NIPNY updated for 2Q results
Overview
Headquartered in Tokyo, Japan, NEC Corporation (NIPNY) provides components and systems service solutions for computing and communication applications. The company operates through three segments: Information Technology (IT) Solutions, Network Solutions, and Electron Devices. The IT Solutions segment offers Internet-related services and other computing solutions, including systems integration (SI) services, software, maintenance, and customer support services, personal computers (PCs), and mainframe computers, to both private and government enterprises. The Network Solutions business provides mobile and wireless network infrastructure, mobile handsets, as well as wireline network infrastructure, to help network service provider’s build and operate their networks. It also designs network systems and products including optical network systems, Internet protocol (IP) network systems, and mobile and wireless network systems. NEC’s Electron Devices segment offers semiconductors (including system-level semiconductor solutions and general-purpose dynamic random access memories/DRAMs), displays, and other electronic components for use in computers, communication products, digital consumer electronic products, and automobiles.
According to the analysts, the decision to buy the stock or not depends upon the following factors (1) a recovery in the cellular-phone business, (2) growth in the overseas wireless infrastructure business, (3) a recovery in IT services, (4) the possibility of a sale of Elpida shares, and (5) the company’s indication that it may implement an exit strategy for non-core businesses.
Positives / NegativesHigher R&D on 3G technologies increases the margins in the long run. / Debt-to-capitalization ratio is still very high, implying hefty interest expenses and a negative swing in operating numbers.
Increasing presence in several emerging markets like China etc. / Decline in shipments of mobile phone handsets have caused inventories to rise.
Growing demand from broadband services. / Increased competition from other mobile players.
The mobile phone business in China is trending above plan (sales could be around 2.5 million units, easily beating management’s 2 million projection). / Deterioration in semiconductor market.
NEC’s domestic market share is improving (management expects its shares to expand to 33% in 3Q from 28% in 1HFY2004).
Ongoing expectations for structural reforms with plans for the takeover of software-related subsidiaries as wholly owned units.
Nine analysts rated this stock, of which two have a positive view, six hold a neutral view and one has a negative outlook. Analysts turned positive on NEC due to the rising mix of 3G handsets in both domestic and overseas market, as well as for increasing production scale, steady growth in the IT Solutions segment, and the synergy from NEC Soft and NEC System Technologies.
Sales
Our consensus model projects revenues of JPY4858.6 billion (-1.0 % y-o-y) and JPY4952 billion (1.9% y-o-y) during 2004 and 2005 respectively. NEC’s new FY2004 forecast is sales of ¥4.9 trillion (flat YoY), which is ¥40 billion lower than the previous one.
Division wise consensus sales model
(In JPY) / 2003A / 2004E / 2005E / 03-05 CAGRFY / FY / FY
IT solutions
/ JPY2098.9 / JPY2143.3 / JPY2208.8 / 2.6%Network solutions / JPY1775.7 / JPY1874.7 / JPY1968.3 / 5.3%
Electronic devices / JPY932.2 / JPY912.3 / JPY955.3 / 1.2%
Others / JPY679.9 / JPY566.7 / JPY570 / - 8.7%
Total / JPY4906.8 / JPY4858.6 / JPY4952.0 / 0.5%
IT solutions - The IT Solutions division accounts for nearly 43% of NEC’s total revenue. IT Solutions 1H revenues rose 1.4% YoY. Thanks to large shipments of charging systems to telecom operators, software sales jumped 9.1% whereas revenue from hardware was down by more than 3% YoY. Analyst believes that the hardware segment may see a downfall because of weak growth in the domestic PC market, while System Integration services would generate profit for the division. Our consensus model now projects 2.1% growth in IT Solutions division’s revenues to JPY2143.3 billion in 2004. However, for 2005 analysts’ estimates range from JPY2180 billion (Morgan Stanley) at the lower end to JPY2227 billion (J.P Morgan) at the higher end. Furthermore, with the announced tie-up with the heavyweight-consulting firm ABeam, analysts anticipate earnings from IT solutions to jump.
Network Solutions -This division accounts for 36% of NEC’s total revenue. The segment is an intermediary for the projects that the IT Solution segment does for communication carriers.1H revenues for network solutions were up 5.6%. The company forecasts full-year sales volume to fall 5% to about 14.7 million units, and sales to decline a bit under 10% YoY from ¥729.7 billion to ¥660.0 billion. However, in 2H the company is pegging sales volume of 8.7 million units, topping last year’s 7.8 million units, and sales to be only slightly lower than last year, at ¥350.0 billion vs. ¥370.0 billion. Analysts believe that the business is headed for a major rebound in FY2005 and expects the market environment to improve only slightly and thus sales to increase minimally.
