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Where did Toshiba go wrong, and where does it go now?

Options for survival look likely to gut the Japanese electronics giant

Pressure to complete two projects, including the Vogtle nuclear plant in Georgia, U.S., led to Westinghouse's rushed purchase of CB&I Stone & Webster, whose massive losses are now weighing on Toshiba.   © Getty Images

TOKYO -- Toshiba is on the brink of disintegration.

One of Japan's leading electronics makers, the company failed what should have been a routine task: release its April-December earnings as scheduled in February. That was just the tip of the iceberg. Later, Toshiba announced an impairment loss of more than 700 billion yen ($6.2 billion) on its nuclear power business, primarily from U.S. unit Westinghouse Electric, and that its liabilities exceeded its assets by 191.2 billion yen as of the end of December.

The stock market did not take this news well. Toshiba's market capitalization stood at 778.4 billion yen as of Feb. 21, down 1.1 trillion yen from late December. The conglomerate has already sold a slew of operations, including mobile phones, medical systems and white goods, in order to focus on core divisions -- but now even these are on the chopping block. Toshiba is considering selling its memory chip unit and may accept outside investment in its nuclear business.

How did a once-mighty company fall so far, and is there anywhere for it to go from here?

Missed appointment

The market and the media were eagerly awaiting the release of Toshiba's latest earnings report, scheduled for 12 p.m. on Feb. 14. But noon came and went with nothing appearing either on the Toshiba website or the Japan Exchange Group's Company Announcements Distribution Service site. Eventually Toshiba posted a short notice on its site: "Toshiba's announcement of its earnings for the first nine months and third quarter of FY2016 was scheduled for today. However, as of 12:00, Feb. 14, JST time, the report has not yet become available."

That announcement prompted a massive sell-off, and Toshiba shares ended the day down 8%.

President Satoshi Tsunakawa apologized for the delay at a news conference held later that day, saying an event had occurred that forced the company to postpone the earnings release. Shortly before the news conference began, Toshiba disclosed "tentative" earnings data with an unusual caveat: "This information is disclosed as is, as a provisional forecast by Toshiba Corporation."

The company warned that the figures, released without authorization from auditors, were "under review by the independent accounting auditor, and there is the possibility of amendment." Toshiba executives explained that "inappropriate pressure" within the group had been discovered, making it impossible to submit an auditor-approved quarterly earnings report on time. A new deadline was set for March 14.

Executives also disclosed a goodwill impairment loss of 712.5 billion yen on its nuclear power operations for the fiscal year through March 2017 and a group net loss of 390 billion yen. These losses are expected to plunge the company's shareholder equity to negative 150 billion yen at the end of March.

Along with this dire outlook, Toshiba announced that Chairman Shigenori Shiga would be stepping down the following day.

But the executives gave little information about the "inappropriate pressure" that held up the auditing process.

Since the company released its financial projections, investor concern over the state of Toshiba has only grown. Its shares closed at 183.7 yen on Feb. 21, down 26% from the day before the earnings report delay. Toshiba bond prices have also plunged. At one point, the yield differential with Japanese government bonds three years from maturity exceeded 600 basis points. The five-year credit default swap -- a contract that protects investors from the risk of a bond defaulting -- soared to just over 5% on Feb. 14, the highest in a year.

Japanese credit ratings agency Rating and Investment Information downgraded Toshiba's rating by three notches from BB to B on Feb. 15. Two days later, S&P Global Ratings suggested the possibility of a multiple-notch downgrade of Toshiba's long-term rating. "Given Toshiba's already very fragile financial standing, whether the company can receive continuous financial support from its creditor banks, including liquidity support, is a key factor in our credit analysis," it said in a statement.

"Delaying the quarterly earnings report could raise suspicions that Toshiba is facing problems that trigger covenants allowing lenders to call in loans," said Mana Nakazora, head of investment research at BNP Paribas Securities (Japan).

Toshiba's main lenders have agreed not to exercise those covenants and to continue their syndicated loans until the end of February. But if new problems come to light, negotiations for financial assistance could go back to square one.

Looming delisting

"I was waiting to see whether Toshiba would give clear explanations about various concerns, such as what caused the huge loss, a possible breach of trust by the management team, financial support and progress in selling its memory chip unit," Nakazora said. But with the delayed earnings report, uncertainties persist.

