Fujifilm's Long Transformation Process Heading In The Right Direction

| About: FUJIFILM Holdings (FUJIY)
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Summary

Fujifilm has shown that it can reinvent itself, and a stronger footing in healthcare should help it overcome growth challenges in its office equipment/document businesses.

Image-based healthcare IT is still a growth opportunity for Fujifilm, as is its biopharmaceutical manufacturing operation, but novel drug development is a riskier, more expensive undertaking.

While investors may legitimately worry that Fujifilm is spreading itself too thin, the growth of the healthcare business should support 5-6% FCF growth and a FV 10% above today's price.

(Editor’s note: There is much greater liquidity on the Tokyo Exchange under the ticker 4901:JP)

Japanese companies used to have a well-deserved reputation for being stodgy; while concepts like just-in-time inventory were adopted relatively quickly, many companies have allowed themselves to become lumbering conglomerates that are slow to jettison operations with poor future prospects for growth or economic returns.

That's not so true with Fujifilm (OTCPK:FUJIY), as this company has launched two significant transformations in the past two decades - one designed to give the company life after the decline of photographic film and a more recent one intended to offset weakening prospects for office equipment. Fujifilm is arguably underrated for its healthcare business and it is this part of Fujifilm that has the best prospects for taking the business forward. Although success in drug development is by no means assured, even modest expectations would seem to support a fair value 10% higher than today's price.

A Morphing Conglomerate

Like a character out of anime or manga, Fujifilm seems to be quite willing to transform itself in response to changing circumstances and challenges. While the company's pivot away from photographic film 20 years ago was imperfect (the move into office equipment and specialty films worked out, the move into cameras not so much...), a more recent re-positioning towards healthcare has gone well and still seems to offer meaningful upside. That said, managing the glide path for less exciting opportunities like printing/office-related equipment and services remains an ongoing challenge.

Imaging solutions now makes up only about 15% of Fujifilm's business, consisting largely of film, digital cameras, smartphone camera modules, and the Instax line of instant film cameras. Recent introductions like the Instax Cheki have gone over really well, with volume up 83% year over year in the last quarter.

"Information solutions" makes up close to 40% of revenue, but the name is rather misleading. Healthcare is the largest part of this business, contributing about 17% of overall revenue, with operations in medical devices, diagnostics, imaging, healthcare IT, pharmaceuticals, cosmetics, and regenerative medicine. This segment also includes graphics systems (offset printing material and inkjets) that contribute about 11% of revenue, recording media (magnetic tapes) at 2% of revenue, industrial/semiconductor materials (including touch panel films and solar panel backsheets) at 4% of revenue, and flat panel films at 4%.

"Document solutions" makes up the remainder, and includes the company's multi-function printer business (partnered with Xerox (NYSE:XRX)), laser printers, production printing, and document services.

Healthcare Will Drive The Growth

I'll talk about document solutions later, but I expect Fujifilm's healthcare businesses to be the main drivers of growth for the business over the next decade (and likely beyond).

About 70% of segment sales today come from "medical systems" products that include x-ray systems, x-ray film, endoscopes, ultrasound, in-vitro diagnostics, and medical IT systems. Although Fujifilm's endoscope business is somewhat limited in scope, it is the number three player in the world in GI scopes (though far behind sector-dominating Olympus (OTCPK:OCPNY), which has more than 75% share). It is also the second-largest player in portable ultrasound, with about 25% share behind General Electric's (NYSE:GE) 34%.

More interesting (to me, at least) is its picture archiving and communications (PACS) medical IT business. Fujifilm is number two in the world with around 20% share (behind GE at 25%), and these systems help medical centers convert away from film-based imaging, allowing doctors to store, analyze, and share diagnostic images digitally. In other words, instead of a doctor holding an x-ray image up to a light source (an old staple of TV medical drama), they can punch up it on a computer. Filmless diagnostics still has less than 50% share in developed markets, though, and the move toward more 3D and functional images (watching organs move, etc.) is leading to much higher requirements for storage and processing.

Fujifilm has also been building up a pharmaceuticals and regenerative medicine business. On the pharmaceuticals side, the company has a biopharmaceuticals contract manufacturing operation as well as a biosimilars development platform (in partnership with Kyowa Hakko Kirin). The company also has a radiopharmaceuticals business built around CT and PET contrasts, with growth initiatives in areas like Alzheimer's diagnostics.

While those are decent businesses that should be able to grow at mid-single-digit (or better) rates with good margins, the proprietary drug development business is more of a high-risk/high-reward opportunity. Fujifilm is looking to focus on the development of novel drugs for unmet needs. To that end, it has in-licensed a customizable peptide-based prostate cancer vaccine (ITK-1) that is in Phase III studies in Japan. The company also has its wholly-owned drug T-817MA in Phase II trials in both the U.S. and Japan. This drug is being studied for Alzheimer's and is a neurotrophic agent different than the recent family of failures in the space (beta amyloid antibodies like solanezumab).

