Legacy Systems And Rising Regulatory Burdens Will Impair Progress

Key Takeaways

• Shifts toward cloud, evolving tech trends, and cybersecurity regulations could raise costs and threaten NEC's legacy business and future profitability.
  
• Dependence on government contracts and exposure to geopolitical risks may constrain margin growth and create uncertainty in international operations.
  
• Strong IT services growth, disciplined capital allocation, and effective portfolio management position NEC for sustained profitability and enhanced global market presence.

Catalysts

Provides information and communication technology solutions in Japan and internationally.

• As more enterprise customers shift to cloud-based solutions, NEC's legacy on-premise IT infrastructure and hardware business is likely to face weakening demand, leading to slow revenue growth despite segmental improvements in IT services and ongoing digital transformation efforts.
  
• The rapid pace of technological innovation in artificial intelligence, 5G, and cloud services heightens the risk that NEC's investments in current platforms and infrastructure will become obsolete, potentially resulting in significant impairment charges, asset write-downs, and declining operating margins.
  
• Heightened global cybersecurity concerns and increasingly stringent regulatory scrutiny are set to raise compliance requirements, which could cause further increases in operating costs and squeeze overall net margins as NEC combats margin pressures in both domestic and international markets.
  
• NEC's heavy dependence on government contracts, which typically have lower margins and are subject to lengthy procurement cycles, may continue to constrain profit growth and limit the company's ability to expand higher-margin, predictable revenue streams, ultimately dampening long-term earnings prospects.
  
• Ongoing geopolitical tensions and protectionist measures threaten to disrupt NEC's international supply chains and restrict market access, creating significant uncertainty around future revenue growth and elevating the likelihood of unforeseen costs or project cancellations.

NEC Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on NEC compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming NEC's revenue will grow by 1.7% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 5.1% today to 6.9% in 3 years time.
• The bearish analysts expect earnings to reach ¥247.7 billion (and earnings per share of ¥189.27) by about July 2028, up from ¥175.2 billion today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 23.3x on those 2028 earnings, down from 30.5x today. This future PE is greater than the current PE for the JP IT industry at 17.2x.
• Analysts expect the number of shares outstanding to grow by 0.17% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.09%, as per the Simply Wall St company report.

NEC Future Earnings Per Share Growth

Risks

• The strong and sustained growth in IT Services and Social Infrastructure, including a 12% year-on-year increase in domestic IT service bookings and robust demand from public sector and enterprise clients, suggests that long-term revenue may remain resilient or even increase if current trends persist.
  
• Significant operational improvements and profitability gains, with non-GAAP operating profit reaching key midterm targets one year ahead of schedule and ongoing enhancements from cost optimization, indicate that net margins and earnings could continue trending upward in the long run.
  
• The company's strategy to accelerate international growth, including moving global IT headquarters to Europe and strengthening high-growth areas, could drive further revenue expansion and global market share, which would counteract potential share price declines.
  
• Increased investment discipline via a focus on cash return on invested capital exceeding the weighted average cost of capital within five years may lead to higher-quality acquisitions and capital deployment, supporting improved long-term profitability and return on equity.
  
• The ability to exit or restructure underperforming businesses, as seen with the reduction of low-profit business units and readiness to divest or partner where profitability cannot be improved, positions NEC to optimize its business portfolio and sustain or grow earnings over time.

Valuation

• The assumed bearish price target for NEC is ¥3500.0, which represents the lowest price target estimate amongst analysts. This valuation is based on what can be assumed as the expectations of NEC's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of ¥4800.0, and the most bearish reporting a price target of just ¥3500.0.
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be ¥3600.6 billion, earnings will come to ¥247.7 billion, and it would be trading on a PE ratio of 23.3x, assuming you use a discount rate of 7.1%.
• Given the current share price of ¥3998.0, the bearish analyst price target of ¥3500.0 is 14.2% lower. Despite analysts expecting the underlying buisness to improve, they seem to believe the market's expectations are too high.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.