Japanese M&A - the surf's up

By Scott B MacDonald

Late last month, Japan Tobacco announced that it was buying its British rival, Gallaher Group Plc, for about US$15 billion. This is big news for two reasons: the proposed deal is the largest-ever foreign acquisition undertaken by a Japanese company, and it marks a new assertiveness by a part of the international business community that has long been in retreat, Japanese corporations.

While considerable attention has been given to the flood of merger-and-acquisition (M&A) money going into Japan over the past several years, it appears that Japanese companies are now equally set on buying foreign companies. Combined with a banking system flush with money and low international interest rates, the renewed health of corporate balance sheets has reopened the door for Japanese companies to the global M&A game.

According to Dealogic, Japanese companies announced 162 acquisitions of non-Japanese entities worth a total of $20.8 billion between January and mid-August 2006. That is more than the $15.9 billion worth of overseas acquisitions announced in 2005 and five times 2003's total. Going international makes considerable sense, but as always it carries risks.

The last time Japanese companies ventured off their islands was during the "bubble economy" of the 1980s. At that time, the yen was strong and Japanese companies appeared ready to take over the global economy. This was, after all, the time that Harvard University Professor Ezra Vogel wrote Japan as Number One, depicting the eclipse of Pax Americana and the rise of Pax Nipponica. It was also a period when Sony Corp bought Columbia Pictures (which has been a drag on its balance sheets for years) and Mitsubishi Estate purchased New York's Rockefeller Center (later sold off for a loss). The peak was reached in 1990, when Japanese companies bought 429 foreign companies for a combined $25.3 billion. Most of these high-flying deals turned bad by the early 1990s, leaving many Japanese investors feeling burned by the experience of foreign M&A.

That was then; this is now. Japan is emerging from a lengthy period of economic stagnation. Large parts of the economy have been restructured and corporate balance sheets are looking their most robust in many years. Even the construction and real-estate sectors appear to be enjoying renewed growth, something significant considering the depths they plunged during the lengthy years of deflation.

There are compelling reasons for Japanese companies to buy foreign companies, chief among them that economic life has become far more globalized. For example, in the international steel industry, consolidation is occurring at a rapid pace, something that was signaled by Mittal Steel's purchase of Luxembourg's Arcelor Steel last year, creating the world's largest producer of steel. And the consolidation process is not stopping - this month it was announced that Mittal was one of four bidders for Mitsui & Co's 51% stake in Sesa Goa Ltd (an Indian iron-ore exporter) and that US-based Nucor was buying Canada's Harris Steel.

In today's globalized markets, standing still means being overtaken. Nippon Steel president Akio Mimura noted this month, "An increasing number of business managers see M&As as an option in Japan as well ... I believe that it is natural for M&As to be used as a means for achieving growth."

There are other reasons for Japanese companies to look overseas for acquisitions targets. Demographics are a consideration, as the aging population means fewer younger people to consume services and goods. A senior M&A banker at Daiwa Securities SMBC stated, "Opportunities for growth are limited in Japan, given the decreasing population. The domestic market is saturated, so companies are looking overseas for further growth." One of the drivers in the Gallaher deal for Japan Tobacco was the British company's strong presence in Russia and Eastern Europe, growth markets for tobacco and related products.

Moreover, Japan's banks are now more flush with cash. Years of restructuring and consolidation have brought Japanese banks back to cleaner balance sheets, the need to generate profits, and put money to work. Consequently, Japanese companies are finding ready partners in seeking acquisition targets overseas. This was evident in the use of loans when Nippon Sheet Glass bought British rival Pilkington PLC for $3.8 billion last year.

Another factor to take into consideration is that there is an increasing presence of foreign shareholders in Japan's equity markets. The proportion of Japanese stocks held by foreigners climbed from 6% in 1991 to 24% in 2005. Institutional Investor magazine noted in September, "These investors are more outspoken than their Japanese counterparts in demanding growth, prodding managements to do more deals ..."

One last factor pushing the M&A wave is geopolitical. Considering that Japan lacks natural resources, particularly energy, and that both China and South Korea are equally resource-hungry, there is a pressing need to acquire energy and commodity assets that can be linked into global networks. And the competition for resources has become fierce, adding a nationalistic element to M&A activity, especially in the energy field.

Will Japanese companies replay the failures of the 1980s? Our bet is that they will be a little savvier this time around. The 1980s saw the first surge of Japanese business managers overseas; they were proud, aggressive - and lacking in experience. Their track record was disappointing to say the least.

The current generation of Japanese business managers is more cosmopolitan and more sensitive to the way globalization has changed business around the planet. They are also returning to the global M&A scene at a very different time - after a lengthy period of painful restructuring. Many of the skill sets used in the 1990s and early part of this decade are very applicable to today's M&A scene.

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