Description

Executive summary

Topcon shares offer an attractive risk-reward along with a catalyst in the form of a new activist investor.  Specifically, the recent involvement of a U.S. activist investor with a successful track record in Japan provides a medium-term catalyst to improve shareholder returns with the possibility of a business structure transformation (i.e., a spin-off of the Positioning segment) which could rapidly close Topcon’s valuation discount to listed peers.  In the near-term, we think Topcon’s quarterly results get “less bad” and believe the company’s full year FY-Mar23 guidance remains achievable.  

If you need a pithy mnemonic to remember the “ABCs” of the investment thesis, here is the set-up:

• A-grade activist investor
• B-grade business
• C (arguably D)-grade valuation

Background

Topcon is a 90-year-old Japanese company which initially focused on developing surveying instruments, binoculars, cameras and sniper scopes for the Japanese army.  Today the company develops, manufactures, and sells positioning, surveying and eye care equipment, with approximately 80% of sales generated overseas.  Following a reclassification of the surveying segment (“Smart IT”), the company now has two reportable business segments:  Positioning (which now includes surveying/Smart IT) and Eye Care.  The Positioning segment accounts for two-thirds of sales and ~85% of operating profit before unallocated corporate expenses so the bulk of this write-up will focus on the Positioning segment.  Topcon’s two segments largely operate independently with limited synergies.  We believe having two unrelated businesses has led to operating inefficiencies in each segment reflected in below average segment margins as well as an overall conglomerate discount.

We are positive on the longer-term outlook of Topcon’s Positioning segment, which we think is positioned (haha) well to benefit from increasing demand for precision positioning technologies.  Topcon Positioning segment equips construction and agricultural machinery with GNSS/GPS and machine control technologies which improve productivity and enable a greater degree of autonomous and remote operations in the construction and agricultural sectors.  From a “thematic” point of view, the Positioning segment helps address potential labor and food shortages.    Please refer to the appendix for more detail on Topcon’s segments and product offerings.

Competition

Topcon has two close peers in the Positioning segment, Trimble and Hexagon.  The exhibit below is from an older Trimble presentation which highlights Topcon and Hexagon as “primary peers” in the Building and Infrastructure and Geospatial categories.  Market share data is difficult to come by, but our research suggests that Topcon’s Positioning segment has been more effective in penetrating small-to-medium-sized customers in North America.  In contrast, Trimble and Hexagon have leading share in Europe and within the large-sized customer segment.  A 2017 initiation report by FISCO (a paid research firm in Japan, which typically obtains information directly from the companies they cover) stated Topcon’s global market shares as follows:  IT Construction – 40% (similar to Trimble); IT agriculture – 20%; #1 share in “total stations” for surveying at 35%; and #1 share in OCT devices (eye care) at 30%;

Since the start of Covid, quarterly YoY sales growth has tracked quite closely at the three companies.

Profitability gap

Topcon’s Positioning margins have historically lagged Trimble and Hexagon.

Based on calls with the company and former execs at Topcon and Positioning competitors, we believe the margin gap is attributable to the following factors:

• Revenue mix:  Topcon told us their internal analysis suggests that on a like-for-like basis, their hardware products generate comparable margins to peers.  But Trimble and Hexagon generate a larger share of revenue from higher margin, recurring software revenu

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• Software investments:  Building up a stronger software offering, and in turn a larger share of recurring revenue, has been a priority for Topcon.  Topcon’s ongoing R&D investment spend in this area have been a drag on margins and exacerbated the margin gap.

• Customer mix:  Topcon generates a higher portion of sales through distributors to smaller-sized end customers.  In contrast, Trimble and Hexagon have a greater portion of direct sales.  We are told direct sales tends to be the more profitable distribution model.  In addition, Hexagon claims it is able to achieve premium pricing and margins due to its exposure to larger, more complex projects with the bigger customers.

• Structural inefficiencies:  All three companies have expanded through acquisitions.  Topcon’s philosophy has been to let acquired operations to continue operating fairly autonomously, believing the acquired companies’ business practices are well-adapted to their specific business and geographic segments.  We believe this approach has led to many cases of duplicative costs.  Topcon Group includes 64 consolidated subsidiaries and 10 equity method affiliates and is “currently engaged in product development at 30 bases around the world, with 16 production bases and 66 sales bases.”  We were told the company has numerous small software development teams sprinkled around the world, including a large development team in Russia which was shut down in the most recent quarter, generating a large one-off charge in the process. 

As mentioned earlier, we would classify Topcon as a B-Grade business based on a combination of market structure, ROE, and management quality.  While the company faces strong, well-resourced competitors in both Positioning and Eye Care, Topcon strengths include a track record of technology innovation, expanding global coverage, and leading market share in various niches. 

Why now?

