, debt plays no roles in preventing the management of specialized firms from investing in deficit or investing with less prospects as shown in column 3, 5, 7 and 8. In sum, Table 3.6 does not demonstrate efficient investment in single-segment firms, and it shows that investment in deficit sectors is pervasive across diversified firms and single-segment firms. We repeat regressions of the subsequent operating performance of a singlesegment firm on its lagged investments in deficit as follows. The dummy variable Profit is 1 − Deficit.   O perating Per f or mance E B I T D A/Assets j,t , Assets T ur nover j,t

1123

132

0.335

R-squared overall

0.335

132

1123

(2.652)

(2.305)

Number of segments

0.418***

0.394**

(−0.515)

−0.071

(10.511)

(10.443)

(1.090) 0.258***

0.258***

(1.108)

(0.541) 1.907

1.863

(0.557)

(2) 0.127

0.138

(1)

Observations

Constant

Debt * q < 1

Institutional Ownership * q < 1

Institutional Ownership * Deficit

Debt * Deficit

Deficit

Cash Flow

Sales Growth

Q

Table 3.5 Investment in the specified electronics companies (3)

(4)

(5)

0.335

132

1123

(2.616)

0.421***

0.335

132

1123

(2.521)

0.413**

0.335

132

1123

(2.686)

0.428***

(−1.064)ara>

(−1.066)

(−0.686) −0.401

−0.533

(−0.824)

(10.319)

0.258***

(1.104)

1.927

(0.517)

0.121

−0.458

(10.391)

0.258***

(1.109)

1.897

(0.537)

0.13

−0.629

(10.333)

0.258***

(1.103)

1.916

(0.523)

0.123

(6)

(7)

(8)

0.335

132

1123

(1.314)

0.306

0.335

132

1123

(2.459)

(continued)

0.335

132

1123

(1.464)

0.334

(−1.301) 0.425**

(−1.318)

(0.884) −0.3

−0.273

0.356

(10.402)

0.258***

(1.101)

1.869

(0.581)

0.166

(0.849)

(10.458)

0.258***

(1.102)

1.847

(0.484)

0.117

0.331

(10.387)

0.258***

(1.106)

1.885

(0.634)

0.186

3.3 Segment Investment and Segment Employment 59

(2) 0.012

0.919

(3) 0.012

0.918

(4) 0.012

0.919

** and *—significant at the 1%, 5% and 10% level respectively. t-values in parentheses

0.012

*** ,

R-squared between

(1)

0.92

R-squared within

Table 3.5 (continued) (5) 0.012

0.918

(6) 0.011

0.919

(7) 0.012

0.918

(8) 0.012

0.917

60 3 Misallocation of Internal Funds to Loss-Making Zombie …

3.3 Segment Investment and Segment Employment

61

Table 3.6 Investment and subsequent performance in the specified electronics companies Ebitda/Assets

Assets turnover

(1)

(2)

(3)

(4)

Q

0.036**

0.036**

0.122**

0.120**

(2.299)

(2.295)

(2.500)

(2.441)

Sales growth

−0.062***

−0.062***

−0.106*

−0.107*

(−5.091)

(−4.501)

(−1.909)

(−1.717)

−0.023

−0.053

0.144

0.188

(−0.175)

(−0.470)

(0.399)

Investment * Deficit Lagged Investment * Deficit

0.027 (0.193)

Investment * Profit

(0.549) 0.222 (0.707)

0.015

0.011

0.022

0.078

(0.177)

(0.147)

(0.102)

(0.346)

Lagged Investment * Profit

−0.179

0.004 (0.045) 0.047*** (2.667)

(2.809)

(13.592)

(13.382)

Observations

1119

1089

1119

1089

Number of firms

132

131

132

131

R-squared overall

0.224

0.244

0.173

0.184

R-squared within

0.087

0.104

0.003

0.002

R-squared between

0.126

0.14

0.033

0.033

*** ,

0.048***

(−0.848)

Constant

0.778***

0.784***

** and *—significant at the 1%, 5% and 10% level respectively. t-values in parentheses

= α + δ1q + δ2 Sales Gr owth + δ3 I nvestmenti, j,t−1 ∗ De f icit + δ4 I nvestmenti, j,t−1 ∗ Pr o f it + δ5 I nvestmenti, j,t−2 ∗ lagged De f icit + δ6 I nvestmenti, j,t−2 ∗ lagged Pr o f it + φi, j + ψi, j,t where the variables are defined as those at segment level: EBITDA/Assetsj,t Assets Turnover j,t Investment SAj,t DEPj,t I j,t

(OPj,t + DEPj,t )/(SAj,t + DEPj,t − I j,t ) SLS j,t /(SAj,t + DEPj,t − I j,t ) I j,t /(SAj,t + DEPj,t − I j,t ) Assets of firm j at the end of year t depreciation of firm j during year t investment of firm j during year t

We use a fixed-effects model to control for the firm-specific component φ j . In addition, we add to the regression a dummy variable for each year except for 2015. We do not report these dummy variables in the tables. ψi, j,t is the error term, and all our regressions use robust heteroscedasticity. In Table 3.6, profitability is positively

62

3 Misallocation of Internal Funds to Loss-Making Zombie …

related to industrial q with significance at the 5% level. Although there is no significant effect of investment in deficit sectors on subsequent operating performance, we find that the sales growth reduces subsequent profitability and sales asset turnover. This might suggest that single-segment firms also ought to downsize, and downsizing in sales is positively related to profitability. In summary, single-segment firms also have excess capacity, whereas they do not cut back on investment in deficit sectors.

3.4 Concluding Remarks In the 2000s, banks’ nonperforming loans problem was solved, and some zombie companies became healthy. However, the entire Japanese economy continued to grow at a low rate. Although Japan has also suffered from another “lost decade” since the 2000s, the long-term and structural causes remain unknown. In this paper, we explored the causes and consequences of the second lost decade, focusing on the electronics industry, which was once the leader in the Japanese economy and the world economy. Over the last two decades, however, the entry of the United States, South Korea, and China into worldwide electronics products markets has contributed to increasing competition in the industry. An efficient internal capital market should cut back on investment in loss-making segments that have poor investment opportunities. We found that segments with better investment opportunities do not invest more. In addition, we found no evidence that the internal capital market cuts back on investment in loss-making segments. Our evidence shows that the internal capital market equalizes the impacts of cash flow shortfalls across segments. At the same time, however, investments in all segments increase when the whole firm is in deficit. Different from previous studies, in this study, segment investment increases with segment employment irrespective of segment operating profitability. However, such positive employment effects on a segment in deficit decrease with institutional investors’ ownership. We also found evidence that institutional investors’ ownership exerts pressure on the management to downsize in a segment with poor investment opportunities. Not surprisingly, investment in a deficit segment exacerbates subsequent segment profitability and segment asset turnover. Likewise, single-segment firms also have excess capacity, whereas they prolong unnatural investment. We conjectured that unnatural investment hidden in deficit segments is the valid reason for the second lost decade. Behind the difficulty of ceasing investments in deficit segments, there is employment protection rather than empire building. The management has few incentives to lay off employees until the problem is unresolvable. This is pointed out by Jensen (1993, 1986, 1989). Investment in a deficit sector with higher employment provides employment security. It is much more difficult to restructure a large number of employees in a deficit segment than to reallocate employees in a small deficit segment. Rather, managers tend to invest more in deficit segments with higher employment to buy labor peace. We showed that unnatural investment prevails among single-segment Japanese electronics firms.

3.4 Concluding Remarks

63

What is responsible for unnatural investment in single-segment firms? Layoffs and performance around horizontal M&A provide natural experiments to test the employment consideration hypothesis in single-segment firms. In Chap. 4, we will provide evidence on the difficulty of eliminating overlapping inefficient operations in horizontal M&A due to employment protection legislation. This analysis is also related to research on diversification and management efficiency. Hanazaki and Matsushita (2014) and Ushijima (2016) have confirmed the damage of corporate value due to diversification. We found that institutional investors’ ownership mitigates the impact of employment on segment investment. However, employment considerations are the cause of the misallocation of internal funds among segments. The internal capital market allocates more credit to a segment with higher employment irrespective of operating profitability. In the context of divisional rent-seeking behavior and the inefficiency of internal capital markets, there are less prospects for the CEO to share private benefits with the manager of a loss-making division. In our paper, a division in deficit with higher employment is still able to extract more credit to invest irrespective of profitability and investment opportunities. We showed that employment protection plays a key role in inefficient segment investment. Resources can flow toward the loss-making division with more employment, and this in turn leads to inefficient investment and subsequent poor operating performance. Our evidence sheds new light on the relationship between employment protection and downsizing in diversified firms. Moreover, we found no evidence that specialized firms tend to downsize quickly in response to operating losses. Our findings also raise doubts that Japanese stand-alone electronics corporations have incentives to make efficient investments. Rather, our evidence is consistent with the hypothesis of buying labor peace proposed by Jensen (1993). Both data analyses and rich anecdotal evidence strongly suggest the difficulty of downsizing and exit in Japan. Downsizing and exit have been required since the early 1990s. Nevertheless, Corporate Japan reacted too late, and it misallocated internal credit to loss-making divisions for so long to maintain employment. It is noteworthy that temporary job security supported by investment in deficit sectors is not sustainable. Facing persistent deficit, the manager has to downsize sooner or later. The practices of NEC are a good example. NEC, once ranked as one of the top five electronics producers in the world, was facing increasing competition due to the entry of Compaq and IBM into the domestic PC market. Despite investment in the loss-making electronic devices business, NEC announced plans to reduce personnel by 20,000 people in 2005 and 10,000 workers in 2009 and 2011, respectively. In 2011, its PC division was finally integrated into Lenovo, and it transferred the shares of the joint venture to Lenovo with 20 billion yen (about 0.2 billion dollars) in 2014. NEC would have been able to pay more earlier retirement incentive compensation if it had conducted spinoffs of its sunset PC businesses earlier at a higher price. By contrast, in 2005, IBM sold the PC division to Lenovo with 1.7 billion dollars, and 10,000 employees moved to Lenovo. This suggests that at an earlier stage, after

64

3 Misallocation of Internal Funds to Loss-Making Zombie …

spinoffs, more employees in a sunset industry are concentrated to a new organization via M&A. In comparison with restructuring in IBM, downsizing and spinoffs of the PC business are late in NEC, Sony, and Toshiba. This is because, as stakeholders, employees’ interests in Japan, particularly employment protection, have the highest priority. Such inflexible employment protection results in “unnatural” intrafirm segment investment in large loss-making businesses and delays in spinouts. In response to declining profitability, slow segment employment adjustment in Sony and NEC suggests that Japanese managers only spend free cash flow to buy short time labor peace and postpone exit from a deficit sector as pointed out by Jensen (1993). They leave exit to rivals or successors. In other words, managers avoid redirecting their business models. Instead of segment investment in deficit sectors, it is possible for Japanese managers to spend free cash more efficiently on employment protection. For example, it is possible to sell declining businesses timely at a higher price to pay more earlier retirement incentive compensation or to help employees to start a new business. The Nokia bridge program provides important lessons for restructuring loss-making businesses in Japan. The mobile phone giant in Finland has shrunk largely during the last decade, similar to NEC. In 2012, Nokia implemented the bridge program of continuing education, retraining and funding startups in 2011 to help laid off redundant employees to find new jobs or to begin new businesses. The program was relatively successful, and 70% of participants found new jobs in 2012 (Halme et al., 2014). As part of the program, substantial startup funding for departing employees led to an explosion of startups. Moreover, merging respective loss-making divisions in a business with excess capacity might prevent each concerned company from continuing the misallocation of internal funds to loss-making businesses. However, just merging without enough downsizing is far from the ultimate solution to excess capacity, because aggressive labor restructuring is necessary for the associated M&A synergy. Unfortunately, layoffs around M&A are also subject to strict regulations. Generally, the rights and obligations are comprehensively inherited by the post-M&A company. Therefore, the pre-merger labor contracts must be maintained as they are. In transfer of business, the succession of rights and obligations of the acquired business is the so-called specific succession that requires the consent of individual creditors. In addition, Article 625, paragraph (1) of Civil Code (Act No. 89 in 1896) provides that a company that transfers the business must obtain individual consent from the prospective worker whose existing labor contracts will be specially succeeded by the company that receives the business, according to the guidelines on matters to be noted by companies when conducting business transfer or M&A in Japan. The Labor Contract Succession Law provides that the labor contracts of workers mainly engaged in the business succeeded in a company split will naturally be succeeded to the newly established or absorbing company. Unlike transfer of business, no worker consent is required, but the succession of the labor contracts of the relevant workers should be stipulated in the split plan (contract) as the rights and obligations to be succeeded. If the split contract does not stipulate that the succeeding company shall succeed to the labor contract that a worker mainly engaged in the business has concluded with the split company, the worker may object in writing. When an objection is filed, the labor

