Fujitsu Limited: Potential Financial Improvement Has Been Priced In (Rating Downgrade)

seekingalpha10-06

Fujitsu Limited is targeting a ROE improvement to 16%-18% in FY 2025 and a 14%-16% earnings CAGR for the FY 2022-2025 time frame, which I think is achievable.The stock is currently trading at a ...

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JHVEPhoto/iStock Editorial via Getty Images My investment rating for Fujitsu Limited (OTCPK:FJTSF) (OTCPK:FJTSY) [6702:JP] is downgraded to a Hold. I am impressed with FJTSF's recently disclosed financial targets, which points to meaningful ROE improvement and a reasonably healthy annualized earnings growth rate for the midterm. While I think that Fujitsu Limited can realize its financial goals, the stock's valuations have already priced in the company's favorable financial prospects to a large extent. Earlier, I wrote about the growth of Fujitsu Limited's consulting business with my April 11, 2024 write-up. Investors should know that they can trade in Fujitsu Limited's shares on the Tokyo Stock Exchange and the Over-The-Counter market. The average daily trading values for Fujitsu Limited's OTC shares and Japanese shares were $4 million and $120 million, respectively according to data obtained from S&P Capital IQ. The company's relatively more liquid Japan-listed shares can be bought or sold with US brokerages such as Interactive Brokers. Company's Financial Goals Are Achievable At its 2024 Investor Relations Day in the prior month, Fujitsu Limited revealed the company's medium-term earnings growth and ROE expansion targets. It is important to note that the company refers to fiscal 2022 as the financial year ended March 31, 2023. On one hand, FJTSF is targeting to improve its ROE from 13.5% in FY 2022 and 15.2% in FY 2023 to between 16% and 18% for FY 2025. On the other hand, the company has set a goal of delivering a bottom line CAGR in the +14%-16% range for the FY 2022-2025 time frame. I sourced these numbers from Fujitsu Limited's 2024 Investor Relations Day presentation slides. I take the view that Fujitsu Limited can attain its financial goals. With respect to top line growth, the company aims to increase its revenue by +21% or +JPY 420 billion between FY 2022 and FY 2025. During this same time frame, FJTSF anticipates that its Fujitsu Uvance business can generate incremental revenue of +JPY 500 billion, which will be partially offset by a decline in legacy or traditional IT services revenue. As such, the top line expansion for Fujitsu Uvance is a key factor influencing the company's ability to meet its +14%-16% earnings CAGR target. At its 2024 Investor Relations Day webcast and in its Fujitsu Uvance business presentation slides, FJTSF described Fujitsu Uvance as its business targeting a \"new service market whereby data is leveraged\" to help clients deal with \"sustainability transformation.\" The new Fujitsu Uvance business was first established in October 2021. A Comparison Of Fujitsu Uvance's Operating Model With That Of Traditional Information Technology Services  Fujitsu Uvance Business Presentation Slides I think that the assumption of a meaningful increase in incremental top line contribution from Fujitsu Uvance in the years ahead is realistic. The worldwide total addressable market or TAM for Fujitsu Uvance is large at JPY 25 trillion ($170 billion) as per third-party research estimates sourced by FJTSF. As a reference, Fujitsu Uvance's most recent fiscal year or FY 2023 revenue was JPY 368 billion or 1.4% of its TAM, which means that it is in the early innings of growth. More importantly, Fujitsu Limited's current financial targets are only assuming that Fujitsu Uvance garners a modest 3% of this new market space by FY 2025. Fujitsu Uvance is now operating in a relatively new and untapped market with a first mover advantage. Earlier, Fujitsu Limited was mainly competing in highly competitive and mature IT consulting segments, which meant slower growth and lower margins. Fujitsu Limited highlighted in its Fujitsu Uvance business presentation that Fujitsu Uvance is already \"acquiring the market ahead of competitors and establishing a leadership position\" in this space which has \"no big tech companies and no market leader yet.