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JAPANESE COMPANIES

Analysis of Fujitsu’s First Half Fiscal 2005 Business Results

Recovery Continues

Solid Hardware Growth Led by Electronics; Japan Drags Down Services

PHOENIX, Nov 29 – Fujitsu’s first half fiscal 2005 results signaled a continuation of the recovery that had led to the company’s return to black last year after two years of bleeding red ink (see Fujitsu: Back in the Black, But..., Aug 2004).  The top Japanese computer vendor reversed an operating loss of $170 million from the first half of last year, turning it into an operating profit of $323 million on revenues of $21.6 billion, up 6.7% (in U.S. dollars; up 3.6% in yen).

The reversal was due to a 90% surge in its second quarter operating profit relative to the same period a year ago.  All three major Fujitsu operating units posted surpluses for both the second quarter and for the first half of the current fiscal year (ending March 31). 

The biggest improvement was in the Electronic Devices unit.  It reported an 8.1% operating profit margin as compared to a 0.3% loss margin a year ago.  The Platforms sector also added almost three points to its profit margin, reversing an operating loss margin of 2.5% last year.  Both hardware units also grew their revenues –by 18% and 9% respectively (in yen).  And both did it both in Japan and overseas.

“We're continuing the momentum of our corporate-wide turnaround, with profitability now restored in all three major business segments as well as in each of our principal geographies,” Fujitsu president Hiroaki Kurokawa said in a statement.

If there is an area of Fujitsu’s business in which the turnaround has stalled, it is in the Services and Software segment. 

Business Segment Analysis

Services & Software.  This unit’s profitability suffered a 1.5-point margin decline, ending the first half of fiscal 2005 with a 1.7% operating margin on an anemic 1.2% increase in revenues (up only 0.8% in yen).  Nevertheless, at $20 billion on an annualized basis, Services and Software continues to be Fujitsu’s largest business unit, accounting for 42% of total business.  And that now makes it Fujitsu’s biggest challenge, especially in the domestic (Japanese) market. 

That’s where competitive pricing pressures are threatening the viability of new contract sales, and where some existing projects are suffering from, what the company calls, “deteriorating profitability.”

“We are now concentrating on reducing losses from projects whose profitability has deteriorated,” Fujitsu said in its filing with the first half results.  The company has made some organizational changes “dedicated to improving project oversight.”  And it promised its shareholders that, “going forward, we will continue to make every possible effort to improve the profitability of our software and services business.”

Now, to be sure, the Services and Software situation at Fujitsu is far from tragic.  Tragic is what’s happening at EDS, for example, were many big contracts are bleeding red ink.  At least Fujitsu’s “deteriorating profitability” still means a 1.7% profit margin rather than multi-billion dollar losses, as in EDS’ case. 

So the fact that the Fujitsu management is jumping on the problem before the situation really deteriorates its financial condition and begins to threaten its recovery is an encouraging sign.  Perhaps that’s why the Fujitsu stock kept moving up in the several weeks since the release of its first half results on October 28 (see the chart on next page).

Besides, things are not bleak in all Fujitsu Services and Software segments.  While its business solutions and systems integration revenues shrank 5.1% (in yen) during the first half of fiscal 2005, the much bigger (58% of total) “infrastructure services” (read “outsourcing”) business grew by 5.7%. 

Furthermore, Fujitsu’s overseas business is moving in a favorable direction, especially in Europe where major government-sector projects have now started to contribute to earnings.  As a result, the overseas Services and Software revenues grew by 9.5% in the first half while the business in Japan contracted by 0.5%.

Looking ahead to the second half of fiscal 2005, we expect Fujitsu’s Services and Software business to grow by 2.7% for the full fiscal year.  This would put it at about $20.3 billion in revenues, slightly ahead of EDS’ expected $20.2 billion in 2004.  So despite its woes in the Japanese market, the Fujitsu IT services unit may end up surpassing EDS and becoming the second largest global IT services vendor (after IBM Global Services, expected to come in with $40 billion in 2004 revenues). 

And if Fujitsu leaders have their sights set on leading rather than following IBM, 2005 may be the year in which they may get a chance to come close to catching up to IBM Global Services.  (For an idea how they may go about achieving that, see the “Summary” section).

Platforms.  Both Fujitsu major hardware units – Platforms and Electronic Devices - exceeded the company’s initial targets for fiscal 2005.  But “due to anticipated deterioration in the market conditions for semiconductors, displays and mobile phones in the second half,” Fujitsu expects the full-year 2005 results “to be roughly in line” with its earlier projections. 

