Since the second half of 1991, the Japanese steel industry has been going through a restructuring process. Output is falling. Profits are declining. Investment plans are being cut back. Across the board, the end of the so-called "bubble economy" has abruptly immersed these companies in the kind of volatile environment that has by now become second nature to their counterparts in Europe and North America. That the immersion has been so long delayed is, in many ways, a tribute to the great accomplishments and capabilities of the Japanese steel industry. But the delay is over. And the capabilities that have served the industry so well in the past may now prove a burden.

Traditional steel companies in all advanced economies confront much the same economic forces: stable or, more likely, declining demand for their products, dramatic shifts in technology, escalating capital costs, and intense competition from both new materials and new entrants. The Japanese come to these challenges with several unique advantages: strong technical capabilities; a history of close, positive ties with customers and government; attractive overall price levels; and healthy balance sheets. In today's restructuring environment, however, some of these strengths may equally prove a burden—an unwelcome limitation on the industry's ability to adapt and adjust.

The real situation in steel

During the late 1980s and early 1990s, Japan's bubble economy boosted domestic steel consumption (and thus steel output) far above sustainable levels. Before then, in the mid-1980s, Japanese steel companies had uniformly projected a dramatic fall in production levels to roughly 90 million tons, down from the 110 million tons projected for 1990 and 1991. Some forecasts were more pessimistic still: 80 million tons or less.

By the end of 1988, however, these worrying numbers—and the downsizing plans to which they had given rise—had faded. Instead, steel consumption boomed in Japan and around the world. In fact, Japanese crude-steel demand rose from 70 million tons in 1987 to almost 100 million in 1990.

Moreover, the nature of this demand growth, linked as it was to the strength of the domestic construction sector, proved especially beneficial to just those products (bars, plates, and structural shapes) that were most vulnerable to the restructuring crisis and that had been hardest hit in Europe and North America (see Exhibit 1). As a result, the restructuring programs announced in the mid-1980s were only partially or halfheartedly implemented, and the industry quickly revised its overall market expectations.

This was a mistake. A hard-headed look at the evidence strongly suggests that the pessimism of the mid-1980s was indeed warranted, despite the recent experience of the bubble. As Exhibit 2 indicates, an updated projection for average annual crude-steel output by the year 2000 comes in at about 90 million tons. The reason is simple: in an average year, domestic consumption is unlikely to exceed 80 million tons, and net steel exports are unlikely to exceed 10 million tons.

The figure for domestic consumption rests on an analysis of "steel intensity"—the observed relationship between steel consumption and the level of development in a particular economy. As Exhibit 3, which maps the steel intensity of several economies, shows, Japan is already at the high end of the band for developed countries. There are several reasons for this, including Japan's net trade surplus in steel-containing manufactured goods and the predominance of steel in Japan's construction sector as a result of earthquake risks.

Now, assuming that net exports remain constant at the 1991 level of 9 million tons (an assumption dicussed below), the relatively smooth shape of the intensity curve implies total annual output levels of less than 90 million tons for the remainder of the 1990s. Substantially higher output levels—for example, the 95 million tons now assumed by some observers—would require that the trend of Japanese steel intensity, as well as its absolute level, differ fundamentally from the pattern consistently observed in all other advanced economies. We see no compelling reason why it should.

The dynamics of entry

The recent deterioration in Japan's net trade position in steel is the product of many different causes, among them exchange rate shifts, protectionist measures in foreign markets, and strong bubble-induced domestic demand. But it also reflects the industry's vulnerability to three major types of new entrant: producers in nearby developing countries, such as Posco and China Steel, which grew tremendously in the 1980s and are now highly competitive with their Japanese rivals; Japanese minimills, such as Tokyo Steel; and competing materials, such as aluminum, which are gaining share in the automotive and other core markets.