3.4 Concluding Remarks

65

contract that the worker concerned has with the split company shall be succeeded to by the succeeding company on the day when the split pertaining to the split contract becomes effective. In short, it is important to keep in mind that it is quite difficult to lay off redundant workers around M&A. Employment protection impedes layoffs around M&A and results in a greater reduction in the volume, number, and synergies of M&A. Dessaint et al. (2017) show that the M&A volume scaled by gross domestic product (GDP) is the lowest among major Economic Cooperation and Development (OECD) countries. Insistence on continuing operations in plants that are overlapping and redundant would reduce activities and gains from M&A. Consequently, in the long run, the entire Japanese economy will continue to grow at a low rate. In Chap. 4, we will illustrate cases where merged respective loss-making divisions in the electronics industry with excess capacity are suffering losses, and substantial post-merger downsizing is required. Renesas Electronics is a good example. Back to the 1990s, Japanese manufacturers lost their supremacy in the semiconductor business with the rise of Asian peers. Moreover, in semiconductors other than DRAM, Hitachi and Mitsubishi Electric integrated their operations in April 2003 to launch Renesas Technologies. However, the post M&A performance did not improve and Renesas Technologies was prolonging losses after the Global Financial Crisis. In 2010, the company and NEC Electronics (NEC’s semiconductor subsidiary) were merged and became Renesas Electronics in response to the adverse economic shock. However, Renesas Electronics also failed to revive. In April 2013, it was acquired by Innovation Network Corporation of Japan (INCJ), a government-affiliated investment fund and a coalition of major customers including Toyota, Honda, and Panasonic. Since then, it closed five plants, sold six plants, and laid off 60% of its redundant workforce. It will additionally close two plants in the future and only keep six operating. For dramatic downsizing, it took an upward turn in its profit margin after 2014. Recently, it announced the layoff of an additional 1000 employees and a plan to shut down operations at its nine domestic plants for up to two months by the end of September 2019. This suggests that Renesas Electronic is required to frequently and promptly restructure or redirect itself in response to economic shocks such as economic slowdown, change in technology, and the entry of South Korea, the Greater China, and India into worldwide product markets. Likewise, most Japanese electronics companies’ LCD divisions were suffering losses since 2000. In 2004, Epson and distressed Sanyo combined their LCD divisions as Sanyo-Epson Imaging Devices Corporation. Thereafter, the M&A of LCD business were repeated. In 2012, led by the government, loss-making mobile LCD divisions of major Japanese electronics companies were combined with the “national” LCD manufacturer, Japan Display Inc., to prevent foreigners from acquiring “Japan’s advanced technology.” Merely combining loss-making small- and medium-sized LCD divisions of major electronics companies did not result in a profitable company, however. At first, JDI was suffering losses. Nonetheless, it placed a bet on the growth of iPhone, Apple’s main high-end product. JDI decided to build a smartphone LCD panel site (Hakusan Plant) in March 2015 with a sales deposit of 170 billion yen

66

3 Misallocation of Internal Funds to Loss-Making Zombie …

from Apple. iPhone 6 was a hit, and both companies dreamed that the iPhone would continue to grow in 2016 and 2017. The dream did not come true. As iPhone 6S sales were slowing down in 2015, Apple has turned to OLED panels to redesign the iPhone. Immediately, Apple decided that the Hakusan plant was not needed and called for the cancellation of plant construction. However, at that point, the production equipment had already been ordered, and JDI would incur a huge cancellation fee. JDI’s board alone could not make the decision, and it needed approval by the largest shareholder, the Industrial Innovation Corporation (INCJ), and the government. While the third parties were negotiating, factory building was almost completed. Consequently, the investment left FDI nothing more than overcapacity and heavy debt owing to Apple with stringent covenants. JDI has been suffering prolonged losses. In response, it laid off 30% of 15,572 employees at the end of March 2016, and the number of employees was expected to decrease to 10,986 at the end of March 2017. The company laid off only 636 employees in the domestic factories, however. It is notable that it seems much more difficult to lay off domestic employees than to reduce overseas employees. Five consecutive annual losses drained its equity capital, and its liabilities was exceeding assets. At long last, it had to turn to foreign investment funds. In July 2019, the company announced that it finally secured the 80 billion yen bailout plan from the Greater China-based Harvest Group, activist investor Oasis Management, and an unnamed JDI customer, which is likely to be Apple. Two months later, unfortunately, the Harvest Group canceled its plans to invest in Japan Display. In December 2019, the company announced a new bailout plan from Ichigo Asset Management to invest up to $830 million in Japan Display. Several days later, it turned out that the company was suspected of having capitalized an excessive inventory of about 10 billion yen due to inappropriate accounting allegations by a former accounting executive, according to the Special Investigation Committee. However, the Special Investigation Committee included an executive of JDI and its independence was questioned. The board had to decide that the details would be reinvestigated by a third-party committee consisting only of external experts. Renesas is specialized in semiconductor manufacturing, and JDI has a single segment of small and medium-sized LCD. Their slow employment adjustment in response to poor profitability around M&A is in support of the employment consideration hypothesis for stand-alone Japanese firms. It is quite cumbersome for the Corporate Japan to downsize or exit, in particular, to lay off workforce, until the problem is unresolvable irrespective of conglomerates or single segments. Consequentially, the Corporation Japan is much lesser profitable than foreign peers (Arikawa et al., 2019). Recently, there is evidence that the Corporate Japan does not downsize or exit unless there are substantial doubts on its ability to continue as a going concern. Saruyama and Xu (2019) investigate the effect of a going concern note (GCN) on subsequent firm performance and restructurings. Financial statements are prepared on going concern basis and a GCN is a financial statement note to disclose substantial doubt about the company’s ability to continue as a going concern. The Japan’s

3.4 Concluding Remarks

67

accounting standard adopted a new rule in March 2002 and the rule provides instructions about disclosing going concern statuses based on international practices. Japanese firms with a GCN are loss-making, more highly leveraged, and smaller than firms without such a GCN. Furthermore, firms that have reached a critical point concerning conventional threshold of layoffs, dividend payout regulations, or delisting criteria are more likely to disclose their going concern uncertainties. In terms of the results of the solutions proposed to mitigate disclosed adverse conditions and circumstances, firms with a GCN in their financial statements undertake more aggressive restructuring measures in assets, borrowings, and workforce, compared to few efforts of comparable firms without a GCN. This suggests that a Japanese company is less likely to downsize unless it recognizes its inability to continue as a going concern. It is too late for Japanese firms with doubts on ability to continue as a going concern in Japan to restructure, however. Regardless of aggressive downsizing, firms with a going concern note tend to prolong poor profitability and have a higher probability to file for bankruptcy subsequently. Unfortunately, most bankrupt firms cannot survive. In response to the substantial increase in bankruptcy filings, Japan reformed its insolvency laws to enhance prompt insolvent resolutions for reorganization (Xu, 2004, 2007). Although the new civil rehabilitation law is aimed to enhance quick resolutions, only 30% of rehabilitation firms survived. Recently, TSR has reported that out of the companies that applied for civil rehabilitation, about 70% were not successful. The breakdown is as follows: 3.6% M&A, 11.9% dissolutions, 36.6% subsequent bankruptcies, 0.6% special liquidations, and 47.1% closings or unknown. Eventually, about 70% of civil rehabilitation firms were forced to close business as bankrupt firms. This suggests that finally most rehabilitation firms were eliminated. It is notable that the difficulty of exit is a worldwide phenomenon that repeats itself. In the 1970s and 1980s, U.S. corporate internal control systems failed to enhance downsizing and exit in response to slow growth and overcapacity. Jensen (1993) provides evidence on wasting internally generated funds for value destroying capital expenditure and R&D of well-known large US firms such as General Motors, IBM, Xerox, and Kodak in the 1980–1990 period. At long last, General Motors went bankrupt in 2009, and Kodak filed for reorganization under the Chapter 11 of U.S. bankruptcy code in 2012. However, General Motors was bailed out by the U.S. government to protect employment in the automobile industry. Nonetheless, the capital markets pressure US companies with excess capacity to change when the problem is resolvable in Jensen (1993). It is most contrasting that the proportion of underperforming firms exposed to capital market pressures such as acquisitions in Japan was nil in comparison with 36.8% in the United States, as pointed out by Kang and Shivdasani (1997). In other words, dysfunctional capital market allowed Sony to generate a waste of internal funds from non-electronics segments. During the mid-2000s, the activist fund led by Mr. Murakami and U.S. investment fund Steel Partners were pressuring non-distressed Japanese corporations to make prompt changes. They were blamed by managers and policymakers and failed to bring threat to force Japanese firms to accomplish early changes due to interlocking shareholdings among Japanese companies. After Japan experienced the second lost

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decade, Japan had to take necessary economic policy measures for its economic revitalization. Now, the investors and the companies are required to follow the Japan’s Stewardship Code and the Japan’s Corporate Governance Code. The Japan’s Stewardship Code requires institutional investors to monitor investee companies to enhance the medium to long-term investment return. According to the Japan’s Corporate Governance Code, a company needs to disclose interlocking shareholdings’ benefits and risks as well as its policy to reduce interlocking shareholdings not in the best interest of shareholders and appropriate actions in accordance with the policy. Fortunately, Japan is changing after experiencing the second lost decade. In 2014, pressured by Third Point, a U.S. activist investment fund, Sony, one of the crown jewels of Japanese business in the 1980s, sold its loss-making PC business to an investment fund. In 2017, Yoshiaki Murakami, an active investor once known as Murakami Fund, and his linked investment companies were successful in appointing an outside director by winning a proxy fight in Kuroda Electric. In 2015, Mr. Murakami’s proposal was overwhelmed. However, it was revealed later that the disclaimer of the employee who became the decisive factor of the company’s victory was forgery. Eventually, Kuroda Electric was acquired by MBK Partners, a north Asian buyout firm known for investing in Komeda Holdings and TASAKI. More recently, Itochu launched a tender offer bid (TOB) against Descente, a major sports goods producer, and ultimately owned 40% of shares after TOB, and the incumbent president resigned. Successfully appointing outside directors by activist investors and successful hostile TOBs are quite rare in Japan. To issue outside threats before distresses, the capital market now puts pressure on firms to accomplish early changes and industrial revival. Japan needs to launch more and more new policy measures to enhance active M&A for non-distressed firms with subsequent rapid cutback on excess capacity before losses in the product markets.

References Arikawa, Y., Inoue, K., & Saito, T. (2019). Corporate Governance, Employment, and Financial Performance of Japanese firms: A cross-country analysis. Available at https://papers.ssrn.com/ sol3/papers.cfm?abstract_id=3312515. Caballero, R. J., Hoshi, T., & Kashyap, A. (2008). Zombie lending and depressed restructuring in Japan. American Economic Review, 98(5), 1943–1977. Dedrick, J., & Kraemer, K. L. (1998). Asia’s computer challenge: Threat or opportunity for the United States and the world? Oxford University Press. Dessaint, O., Golubov, A., & Volpin, P. (2017). Employment protection and takeovers. Journal of Financial Economics, 125(2), 369–388. Giroud, X., & Mueller, H. M. (2017). Firm leverage, consumer demand, and employment losses during the great recession. Quarterly Journal of Economics, 132, 271–316. Halme, K., Lindy, L., Piirainen, K. A., Salminen, V., & White, J. (Eds.). (2014). Finland as a knowledge economy 2.0: Lessons on policies and governance. Directions in development science, technology, and innovation. World Bank.

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Hanazaki, M., & Matsushita, K. (2014). Corporate governance and corporate diversification: Empirical analysis based upon corporate financial data in Japan. Economics Today, 34(5), 1–74. (in Japanese). Jensen, M. C. (1986). Agency cost of free cash flow, corporate finance, and takeovers. American Economic Review, 76, 323–329. Jensen, M. C. (1989). Eclipse of the public corporation. Harvard Business Review, 67, 61–74. Jensen, M. C. (1993). The modern industrial revolution, exit, and the failure of internal control systems. The Journal of Finance, 48, 831–880. Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3, 305–360. Kang, J. K., & Shivdasani, A. (1997). Corporate restructuring during performance declines in Japan. Journal of Financial Economics, 46, 29–65. Maksimovic, V., Phillips, G., & Prabhala, N. R. (2011). Post-merger restructuring and the boundaries of the firm. Journal of Financial Economics, 102, 317–343. Nakamura, J., & Fukuda, S. (2013). What happened to ‘zombie’ firms in Japan?: Reexamination for the lost two decades. Global Journal of Economics, 2(2), 1–18. Ozbas, O., & Scharfstein, D. S. (2010). Evidence on the dark side of internal capital markets. Review of Financial Studies, 23(2), 581–599. Peek, J., & Rosengren, E. S. (2005). Unnatural selection: Perverse incentives and the misallocation of credit in Japan. American Economic Review, 95(4), 1144–1166. Rajan, R., Servaes, H., & Zingales, L. (2000). The cost of diversity: The diversification discount and inefficient investment. Journal of Finance, 55, 35–80. Saruyama, S., & Xu, P. (2019). Going concern notes, downsizing, and exit. REITI Discussion Paper, 19-E-001. Scharfstein, D. S., & Stein, J. C. (2000). The dark side of internal capital markets: Divisional rent seeking and inefficient investments. Journal of Finance, 55, 35–80. Servaes, H. (2000). The value of diversification during the conglomerate merger wave. Journal of Finance, 51, 1201–1225. Shin, H. H., & Stulz, R. (1998). Are internal capital markets efficient? Quarterly Journal of Economics, 113, 531–552. Tate, G., & Yang, L. (2016). The human factor in acquisitions: Cross-industry labor mobility and corporate diversification. Available at SSRN 2578636. Tian, X., & Wang, W. (2020). Hard marriage with heavy burdens: Labor unions as takeover deterrents. The Review of Corporate Finance Studies, cfaa002. https://doi.org/10.1093/rcfs/cfa a002. Ushijima, T. (2016). Diversification, organization, and value of the firm. Financial Management, 45, 467–499. Xu, Peng. (2004). Increasing bankruptcies and the legal reform in Japan. Journal of Restructuring Finance, 1, 417–434. Xu, P. (2007). Corporate governance in financial stress: The new role of bankruptcy. In M. Aoki, G. Jackson, & H. Miyajima (Eds.), Corporate Governance in Japan. Oxford University Press.

