Description

Canon is one of the last remaining consumer electronic covid over-earners that have yet to crack.  The market sees a stable, iconic brand with a steady dividend, benefiting from a weak Yen and with optionality in its smaller emerging segments.  We see a structurally declining, disadvantaged behemoth whose decline has been masked by temporary pricing benefits that are in the process of reversing.  Black Friday, we believe, ushered the return of ultra-promotional discounting in print hardware, as well as the return of normal levels of discounting in cameras.  We forecast EPS 33% below consensus next year.  We believe EPS will continue to decline from there.  As such, we see Canon as a long-term short that should materially underperform the indexes over the next several years. 

Business Overview:

Canon has several business segments: the two that matter in our view are print (54% of revs, 61% of EBIT) and Cameras (19% of revs, 32% of EBIT).  The remaining segments barely cover unallocated corporate expense.  Canon has a market cap of over $30B USD, which is kind of shocking to us for a company that mostly makes printers and cameras.  As such, we will focus on the printer and camera segments respectively.

Printers:

Here is a brief financial summary of what has happened in the print segment since 2018:

Rough split is 45% Office, 40% Prosumer (Consumer), and 15% production.  We believe Consumer and Production are both over-earning and that Office is likely at best at normalized and at worse over-earning.  We see the business in 2023 returning to revenue and profitability levels between 2019 and 2020 and declining from there.

Prosumer:

This business is meaningfully over-earning on the back of substantial price increases in consumer printers.  HP – who we believe has a similar business mix within its print segment – quantified the margin benefit of lower discounting on consumer hardware at 200bp. Based on worldwide point of sale data, we believe printer units are down nearly 25% from 2019 levels, but printer revenues are basically flat (all price). Furthermore, we believe so far this year, sell-in has exceeded sell-out as retailers have restocked their depleted printer inventory levels.  Due to a shortage in image sensors for scanners, multi-function printers have been one of the last consumer electronics to see their supply chains normalize (and overshoot).  We believe this shortage has caused substantial price increases for similar printers, which is unheard of in the history of printers but is familiar for anyone who has looked at covid over-earners.  This is all in the process of rolling over. Let’s have some fun with some specific models:

Pixma TR4720 – This is Canon’s best-selling printer in the US.  Launched August 2021, it was priced at $100.  During Black Friday last year, there was no discounting.  Fast forward to October 2022, and its average ASP was $81.64.  Here is a screenshot from Amazon as of this writing (12/12), over a week after Cyber Monday:

There are many other examples of this with all of Canon (and HP’s) best-selling units: The TR8620 price fell to $159 in October, from $220 a few months prior, and is at $149 on amazon today.  The MG3620 is down to $69 as of October (and still at that price on Amazon today) vs. $90 in April.  In short, we think all the excess margin Canon has earned in their Prosumer segment is coming out of the business this holiday season and it’s not coming back.  Calls with industry experts confirm a likely “glut” of printer inventory for the first time in years and accept discounting to return to or temporarily overshoot its prior cadence.

The story in cartridge is a bit different: we estimate cartridge units are down 19%, while revenues are down 9%. We believe cartridges should have more pricing power, but there is a limit.  With volumes now down low double digits two years in a row, there is concern in the industry that the historical 5% volume decline / 3% pricing growth is going to have to change to 7-8% pricing growth to keep operating profit flat.  We are skeptical price increases of that magnitude are sustainable over multiple years.

Office:

One would think that this business is still potentially underearning, but we don’t think it is.  While sales plummeted in 2020 and 2021, sales are expected to recover to pre-covid levels in 2022 – amazing considering the substantial, permanent impairment in office print volumes.  Much like in Prosumer, this has been driven by massive ASP inflation on hardware units.  We can see this trend with Canon’s best-selling business Laserjet, the ImageClass MF743Cdw printer, which regularly sold for low $300s pre-covid vs. $550 today.  While this pricing hasn’t rolled over yet, we think it’s just a matter of time, especially given the massive amount of competition and participants in this segment of the market vs. consumer, which is more consolidated.  We believe there are already some signs of this – as of this writing, multiple lower end Imageclass printers are on sale – the MF451, MF452, MF453, and MF455 are between 25-33% off list.  That said, many of the higher end ($500-$800) are either out of stock or not currently discounted.