Japan's net steel trade balance declined from 30 million tons in 1985 to 9 million in 1991

The growing sophistication of steel producers in other Asian countries has had a demonstrable effect on Japan's net steel trade balance, which declined from 30 million tons in 1985 to 9 million in 1991. During the same period, imports, primarily from Korea, increased from 3 to 9 million tons, and exports fell from 33 to 18.¹ Net indirect steel exports—for example, the steel contained in an automobile that is exported—have also trended downward: 15 million tons in 1985; less than 12 million in 1990. Although expanding Asian markets, particularly in China and the ASEAN countries, may eventually provide opportunities for a renewed export thrust, Japan now confronts formidable competitors in its export markets. Even in a best-case scenario, this suggests lower future price levels in those markets.

Domestic minimills have successfully challenged traditional producers in the Japanese beam market, and are now poised to do the same in the sheet market

Meanwhile, domestic minimills, led by Tokyo Steel, have successfully challenged traditional producers in the Japanese beam market, and are now poised to do the same in the sheet market. Moreover, these minimills are likely to get a strong competitive boost as the country's maturing economy provides increased scrap supplies. Japan, in fact, is already self-sufficient in scrap: its transition from net scrap importer to net scrap exporter implies a major reduction—as much as 400 yen per ton (nearly 10 percent of typical operating costs)—in the market price of scrap. When combined with the minimills' much lower capital costs and very lean cost structures, falling scrap prices constitute a profound challenge to traditional Japanese integrated producers.

From a longer-term perspective, minimills represent not only an immediate competitive threat, but also a model of what the successful steel companies of the twenty-first century will be like: small in scale, environmentally friendly, highly adaptable, and with low capital costs and extremely high productivity. The key to their challenge to established producers lies in their ultra-lean management systems and processes.

Nucor in the United States, for instance, has built much of its success on highly effective—and in some ways "Japanese"—human resources policies, including the very careful hiring and "Nucor-izing" of new employees. (All applicants for positions above the level of front-line foreman are interviewed by the chairman.) In addition, sophisticated yet straightforward incentive systems, based on natural work teams, ensure that the entire company is oriented toward profitability and growth. Hourly employees earn up to 70 percent of their total compensation from production-oriented incentives; plant managers, up to 40 percent of theirs based on the plant's return on assets.

This system is reinforced by a lean structure (only three layers between the chairman and the shop floor) that ensures top management attention, on a timely and detailed basis, to plant performance. Shortfalls in performance, highlighted by healthy competition among the plants, are quickly identified and rectified. Although the system encourages experimentation and acknowledges the right to make mistakes, all managers are held strictly accountable for the performance of their operations.

The eventual triumph of this minimill model, although still disputed, is now widely accepted in North America and increasingly in Europe. Until the mid-1980s, it was the leading Japanese steel producers that acted as performance and "best practice" models both for their rivals in developed countries and for start-up operations in the developing world. This is no longer the case: the model of choice is now provided by the best minimills. Even in Japan, the best independent minimill consistently outperforms its integrated rivals (Exhibit 4).

The final threat of new entry comes from the growing use of alternative materials by large, sophisticated customers like the automotive companies. Aluminum, for example, offers potentially significant advantages in weight, formability, and corrosion protection. Although the technical sophistication of the Japanese steel industry gives it a strong position in the materials battle, some erosion of share is likely—particularly as alternative materials become more widely used outside Japan.

The capital-cost dilemma

In the late 1980s, Japan's Big Five steel companies issued convertible securities worth almost 2 trillion yen—almost two-thirds of which comes due before 1995

Capital expenditures by the Japanese steel industry increased tremendously during the speculative environment that prevailed during the bubble economy: 1990 outlays of nearly 900 billion yen were almost double the 450 billion yen figure for 1987. Because the market was receptive to their issuing of stock warrants, these companies could act as if they had virtually unlimited access to very low cost (or even no cost) capital. In the late 1980s, Japan's Big Five steel companies—Nippon, NKK, Kawasaki, Sumitomo, and Kobe—issued convertible securities worth almost 2 trillion yen. Access to funds on such a scale encouraged a huge increase in investment, targeted mostly at facility modernization and at capacity expansions in relatively sophisticated processes such as continuous annealing and electrogalvanizing.