Chapter 4

Slow Downsizing After Mergers of Individual Loss-Making Parts and Components Divisions

Abstract In this section, we focus on the consequences of M&A of disintegrated in-house parts and components businesses. Renesas Electronics, a hodgepodge of semiconductor divisions, suffered prolonged losses after M&A. Drastic downsizing in employment after Innovation Network Corporation of Japan (INCJ), a government investment fund, taking control of distressed Renesas, successfully restructured its business. On the other hand, the inopportune and easy collection of loss-making LCD divisions, that is, the birth of JDI led by INCJ, did not result in a new sustainable display company. Irrespective of post-M&A losses, JDI expanded production capacity rather than downsizing. Moreover, the company failed to drastically downsize employment promptly even when the new plant turned out impaired assets. At last, foreign investors withdrew the bailout plan due to debt overhang. Despite this, Japan has been supporting loss-making JDI. The slowdown in the smartphone market due to a prolonged smartphone life cycle, overcapacity in the smartphone industry, the new entry of the display manufacturers of China, and the widespread adoption of OLED by smartphone makers are responsible for JDI’s declining sales and consecutive losses. Renesas is specialized in semiconductor manufacturing, and JDI has a single segment of small-medium LCD. Their slow employment adjustment in response to poor post-M&A profitability is in support of the employment consideration hypothesis for stand-alone Japanese firms. Keywords Electronics · International horizontal division · Disintegration · Parts and components division · M&A · Employment consideration · Overcapacity · Downsizing

This work was supported by JSPS KAKENHI Grant Number JP17H02528. All remaining errors are our own. Any opinions, findings, or conclusion expressed in this book are those of the authors and do not reflect the views of the Development Bank of Japan or the authors’ affiliations.

© Development Bank of Japan 2021 S. Saruyama and P. Xu, Excess Capacity and Difficulty of Exit, Development Bank of Japan Research Series, https://doi.org/10.1007/978-981-16-4900-4_4

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4.1 Introduction In the 1970s, Japan had developed into the world’s most competitive industrial power. Since the best-selling book “Japan as Number One” came out in 1979, the United States has learned from Japan the Japanese management techniques such as total quality management and just-in-time production system. As U.S. companies learned more from Japan, ironically, Japanese companies came to appear like the 1980s U.S. companies as predicted by Jensen (1989). The two decades since 1970 indicate that the U.S. corporate internal control systems failed to enhance downsizing and exit in response to slow growth and overcapacity. Jensen (1993) provides evidence on the waste of internally generated funds for value destroying capital expenditure and R&D of a considerable number of firms such as General Motors, IBM, Xerox, and Kodak in the 1980–1990 period. As Japan’s success in worldwide product markets created free cash flow far in excess of investment opportunities, without effective internal control, Japanese managers would have wasted internal funds like U.S. managers in the 1980s. Unfortunately, Jensen’s (1989) prediction came true since the early 1990s. Japan’s electronics business is a suitable industry setting to examine how internally generated funds are used as capital expenditures for deficit segments. Jensen (1993) argues that it is difficult for companies that enjoyed rapid growth, dominant market presence, and rich free cash flow and high profits for long periods to promptly downsize or exit from low profit businesses. Indeed, Japanese electronics makers achieved great historical success in worldwide consumer electronics. We highlight through case studies how investments in loss-making businesses in major electronics manufacturers deteriorate their subsequent performance. Jensen (1993) points out the reason why firms cannot make the decision of efficient exit, focusing on U.S. companies. First, large enterprises that are enjoying the glory of growth tend to leave declining businesses even though they are aware of the necessity of terminating them until they cannot postpone the problems any longer. If one dares to embark on implementing early reforms, the president should expect to be expelled from the post. Securing employment tends to be a good excuse made by the top management to continuously spend abundant cash flow on deficit segments. In Chap. 2, we focused on the misallocation of credit to loss-making electronics business segments in major Japanese electronics companies. We showed that Sony generated waste of its internal funds from profitable finance and entertainment businesses to subsidize its primary loss-making electronics business. Similarly, NEC spent most free cash flow on its loss-making electronic devices sector. In contrast, Mitsubishi has been promptly cutting off investment in deficit business segments and improving its profitability. It is not surprising that the investment in loss-making segments prolongs poor performance. The direct reason is that free cash flow is in excess of investment opportunities in the electronics industry. However, the outsidedominated board did not prevent Sony from investment in deficit segments. In addition, foreign institutional investors neither voiced nor voted with their feet against perverse segment investment in Sony and NEC. Exceptionally, Third Point, a U.S.

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based activist investor fund, exerted pressure, and then Sony spun off its loss-making PC business. Notably, the allocation of credit to loss-making segments increases with segment employment as well as cash flow from other profitable sectors. Using cross-country data, recently, Arikawa et al. (2019) found that the Japanese employment practice and labor protection significantly explain the poor performance of Japanese firms compared to their global peer firms. The fragile employment system hinders flexible employment adjustments, which are necessary in response to industrywide overcapacity. The difficulty of laying off overlapping redundant labor force also reduces the activities and gains from M&A. Indeed, Dessaint, Golubov, and Volpin present evidence that the increase in employment protection impedes layoffs, resulting in wage costs that reduce synergy gains from takeovers. They show that the M&A volume scaled by gross domestic product (GDP) in Japan is the lowest among major OECD countries, although its OECD employment protection legislation (EPL) index is moderate. This suggests that Japanese corporations could pay more attention to employment protection as EPL requires, as shown in the above anecdotal example. Labor law in Japan strictly prevents loss-making companies from laying off workforce. In addition to EPL, it is more likely that the Japanese managers buy short time peace between management and labor, similar to U.S. managers in the 1970s. Indeed, 66% of respondents answered in the 2018 Ministry of Economy, Trade and Industry (METI) survey on corporate governance that they need the agreement of labor unions or labor-management councils when laying off workers. Focusing on asymmetric segment employment, in Chap. 3, we examined the misallocation of internal funds to business segments for employment considerations. We investigated whether a segment that contributes more to employment is able to extract more credit for investment. We found that a segment with higher employment attracts more investments irrespective of operating losses. Surprisingly, all segments in a loss-making diversified electronics corporation attract more investments. Consequently, investment in a deficit segment exacerbates subsequent segment profitability and segment asset turnover. Moreover, we found no evidence that specialized electronics firms cut back on investment in deficit and that firm performance improves as sales shrink. An efficient internal capital market should cut back on investments in loss-making segments that have poor investment opportunities. In addition, exit from loss-making businesses would increase cash flow and thus private benefits for the CEO. Thus, the internal misallocation of credit to loss-making divisions cannot be rationalized by either simple empire building of the CEO or internal cross subsidies in a conglomerate. Indeed, our evidence shows that the internal capital market equalizes the impacts of cash flow shortfalls across segments. Hence, investment in a segment depends uniformly on its own cash flow as well as on the cash flow of other segments. Thus, the most plausible answer is that job security is a matter of the highest priority in Japan. To grant job security to employees, the CEO has been misallocating funds to loss-making divisions until the problem became unresolvable. Most importantly, we shed new light on the internal capital market and show that employment can be a source of bargaining power for division investment. The diversity of employment

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and profitability can lead to the most inefficient segment investment. Our evidence suggests that the shareholder-employee conflicts could affect a firm’s internal capital market. In previous studies, single-segment firms are used as a benchmark for investment opportunities and distorted investment in the segments of diversified firms as demonstrated by Shin and Stulz (1998) and Ozbas and Scharfstein (2010). However, we found that single-segment electronics firms have poor investment opportunities in terms of the average Q ratio or sales growth. Moreover, 15% of the single-segment firms were suffering losses. This is not surprising as we have shown that the PC business, TV manufacturing, DRAM business, and LSI business are all underperforming due to worldwide overcapacity. Regardless of poor investment opportunities, investment in single-segment firms is only sensitive to cash flow, and neither investment opportunities nor sales growth has any impacts on investment. Moreover, the performance of single-segment firms is positively related to investment opportunities but is negatively related to sales growth. In short, most single-segment firms also ought to divest rather than to invest, but they continue to waste free cash flow. In this chapter, we provide evidence on slow employment adjustment in response to poor profitability in two stand-alone firms in support of the employment consideration hypothesis. Horizontal M&As among stand-alone firms play an important role in eliminating excess capacity. The difficulty of eliminating overlapping inefficient operations due to employment considerations makes M&A inactive, although Japanese firms have been required to downsize and exit since the 1990s. Faced with excess capacity, all managers failed to downsize, while they continued to invest to maintain employment. Consequently, downsizing and exit were also significantly delayed in stand-alone firms due to the misallocation of credit to businesses with excess capacity for employment considerations, even though the non-performing loans problem was resolved. Rather, zombie lending itself was in part due to the employment considerations of banks that were specializing in banking. Merging respective loss-making divisions in the same business such as DRAM, LSI, or display with excess capacity might prevent each concerned company from continuing the misallocation of internal funds to loss-making businesses. However, aggressive labor restructuring is necessary for the associated M&A synergy gains; thus, just merging without enough downsizing is far from the ultimate solution to excess capacity. In this chapter, we illustrate cases where merging respective lossmaking divisions in the same business with excess capacity has incurred losses, and we show that post-merger downsizing is required. Renesas Electronics is a good example. Back to the 1990s, Japanese manufacturers lost their supremacy in the semiconductor business with the rise of Asian peers. Moreover, in semiconductors other than DRAM, Hitachi and Mitsubishi Electric integrated their operations in April 2003 to launch Renesas Technology. However, post-M&A performance was poor, and Renesas Technology made prolonged losses since the Global Financial Crisis. In 2010, Renesas Technology and NEC Electronics (NEC’s semiconductor subsidiary) were merged and became Renesas Electronics (hereinafter, Renesas) in response to the negative economic shock.

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However, Renesas failed to revive. In April 2013, it was acquired by Innovation Network Corporation of Japan (INCJ), a government-affiliated investment fund and a coalition of major customers including Toyota, Honda, and Panasonic. Since then, it closed five plants, sold six plants, and laid off 60% of its redundant workforce. It will additionally close two plants in the future and only keep six operating. For dramatic downsizing, it took an upward turn in its profit margin after 2014. In 2019, it announced the layoff of an additional 1000 employees and a plan to shut down operations at its nine domestic plants for up to two months by the end of September 2019. This suggests that Renesas is required to frequently and promptly restructure or redirect itself in response to economic shocks such as economic slowdown, technological changes, and the entry of South Korea, Greater China, and India into worldwide product markets.

4.2 The Case of Renesas Renesas Electronics is one of the companies symbolizing the plight of Japan’s semiconductor industry. Back in the 1990s, Japanese manufacturers lost their supremacy in the semiconductor business with the rise of Asian peers. In December 1999, Hitachi and NEC integrated their DRAM businesses and established Elpida Memory (which Mitsubishi Electric joined later) in the hope of surviving by consolidating their operations. Moreover, in semiconductors other than DRAM, Hitachi and Mitsubishi Electric integrated their operations in April 2003 to launch Renesas Technology (hereinafter “Renesas Tech.” for short), and NEC also spun off semiconductor businesses other than DRAM as NEC Electronics (hereafter “NEC El.”). These reorganizations only reduced the number of companies in the domestic non-DRAM semiconductor industry from three to two, but the performance of the two remaining companies did not recover during and after the recession triggered by Lehman Shock, and they were forced to further consolidate their business. In 2010, the two companies were merged and became Renesas Electronics (hereafter “Renesas”). Even after the merger, Renesas failed to revive. It became increasingly difficult to survive on its own. In April 2013, Renesas finally asked for rescue by Innovation Network Corporation of Japan (INCJ) and entered the organization. After that, Renesas made substantial reduction of its employees more than ever before. It took an upward turn in its profit margin since 2014. INCJ, which held 69% of shares at the initial capital injection, began selling its shares since 2017. As of October 2018, its shareholding ratio declined to 33%. Renesas is regaining independence of the management. Renesas may appear to have fared better than Elpida, which filed for bankruptcy protection under the Corporate Rehabilitation Law in February 2012. However, Renesas was only rescued by INCJ, the government’s investment fund, and should be regarded as a failed company. We explore why Renesas has been an ailing company from the following three perspectives.

