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UFJ and Daiei: Japan’s Malaise and its Salvation

By Daryl Whitten

TOKYO (KWR) UFJ Holdings and retailer Daiei were the poster children of what was wrong with Japan during the Heisei malaise. However, the solution for the problems these two companies face, underlies the salvation that will allow Japan to emerge from its decade-long period of economic stagnation. In other words;

• Japan’s banking industry is evolving from a “protected species” into a (hopefully) globally competitive industry, with each participant being left to find its own unique positioning;
  
• Substantial consolidation is already taking place in many Japanese industries;
  
• This is accompanied by a growing globalization of Japan’s domestic economy as well as freer cross-border capital flows that have fostered substantial net portfolio purchases of Japanese equities, and
  
• As a result we are seeing both a growing domestic M&A as well as cross-border M&A wave that that is accelerating the consolidation/revitalization of Japan Inc.

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Daiei Inc.

Supermarket chain Daiei Inc. was founded by former Chairman Isao, who has since been forced to resign. During the 1980s, Daiei was the symbol of the retailing revolution in Japan. At its peak, it grew to operate 2,252 regular stores and specialty stores through its subsidiaries and franchisees. Its retail businesses include supermarkets, discount stores, department stores, and specialty shops. Other businesses include restaurants, hotels, and real estate services. Domestic sales make up more than 90% of its revenues.

A “Bubble” Poster Child

But in typical “bubble” fashion, Daiei diversified haphazardly during the 1980s, loading up on debt, but failing to keep up with new, more efficient competitors. Finally in FY2001 (to February 2002), the company effectively went bankrupt, losing ¥322.5 billion at the net income level, and reporting net negative equity of ¥297.4 billion. Interest bearing debt that year ballooned to ¥2,139.3 trillion, with 90% of this debt either short-term borrowings, or long-term debt due within one year.

Ever since, the company has been on life support, courtesy of its banks and the Japanese government, which have extended Daiei credit despite the ongoing deterioration of its businesses. Daiei came to epitomize the industrial sclerosis that befell much of Japan in the 1990s, and has proved to be one of the most challenging restructuring efforts to date. This is because Daiei had become “too big to fail”. Bubble logic dictated that Daiei couldn't be allowed to die, because they'd bring down their banks, trigger massive unemployment and cause heads in government to roll. With over ¥2 trillion in debt, Daiei effectively owned the banks, who were very reluctant to push for repayment from the company, or to write down their loan exposure. The latest restructuring plan represents the third such plan to be created since 2001, all with marginal success.

Daiei management has continued to reject requests by its main creditors to seek aid from the Industrial Revitalization Corp. of Japan, which ostensibly was set up to facilitate such restructuring. Daiei continues to insist it can halve its interest-bearing debt of ¥1,638.4 billion as of the end of Feburary 2004 by March, 2005 , by shutting outlets, selling assets, and asking banks and investors for more financial aid.

"Previously we had envisioned a new business plan that involved three banks and Daiei, but now we're working on the premise we'll need new business partners or investors," Daiei’s president Takagi said. Daiei is trying to persuade banks that the involvement of lawyers and securities companies in its latest plan will meet creditors' requirements for greater transparency, one of the reasons the banks are seeking the involvement of the bailout agency.

In Daiei’s revised restructuring plan to UFJ Bank and its other lenders, it is calling on Marubeni Cop. to assist it in its supermarket operations, and Tokyu Land Corp. to help it attract and administer tenants. The struggling supermarket operator also intends to ask the two companies and Deutsche Securities Ltd. to buy most of the ¥100 billion yen worth of new shares it plans to issue to increase its capital, while seeking roughly a ¥400 billion in loan waivers by banks, a move that will cut the firm's interest-bearing debt to less than half.

Daiei has been closing stores over the past two years. As of February of this year (FY2003), total stores (regular stores and specialty stores) had fallen to 1,677 stores from a peak of 2,252 in FY2001, including 84 regular store closures and 1,009 specialty store closures.

But revenues continue to undershoot plan targets. Same-store sales at Daiei appear to have fallen about 6% on the year in August, marking the sixth straight month the firm has missed its sales target of a 1% decline for this fiscal year. This partially reflects Daiei’s priority in the fiscal first half on generating profit rather than lifting sales, but its efforts to slash expenses are nearing their limit. Although a year-on-year fall in same-store sales was factored into its business plans from the beginning, the pace of decline is larger than expected.

President’s Resignation Will Tip the Scales

Investors appear to be betting Daiei will eventually lose its battle to restructure without falling into the arms of the IRC, as president Takagi reportedly will be resigning to accept responsibility for the company’s problems, and the intransigence of Daiei in responding to creditor demands. This is because the new restructuring plan failed to impress, and the company has had serious problems meeting its restructuring targets. Japan’s R&I credit rating agency recently downgraded Daiei’s credit again on Aug. 11, lowering its rating for Daiei’s long-term bond by one notch from B to B-. "The smooth relationship between Daiei and its main banks, on which the evaluation of Daiei's creditworthiness has been premised thus far, is changing due to differences emerging between the company and the banks over the formulation of a reconstruction plan," R&I said.

