Description
A global brand with leadership in its markets and a solid balance sheet is overlooked and undervalued by the market. Recommend a Buy at current levels.
What does Canon do?
Canon is one of the world’s leading consumer and corporate electronics brands. Founded in 1937, it boasts an enviable list of patents that place it in the Top 3 of the world’s largest patent and Intellectual-property holders. Canon has built its global brand from years of extensive innovation and a strong focus on R&D.
Canon has 5 main segments or markets it serves: office Imaging Products, that includes copying machines and multi-function devices (MFDs) for personal and office use (32.3% of 2004 revenues); Computer Peripherals, that includes laser-beam printers, inkjet printers and image scanners (33.2%); Digital Cameras, that include SLR cameras, compact cameras and digital camcorders (22%); Business Information Products, that includes computer information systems, micrographic equipment and personal information products (3.4%) and Optical Products that includes semiconductor production equipment, technology for LCD panels and medical equipment (9.1%). Canon generated revenues of $33.3 Billion (or 3.467 Trillion Yen) in 2004 with operating profits of $5.2 Billion and Net Income of $3.3 Billion last year.
?
What is so great about Canon?
Canon was founded in 1934 and has consistently been known for top-notch quality and innovation. The company maintains a #1 or #2 position in almost all its markets. In the consumer camera market it is by far the market share leader in both the compact cameras and the Digital SLR market. Canon cameras are ubiquitous and are trusted and used by numerous professionals and journalists and are regarded as the best-in-class and the most reliable photography equipments in the market. In the office equipment market, its copiers and its office printers command a an overwhelmingly high market share. Canon is the leader in the manufacturing of laser beam printers and has the capacity to manufacture 70% of the world’s supply of laser printers. Canon supplies all of HP’s laser printers and consumables under OEM arrangements. Canon is the Top 3 holders of patents and intellectual property in the world. Its intense and consistent focus on R&D for innovation has yielded a vastly recognized and superior IP portfolio.
Canon is also a leader in corporate social responsibility (CSR) and has implemented a Kyosei approach to functioning – “working for the good of the consumer and society” and has ensured over the last several years eco-sustainable products and manufacturing processes in several of its locations. 40 of its plants in Japan and the U.S. have zero waste products with the entire waste and processed water output recycled for use. Canon has established leading practices in its facilities around the world that incorporate efficient manufacturing (the cell-production method) and sustainable and safe environmental policies.
Canon has grown its revenues at an annual rate of 4.5% in the last ten years while growing its earnings by an annual rate of 24%. This has primarily been the result of substantial cost-cutting and adoption of efficient operational and manufacturing processes. In its new 5-year plan starting in 2006, Canon plans to push its top-line growth rate from its new and innovative products (excellently showcased at the Canon Expo a few weeks ago, its first “new-product” event in 5 years). Canon’s revenues have grown from $21.03B in 1995 to $33.34B in 2004 while its Net Income has grown from $534.3M to $3.3B during the same period. The company’s net profit margins have gone from 2.5% in 1995 to around 10% in 2004 providing excellent operating leverage from cost-cutting, rationalizing and realignment. Canon also has an excellent balance sheet with close to $9B in net cash (or around $10/ADR). In profitability, Canon generates ROE’s and ROIC’s (net of cash on balance sheet) of around 20% - very strong. Free cash flow has been robust as well – at a rate close to 10% of revenues.
Canon continues to gain market share across several of its segments – copiers, printers and cameras. Though we like Canon’s leadership position and strong market share in key markets we are also excited about its new products. At the recent Canon Expo, the company revealed new products and emphasized video cameras, professional SLR cameras and SED technology on the consumer front and new “print-shop” quality office-copying and document-management machines in addition to their continued progress in medical and semiconductor technology on the corporate front. Ending a 5-year period of cost-cutting and rationalization, Canon has now embarked upon a 5 year period of driving new growth while maintaining its healthy margins. Areas of growth, we think, could continue to be the consumer market in cameras - both still and video - where we think Canon could continue to gain market share. Canon could drive market share and volume from its new line of ink-jet PIXMA printers targeting the at-home, photo-hungry consumer. On the office front, its integrative theme of optimizing workflow and using its strong standards-platform (with Adobe and Microsoft) could yield higher market share in copiers and printers. Canon’s SED technology appears to be superior to other technologies in the market. We think Canon has a strategy of driving adoption of its new products and technologies through innovation, product leverage and competitive pricing. Canon’s emphasis on product innovation in medical technology through use of its leading-edge lens and optics technology should also allow it to gain market share.