\" As per the chart presented below, Fujitsu Uvance possess specific characteristic that allow it to compete effectively against rivals in the sustainability transformation space. Fujitsu Uvance's Competitive Edge In Competing In The Sustainability Transformation Focus Areas Fujitsu Uvance Business Presentation Slides In terms of profitability, Fujitsu Limited is expecting to improve its operating margin from 8.6% for FY 2022 to 12.0% in FY 2025. Apart from positive operating leverage effects, FJTSF indicated in its Investor Relations Day presentation slides that it targets to expand its gross margin by +300 basis points in the FY 2022-2025 period through \"standardization, automation, and insourcing\" initiatives. At its earlier Q1 FY 2024 earnings call in late July, Fujitsu Limited noted that it has observed \"productivity improvements\" with the \"standardization of development work, automation, the expansion of in-house work.\" The company has relevant expense optimization levers to pull, and cost reduction is usually a low-hanging fruit when it comes to profitability improvement. A higher level of automation means that fewer workers are required, which could translate into a decrease in staff expenses. On the other hand, standardization reduces the number of duplicate processes, and that usually results in lower costs. Also, increasing the proportion of business operations done in-house does away with the need to hire expensive outsourcing services providers in specific areas of the business. With regards to the shrinkage of the capital base to boost ROE, FJTSF is keen on returning more capital to its shareholders. Improving ROE involves revenue growth, margin expansion, and the reduction of the capital base via dividends and buybacks. As highlighted above, Fujitsu Limited has the potential for top line growth and profitability improvement, which are supportive of a higher ROE. As disclosed in its Investor Relations Day presentation, the company has guided for an increase in capital returned to shareholders from JPY 151.5 billion in FY 2023 to JPY 230 billion and JPY 220 billion for FY 2024 and FY 2025, respectively. The JPY 151.5 billion of capital returned to shareholders in FY 2023 represented 59% of FJTSF's actual earnings in that fiscal year. As such, Fujitsu Limited has the potential to grow its future dividends and buybacks via both bottom line expansion (explained above) and a higher capital return ratio above 59% in the future. In a nutshell, Fujitsu Limited is hoping to achieve a mid-teens percentage earnings CAGR for the next few years and increase its ROE to the high-teens percentage level by FY 2025. Taking into account the company's financial improvement and capital return initiatives, I view FJTSF's financial targets as achievable. But The Stock Is At Best Fairly Valued Fujitsu Limited's current valuations have already factored in the company's potential financial improvement for the intermediate term to a large degree. Fujitsu Limited is now trading at a consensus FY 2025 normalized P/E of 19.5 times based on S&P Capital IQ data. In McKinsey's book \"Valuation: Measuring and Managing the Value of Companies\", the consulting firm has a valuation equation derived from the discounted cash flow model known as the key value driver formula. According to the key value driver formula, a fair P/E valuation multiple is equivalent to (1-g/ROE)/(k-g) where g, ROE, and k refer to the perpetuity growth rate, the return on equity, and the cost of equity, respectively. I arrive at a target P/E ratio of 16.7 times for Fujitsu Limited using this valuation formula. My ROE, cost of equity, perpetuity growth rate assumptions are 18% (the high end of FJTSF's FY 2025 ROE target), 8% (pegged to the average cost of equity for information services companies), and +3% (pegged to a mature economy's expected long-term GDP growth rate in the low single-digit percentage range), respectively. My target P/E of 16.7 times is 14% below Fujitsu Limited's current P/E of 19.5 times, which I deem to be in an acceptable range to consider the stock as fairly valued. Separately, Fujitsu Limited's current Price-to-Earnings Growth or PEG multiple is 1.2 times or slightly above the 1 times indicative of fair valuation. This is calculated based on the stock's consensus FY 2024 P/E of 19.5 times and the high end of the company's FY 2022-2025 EPS CAGR target of +16%. As another comparison, Fujitsu Limited's historical three-year and five-year mean P/E multiples were 19.9 times and 19.8 times, respectively, as per data taken from S&P Capital IQ data. This is on par with the stock's current P/E valuations. To sum things up, it is reasonable to say that Fujitsu Limited is now fairly valued or even slightly overvalued based on the metrics presented in this section. Conclusion Fujitsu Limited is well-positioned to achieve ROE expansion and earnings growth in the years ahead. But the company's positive financial outlook is already reflected in its stock price, which explains why I have lowered my rating for FJTSF to a Hold.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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