(FORTUNE Magazine) - ASK CANON CEO FUJIO MITARAI to explain how he turned a floundering Japanese electronics maker into one of the world's most profitable technology giants, and he's apt to tell you about an Internal Revenue Service auditor named Greg. It was 1966, and Mitarai had been put in charge of accounting at Canon's new U.S. subsidiary. In its first year the venture reported a profit of just $6,000, a sum so paltry it aroused suspicion at the IRS. After scouring Canon's books for a month and verifying that its U.S. earnings were every bit as meager as claimed, Greg, the agency's lead auditor, offered Mitarai some free advice: Deposit your accounts receivable in the bank, close the company, and go home.

"'Go back to Japan!' That's what he told me," Mitarai says, slapping the arm of his chair in an airy conference room atop the company's suburban Tokyo headquarters. "U.S. banks were offering 5% on time deposits. If I couldn't do better, Greg said, I was wasting my time." To a young Japanese executive, steeped in a business culture that prized technical achievement, export volumes, and market share, the admonition came as a shock. "That's when it dawned on me," says Mitarai. "The primary purpose of any business is to make a profit. If you can't beat bank savings rates, your company has no reason to exist."

In the years since, Mitarai has taken Greg's advice to heart. As head of Canon USA from 1979 to 1989, he beat the savings rate every year--usually by a wide margin. And since he was named CEO of the parent company in 1995, Mitarai has transformed Canon from a debt-ridden industry also-ran into a money machine. During his tenure Canon has emerged as the world's largest manufacturer of office copying equipment, become a leading player in the market for home and office printers, and eclipsed Sony as the world's No. 1 maker of digital cameras. Sales are up 40%, while earnings have improved sixfold. In 2004, the last full year for which figures are available, Canon reported a net profit of $3.1 billion on sales of $32.1 billion--and made almost as much money as Hewlett-Packard, a business more than twice its size.

Canon's success is reflected in its share price, trading at $62 in mid-January, a threefold improvement since Mitarai's appointment. The company is the darling of global investors hunting for value in the world's second-largest economy. Indeed, non-Japanese investors now own more than half of Canon's shares. Goldman Sachs analyst Shin Horie predicts that ratio will climb even higher as overseas investors gain confidence in Japan's recovery.

Mitarai's record more than qualifies him to be FORTUNE's Asia Businessman of the Year for 2005. For our money, he may be the best Japanese CEO in a decade. True, Toyota rakes in more cash. But Canon has higher margins--higher than any other Japanese manufacturer's. And while the main task for Toyota's skippers has been keeping the juggernaut on course, Mitarai had to bring his ship about sharply just to keep it from going under. The turnaround may not have been as dramatic as Nissan's, but changes at that company came at the hands of a Western CEO, and only after foreign investors gained management control. Mitarai turned Canon around before being forced to by outsiders. His willingness to make tough choices early and independently is the difference between success at Canon and the mess at Sony.

Mitarai, who recently turned 70, insists the best is yet to come. He has rolled out an ambitious five-year growth program for Canon that he says will keep profits high and lift sales beyond $50 billion by 2010. Longer term, he's betting billions on a new technology called surface-conduction electron-emitter display, or SED, that he believes will enable Canon to muscle into the flat-screen TV market and occupy a central role in the daily lives of global consumers.

But Mitarai's success has brought him a new challenge. Late last year Toyota chairman Hiroshi Okuda asked Mitarai to succeed him as chairman of Keidanren, the influential business lobby that represents Japan's largest corporations. It's an unexpected honor. The post, which will make Mitarai the public face of Japan Inc., has long been reserved for leaders from the nation's smokestack giants--power companies, steelmakers, auto manufacturers--and it was widely assumed Okuda would pass the mantle to his successor at Toyota, Fujio Cho. Mitarai's elevation to the Keidanren chair has big implications for Canon. Past Keidanren chairmen have devoted nearly all their time to the role, surrendering day-to-day management of their companies. But Mitarai has no obvious successor at Canon, and some analysts have cited his Keidanren appointment as a negative for the company's stock. He says he hasn't made a decision about succession--and doesn't plan to until May, the month before his Keidanren term begins. But in an interview with FORTUNE, he dropped a hint that he means to keep his day job. "I'll have to think about it a bit more," he says. "I've served as a Keidanren vice chairman for the past four years, and all that time I was CEO. I already know most of what goes on."

Should Mitarai opt to stay on as CEO at Canon, it would be a first for Keidanren --but hardly the first time Mitarai has flouted convention. In the Western media, he is often portrayed as a traditionalist for venerating old-fashioned Japanese management practices like lifetime employment and sniping at the American system of hiring outside directors. He is also known for questioning the wisdom of moving Japanese factories to China. But at home he's considered a maverick. He keeps a low profile in Japan's business establishment, and when he does speak out, he has an un-Japanese tendency to say what he really thinks. In the Japanese press, he's often described as an American-style reformer for his emphasis on the bottom line and hailed as an "internationalist" for his 23 years of management experience in the U.S. Mitarai prefers a different label. "I'm a pragmatist," he says. "I like to do what works."

