Canon (CAJ) Ratings Placed on Review for Downgrade by Moody's

Moody's Japan K.K. has placed Canon Inc.'s (NYSE: CAJ) Aa1 issuer rating under review for downgrade.

RATINGS RATIONALE

The review was prompted by Canon's announcement of its JPY665.5 billion acquisition of Toshiba Medical Systems Corporation (TMSC, not rated).

"The review for downgrade principally reflects our concern over the material size of the acquisition, which we understand will be funded by existing cash on Canon's balance sheet and new debt," says Takashi Akimoto a Moody's Analyst and also Lead Analyst for the company.

"Given the magnitude of the transaction, issuance of new debt will, in our estimation, lead to pressure on Canon's financial profile, in light of its very high Aa1 issuer rating -- three notches above the Government of Japan's A1 rating -- and its position as the highest rated corporate entity in Japan," says Akimoto.

"In addition, while the transaction will bring important diversification benefits to Canon -- a credit positive -- we have concerns that the lower margins currently derived from the TMSC business will dilute Canon's existing margins and, at the same time, heighten the need for capex and R&D costs, thereby decreasing free cash flow in future years," adds Akimoto.

On March 17, 2016, Canon announced that it had concluded a share-transfer agreement with Toshiba Corporation (B2 review for downgrade) on the acquisition from Toshiba of TMSC shares in order to make it a Canon subsidiary. The acquisition price was approximately JPY665.5 billion.

In addition, according to Toshiba's press release, TMSC has separately paid approximately JPY22.5 billion to Toshiba America, Inc., (not rated) -- Toshiba's holding company in the US -- for the shares of TMSC's US subsidiaries.

The transaction with Canon was "determinately completed" on March 17, but TMSC will only become a subsidiary when Canon receives necessary approval from competition regulators and, as such, is conditional upon such approval.

TMSC is one of the leading global companies in the medical equipment industry. Within the field of medical X-ray computed tomography (CT) systems in particular, it is the leader by market share in Japan. It has also been steadily increasing its global market share.

Additionally, TMSC is the only company in the industry with a broad product portfolio that spans diagnostic X-ray systems, magnetic resonance imaging (MRI) systems, diagnostic ultrasound systems, and diagnostic nuclear medicine systems. It also offers cutting-edge medical imaging solutions and in-vitro diagnostics aimed at individualized care.

With the announcement of the acquisition, Canon stated that it plans to procure funds for the acquisition of TMSC's common stock through utilizing its own funds and borrowings.

Moody's notes that Canon had JPY633.6 billion of cash on hand at end-2015, but which is not enough to cover the total JPY665.5 billion in acquisition-related payments.

Therefore, to fund the acquisition, Canon will move into a net-debt position after having maintained a net-cash position over more than ten years.

However, at this moment, Canon has not disclosed what portion of the acquisition price will be finally funded by new debt. If it did fund the entire amount with debt, then adjusted debt/EBITDA would rise to around 1.7x from 0.7x at end-2015.

Currently, we are assuming that this scenario is unlikely, and believe that some of the amount will be funded by cash on hand.

Although Canon has maintained high and stable levels of profitability from its two main businesses -- office systems (copiers and multifunction devices) and imaging systems (cameras and lenses) -- both are mature, leaving it with a pressing need to establish new businesses with growth opportunities.

"At the same time, the TMSC acquisition, as indicated, places pressure on Canon's Aa1 financial profile, although we also recognize that it is consistent with management's stated initiative to reinforce and expand into new and viable business areas. As such, it would enhance Canon's operational diversity as well as provide potential synergies with its existing business lines," says Akimoto.

Through the acquisition, Canon aims to achieve various specific benefits, such as (1) accelerated entry into new sectors, (2) further improvements in product quality through shared production technologies, and (3) expansion of its business domains through the enhancement of its R&D capabilities.

"On the other hand, we think that it will take some time for Canon to fully benefit from such synergies, since the company's own medical-related business is small when compared with TMSC. Therefore, TMSC's operating margin, which has been 5%-7% for the past three years, is unlikely to improve soon after the acquisition. The acquisition will, in our estimation, dilute Canon's overall operating margin, which had fallen to 9.3% for 2015 from 9.8% for 2014," says Akimoto.

Moody's considers that the headroom within the company's current rating is now minimal with the completion of the acquisition. Its rating faces the possibility of being downgraded, at the end of the review.

The review will focus on: (1) the impact of the acquisition on Canon's financial profile, especially on leverage -- on a gross-debt basis -- as well as its ability to grow TMSC successfully, while maintaining positive free cash flow, (2) Canon's plan and ability to recover its previous financial profile, and (3) synergy benefits likely to be achieved as a result of the acquisition.

The principal methodology used in this rating was Global Manufacturing Companies (Japanese) published in August 2014. Please see the Ratings Methodologies page on www.moodys.com for a copy of this methodology.

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