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First, Renesas did not have sufficient competencies in technology and marketing to compete with rivals. In terms of marketing, Renesas had limited customers other than the parent companies that founded the company. The predecessors of Renesas used to be the divisions of the parent companies and were responsible for supplying semiconductors for final products assembled within the companies. As the parent companies lost their shares of final products such as personal computers, televisions, and mobile phones, Renesas also faced decreasing sales of semiconductors. It was not well organized to divert its semiconductors to other manufactures of final goods. Renesas has the world’s top share of the semiconductors for automobiles. Most of them, however, are said to be custom-made products upon request. When its Naka factory, located in Ibaraki prefecture, was struck by the Great East Japan Earthquake, many automakers had to suspend their operations due to a shortage of supply from the factory. The reasons why Renesas lingered in the doldrums while producing indispensable components include the following. (i) It could not raise the plant utilization rate with so many diversified custom products. (ii) It neglected to capture customers’ needs in advance and to massively produce what would meet their needs. In terms of technology, its competitiveness in semiconductors controlling mobile phones and smartphones, which became the growth field after PC, was weak. It remained inferior to overseas companies such as QUALCOMM. Second, it had a problem with management and corporate governance. Renesas was far from independent of its parent companies. Analyzing the financial results of the two preceding firms, we found out that Renesas sustained net losses for nine consecutive years. NEC El and Renesas Electronics were publicly listed firms, while the former Renesas Tech. remained unlisted. It is not normally permitted for public companies to make persistent losses in such a long period. Before 2013 when Renesas entered the umbrella of INCJ, almost 90% of shares were held by parent companies. It was irregular as a listed company to have only 10% of floating shares. The top management was always occupied by those executives from parent companies. Renesas behaved as if it were a division jointly owned by the parent firms. Discipline to terminate loss-making business was not enforced in Renesas. It was not until INCJ took control that it withdrew from unprofitable system LSI business. Third, it postponed drastic adjustments in employment. The number of employees was almost unchanged until 2010, while it had stepped up efforts in asset downsizing ahead of the merger. In 2012, with its survival being increasingly in danger, it finally started making substantial employment reduction. It is not surprising that layoffs around M&A are difficult due to stringent regulations. Generally, the rights and obligations are comprehensively inherited by the post-M&A company. Therefore, the pre-M&A labor contracts must be maintained as they are irrespective of merger, acquisition, or split according to the labor law. The second and third points are in line with the preservation of loss-making business observed among big electronics manufacturers described in Chap. 2, where we found that NEC kept investing in electronic devices and sustained consecutive losses during 2005–09. It was also highlighted how major electronics manufacturers gave priority to securing jobs. NEC El. was one of NEC’s consolidated firms until 2009. This study aims to further investigate NEC’s semiconductor business in depth. It also

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explores what happened since 2010 when Renesas became outside of NEC’s consolidation accounting because NEC reduced its ownership of Renesas. We examine how Renesas suffered more serious deficit after 2010, and we demonstrate that no effective reform in corporate governance was adopted until it accepted a backup by INCJ. This section is organized as follows. In Sect. 4.2.1, we review the basic financial results including sales by sector. In Sect. 4.2.2, we inspect Renesas’s governance structure. Sections 4.2.3 and 4.2.4 look back on how they tackled downsizing and restructuring. Section 4.2.5 is dedicated to discussion and conclusion.

4.2.1 Sales and Profit by Business Line In this sub-section, we will investigate the sales and profits of Renesas. The former Renesas Tech. was unlisted, and its disclosure of financial results was very limited. Thus, we should note that there is a difference in the range of available data between the two preceding companies. Assuming the sales of Renesas Tech. were similar to those of NEC El. in time series change, the total sales of the preceding companies were around 1.6 trillion yen in the first half of the 2000s. Sales significantly declined at the time of the Lehman shock, and the contracting trend persisted after that (Fig. 4.1 left). Later, sales were about a half of what the two firms earned in earlier years. The most noteworthy thing is the net income (Fig. 4.1 right). The former Renesas Tech. produced a small surplus in 2006–07; however, the two companies combined suffered deficit for nine years from 2005 to 2013. Retained earnings were negative for NEC El. and the current Renesas from 2005 to 2014. Dividends had not been paid after 2008 until the term ended in December 2017. As mentioned later, Renesas produced a small surplus in operating profit (or EBIT, earnings before interest and Sales

(Trillion Yen)

2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 2002 04

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08

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1500 1000 500 0 -500 -1000 -1500 -2000 -2500 -3000 -3500 2002 04

Source: NEEDS-FinancialQUEST and disclosures

Fig. 4.1 Renesas’s sales and net income

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NEC El. (2004-09) 8000

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Fig. 4.2 Renesas’s sales by business line

taxes) for some years. Because of impairment losses from earlier investments in unprofitable businesses, the net income was in the red while producing a surplus in operating accounts. In other words, the past investment by Renesas Tech. and NEC EL. resulted in impaired assets. Why did Renesas suffer such serious losses? One of the culprits was the system LSI business. The companies sharply cut back its system LSI business in the 2012 hardest distress. If we take a look at sales by semiconductor business lines which are disclosed (Fig. 4.2),1 we find out the following. (i) Between 2004 and 2009, sales of telecommunication equipment and computer-related products significantly shrank, while those of automobiles were robust. (ii) In the 2010–13 period, System of Chips, which is a synonym for system LSI, decreased. In short, sales of telecommunication products and system LSI were poor, while sales in the automobile industry remained generally healthy in all periods. A contraction in telecommunication equipment was partly caused by a decline in the parent companies’ competitiveness in products such as mobile phones and smartphones. The share held by Japanese manufacturers was eroded by overseas makers, while they secured some shares only in the domestic market in the early 2000s. The setback to Japanese electronics products is deeply related to progress in the international horizontal division: outsourcing the assembly of electronic equipment to Electronic Manufacturing Services (EMSs), such as Foxconn Technology 1

Renesas formally states it has only one segment. We, however, can collect the annual sales results by business line from the text of their annual financial statements.

4.2 The Case of Renesas 50

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(EBIT/Sales,%) Renesas (JP)

40 30

NXP Technologies (NE)

20

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Note: Comparable firms with Renesas in product lines. Source:Quick FactSet. EBITstands for earnings before interest and tax.

Fig. 4.3 Ratio of EBIT to sales for selected semiconductor firms

Group, and manufacturing of semiconductors to what is called a foundry, such as Taiwan Semiconductor Manufacturing Company (TSMC). Rather than developing and manufacturing parts and basic technologies themselves, set makers procure standardized items from specialized parts manufacturers. EMSs and foundries can supply products and parts at low cost while achieving economies of scale by performing large-scale capital investment embedded with advanced technology in a short cycle. There emerged an environment where many set makers outsource manufacturing to a small number of EMSs and foundries. On the other hand, Japanese electronic machinery manufacturers took it for granted that they should compete with other companies by developing technology in-house, applying it to their products, and procuring parts from within the group. This is the so-called vertical integration model. In this model, individual makers need to bear huge capital investments and R&D expenses. If this cannot be done, they fail to implement cutting-edge technology and to offer the cheapest prices, and they finally lose support from the customer. Due to the progress in horizontal divisions, the existence of Japanese manufacturers has become minimum in the era of mobile phones, which were in full swing since the latter half of the 1990s, and the subsequent expansion of smartphones starting with Apple’s introduction of iPhone in 2007. Similar changes occurred to LCD televisions and tablet computers. As a result, Renesas has lost dominant sales channels to supply its semiconductors. There is one more point to be emphasized. Renesas was inferior to rivals in core technologies related to telecommunication and wireless communication. QUALCOMM and Texas Instruments’ (TI) buoyant performance in the field indirectly demonstrates the relative weakness of Renesas. The ratio of EBIT to sales for selected major global

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4 Slow Downsizing After Mergers of Individual Loss-Making Parts …

firms competing in the same field such as Renesas is shown in Fig. 4.3.2 While the two companies enjoy a high profit margin, we can see that other manufacturers including Renesas suffered low profitability especially till 2009. QUALCOMM and TI both have strengths in the communication field. QUALCOMM exclusively monopolized CDMA-related patents, which are adopted as the communication standards of the second generation (2G) and the third generation (3G). It also manufactured chips (LSI) that efficiently operate music, moving images, and position identification via a mobile phone and expanded their sales. TI has a high share in parts called Digital Signal Processor (DSP) suitable for constantly updating a large amount of information like streaming, which sequentially transmits and receives data.3 One of the factors behind QUALCOMM securing a high-profit sales ratio is what is called a “fabless” manufacturing system that owns no factories and thus the company can reduce its fixed cost burden. TI, however, has many factories on its own. It is not a simple picture of high profit attributable to the fabless system. In addition to having lost the sales channel to parent companies, Renesas had no advantageous weapons in the growing communication market. It did not take active steps to capture global customer needs. It was inevitable for Renesas to witness its performance decline. The same things happened to a certain extent to European semiconductor manufacturers.

4.2.2 Changes in Ownership Renesas had a very irregular governance structure. Despite being a listed company, it behaved as if it were a business division jointly owned by the parent companies. Looking first at the ownership structure during 2010–12 before INCJ took control, the three former parent companies held over 90% of the shares (Fig. 4.4). The same structure was observed for the lineup of the president and the chairman. In the former Renesas Tech. which was jointly owned by Hitachi and Mitsubishi Electric, the president was from Hitachi, and the chairman was from Mitsubishi Electric. The former NEC El. naturally appointed a former executive of the parent company NEC as the president (Table 4.1). Mr. Hisao Sakuda from OMRON was the first outsider who assumed one of Renesas’s top management in 2013. Listed companies that sustained consecutive losses would normally make their top management resign. In Renesas, however, the top positions were shared by the top two large shareholders in a cycle of about two years, and the former president became the chairman. The post M&A company was managed by a scratch board rather than by a unified team. 2

We did not include Intel that dominates in MPUs for PCs or Samsung Electronics which shows strengths in DRAM and final products. The two companies are not comparable with Renesas in product lines. 3 TI also has strengths in analog semiconductors. Analog semiconductors convert voice, pressure, temperature, electricity, and the like into digital signals. MediaTek is also a strong firm in semiconductors for communication equipment.

4.2 The Case of Renesas 0

81

(%)

0

Renesas Tech (unlisted)

20 40

(%)

10 20

60

30

80

40

100 0

50

Hitachi Mitsubishi

60

NEC El (listed)

50

Others

70 80

Innovation Network Corporation

90 100

2003 04

05

06

07

08

09

100

10

11

12

13

14

Source: Financial Statements of Renesas and its preceding firms.

15

16

17 End of year/fiscal year

Fig. 4.4 Large shareholders of Renesas

Table 4.1 Renesas’s top management and its origin

Renesas Technology Year

President

2003 Satoru Ito

From Hitachi

Chairman Koichi Nagasawa

NEC Electronics From Mitsubishi

2005 2007

Katsuhiro Tsukamoto

Mitsubishi

Satoru Ito

Katsuhiro Tsukamoto Renesas Electoronics Junshi Yasushi Akao Hitachi Yamaguchi Tetsuya Hitachi Hisao Sakuda Tsurumaru Oracle Takao Endo as above Japan Nidec Tetsuya Bunsei Kure Corporation Tsurumaru

Mitsubishi

2010

NEC

2015 2016

From

Kaoru Tosaka

NEC

Toshio Nakajima

NEC

Hitachi

2009 Yasushi Akao Hitachi

2013

President

Omron

NEC Junshi Yamaguchi

NEC

INCJ took control

Hitachi

Note Shaded parts stand for appointment from outside parent companies Mitsubishi stands for Mitsubishi Electric. Source NEEDS-Financial QUEST and disclosures

In the literature on corporate finance, ownership concentration and a small board, such as a leveraged buyout (LBO) or a management buyout (MBO), are necessary to turn around a deeply distressed firm (Jensen, 1989), because it needs quick and tough decisions. In addition, it has been proved that it is difficult for Japanese electronics companies to promptly restructure their loss-making segments as shown in Chaps. 2

82

4 Slow Downsizing After Mergers of Individual Loss-Making Parts …

9000 100 Million Yen) 8000 7000 6000 The former NEC El 5000 4000 3000 2000 1000 0 2002 04 06 08

Borrowings Liabilities

10

Source: NEEDS-FinancialQUEST and disclosures.

12

14 16 year/fiscal year

Fig. 4.5 Borrowings and liabilities of Renesas

and 3. Similarly, the three large shareholders and the poorly governed management, that is, a hodgepodge of LSI divisions, took no actions until the problem became unresolvable. Eventually, shareholding in each company finally fell to less than 10% when INCJ held the majority in 2013. This way, Renesas survived with net income losses for several consecutive years until 2012, attended by the parent companies in its capital and personnel affairs. It seemed as if the parent companies ignored the minority shareholders and left unprofitable business within their firm. The involvement of banks seems to be limited. The four major financing banks, Mitsubishi Tokyo UFJ Bank, Mizuho Corporate Bank, Mitsubishi UFJ Trust Bank, and Mitsui Sumitomo Trust Bank lent 47.5 billion yen during the 2012 management crisis while the three parent companies also investing a total of 49.5 billion yen. The parent companies had already invested a total of 200 billion yen as capital in 2010. It is thought that the parent companies were the main channel of required funds. Long-term and short-term loans remained almost unchanged, and the presence of banks did not increase (Fig. 4.5).4 Even when Renesas was deeply distressed, no banks intervened.

4.2.3 Slow Downsizing and Restructuring Next, let us trace the restructuring made by Renesas when it faced difficulties. Renesas had several serious moments in terms of its deficit. The former NEC El. slipped into a deficit of nearly 100 billion yen in 2004. The next slump took place in 2008 hit by the Lehman shock when losses reached more than 200 billion yen. Even after the merger, the company could not escape from the chronic deficit. In 2012, with its loss 4

In addition, the balance of convertible bonds with stock subscription rights was 110 billion yen. The convertible bonds were issued before M&A by the former NEC Electronics in the term March 2005 to March 2011 and were inherited by Renesas after M&A.