Moreover, allegations have surfaced that the "inappropriate pressure" came from a senior manager at Westinghouse and was related to the acquisition of nuclear power plant builder CB&I Stone & Webster in 2015.

Toshiba said in a statement that it asked for a one-month extension in filing its quarterly earnings report after it became aware of a possible impropriety. "On Jan. 8 and 19, 2017, internal reports were made to Toshiba's Audit Committee that suggested that internal controls related to the Purchase Price Allocation process for Westinghouse's acquisition of CB&I Stone &Webster were inadequate," the company said.

According to the extension notice, filed on Feb. 14, Toshiba's auditing committee has "outsourced investigation of this to the law firm Nishimura & Asahi, and Westinghouse hired K&L Gates to investigate the reports." It also says that "although no particular item requiring revision has been found in the consolidated quarterly business report, it was decided yesterday afternoon that additional investigation was required in order to clarify the existence and extent of the effects of any actual occurrence of management pressure."

When reporters at the news conference asked whether the senior manager in question is Westinghouse Chairman Danny Roderick, Audit Committee Chairman Ryoji Sato declined to comment, saying only that the matter is under investigation.

Information disclosed by the company shows that reports concerning a breach of internal control were addressed to Interim President and CEO Jose Emeterio Gutierrez, apparently ruling him out as a potential source of the "pressure."

But Shiga, who as chairman oversaw Toshiba's nuclear operations, and Roderick have been implicated, a source familiar with the matter said.

When Westinghouse acquired CB&I Stone & Webster at the end of 2015, the unit's value was pegged at negative 10.5 billion yen. That figure has since ballooned nearly 60 times, to negative 625.3 billion yen, due to "price contracts inked right after the acquisition," an executive revealed.

The introduction of tighter nuclear safety standards following the 2011 earthquake and tsunami in Japan left plant builders around the world struggling to keep projects on time and on budget. Westinghouse was no exception. As construction timelines stretched out, the company logged some 420 billion yen in additional labor costs and 200 billion yen for materials -- costs it could not pass on to utilities ordering the facilities. Purchasing CB&I Stone & Webster was seen as a solution for getting delayed projects finished.

The problem was that no executive other than the one directly responsible for the contract thoroughly examined what that acquisition would entail. As CB&I, the former owner of the acquired unit, was a listed company, "we had no choice but to trust what material was presented," said Mamoru Hatazawa, Toshiba's executive officer in charge of nuclear operations.

This spectacular managerial lapse was all the more dismaying for those within and outside the company as it came at a time when Toshiba was trying to bolster its internal governance.

Control issues

Founded in 1875, Toshiba got its start making incandescent bulbs and telegraphic equipment. It later expanded into refrigerators, washing machines, color television sets, laptops and DVD players, some of which were the first in Japan or even the world.

Despite being a time-honored company with brands that are household names, Toshiba's many recent scandals have left its reputation in tatters. The root of these scandals can be traced to slipshod corporate governance -- a lack of oversight that failed to contain rivalries between former executives and which allowed excessive pressure on employees, leading to the accounting irregularities that came to light in 2015.

Three former presidents have stepped down or retired to take responsibility for the scandals. They are Atsutoshi Nishida, who served for four years from 2005 and whose background was in the PC business; his successor Norio Sasaki, who used to work in the nuclear power business; and Hisao Tanaka from the procurement division, who held the post between 2013 and 2015. Toshiba acquired Westinghouse in 2006 when Nishida was at the helm.

The conglomerate has provided ample evidence of poor governance in recent years. Toshiba released revised profit figures for business years affected by the accounting scandal on May 13, 2015 -- at 11:45 p.m. In November that year, the company held an important news conference, which included announcements that it was filing a civil lawsuit against former management and details of its restructuring plan, on a Saturday. And in August 2016, it released an earnings report during Japan's summer holiday season. All of this is in addition to the recent delays in the disclosure of Westinghouse's past earnings and Toshiba's own earnings delay.

"The acquisition of S&W was decided when Toshiba was trying to improve its governance, but things still ended up this way," said Masayuki Kubota of Rakuten Securities Economic Research Institute. "I can't help but question whether Toshiba's management system is adequate for a listed company."