MITARAI HAS LONG HELD STRONG OPINIONS ABOUT WHAT works and what doesn't work for Canon. Those opinions haven't always been heeded, despite his status as a nephew of the company's founder. Mitarai grew up in a family of physicians. His father was a doctor, as were his uncles and three older brothers. But as a young boy during World War II, he was so horrified by the cries of the wounded that he shunned medicine and earned a degree in law instead. Upon graduation in 1961, he went to work for the burgeoning camera-manufacturing business run by his father's younger brother Takeshi, a Tokyo obstetrician who had launched the company as a sideline before the war. By the early 1960s, Uncle Takeshi's modest optical-instruments venture was cranking out cameras for consumers throughout Japan, expanding into office equipment, and wresting market share overseas from German camera makers. By the time Fujio was dispatched to New York City in 1966, Canon boasted an office on Fifth Avenue and $3 million in U.S. sales.

From the beginning, Canon's culture was dominated by scientists and technicians. It attracted some of Japan's most talented tinkers and entrepreneurs, invested heavily in research and development, and claimed a slew of new patents every year. But by the 1980s Mitarai began to worry that the company's enthusiasm for technology was hurtling out of control. The spirit of freewheeling independence that had generated some of Canon's most successful products was giving way to anarchy. As Mitarai saw it, Canon was devolving into a clutch of warring fiefdoms, each with its own strategy and free to lavish capital and manpower on pet projects without regard for the rest of the company. Money-losing ventures staggered on year after year, siphoning resources from products with genuine promise. The yen's surge following the 1985 Plaza Accord sapped Canon's competitiveness in foreign markets. The company's debt ballooned. No one wanted Canon's stock. To Mitarai, it seemed that his physician uncle's brainchild had suffered a "collapse of its central nervous system."

After he was called back to Japan to head the company's administrative division in 1989, Mitarai did his best to sound the alarm. He clashed repeatedly with other executives. "I offered all kinds of suggestions for reform, but no one listened," recalls Mitarai, who was fifth in the executive pecking order but the only senior manager with a background in accounting and finance. "They were all techies. It was as if I spoke a different language." The odds that his suggestions would ever be implemented seemed all the more remote when, in 1993, the board chose Takeshi's eldest son, Hajime--a Stanford-trained electrical engineer ten years Mitarai's junior--as CEO.

Hajime's death from pneumonia in 1995 thrust Mitarai into the corner suite. He set a new tone from the outset, yanking the plug on Canon's personal-computer business. By 1999 he had ordered the company out of six other money-losing divisions, including liquid-crystal displays, photovoltaic batteries, and electric typewriters. The announcements stunned Japan and drew resistance inside Canon. Mitarai reckons it took two years for enough of the old guard to retire to give him real control.

He sought further savings on the factory floor, experimenting with a new manufacturing approach known as cell production that replaced conveyor belts and old-fashioned assembly lines with small teams of workers who produced entire products in carefully considered, sequenced steps. In early trials, the method yielded dramatic gains in productivity. Workers limited to the pace of slower colleagues under the old system were free to produce at their own speed. By 2000, Canon had ripped out more than 12 miles of conveyor belts from its factories and implemented cell production throughout the company. The switch enabled the company to slash inventories, speed response time, and bring new designs to market faster.

One thing Mitarai hasn't scrapped, however, is the Canon tradition of investing heavily in research and development. The company spent $2.5 billion in 2004, and Mitarai wants to raise that figure to $4.5 billion. Last year Canon ranked just behind IBM as a recipient of new U.S. patents. But Mitarai has worked hard to change the mindset. Directors, who gather at 7:45 most mornings for a meeting outside Mitarai's office, know they must pull together and keep the focus on making money.

CANON IS IN A STRONG POSITION TO CONTINUE doing just that in its major business groups. Markets for printers and copiers, which account for 67% of Canon sales, are fiercely competitive and in recent years have shown signs of maturity in developed economies. But Canon is benefiting from the transition to color machines from black-and-white and profiting from increased sales of toner and ink cartridges, as well as new equipment. Laser printers, the heavy-duty workhorses used in large offices, are a key segment for Canon, generating a third of its annual operating profit. Even though Canon claims only 5% of the global market for laser printers--it trails HP, Konica Minolta, Seiko Epson, and Xerox--those figures belie its strength as the manufacturer of key components that account for most of the value of laser printers sold under the HP logo. Canon and HP don't disclose the financial terms of their relationship, but Canon says that for the past several years, laser printers sold under the HP logo have accounted for about 20% of Canon's worldwide sales.

