Holding Off on Canon, Despite Strong Fundamentals

Over the last six months I have had a chance to research and purchase a few laser and inkjet printers made by Dell (DELL), HP (HP) and Canon (CAJ). As many of you are aware, manufacturers make their money on inkjet printers through the refill cartridges and sometimes use the actual printer as a "loss leader". A good example of this was Dell giving away printers for free along with the purchase of a computer. Consumers buying printers for personal or light business use often prefer inkjet printers because the initial cost is low and the quality of color prints is much better. With the widespread use of digital cameras, more and more people are buying inkjet printers to print pictures at home.

I recently purchased a Canon PIXMA MP600 inkjet printer for light home office use and was very satisfied with both the quality and functionality offered at such a low price. I also happened to notice that the stock of ink cartridges for this Canon printer was low at my neighborhood Circuit City and these cartridges also happened to be one of the top ten best sellers at Amazon.com under the electronics section. The fact that this printer won PC Magazine's reader's choice award may have something to do with this. While this can be construed as nothing more than anecdotal evidence of demand for Canon's printers and ink, consider the fact that Canon recently announced plans to open a factory to manufacture printer cartridges.

Canon cameras hold 8 out of the 10 spots on Amazon.com's top 10 best sellers list under the cameras and photo category. Incidentally I happened to purchase a Canon PowerShot Pro S3 IS camera for someone at work just a few months ago. Canon has done a great job covering the low, mid and high end segments of digital cameras with its Digital Elf SD 1000 7.1 MP camera, the Canon PowerShot Pro S5 IS 8.0 MP camera and the Canon Digital Rebel 10.1 MP SLR camera.

As an investor, I started looking into Canon's stock as a potential investment and candidate for the September investment newsletter and liked what I saw. Canon currently trades at a current P/E of 16.11, a forward P/E of 14.45, a P/S ratio of 1.79, sports a 1.6% dividend yield, has a rock solid balance sheet with $10.84 billion in cash and investments and only $262 million in debt. The company not only grew both revenue and earnings by 11% and 20.8% respectively in the first half of 2007, it raised its full year operating profit forecast to $7.44 billion representing year-over-year growth of 18%.

But wait a minute, haven't the days of double digit growth in digital camera passed us by and aren't we worried about the US consumer cutting back on spending with the weakness in the housing market? While the original assumption was that sales of digital cameras would grow in the single digits, it turns out that these assumptions were revised upwards for growth of 15% following strong sales of digital cameras in the first half of the year. The fact that some people are buying a second or third digital camera to replace their earlier less powerful models was cited as one of the reasons behind this trend. A cautious US consumer who can no longer use his/her home as an ATM machine will indeed impact most consumer electronics companies and retailers but I think the market has already priced some of this risk into the stocks of these companies. Canon also does not derive a majority of its revenue from the US as you can see from the revenue breakdown table below:

Canon Revenue Breakdown By Country United States 31% Europe 32% Domestic 22% Other 15%

Canon is making a major push into developing markets like India. As investors in Nokia have come to realize, a second wave of product adoption from emerging markets like India, China and Africa can be extremely beneficial. I bought Nokia (NOK) exactly two years ago based on increasing market share driven by sales in emerging markets and the stock is up more than 100% at this point without taking dividends into account.

If everything looks so good, why did I hold off on featuring Canon in this month's newsletter? Canon and other Japanese companies have been in a major downtrend in the last few days as the Yen has appreciated in value against both the US dollar (USDJPY=X) and the Euro (EURJPY=X). Every 1 yen move against the US dollar in the second half of 2007 is estimated to have a $41.74 million impact on Canon's operating profit and a similar move against the Euro is going to have a $27.83 million impact on operating profit assuming a conversion rate of 115 yen per US dollar. At the current exchange rate this amounts to a 5% reduction of expected full year operating profits. Japan is also going through a period of political turmoil with its Prime Minister Shinzo Abe quitting office amidst scandals and low voter support.

In this environment it may be prudent to wait a little and I am going to add Canon to our watchlist for now and start a position when the market turmoil in Japan quietens down a little.

Comments

[Tom B]

The digital camera market will be slow to saturate, because the models show strong improvement year-to-year. MY Powershot 3s IS cost just a bit more than the A70 I bought 3 years ago.

I like CAJ; they have a strong line-up. I have some CAJ which I will probably hold another 5 years.

[Asif]

I agree with you that digital camera sales are likely to stay strong well into 2008. My old Fujifilm digital camera is probably worth next to nothing and even my camcorder takes better pictures. I like CAJ a lot but am glad I waited as the stock has dropped a lot in recent days because of the yen appreciating against the dollar and the euro.