As I wrote about Fujifilm (OTCPK:FUJIY) last week, that company is a relatively rare example of a Japanese conglomerate that has moved reasonably quickly to transform itself in response to changing market realities. If Fujifilm is the "after" picture, Fujitsu (OTCPK:FJTSY) is more like the "before" picture, as weak profitability in its manufactured products continues to weigh down the margin and cash generation potential of its more competitive services operations. Fortunately, management is not blind to these realities and has already initiated a process to transform the business away from its legacy hardware operations.
As of now, the Street isn't buying the notion that Fujitsu will move itself away from low-to-no profit businesses like PCs, phones, servers, and chips and re-base itself around IT services. Even though I believe the business restructuring efforts will likely lead to no net long-term revenue growth (as growth in the IT services business is canceled out by sales and divestments), I think lifting the burden of these lower-margin businesses will allow for FCF margins to improve into the low-to-mid single digits, supporting a fair value more than 25% higher than today's price.
Readers should note that Fujitsu's ADRs are not particularly liquid. With that said, I would suggest investors consider buying the Japanese shares (6702.T); most of the better brokers now support international trading and the hassle/costs are not too onerous.
A Hodgepodge That No Longer Creates Value
Not unlike IBM (NYSE:IBM), Hewlett Packard Enterprise (NYSE:HPE) (or its forerunner), and NEC Corp., Fujitsu did very well for itself developing and manufacturing increasingly sophisticated hardware products for businesses (and, to some extent, consumers) in the decades following World War 2. And like IBM, NEC, and HP, Fujitsu also added IT services and solutions to its mix along the way so that it could offer large business and government clients a full range of services and products.
Fujitsu is now dealing with the realities that hit IBM (et al) a while ago - businesses like PCs, enterprise servers, enterprise storage, and semiconductors don't offer the returns that they used to, and they are actually getting in the way of the earnings potential of the services business.
Broadly speaking, about 60% of Fujitsu's revenue now comes from IT services. Infrastructure services make up about two-thirds of this, including outsourced business services (Fujitsu operates around 100 data centers around the world), network services, and system support services. The solutions/system integration business makes up the rest, with Fujitsu being the largest systems integrator in Japan (by a large margin) and one of the five largest in the world (though that is a bit misleading, as I'm not sure they'd be in the top 10 ex-Japan). Many of the offerings here are very similar to those of IBM, HPE, Accenture (NYSE:ACN), Computer Sciences (CSC) and Tata (OTCPK:TTNQY), with Fujitsu competing on the breadth of services it offers, service quality, price, and so on. Business tends to be sticky with high switching costs, and Fujitsu is trying to up its game in terms of cloud, IoT, and machine learning offerings.
The remaining 40% of Fujitsu's business is a mix of largely legacy hardware offerings that I expect management will try to sell, spin off, or wind down over time. Fujitsu generates a low double-digit percentage of revenue from enterprise IT products like servers and storage and network products like base stations and optical transmission equipment. These businesses do okay in Japan, but the optical transmission equipment business (which competes with the likes of Ciena (NASDAQ:CIEN), Cisco (NASDAQ:CSCO), and Nokia (NYSE:NOK) is really the only one that's competitive on a global basis. Margins with these two businesses have been volatile, but generally poor.
The company's "Ubiquitous Solutions" business contributes almost a quarter of revenue and offers even worse margins (though they have improved recently into the low single digits). This business consists of PCs (#2 in Japan with high teens share), mobile phones (sold only in Japan), and a car infotainment business called Fujitsu Ten.
With low margins and minimal global competitiveness, Fujitsu's management has already made moves to shrink this business. The company will be reducing its stake in Fujitsu Ten from 55% to 14% (with auto parts supplier Denso (OTCPK:DNZOY) upping its stake from 10% to 51%) and has announced that it is in discussions with Lenovo (OTCPK:LNVGY) about a possible transaction with its PC business. Lenovo already has a JV with NEC that gives it more than a quarter of the market, and a deal here could make Lenovo-NEC-Fujitsu the dominant Japanese PC player with over 40% share. Disposing of the mobile phone business could prove more challenging, as it has just single-digit market share (and NEC got out of this business a while ago).
