NEC (TSE 6701) TAP Japan Research powered by. Why look at NEC? Advantages & Risks. Authors. Company report 20 January 2017

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NEC (TSE 6701) Company report 20 January 2017 TAP Japan Research powered by Why look at NEC? Restructuring should lead to higher sales and better margins over the next 2 3 years.

1 NEC (TSE 6701) Company report 20 January 2017 TAP Japan Research powered by Why look at NEC? Restructuring should lead to higher sales and better margins over the next 2 3 years. Attractively priced at 11x our EPS estimate for FY Mar % upside potential to 420 no-growth valuation calculated by Japan Analytics based on company s current fiscal year forecast. 79% upside to 576 based on TAP Japan Mar-19 forecast Internally generated funds exceed capex and could pay for M&A if opportunities arise. At long-term low relative deviation to market Advantages & Risks Has retained advanced telecom, IT service and cyber security technologies while exiting unprofitable businesses. Financially sound with strong balance sheet and positive free cash flow. Needs to generate greater operating cash flow. Highly dependent on Japanese domestic market (77% of sales), but should benefit from 2020 Olympic preparations, e- government, the Internet of Things and the introduction of 5G mobile telecom services. Must seek additional growth overseas. Has room to increase future-oriented investments. Authors Scott Foster sf@tapjpan.net Campbell Gunn cg@japananalytics.sg Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 1

2 Contents Executive Summary... 3 Renewed focus on growth and efficiency gains... 3 Company highlights... 5 Japan s top supplier of computing and communications equipment, software and services... 5 Change in accounting... 6 Geographic Revenue Breakdown... 7 Sales and profits... 8 Streamlining and reorientation H results & FY Mar-17 guidance... 9 New medium-term plan Consolidated sales & profit forecast Consolidated Segment Data Quarterly Revenue & Revenue Change Quarterly Operating Income, Operating Margin & Year-on-Year Changes Gross & Operating Margins By Quarter Net Operating Income After Tax Financial Position Strong balance sheet Investments covered by internally generated funds Dividend payout ratio heading toward 35% Quarterly Cumulative Cash Flow TTM Core Return on Net Operating Assets Trailing Twelve Month Residual lncome Drivers Trailing Twelve Month No-Growth Valuation NEC Segment History Appendix: Financial Statements Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 2

3 Executive Summary Renewed focus on growth and efficiency gains For several years now, management has taken steps to reduce its exposure to unprofitable businesses and reorient the company toward new markets. Reported sales have declined while, until this fiscal year, the sales of the current business and overall operating profit have increased. Year-on-year declines in sales and operating profit in the six months to Sep-16 were due a combination of project timing and weak demand in Japan and overseas, which overwhelmed efforts to cut costs. In order to get the company back on a growth track, management has launched a new medium-term plan that focuses on future-oriented businesses cyber security, the Internet of Things (IoT), IT services for retailers, advanced telecom technology - and more efficient use of resources. As a result of these efforts, plus the consolidation of Japan Aviation Electronics (JAE) and a more favorable operating environment, we expect sales to rise from 2,900 billion this fiscal year to 3,100 billion in FY Mar-19, operating profit to rise from 92 billion to 140 billion and net profit from 45 billion to 78 billion over the same period. The operating margin should rise from 3.2% to 4.5% and ROE from 5.8% to 9.2%. At 321 (January 20 closing price), the shares are selling at 18.5x our EPS estimate for this fiscal year, 13.5x for next year and 10.7x for the year to Mar-19. Projected EV/EBITDA multiples for the same three years are 8.4x, 7.0x and 6.0x. Projected price/book value multiples are 1.1x, 1.0x and 1.0x. These valuations are in the middle of their historical ranges. Since the company turned profitable in FY Mar-13, the P/E multiple has ranged from 8.3x to 26.9x. For reference, 15x our EPS estimate for FY Mar-19 is 450, indicating upside potential of 40%. Capital spending is currently running at an annual rate of about 45 billion roughly equivalent to depreciation and well below total depreciation and amortization, which is roughly 70 billion. This is likely to continue, in our estimation, resulting in positive free cash flow of 50 billion or more each year through FY Mar-19. If suitable targets can be found, these funds could be applied toward M&A. Management has not announced a target, but the dividend payout ratio is likely to be about 23% this fiscal year and 35% next year and the year after, in our estimation. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 3