What are the market’s current concerns?
The market has been concerned about the global precision instrument and office-machines segment in general. The Street is concerned that copiers, printers and the consumer segment are all experiencing tough competition and reduced pricing, and are worried that Canon, though a leading player in all these segments, may not be able to grow much or perhaps even hold on to its high margins in the future. Will Canon continue to be able to utilize its cash hoard well? Which direction will HP take with its ink-jet printers? Will its strategy change direction and push its own manufactured ink-jet business as opposed to its Canon manufactured laser-printer business? The other concern is the consumer - especially in the United States - and the fear that rising rates, weakening credit-quality and a slowing economy may have a debilitating effect on the consumer’s disposable income thereby putting Canon’s consumer business at risk.
Canon has the leading market share, brand and technological expertise in almost all of its markets. Though copiers, printers and cameras are considered relatively maturing businesses, Canon can still drive higher adoption of its machines through improved technology and competitive pricing – more so than many of the other players. Further penetration into video, workflow integration and a higher market share in cameras, copiers and printers (both hardware and consumables) could continue to drive top-line and bottom line growth. New markets in medical technology, flat-screen TVs and nanotechnology should be able to drive growth significantly as well. Besides, we believe, all the above concerns are adequately priced into the stock.
Investment Conclusion
We stepped back and saw Canon as a top, world-class, industrial and consumer player in technology and instrumentation. It has a solid balance with ample amount of cash (around $10 a share) that it intends to use selectively in acquiring promising new technologies. Canon has done a remarkable job of growing its bottom-line by 20% annually in the last five and ten years and yields among the highest net margins and ROE’s in the industry. It is in the Top 3 holders of patent and IP worldwide and has a commendable brand recognized for its innovation and its top-quality. In the past ten years, Canon has realigned segments, cut costs, solidified market leadership and accumulated cash. On fears of slowing growth and lower pricing in some of its segments, the Street now assigns a 11.5x, EV/E multiple on its projected earnings of $3.88 per share and a 10.6x EV/E multiple on FY06 EPS estimate of $4.20 per share. This valuation implies Canon will grow its bottom-line at around 3% into the future whereas it has grown its bottom line at more than a 20% CAGR for the last 10 years. Now, we are not banking on a 20% earnings growth rate into the future but feel very confident (especially after reviewing the company’s new product line-up at the Canon Expo recently) that Canon can grow its bottom-line by at least 6% per year into the future. Achieving that for FY05 may be a stretch but we believe Canon is capable of a minimum 5%-6% CAGR growth rate into the future. Our conservative DCF analysis using a 15x terminal multiple and a 10% discount rate yields a $79 intrinsic value (a 32% discount at the current market price). Historically, Canon has traded at average multiples north of 20x for eight of the last ten years and we believe that it should garner a multiple north of at least 17-18x implying a target price of $75 ($4.20 FY06 x 18) in the next 18-24 months. We want to point out to Mr. Buffet that if he likes Lexmark (LXK) so much as an investment, he ought to like Canon even more. Though we think Lexmark has a solid balance sheet, very good profitability and a low multiple, Canon has similar balance sheet strengths, higher net margins, higher market shares, more product and geographical diversity and has a similarly low valuation multiple. We are also comforted by Canon’s experienced management, its longer-term focus, its cash balance and its strong emphasis on corporate social responsibility. We believe investors should accumulate stock in this high-quality and undervalued company at the current levels.