4.2 The Case of Renesas 1.2

83

Liabilities/Total Assets

Renesas Electronics

1 NEC El

INCJ took control

0.8

Net income turns to positive 0.6 0.4

Net Income Loss ¥bn 200

0.2

Large-scale voluntary retirement Closing 10 major facilities

Net Income Loss ¥bn 100

0 2002

04

06

08

10

12

14

Source : NEEDS-FinancialQUEST

16 Year/Fiscal Year

Fig. 4.6 Liability to asset ratios of Renesas

expanding again and a risk of falling into excess liability mounting, it was thrust into a large-scale downsizing by soliciting voluntary retirement and closing tens of its key factories. It finally accepted the investment by Innovation Network Corporation of Japan (INCJ) in 2013 (Fig. 4.6). In the following year, its net income turned to positive, and thereafter the debt ratio has been slowly declining. To what extent did Renesas seek to reduce its resources when it faced continuing deficits? One striking aspect was the delay in employment adjustment. On the assets side, the former NEC El. saw its total assets decrease after the deficit in 2004. The former Renesas Tech. also has compressed its assets since 2007. In contrast, the number of employees had scarcely decreased until 2010 (Fig. 4.7). Although we cannot trace how many employees the former Renesas Tech. maintained except 2002 Number of Employees

Total Assets 1.8

(Trillion Yen)

NEC El. (1) Renesas Tech. (2) Renesas El. (2010-) (1) + (2)

1.6 1.4 1.2 1.0

6

(10000)

5 4 3

0.8 0.6

2

0.4

1

0.2

(Fiscal year)

0.0 2002 04

06

08

10

12

14

16

(Fiscal year)

0 2002 04

06

08

10

12

14

16

Source: NEEDS-FinancialQUEST and disclosures. The number of Renesas Technology's employees is only available for 2002 and 2009.

Fig. 4.7 Total assets and number of employees

84

4 Slow Downsizing After Mergers of Individual Loss-Making Parts …

and 2009, its foundation year, and the year preceding the merger, we could naturally assume that the number of employees in both the former NEC El. and Renesas Tech. stayed almost flat. We find a significant lag in employment reduction compared to the downsizing in assets. We could see here the preservation of employment highlighted in Chap. 2. Even after the merger in 2010, it did not cease to face deficit and came closer to excess liability. Since 2011, it was driven toward full-scale staff reduction, and the number of employees began to decrease at a steep angle. The number of employees declined to less than half in four years till 2014. In general, when a company stays in the red two years in a row, it likely embarks on staff reduction (Saruyama, 2018). Renesas, however, postponed required adjustments for many terms and made a drastic reduction when the survival of the company became precarious.

4.2.4 Restructuring by Business Line Next, we examine Renesas’s restructuring by the business field. To this end, we used Nikkei Corporate Action Database that recorded various actions that appeared in disclosure and news reports. We counted the number of events where Renesas made withdrawal and contraction on the one hand and investments and expansions, including making alliances, on the other hand (Table 4.2). We also discriminated the actions taken by the former NEC El. and Renesas Tech. We could note the following three points from this table. (1) We see many withdrawal cases from individual projects but few employment reductions until 2009. It was after the merger that the number of cases of employment reduction increased especially during 2010 and 2014. (2) In the field of communication equipment and LSI, the former NEC El. made scarce withdrawals, while the former Renesas Tech. made withdrawals and expansions at roughly the same frequency. (3) Even after the merger, the expansion of the communication and LSI business exceeded withdrawal until 2012. The withdrawal accelerated after 2013 when it entered under the umbrella of INCJ. (4) Since 2015, with its financial performance stabilized after it completed withdrawal from the communication and LSI business, it aggressively began investing in the automotive and industrial fields, in which it gained advantages, and also in the Internet of Things (IoT) and Artificial Intelligence (AI), which might turn to be promising fields. It is interesting that the former Renesas Tech. and NEC El. were quite different in their attitude toward the communication and LSI business. In retrospect, it was the former NEC El. that continued making expansions and brought excessive capital to the merged company, which made the company’s wound deeper. In addition, regarding the deficit size before the merger, it was the former NEC El. that slipped into larger deficit. NEC El. was more inclined to stick to loss-making businesses than the former Renesas Tech. A typical example of the expansion of the communication field that took place after the merger is the challenge of developing a system LSI for mobile terminals

1

4

1

2

Power Semicon

Flash Memory

Closure

Layoff

4

6

Power Semicon

Flash Memory

Source Corporate Action Database of Nikkei

IoT/AI

10 2

18

1

Auto & Industry related

1

2

Comm. related & LSI 10

Expansions and Investments

8

Auto & Industry related

1

2003–09

2003–09

Comm. related & LSI 10

Withdrawals and exits

NEC El (NEC)

Renesas Tech (Hitachi and Mitsubishi)

Table 4.2 Withdrawals and expansions (number of events)

1

1

4

4

2

2

2010–12

Renesas Electronics

1

7

4

1

4

2013–14

10

1

2

21

2

2015–17

4.2 The Case of Renesas 85

86

4 Slow Downsizing After Mergers of Individual Loss-Making Parts …

by establishing the subsidiary “Renesas Mobile” in December 2010. At the time, the third-generation (3G) communication standard was still mainstream. Renesas Mobile aimed to manufacture and sell semiconductors that enable advanced multimedia processing on smartphones in compliance with LTE, which was the next highspeed communication standard. Only QUALCOMM and ST Ericsson of Switzerland were able to supply such products, so Renesas aimed to break down the strongholds of the two companies.5 It acquired wireless modem business from Nokia of Finland for about 18 billion yen and accompanying 1100 employees because Renesas lacked appropriate modem technology. The company’s business, however, did not grow sufficiently and had continued deficit without breaking the momentum of QUALCOMM. It announced the suspension of its business in June 2013.6 Another case we might note is the establishment of “Access Network Technology” in which NEC participated, although Renesas was not directly involved. It is a manufacturing company of LSI for mobile terminals launched mainly by Fujitsu in 2012. Fujitsu’s equity stake in the new company was 62%, NTT Docomo’s 20%, and NEC 18%. The new company attempted to manufacture semiconductors controlling the wireless communication of mobile phones, the so-called baseband chips. However, as Samsung Electronics, which was initially supposed to participate, did not participate, sufficient development budget could not be secured. As it failed to make progress in product development, it was forced to liquidate in just a year and a half. Another disadvantageous factor was a setback in the Chinese market where the annual sales of smartphones reached 400 million units. Renesas failed to overturn its inferiority to Qualcomm and MediaTek. The predominant rivals distributed a large number of design blueprints, called “reference design”, that made it easy for local terminal manufacturers to assemble smartphones using their semiconductors. This was leading to the expansion of semiconductors sales. Renesas could not have such a “reference design” sales system.7 After all, in the field of communication semiconductors, Japanese companies could not compete with leading overseas manufacturers either in development or in marketing. It can be judged that they have stuck to a battle with a poor winning chance.

4.2.5 Discussion and Conclusion In this study, we have traced the trajectory of Renesas’s difficulties and its resurgence. The most noteworthy thing is its prolonged deficit in the net income for nine years under distorted governance. Normally, such a distressed firm would terminate lossmaking businesses and remove the top management from office. It did not let go of the system LSI businesses that were presumably a principal cause of the deficit until it 5

Nikkei, January 1, 2011. According to the Financial Statement in March 2014, its liability exceeded ¥40.9 billion. 7 Nikkei, August 2, 2012. 6

4.2 The Case of Renesas

87

became under the control of Innovation Network Corporation of Japan (INCJ). Even when faced with deficit, the top management was peacefully replaced by successors from parent companies who held the majority of its shares. Criticism may be directed toward the listing of parent/subsidiary pairs. In fact, NWQ, a U.S. investment management firm, which had a stake of the former NEC El, demanded its withdrawal from the LSI business and stepped up its attack on Renesas’s management who could not manage the company on their own. Blackstone and Warburg Pincus, famous U.S. buyout funds, proposed an MBO to NEC EL. In retrospect, an MBO could have been a golden opportunity for NEC EL. to revive. NEC that held 65% of the shares, however, declined the proposal.8 We could present a counterexample of Europe, which made a quick recovery from stagnated semiconductor business. One good counter-example is the separation of semiconductor sector by Philips. It became independent as NXP Semiconductors, with 80% of its shares being held by investment funds.9 Phillips lowered the shareholding ratio to less than 20% and gave away the control of the firm. As a result, NXP managed to turn EBIT into a surplus even in 2010 when the Lehman shock subsided (Fig. 4.3). Philips, which separated the semiconductor business, also strengthened medical related business through M&A, which would become one of its leading profitable sectors. Philips also handed over the remaining shares of NXP shares in 2010, withdrawing from mobile phones, televisions, and liquid crystal panels. In 2013, the company removed “Electronics” from the official company name Royal Philips Electronics, and the company name became Royal Philips. It managed to quickly give up on the semiconductors business that the U.S. and Asian manufacturers were gaining dominance over and replaced it with a business that can generate profit. This is in contrast with NEC, Hitachi, Mitsubishi, and Renesas that continued to invest in deficit business for a longer time. Philips’s revitalization of the semiconductors business suggests that the role of turnaround funds is important for rebuilding a deficit business. Even in the case of Renesas, the fact that the management moved to an investment fund, Innovation Network Corporation of Japan (INCJ), became a trigger for urging the departure from the chronic deficit. A doubt still remains as to whether the government-funded fund can effectively monitor the business. It is difficult to evaluate its role in business turnover solely by Renesas’s case. However, it can be said that INCJ managed to terminate deficit businesses by eliminating the influence of the parent companies on Renesas, which had no independence as a listed company and whose internal governance was not functioning properly. Factors that prevented Renesas from terminating deficit businesses may be a curse on successful companies. The Japanese electronics industry once overwhelmed the world as if it had no enemies overseas. In particular, NEC, one of the parent companies of Renesas, is a company that has blossomed in the telecommunication and semiconductor fields. In the 1980s, it became the world leader in semiconductor production, 8 9

Nikkei newspaper dated March 8, 2007. See https://media.kkr.com/static-files/bb9fe40d-d172-4b1f-861f-90ee02e4b6ea.

88

4 Slow Downsizing After Mergers of Individual Loss-Making Parts …

and in 2001, it occupied the top position in the domestic market share of mobile phones. The contrast in the communication and LSI field, where the former NEC Electronics had a stronger expansion stance than the former Renesas Technology, may be rooted in NEC’s past success in the same field. In the former Renesas Tech., cases of withdrawal and expansion in the field were comparable, while the former NEC El. was entirely devoted to expansion. NEC presumably had successful experiences and overconfidence in the field. The newly established Renesas remained stubbornly attached to communication and LSI businesses. In 2010, it acquired Nokia’s wireless modem business and aimed to develop LSI for mobile terminals. Fujitsu, almost a twin company of NEC and a “family member of the former Nippon Telegraph and Telephone Public Corporation,” shared a similar “cursed” experience. It moved to establishing a new company of telecommunication LSI in 2012 that subsequently failed soon. Jensen (1989, 1993) argues that successful big companies tend to leave declining segments and avoid withdrawal from them until problems cannot be postponed. The top management would not dare to make employment reduction in the interest of shareholders and would let declining segments survive by spending cash flow on them. It can be said that Renesas is one of the typical examples of traps that successful companies fall in, as pointed out by Jensen. Issues we cannot fully clarify in this study include the following: (i) to what extent has a patched-together firm comprised of three companies hindered timely management judgment; (ii) how much improvement is achieved in producing varieties in smaller quantities that led to reducing their profit margin in the course of restructuring. These are difficult to fully assess by relying only on disclosed information. These are topics that we will attempt to discuss in future studies.

4.3 The Case of Japan Display Sony, Panasonic, Toshiba, Sanyo, Sharp, Kyocera, Mitsubishi, Canon, and SeikoEpson were, respectively, manufacturing LCDs in the 1990s, as happened with semiconductors. As they lost market share in end products such as smart phones and televisions, most Japanese LCD divisions were also suffering losses. In 2004, Epson and distressed Sanyo combined their LCD divisions as Sanyo-Epson Imaging Devices Corporation.10 Thereafter, the M&A of LCD business were repeated. In 2012, led by the Japanese government, loss-making mobile phone LCD divisions of major Japanese electronics companies were combined with the national LCD manufacturer, Japan Display Inc., to prevent foreigners from acquiring “Japan’s advanced technology of LCDs.”

10

Nikkei, March 24, 2004.

4.3 The Case of Japan Display

6 4 2 0 -2 -4 -6 -8 -10 -12

(%)

2013

89 Net Income

Operating Margins (Operating Income/Assets)

100 50

(Billion Yen)

Sharp JDI

0 -50

Sharp JDI

-100 -150 -200 -250

2014

2015

2016

2017

2018

-300 2013

2014

2015

2016

2017

2018

(Fiscal Year)

Source : NEEDS-FinancialQUEST. JDI's consistent financial results are only available since fiscal 2013 due to its adoption of Hitachi's display manufacturing subsidiary as a surviving company.

