Panasonic: positive signs of recovery, neutral sales rating

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Investment thesis

Shares of Panasonic (OTCPK: PCRFY) have corrected 25% since our last piece in April 2021. We believe that high input costs and continued capital spending in the battery business will put pressure on margins and free cash flow generation in fiscal year 3/2023, and consensus estimates remain too bullish. However, with market expectations generally low and stocks trading at book value, we are raising our sell rating to neutral.

Quick start

Panasonic Holdings Corporation is a Japanese electronics manufacturer. Its product lines cover home appliances, lighting, auto parts, industrial systems and automotive batteries. In April 2021, the company purchased the remaining 80% stake in Blue Yonder Group (a leader in supply chain management software and SaaS) from Blackstone Group and New Mountain Capital for $7.1 billion, financed by debt.

Key financial data with consensus estimates

Panasonic Key Financials

Key financial data (Refinitiv, Company)

Third Quarter FY3/2022 Sales Breakdown by Business Segment

Panasonic sales broken down by industry

3rd Quarter FY 3/2022 Sales Breakdown by Line of Business (Company)

Cumulative operating margin in the 3rd quarter of 2022 by business segment

Panasonic operating margin by business segment

Cumulative operating margin in the 3rd quarter of 2022 by business segment (Company)

Breakdown of sales for the third quarter of fiscal year 3/2022 by geographical area

Panasonic sales broken down by geography

Third quarter FY3/2022 sales broken down by geography (Company)

Our goals

Stocks are down 25% since our last comment in April 2021. We would like to assess the following:

  • Understand why despite an estimated year-over-year earnings recovery for fiscal year 3/2022, the market acted negatively towards equities.
  • The company announced its latest group strategy on April 1, 2022 to a low-key response, and an IR day is planned for June 2022. What is the outlook for the company?

We will take each in turn.

Unattractive cash burn

Fiscal 3/2022 was supposed to be a recovery year for Panasonic and early signs were relatively positive. Despite a year-on-year jump in profitability in the Energy business (batteries for electric vehicles), rising commodity prices have started to weigh on margins in the core Lifestyle (household appliances) and Connect (laptop PC) businesses. We saw profit margins decline in the third quarter of fiscal year 3/2022, which is a seasonally strong period.

Quarterly margin trend

Panasonic Quarterly Margin Trend

Quarterly margin trend (Company)

Purchasing pressures meant an inability to complete production, putting working capital under pressure as inventory soared – there was also an element of hoarding of parts and supplies. This led to a decline in operating cash flow to JPY 104 billion/USD 0.8 billion in Q3 FY3/2022 YTD from JPY 330 billion/USD 3.0 billion in Q3 FY3/2021 YTD.

Declining profitability and negative working capital led to an estimated negative free cash flow of JPY 318 billion/USD 2.5 billion for FY3/2022. Investing activities also increased following the acquisition of Blue Yonder as well as last year benefiting from a one-time net positive transfer of assets.

As Panasonic entered H2 FY3/2022, it became apparent that its business has limits on how it can handle rising input costs. Despite the majority of sales being made overseas, it is unable to benefit as an exporter (unlike Nintendo (OTCPK:NTDOY) and Sony (SONY)).

Although commodity prices are beginning to stabilize, we believe Panasonic will remain under pressure to manage working capital year over year. Next, we look at the company’s outlook.

Positive messaging can be difficult

Consensus estimates show that FY3/2023 will be a year of moderate growth (4% YoY sales and PO growth), with a return to positive free cash flow generation. We think this view is too positive for the following reasons.

Although prices may eventually revert to the mean, commodity prices such as iron and copper show no signs of slowing down. Shortages of parts and materials in semiconductors continue. As a result, we expect margin pressure to continue year-over-year with limited product price increases – prices for non-discretionary items (e.g. food and gas) have tend to rise faster than discretionary items (such as appliances) which are more price elastic.

The group’s strategy presentation this month underscored Panasonic’s call to be seen as an ESG play. The battery angle is fully implicated in the push towards decarbonization, but despite this the MSCI Implied Temperature Rise ranks the company as ‘Misaligned‘. MSCI’s overall ESG rating is a respectable ‘AA’, but we note that Refinitiv assigns a low ‘C+’ rating in FY3/2021 due to controversy over loss of personal data from breach after hackers gained access to his network. Another data breach was announced this month as the Canadian operation suffered a Ransomware offensive. Panasonic was keen to highlight its efforts to reduce fixed costs, but those efforts may be misdirected.

The acquisition of Blue Yonder is expected to transform the company into a market-leading supply chain player in the era of IoT and cutting-edge services. We were a little nervous that Panasonic had to’revalue assets and liabilities‘ (page 23) at Blue Yonder, which meant higher depreciation costs in Q3 FY3/2022. Although Blue Yonder’s Q3 FY3/2022 sales increased 11.8% YoY, we are concerned that the Net Revenue Retention Rate (NRR) fell to 108% from 119% QoQ (page 24), indicating that existing customers are experiencing a sudden drop in satisfaction levels.

The most positive note is that the energy segment becomes the company’s highest margin business. Panasonic’s ties to Tesla (TSLA) are well documented, but its joint venture with Toyota Motor (TM) to produce solid-state batteries could be the long-term profit driver the company needs. Although the product release is for hybrids by 2025, this should allow Panasonic to expand its operations although this will inevitably require more investment. The 49% stake in the joint venture will also have a limited impact on results.

Overall, we don’t expect any major negative surprises from Panasonic in the short to medium term, but we don’t expect much in terms of positive developments either.

Debt rating

Fitch Ratings affirmed its ‘BBB-‘ debt rating with a stable outlook for Panasonic in March 2022. It has previously had concerns over the increased leverage of the Blue Yonder acquisition and continued investment in car batteries, and rates the company with a lower credit profile compared to Sony. , LG Electronics (066570.KS) and Lenovo Group (OTCPK: LNVGY). Interestingly, he expects a free cash flow shortfall in fiscal years 3/2022 and 3/2023.

Ratings

Consensus estimates have the shares trading at a FY3/2023 P/E of 10.7x and a free cash flow yield of 7.0%. These valuations are attractive. However, we believe the consensus is optimistic.

With stocks trading at their book value, this seems like a fair valuation to us.

Risks

The upside risk comes from the Lifestyle and Connect segments which are experiencing a major improvement in commodity prices. With improved supply chains, the business will see better working capital as well as a return to profitability.

In the short term, management could make some bold and positive announcements about future growth on IR Day in June 2022. However, we believe the market will be in “wait and see” mode.

The downside risk comes from continued commodity pressure, combined with a sustained need for Capex to scale the battery business. Both will have negative implications for free cash flow generation.

If management execution is judged to be inadequate, the market may have a poor opinion of how the business is run.

Conclusion

Panasonic remains a work in progress in our view. The battery business is showing positive signs of recovery, but the overall picture remains a low performing business with limited room for improvement. Blue Yonder remains a key opportunity to reshape the business but early results are inconclusive.

Current consensus estimates and resulting valuations look too positive. However, with a stabilized balance sheet and stocks trading at book value, we believe stocks are now priced at fair value. We rate equities as neutral.

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