?Key Data as of 9/29/05 ($M except per share data)
Share Price 54.07 Revenue (FY05) 33,438.5
52 Wk Hi-Lo 45.76-55.71 Revenue (FY06) 35,527.5
Mkt. Cap 48,011.6 EPS (FY05) 3.88
Debt 227.3 EPS (FY06) 4.20
Cash 8,604 Book Val/Share (FY05) 23.9
Enterprise Value (EV) 39,635
Avg Daily Vol. 215045 P/E (FY05) 14.0
P/E (FY06) 12.9
ROIC (FY04) 23.39% EV/E (FY05) 11.5
ROIC (FY05) 22.06% EV/E (FY06) 10.6
Canon’s Business Segments
We discuss Canon’s business under three main categories: Office Equipment, Camera and Optical/Other. The charts below show the breakup of Sales and Operating profits by segment and also Operating Margins by each segment. While Office Equipment (or Business Machines), Cameras and Optical Equipment/Other account for 69%, 22% and 9% of sales respectively, they account for 77%, 19%, and 4% of operating incomes respectively.
Market Shares tables can be provided separately ?
Business Segment Detail
Office Equipment/Business Machines is further broken down into: Office Imaging Equipment (Monochrome copiers/multi-function printers (MFP), Color copiers, solutions and personal copiers); Computer Peripherals (Laser Beam Printers (LBPs) - monochrome and color and Ink-Jet Printers (IJPs)); Business Information Equipment – computers and handy terminals
Cameras consists of single-lens reflex cameras (SLRs), compact cameras, lenses and digital camcorders.
Optical/Other consists of Semiconductor-related exposure equipment for semiconductors and LCDs etc. and Optical Equipment – TV lenses for broadcasting, micro motors, SED flat-screen TVs (slated to start production in late 2005).
Office Equipment/Business Machines
Office Imaging Equipment with revenues of 1.121 trillion Yen in 2004 accounted for the largest segment of Canon’s business or about 32% of the total. Of this, Copiers was about 82% of its revenues. In profitability, copiers stand at around 20% operating margins and contributes around 30% overall operating income.
Canon currently leads the global market with a 27% market share in copiers. Canon’s market share is far higher in the personal copier (especially the monochrome) market with around 80%. Canon lags the market in the office copier space with 18% of the market where Ricoh has the leading share. Canon ranks third in overall global market share in color copiers. It leads the market in North America and Western Europe but Fuji Xerox and Ricoh lead the charge in Japan where color is the geographical stronghold.
The monochrome market is seeing tough industry dynamics as inkjet printers and multi-function devices chip away at its market. In the office market, higher-end monochrome players are losing out to the lower-end manufacturers. Canon has led the market in monochrome copiers but is still small in color copiers. We believe the market and its players are making a strong push to B2C or “Black to Color” and Canon’s new lineup of products should help it to gain market share in color.
Despite a Top 3 market share in color copiers globally, Canon has lagged in its color lineup as other players like Fuji Xerox, Konica and even Ricoh have introduced new high-speed models. Canon has had fewer color models and has not had higher-speed (>40 ppm) models. Canon has kept abreast of the technological improvements and also kept ahead in other areas such as software development but hasn’t introduced new, fast and cost-competitive models until they unveiled new models at the Canon Expo a few weeks ago. Canon is not far behind on the color copier curve and we believe it may have a very good chance of winning market share in the next few years especially from Xerox and from some smaller players. So, while the company expects the monochrome copier revenues to have plateaued to decline a little, they expect to make strong advances to the tune of 35%-40% each year in the color segment. Consumables, we believe, will continue to drive stable revenues for this segment.
The copier market has been transitioning from monochrome to color. Last year, color copiers constituted 10% of the overall copier market of 5 million copiers. Industry participants expect this ratio to grow to 20% by end of 2007 implying a greater than 30% yearly growth rate. We believe Canon with its efficient sales model, cost competitiveness and strong brand should be able to garner a higher growth rate of at least 35% per annum on the color side. The copier market has had its issues of competition and pricing pressures. There has also been concern about erosion of industry demand due to laser printers. We believe competition will be stiff and pricing will be one mechanism to drive an ever-increasing demand for color copiers. We project overall sales growth of 5.4% for 2005 for the Office Imaging products and increasing to 8.3% in 2006. We also recognize that Canon could surprise us to the upside as our growth assumptions prove conservative.