Fig. 4.8 Profitability of JDI and sharp

4.3.1 Overcapacity in the Industry Merely combining the loss-making small- and medium-sizes LCD divisions of major electronics companies did not result in a profitable company. Indeed, JDI was suffering losses at the starting point (Fig. 4.8) and faced international competition from Greater China makers such as Tianma, BOE, and AUO and Samsung, a Korean company. In 2014, Tianma’s shipments of low-end small- and medium-sized a-Si display products for smartphones ranked first among the global panel factories,11 while the share of JDI’s middle-high-end Low-Temperature Polycrystalline Silicon (LTPS) LCD ranked No. 1. In 2018, JDI’s ranking was pushed back to the second position, and Tianma ranked No. 1. The significant growth of Chinese smartphone makers, such as Huawei and Xiaomi, contributed to Tianma’s exponential growth. The entry of Chinese smartphone makers also would threaten Apple’s position. Nonetheless, JDI placed a bet on the growth of iPhone, Apple’s main high-end product. Irrespective of earning zero operating income in the accounting year 2014 (Fig. 4.8), JDI decided to build a smartphone LCD panel site (Hakusan Plant) in March 2015 with an advance received of 170 billion yen from Apple. iPhone 6 was a hit, and the both companies dreamed that iPhone sales will continue to grow in 2015 and 2016. However, the dream did not come true. As iPhone 6S sales slowed down in 2015, Apple turned to OLED panels to redesign the iPhone. Immediately, Apple decided that the Hakusan Plant was not needed and called for the cancellation of plant construction. However, at that point, the production equipment had already been ordered, and JDI would incur a huge cancellation fee. JDI’s board alone could not make the decision, and it needed approval by the largest shareholder, INCJ, and the government. While the three parties were negotiating, factory building was almost completed. Consequently, the investment left FDI nothing more than overcapacity 11

China-based Tianma is ranked No. 1 in the smartphone LTPS LCD market, THEELEC, http:// en.thelec.kr/news/articleView.html?idxno=185.

90

4 Slow Downsizing After Mergers of Individual Loss-Making Parts …

and the advanced received owing to Apple, which resulted in debt overhang later and dissuaded new investors from providing new funds for turnaround. Apple is the dominant customer of JDI, while JDI is just one of the display suppliers. In 2012, a Japanese display maker, Sharp, and Apple built Kameyama First Plant for exclusive supply to the iPhone maker. JDI needs to compete with other suppliers, such as Sharp and Samsung. Even though iPhone 6S was a hit, JDI made losses due to overcapacity in the industry. Moreover, the heavy reliance on iPhone also restricted development in marketing. Sharp was not allowed to utilize Kameyama No.1 Plan to supply panels to smartphone makers other than iPhone, because Apple was warrying of Sharp’s supplying panels to its biggest rival, Samsung Electronics. As the price of large TV panels continued to fall, Sharp shifted to smalland medium-sized businesses with high profit margins, and it mass-produced the world’s first energy-saving panel for smartphones, the IGZO in the Kameyama No. 2 Plant in 2012. It was adopted for ZTE’s high-end smartphone in 2013. To diversify customers, the company entered into negotiations with Apple to produce it for other smartphone makers in the Kameyama No. 1 Plant, which was Apple’s exclusive factory. In 2014, Sharp sought to acquire Apple’s stake in the Kameyama No. 1 Plant. Moreover, the company attempted to renegotiate terms so that it can supply panels to customers other than Apple. One year later, Sharp was allowed to produce LTP panels for Chinese smartphone makers. JDI was involved in a price competition with Sharp. Since the accounting year 2014, both Sharp and JDI were suffering losses irrespective of the success of iPhone 6. Figure 4.9 indicates aggressive downsizing in assets and core employees in Sharp, while JDI was expanding irrespective of losses. In March 2016, deeply distressed Sharp at last was acquired by Hon Hai Precision Industry Co., Ltd (Foxconn Technology Group), the world’s largest electronics manufacturing service. It is the first Japanese major electronics company acquired by a foreign company. Thanks to the prompt restructuring led by the new owner (Fig. 4.9), Sharp quickly recovered as Fig. 4.8 indicates. In contrast, JDI has been suffering prolonged losses due to slow downsizing in response to industrywide excess capacity. Assets (Trillion yen) 2.2

2.2

Sharp

2.1

JDI

2.0

0.8 2.0

1.9

Employees(Thousand) 1.0 55.0

0.9

2014

2015

0.5 2016

14.0 13.2

2017

43.5

0.6 43.0

1.6

0.5 40.0

2018

Source : NEEDS-FinancialQUEST Fig. 4.9 Employment and assets of JDI and sharp

17.0 54.2 16.0 15.0

49.1

0.7 46.0 0.6

Sharp

15.7

1.9

1.8

1.7

1.5 2013

JDI

50.3

0.8 49.0

1.9

0.8

1.6

16.0

0.9 52.0

0.8

1.8

17.0

47.2

11.5 41.9

13.0 12.0 11.0 10.110.0

2013

2014

2015

2016

2017

2018 (Fiscal year)

4.3 The Case of Japan Display

91

Things were getting worse in JDI. In 2017, Apple adopted OLED panels for iPhone X premium, and this reduced JDI’s sales to Apple. Ironically, Samsung, which was excluded from Apple’s supply chain, has been supplying OLED with a dominant position in the global premium screen market. Due to the sharp drop in orders for smartphone panels, JDI was struggling with cash flow, and the company requested financial support from INCJ. INCJ agreed to provide financial support of ¥75 billion for JDI to shape on a new business model scale utilizing its patents and development of OLED.12 At the same time, an overseas parts assembly subsidiary was sold to a Chinese company, and the plant in China was reorganized. As a result, the number of employees, which was 15,572 at the end of March 2016, was expected to decrease by 30% to 10,986 at the end of March 2017. The domestic plants only reduced personnel of 636 employees. It is notable that it seems much more difficult to lay off domestic employees than to reduce overseas employees. JDI decided to stop the outdated plants and recruit domestic retirees in March 2016. However, “waiting” came from an unexpected place. Employment, in particular, is an economic indicator emphasized by the administration. INCJ was oversensitive to employment adjustment by the national display company. The restructuring plan was “half-finished,”13 as indicated in Fig. 4.9.

4.3.2 Debt Overhang JDI has been prolonging losses and five consecutive annual losses drained its equity capital. The new plant did not contribute to sales and became an impaired asset. At long last, it had to turn to foreign investment funds. In July 2019, the company announced that it finally secured the 80 billion yen bailout plan from a Greater China investment group, activist investor Oasis Management, and an unnamed JDI customer, which is likely to be Apple. Two months later, unfortunately, the Harvest Group canceled its plans to invest in Japan Display. In the 2018 accounting annual report and the 2019 first quarter accounting year report, the company already disclosed uncertainty about its ability to continue as a going concern due to the difficulty of raising new funds, in addition to poor operating performance. This is not surprising, however. In March 2019, JDI owed Apple about 100 billion yen with a covenant trigger, which gave Apple the right to request full repayment or foreclosure of Hakusan plant once JDI’s cash holding is below 30 billion yen.14 New investors have little incentive to provide funds because new money and earnings would mainly go to Apple. This is known as debt overhang. According to insiders in the investment funds, renegotiating repayment conditions for Apple was necessary for injecting funds into JDI. Just before the end of the 2018 accounting year, INCJ’s Chairman Shiga and related government officers 12

Nikkei, December 22, 2016. Nikkei, August 7, 2017. 14 Nikkei, April 23, 24, 25, 27, 2019. 13

92

4 Slow Downsizing After Mergers of Individual Loss-Making Parts …

visited Apple’s headquarters to negotiate covenant trigger. On March 23, 2019, Apple disregarded the request since it adopted OLED panels in 2017. At that time, only Samsung Electronics Korea (currently Samsung Display) was able to mass-produce OLED panels. The iPhone maker bought OLED from Samsung and LG Display. To win price cuts from the South Korean suppliers, Apple tested BOE’s flexible OLED displays, according to sources.15 The entry of BOE as an OLED supplier could give Apple more bargaining power over the South Korean suppliers. BOE began producing flexible OLED screens at the end of 2017 and also supplied advanced displays to Huawei’s revolutionary Mate X smartphone. JDI would have been involved in a price competition with other suppliers even if the company had successfully developed OLED. The Board of JDI on June 12, 2019, decided to shrink the mobile business, which was unlikely to witness a significant recovery in demand, and to suspend the operation of the Hakusan Plant. It has been decided to close the post-processing line of the Mobara Plant. At the same time, the company reduced personnel and cut back on executive remunerations and the wages of employees. In December 2019, the company announced a new bailout plan from Ichigo Asset Management to invest up to $830 million in Japan Display. Several days later, it turned out that the company was suspected of having capitalized an excessive inventory of about 10 billion yen due to inappropriate accounting allegations by a former accounting executive, according to the Special Investigation Committee. However, the Special Investigation Committee consisted of JDI’s executive officers and thus was lack of independence. The details will be investigated by a third-party committee consisting only of external experts. At the same time, JDI is negotiating selling its flagship Hakusan Plant to Apple and Sharp. The plant has been suspended since July 2019 due to sluggish operation to improve its financial position. Nonetheless, Sharp is carefully examining the benefits and risks arising from the acquisition.16 With this movement, no one can predict whether JDI will be bailed out.

4.3.3 Discussion JDI is a single-segment company specializing in small- and medium-sized LCD. Similar to Renesas, consecutive annual losses since the starting point suggest the difficulty of downsizing and merging the loss-making LCD divisions of major electronics companies. Rather, the company easily invested in Hakusan Plant and betted on Apple irrespective of losses and declining profitability. At the same time, Sharp

15

Apple puts China’s BOE to test for cutting-edge iPhone screens by CHENG TINGFANG, LAULY LI, SHUNSUKE TABETA, and KIM JAEWON, August 21, 2019, Nikkei Asian Review (https://asia.nikkei.com/Business/China-tech/Apple-puts-China-s-BOE-to-test-forcutting-edge-iPhone-screens). 16 Nikkei, December 27, 2019.

4.3 The Case of Japan Display

93

has been shifting from large-sized LCD to small- and medium-sized LCD for smartphones since 2012. The investment would only increase Apple’s bargaining power to win price cuts from Sharp and JDI. The JDI management and INCJ did not recognize this point, however. Although sales to Apple substantially increased for a while, profitability never improved. Even if the Hakusan Plant turned out impaired assets, drastic downsizing was hindered by the administration’s oversensitivity to personnel reduction in the government-controlled company. Even worse, JDI window-dressed its operating income during the 2015 and 2016 accounting years.17 JDI turned out to be a zombie firm, but it has been supported by INCJ. Due to debt overhang, however, the financial support would mainly go to Apple, which provided the advance received with covenant trigger. This is the valid reason why the Harvest Group canceled its bailout plan for Japan Display. Outside investors have little incentive to provide new funds unless Apple subordinates its claims to bail out JDI. The fate of JDI depends on its importance to Apple. The easy financial support by INCJ mainly benefitted employees and Apple rather than helped FDI. Fortunately, Apple dramatically launched measures to help JDI, including a longer down payment period, more orders, and shorter payout sites, and has promised up to $200 million conditional funding, according to sources. This helps FDI to seek new funds. Although the specific terms have not yet been decided, Ichigo will have more than 50% of the voting rights, and Mr. Caron will be the chairman and will lead the restructuring process.18 INCJ’s zombie lending to JDI is not surprising because the main purpose of merging loss-making smartphone screen manufacturing divisions was only to prevent foreign investors and foreign companies from taking over “Japan’s advanced technology.” However, we have shown that Apple is the biggest beneficiary to keep JDI alive. In contrast, Sharp and JDI were suffering losses, and this proves that the so-called Japan’s advanced technology did not contribute to the profitability or productivity of Japanese LCD makers. It was nothing but a mirage to survive with growing Apple. The problem lies in the fact that JDI relies on Apple, but JDI is not so essential to Apple. In particular, iPhone’s demand for LCDs is declining due to the recent widespread adoption of OLED displays by smartphone makers. Although Japan is alert to foreigners acquiring Japanese electronic technologies, more and more restructured talented engineers in distressed Japanese electronics companies are reemployed in South Korea and China since the late 1990s. At the same time, electronics giants such as Hitachi, Sony, and NEC have been reducing employees. This suggests that intensive R&D was not affordable for these companies. The restructured Japanese core human resources have played a leading role in the rapid development in technology in China and South Korea.19 Indeed, since 2017, ironically, Apple has been considering purchasing Samsung’s OLED, but in 2014, the iPhone designer did not allow Sharp to use its jointly owned Kameyama No.1 17

Asahi, January 10, 2020. Reasons why “JDI” in the business crisis is still not crushed by Yudai Yamada, Toyokeizai, December 28, 2019, in Japanese (https://toyokeizai.net/articles/print/322308). 19 Nikkei, October 7, 2016, December 7, 2016. 18

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Plant to supply smartphone screens to Samsung, that is, Apple’s rival. Moreover, Chinese LCD makers have been rapidly catching up with technology. As a result, the business environment surrounding JDI has become increasingly severe, as stated in the Management Discussion and Analysis of the 2018 accounting year annual report. However, it is too late to realize that its technology is already outdated. Nonetheless, it is still unquestioningly believed that Japan needs to prevent its polished and accumulated LCD technology from flowing overseas, due to concerns about the fact that the basis for economic growth must be weakened if the technological capabilities of Japanese companies, such as Sharp, continue to flow overseas. However, such fears are needless. Apple has been achieving substantial growth in iPod, iPad, MacBook, and iPhone, but the company has been purchasing screens from JDI, Sharp, Samsung, and LG outside the United States. In spite of owning LCD divisions, Japanese electronics companies have lost their market shares in PCs and smartphones. Notwithstanding the lack of domestic LCD technology at an early stage, Samsung, Huawei, Xiaomi, Oppo, and Vivo have been catching up rapidly. This means that domestic LCD technologies are not necessary for economic growth. Now, this raises the following question: Why does Japan need to prevent foreigners from acquiring zombie firms in fear of technological capabilities flowing overseas? Facing this question head-on, Mr. Yokoo, the new president of Japan Investment Corporation (JIC), that is, the parent company of INCJ, stated that JIC will never bail out companies that ought to exit in September 2018.20 In 1998, Japan’s share in the global LCD market was 70% in terms of production capacity. Only five years later, Japan lost its glory, and South Korea ranked top (Nakata, 2005). However, employment considerations have been hindering the prompt M&A of in-house LCD business. Even in 2012, Sharp, Mitsubishi, and Kyocera did not join JDI probably because they were somewhat profitable. Consequently, merging non-profitable LCD divisions led to a weak firm due to intensified price competition among LCD manufactures, and weak JDI cannot afford intensive R&D expenses. Therefore, it must not go on forever clinging to past glories.

