Hitachi Ltd and Mitsubishi Heavy Industries Ltd have begun talks on what would be Japan's biggest domestic merger, three sources said, heralding a long awaited shake-up of the nation's industrial behemoths.     

Traditionally seen as a last resort of failing firms, Japanese companies until recently have largely avoided strategic mergers. A combination of two of Japan's oldest, most established conglomerates would mark a deeper embrace of mergers as a tool for corporations to squeeze costs, combat a surging yen and gain competitive scale. 

"If the merger is confirmed it'd be very positive news for Japanese industry, because Tokyo companies wouldn't compete against each other when bidding for overseas infrastructure projects, thus increasing their chances and through this helping the country's economy," said Kiyoshi Noda, chief fund manager at MU Investments.    

Although still on, discussions teetered close to collapse on Thursday after a leak to local media startled executives at the industrial giants, two of the sources with knowledge of the matter told Reuters.

Executives from Hitachi and Mitsubishi Heavy have met to discuss merging in areas such as next-generation power operations and smart grids, the sources said.

But after media reported the news and Hitachi's President Hiroaki Nakanishi said an announcement would come later on Thursday, both Hitachi and Mitsubishi Heavy officials denied the talks, adding no announcement was now planned. 

The Nikkei newspaper, which broke the story, said the firms planned to set up a merger preparation committee.

Both companies have been weighed down for years by high cost structures. Hitachi, Japan's biggest industrial electronics firm, turned its first net profit in five years in the year ended in March and is still trying to reduce the size of its empire of 900 group firms. It has lost $14.3 billion in the last 10 years, compared with rival General Electric , which generated net profit of $160 billion in the same period.

Mitsubishi Heavy, the nation's leading heavy machinery maker, remains saddled by losses on its jet and shipbuilding operations. Operating profit in the three months to June 30 dipped 1 percent from a year earlier to 38.7 billion yen the company said on Thursday, with its aerospace unit posting a 2.9 billion yen loss.

A merger would create a $150 billion revenue infrastructure firm second only to GE, and could provide impetus for cost cuts essential if the two companies are to thrive in an environment with the yen trading at around 77-79 yen to the dollar.

The merged entity would still be small in terms of market value relative to other global industrial groups, such as GE, Siemens and ABB.

Hitachi has a market value of $27 billion, making it the likely dominant partner in any tie-up. Mitsubishi Heavy was valued at nearly $16 billion as of Wednesday's closing price.

Sources said nothing had been decided, from a merger ratio and even which would be the surviving entity.

"Many of the key questions remain unaddressed. Who will take leadership in what? What will happen to overlapping businesses? What happens to each company's alliances? There is still some confusion internally," said one executive with direct knowledge of the talks.

While the scope and structure of any deal is uncertain, a full takeover of Mitsubishi Heavy, including its debt, could cost Hitachi around $28 billion, according to Thomson Reuters data. That would top Softbank's $17.5 billion purchase of Vodafone Group's Japan unit in 2004 as the country's biggest local deal.  

Such a deal would mark a significant shift in a business landscape dominated by large, sprawling conglomerates with close ties to peers across a range of different industries. - Reuters