We believe Japanese capital goods manufacturers' expansion of highly competitive overseas businesses over the next two to three years will benefit their creditworthiness. Many of Japan's major capital goods manufacturers have strong global market positions and are steadily expanding their overseas operations. Major changes in the global business and competitive landscape, such as U.S.-China tensions and the rapid rise of Chinese manufacturers, will force companies to make difficult decisions. However, amid a maturing Japanese market, expanding overseas business by many of Japan's major capital goods manufacturers will benefit their creditworthiness, in our view.

Companies can build on strong business bases overseas to capture growing demand and reap higher earnings, in our view. This is despite the various risks associated with new overseas operations. Major overseas peers, however, have strong market positions and very high profitability. We think it will be difficult for the biggest Japanese companies to bridge this gap in the next two to three years.

We expect rated capital goods manufacturers Hitachi Ltd. (A/Stable/A-1), Mitsubishi Electric Corp. (A/Stable/A-1), Komatsu Ltd. (A/Stable/A-1), and Kubota Corp. (A/Stable/A-1) to maintain sound financial bases through disciplined financial management while maintaining high competitiveness and profitability in their core businesses. Despite increasing pressures and demands from shareholders, we believe there is low likelihood in Japan of overly aggressive investments or extremely large shareholder returns, as we have observed among some of the largest U.S. capital goods manufacturers.

Overseas Strategies Key To Competitiveness

We define capital goods manufacturers as those that generate most of their revenues from the production and sale of industrial equipment and facilities. This includes manufacturers of construction, agricultural, air conditioning, and factory automation equipment. However, in this commentary it does not include heavy industry manufacturers that produce and sell, for example, power generation turbines with long operating cycles.

Table 1

Overseas operations drive earnings growth

With a declining birthrate and aging and shrinking population, significant growth in Japan is unlikely, and overseas business will lead earnings expansion over the next three to five years, in our view.   Japanese capital goods manufacturers have built strong business foundations overseas.

In fiscal 2024, combined overseas sales will increase by about 25% from fiscal 2021, in our view. This is thanks to the favorable effects of the yen's depreciation and product price hikes over the past a few years.

Chart 1

Selection of foreign markets becoming more important

Japanese capital goods manufacturers' competitiveness will depend on which market they choose to focus on for the next two to three years, in our opinion.   Today, the major overseas markets for many of them are China, Southeast Asia, and the U.S. As geopolitical risks increase, protectionism in the U.S. and other countries and the rise of emerging manufacturers from countries such as China will likely change the business environment in these markets. We believe there will be a greater need to implement quick and accurate measures to strengthen business and redesign supply chains.

We expect business conditions in China and other Asian markets will be relatively tougher over the next two to three years.  This is because potential tariffs mentioned by U.S. President Donald Trump will hit the Chinese economy, in our view. We assume intensified pressure on the prices of construction machinery and factory automation equipment as Chinese manufacturers become increasingly aggressive in Asian markets with cost-competitive products.

In the U.S. market, we expect Japanese companies to build up local production bases.  This is because we expect they will work to build supply chains that do not involve China and to limit geopolitical risks.

We believe Chinese manufacturers' potential slowdown in the U.S. market due to intensified U.S.-China tensions will somewhat benefit Japanese companies. However, we expect that tariffs will have an overall negative impact on Japanese capital goods players if raised. With the exception of Komatsu, which manufactures a high ratio of its production locally in the U.S., each company is highly dependent on exports.

Japanese Players Trail Largest Global Peers

For the major Japanese capital goods manufacturers, we believe that expanding overseas operations will strengthen competitiveness.   There is generally a high risk developing new business overseas because of the difficulty of forecasting demand and intense competition. But the five major Japanese capital goods companies--Hitachi, Mitsubishi Electric, Komatsu, Kubota, and Daikin Industries--have spent decades laying solid foundations in key markets around the world (see Appendix below).

We believe business strategies to further expand and strengthen the businesses in which these companies have established businesses will lead to a steady strengthening of competitiveness. However, such a strategy will take longer to bear fruit than acquisition activity.

Maintaining strong business bases

We assess the business profiles of all four rated capital goods manufacturers as strong. Daikin (unrated) is just as competitive. Among our 24 rated Japanese manufacturers, eight have strong business profiles: Four are the capital goods companies.

Several factors will underpin the strong business bases at the major companies, including non-rated Daikin.  These include an ability to develop products that precisely capture customer needs, extensive direct and dealer sales networks, and capacity to provide maintenance services that enable them to respond quickly to customers. Because these factors are built over the medium- to long-term, we believe it is unlikely Chinese or other emerging manufacturers could disturb the sound business foundations of the Japanese majors in the short-term.