4.4 Conclusion Merging non-profitable semiconductors businesses resulted in a weak Renesas. Irrespective of losses, Renesas hesitated to take drastic restructuring measures. Led by INCJ, Renesas conducted drastic downsizing in employment and achieved recovery. In addition, Sharp carried out drastic restructuring soon after Foxconn’s acquisition, and its performance has improved. In contrast, JDI has been suffering prolonged losses due to the administration’s employment considerations, that is, the lack of drastic downsizing. At long last, JDI implemented an additional early retirement program and 1200 employees resigned in 2019.21 The key factor is prompt 20 21

Nikkei, September 26, 2018. Nikkei, January 13, 2020.

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downsizing, in particular, employment adjustment in response to industrywide overcapacity. Nonetheless, diversified Japanese electronics companies were more likely to forebear prompt downsizing in loss-making segments until the problem became unresolvable, as shown in Chaps. 2 and 3. Apple specializes in R&D and leaves production to set makers. Rather than developing and manufacturing parts and basic technologies itself, the iPhone maker purchases standardized items from specialized parts manufacturers. EMSs and foundries can supply products and parts at low cost while achieving economies of scale by making large-scale capital investments embedded with advanced technology in a short cycle. So far, a considerable number of Japanese electronics assemblers developed the technology of parts and components in-house, the so-called vertical integration model. However, the lack of economies of scale prevents individual makers from implementing cutting-edge technology and offering the cheapest prices, and they eventually lost market shares. Due to the progress in global supply chains, the presence of Japanese manufacturers has become minor in the era of mobile phones, which were in full swing since the latter half of the 1990s, and the subsequent expansion of smartphones starting with Apple’s introduction of iPhone in 2007. Similar changes took place to PCs, LCD televisions, and tablet computers. It is opportune to merge Japanese PC assemblers soon after the Compaq shock in the early 1990s (Dedrick & Kraemer, 1998). However, we could not see any attempts at M&A until 2011. Rather, Japanese electronics companies continued to waste internal funds on investment in their loss-making PC assembling segments. Likewise, it took a very long time for 11 Japanese mobile phone makers to downsize or exit, and now only three are still producing a small number of smartphones. In 2016, Sharp was acquired, and Toshiba sold its television business to Hisense Group in 2017 and its consumer electronics business to Media Group.22 It is a long journey for Japan to restructure electronics businesses due to employment considerations. At the same time, Japanese electronics companies needed to disintegrate their inhouse parts and components businesses such as semiconductors, LCD, and DRAM. After disintegration, there is a need to merge individual small shrinking semiconductor divisions. Merging individual unprofitable divisions in the same business such as DRAM, LSI, or display with excess capacity would prevent individual companies from continuing the misallocation of internal funds to loss-making segments. Again, however, employment considerations impede layoffs, resulting in wage costs that reduce synergy gains from takeovers. Consequently, it is too late to merge individual loss-making divisions when the problem was unresolvable. Such inopportune and easy collection did not give birth to a new profitable parts and components company. Thus, just merging without enough downsizing is far from the ultimate solution to overcapacity. Employment considerations lead to a low volume of M&A and inopportune M&A as well. Renesas and JDI are good examples of inopportune M&A of electronic parts and components businesses.

22

Nikkei, March 30, 2016, November 14, 2017.

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According to the three-digit standard industrial classification, both Renesas and JDI are single-segment firms. Due to employment considerations, they did not downsize or exit promptly in response to prolonged losses. In particular, single-segment companies did not cut back on investment in spite of industrywide overcapacity. This supports our findings in Chap. 2 that Japanese single-segment electronics companies did not make more efficient investments than diversified electronics companies. Even when a bankrupt Japanese company is acquired, job security is still a main concern. At a press conference on the completion of acquisition of all shares of Elpida Memory on July 31, 2013, the former President Sakamoto said, “The common understanding of Micron and Elpida is to maintain employment ….” It is noteworthy that Renesas, Elpida, and JDI’s failures are anecdotal examples that demonstrate that employment considerations prevail irrespective of diversification or specification. Once INCJ took over distressed Renesas and successfully restructured its business by initiating drastic downsizing in employment. However, the inopportune and easy merging of loss-making LCD divisions led by INCJ did not result in a new sustainable company. Irrespective of losses after M&A, JDI expanded production capacity rather than downsizing. Moreover, the company failed to drastically downsize its workforce promptly even when the new plant turned out impaired assets. At last, foreign investors withdrew the bailout plan due to debt overhang. However, INCJ supported loss-making JDI without timely employment adjustment, probably pressured by the government to maintain employment of the national display company. If the slowdown in due to a prolonged smartphone lifecycle, overcapacity in the smartphone industry, the new entry of Chinese display manufacturers, and the widespread adoption of OLED by smartphone makers are responsible for the declining sales and consecutive losses. If JDI has the “real technology” that customers want, the company will be bailed out. Now, it is time for INCJ to leave JDI to the capital market. Sony quickly recovered after drastic downsizing during 2013–2015. Downsizing and redirection are the only solution to industrywide overcapacity and changes in technology. More and more Japanese companies have learned lessons from the difficulty of downsizing. In 2019, 35 companies implemented a voluntary early retirement program, and 20 companies were not suffering losses.23 Different from the all-atonce massive layoff of distressed electronics companies around 2013, a profitable company is able to compensate voluntary retirees more. Also, it is much easier for voluntary retirees to seek a job in a nonrecession period than in a recession period. Thus, such timely employment adjustments by profitable companies in a nonrecession period are also in the interests of employees in comparison with all-at-once massive layoffs in a recession period. Moreover, timely implementing early retirement programs would enhance the metabolism of human resources. This would also lead to improvement in the profitability and comparative advantage of Corporate Japan. In short, timely downsizing and exit are the only way to prevent Japan’s technology from flowing overseas.

23

Nikkei, May 26, 2016, January 13, 2020.

References

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References Arikawa, Y., Inoue, K., & Saito, T. (2019). Corporate governance, employment, and financial performance of Japanese firms: A cross-country analysis. Available at SSRN: https://papers.ssrn. com/sol3/papers.cfm?abstract_id=3312515. Dedrick, J., & Kraemer, K. L. (1998). Asia’s computer challenge: Threat or opportunity for the United States and the world? Oxford University Press. Jensen, M. C. (1989). Eclipse of the public corporation. Harvard Business Review, 67(5), 61–74. Jensen, M. C. (1993). The modern industrial revolution, exit, and the failure of internal control systems. The Journal of Finance, 48(3), 831–880. Nakata, Y. (2005). Why is Asia Pacific so strong in liquid crystal display industry?: Approach from industrial architectures of liquid crystal display. In Proceeding of PICMET’05 (Portland International Conference on Management of Engineering and Technology, August, 2005, USA) Ozbas, O., & Scharfstein, D. S. (2010). Evidence on the dark side of internal capital markets. Review of Financial Studies, 23(2), 581–599. Saruyama, S. (2018). Do withdrawals improve subsequent corporate performance? Hosei University’s Bulletin of Graduate School 111–125. (in Japanese). Shin, H. H., & Stulz, R. (1998). Are internal capital markets efficient? Quarterly Journal of Economics, 113, 531–552.

Chapter 5

Final Remarks

Abstract In this chapter, we will summarize the lessons learned from the two lost decades. Successful Japanese electronics companies were experiencing steady decline in the early 1990s, but they continued to invest in declining segments to maintain employment. Ultimately, employment adjustments were frequently made till the first half of the 2010s, to resolve overcapacity problems that were abandoned in the first lost decade. Japan has been constantly facing new entrants and technological changes. As fruitful outcomes of the massive downsizing in the electronic products unit, some companies have achieved concentration in core competence and their performance has improved. However, most declining electronics companies are still struggling. Worldwide new entries and technological changes are taking place in many industries after the two lost decades, and it is still a major issue to prevent profitable companies that are beginning to fade from easy investment and outdated R&D. Instead, labor market reform, capital market reform advocating investment activism, spinoffs, M&A, buyouts, open innovation, and corporate venture investment are necessary to regain technological advantages and to acquire the seeds of growth. Keywords Two lost decades of the Japanese economy · Electronics industry · Zombie firms · Excess capacity · Technological changes · Employment practices · Exit · M&A · Regulation · Startups

5.1 Lessons Learned from the Two Lost Decades of Japan In this book, we examined Jensen’s (1989) prediction that successful Japanese companies would repeat the failure of the most well-known U.S. companies in the 1980s. Technology and the economic environment are constantly changing. In response, companies need to promptly introduce changes. GE successfully achieved All remaining errors are our own. Any opinions, findings, or conclusion expressed in this book are those of the authors and do not reflect the views of the Development Bank of Japan or the authors’ affiliations.

© Development Bank of Japan 2021 S. Saruyama and P. Xu, Excess Capacity and Difficulty of Exit, Development Bank of Japan Research Series, https://doi.org/10.1007/978-981-16-4900-4_5

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Early Voluntary Retirement 250

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Fig. 5.1 Downsizing in employment in Japanese listed companies during 2000–2018

concentration in core competence in the 1980s, but most U.S. companies failed (Jensen, 1993). Likewise, the most well-known Japanese electronics companies failed to downsize and exit properly. Regardless of the decline in profitability after 1990, segment investment in electronics companies increased with segment employment irrespective of segment operating profitability. Investment in loss-making sectors to maintain employment not only destroys corporate value but also is not in the employees’ best interest. As shown in Fig. 5.1, eventually, Japanese companies had to launch early voluntary retirement frequently during the second lost decade, to resolve overcapacity problems that were abandoned in the first lost decade. Zombie investment crowds out the entry and investment of healthy peer firms, as indicated by Caballero et al. (2008). However, overcapacity is more of an industrywide problem than a zombie firm’s problem. Zombie firms must dramatically undergo restructure, and healthy peers should refrain from investment. What is much more important is that investment in loss-making electronic devices and components businesses hinders the reallocation of human resources to high-growth ICT service businesses. As a consequence, the lack of investment in ICT in Japanese companies leads to prolonged productivity stagnation. As shown in Chap. 2, investment in NEC’s deficit devices division hindered the growth of its IT and network sector. Even now, only 32% of large firms are engaged in sales via e-commerce, compared to an OECD average of 43%, and a relatively small number of workers take up ICT task-intensive occupations since 2011 (OECD, 2019). This suggests that sluggish downsizing in the electronics industry crowded out investment in ICT business, and this, in turn, has a long-term negative effect on digital transformation in Japan. It is worth noting that it is more likely that investment made by highly profitable companies in declining sectors leads to overcapacity. Moreover, it is too late to leave profitable but low-growth companies alone until they turn into zombies. Following the electronics industry, the machine tool industry is also facing new entries and technological changes. Universal Robots, a Denmark startup founded in 2005, launched collaborative robots and entered the market in 2008. The company was acquired in 2015 and became a new platform for the growth of TERADYNE INC. After seeing

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the great potential of collaborative robots, Fanuc and other major Japanese robot makers have entered the market. In addition, China’s SANY was founded in 1989, and it has emerged as one of the top construction machinery companies, along with the U.S. Caterpillar and Japan’s Komatsu. At the same time, Japan’s Komatsu and Hitachi Construction Machinery have been largely losing their market share in China since 2000 due to the rise of the cheap and high-quality products of SANY. According to the Nihon Keizai Shimbun’s report (January 20, 2020), Japan’s share in the global robotic industry has declined since 1990. More recently, Fanuc’s operating profit margin also is in steady decline from 40% in 2014 to 15% in 2019. The decline in profitability is directly attributed to the heavy depreciation of aggressive investment after 2015. On February 11, 2015, the morning edition of the Nihon Keizai Shimbun reported that Third Point had acquired a stake in the company, and on February 12 morning, the fund had demanded a share buyback. It is reasonable for the company to repurchase shares. Unfortunately, Fanuc also doubled its investment plan after the Third Point challenge. Regardless of aggressive investment, sales have not increased significantly, but profitability has deteriorated since 2015. The company should have rejected the demand for increase in investment. If the decline in profitability is attributable to the rise of the products of industrial peers and new entrants, possible strategies for Fanuc are as follows. First, it is a quick and feasible method to divest or downsize in manufacturing low-margin products for concentration in core competence. In particular, the company should figure out products that are less competent and vulnerable to new entrants. In addition, M&A can be used as a growth strategy without the expansion of industrial capacity. In particular, Fanuc should acquire the seeds of growth. There are a considerable number of robotic startups around the world. In 2018, to boost its new business, Fanuc acquired a collaborative robotics startup to pursue outside knowhow. If organizational changes are necessary for Fanuc, an LBO can be a solution. Jensen (1989, 1993) stresses that LBOs, leveraged restructuring, and takeovers dramatically improved organizational efficiency in low-growth or declining U.S. firms in the 1980s. A considerable number of public companies in Japan were bought out via MBO after 2000. Fanuc was started as an in-house venture in Fujitsu in the 1950s and was spun off in the 1970s. If the organizational efficiency has been lost in Fanuc, now it is may be a good choice for the company to go back to the beginning. Fanuc can use an LBO as an opportunity for a second startup. To bring in new technologies and regain technological superiority, it is better to engage in open innovation with venture companies and startups and expand corporate venture investments. Moreover, it is important to launch incubation programs for experimentation of early-stage projects. Organizationally, it is much more efficient for venture companies to create destructive technologies than established public held corporations (Jensen, 1989, 1993). Although Fanuc is still a reputable and highly profitable company, the lesson learned from the two lost decades is that expansionary investment and easy R&D in the same manner as before will only lead to another lost decade. In Chap. 3, it is shown that profitability and assets turnover ratios decrease with investment or growth of sales in declining firms. The so-called main bank system does not work anymore, and banks themselves have to resolve banking problems.