The collapse of the bubble economy has dramatically altered this situation. Today's lower stock prices no longer support the assumptions on which the warrants were issued—a situation that implies a major increase in costs and cash outlays as the warrants come due. (Almost two-thirds of the 2 trillion yen overhang comes due before 1995.) At the same time, escalating interest costs threaten to undermine the returns generated by traditional integrated technology, a situation which, in turn, implies extremely high investment costs.

In most developed countries, where steel consumption is stagnant, the capital markets have not in recent years supported full-scale modernization of integrated plants: the prices companies receive for their products are too low to cover both operating costs and a fair return to investors. As a result, facilities in these regions are either wearing out or becoming technically outdated. In Europe and North America, this creeping obsolescence has led to facility closures, bankruptcies, and (particularly in Europe) government support for investment. Before long, much the same combination of forces will begin to erode the position of Japan's integrated producers as well.

Japan's strengths

As European and North American experience has shown, restructuring in the steel industry involves major discontinuities that can rapidly change the rules of the game. Traditional leaders begin to stumble, and formerly effective strategies—for example, the multi-product portfolios of US integrated producers—lose their force and ultimately prove counterproductive. As longstanding patterns of competitive behavior such as oligopolistic pricing unravel, new entrants are often able to exploit the vulnerabilities of established players.

The Japanese steel industry confronts this restructuring environment with substantial advantages relative to its European and North American counterparts. Most importantly, it enjoys a position of technological leadership within the world steel community in new product development, automation, and process optimization through continuous improvement. Partly financed by the investment boom associated with the bubble economy, it has relatively modern, world-class facilities and highly developed technical skills. Indeed, Japanese plants frequently deploy twice as many qualified engineers as one finds in European or North American facilities.

Also, as noted above, the industry has excellent management systems—including those for continuous improvement—which rely heavily on resident technical skills and deep, sustained experience. Many of the quality taskforces at Japanese plants were founded thirty years ago. It is difficult to find comparable groups at US or European plants that have a history longer than ten years.

Traditionally, Japan's integrated producers enjoyed an industry structure that supported prices 20 to 30 percent higher than those in the United States and Europe

A second advantage traditionally enjoyed by Japan's integrated producers is an industry structure that supports prices 20 to 30 percent higher than those in the United States and Europe—and that provides a return on capital that Japan's rivals have not been able to earn for a decade or more.

This difference in prices derives, in part, from quality levels. But its principal cause to date is the pattern of inter-company cooperation and industrywide discipline that traditionally characterized successful steel industries, but that has broken down in other regions. In the United States, for example, traditional industry leaders now control less than 50 percent of the market, compared with over 80 percent in the early 1960s. When this happens, with competitive pressures so much more intense, both prices and profitability fall.

A third source of advantage is Japan's proximity to the rapidly growing steel markets of the Pacific Basin, which will continue to be a major net importer of steel even as local capacity grows. To a great extent, this region is Japan's "natural" market. Political and economic considerations will, inevitably, complicate things, but the Pacific Basin's underlying dynamism provides a degree of freedom for Japan's restructuring in steel that is absent in North America and, especially, Europe, where the proximity of former Eastern bloc producers offers not attractive markets, but low-cost competitors and the threat of significant excess capacity.

Areas of concern

The current strategies of the leading Japanese steel companies are grounded in the advanced facilities and technical prowess that represent the industry's greatest strengths. But they may also reflect a basic misreading of the competitive forces at work in the global marketplace, as was the case with many European and American steel company strategies in the late 1970s and early 1980s.