Electron Devices -This division accounts for 19% of NEC’s total revenue. Analysts estimate that corrections in the semiconductor market should soon be complete, and set to improve profitably, thanks to the effects of the increased sales at NEC Electronics. Further, they added that the sale of the company’s PDP operations to Pioneer would be a plus, if only a slight one, since that loss-making business will no longer have a negative impact. Our consensus model now projects Electron Devices division’s revenue to grow by 4.7% to JPY955.3 billion in 2005.
Please see the separately saved spreadsheet for more details.
Margin
NEC substantially revised down its full-term operating profit projection to ¥150.0 bn from ¥220.0 bn due to earnings targets for NECEL and the disappointing results in the cellphone business resulted in ¥60.0 bn of this downward revision (¥30.0 bn each in 1H and 2H). NEC’s lower operating income break down is ¥50 billion for telecom, ¥15 billion for electronic devices, and ¥10 billion for IT solutions. The forecast for “other” divisions/eliminations was raised by ¥5 billion. Our consensus model projects operating margin of 3.0% and 3.5% for 2004 and 2005, respectively. Analysts expect margin growth to come from the IT Solutions and Electron Devices segments and from the cost-cutting initiatives in the broadband business of the Network Solutions segment.
Consensus margins/ FY2002A / FY2003A / FY2004E / FY2005E
Gross Margin / 26.4% / 26.7% / 25.8% / 25.8%
Operating Margin / 2.5% / 3.7% / 3.0% / 3.5%
Net Income Margin / -0.5% / 0.8% / 1.1% / 1.3%
Please see the separately saved spreadsheet for more details.
Earnings Per Share
There has been a significant revision to analysts’ 2004 EPS estimates after the shortfall in the 2QFY04 operating profit figure. Our digest model now projects EPS of JPY 28.63 (29.2%) for 2004 and JPY 32.73 (14.3%) for 2005.
Fiscal Year ends march 31, 2004 (In JPY.)
/FY04E
/FY05E
/FY06E
Zacks consensus / - / - / -Digest High / JPY31.10 / JPY45.60 / JPY52.70
Digest Low / JPY22.73 / JPY18.10 / JPY20.70
Digest Average / JPY28.63 / JPY32.73 / JPY41.48
Digest average Y-O-Y growth / 29.2% / 14.3% / 26.7%
Please see the separately saved spreadsheet for more details.
Target Price/Valuation
The target price for NEC Corporation ranges from JPY520 to JPY660. The consensus average price target of five analysts, with published target prices, comes roughly to JPY602 a share. After the 1H/FY3/05 results, analysts revised downwards their target prices as well as the EPS estimates for 2004 and 2005 due to some segmental earnings faced some downside risk in FY04.
Analyst (Nikko Citigroup) with the highest price target of JPY660 has based it on PCFR of 5x FY2005 CFPS of JPY 132.1. The lowest target price of JPY520 (Deutsche Bank) is based on (1) 20x FY3/06 P/E and (2) 7.3x EV/EBITDA.
Please see the separately saved spreadsheet for more details.
Long-Term Growth
NEC Corporation’s long-term growth is inextricably linked to improved capital spending in the software and electronics sectors. Analysts expect robust growth in the SI services and computer platform areas to bode well for its IT Solutions business, which accounts for 43% of revenue. The company has earmarked China as a potential market for future growth and plans to expand its outlets there from 700 (in April-May) to 2,000 (by FY3/05). It expects to open nearly 4,000 stores by FY3/06. NEC also aims to ship 2mn units in FY3/05, 3mn units in FY3/06, and 5mn units in FY3/07 to China.
Robust demand for semiconductors in the area of digital AV products, PC peripherals, and mobile handsets continue to spur top line growth. The steady demand in industry-type color crystal displays (LCDs) is expected to keep this division on the growth trajectory. Solid growth in broadband operations, increased sales to Japanese telecommunication operators for establishment of new services, and the ongoing IP investment in the domestic enterprise market are expected to be the major growth drivers in the coming future.