We believe new entrants pose a relatively low risk of threatening competition. The pace of innovation in major areas for each company is rather slow. It is therefore not susceptible to rapid disruption observed for example in the automotive industry wrought by electric vehicle manufacturers.

We believe the Japanese companies can expand overseas businesses while their home market is maturing.  Demand will grow in the medium- to long-term, especially overseas, as Japan's majors make many products addressing global megatrends such as climate change, increasing urbanization, and rising automation needs, in our view. We believe the companies will be able to capture demand by investing to strengthen overseas operations and steadily reaping the results of investments supported by relatively prudent operations and sophisticated management.

Remaining gaps in market share and profitability

When we analyze the competitiveness of our rated companies in Japan, we compare them with the world's largest peers in their respective industries. Specifically, we compare:

• Komatsu with U.S.-based Caterpillar (A/Stable/A-1) in construction and mining equipment;
• Kubota with U.S.-based Deere & Co. (A/Stable/A-1) in agricultural equipment; and
• Hitachi and Mitsubishi Electric with German manufacturer Siemens AG (AA-/Stable/A-1+) and French Schneider Electric S.E. (A/Stable/A-1) in the fields of factory automation and Internet of Things.

U.S. and European companies will continue to outperform the major Japanese companies in several respects, in our view.   This is despite the same business profiles of strong of these U.S., European, and Japanese rated companies.

Firstly, we expect Western companies to maintain strong global market positions.  We believe it will be difficult for Japanese companies to significantly overturn the market positions of Western peers' despite business expansion in line with market growth, or in niche areas where they do not compete directly with Western peers. In our view, this is because:

• The Western companies have the largest business and customer bases in their home markets in North America and Europe. These markets are vastly bigger than Japan and have higher growth potential;
• The largest Western companies' business bases in Europe and the U.S. are based on high product development, sales, and brand power. They use these strengths to build business bases in overseas markets in Asia and Latin America, which have higher growth potential than their home markets.

In addition, we expect the profitability of companies in Europe and the U.S. to outperform Japan's top five companies over the next two to three years.  We believe the profitability of European and U.S. companies will be supported by the following factors:

• Pricing power due to strong market positions.
• Economies of scale far outperforming Japan's big players.
• High solution capabilities utilizing digital technologies.

Other factors are likely to help Western companies profitability, in our view:

• Price increases are more likely to occur during inflationary periods in Europe and the U.S., as business practices and trade flows are generally not as complex as in Japan. We believe that has increased the profitability of Western peers over the past two to three years.
• Their management's ability to carry out drastic structural reforms, rationalization, and business portfolio transformations focusing on growth areas.

We believe fierce competition in Japan will pressure the profitability of Japanese manufacturers.   While the market matures in Japan, we believe there is excessive rivalry among several Japanese manufacturers. Due to the burdens of potential structural reforms and anti-monopoly laws, there will be neither progress in industry consolidation nor major changes in the competitive environment among Japanese manufacturers in the next two to three years, in our assumption.

Chart 2

Sound Financial Standing Amid Overseas Expansion

We expect the five major companies to increase capital spending to expand their overseas operations over the next two to three years.   Overseas production accounts for nearly 70% of total manufacturing by Komatsu, which focuses on localizing production. However, many other capital goods manufacturers still export large amounts from Japan.

We believe that all companies will accelerate efforts to localize production and promotion strategies to make goods closer to points of sale. This follows supply chain disruptions caused by the pandemic, the rise of protectionism worldwide, and the emergence of geopolitical risks.

However, these companies will manage their key cash flow metrics well, in our view.   Each company has a very sound financial base. Our rated companies are unlikely to experience a significant deterioration in their financial positions beyond what is permissible under their current ratings because they keep their debt under control with conservative financial policies while implementing growth strategies, in our view.

We also believe that the sort of investor pressure seen overseas will have a limited impact on Japan's five capital goods majors.   For example, we believe that Caterpillar's creditworthiness is constrained by its large share repurchases due to the company's commitment to return a substantial amount of its free cash flow to shareholders over time. In Japan, however, we believe that banks and investors generally value the soundness of their balance sheets. Therefore, we do not believe that even if large Japanese companies provide increased shareholder returns, they would not be so excessive to significantly reduce their capital.

Nevertheless, we believe that the sound financial bases of large Japanese companies will not be a major differentiator from those of major Western companies.   The largest U.S. and European companies have also significantly improved their financial bases over the past few years. We also expect large foreign capital goods companies to maintain relatively healthy financial positions on the back of high earnings.

