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Kawasaki Heavy train fault evokes earlier scandal

Heavy machinery maker must move fast to regain customers' trust

A 14cm crack was discovered in the undercarriage of a West Japan Railway bullet train.   © Kyodo

TOKYO -- Kawasaki Heavy Industries is under pressure following the announcement of production faults in components for Japan's shinkansen bullet trains. The Japanese company this week admitted supplying substandard undercarriages to West Japan Railway, after a cracking frame was discovered in December.

The scandal has emerged amid a series of product-quality problems at Japanese companies, but it also reminded investors of another scandal that hit the leading Japanese heavy machinery maker five years ago.

The announcement on Wednesday evening sent the company's stock price down over 6% over the last two days of the week, to close at 3,675 yen on Friday. The fall was steeper than that of the benchmark Nikkei Stock Average, which dropped 4% over the same period.

The undercarriage problem has reawakened investors' memories of a scandal at Kawasaki Heavy in June 2013, when the company's management was split over a possible business integration with Mitsui Engineering & Shipbuilding. The dispute resulted in the dismissal of the then-president of Kawasaki Heavy and revealed corporate governance weaknesses.

Meeting reporters on Wednesday evening to discuss the problem of the substandard undercarriages, Yoshinori Kanehana, incumbent president of Kawasaki Heavy, said: "Although we have sought to narrow the [management's] distance from workers on the production floor, we have ended up with an outcome of this kind." Kanehana evidently had lessons from the earlier scandal in mind.

Kawasaki Heavy President Yoshinori Kanehana, center, bows in apology over the problem of faulty train undercarriages, at a press conference in Kobe, Hyogo Prefecture, on Feb. 28.

The previous scandal had prompted Kawasaki Heavy to promote management transparency, enhancing communication between management and employees in the workshop, and between business sections, through such means as the active use of in-house social networking services.

Engaging in a wide range of manufacturing operations from railways to dynamos to motorcycles, the company has shifted priorities to management based on the return on invested capital, an index that measures how efficiently capital, invested in divisions, can generate profit. The company has even adopted the ROIC index to calculate bonuses for workers in each division, prompting one foreign brokerage house analyst to say: "Kawasaki Heavy is changing."

Because the undercarriage scandal has been exposed at a time when the market assessment of Kawasaki Heavy was starting to improve, the disappointment may linger.

The undercarriage fault emerged after problems developed in a shinkansen train in operation in December last year. The undercarriage in question was produced some 10 years ago, when the manufacturing operation was left to the discretion of employees on the production floor.

Faced with questions over insufficient corporate governance and reduced reliability, Kawasaki Heavy urgently needs to establish and manage a company-wide quality management system that will not rely exclusively on judgment in the workshop. The task is directly linked to corporate governance.

There are many concerns about Kawasaki Heavy's credibility. In January, the company won an order for up to 1,600 rail cars, valued at around 400 billion yen ($3.8 billion), from New York City because of trust in the Kawasaki brand built up over many years.

Kawasaki Heavy will "carefully explain [the undercarriage problem] to overseas customers to win their understanding" about the trustworthiness of other products, Kanehana said.

But weakened credibility will "undeniably" affect Kawasaki's pursuit of orders, a Japanese brokerage house official said.

Kawasaki Heavy has received MSCI's second-highest "AA" rating for its environmental, social and governance (ESG) criteria, a set of standards referred to by pension funds and other ESG-conscious investors. Kawasaki Heavy stock may fall further if more investors turn risk-averse over the company.

The company said it is "too early" to estimate the impact of the latest scandal on its earnings.

A total of 167 undercarriage frames need to be replaced. Assuming that the price of each will be 10 million yen, Shinji Kuroda of Credit Suisse Securities (Japan) said Kawasaki Heavy will bear a cost of some 1.6 billion yen. On top of this expense, the cost of compensation for West Japan Railway and other affected railway operators will be a key issue.

In fiscal 2017 to March 31, Kawasaki Heavy is currently expected to log a group net profit of 33.5 billion yen, up 30% from the previous year, on a 5% rise in sales to 1.59 trillion yen.

Compared with Nissan Motor and Kobe Steel, which have set aside huge expenses in connection with their product quality problems, Kawasaki Heavy may face limited impact on earnings even after the adverse effects of the faulty undercarriages are taken into account. But it will have to pay an immeasurable social price.

Kanehana has been spearheading Kawasaki Heavy's reform under the catch phrase of Kawa-ru Saki-e (Change and Forward), based on the company's name. He needs to accelerate reform to reinforce governance and rebuild trust in the company.

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