During the middle of November, NEC announced its business tie-up with ABeam, one of Japan’s largest consulting firms. It plans to acquire over 51% by March 2005, with the ultimate aim of making it a wholly owned subsidiary by 2010. The tie-up provides NEC a much-needed boost to its top-end consulting capabilities and trade rights (mostly in Asia). Analysts believe the move should be a positive one for the earnings of NEC’s IT solutions division. Analysts also have a positive view on NEC Soft and NEC System Technologies to become wholly owned subsidiaries, which should support rebuilding of the fractured value chain, enhance business efficiency and prevent the outflow of value from core businesses to minority shareholders in the long term.
Individual Analyst Opinions
POSITIVE RATINGS
Bear Stearns (updated-9/02/2004)- Stock is rated Outperform with a target price of JPY990, based on a FY2005 P/E multiple of 21x. Analyst believes that the rising mix of 3G handsets, both in domestic and overseas market, and the rising production scale will help NEC’s margins over the next two years. According to the analyst, NEC’s attractive valuation, telecom equipment, NECEL, and margin expansion are still driving earnings growth. He expects NEC to generate FY2005-2008 earnings CAGR of 21%.
Lehman brothers (updated-8/04/2004)-Stock is rated 1- Overweight with a target price of JPY 900 as opposed to the earlier JPY 1130. According to the analyst, there is a likelihood of a decline in profit and weak growth in the domestic PC market again in 2H. He feels management’s target of shipping 19 million cell phones are unrealistic. He also expects steady growth in the IT Solutions segment and a slight profit growth in the Electron Devices segment, but is less certain about the improvement in the Network Solutions segment, centered on cell phones.
J. P. Morgan Sec (updated-12/06/2004)-Stock is upgraded to Overweight from Neutral earlier. Analyst revises its forecasts based on information presented at the December 3 briefing. Regarding FY2004, it lowers its operating profit estimate for the electronic devices segment to ¥48 billion from ¥55 billion to reflect the downward revision to our forecast for NEC Electronics, which analyst reported in its December 1 note. However, he raises its profit forecast for the networks segment to ¥32 billion from ¥27 billion because (1) the mobile phone business in China is trending above plan (President Kanasugi suggested that FY2004 sales could total around 2.5 million units, easily beating management’s 2 million projection); and (2) NEC’s domestic market share is improving (management expects its share to expand to 33% in 3Q from 28% in 1H FY2004).
Goldman (updated-8/04/2004)-Stock is rated In-line. According to the analyst, 1HFY04 results came as a negative surprise, but it believes the negative news surrounding NEC has largely been exhausted. Analyst sees five main positive catalysts likely to impact the stock over the next six to nine months: (1) a recovery in the cellular-phone business, (2) renewed growth in the overseas wireless infrastructure business, (3) a recovery of confidence in IT services, (4) the possibility of a sale of Elpida shares, and (5) the company’s indication that it may implement an exit strategy for non-core businesses. Analyst also sees three main risks that should be borne in mind: (1) the possibility of NECEL earnings falling short of guidance, (2) downside for LCD earnings, and (3) the adoption of a negative stance by NTT DoCoMo, including delays to the introduction of HSDPA (High-Speed Downlink Packet Access).
NEUTRAL RATINGS
UBS (updated-12/03/2004)-Stock is rated Neutral with a target price ranging from ¥585, based on a PBR of 1.4X, the historical support line. Analyst expects the firm to target a recovery in profitability through improved development efficiency, but examples such as MCI suggest this may not be easy. The company is aiming to increase minorities holdings by making listed subsidiaries in the software services segment wholly owned. Analyst views, the likely boost from paring such costs is unclear as management expects to reduce outsourcing costs and boost OP by ¥15bn through amalgamation/efficiency improvement with partner firms, but thinks the overall SI market is gradually picking up.
Merrill Lynch (updated-12/02/2004)- Stock is rated Neutral. According to the analyst, NEC’s 70% shareholding in NEC Soft and NEC System Technologies is too high, but it is unrealistic to try and increase this to 100%. Analyst would like to see this cut from 70% (now) to below 50%. The sale of Toyo Communication Equipment to Seiko Epson has already been decided. Analyst believes NEC’s efforts to integrate its communication equipment and IT solutions businesses face their sternest test. It believes the company will face questions about its bold decision to try and accomplish this more rapidly than the other four integrated electrical equipment manufacturers at tomorrow’s the company’s strategy briefing.