Investors' voices are reaching Japan's corporate boardrooms.

Many Japanese companies are likely to listen to shareholder demands for growth strategies and higher returns, in our view.  In 2023, the Tokyo Stock Exchange (TSE) requested companies improve corporate value over the next three to five years in Japan, where the stock market has long remained stagnant. In response, Japanese corporates--including industrial companies, banks, and insurers--have increasingly acted to incorporate capital costs and stock prices in their business and financial operations. Among specific measures, efforts to eliminate price-to-book ratios (PBRs) of less than one have gathered a lot of attention. In fact, the share of companies with a PBR of less than one shrank to about 40% of all those in the TSE prime market of mainly large companies as of March 2024. This was down from about 50% as of March 31, 2023. We believe Japanese companies will continue to gradually improve their PBRs and their return on equity. We base this on their expectations of relatively stable earnings for the next one to two years and because many continue to unveil medium-term management plans reflecting shareholder demand for growth strategies and better returns (see "Improving Price-To-Book Ratios").

We must prudently evaluate efforts to improve capital efficiency and enhance profitability in our assessments of companies' creditworthiness.  In going after these goals, companies may encounter different or new business risks than those they are used to and find themselves with insufficient financial buffers to cope. Companies might also pursue large mergers and acquisitions (M&A) and shareholder returns, which could lower measurements of their cash flow adequacy, reflecting negatively in our evaluation of their creditworthiness. Examples of cases that might arise include the following:

• A company's overall competitiveness and profitability weakens, dimming prospects for early recovery of investments. This could occur if the company aspires to break into new or unfamiliar businesses or regions under its growth strategy.
• A company pours too much funding into its growth strategy, acquisitions, or shareholder returns, leading to excessive growth of debt. This could upset a balance in financial soundness, and its ratios of operating cash flow or EBITDA to increased debt might fall materially and stay at the lowered levels.

Conversely, continued enhancement of competitiveness in a company's business base might steadily lift sales and profits and improve operating cash flow generation, leading to more sustained profitability and debt servicing ability.

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An increasing number of companies in Japan have been trying to improve operational efficiency and place more weight on shareholders' opinions in recent years. The impact of such efforts on our evaluation of creditworthiness varies from case to case. We list typical individual cases and points to monitor in the following table.

Table 1

Case 1

Better Portfolio Efficiency As Weaker Businesses Cut: Positive

Downsizing or selling less competitive or marginally profitable businesses to improve stability of a business portfolio is often positive for creditworthiness.  We may evaluate a company's management and governance as positive if it moves to improve efficiency of its business portfolio ahead of its peers under a clear strategy in response to calls from shareholders with a long-term point of view and it takes such measures while business operations are still stable. However, if proposals from activist shareholders among others overemphasize short-term benefits, and if we consider the ratio of the company's cash flow generation to debt likely to deteriorate materially as a result, we may evaluate the company's management and governance negatively in our creditworthiness assessment.

We evaluate the following cases positively because companies rebuilt their business portfolios over three to five years or longer, raising profits and stabilizing operations. 

• Hitachi Ltd. (A/Stable/A-1): Characterized by highly diversified businesses and a large number of companies within the group, the company had sold or spun off listed subsidiaries including construction machinery, metals, chemicals, transportation, and financial services. It then concentrated management resources on IT services and infrastructure (e.g., power grids, energy, and railways) businesses where the company has had strengths.
• Sony Group Corp. (A/Stable/A-1): Transformed its business portfolio into one less susceptible to changes in external business environment and economy. To achieve this, it downsized its volatile consumer technology hardware business, which produces goods such as TVs, PCs, and mobile handsets. It then expanded its image sensor device business for mobile telephones, a niche with strong global competitiveness. Also, it focuses more on entertainment, including gaming, movies, and music, where the company can expect business expansion using its rich intellectual property (IP) assets and grow from recurring income.
• Seven & i Holdings Co. Ltd. (A/Stable/--): Rebuilt its business portfolio with the sale of its domestic department store business (Sogo & Seibu Co. Ltd.), which suffered fierce competition and low profitability, and material downsizing of its similarly unprofitable domestic supermarket business (Ito-Yokado).
• General trading and investment companies (GTICs): Characterized by development of extremely diversified industries and many group companies, GTICs have replaced businesses in their portfolios on an ongoing basis, with a focus on jettisoning those with low profitability or low growth potential. Among others, Itochu Corp. (A/Stable/A-1), stabilized its overall business portfolio by cutting many unprofitable group companies ahead of peers and enhancing its business base mainly in the lifestyle segment in which the company has strength.