Wal-Mart To the Rescue?

Wal-Mart Stores, the world's leading retailer, has visited the IRC, and has hired banks to advise it on a possible investment in Daiei. The world's biggest retailer should make a bid for Daiei, say many Wal-MartÅfs shareholders and analysts who follow the company. Adding Daiei may help Wal-Mart overtake Aeon Co. and Ito-Yokado Co. to become Japan's biggest retailer by sales at the parent level. Wal-Mart's international sales in the six months to July 31 rose 19%, or almost twice the pace of its U.S. unit, to $25.6 billion.

Wal-Mart tentatively entered Japan in May 2002 by buying a 6% in Seiyu, and has an option to raise its current 37% holding to as much as 69% in 2007.

Wal-Mart is just beginning to work its magic on Seiyu Ltd.. It is plugging Seiyu into its international supply network and introducing new inventory controls. Those moves helped Seiyu narrow its first-half loss to ¥2.9 billion yen from ¥50 billion yen a year earlier. Interest-bearing debt was down to ¥460.4 billion as of December 2003, versus ¥633.3 billion in February 2002. But Seiyu, which reported losses in two of the past five years, recently cut its full-year sales forecast 1.3% to ¥1.09 trillion yen. Moreover, investors have yet to buy into the Seiyu restructuring story. Its stock is the second-worst performer on the Topix Retail Index in 2004, dropping 21%.

Will the Wal-Mart ploy work? There are a couple of conditions. Daiei first has to fall into the hands of the IRCJ. If this happens, then Wal-Mart is one of just two or three players in Japan with the experience and cash to turn around a retail operation as massive as Daiei. Secondly, Wal-Mart's Seiyu success story is still a work in progress.

Daiei’s Stock: A Roller Coaster Ride

Daiei’s stock had plunged from ¥500 in Q3 2001 to a mere ¥100 as the Nikkei 225 was hitting 7,600 at the height of investor concerns about financial fragility, deflation and Japan’s exposure to external shocks. In short, Daiei was being priced for bankruptcy. Thereafter, the major banks scrambled to bolster their balance sheets and Resona Bank’s rescue by the FSA, greatly relieved concerns that new FSA Minister Takenaka would push the banking sector to the brink of another financial crisis.

From Q2 2003, stock previously priced for bankruptcy soared, on the assumption that if other troubled banks were rescued, their most heavily indebted borrowers would also be saved, especially because a new organization called the Industrial Revival Corporation of Japan (IRCJ) was formed with the express purpose of revitalizing such troubled borrowers. Daiei’s stock price soared from the ¥100 level to a ¥635 high by April 2004, representing a massive 6.3-fold gain, and more than making up for the ground lost since Q3 2001.

But then the war of words between Daiei and its major creditors began, exposing serious differences about how the company was to be revitalized. Moreover, the company was refusing to consider revitalization under the IRCJ. As speculators bailed out of the stock, it plunged 75% from the ¥635 high to a recent low of ¥156, or basically where it was in early 2003.

Presently, there is an overhang of cumulative trading volume between ¥150~¥300, and the stock is still in a bear market, trading below its 13-week and 26-week MA. In reality, the stock is not worth ¥635 a share, unless it is broken up, the best pieces sold off, and the remainder successfully revitalized by someone such as Wal-Mart.

Solving “the Daiei problem”, however, will not only represent a major turning point in Japan’s bad debt problem, but also a big turning point in the restructuring of corporate Japan.

More Similar Corporate Culture

As Japan's corporate culture becomes more similar to that of Europe and the U.S., Japanese companies are less resistant than before to personnel reductions and the sale of operations. The stock cross-holding structure, which had impeded M&A bids, has disintegrated as well. A Commercial Code revision in early 2006 will make it easier for overseas companies to acquire Japanese firms through equity swaps.

Buyouts of well-managed Japanese companies could remain difficult in light of past experiences with failed takeover bids. To ward off unfriendly takeovers, managers of Japanese firms are likely to seek realignment of domestic companies and launch stock repurchasing programs and other measures to boost corporate value. These moves could lead to higher stock prices as corporate value is improved.

However, the fact remains that the stock market capitalization of leading Japanese companies is but a fraction of their largest global competitors.

Major corporations such as Canon Inc. and Kirin Brewery Co. are seeking increased flexibility in their stock buyback structures so they can be prepared for potential mergers and acquisition deals that involve these arrangements.

Until the changes to the Commercial Code were implemented last September, companies were bound for an entire year to a ceiling for stock buybacks that was decided at a shareholders meeting. So even if an unexpected acquisition opportunity presented itself, methods involving stock swaps faced restrictions.

Under the revised Commercial Code, the board of directors at a company has the freedom to set buyback amounts, in exchange for more information disclosure. This allows companies more flexibility in their capital strategies that make use of stock swaps. The changes will raise the number of options available to companies involved in M&As. However, it will also increase the corporate governance burden on companies to ensure that decisions about capital policies are fully explained to shareholders.

As a result of these changes, one can expect to see more restructuring and rationalizations over time, and continuing progress in Japan’s attempts to move further along the road toward a sustainable economic recovery.