The premises of strategy

The prevailing strategy in the Japanese industry is to invest in core facilities for supplying premium products while diversifying into new product and geographic markets. The key assumptions embedded in this strategy are that a substantial market for premium products exists—and will continue to do so—and that Japanese producers have skills that can be effectively and rapidly leveraged outside their core domestic business. Together, these assumptions imply that commodity markets can safely be surrendered to foreign or minimill competitors, that major investments will—and should—be made in advanced equipment for the core plants and for R&D, and that diversification initiatives will absorb a significant portion of the cashflow generated by the core business.

Unfortunately, these assumptions are highly problematic and their implications potentially dangerous. The premium, high-quality segment of the steel market in Japan is small: even the potential premium market accounts for less than 12 million tons in a total carbon steel market that in average years amounts to less than 70 million tons (Exhibit 5). For carbon at-rolled products, the bread and butter products for integrated plants, the potential premium market is around 8 million tons—roughly equal to the capacity of any one of the large Japanese plants (Kimitsu, Mizushima, and Fukuyama among them). There is simply not enough room in the marketplace to provide good returns for all the producers seeking to serve the high-quality niche.

What happens when too many players chase after a specialty niche that is too small?

What happens when too many players chase after a specialty niche that is too small? First, such specialty products quickly become commodities—that is, excess capacity forces prices down toward marginal cost levels. Second, investment decisions tend to go awry. Companies typically make ever-higher investments in state of the art facilities in the hope that competitors will not follow suit. But they do. Each investment therefore generates lower than expected returns. And third, operational performance deteriorates. As excess costs get built into the system to support a high-end strategy, they penalize the commodity products that inevitably dominate each company's sales.

Integrated companies can also incur substantial complexity costs, which frequently go unrecognized because accounting systems mask the true costs and margins of specific products sold to specific customer accounts. Exhibit 6 shows the wide range in product and account profitability that emerged from a careful recasting of accounting data at one company. A large portion of its sales generated negative returns when evaluated on an actual, rather than accounting, cost basis—a situation exacerbated by a management focus on markets that were difficult to serve and almost hopelessly unprofitable.

In strong market conditions or in stable oligopolies, high prices can mask such problems. Especially when markets are sluggish, however, these problems leave full-line producers vulnerable to focused competitors such as the minimills.

Consider, for example, what happened to traditional specialty bar producers in both Europe and the United States. Challenged by minimill competitors, they each aggressively pursued the high-quality end of the market, thus generating widespread excess capacity and low returns. Meanwhile, minimills incrementally expanded their product capability, making further inroads into the low end of the specialty market with a cost structure that the traditional producers could not match. This reinforced the whole vicious cycle.

The skills and systems that are so impressive in the Japanese context are not always effectively transferable

The final element of conventional strategy—diversification—is also fraught with risks. It is extremely difficult to execute financially successful diversification into unrelated markets, a finding confirmed by many of the Japanese steel industry's initiatives during the 1980s: theme parks, bioengineering, electronics, and the like. Moreover, even those diversification efforts that fell within the core industry's business—its substantial investments in the United States, for example—have often proved disappointing. The skills and systems that are so impressive in the Japanese context are not always effectively transferable.

The limits of functional organization

Another source of concern is the Japanese steel industry's management processes and systems: they may be too rigid and over-functionalized to deal with the major changes in market environment now occurring. These companies are usually organized to achieve extraordinary levels of operational performance in the plants, which are by and large the domain of the engineers. The other key functional activities are separated from the plants to a much higher degree than is the case in Europe or North America—even to the extent that most commercial functions are undertaken outside the company, through trading rms.

It is easy, therefore, for operational performance to become divorced from commercial or financial considerations. When this happens, plant relations with headquarters regarding output levels, capital expenditures, improvement targets, and the like virtually take on the character of formal negotiations. And when an engineer from the operating side assumes a chief executive position, as recently happened at NKK and Sumitomo, it is a rare enough event to become a news item.