5 Company highlights Japan s top supplier of computing and communications equipment, software and services Established in 1899 as a joint venture with Western Electric, Nippon Electric Company (NEC) is one of Japan s oldest and most diversified suppliers of electronic equipment. Management currently divides the company s business into five segments: Public, Enterprise, Telecom Carrier, System Platform and Others. The Public Business includes system integration, maintenance & support, cloud services and equipment for government, public services, healthcare, finance and media. The Enterprise Business includes system integration, maintenance & support, outsourcing and cloud services for manufacturing, retail and services. The Telecom Carrier Business includes network infrastructure, services & solutions for NTT and other domestic and overseas telecom carriers. The System Platform Business includes hardware (servers, computers, storage, etc.), enterprise network systems and data center infrastructure, maintenance & support. Other Businesses include smart energy, lighting equipment, biometrics (face recognition, fingerprint identification) and surveillance. For further detail, see: In FY Mar-16, the breakdown of sales by segment was Public 27.2%, Enterprise 10.7%, Telecom Carrier 24.8%, System Platform 25.8% and Others 11.6%. NEC has just over 100,000 employees working in more than 100 countries and territories worldwide. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 5

6 NEC s consolidated business segments have changed many times over the past two decades as a result of new business development, divestitures and reorganizations. Over the past 20 years, the company has announced results for a total of 26 segments more than any other Japanese manufacturer. But current segments have been reported for almost five years now and seem unlikely to change in the near future. Change in accounting NEC adopted International Financial Reporting Standards (IFRS) this fiscal year (FY Mar-17). Results for the six months to Sep-16 and 1H of the previous fiscal year were reported according to IFRS, but the data for FY Mar-16 as a whole is incomplete, unaudited and subject to revision. The changes from J-GAAP to IFRS are noted in the financial tables that appear later in this report. The most significant changes are to the operating profits of the System Platform and Other businesses. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 6

7 Geographic Revenue Breakdown As of the first quarter of fiscal 2017, 77% of sales were in Japan with a further 10% in Asia. The rest of the world totaled 13%. In the last ten years, Japan revenue has never fallen below 76% of total revenue. NEC has not disclosed a geographic breakdown of Operating Income since Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 7

Sales and profits Streamlining and reorientation Over the past several years, management has taken steps to reduce its exposure to unprofitable businesses and reorient the company toward new markets.

8 Sales and profits Streamlining and reorientation Over the past several years, management has taken steps to reduce its exposure to unprofitable businesses and reorient the company toward new markets. Reported sales have declined while, until this fiscal year, the sales of the current business and overall operating profit have increased. The year-on-year declines in sales and operating profit in the six months to Sep-16 were due a combination of project timing and weak demand in Japan and overseas, which overwhelmed efforts to cut costs. 4, , , , , , , NEC (JPYbn) - Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Reported Net Sales Sales of the Current Business NEC does not benefit directly from a weaker yen. Rather, due to overseas procurement, management estimates that a one-yen depreciation of the yen against the U.S. dollar results in 300m decrease in annualized operating profit. On the other hand, with nearly 80% of sales made in Japan, the company is highly geared to domestic economic conditions, which tend to improve with a weaker yen. In our estimation, this is more important for NEC. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 8

1H results & FY Mar-17 guidance In the six months to Sep-16, consolidated sales were down 8.3% year-on-year to 1,201.1 billion, operating profit was down 80.3% to 3.7 billion and net profit up 52.

9 1H results & FY Mar-17 guidance In the six months to Sep-16, consolidated sales were down 8.3% year-on-year to 1,201.1 billion, operating profit was down 80.3% to 3.7 billion and net profit up 52.4% to 13.1 billion due to a lower effective tax rate. By segment, the results were: Public Business: Sales were down 16.0% to billion due to the completion of relatively large government and public service projects the previous year and a decline in demand for the digitalization of emergency radio systems. Operating profit was down 7.2% to 13.4 billion. Enterprise Business: Sales were up 5.8% to billion, primary due to an increase in demand from manufacturers. Operating profit was up 33.7% to 13.2 billion. Telecom Carrier Business: Sales were down 13.8% to billion due to weak capital spending by domestic and overseas carriers and the strong yen (more than 30% of the division s sales are made overseas). Operating profit was down 66.6% to 4.3 billion. System Platform Business: Sales were down 2.3% to billion, primarily due to weak demand for hardware. Operating profit was 15.6% to 7.8 billion. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 9

Other Businesses: Sales were down 6.8% to 141.3 billion, primarily due to weakness in smart energy. The operating loss increased to 7.2 billion from 2.5 billion the previous year.

