Rising Labor Costs And GDPR Mandates Will Crimp Operating Margins

Key Takeaways

• Rising compliance and labor costs, along with legacy dependencies, threaten NEC's profitability and limit growth in digital and international markets.
  
• Increased competition from hyperscalers and rapid IT commoditization risk eroding NEC's market relevance and pricing power.
  
• Strong digital transformation demand, operational improvements, and high-value recurring projects position NEC for stable growth, higher profitability, and greater international revenue diversification.

Catalysts

Provides information technology services and social infrastructure in Japan and internationally.

• Ongoing global labor shortages and persistent wage inflation are likely to keep increasing NEC's operating costs, which will put pressure on net margins even as the company attempts to improve profitability through cost efficiency initiatives.
  
• Expanding regulatory requirements around data privacy and AI, such as further tightening of GDPR or new localization mandates, will drive up compliance costs and potentially hinder the growth of NEC's digital services and cybersecurity offerings, limiting long-term revenue expansion.
  
• The risk of increased geopolitical tensions and protectionist trade policies could further fragment NEC's supply chains and restrict access to international markets, jeopardizing overseas revenue growth and subjecting the company to greater business volatility.
  
• NEC's dependence on legacy domestic IT systems and hardware contracts, combined with the industry's acceleration toward cloud-native and SaaS solutions, could increase structural revenue headwinds and result in a loss of core customer base, directly impacting future top-line growth.
  
• The rise of global hyperscalers and the rapid commoditization of IT infrastructure threaten to erode NEC's pricing power and market relevance, leading to declining profitability and long-term earnings challenges despite recent strong performance in certain segments.

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 1.5% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 5.8% today to 6.9% in 3 years time.
• The bearish analysts expect earnings to reach ¥248.1 billion (and earnings per share of ¥189.62) by about August 2028, up from ¥200.3 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 23.2x on those 2028 earnings, down from 30.5x today. This future PE is greater than the current PE for the JP IT industry at 17.6x.
• Analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.22%, as per the Simply Wall St company report.

NEC Future Earnings Per Share Growth

Risks

• Sustained strong demand for digital transformation and high utilization of BluStellar have led to a 14.4 percent year-over-year increase in revenue and improved profit in Domestic IT, supporting continued growth in both topline revenue and operating profit.
  
• Profitability initiatives, cost efficiencies, and subsidiary performance improvements in IT services and Social Infrastructure have resulted in significant operational improvements, which may help maintain or increase net margins over the medium to long term.
  
• The expansion of recurring high-value projects in Domestic IT, underpinned by strong bookings from the public sector and ongoing municipal standardization, indicates a robust pipeline that could stabilize or grow revenue streams beyond short-term cycles.
  
• Persistent advancements in cybersecurity and internal AI investments, alongside increased bookings for disaster prevention and municipal platforms, align with industry tailwinds and can drive higher operating profit and earnings stability.
  
• Strategic focus on improving international segment profitability, including successful restructuring and elimination of one-off expenses, as well as targeted investments to capture future business in ANS, could support global revenue diversification and long-term earnings growth.

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 ¥5450.0, 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 ¥3607.8 billion, earnings will come to ¥248.1 billion, and it would be trading on a PE ratio of 23.2x, assuming you use a discount rate of 7.2%.
  
• Given the current share price of ¥4580.0, the bearish analyst price target of ¥3500.0 is 30.9% 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.