Computer Peripherals Segment
Laser Printers
Laser Printers generated 816 billion Yen for FY2004 accounting for 24% of overall sales. This segment though generates 40% of the company’s operating profit and has the highest operating margins, close to 30%, of any of Canon’s divisions. Laser printers generate a high degree of profitability for Canon primarily because of their consumables sales (similar to copiers) and also because laser printers don’t need near as much service professionals and service calls as do copiers. Canon is the undisputed leader in laser beam printers. It controls close to 60% of the world’s laser beam printer supply (if you include the laser printers that Canon sells to HP). Canon supplies HP with all its hardware and consumables’ needs.
Canon garnered the highest market share in this space primarily because of its pioneering technology that was the first in the market to develop and commercialize laser-printing technology. Canon’s contract to supply HP as an OEM also pushed the widespread acceptance of laser printers as PC printers. While there is no other player that covers the entire gamut of color and monochrome and low-speed and high-speed printers, competition is now intensifying as several players are attacking different parts of Canon’s laser printer empire. Dell, Samsung and others are launching steep-price cuts in the mid-speed monochrome side while Konica, Seiko and others are competing in the color segment.
?Going ahead, the color laser printer market should show at least 15-20% growth from current levels. The monochrome market should grow in the low single digits with growth in Japan, America and Western Europe at flat to negative levels and some mid-single growth in China, Russia, India etc. With pricing pressure causing pricing declines of 15-20%, overall revenues for the industry should be flat to up some on a worldwide basis. Canon projects its own laser printer volume growth to be 15% (13% for monochrome and 36% for color) in 2005 versus the industry at 5% for monochrome and 15% for color). Net of ASP declines we have modeled a conservative 5.3% sales growth for this segment in 2005 and 7.2% in 2006.
Inkjet Printers
Inkjet printers accounted for 9% of FY04 sales or 310 Billion Yen. In operating profit terms, it accounts for about 7% of overall operating profits with around 15% operating margins. While Canon lags HP, Lexmark and Seiko Epson in sales volumes (see below), it leads Lexmark and Epson in operating margins. Canon’s global market share in IJPs is about 16% (behind HP at 38% and Seiko Epson at 19%) and ranks third globally. In North America, it ranks fourth with an approximate market share of 10%. Canon’s profitability matches that of HP though we believe it is likely to beat HP and become the most profitable inkjet player in the next year or so. Canon has superior margins in the industry due to its efficient manufacturing processes and effective cost cutting.
The IJP market has enjoyed double-digit growth in the last several years due to the transition from SFPs to MFPs. In the last six months or more, growth began to slow to about 8-10% per year. Heavy price discounting and a slowdown in volume growth could turn this segment negative this year. While prices for both SFP and MFPs are expected to decline for the next year or so, Canon is likely to do better than the industry in terms of its overall pricing due to its higher MFP to SFP ratio going forward. While Canon lagged behind HP and Lexmark as MFPs took off in 2002, it has now been coming back strong with a more robust line-up of multi-function printers (that are priced around 35-50% higher than SFPs). So while Canon expects the overall IJP market to grow by 5% in 2005, it expects its own growth to top 17% as a direct result of gaining several points of market share in MFPs and maintaining its share in SFPs (we have modeled volume growth of 19.5% in 2005 but 6.6% in 2006). Consumables should grow in-line with or slightly lower than the 19.5% growth in printers this year.
Cameras
This segment accounts for 763 Billion Yen (FY04) or 22% of total Canon sales. The segment consists of digital cameras (compact and SLR), video cameras and traditional cameras (and SLR lenses). Where traditional cameras used to account for over 60% of the camera segment in 2000 it now accounts for only 16% of this segment – most of its decline being more than made up by the huge growth of digital cameras in the last 5 years. Digital cameras (compact and SLR) now account for 69% (FY04) of this segment (up from around 15% of the segment in 2000).
