Talks to merge Japanese industrial giants Hitachi Ltd <6501.T> and Mitsubishi Heavy Industries Ltd <7011.T> have stalled after news leaked to the media, two sources said, a potential setback in efforts to reform corporate Japan.

Traditionally seen as a last resort of failing firms, Japanese corporations until recently have largely eschewed 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.

Executives from Hitachi and Mitsubishi Heavy have met to discuss merging in areas such as next-generation power operations and smart grids, with Hitachi's President Hiroaki Nakanishi saying on television an announcement would come later on Thursday.

But after media reported the news, both Hitachi and Mitsubishi Heavy officials denied the talks were in progress and said no announcement was now planned.

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.

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 sprawling 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.

PIPE DREAM

A merger would create a $150 billion revenue infrastructure firm, 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 relative to other global industrial groups, such as GE, Siemens and ABB .

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.

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.

It's going to be a history-changing event if true, said Fujio Ando, senior managing director at Chibagin Asset Management. It would really be praiseworthy if they can really move this forward because the merger means they will be creating a new company with companies from different ex-zaibatsu or business groups. This used to be seen as extremely difficult.

Hitachi has a market value of $27 billion while Mitsubishi Heavy was valued at nearly $16 billion as of Wednesday's closing price.

After news of the stalled talks broke, Hitachi was up 1.9 percent after rising as much as 3.8 percent, while Mitsubishi Heavy was up 3.4 percent, after jumping 5.4 percent.

A merger between the two industrial groups has not yet been discussed with workers, a union official said

We have not heard about the merger. It was a big surprise to find out about the talks in the paper, said an official at Hitachi Workers Union, which represents around 30,000 workers at Hitachi. The official, who declined to give his name, said his union couldn't comment until it had more information.

Managers at Hitachi however, will likely have to seek the understanding of workers before any agreement to absorb Mitsubishi Heavy because doing so could result in the sale or closure of some units.

YEN STRENGTH

Spurring a revamp is a gain in the yen to record levels and a weak global economic outlook that is prompting more Japanese companies to mull mergers with rivals, in a bid to lower costs and stay competitive.

Japan intervened in currency markets on Thursday in an effort to stem the rise of the yen that is threatening to derail the economy's recovery from the March earthquake.

In May, Nippon Steel Corp <5401.T> and Sumitomo Metal Industries <5405.T> submitted plans to merge in a $10 billion deal to create the world's second-largest steelmaker to battle competition from Asian rivals and shrinking demand from domestic automakers.

Hitachi makes products ranging from rice cookers, televisions to excavators, lawn mowers and computer chips and projects annual sales this business year of 9.5 trillion yen. The company, which employs 360,000 people, said on Wednesday it would halt production of television panels.

Mitsubishi Heavy is Japan's leading aircraft builder, defense contractor, a major shipbuilder and the lead system integrator for Japan's space program. A major partner of Boeing Co , it racks up annual sales of about 3 trillion yen with 69,000 workers worldwide.

By combining their reactor businesses, Hitachi, which makes boiling-water reactors, would have access to Mitsubishi Heavy's pressurized-water reactor technology, which has become the technology of choice by countries around the world.

But for Mitsubishi Heavy, the advantage would be solely in the scale afforded by the merger, which could help it better weather an industry downturn as nations around the world demand more stringent safety requirements in the wake of the Fukushima nuclear power plant crisis.

I don't see what Mitsubishi has to gain from this, said Muramoto Takashi, general secretary of the main union representing Mitsubishi workers.

The two sides were already working together to try to speed up a resolution at Japan's stricken Fukushima Daiichi nuclear power plant.

Hitachi has a nuclear power joint venture with GE, while Mitsubishi Heavy has teamed up with industry giant Areva . Their common rival is Toshiba Corp <6502.T>, which has acquired U.S. nuclear unit Westinghouse and is aggressively bidding for contracts in China, Southeast Asia and the Middle East.

(Additional reporting by Jochelle Mendonca and Megha Mandavia in Bangalore and Tokyo Company News Team; Editing by Lincoln Feast and Dean Yates)