Last and not least is the regenerative medicine business. Such has been the history of regenerative medicine that I can hear people's eyes rolling as they read this, but Fujifilm has built up strong know-how in induced pluripotent stem cell development and production. While the company is looking to develop some proprietary stem cell therapies on a limited business, it sounds as though management is more keen on establishing itself as the "picks and shovels" supplier and partner to the industry.

I have few problems projecting good growth and improving margins for the core device/systems businesses, as well as the biopharma business. The regenerative medicine business is more of a "we'll see" opportunity, but it's not costing it a lot to build the business today. The drug development operation is a different story - we all know it is very expensive to develop new drugs, and Fujifilm's intention to focus on unmet needs likely means lower success rates. Still, management is looking to out-license/partner compounds as a way of defraying costs, and it only takes a few winners for the business to work.

I do expect ongoing M&A here. Back around 2010-2013, there was a lot of expectation that Olympus, Fujifilm, Hoya (OTCPK:HOCPY), and other Japanese conglomerates would continue to buy up medical device companies to accelerate their diversification plans. That never really happened, but I do think it is possible that Fujifilm will look to acquire more in the biopharma space, particularly "nuts and bolts" technologies like the cell culture media and chemical synthesis capabilities it acquired in its recent acquisition of Wako Pure Chemical. I would note that the company missed out on Toshiba's (OTCPK:TOSYY) medical business, and adding more imaging technology would have made some strategic sense (though not necessarily at the price paid).

And The Rest?

Fujifilm's flat panel films business is probably in for a tough time in the coming years. Like 3M (NYSE:MMM), Fujifilm has a strong business supplying films used to make LCD panels, but the company is much less leveraged to OLEDs and will likely see pressure as more business switches over to OLEDs. Still, the company has shown it has know-how in components that still do apply to OLEDs (and other applications like touch panels), so the business isn't going to vanish.

The bigger concern is the office-based printing business. Fujifilm and Xerox have over one-quarter share in A3 multi-function printers, and the shift toward A4 printers does offer some opportunity (though also competition from the likes of HP (NYSE:HPQ), as well as frequent competitors like Ricoh (OTCPK:RICOY) and Canon (NYSE:CAJ)). What's more, Xerox will be pushing its largest-ever line-up of new products in 2017 and 2018, and that should help Fujifilm (Fujifilm not only manufactures product for Xerox, but it also splits marketing territories).

Even so, I think the market for office printing equipment is past its peak and likely to see weakening revenue growth potential and lower margins in the coming years. What's more, I'm not convinced that managed print services and other document management offerings will do much to reinvigorate growth. As I wrote some time ago in reference to ARC Document Solutions (NYSE:ARC), I think the revenue growth prospects here are modest (mid single digit at best) and will largely only help soften the erosion (not prevent it), albeit potentially with respectable margins and cash flows.

The Opportunity

I expect Fujifilm's healthcare business to support long-term revenue growth in the mid single digits, with margins above the current/recent company average. The drug development business is a major unknown; developing novel branded drugs can indeed generate strong returns on capital, but it requires a lot of upfront investment with no assured outcome. I expect the other businesses, particularly the camera/film-related businesses and the office printing/documents-related businesses, to see low-single-digit growth, and it will behoove management to make these operations as cost-efficient as possible.

I believe the company will also continue to find and pursue opportunities like its specialty films and specialty materials/chemicals operations - these businesses (and to some extent its pharmaceutical and diagnostics businesses as well) were built in part on the foundation of the company's strong know-how in chemical development, processing, and manufacturing, and I think there will always be opportunities that feed off of that skill set. It likely won't be enough to really move the needle for the company as a whole, but it does represent a source of "shots on goal" that could ultimately lead to more significant opportunities.

All told, I'm looking for long-term revenue growth in the range of 2% to 3%, with FCF margins moving into the "high-mid" single-digit range as higher-margin healthcare businesses contribute more in the future. I also expect the document-related businesses to increasingly be run with an eye toward optimizing them as cash cows. With that, I'm looking for long-term FCF growth in the 5% to 6% range.

The Bottom Line

Given Fujifilm's lackluster ROIC history and the fact that a lot of its business is facing major structural challenges, I use a double-digit discount rate in my model. That still gives me a fair value about 10% above today's price, making this look like a surprisingly interesting opportunity. Investors must of course do their own due diligence, and be aware of the impact foreign currency can have, but if Fujifilm can grow its healthcare business on pace with the market and maximize the margin/cash flow potential of the documents business, these shares could outperform from here.

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Disclosure: I am/we are long MMM.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.