Canon hasn't fared as well with inkjet printers, trailing HP, which has a 40% global market share, compared with Canon's 20%. Its photo printers are popular, but the company has yet to challenge HP and Lexmark in sales of multifunction printers that are big in the U.S. And at the low end Canon faces growing pressure from Dell, which last year launched its own line of inkjet printers and has already carved out a market share of about 7%.

Those difficulties have been more than offset by big gains in sales of digital cameras. Last year Canon bolstered its lead over Sony by selling nearly 17 million digital cameras, boosting its worldwide market share to 20%. The company expects to sell 23 million cameras in 2008, ratcheting global share to 23%. In the higher-margin digital SLR segment, Canon, only three years after introducing its first entry-level model, now claims a 59% global share.

Mitarai is betting that, five years on, the picture will be just as bright for flat-screen TVs using the SED technology that Canon is developing jointly with Toshiba. Canon engineers, who have been tinkering with the technology since 1986, say it will yield images of dramatically superior quality to liquid-crystal or plasma screens while consuming far less power. A prototype at the headquarters of the Canon--Toshiba joint venture in a quiet suburb 40 miles south of Tokyo seems to live up to the hype: images that are almost palpable, rich colors, and clarity even with rapid movement. It also got a good reception at the Consumer Electronics Show in Las Vegas last month. "Five minutes with this sleek puppy, and plasma and LCD were but a memory," raved a technology writer for the Atlanta Constitution. "Daddy wants one."

The new SED displays operate on the same principle as a cathode-ray television, emitting light by shooting electrons into a phosphor-coated screen. But where cathode-ray TVs use a single large electron gun that has to be set back from the glass screen (meaning they're usually as deep as they are wide), SED screens are illuminated with millions of tiny electron guns known as emitters that can be aimed at point-blank range, enabling images to be projected across wide screens only a few centimeters deep. Canon has invested $1.8 billion developing the technology for the screens and building the factories to produce them. It plans to roll out the first 55-inch screens for consumers in Japan later this year. Mitarai says he wants to offer the TVs for about the same price as LCD and plasma screens of comparable size. He hopes to expand capacity to three million panels a year and capture at least 20% of the global market for flat-screen TVs by 2010. "We have big plans for the digital television business," Mitarai announced at a Canon exhibition late last year. "We intend to grow this area into a new business pillar for Canon."

With SED screens, Mitarai is thinking big in more ways than one. The common TV, he predicts, is destined to morph into something far more useful--what he calls a "multifunction information device," with potential applications in other areas where Canon has patents and expertise. "In the near future," says Mitarai, "SED displays will serve as an image and information window in living rooms, linked through a wireless connection with digital cameras, digital video camcorders, printers, and other imaging devices. Digital photos and video can be stored in electronic albums on a network, and users can view these on an SED display anytime or print them on the spot."

The key question is whether production costs can be lowered far enough and fast enough to turn a profit. Goldman's Horie has his doubts, but he remains bullish on Canon's stock. If the SED falls behind projections, he reasons, Mitarai won't hesitate to close it down.

MITARAI'S PRAGMATISM IS EVIDENT in Canon's employment policies. Though he has defended the principle of lifetime employment for workers in Japan and pushed through Canon's restructuring without resorting to layoffs at home, the commitment doesn't extend to workers in the U.S. or China, where labor markets are more flexible. And even in Japan, Canon has kept its payroll in check by making greater use of temporary and part-time workers. Nor does Mitarai celebrate the virtues of another Japanese labor tradition: the seniority-based wage system. He has championed written tests as a prerequisite for promotion and has increased the extent to which merit determines worker pay. Similarly, Mitarai defends his pledge to keep 60% of Canon's production in Japan on utilitarian, not nationalist, grounds. Keeping operations at home, he argues, makes good business sense and has nothing to do with politics. Wages may be cheaper in China, he says, "but labor accounts for only about 10% of total production costs. Instead of rushing overseas to get those small savings, doesn't it make more sense to focus on how to reduce the other 90%?"

With the top man that focused on the bottom line, there seems little danger tax guys like Greg will need to worry about meager profits at this Japanese company anytime soon.

FEEDBACK cchandler@fortunemail.com

Copy, Print, Shoot!

Canon started with cameras, added copiers and printers,

and is now betting on TV.

CAMERAS

Canon has captured 59% of global digital SLR sales with models like this EOS

5D.

EOS

COPIERS

The transition to color laser office printers has helped boost sales.

IMAGERUNNER

PRINTERS

Canon has 20% of the global market in inkjet printers but trails HP.

PIXUS

FLAT-SCREEN TVS

Mitarai's next bet is surface-conduction electron-emitter displays.

SED