Column 8 - Business Realignment and the Revival of Japanese Firms

Japanese firms have recovered from the long period of struggle following the burst of the bubble economy. Today, firms face pressing concerns (such as rising resource and energy prices, the slowdown of the U.S. economy triggered by problems in the housing and financial markets, and the strengthening yen) but, having overcome post-bubble hardship, they seem emboldened to not recoil in the face of new challenges. But how was this remarkable comeback achieved? I would like to examine this question, focusing on the business realignment that Japanese firms have carried out over these years.

In the latter half of the 1980s, many Japanese firms, riding on the booming economy, ventured into new businesses. Their struggle after the bubble burst can be defined as a process of realigning diversified business segments. First, I will consider the question of whether this process was simply geared to consolidating their diversified business operations. Then, I will examine whether the "selection and focusing" strategies popularly advocated during that period differ from consolidation.

The Ministry of Economy, Trade and Industry (METI) Basic Survey of Japanese Business Structure and Activities provides some clues for addressing these questions. The survey covers all firms of 50 or more employees and paid-in capital of ¥30 million or more (except for financial institutions and firms belonging to some other specific sectors), which means this discussion is not limited to large listed firms. Firms in the survey were asked to indicate their sales composition by product group, which corresponded to an industry group that was given a three-digit classification code. Actual business structures should be more segmented than a mere three-digit classification, but this common, standardized classification is meaningful in that it enables comparison of business structures among firms. For instance, in the case of an analysis using segment information provided in financial statements, only listed firms are covered. It is also difficult to compare business structures because each firm classifies its products, or segments, by its own standards.

Using the survey results on sales composition based on the three-digit classification, the realignment of corporate business segments can be examined from the viewpoint of whether it represents an "exit from an existing business" or "entry into a new business." A firm that ceased to report sales for a certain product group during a designated period is considered an "exit" from the business, whereas the reporting of sales for a new product group is an "entry" to the business. Generally, as an indicator of concentration or diversification, analog-type changes in the Herfindahl Index, a measurement reflecting the degree a firm's sales are concentrated in a certain product group or diversified across multiple product groups, are used. Here, however, I focus on digital-type changes in two aspects - exits and entries. For instance, in a case in which a firm has withdrawn from one existing business and launched a new, comparable business in terms of sales, even though no changes occur in the Herfindahl Index, business realignment has certainly proceeded in the form of exit and entry. From this viewpoint, business consolidation can be defined as a case in which exits outnumber entries.

I divided the post-bubble period into Phase I - 1995-1999 and Phase II - 1999-2003, and focused on some 7,000 firms which are diversified, that is, which have at least two businesses at the beginning and the end of each phase. Firms that withdrew from any of their existing business during Phase I accounted for 46% of those surveyed. This fairly high percentage seemingly indicates a trend toward business consolidation. However, a good number of firms also entered into new businesses, accounting for 39% of the total. It is quite surprising that a broad range of firms ventured into new businesses in the period immediately after the collapse of the bubble. Why was this possible?

Actually, 65% of the firms that launched new businesses "simultaneously" withdrew from some of their existing businesses. Conversely, 55% of the firms that closed an existing business also embarked on a new business. That is, firms that expanded their business portfolio with no withdrawal and those that consolidated without launching a new business were minorities, accounting respectively for 14% and 21% of all firms surveyed. A greater number (25%) of firms undertook both entry and exit simultaneously. What are the implications of this seemingly contradictory behavior of these firms? Deferring the answer to this question, at present I want to point out the followings: 1) simultaneous pursuit of business expansion and consolidation enables the firms to utilize the internally accumulated management resources; and 2) it is observed that the firms engaged in this simultaneous pursuit tend to show higher business performance than those pursuing only one.

These tendencies generally remained unchanged in Phase II. But the proportion of firms that withdrew from an existing business increased to 60% compared to 46% in Phase I. Companies that pursued only exit accounted for 31% of the entire sample (those that pursued both entry and exit were 29% and those that pursued only entry 10%). Seen in this context, business consolidation in Phase II outpaced that in Phase I.

These tendencies do not change when firms are classified by size and each group examined separately. Average capital of firms classified as the largest sized is nearly 300 times that of the smallest sized firms. The fact that firms in these two groups, despite such huge differences in size, have been behaving similarly shows that this pattern of business realignment has been commonly and broadly observed across Japanese firms.

There are many possible factors that prompt firms to decide on entry or exit. However, for the purpose of this article focusing on firms with diverse business portfolios, I examine factors in view of their relevance to the largest business segment in terms of sales ("core business") within each firm's business portfolio. I found that the greater the "mean" value for growth rates in the sales of a firm's core business over a period of time, the more likely is the firm to exit and less likely to enter; and that the greater the "variance" value for growth rates, the more hesitant the firm to withdraw and more inclined to expand (breakdown data by business segment is available only for annual sales). In other words, robust growth in core business sales tends to prompt firms to withdraw from other businesses, whereas they are more inclined to expand into new businesses when they see a greater risk in relying on their core business.

The question of what sorts of businesses have been selected by firms as areas from which they exit or into which they enter can be examined by focusing on the "proximity" to the core business. Two types of indicators, input relevance and marketing relevance, are employed for this purpose. The input relevance index measures technical similarities between two products in terms of how they are produced (the combination of goods and resources required for their production), whereas the marketing relevance index measures similarities between two products in terms of their market channels. Analysis using either of these indexes found that firms tend to exit from businesses further from (less proximate to) their core business and are inclined to enter new businesses closer (more proximate) to their core business.

Now is the time to answer the question. Above I mentioned the seeming contradiction in a firm simultaneously pursuing exit and entry. However, it is quite reasonable, as a business realignment behavior undertaken by firms, to withdraw from businesses remote from the core business and, at the same time, expand into businesses close to the core business. Instead of single-mindedly pursuing consolidation, many Japanese firms sought to strengthen a set of businesses around the core business by implementing strategic business realignment that combines both offensive and defensive measures. This can be seen as the real picture of the "selection and focusing" strategy. Indeed, firms implementing such strategic realignment have shown better term-end business results (ROE, ROA). Moreover, this tendency is observed broadly across Japanese firms regardless of their size, implying that the extensive employment of such strategy paved the way for their across-the-board comeback.

Finally, however, one area no less important than what is discussed above is the need for attention to the negative aspects of business realignment, such as workforce reductions (resulting from withdrawal without expansion), the problem of the increase in the non-regular workers, and moving factories overseas. It should be noted that the tendencies identified in this article were found for firms that remained a going concern throughout the period under review. Behind those firms there were many other firms that went out of business. In this context, it is also important to examine the question of how in a broad sense mergers and acquisitions (M&As) have been related to the revival of Japanese firms, for instance, in the form of the transfer of a business division or sale of a subsidiary to another firm as a means to exit.