CAJFF - Canon: Key Valuation Re-Rating Driver Is ROE Improvement

2023-08-17 13:17:36 ET

Summary

• Canon Inc.'s current P/B multiple is below its long-term historical mean.
• The company can potentially improve its ROE by introducing new products, optimizing its business mix, and return more excess capital to shareholders.
• l have a Buy rating for Canon, as I think that the stock can be valued by the market at a higher P/B ratio when it achieves a better ROE.

Elevator Pitch

I award a Buy rating to Canon Inc. ( CAJPY , CAJFF) [7751:JP] stock. I believe that Canon can trade at a higher P/B valuation ratio with an improvement in its ROE driven by better profitability and continued shareholder capital return.

Canon is listed on both the OTC market and the Tokyo Stock Exchange. The three-month average daily trading values for Canon's OTC and Japan-listed shares were roughly $1.5 million and $120 million, respectively, as per S&P Capital IQ data. Readers who wish to invest in Canon's shares listed on the Tokyo Stock Exchange can use U.S. brokers that have foreign markets trading services such as Interactive Brokers.

Company Description

Canon is a Japanese conglomerate which refers to itself as a "leading manufacturers of office MFDs (Multifunction Devices), laser printers, inkjet printers, cameras, medical equipment and lithography equipment" in its fiscal 2022 20-F filing .

An Overview Of Canon's Business Segments And Key Products

The company's Printing, Imaging, Medical, and Industrial segments contributed 56%, 20%, 12%, and 7% of its revenue, respectively for 1H 2023. Other businesses accounted for the remaining 5% of Canon's 1H 2023 top line. Canon is also geographically diversified, with foreign markets outside of Japan representing 78% of its sales for the first half of this year.

Valuations And ROE

As per S&P Capital IQ data, the market currently values Canon at slightly above book value, or more specifically a trailing price-to-book or P/B valuation multiple of 1.08 times. In contrast, Canon's 15-year historical mean P/B valuation ratio was much higher at 1.53 times.

Canon's shares were trading in the 2.5-3.0 times P/B valuation range in 2006 and 2007, when the company was delivering ROEs of above 15% in both of these years. As such, it is reasonable to assume that Canon can command a higher P/B valuation metric, if and when its ROE improves.

The company's actual ROEs for FY 2021 and FY 2022 were 7.9% and 8.1%, respectively, based on data sourced from S&P Capital IQ . In my opinion, I think that there is the potential for Canon to expand its ROE from the current high single digit percentage to above 10% in the intermediate to long term.

At its Corporate Strategy Conference on March 6, 2023, Canon set a goal of increasing its yearly operating profit margin from below 10% in FY 2022 to 12% or better by FY 2025. Canon also committed to returning "profits to shareholders in a stable and proactive manner" at the recent investor event in early March this year. Operating margin expansion and sustained shareholder capital return are expected to drive an improvement in ROE for Canon.

In the subsequent sections of this article, I detail how Canon plans to improve the company's profitability and distribute larger dividends to its shareholders.

New Products

At its 2023 Corporate Strategy Conference's investor question-and-answer session , Canon revealed that it has plans in place to introduce "new high-margin competitive products," which is "a key component of Canon's strategy to expand its profit margins."

Based on the company's disclosures at the 2023 Corporate Strategy Conference, acquiring new companies and focusing on parts sales are two key ways by which Canon can widen its range of product offerings.

An area of focus for Canon is the sale of parts and components. The company's new products in the pipeline include virtual reality accessories for the Imaging business segment and modules relating to semi-detectors for its Medical business segment.

Another source of new product growth opportunities for Canon is mergers & acquisitions or M&A. The company is currently on the lookout for M&A targets that operate in industries such as medical, materials, and those which sell products like network cameras.

Business Mix Optimization

In the first half of 2023, the Imaging segment was the most profitable business, with an operating profit margin of 17.4% . Therefore, it makes a lot of sense for Canon to grow the revenue contribution of its highest margin business segment going forward, if it wants to improve the company's overall profitability.

Plans To Broaden The Range Of The Imaging Segment's Products

As per the chart presented above, Canon's Imaging business has traditionally focused on imaging products used for "shooting & viewing." But there are new product areas for Canon's Imaging segment which hold significant promise, like "ultra-high-sensitivity cameras" and "IP (Internet Protocol) remote cameras."

In specific terms, Canon's target is to increase its Imaging business' sales by about +25% from JPY804 billion in fiscal 2022 to JPY1 trillion for FY 2025. As indicated earlier in this article, the Imaging segment was the second-largest revenue contributor for the company behind the legacy Printing business last year, but there is ample room for Canon to expand the revenue base of its Imaging business considering the new product areas highlighted above.

Shareholder Capital Return

Canon can shrink its equity base (denominator in the ROE equation) and boost its ROE, by continuing to return excess capital to the company's shareholders.

Canon raised the company's actual annual dividend distribution by +20% from JPY100 per share in FY 2021 to JPY120 per share for FY 2022. Moving forward, Canon committed to "a dividend payout ratio of up to 50%" at the company's Corporate Strategy Conference in early March of the current year.

Looking ahead, the sell-side analysts see Canon growing its dividend per share by a pretty healthy CAGR of +7.5% (source: S&P Capital IQ ) for the FY 2022-2026 financial period. Canon currently offers a reasonably appealing consensus forward next twelve months dividend yield of 4.1% as per S&P Capital IQ data.

Closing Thoughts

New products, business mix optimization, and sustained dividend payouts are expected to lift Canon Inc.'s ROE to 10% or higher in the mid-to-long term. In my view, ROE improvement is the catalyst that expands Canon's P/B valuation multiple and pushes up its share price.

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