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The pressure exerted by the U.S. investment fund, Third Point, accelerated Sony’s downsizing and restructuring. Likewise, Fanuc is a low leverage and highly profitable company, but its profitability is in steady decline. It is not surprising that low-growth profitable firms that have abundant cash flow are less likely to resort to bank debts. Thus, banks can do nothing and the best solution is the pressure of capital markets such as shareholder activism to require share repurchases in such cases. Furthermore, EV makers are emerging. On July 1, 2020, Tesla has become the most valuable automaker. Moreover, it is highly possible that Apple will design EV in the near future as it designs iPhone now. The rise of EV products in Tesla and other emerging EV makers and Apple’s potential entry into the EV market are likely to contribute to overcapacity in the automobile industry worldwide. In this sense, conventional automakers do not have many growth opportunities in assembling gasoline cars even if they are still profitable. If investors’ bet on electric vehicles comes true, there would be severe excess capacity and employment destruction in the traditional gas car and diesel car business. Even worse, well-known automakers may have to quickly exit from manufacturing hybrid cars and hydrogen automobiles in the near future. Potentially, there will be overcapacity in the automotive industry worldwide. This is the valid reason why Toyota invests conservatively and repurchases more shares. Even if industrial robotic makers and automakers look healthy after the second lost decade, managers should recognize that it is more likely that the massive expansion of employment and investment drives down profitability as can be seen from the failure of electronics companies. Japan’s electronics giants enjoyed high profitability due to having the advantages of quality, cost, and technology in the 1980s. The decline in profitability after 1990 is attributable to new entrants and technological changes, and new entrants had the advantages of quality, cost, and technology. Thus, investment in incumbent companies that are losing advantages only leads to overcapacity and further decline in profits. Probably, such firms hold more cash rather than spend money on investment in plants and equipment to prepare for the shortfall of cash flow in the future due to rapid technological, regulatory, and economic changes. In early 1990s, there was apparent overcapacity in the electronics industry, but companies continued to invest in declining businesses to achieve job security, and ultimately they lost global market positions and employment. We believe that more and more Japanese managers have learned lessons from the failure of electronics companies. This might be the reason for sluggish job creation and investment by healthy firms after the substantial decline in supposed zombie firms (Nakamura, 2016). Moreover, we should revisit the reason why the zero interest rate policy and bold monetary easing cannot stimulate investment in Japan.

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5.2 Policy Implications and Remaining Issues Policy makers, economists, and managers should recognize that investment in profitable but low-growth companies would lead to overcapacity. Of course, Japan must pursue bold investment in reputable and high-growth firms to accelerate the metabolism of economy. Previous studies have identified zombie and non-zombie firms. More importantly, we need to shed light on investment and the subsequent performance of investment in profitable firms that are starting to fade and take precautions against easy investment in profitable but low-growth firms as early as possible. It is too late to leave reputable firms in decline alone until they turn out to be zombies. Although there are still many high-growth companies in Japan, more and more companies are facing upcoming regulatory, technological, and economic changes. Now, it is time for Fanuc, Komasu, Hitachi Construction Machinery, and Toyota Motor to introduce changes. For such firms, the only solution is to change themselves. Investment in low-growth and profitable firms may boost temporary growth but would lead to overcapacity. Rather, we should admire patient, conservative investment decisions in such firms. Instead of promoting investment in capital, we should use tactics to pursue the repurchase of shares, M&A, spinoffs, open innovation, incubation, organizational changes, and digital transformation. Most importantly, policymakers must adopt measures against excess investment and R&D in the same manner as before in profitable companies that are facing new entries and technological changes. Managers must always pay the utmost attention to the early warnings and signals of changes in the global markets. It remains a future topic to compare the performance of capital expenditures and R&D expenditures in high-growth firms and low-growth or declining profitable firms. One may argue that the failure of electronics companies is due to the lack of effective internal control over their boards dominated by insiders. Ironically, Sony’s board dominated by outside directors as today’s U.S. companies was not effective to make efficient decisions to downsize and exit. Foreign institutional investors with high ownership in major electronics manufacturers, including Sony, rarely demand their owned Japanese electronics firms to improve their management and performance, nor they express their dissatisfaction by selling shares following the Wall Street rule. This is consistent with the evidence in previous studies on remarkably powerless institutional investors in U.S. corporate governance. At the same time, non-performing loans and zombie lending are the consequences of overcapacity in the banking industry attributable to the financial deregulation in the 1980s. Banks wrongly expanded lending in response to their own overcapacity and their borrowers’ overcapacity. Rather, such financial system hindered startups in Japan till the 1990s. In sum, isolated from the pressure of the capital market, Japanese managers were able to generate waste even when companies turned into zombies. Activist investors are different, however. Third Point has been demanding Sony, Fanuc and other Japanese companies to improve profitability and its demands have partially succeeded. So far, Japanese managers have been isolated from the capital market pressure due to Japan’s unique interlocking ownership structure. Since the

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late 1990s, failed Japanese banks were bought by U.S. private equity funds, and cross border investment played an important role in turnaround. In addition, U.S. activist investors like Steel Partners entered Japan and hosted several hostile takeovers as the Japanese economy had been sluggish for many years. Unfortunately, this ended up with takeover defense measures taken by Japanese firms under cross-shareholding. Steel Partners was criticized for being an example of abusive acquisitions, and Japan lost an opportunity to activate its capital market to pressure profitable companies in decline to downsize and exit early on. To boost stock prices, the second Abe administration implemented a series of corporate governance reforms including Japan’s Stewardship Code and Corporate Governance Code. Japanese managers are required to reduce cross-shareholdings or to explain the cross-shareholdings policy. Corporate governance reforms help activist investors make a comeback. Activist investors’ demand for share buybacks and spinoffs would prevent such firms from generating waste, as Third Point has been doing. At the same time, activist investors must be cautious that demand for investment in capital can be a wrong tactic. Employment considerations are the major reason for the difficulty of exit. Japan needs to reform its labor market. Of course, employers are important stakeholders. However, investment in declining firms to maintain employment is not in the employees’ best interest. Sooner or later, the company has to launch early voluntary retirement as it turns into a zombie. Moreover, a company has to cut back on new hiring to maintain expensive senior employment. Recently, it is difficult for Japanese firms to secure highly skilled young human resources because young employees can only be paid low wages under seniority-based wages. In particular, knowledge and skills of AI and big data are necessary to make changes in Japanese electronics companies but no incumbent employees have such knowhow. In addition to senioritybased wages, the lack of mobility in the labor market hinders Japanese companies to hire skilled workers in response to rapidly changing technologies and global markets. Such employment practices hindered changes in Japanese electronics companies in response to the PC revolution in the early 1990s (Dedrick & Kreamer, 1998). It is essential to retrain employees in core segments that are beginning to fade and move them into high-growth sectors. Moreover, prompt early voluntary retirement offers with more additional retirement benefits during boom times, rather than adjusting employment during recessions, are more helpful for senior employees to find new jobs or start their own businesses. After 2013, the considerable depreciation of the yen after the second Abe cabinet reduced relative labor costs in Japan and contributed to the recovery of export industries and inbound investment. In addition, Japan has been attempting to change its seniority-based employment practices. During the 2019 economic boom time, a considerable number of non-loss-making Japanese companies launched early voluntary retirement programs. Moreover, recently, several major electronics and IT companies, such as Sony, are offering much higher payrolls than seniority-based wages to attract young AI engineers and data scientists from the world. As the fruitful outcome of the massive downsizing in the electronic products unit, Sony has achieved concentration in core competence and its performance has improved. However, most declining electronics companies are still struggling. At

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the same time, many profitable companies withhold investment due to decline in profits and market share, attributable to the rise of global peers and new entrants. Bessembinder (2018) shows that the value created by the 4% of the best-performing listed companies explains the net gain of the entire U.S. stock market. In other words, the U.S. economic growth is driven by a small number of high-growth companies such as Microsoft, Apple, Cisco, Amazon, and Tesla. Startups in the United states also have contributed to the survival of Fujifilm, Kodak’s rival. After the decline in film business, the company expanded its healthcare business by buying up foreign young firms including U.S. startups founded in the 2000s. In contrast, the entry rate in Japan has declined since 1960, and we expect to see many fast-growing startups that can take the place of declining electronics companies. The strict regulatory constraints on capital markets hindered entrepreneurial startups till the 1990s, and the conventional bank-centered financial system is also responsible for the two lost decades. For a long time, the Japanese government has been eager for deregulation and liberalization. So far, it has made limited progress in some policy areas important to new businesses. For example, Japan has strict regulations regarding ridesharing, and Uber has to cooperate with local taxi companies. The U.S. technology company has focused on growing food-delivery business. Interestingly, taxi drivers (passenger transport) were not allowed to enter the food-delivery (cargo transport) business in Japan until the COVID-19 pandemic. During the pandemic, many taxi operators had to shut down their business. However, there has been a growing need for food-delivery services. In response, in May 2020, the Mistry of Land, Infrastructure, and Transport (MLIT) decided to exceptionally allow food delivery by cabs till September 2020. Thanks to this exceptional measure, more than 1000 taxi operators have obtained permissions to enter the food-delivery business. Users and taxi drivers all benefit from this deregulation and no one loses. Consequently, in September 2020, the exceptional measure was extended permanently (https://www.mlit.go.jp/report/press/jidosha04_ hh_000220.html). However, the MLIT constantly monitors the situation, and entry permissions can be revoked. At the same time, Japan exceptionally loosened control over online doctor visits as the outbreak hit hospitals in April 2020 (https://www. mhlw.go.jp/content/R20410tuuchi.pdf). Conventionally, regulations in Japan have aimed to protect incumbent domestic producers, and the government has been slow to loosen its control over the banking industry, transportation industry, and healthcare industry. Indeed, the strict control over transport industries has minimized competition, and this means unbelievable high prices for taxi services. In particular, the pandemic has exposed the harmful effects of these regulations. Due to these regulations, companies failed to make prompt changes in response to the COVID-19 outbreak. More importantly, such regulations and controls over entry have hindered the efficient allocation of resources, innovation, digital transformation, and startups. Facing upcoming technological changes such as autonomous driving, Japan should be more and more eager for deregulation to enhance proper changes in incumbent companies and startups. For the past 150 years, Japan has caught up with the global market by introducing and improving advanced technologies from Western countries. Now, Japan needs to

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create its own destructive technologies or to absorb new technologies from outside. In the 1980s, R&D expenditures in many well-known U.S. companies created losses (Jensen, 1993). Today, ventures and startups have been emerging as organizations more suitable for innovation. Acquisition and development are a quick way to bring in new technologies rather than easy in-house R&D. Fujifilm may be a good example. Additionally, corporate venture investment is much better than investment in plants and equipment in profitable firms facing major technological changes. In addition, Japanese companies need to transform their innovation architectures. Toyota, Japan’s automaker giant, has launched open innovation programs by inviting ventures. If inhouse innovation is not efficient, spinoffs of in-house ventures that have already been launched may lead to more startups. Moreover, it is important to constantly launch early voluntary retirement programs particularly during boom times as an incubation program would foster startups and innovation. We should always keep in mind that easy investment in capital and outdated R&D expenditures in companies facing new entrants and technological changes would drive down profitability and lead to overcapacity.

References Bessembinder, H. (2018). Do stocks outperform treasury bills? Journal of Financial Economics, 129(3), 440–457. Caballero, R. J., Hoshi, T., & Kashyap, A. (2008). Zombie lending and depressed restructuring in Japan. American Economic Review, 98(5), 1943–2197. Dedrick, J., & Kraemer, K. L. (1998). Asia’s computer challenge: Threat or opportunity for the United States and the world? Oxford University Press. Jensen, M. C. (1989). Eclipse of the public corporation. Harvard Business Review, 67(5), 61–74. Jensen, M. C. (1993). The modern industrial revolution, exit, and the failure of internal control systems. The Journal of Finance, 48(3), 831–880. Nakamura, J. (2016). Japanese firms during the lost two decades: The recovery of zombie firms and entrenchment of reputable firms. In Springer briefs in economics: Development Bank of Japan research series. Springer. OECD (2019). Promoting digitalisation, harnessing digital transformation for Japan’s economy and society. Japan Policy Brief. https://www.oecd.org/policy-briefs/Japan-Policy-Brief-Digitalis ation.pdf.