FACED with a shrinking domestic market, should Japanese corporations seek out new frontiers by acquiring foreign companies? Or should they focus on domestic mergers and consolidations to take advantage of economies of scale, thus making them more internationally competitive?

Recent Japanese corporate history suggests that both strategies carry significant risks.

The Japanese economy, which has been stagnating for years, shrank 3.7 per cent in the first quarter of this year as the March 11 earthquake and tsunami disrupted production and nervous consumers cut back on spending. The contraction was almost double the annualised 2 per cent drop expected by economists. The downturn may be even worse in the April-June period as unresolved nationwide supply chain problems continue to disrupt production, and government reconstruction efforts fail to lift the economy.

Many companies have responded by looking abroad. Thomson Reuters indicates that Japanese companies spent US$25 billion (S$31 billion) making acquisitions overseas in the first five months of this year – as much as for the whole of last year.

Japanese companies are cash rich and have access to cheap financing. They also have the advantage of a strong domestic currency. What better way to gain access to fresh markets at a time when domestic sales are falling?

Indeed, the overseas acquisition mantra has become so strong that analysts have begun to question the laggards. Sony, for example, has not followed suit, despite the fact that it has posted three straight years of losses and is sitting on US$8.3 billion in cash reserves. Observers such as Mr Sachin Shah, a merger arbitrage strategist at Capstone Global, recently urged Sony to consider acquiring companies such as Imax Corp, the operator of large-screen movie theatres, and Netflix Inc, a California-based mail-order and online movie-rental service.

But is this strategy really such a good idea? If they are not careful, Japanese companies may repeat their mistakes of the 1980s when corporations paid high prices to acquire overseas assets, only to lose out during the hard times of the 1990s when they were forced to sell them at much lower prices.

Interestingly, Takeda has already been criticised for paying more than 13 times Ebitda for Nycomed. Ebitda (which stands for earnings before interest, taxes, depreciation, and amortisation) is a financial indicator widely used as a measure of efficiency and profitability. By this yardstick, the Nycomed deal looks expensive. Bloomberg data showed that acquirers paid a median of 7.1 times Ebitda for drug-industry takeovers larger than US$1 billion in the past two years.

An alternative to overseas acquisitions that allow for economies of scale is industrial consolidation. Japan has five car manufacturers, four brewers and numerous mobile telephone manufacturers, for example. By creating more efficient domestic businesses through mergers, goes the argument, Japan would be better placed to compete globally.

This approach is certainly being tried. Nippon Steel and Sumitomo Metal Industries have asked Japan’s fair trade commission to approve a proposed merger which they say is critical to ensuring that the country’s steel industry remains competitive worldwide. Sony and Toshiba plan to merge their LCD units after coming under pressure from South Korean and Taiwanese rivals.

Such mergers, however, are risky. The corporate culture of many Japanese companies does not favour the seamless integration of functions that such mergers require. The catastrophic computer system failure in March involving the breakdown of ATMs owned by Mizuho, Japan’s second-largest banking group, illustrated the point. Mizuho, formed a decade ago from the merger of three smaller banks, still practises a system in which rival executives from the merged banks split the top posts among themselves. The breakdown was blamed on poor management due to overlapping functions in the bank’s units.

Japan’s corporate strategists face difficult decisions. And the way they respond could well turn out to be every bit as significant as the machinations of the politicians in Tokyo.

Copyright © 2011 Singapore Press Holdings Ltd