Production:

While relatively small, production also benefited substantially from printer and consumables demand driven by the need to post signage around masks, social distancing, etc.  We expect this business to shortly return to pre-covid levels as well.

Cameras:

Canon has two businesses within its imaging segment – a network camera business called Axis, that reports it’s financials on a yearly basis here: https://www.axis.com/about-axis/sustainability/reports-and-policies

By backing out Axis’s reported results, we can isolate the performance of Canon’s consumer camera business.  At a high level, 2022 Canon EBIT is on track to exceed 2018 camera EBIT.

When we first began to research Canon’s camera segment, we assumed it would be obvious that this business is in secular decline.  But it’s not that simple.  Although the smartphone has displaced sales of nearly all point and shoot cameras, the interchangeable lens camera market has seen slower declines in sales, with weakness in new camera sales largely being offset with higher ASP mirrorless cameras as well as more expensive lenses.  That said, despite that nuance, we believe the secular decline in cameras continues, but has been masked by covid induced demand, sell-in / sell-out dynamics, and a mix shift that has benefited dollars sold. Based on Canon's reported numbers, it looks as though DILC (Interchangeable lens camera) volumes have been flat since 2022.  POS data, that ignores sell-in / sell-out dynamics, shows a clearer picture:

We believe the vast majority of Canon’s user base at this point has transitioned from mirrored to mirrorless cameras and have upgraded their lenses accordingly (when people go to mirrorless, they tend to buy all new lenses, whereas upgrades within mirrored or mirrorless don’t involve new lens sales).  We believe that Canon will find it difficult to continue to upsell its loyal client base more expensive mirrorless cameras and that the one-time upgrade cycle driven by conversion of customers from mirrored to mirrorless is largely complete.  Without the benefit of further ASP mix benefits from this upgrade cycle, we believe the decline in camera sales will resume.

A third wildcard element are sales to online streamers, who use digital cameras to stream content.  Our general sense from talking to people in industry is that this market is small relative to the total market that is dominated today by Sony and exists mostly at lower price points. While there is an upside risk if this market continues to grow, we also see downside risk as this consumer demographic is arguably not in the healthiest financial situation and may have benefit from the stimulus / crypto / ad sales boom. And benefits associated with this demand is reflected in the unit numbers above, which have still declined HSD the last couple years.

In addition to all the above, there are two other issues that we believe have inflated 2022, 2021, and 2022 results – a total lack of discounting (until Black Friday) in both lenses and cameras, as well as substantial sell-in in excess of sellout this year as the supply chain has finally caught up with consistent product shortages that have existed the last couple years.  Even if we assume flattish sell-out next year, which we are skeptical of, a return to a more normal discounting cadence and convergence of sell-in and sell-out presents substantial downside to next year’s EBIT results.

Up / Down:

Canon trades at 11x NTM consensus earnings and 17x our 2023E EPS numbers.  There is some level of fear of over-earning in the stock, but not nearly as much as we think should be there, given hope of office print rebound as people return to work, excitement on FX, and the company’s optimistic targets (which they never hit).  We see 25% downside short-term, 40% downside longer-term, and minimal upside if we are wrong.

Key Risks:

1. Currency – if you short Canon or leave currency unhedged if shorting Japan, we view this as a non-issue.  We believe the bulk of Canon’s currency benefit is translational, not outsized cost structure in Japan vs. other markets.
2. No one cares – Canon pays a healthy dividend yield in a local market bereft of yield options.  The dividend is unlikely to be slashed anytime soon, so we worry our downside is capped at about 20-25% down which, depending on your view of the direction of the market, isn’t great.

DISCLAIMER

As of the publication date of this report, the author has short positions in Canon and stands to realize gains in the event the stock decreases. Following publication of the report, the author may transact in securities of Canon. All content in this report represents the opinions of the author who has obtained all information within this report from sources they believe to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind – whether express or implied. 

Catalyst

**2023 results

**Continued structural decline

**Highetened competition as competitors once again discount to get volume share in a declining market