In other words, the company anticipates doing worse than expected in the second half.  Such pessimism seems strange especially coming at a time when Fujitsu’s biggest rival and an unwitting role model – IBM – is burning the track again with its servers’ performance (see “Server Renaissance,” Nov 2004).  Is Fujitsu trying to lower the bar so it could clear it more easily come March 31? (the end of its current fiscal year).

Fujitsu’s $16.5 billion-Platforms business showed strong growth in the first half, both in the domestic (Japanese) market, and overseas.  By contrast to Services and Software, the Platforms’ Japanese revenues actually grew faster than the international ones (up 9.4% vs. 7.7% in yen) despite the fact that the overseas growth was boosted by a weakening U.S. dollar.  As a result, the Japanese market continues to account for nearly three-quarters of the Platforms’ revenues (see the chart). 

Within the Platforms business, the Mobile/IP Networks and HDD (storage) areas grew the fastest (up 27% and 20-% respectively).  The Servers revenues also grew in double digits (up 13%), while the PC and Transmission businesses edged up only slightly (up 1.2% and 0.6% respectively).

Electronic Devices.  The Electronic Devices unit was the “hero” of Fujitsu’s first half.  Its revenues surged by 34% in Japan, and by 19% overseas, for a combined growth rate of 27%.  Within that, the semiconductor sales jumped by 21%, while other component business revenues increased by 14%.

For the full fiscal year, we expect this segment to reach about $8 billion in revenues, up 16% from the fiscal 2004 total.  And we figure that the Electronic Devices’ overseas revenues will still account for the largest share of any Fujitsu businesses (44%, down from 49% in fiscal year 2004), despite the faster growth in the Japan during the current fiscal year.

Summary

Speaking of overseas growth, that’s what Fujitsu needs more than anything in order to become a truly global leader.  That’s especially true in the IT services sector, where its sheer size and the No. 2 ranking already imply leadership.  And there is a way of even doing it in one fell swoop.  But it would take boldness and courage. 

Here’s an excerpt from our August 2004 report on Fujitsu:

Secondly, setting its sights on EDS as a possible acquisition target could be a way for Fujitsu to kill two birds with one stone.  It could become the second largest IT services provider in the world, practically overnight.  And it could acquire a widely recognized global brand name.  With some spit and polish, and with new (American) leadership, EDS could easily regain its former luster.  And Fujitsu would finally break out of its 25% to 30% overseas market share barrier.  It would be a win-win deal.

Do Messrs. Akikusa (the chairman) and Kurokawa (the president) have what it takes to carry out such a bold play?

Time will tell… And time seems to be one commodity in ample supply in the Japanese culture (think “Lost in Translation,” a 2003 Oscar-winning film).

Ironically in EDS’ case, time will work in Fujitsu’s favor, at least in the short term.  EDS share prices are likely only to go one way – down.

(An excerpt from “Back in the Black…”, Aug 2004)

As it turned out, the EDS stock has inexplicable risen despite a myriad of bad news that has emerged since the above comment was made.  At the current grossly inflated price of $22 per share and an $11 billion market cap, EDS is a wholly unattractive target for any would-be buyer, including Fujitsu.  Stand by, however, for a likely sell-off in the new year, after the major institutional holders of the EDS stock dress up their positions for the year-end capital gains and tax reporting.  As the EDS shares approach a $13 to $14 per share level, even such a beleaguered company may become an attractive takeover target.  And at the market cap of about $7 billion, EDS would be an easier bite for Fujitsu to swallow.

What would it take?  As we said in the Summary lead, it would take boldness and courage. 

Do Fujitsu’s current leaders have it?  We don’t know.  Time will tell, as we said.  But we are pretty sure that Taiyu Kobayashi would not hesitate to make a bold move.

Who is Taiyu Kobayashi?  He is the legendary Fujitsu leader from the early 1980s who wrote a book on courage.  Literally.  The book’s title was, “Fortune Favors the Brave.”  Maybe Messrs. Akikusa and Kurokawa will take a page out of his book?  Also, literally. 

Happy bargain hunting

Bob Djurdjevic

For additional Annex Research reports, check out... 

2004 HP:  HP Hits Home Run (Nov 2004);; HP Savaged by Wall Street (Aug 2004); "HPS Wins by a Nose!" (Octathlon 2004); "A Passage FROM India" (Feb 2004);  "Still No Cigar" (Feb 2004); "Nokia Dials HP!" (Feb 2004)