Canon's performance was driven primarily by sales of business peripherals and a truly stunning performance in the camera business. Through the first six months of the year, the camera business sales are up 14.9% on a local currency basis and operating profits are up 75.8%, because margins in the business have expanded from 16.3% last year to 23.6% this year. The company expects that its camera business and its optical products business will continue to be strong in the second half of the year and drive overall performance.
Through the first half of the year, free cash flow grew 32% as well, but capital spending will be higher in the second half of the year and free cash flow should actually finish slightly below last year's level. The capital spending will increase the company's capacity to produce ink jet parts, toner, and cartridges for printing and will also include further automation of the manufacturing processes and a new research and development facility.
With Canon's performance coming in so strong with 20% growth, it becomes logical to question whether I should ratchet up my 8.5% growth assumption over the next few years in my valuation. However, I see a few items that lead me to believe that my 8.5% assumption could still end up being the compound annual growth rate of the company's earnings over the next five years. Below is a list of the items that are keeping me from changing my assumptions:
- Canon is dominant in its business machines business and doing well in computer peripherals and cameras. However, competition from Sony
(NYSE:SNE), Hewlett-Packard (NYSE:HPQ), Olympus, Eastman-Kodak (NYSE:EK), and others is always a concern if the company misses a product cycle in its camera or printing businesses.
- I believe that part of the future growth is dependent on the ability to successfully roll out flat-panel SED (Surface-conduction Electron-emitter Displays) technology, and it is yet to be seen how Canon will fare here against traditional LCD, plasma, and rear-project screens.
- North America and Europe are more important to sales totals than domestic Japanese sales, and signs of an economic slowdown in the U.S. are beginning to show.
That said, I'm not at all downbeat on Canon. I like the strong balance sheet, see the stock as approximately 10% undervalued, and the business as extremely well managed. I'm particularly impressed by management's move to automate as much of its operations as possible because of the shrinking labor pool that is likely to develop in Japan over the next 10 to 20 years. Should the company materially pass my valuation estimate, I may change my mind and sell, but for now, I'm happy to wait and see how future quarters develop and continue collecting dividends.
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