Once the March 14 deadline for releasing its earnings report passes, Toshiba will have to resubmit a written confirmation of its internal management framework to Japan Exchange Group. If the stock exchange operator concludes that governance has not improved, it will maintain its designation of Toshiba as "securities on alert." Fumio Matsumoto, senior fund manager at Dalton Capital (Japan), warns that a delisting could become more likely.

Ciao, chips?

Poor management has lead to Toshiba's other major risk factor -- a balance sheet ravaged by massive losses. It looks increasingly likely that the company will become technically insolvent at the end of March and be demoted to the second section of the Tokyo Stock Exchange. Toshiba is scrambling to avoid this, revealing on Feb. 14 a drastically revised plan to spin off or sell its flagship memory chip business.

"We must be ready to sell off 100% of our memory operations. Without that commitment, the company's not going to make it," said Yasuo Naruke, a senior executive vice president, at the board meeting on Feb. 14. That Naruke is willing to part with a business so dear to him speaks volumes about Toshiba's crisis.

A Toshiba chip fabrication facility in Yokkaichi, Japan.

Though Toshiba previously said outside investors would have less than a 20% stake in the new memory chip unit, the embattled conglomerate has realized that it needs to boost its capital base, even if it means giving up a majority stake in a key unit. Western Digital was among those reportedly interested in taking a minority stake, but Toshiba says it will solicit fresh proposals for a sale under the new conditions.

Speculation is rife that Toshiba, hoping to maximize its profit, will push back the sale of the memory chip unit to give potential buyers more time to examine its assets. This speculation is fueled in part by the fact that the general criterion for loans in Japan is not a company's equity alone, but its net assets -- its equity plus stakes held by minority shareholders, etc. More of Toshiba's lenders are starting to feel confident that their loans will not be affected even if Toshiba's equity turns negative at the end of March and the company is demoted to the TSE's second section.

Tsunakawa told reporters that Toshiba is also considering looking for investors for Westinghouse to lower its stake from the current 87%. "We haven't decided whether to lower our stake in Westinghouse to below 50%, but any options are possible," he said.

Toshiba has sold many of its main operations and stakes in other companies in recent years. In 2015, it sold its stake in Finnish elevator-maker Kone Oyj for 864.7 million euros ($919 million) and a silicon wafer production line to Sony for 19 billion yen. Last year, it sold Toshiba Medical Systems to Canon for 665.5 billion yen and its white goods business to China's Midea Group for 53.7 billion yen.

As the developer of NAND flash memory chips, Toshiba has a reputation for cutting-edge semiconductor technologies. Its chip business is said to be worth 1.5 trillion yen, and despite the company's numerous troubles, Toshiba is still one of the world's leading players in the nuclear power business. It also has a competitive edge in such operations as elevators, air conditioning and lighting. Its survival depends on continuing to evolve from a consumer-oriented appliance and electronics maker to a new kind of company.

"The technologies at Toshiba's disposal are not in dispute," said Atsushi Osanai, professor at the Waseda Business School in Tokyo. Osanai said that even after selling off its semiconductor business, the company will be able to survive if it can find the right management, one capable of transforming those technologies into concrete businesses. "If the new management can do that, then I think Toshiba can still be a valuable player in areas like infrastructure solutions; not a company with the top share, but valuable nonetheless."

Osanai sees the company's nuclear operations as a burden best jettisoned. "I think Toshiba needs to cut off the business," he said. "Nuclear is a risk that other private companies cannot take, so I think the state should get involved and help out one way or the other."

Transforming the company, however, will take a level of coordination beyond what it currently possesses.

"Toshiba may be able to avoid an imminent crisis by selling its semiconductor business, but where is a future revenue source?" said a certified public accountant who does business with Toshiba. "It has various divisions, but they each seem like an independent company because of the lack of communication between them. Toshiba is reforming its accounting system in the wake of the scandal, but cross-divisional communication remains insufficient. That's the problem."

Toshiba's troubles began with quarrels among top management, but undoing the damage those quarrels have caused will take a healthy amount of outside help. The company has a long way to go to regain investors' trust and draw up a new growth strategy.

Nikkei staff writers Hiroto Tanaka, Yukihiro Omoto, Misa Hama, Marimi Kishimoto, Kentaro Iwamoto and Shotaro Tani, and NQN senior staff writer Yoichi Nagai contributed to this article.

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