Chart 3

Appendix

Hitachi Ltd. (A/Stable/A-1)

Hitachi is Japan's largest general electronics and capital goods manufacturer. Over the past few years, the company has actively promoted consolidation and integration of noncore businesses, including listed subsidiaries. At the same time, it acquired Switzerland-based ABB Ltd.'s power grids business in 2020, GlobalLogic Inc., an IT service company in the U.S., in 2021, and the railway signal business in Thales S.A., France, in 2024.

Including these acquisitions, the company is strengthening its market position and customer base in areas with higher growth potential both in Japan and overseas. Overseas sales accounted for 61% of total sales in fiscal 2023 (ended March 31, 2024).

We are watching to see whether the company's ongoing efforts to strengthen its business portfolio will steadily improve the earnings of the entire group. In particular, in the power grids business, we believe that expansion of the service business with higher profit margins has been delayed because of prioritizing management resources for production to meet a surge in orders.

In the next two to three years, we believe the growth of the services business is important for continuation of the improvement in profitability. But we believe the selection of profitable projects and the economies of scale resulting from facility expansion will support an improvement in profitability.

Mitsubishi Electric Corp. (A/Stable/A-1)

Mitsubishi Electric's overseas business is centered on its mainstay factory automation equipment and air conditioning operations. In the field of factory automation equipment, Mitsubishi Electric operates mainly in Japan and Asia, and has an advantage in control equipment that realizes high-precision and high-speed operation. Europe and the U.S. have a small share of the factory automation equipment business.

Volatility for factory automation equipment earnings is high. This is because the business is concentrated in Japan, China, and other parts of Asia and the ratio of business related to the volatile semiconductor and automobiles industries is high, in our view. Overseas sales accounted for 51% of total sales in fiscal 2023.

We are interested to see if the company can improve the overall profitability of the group while reducing the volatility of earnings in the factory automation equipment business.

The expansion of sales of profitable solutions and progress in improving and restructuring low-profit businesses are key to raising the profitability of the entire company, in our view. Diversification into areas such as infrastructure, air conditioning, and home appliances has a stabilizing effect on the portfolio in some extent.

Komatsu Ltd. (A/Stable/A-1)

Komatsu is the world's second-largest construction and mining equipment maker after Caterpillar. The company strengthened its North American and Latin American operations by acquiring Joy Global Inc., a major U.S. mining equipment company, in 2017. The company's China business is getting smaller, but given its operations elsewhere in Asia and in Europe, revenue sources are highly diversified geographically. Overseas sales accounted for 89% of total sales in fiscal 2023.

We will focus our attention on whether the company can maintain its high profitability through the demand cycle of construction and mining equipment in the next one to two years. We expect demand for construction and mining equipment to be negatively impacted by a global economic slowdown and softer resource prices over the next one to two years.

Amid these conditions, the company gets support from the following:

• Its parts sales and after-sales service businesses, which are a stable source of revenue; and
• Its sophisticated management system to optimize production and procurement to meet demand, both in Japan and overseas.

If it can maintain its EBITDA margin close to what it was in fiscal 2023 (19.6%), it would benefit the company's creditworthiness, in our opinion.

Kubota Corp. (A/Stable/A-1)

Kubota is the leading producer of agricultural and construction equipment in Japan and other major Asian countries. The company gained a top position in North America and Europe by developing the small farming and construction machinery markets, which made it less likely to be a direct competitor of Deere, the world's largest manufacturer of large agricultural machinery.

Overseas sales accounted for 79% of total sales in the fiscal year ended Dec. 31, 2023. The ratio of overseas production was a little low at 40%-50%. We believe a heavy burden of export and logistics costs is a weakness in management efficiency.

We are focusing on the extent to which the company's earnings will improve, which is somewhat inferior to the world's major construction and agricultural machinery manufacturers.

Kubota's consolidated cost ratio can be improved by creating synergies in production and procurement with Escorts Kubota Ltd., which became a consolidated subsidiary in 2022, in our view. In the North American small construction equipment market, we believe the company's new products and expansion of local production will enable it to strengthen earnings in the next two to three years.

Daikin Industries Ltd. (unrated)

Daikin Industries Ltd. is the world's largest manufacturer of air-conditioning equipment. Through acquisitions such as that in 2012 of Goodman Global Inc., a major U.S. air conditioning manufacturer, and by developing businesses based on regional market characteristics, it is geographically diversifying its customer base and revenue sources. Overseas sales accounted for 84% of total sales in fiscal 2023.

We are closely looking at the timing of demand recovery and the extent to which the company's earnings will improve. Demand for air conditioners is vulnerable to decarbonization policies and environmental regulations around the world. Currently, weak demand in Europe due to changes in subsidy policies has hurt the company's profitability, in our view.

Related Research

• Japan Corporate Credit Spotlight: Resilience Amid Adversity Abroad, Oct. 17, 2024