Last is the company's semiconductor and electronic components business (Device Solutions), which contributes close to 15% of revenue but again at low (sub-5%) margins. Fujitsu manufactures semiconductors at three fabs, two of which have JV partners (UMC (NYSE:UMC) and ON Semiconductor (NASDAQ:ON)) holding small stakes, as well as semi packaging materials, batteries, connectors and other components, and PCBs. While I think the components business could probably be sold relatively easily, I'm not sure the same is true for semiconductors; Fujitsu has been scaling down this business for years and may elect to just let it run out the clock if it can't find a buyer.
Transformation - Better Late Than Never
IBM and NEC seem to have figured things out quite a bit faster than Fujitsu has, and those companies are further along in their efforts to transition away from hardware and uncompetitive consumer product businesses. Fujitsu may be late in catching on, but that doesn't mean that restructuring away from hardware can't pay some dividends.
Selling what's left of the hardware businesses is an uncertain path in my mind. It looks like the deal with Lenovo for the PC business will move forward, and I think finding buyers for the storage, server, and networking equipment businesses is possible, but I'm not so sure about the mobile phone or semiconductor businesses. If they can't be sold, I would prefer to see Fujitsu run them so as to maximize cash flow and minimize losses with an eye toward basically winding them down over time.
On the IT services side, Fujitsu is strong in Japan (approximately 25% share), but still has room to improve. The company has moved into cloud services, but won't be directly challenging Amazon's (NASDAQ:AMZN) AWS on a one-to-one head-on basis. The company is also looking to position itself for the growth in IoT by building up its offerings in data collection/management, machine learning, security for edge systems, and integration with legacy systems. That latter point could prove to be invaluable, as I believe integrating IoT with existing systems will represent a meaningful challenge for many enterprises.
Fujitsu also needs to build up its overseas position. While Fujitsu is a major force in Japanese IT services, it's more of a "bottom of the top 10" or outside the top 10 player in most of Western Europe and North America. Given the relatively weak outlook for long-term economic growth in Japan, maximizing the global opportunity should be more of a focus for management, but that will mean up-front spending in personnel and infrastructure.
As I believe the IT services business can generate operating margins in the mid-to-high single digits on its own, exiting the hardware operations would be a case of addition by subtraction. While the resulting FCF margins in the 3% to 5% range still wouldn't be stellar (though not too dissimilar to Computer Sciences), they would still be a meaningful improvement from here. Moreover, given time, maybe an upgraded IT services business that gets management's full attention and reinvestment could generate more compelling margins.
With that, I see the restructuring opportunity as two-pronged - get rid of (or minimize) the underperforming hardware businesses, and make the IT services business more profitable, more dynamic, and more globally competitive. I believe management has already shown that they're serious about the first, but there is still meaningful (and fair) skepticism that they can really make much headway on the latter.
In modeling Fujitsu, I'm looking for no meaningful revenue growth across the decade and there could be meaningful revenue contraction in store if the company moves more aggressively to exit its semiconductor, components, and server/networking businesses. On the other hand, I would not be overly surprised if Fujitsu attempted to bulk up its IT service offerings through M&A, and particularly in North America. On the margin side, I expect a lower contribution from hardware to lift margins and allow Fujitsu to generate FCF margins in the 3% to 5% range, supporting double-digit FCF growth even on little-to-no revenue growth. Discounted back, that supports a fair value of around $36/ADR today.
The Bottom Line
The biggest downside I see with Fujitsu is that management's enthusiasm for restructuring wanes and they try to hang on to their lackluster, low-margin, low-FCF hardware operations. While walking away from revenue is difficult, reinvesting meaningful capital into these businesses now would be throwing good money after bad, as I just don't see how they can earn back a reasonable cost of capital.
Success in the IT services business is no guarantee, as NEC, IBM, Accenture and others are not pushovers, but Fujitsu at least has a firm foundation to growth off of, and multiple growing markets to serve. While there are risks that the IT services operations won't grow as much or be as profitable as I expect, I think Fujitsu is still relatively early in a turnaround/restructuring process that can unlock more value than the Street currently recognizes.
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Disclosure: I am/we are long LNVGY.
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