It is inappropriate to evaluate entities in the public utility sector, such as electricity and gas, and the infrastructure sector, such as railways, under the same standards as general industries, in our view.  This is because of the nature of their businesses and certain characteristics, including their role to provide infrastructure nationwide and high capital intensiveness. We note characteristics of low profitability and growth potential as well as solid prospects for cost recovery thanks to regulatory benefits. We incorporate these in our analysis as supportive of their creditworthiness.

Case 2

Reducing Cross-Shareholdings: Case By Case

We will examine reduction of long-term cross-shareholdings, a unique characteristic of Japanese companies, to improve capital efficiency on an individual basis.   In addition to securing business relationships and maintaining stable shareholders, cross-shareholdings in Japan helped stabilize management (limiting excessive involvement of outside shareholders), and supported stable fundraising from banks and insurance companies. In recent years, however, there has been an increase in the number of Japanese companies significantly reducing cross-shareholdings. We see two factors behind this, especially at Japanese industrial companies. First is the need to secure funding sources for increasing growth investments to further strengthen global competitiveness as businesses expand overseas, particularly among large corporations. Second is wider funding options. These have expanded from borrowing from domestic banks to market funding (equity and debenture issuance) including overseas markets, bringing greater expectations from market participants of improvement in financial targets such as higher PBR and return on equity (ROE). Therefore, it has become more important to enhance accountability to improve capital efficiency through the sale of cross-shareholdings, for which investment returns are usually low.

How we assess reduced cross-shareholdings will vary depending on incoming shareholders' financial discipline and how companies use sales proceeds.  Some Japanese companies have valued stable business operations and profits achieved through strong cross-shareholding relationships with group companies or financial support in times of stress. A sudden decline in capital ties may reduce the likelihood of receiving those benefits for stable business operation, in our view.

If extensive cross-shareholdings continue, when we see conflicts of interest through significant intergroup transactions or diminished transparency in group governance, we may consider this negative for creditworthiness.  When activists propose to reduce cross-shareholdings, they usually focus on short-term shareholder returns, which can lead to significant changes in a company's management policy, business strategy, and financial discipline. This can result in unconservative management and aggressive financial policy. In such cases, we would view reductions in cross-shareholdings as negative for creditworthiness.

Reduced cross-shareholdings are somewhat positive.  For example, cases occur in which the traditional composition of major shareholders does not change significantly after cross-shareholdings are unwound, and others have resulted in sale proceeds being used for future growth investments with the intention of increasing capital efficiency without affecting financial discipline. We expect industries and companies facing more burdensome growth investments to increasingly reduce longstanding cross-shareholdings to secure growth investments. A listed insurance company's unwinding of cross-shareholdings increases the stability of its capital through reduced inherent asset investment risks, and thus can be positively assessed in creditworthiness.