10 Other Businesses: Sales were down 6.8% to billion, primarily due to weakness in smart energy. The operating loss increased to 7.2 billion from 2.5 billion the previous year. For FY Mar-17 as a whole, management s guidance is for a 2.0% increase in sales to 2,880 billion, a 9.4% increase in operating profit to 100 billion, and a 34.1% decline in net profit to 50 billion due to higher taxes. In view of the first half results, we expect the company to fall short of its profit targets, but year-on-year comparisons should turn positive in 2H. New medium-term plan In order to reverse the declines in sales and operating profit and get the company back onto a growth track, management has come up with a new medium-term plan that focuses on businesses believed to have above average growth potential and more efficient use of resources. The Public Business will focus on preparations for the 2020 Summer Olympics, which will be held in Tokyo, services enabled by the new My Number personal identification system, and cyber security. The Enterprise Business will continue to emphasize IT services for retailers and the company s Manufacturing Co-Creation Program, which provides customers with best practice solutions derived from NEC s own manufacturing experience. The Telecom Carrier Business will focus on TOMS (Telecoms Operations and Management Solutions), SDN (Software-Defined Networking) & NFV (Network Functions Virtualization), and preparations for 5G. The Systems Platform Business will focus on maximizing the profitability of existing operations and establishing an IoT (Internet of Things) platform focused on safety and retail. The focus in Other Businesses will be on international safety (cyber security, face recognition, surveillance, etc.) and eliminating losses on smart energy. On the cost side, management sees potential savings of 82 billion in the three years to Mar-19: Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 10

11 Consolidated sales & profit forecast For the full year to Mar-17, we are forecasting a 2.7% increase in consolidated sales to 2,900 billion, a 1% increase in operating profit to 92 billion and, assuming a higher effective tax rate, a 41% decline in net profit to 45 billion. These estimates imply a 12% year-on-year increase in sales and a 22% increase in operating profit in 2H. This improvement is based on anticipated project completions, somewhat stronger demand, efficiency gains and approximately 40 billion in additional sales from the consolidation of Japan Aviation Electronics (JAE). As of January 17, NEC had acquired an additional 10 million shares of JAE, raising its share of voting rights in the company from 39.80% to 50.77% and thereby converting it from an equity method affiliate into a consolidated subsidiary. JAE - a maker of connectors, user interface solutions (touch controls, panels and panel monitors) and motion sensors for the aerospace, automotive and oil & gas industries - is a long-standing member of the NEC Group. JAE plans to maintain its listing on the Tokyo Stock Exchange (TSE Code: 6807). Next fiscal year, we expect JAE to generate more than 200 billion in sales, 12 billion in operating profit and 7 billion yen in net profit. Single-digit growth should follow in FY Mar-19. Based on discussions with management, we expect all or most of its sales and NEC s share of its profits to be included in the Public Business segment. As a result of this and other developments, we are forecasting a 5% increase in total consolidated sales to 3,050 billion in FY Mar-18, followed by a 2% increase in FY Mar-19. Operating profit should rise to 115 billion and 140 billion over the same two years and net profit to 62 billion and 78 billion. Management s targets for FY Mar-19 are currently 3,000 billion, 150 billion and 85 billion. Our forecast (and management s) assumes sales growth and margin expansion in all segments except Others, which should turn profitable on lower sales as loss-making projects are eliminated. The overall operating margin should rise from 3.2% this fiscal year to 4.5% in FY Mar-19. ROE should rise from 5.8% to 9.2%. Management s ROE target for FY Mar-19 is 10%. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 11

Consolidated Segment Data Copyright Triple A Partners

Quarterly Revenue & Revenue Change Copyright Triple A Partners

Quarterly Operating Income, Operating Margin & Year-on-Year Changes Copyright

Gross & Operating Margins By Quarter Copyright Triple A

Net Operating Income After Tax NEC s trailing twelve-month Core Operating Income after Tax has improved from 60b to 100b in the last four quarters however this has been offset by Pension Liability

16 Net Operating Income After Tax NEC s trailing twelve-month Core Operating Income after Tax has improved from 60b to 100b in the last four quarters however this has been offset by Pension Liability and Currency Translation Adjustments with the result that NOPAT margins have been close to zero for the last three trailing twelve month periods. Pension Adjustments have exceeded - 60b in each of these periods having averaged 70b in the four prior periods. With a Pension Plan fair value of 790b at the end of Fiscal 2016, market fluctuations will continue to have an impact on NOPAT but should not detract from the improvement in Core Operating Income. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 16

