Dividends aren’t the be-all and end-all of a company’s quality, but I would still argue that Canon’s (NYSE:CAJ) first dividend cut in 33 years is a pretty accurate reflection of the ongoing challenges at this Japanese conglomerate. Despite a high level of ongoing R&D, Canon’s revenue has fallen over the last five, 10, and 15 years, and the long-term average FCF margin has been basically static, as management hasn’t moved aggressively enough to transition more of its businesses to “cash cow” status.
Canon is not without hope – I see worthwhile potential in businesses like commercial printing, medical, and nanoimprint lithography – but the company’s ability to execute is in serious doubt. The shares do look undervalued today, but absent more dramatic progress on cost-cutting, I’m concerned this will be a value trap for investors.
Office And Imaging Need A More Serious Rethink (And Restructuring)
Canon is still a major global player in multifunction office printers, laser printers, and inkjet printers, having actually gained share over the last decade. Unfortunately, while the “paperless office” may not really be a reality, there has been a definite decline in usage and system sales. Likewise, in the camera business, Canon has gained share in the camera business over the last decade, but advances in smartphone cameras have significantly shrunk the market.
Both of these businesses have shrunk over time, and while that is perhaps not so surprising, given those macro tends, the profitability of the businesses has faded too, with margins falling from the mid-teens to around 12% in 2018 and to 10% and 6% in 2019. This wasn’t an inevitable outcome – many companies have been able to slash costs in “sunsetting” businesses and milk them for cash flow, sometimes for decades.
Based on what I’ve seen from Canon management, though, I have serious doubts as to whether Canon is prepared to do what they need to do to make that happen. HP (HPQ), for instance, has made it clear that they’re really just in the business of selling higher-margin consumables for their printing business. Coincidentally, Canon is a major supplier to HP, getting about a quarter of its Office segment income from HP, and were Canon to lose that business to an even cheaper third-party partner (or resumption of internal production), the loss of scale efficiencies would be meaningful.
There is one modestly promising part of this business – commercial printing. Canon has been repositioning the business toward commercial printing systems, including continuous packaging printing systems. Commercial printing is a pretty good business for companies like Dover (NYSE:DOV) and Danaher (NYSE:DHR) (Markem-Imaje is Dover’s highest gross margin business), and it has also become a good business for Canon peers Brother (OTCPK:BRTHY) and Konica Minolta (OTCPK:KNCAY) – companies previously known more for their office equipment and camera operations. Whether Canon can execute here remains to be seen, but it is a credible growth driver.
Medical Needs More Work
Canon vaulted itself into the medical technology space with the acquisition of Toshiba Medical back in 2016, acquiring a business largely focused on medical imaging (CT, MRI, ultrasound, and digital radiology). While these have been good businesses for larger global rivals like Phillips (PHG) and Siemens Healthineers (OTCPK:SMMNY), the Canon/Toshiba business doesn’t really compete on the same level, with 40% of sales still coming from Japan.
The issue here has a lot to do with the peculiarities of the Japanese healthcare system. To oversimplify a complex topic, the Japanese system doesn’t really pay well for imaging procedures, and that has incentivized Japanese med-tech companies to develop smaller, less expensive, and less feature-rich systems for the market. They work well, but they don’t have the “bells and whistles” that a lot of potential customers in North America and Europe are accustomed to, so you don’t see Japanese imaging/capex companies playing such a large role in the global market.
That doesn’t mean that there isn’t an opportunity here, though. I believe the systems that work well for the Japanese market also work well for the dynamics of the Chinese market, as well as other large emerging markets (India, Indonesia, Brazil, et al) – healthcare systems that need a lot more imaging equipment in place, but can’t necessarily afford the standard systems from the big players. This dynamic is already playing out in radiation oncology, where Varian (VAR) (which is being acquired by Siemens) and other players have started developing simpler, more affordable solutions for the Chinese market.
Can Nanoimprint Lithography Drive Growth In Industry?
Canon has long been an arguably underappreciated player in the semiconductor space, particularly on the lithography side. While the company has chosen not to compete with ASML (ASML) in EUV lithography, the company still has a meaningful place for itself in KrF lithography and in 2x steppers used in advanced packaging applications.
The big question today is whether the company’s investments in nanoimprint lithography (or NIL) can pay off. I can’t do the subject justice here, and I strongly encourage interested readers to investigate the topic – nanoimprint lithography is a pretty interesting approach to the challenges of advanced lithography. While this technology can, at least, in theory, achieve sub-3nm resolution and sub-7nm half-pitch and doesn’t require the expensive optics that contribute to the high cost of EUV, there have been issues with throughput, overlay, and defectivity.
Canon may have figured these issues out – or at least, well enough to make it a player in equipment for 3D NAND manufacturing. Toshiba (OTCPK:TOSYY) has adopted NIL for some of its memory production, and this could become a significant growth driver for Canon. I don’t see NIL as a real alternative to EUV today, particularly in leading-edge logic chip production, but there could be something here.
Canon management is also pretty excited about the potential of its network security camera business, but I don’t share this enthusiasm. Yes, the security market is large and growing (particularly in emerging markets), but I don’t see how this will ever be a particularly high-margin business. At best, it’s an opportunity to repurpose some technology from the imaging operations.
Canon had a poor second quarter, with operating income well below expectations at a time when many companies surprised to the good through better cost-cutting, and guidance was likewise disappointing. While some of the issues impacting Canon’s performance were understandable (COVID-19 limiting equipment installs for semiconductor capex and so on), the reality is that there has been a distinct lack of progress at Canon where cost-cutting is concerned, leading to the first dividend cut in 33 years. Moreover, there was a poor trend of underwhelming performance and lower guidance even before COVID-19 came onto the scene.
Canon spends a lot on R&D, but I believe that they often struggle to leverage/commercialize that spending into meaningful new products. I don’t necessarily advocate cutting R&D, but I do think there needs to a more comprehensive re-think of almost all parts of the business – product development, go-to-market, sourcing, logistics, manufacturing (more than 60% of which is still done in Japan), and so on.
Although I see growth opportunities (commercial printing, medical, NIL), I’m concerned that the erosion of older businesses will largely keep pace, leading to minimal revenue growth over the next decade. I’m likewise concerned about whether management can do what needs to be done on margins to make this business as profitable as it could (and should) be. So, with that, I’m assuming that FCF margins more or less stay where they’ve been for the last twenty years or so.
The Bottom Line
Under this low-to-no-growth scenario, Canon shares still end up looking undervalued on both discounted cash flow and margin/return-driven EV/EBITDA. Still, the “value trap” risk is real, as Canon’s performance in recent years doesn’t inspire confidence that management will maximize the opportunities it has in commercial printing, medical, and NIL. At a 20-year-plus low, I can understand why value hounds may be interested here, but I’d prefer to wait for a new management team or at least a new plan that points to how the company will deliver a better future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.