Functional blind spots made it difficult for these companies to recognize the breadth and depth of the problems, especially the marketing problems, facing their US partners

Failed diversification efforts—especially those associated with poorly performing equity investments in the US steel industry—provide clear evidence of the risks inherent in the typical functional organization of the leading steel companies in Japan. Functional blind spots made it difficult for these companies to recognize the breadth and depth of the problems, especially the marketing problems, facing their US partners. Moreover, the Japanese firms grossly underestimated the difficulty of applying their technical expertise and management approaches in the US environment. This shortsightedness is doubly worrisome because overseas investment offers a reasonably close parallel to the kinds of dramatic shifts that the Japanese steel industry is now facing in its home market.

Bad habits

Low returns may have seemed acceptable in the late 1980s, but in the current financial environment, they are a sure recipe for disaster

A third major concern is that, in their diversification and modernization programs, Japanese steel firms have learned bad habits regarding return on investment. Low returns may have seemed acceptable in the late 1980s, but in the current financial environment, they are a sure recipe for disaster. As their US and European counterparts have discovered, persistently low returns on investment represent an insidious and debilitating problem. They squander wealth and resources, which are then unavailable for the restructuring initiatives that the marketplace requires.

European and American experience illustrates the many forms this disease can take: failure to recognize technical change, capital rationing across too many plants, attempts to support inappropriate technology, and potentially excessive reliance on "high tech" with inadequate regard for commercial realities. Too many wrong moves of this nature make it impossible for a company to renew itself, a problem that has typically led to government subsidies in Europe and various forms of financial engineering (capital leases, for example, or bankruptcy proceedings) in North America.

All the traditional steel firms in Japan seem to be pursuing the same strategy, using the same means, the same assets, and the same resources

A nal concern is the fact that all the traditional steel rms in Japan seem to be pursuing the same strategy, using the same means, the same assets, and the same resources. This problem also plagues traditional steel producers in Europe and North America. Indeed, a lack of strategic diversity is common in any highly concentrated industry where company performance is largely determined by industry performance and where company conduct is governed by well-understood (if rarely documented) "club rules." In a stagnant market facing a signicant threat of new entry, however, even inherently effective strategies lead to poor results if pursued by all the major players.

The high-end strategy unravels

All these areas of concern—inappropriate strategies, excessive functionalization, inadequate regard for investment returns, and lack of diversity—were masked by the boom market that prevailed from 1988 to 1991. Strong demand across all product categories pushed prices upward, a trend that was reinforced by longstanding patterns of cooperation within the industry. Moreover, demand levels made it possible to ignore the challenge posed by new entrants, whether minimills or foreign producers. With demand high, there seemed little reason to defend the low end of the market, and apparently low capital costs ensured that little attention would be paid to return on investment.

Today, however, burdened by functional rigidity, poor investment discipline, and excessive uniformity, the high-end strategy of traditional Japanese producers is beginning to unravel under the prevailing market conditions. Established players suddenly need the volume that has been surrendered to imports and minimill entrants such as Tokyo Steel. In addition, low operating rates, combined with the high fixed costs of integrated operations and the availability of alternative sources of supply, put substantial downward pressure on prices. And this, in turn, leads to cost-reduction and restructuring pressures that are likely to dominate the management agenda at leading Japanese companies during the next few years.

An agenda for management

What issues, then, should be high on the management agenda of the leading Japanese steel companies? The restructuring of the steel industries of Europe and the United States over the past decade provides several valuable background lessons:

• Do not underestimate the severity of the restructuring challenge. The primary lesson from European and North American experience is that the most successful companies—British Steel, for example—have been the most aggressive in changing their assets, their performance, and their culture. Although these companies continue to face major restructuring challenges, their prospects of meeting them successfully are relatively good. Their financial positions are stronger than those of their less aggressive competitors; their agendas are focused more clearly on the future; and they can build on the momentum established by the improvements they have already achieved. Companies that have been slower to accept the need for change will find things much more difficult.
• Recognize the importance of real leadership. All successful restructuring programs have been driven by strong, visionary leaders. Since the changes required are fundamental, organizations inevitably resist them with great energy. True leadership is necessary to overcome this resistance.
• Make sure you are cost competitive. Because steel has become, by and large, a commodity product, only low-cost producers can expect to earn acceptable returns throughout the business cycle. Although low costs alone cannot guarantee good results, they provide the necessary resources for implementing the strategic initiatives that will determine not just success, but survival itself.