Recent examples include:

• Toyota group companies (Toyota Industries Corp., Denso Corp., Aisin Corp.): Cross-shareholdings among the group companies have been shrinking. We understand that Denso and Aisin do this to secure funds for increasing capital investment and research and development (R&D) to strengthen their electric vehicle (EV) businesses. For Toyota Industries, we have lowered its position within the Toyota group a notch and lowered our long-term issuer credit rating on it to 'A' from 'A+' due to ongoing elimination of cross-shareholdings within the group. We believe this is because of a growing need for group companies to further enhance capital efficiency to expand their EV businesses and further strengthen their overseas businesses, which are different from gasoline and hybrid vehicles. However, we do not expect the reduction of cross-shareholdings within the group to affect solid business relationships and joint technology development plans between Toyota Industries and other group companies.
• Megabanks (Mitsubishi UFJ Financial Group Inc. (MUFG), Sumitomo Mitsui Financial Group Inc. (SMFG), Mizuho Financial Group Inc.): Since about 2023, the three groups have gradually reduced more than ¥10 trillion in cross-shareholdings.
• Major non-life insurance companies (Tokio Marine Holdings Inc., MS&AD Insurance Group Holdings Inc., non-life insurance company under Sompo Holdings Inc.): Taking advantage of an administrative punishment from the regulator, the Financial Services Agency, for colluding with other insurance companies to fix prices of insurance premiums sold to their clients (industrial companies), the three major nonlife insurers announced in May 2024 that they would sell all of their cross-shareholdings (excluding those of their business partners) totaling more than ¥9 trillion over the next several years.

Case 3

Uncurbed Share Buybacks: Negative

Share buybacks are negative for corporate creditworthiness because they entail massive outflows of funds.  Growing numbers of companies with higher net income and free cash flow have sharply increased share buybacks to improve ROE when unable to find good growth investments. Louder calls for enhanced shareholder returns often result from increased shareholdings or ownership in Japanese companies by overseas investors and private equity funds, including activists. Companies in a wide range of industries announced large share buyback plans on the back of rising profits and ample cash at hand in 2024, including automakers such as Toyota Motor Corp. and Honda Motor Co. Ltd., general trading and investment companies such as Mitsubishi Corp. and Mitsui & Co. Ltd., and Recruit Holdings Co. Ltd. and Canon Inc.

Many rated Japanese industrial issuers have maintained sufficient financial discipline, in our view. In many cases returns to shareholders are within annual free cash flow, and in some cases equity capital has increased sufficiently above companies' targets. As a result, very few cases arise in which we downgraded credit ratings solely because of large share repurchases. However, downward pressure on a credit assessment will intensify if we determine a company's financial discipline has deteriorated and the outlook for significant weakness in key indicators of financial health has increased amid insufficient financial capacity relative to our credit ratings on it.

Case 4

Deteriorating Financial Health And Rising Integration Risk Due To Large M&A: Negative

Large M&A could negatively affect assessments of creditworthiness.  This is because it usually takes years to recoup investments from future sales and profits, while debt burdens surge immediately after a large acquisition, though the extent to which this occurs depends on the funding scheme. This can result in rapidly and substantially worsening cashflow adequacy, for instance debt to EBITDA, a ratio we focus on in our analysis.

Given that the domestic economy is inevitably expected to shrink over the long term, albeit slowly, because of the country's decreasing and aging population, many large Japanese companies are accelerating business expansion into growing overseas markets as a pillar of their long-term growth strategies. In line with this expansion, the size of acquisitions continues to grow, in our view.

We rarely incorporate significant positive effects of an acquisition in an evaluation of a company's business operations immediately after the deal.  Recently, we have observed that Japanese companies tend to acquire companies in the U.S. or Australia, which have lower country risk than companies in emerging countries, to achieve stable growth over the long term. We think this helps companies control country risk in such M&A transactions. Still, we are prudent about positively incorporating the benefits an acquiring company expects to realize into our rating analysis soon after an acquisition in a country or region where acquired companies have different production or sales bases, brand recognition, customer bases, or market volatility. In addition, we see many cases where the market environment has become volatile, counter to our previous assumptions, and competitiveness of the acquired company falls materially from the acquiring company's initial expectation.