Canon now holds the largest market share (20%) in the world leading Sony at 18% and Kodak and Olympus at 10% each. Competition is stiff in this segment though it doesn’t seem to hurt Canon and Sony much. There are more than 20 players in this segment and most suffer from not being able to generate marginal profit. Intense competition for most players has prompted them to release products with short lifespans. Canon in contrast has benefited from lower manufacturing costs, greater production efficiencies and a lower inventory burden due to releasing products with longer and more stable lifespans. We believe this should continue to strengthen bigger players like Canon and Sony and as a result allow them to be more profitable and gain more market share.
The camera market has increasingly gone digital and in the last few years, number of pixels offered on compact and SLR cameras have increased steadily. Compact camera models are increasingly offering over 3 megapixels while the SLR cameras offering 6-8 megapixels are now being priced under $900 or so. Overall the digital camera market now sports a total of around 75 million units looking to grow to 85 million in 2005, implying a growth rate of around 14-15% this year. And while pricing is likely to remain under pressure, the pressure would likely be soft given the precarious ability of most camera makers to afford any price cuts.
With the continued trend toward digital SLRs being adopted by more non-pros, growth in digital SLR could be close to 50% in FY05 and continue to be double-digit for the next few years. On the compact side, Canon plans to continue to bring new models to the market further rounding out its full-line strategy. Canon expects to grow cameras by 20% this year but with expected price declines of about 10%, sales growth will likely be close to 8%-10% this year. Operating income could grow more than 10% given the likelihood of slightly higher operating margins from more SLRs in the mix (though we are modeling almost unchanged operating margins this year).
Optical and Other (or Industrial Products)
Optical and Other segment accounts for about 317 Billion Yen or 9% of overall sales. Of this semiconductor production equipment (Lithography or Steppers) accounts for about 6% of total Canon sales but only about 2% of total operating profits of the company. Lithography entails the semiconductor exposure tools that expose circuit patterns to etch to create circuit widths measuring 80nm. Canon sells this equipment to semiconductor companies around the world and has a 27% share of the market (after ASML and Nikon). Canon used to be number 2 in this space until ASML gained wide acceptance with Taiwan foundries and made inroads into Northern American semi players through certain strategic acquisitions. Canon’s main customers in this space were Japanese foundries which have not done as well as their Taiwanese counterparts in the last several years. Lithography has 7% operating margins and relatively high development expenses. This division’s market share does not match the strong positioning Canon has in its other product areas.
Steppers are high technology equipment sold to semiconductor chip manufacturers and require very high-end optical and precision process technology to produce increasingly higher density chips. These steppers run at around $10M each and therefore constitute a cautious decision making process. Sales in the last year or so have been hard as growth in capital spending budgets at semiconductor firms have slowed. The main culprit has been falling DRAM prices. Canon has been refining their laser-beam and optical technology significantly to prompt them to make strong claims of regaining supremacy over ASML once again by 2007. We do believe that its prospects in this space, with the coming NAND flash memory ramp, should position it well into the future.
Other areas in this segment that got us pretty excited at the Canon Expo were the new SED technology for flat-panel TVs and the use of Canon’s leading optical technology for medical applications. Canon’s mirror-projection aligners used in the manufacture of LCDs also hold significant growth promise for Canon as they now enable LCD panels for 48-inch widescreen TVs to be made with a single-exposure process.
Canon expects the industry to suffer revenue declines in both steppers and LCD aligners in 2005. But though it expects industry shipments to drop 15-20% in 2005 it expects to gain market share in steppers from 27% to 30% and in aligners from 65% to 80% in 2005. We believe there is risk to these projections. It may be hard for Canon to gain substantial market share and do better than the industry in 2005 as DRAM makers slow down their capital spending. Also, newer technologies and products may not kick start results in this segment until 2006. We are projecting 7.2% sales growth this year and -3% in 2006 but picking up again in 2007. Canon continues to stay firm on its long-standing history of making top-quality products in a cost-competitive way. We believe Canon’s increased R&D spending and its suppressed optical earnings results are dampening overall earnings for this year. The market is, perhaps incorrectly, extrapolating suppressed FY05 results into the future.
Catalyst
Street realizes this solid brand has overwhelming leadership in many "growth" segments. Priced to imply yearly growth of 3%, any indications otherwise would move the stock up.
The Japanese stock market.
Investor awareness.