S&P: Ratings On Australian State of Victoria Affirmed At 'AAA/A-1+'; Outlook Remains Negative
The outlook revision reflects our view that, in addition to a trend of declining profitability over recent years, the negative effects of an appreciating yen and sluggish sales of laser printers have hurt the company's operating performance and profitability. Also, we see at least a one-in-three chance Canon's profitability will not recover quickly to a level commensurate with the current ratings, even taking into account the planned introduction of new products and the benefits of continued cost reduction.
Demand for Canon's main office equipment has diminished in developed countries and stagnated in slowing emerging economies, in turn eroding Canon's profitability over recent years. In addition, sales of laser printers, Canon's specialty, have been sluggish as the company cuts production to reduce stock held by distributors in emerging markets. We believe these factors, coupled with a rising yen, will cause a steep decline in operating profit year on year in Canon's office equipment business in fiscal 2016 (ending Dec. 31, 2016). Although inventories of laser printers held by distributors are likely to adjust in due course, we believe Canon's path to a recovery in profitability is challenging because the office equipment business faces the structural problem of intensifying competition in a matured market. We also expect operating profit in the camera business to fall sharply in fiscal 2016. This is because although Canon has benefited somewhat from a shift to high-end models amid market saturation, the appreciating yen has a large impact.
Canon has a higher EBITDA margin than its peers, but saturation of both office equipment and camera markets is shrinking it gradually. Therefore, we expect its EBITDA margin to worsen to the mid-14% level in fiscal 2016. Its EBITDA margin is likely to take time to recover to the 16%-17% levels of fiscal 2015 (ended Dec. 31, 2015) and earlier, even when we consider continuous improvement in productivity, continuous cost reductions, and profit contributions from new product launches and new businesses. Nevertheless, the company maintains the largest or second-largest shares of global markets for a wide range of products, including office equipment and cameras, thanks to its strength in optical technologies. In addition, consumables and services, which produce more stable profitability than hardware products, account for a major proportion of Canon's profits. Reflecting these factors, we assess Canon's business risk profile as strong. Specifically, it is at the higher end of our assessment of strong because Canon has maintained higher profitability and market position than its peers. However, its high profitability is gradually weakening, in our view.
Canon is likely to maintain its potential to generate strong cash flows, although we expect its EBITDA and EBITDA margin to worsen. To enhance its competitiveness, we expect the company to conduct a certain level of merger and acquisition (M&A) activity and to make slightly higher capital expenditures than it has in the past few years. Nevertheless, the company is likely to continue to generate strong cash flow and maintain reasonably conservative financial management of investments, acquisitions, and shareholder returns. We, based on this, expect the company to continuously generate about ?200 billion in free operating cash flow per year and to maintain an extremely low debt ratio as a consequence. We, based on these factors, assess Canon's financial risk profile as minimal. We believe Canon will maintain adequate liquidity even after taking into consideration its acquisition of Toshiba Medical Systems.
Our base-case scenario for Canon assumes the following:Growth of the copier and printer market is likely to stall in 2016 against the backdrop of an economic slowdown in China and emerging Asian countries;A slower pace of contraction in the digital camera market in 2016;A substantial fall in operating profit in the office equipment business in fiscal 2016, owing to sluggish sales of laser printers and the negative effects of a strong yen, but an increase of about 13%-15% in fiscal 2017 thanks to a modest recovery in unit sales and benefits of cost reductions;A material fall in operating profit in the imaging system business, which includes cameras, primarily because of a strong yen and despite a better product mix; but a moderate recovery in operating profit in fiscal 2017 thanks to continuous improvement in product mix and cost reductions; andAbout ?250 billion in capital expenditures annually and continuing M&A activities at a certain level following completion of the Toshiba Medical Systems acquisition to enhance competitiveness. Under this scenario, we expect the following financial indicators:A deterioration in EBITDA margin to the mid-14% level in fiscal 2016, but a recovery to about 15% in fiscal 2017; andContinued debt to EBITDA of below 0.5x even after completion of the Toshiba Medical Systems acquisition. The outlook is negative. Even considering cost reductions and other measures to recover profitability, we see at least a one-in-three chance Canon's EBITDA margin will not recover to above 15%, a level commensurate with the current rating, in the next six to 18 months. This is because market saturation has gradually eroded the company's profitability and an appreciating yen and sluggish sales of highly profitable products have dealt a heavy blow. We would consider downgrading Canon if profitability in its core office equipment and cameras businesses shows no sign of recovery and we believe the EBITDA margin is likely to stay at or below 15%. We may also consider a downgrade if more aggressive M&A activities and shareholder returns were to increase the ratio of the company's debt to EBITDA to above 1.5x for an extended period.
Conversely, we would consider revising the outlook to stable if we were to see a higher likelihood of Canon achieving and maintaining a steady EBITDA margin above 15%. This might occur if profitability recovers thanks to cost reductions or a further shift to highly profitable products.