Examples since the end of 2023 include the following:

• Nippon Steel Corp. (BBB+/Watch Neg/--): Our rating has remained on CreditWatch with negative implications since December 2023 when the company announced it would acquire United States Steel Corp. for about US$14 billion (about ¥2 trillion). We think the acquisition is likely to significantly weaken key cash flow indicators for Nippon Steel because of a sharp increase in debt for the acquisition. We also think the acquisition is likely to weaken its earnings stability.
• Renesas Electronics Corp. (BBB/Stable/A-2): Acquisition of U.S. semiconductor company Altium Ltd. was announced in February 2024 for about A$9.1 billion (about ¥890 billion), with the aim of expanding the company's business base in the U.S. If implemented, the acquisition is likely to significantly deplete the company's financial buffer. In addition, we do not consider repeated large acquisitions in a short period as part of a growth strategy to constitute stable and predictable financial management. The company acquired U.K.-based Dialog Semiconductor PLC in 2021 for about €4.9 billion (about ¥615.7 billion).
• Sekisui House Ltd. (BBB+/Stable/--): We downgraded Sekisui House two notches in June 2024 following its acquisition of U.S.-based MDC Holdings Inc. The company financed most of the deal (about ¥780 billion) with debt, which is likely to keep its key cash flow ratios significantly deteriorated in the next two to three years. We believe the financial burden will largely outweigh the positive effect of an enhanced market position in the U.S.
• Tokyo Gas Co. Ltd. (AA-/Stable/A-1+): The regulated utility company acquired U.S.-based unregulated gas development and production company Rockcliff Energy II LLC for US$2.7 billion in December 2023. Market fluctuations because of unregulated offshore upstream business could affect the issuer's overall business stability. If unregulated utility business makes up a larger share of Tokyo Gas' overall business, the company will likely suffer less stable earnings and cash flows, in our view. This acquisition may increase pressure on the company's business risk profile, in our opinion.

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Balancing Shareholder Value And Financial Soundness

Financial discipline and funding schemes aimed at maintaining good finances are key

We expect Japanese companies to continue or increase business expansion in overseas markets, where they have less experience and weaker business bases. This is also the case for share buybacks as a means of larger shareholder returns in the next one to two years. Companies aim to accelerate growth investment to achieve higher PBR and ROE, in our view. And these indicators would get higher attention in the Japanese capital market as key performance indicators (KPIs).

In fiscal 2023 (ended March 2024 for most companies), major companies comprising the Nikkei 225 index (of the leading 225 Japanese companies) saw a continued rise in profit amounts and profitability. Aggregated ROE rose above 10% but remained lower than the 14%-16% range of U.S. companies. The average PBR of Nikkei 225 companies remained slightly over 1.0x, although the proportion of companies with a ratio of less than 1.0x declined to above 40% as of March 31, 2023, from above 50% as of March 31, 2024. For Nikkei 225 component companies, while their aggregated net profit rose to about ¥41 trillion in fiscal 2023 from ¥35 trillion in fiscal 2022, the total of their dividend payments to shareholders and share buybacks remained about ¥20 trillion for the second year in a row (see chart 4). Free cash flows after dividend payments, or the resources available for debt payment, had remained largely negative for two years in a row (see chart 5). We forecast that free cash flow after dividend payments will remain largely negative in fiscal 2024 (ending March 2025), along with solid earnings performance. Accordingly, we think that most companies will come under stronger pressure from shareholders to improve PBR and ROE.

Nevertheless, efforts to improve PBR and ROE may weaken financial resilience.  This could happen if free cash flow after dividend payments, which is used to repay debt, continues to decrease over the long term or if companies incur an extreme financial burden more often. Accordingly, we consider this a negative factor in our assessment of creditworthiness.

Disciplined business strategies will be key for Japanese companies placing more weight on shareholder evaluations.  They need to balance three factors:

• Investments for sustainable growth;
• Temporarily increased shareholder returns when companies are unable to find good growth investment opportunities; and
• Financial buffers that support changes in business risk profile.

It is also crucial that Japanese companies have corporate governance able to sustain their business strategies for a prolonged period. Furthermore, amid an increase in aggressive overseas shareholders and rapid business expansion, we believe companies will need to place higher importance on explaining their business expansion strategy and financing scheme through close communications with market participants on an ongoing basis.

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