Canon Deserves a Closer Focus

By Tom Gibbs - May 7, 2012 | Tickers: CAJ, IBM, PBI, SNE, XRX | 0 Comments

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Canon (NYSE: CAJ) as historically never been the hot topic in the world of consumer electronics.  The corporation does not participate in the crowded, yet exciting smartphone and tablet markets, and its core product offerings are geared toward very specific consumer types rather than the everyday customer. 

Although Canon’s heavily concentrated operating focus possibly leads to a lack of attention and excitement from a general consumer standpoint, it is the ideal set-up for an investor seeking a corporation with a deeply ingrained competitive advantage. 

The “All Strategies are Local” Technique

Canon’s above-average success is less attributable to its high-quality manufacturing process or any low-cost advantage it may enjoy, and due predominately to its concentrated product focus.  Because the corporation does one thing and it does it well – continually innovates imaging technology, hardware, and software – it has become the go-to name for the majority of the consumers shopping in this space.  Its strategy, in essence, is localized to one very concentrated, yet highly profitable, niche.

This “all strategies are local” concept is rather simplistic in nature, but is one that many corporations cannot execute with everlasting success.  Many corporations, such as Kodak, end up forfeiting long-term operating strategies focused heavily on core competencies for short-term profits made by attacking additional markets.  Kodak, as its recent bankruptcy filing indicates, gradually lost focus on its competitive advantage in imaging innovation to expand its popular brand name in new areas – the corporation’s acquisition spree even included a pharmaceutical company purchased in the late 1980s. 

Likewise, players like Sony (NYSE: SNE) can effectively leverage its high-quality image and popular brand name to generate profits in adjacent markets, but will never experience meaningful long-term profitability due to a dilution of their efforts.  The corporation, for instance, produces high-quality products in the television, laptop, tablet, digital camera, audio, and video gaming spaces, but hardly controls a dominant share or generates excess profits in any individual market. 

Unlike these two competitors, Canon has always focused heavily on its core competency in image innovation, and has strategically identified and attacked underserved or underdeveloped markets rather than competing head to head with existing players as Sony has often done.  Canon’s move against Xerox (NYSE: XRX) in the copier market offers a suitable example.  Xerox’s introduction of innovative copying technology in the late 1950s, which were protected for a prolonged period by patents, gave the corporation a significant first-mover advantage in the niche.  When the patent protection expired, Xerox controlled more than 90% of the market, and was able to easily fend off direct competition from new entrants like Kodak, IBM (NYSE: IBM), and Pitney Bowes (NYSE: PBI).  Instead of attempting to chip away at Xerox’s unbeatable market share, Canon identified and filled a specific niche that the expensive Xerox copiers did not serve – affordable, yet high-quality and reliable, copying machines for small and medium-sized businesses. 

Instead of attempting to capitalize on its popular brand name in many different markets as did Kodak and Sony, Canon has produced a well-rounded, but highly focused product portfolio by directly transferring this imaging competency into different markets.  Canon’s dominant share of the photography niche is a direct extension of its play in the copier market – the company’s high-quality DSLRs and lenses cater specifically to those extremely serious about photography, whether as an intense hobby or for professional use. 

Monetizing on a Localized Strategy

A snapshot of Canon’s past ten year operating performance illustrates the effectiveness of its localized strategy.  Aside from the consistent sales growth the corporation experienced prior to the economic downturn – sales grew at a meaningful 8.8% CAGR from 2002 to 2007 – the company, more importantly, reported above average returns on core assets.*

Sales in millions of yen, see footnote for return on net operating assets (RNOA) methodology.

Average return on core operating assets (pre-recession: 2002-2008)

• Canon: 21.3%
• Sony: 3.8%
• Xerox: 3.5%

The corporation’s return on core operating assets in excess of 20% indicates a significant, and sustainable, competitive advantage.  Despite the dip in sales and profitability in 2009, Canon’s performance has begun to rebound and its recent sales/RNOA trajectory is normalizing.

By placing highly concentrated bets on several key niches, the corporation now enjoys a dominant share in its core markets.  The IDC reported that Canon’s 2010 market share of 44.5% in the digital camera market was far superior to Nikon’s 29.8% share and Sony’s 11.9% share.  Likewise, Canon’s 18.6% share of the total copier market (black and white and color), trumps Ricoh’s 11.2% share and Xerox’s 8.7% share. 

As long as the corporation continues to follow its historical strategy – concentrate heavily and dominate several key profitable markets, and place concentrated bets on new underserved or underdeveloped markets with a direct translation of the core imaging competency – Canon will continue to report above-average profitability. 

A Good Investment?

Successful long-term investors understand the difference between a great company and a great investment.  Canon’s apparent undervaluation may indicate that the stock is an inexpensive buy and a potentially lucrative play on the rebound of the general economy and discretionary income spending levels. 

The corporation currently trades inexpensively on a relative basis:

Enterprise Value Multiple (TTM)

• Olympus 9.71
• Ricoh 8.55
• Sony 6.50
• Xerox 6.0
• Canon 5.02

This relative undervaluation is made even more attractive when considering the corporation’s historic above-average profitability, its dominant shares of key markets, and its sustainable advantage in the continuous innovation of the imaging field. 

Likewise, despite the corporation’s huge improvement from recessionary trough levels in 2009, the market’s price does not have wild assumptions about the future.  At a market price of $43.98, book value per share of $27.41, and $0.69 per share in residual earnings generated on those net assets, the market implies a 6.21% growth rate over the mid-term.*

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$43.98 = $27.41 + [($0.69) / ((1.10) * (.10 – G))]

G = 6.21%

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Why is this growth rate not unbelievable?  As Canon continues to emerge from the recessionary trough levels experienced in 2009, it has the ability to continuously improve the various residual earnings drivers – sales, margins, and asset efficiency (turnover).  Gross and operating margins in 2011 of 48.8% and 10.6%, respectively, have improved significantly from their 2009 trough levels of 44.5% and 6.7%.  Likewise, as sales continue to grow and operating margins normalize to their pre-recession averages of around 15.2%, the ability to generate returns above and beyond the firm’s cost of capital requirements will be magnified. 

The market’s implied 6.21% growth rate compares with the actual growth in residual operating income of 64.5% between 2010 and 2011.  With its undeniable sustainable competitive advantages, coupled with the market’s less-than-optimistic valuation, Canon should be one of the best performing stocks in the consumer/business electronics market over the mid-term. 

*Methodology.  Canon’s unlevered balance sheet separated the accounts into financial assets (excess cash/equivalents, etc.), operating assets (receivables, fixed assets, etc.), financial liabilities (short/long term debt and notes), and operating liabilities (payables, etc.).  Net Operating Assets (core operating assets) = (Operating Assets – Operating liabilities).  Return on net operating assets (RNOA) = (Post Tax Operating Income) / (Average Net Operating Assets).  Residual Income = (RNOA – 10% Cost of Capital) * Average Net Operating Assets. 

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