  Because steel has become a commodity product, only low-cost producers can expect to earn acceptable returns throughout the business cycle

• Make the transition to new technologies and new ways of doing business an explicit part of the restructuring process. Ultimately, the old-line integrated producer approach to steel will not be a viable economic proposition in developed countries—even if its final day of reckoning has yet to arrive. Although it is natural for restructuring initiatives to focus on improving the current business, the apparently more farsighted restructurers—for example, Arbed with its transition to electric-furnace technology, or Dofasco with its commitment to thin-slab casting—will direct their energies toward moving closer to alternative technologies and cultures.

The challenges ahead

A strategy of investing in core assets to serve the high end of the market, while diversifying into new product and geographic markets, cannot work. The market is just not there

First and foremost of the challenges facing the large Japanese steel companies is the urgent need to rethink their current strategy: investing in core assets to serve the high end of the market, while diversifying into new product and geographic markets. If our assessment is correct—that is, if European and American experience is relevant—this strategy is likely to prove disastrous for the Japanese steel industry. The market is just not there.

If executed properly, a thoroughgoing strategic reassessment could also help address the industry's problems with functional rivalries, overinvestment, and lack of differentiation. Such a reassessment will not be effective, however, unless it is carried out by a team that truly bridges functional divides, that focuses on return on investment, and that seeks to chart a strategic direction different from that of competitors.

Second, Japanese steel firms must take a very careful look at the value of their assets and make an objective assessment of where the leverage really exists for increased wealth creation. The evidence strongly suggests that the major opportunities, and the major leverage, lie in these companies' core steel business—for example, fixing underperforming steel ventures outside Japan. To date, however, these ventures have received nowhere near the attention their potential warrants.

Third, much greater attention must be paid to cost performance and productivity. Some Japanese plants are among the most efficient in the world; others have lost ground because the restructuring initiatives begun in the mid-1980s, such as reducing staffing levels (Exhibit 7), were allowed to lapse during the boom. This is especially true of those plants that have had to reduce output more than capacity, a task that imposes a burden that may prove very difficult to bear as the market becomes more competitive.

Finally, Japanese steel companies must find a way to exploit their geographic advantage so as to participate actively in the growth of the Asian market. Many of the emerging countries in the region will, of course, want to build their own facilities, replacing imports from Japan and elsewhere. Nevertheless, the effectiveness with which Japanese producers manage relationships with their neighboring markets and maintain a healthy regional balance between supply and demand will make an enormous difference to their performance. Given the low operating rates and prices in their home market, why not consider, for example, dedicating one or two large Japanese plants to the Chinese market, transferring the product at cost?

A search for balance

By traditional standards, the Japanese steel industry is a contradiction in terms: a huge national industry in a country with none of the natural resources that have usually determined both location and success. In the past, by changing the rules of the game—in particular, by creating massive economies of scale at tidewater plants built to take advantage of (and encourage) new raw materials discoveries—Japanese producers turned weakness into strength. By any reasonable judgment, this accomplishment ranks with the great success stories of the modern industrial era.

Today, however, others are changing the rules of the game, and the Japanese industry must adapt to them. Adaptation, here, means finding the right balance between:

• steel versus other businesses
• company versus industry
• plant versus company
• commodity versus specialty
• domestic versus foreign
• integrated versus minimill.

The relative importance of these issues, as well as the most appropriate balance within each, will shift over time and will differ from company to company. The Japanese steel producers that find a workable balance are likely to remain world leaders even as they evolve into something very different from what they are today.