17 Financial Position Strong balance sheet NEC has a strong balance sheet. At the end of Sep-16, the current ratio was 1.5x, the quick ratio was 1.3x and net debt/shareholders equity was 34.1% - down from 66.8% at the end of Mar-12. According to management, debt has been cut far enough: they have no plan to cut it to zero or pile up cash. Interest costs are covered several times over. Inventories appear to be under control. Investments covered by internally generated funds Capital spending is running at an annual rate of about 40 billion roughly equivalent to depreciation and well below total depreciation and amortization, which is roughly 70 billion. This is likely to continue, in our estimation, resulting in positive free cash flow of 60 billion or more each year through FY Mar-19. If suitable targets can be found, these funds could be applied toward M&A. Shareholders equity was 747 billion at the end of Sep-16, down from 824 billion at the end of Mar-15 but up from 657 billion at the end of Mar-12. Net assets amounted to 815 billion at the end of Sep-16, total debt to 525 billion and cash & equivalents to 271 billion. Dividend payout ratio heading toward 35% The dividend was raised from 4.00 to 6.00 per share in FY Mar-16, should be the same this fiscal year and is likely to be raised to 8.00 by FY Mar-19. Management has not announced a target, but the dividend payout ratio is likely to be about 23% this fiscal year and 35% next year and the year after. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 17

18 Quarterly Cumulative Cash Flow NEC has generated over 400b in Free Cash Flow in the last 28 quarters of which half has been used to reduce debt. Operating Cash Flow over this period has been close to zero; cumulative fixed asset and inventory reductions of nearly 300b and 150b, respectively have been the main drivers. With Net Operating Assets now one third of their 1999 peak of 2.3t, NEC can now focus on generating greater Operating Cash Flow. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 18

19 TTM Core Return on Net Operating Assets The company has seen a strong improvement in core returns in the last twelve months which we believe is sustainable. An historical aversion to leverage has resulted in the company having both negative operating and financial leverage. NEC has significant untapped borrowing capacity and appears to be overly generous to to its suppliers. Machinery & Equipment is now only 6% of Fixed Assets, having been 63% in R&D spending is now only 4.4% of revenue, down from 8% seven years ago. The company has successfully managed the financial stresses of the past 20 years; from today s strong financial position, it should be able to increase future-oriented investments. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 19

Trailing Twelve Month Residual lncome Drivers NEC has generated TTM Residual Core Income in each of the last 11 quarters and with a continued decline in Net Operating Assets, the

20 Trailing Twelve Month Residual lncome Drivers NEC has generated TTM Residual Core Income in each of the last 11 quarters and with a continued decline in Net Operating Assets, the Residual Return on Net Operating Assets was 7.4% for the latest TTM period a 30-year peak. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 20

Trailing Twelve Month No-Growth Valuation The strong improvement in Residual income is reflected in a No-Growth Valuation based on the most recent TTM period of over 1.6 t.

21 Trailing Twelve Month No-Growth Valuation The strong improvement in Residual income is reflected in a No-Growth Valuation based on the most recent TTM period of over 1.6 t. The current market value of 0.83t partly reflects the current company forecast for the current fiscal year which would result in a 60% decline in Residual Income relative to the most recent TTM period. Based on the TAP Japan forecast for Operating Income of 140 billion for the year to March 2019, a no-growth valuation would suggest 79% upside potential to a share price of 576. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 21

22 NEC Segment History Since 1992 NEC has disclosed its business segment data using 26 different segments. While a number of companies have disclosed more, NEC has the largest number among manufacturing companies. Many of these segments have a life of only three or four years and cease to exist when segment operating income turns into the red. The chart above shows only the largest 17 business segments over the last 20 years. The current breakdown has existed since 2014, with the previous year s data revised for purposes of comparison. As all segments are currently profitable except Others, which we expect to turn profitable in FY Mar-18 if not sooner. Copyright Triple A Partners Japan Co. Ltd. & PD Analytics Pte. Ltd. All rights reserved. 22

Consolidated Financial Results. for the First Quarter. of the Fiscal Year Ending

Press Release - Media Contacts: Seiichiro Toda/Joseph Jasper TEL: +81-3-3798-6511 ***** For immediate use July 31, 2018 Consolidated Financial Results for the First Quarter of the Fiscal Year Ending March