• Activist involvement:  ValueAct Capital reported a 5.7% stake in Topcon in May 2023, acquired at an average price of 1,705 per share.  In recent years, ValueAct has been involved in multiple activist engagements in Japan with mostly positive outcomes.  We believe new management at Topcon is receptive to ValueAct’s involvement which at a minimum could lead to an improved focus on profitability, capital allocation, and shareholder returns.  In addition, ValueAct’s involvement could evolve into a more comprehensive change in the company’s business structure which could help remove the corporate valuation discount.

• New President & CEO:  Topcon appointed Takashi Eto as its new President & CEO, effective April 1, 2023.  While Eto-san is not an outsider – he joined Topcon in 1990 and has previously led the healthcare business and the domestic positioning segment – the board cites his ability “to promote further business growth with his pioneering spirit.”  It remains too early to say whether Eto is a “change agent”, but we think having a new leader with a relatively blank slate increases the likelihood for new strategic directions.

• Near-term improvement in fundamentals:  Topcon shares are down -20% on the back of disappointing June quarter results.  We believe the market has overreacted to a temporary period of inventory destocking during a seasonally weak quarter which included some one-offs.  We expect quarterly results to improve in the next 1-2 quarters as inventory levels normalize. 

• Attractive valuation:  At ~13x forward PE and ~7x forward EV/EBITDA, Topcon trades at the low end of its 10-year valuation range.  Furthermore, Topcon trades at a significant discount to Positioning and Eye Care peers.

Topcon market capitalization and Enterprise Value

Topcon also holds treasury shares and other listed stakes equivalent to 5% of the market cap or ~86 JPY per share. 

Topcon shares are trading at the low-end of its 10-year historical forward PE range

13.4x forward PE vs. 10-year range of 11.0x - 39.5x and median 18.6x

Topcon shares are trading at the low-end of its 10-year historical forward EV/EBITDA range

7.2x forward EV/EBITDA vs. 10-year range of 6.3x -15.9x and median 9.9x

Topcon trades at a large PE and EV/EBITDA discount to both Positioning and Eye Care competitors

We believe Topcon’s valuation discount to both Positioning and Eye Care comps is due in part to a conglomerate discount for operating two seemingly unrelated business segments.  Some observers have speculated that separating the two businesses could lead to a re-rating of each segment toward peer multiples.

Notes on peer groups

• Positioning:  Trimble and Hexagon are Topcon’s closest comps in the Positioning segment.  Both companies have historically traded at premium valuations and currently trade at high teens forward PE and low teens forward EV/EBITDA multiples.

  • Note that Hexagon shares are down -30% in the past 3 months following a Viceroy short report.

• Construction / ag equipment:  I’ve included a group of these as many of Topcon’s positioning solutions are attached to this equipment and they serve the same end customers (construction firms and farmers)

• Eye Care:  I’ve included a group of eye-care related companies including equipment manufacturers, contact lens companies, and eyeglasses retailers (Topcon’s customers)

Notes on accounting

For Japanese companies in the comp set, I have:

• Adjusted for treasury shares which is similar to Bloomberg accounting treatment

• Added back to net income amortization of goodwill which is expensed under J-GAAP accounting.  Bloomberg does not make this adjustment which is why the Topcon forward PE multiples in the comp set above are ~10% lower than figures pulled directly from Bloomberg and shown elsewhere in this write-up.

ValueAct Capital Involvement

In May 2023, ValueAct Capital disclosed a 5.7% stake in Topcon at a cost basis of ~1,705 JPY per share.  ValueAct is a San Francisco-based hedge fund that manages $16 billion and is known for taking an activist approach to its investments.  ValueAct characterizes its strategy as “transformational activism”, which encompasses everything from board composition and management compensation to financial planning, M&A and investor relations.  For investors, the end result of a successful ValueAct-influenced transformation is both a change in company fundamentals as well as change in investor perception and valuation.

ValueAct has been active in Japan since 2017.  In a November 2021 Nikkei interview, the firm disclosed it had allocated more than $3.5b in Japan since 2017, roughly 25% of AUM at the time.  Major Japan investments include Olympus, JSR, Nintendo, Seven & I.  We would classify all but Seven & I as successful investments, with ValueAct heavily involved at Olympus and JSR, including Board representation and input on corporate transformation.  Seven & I has been a more frustrating engagement, which has provoked ValueAct to be atypically vocal in agitating for changes in management, board, and strategy (see ValueAct’s 151-page presentation calling for the replacement of Seven & I’s President and a new slate of directors:  PowerPoint Presentation (valueact.com)). 

A common theme in these investments has been the existence of an undervalued, high quality business unit, often hidden by distracting, underperforming segments.  In the case of Olympus, the company had a market leading gastrointestinal endoscopy franchise and a struggling camera business, while for JSR, the company had a market leading share in photoresists, materials used in semiconductor manufacturing. Similarly, Seven & I operates the largest CVS chain in Japan and the US.  However, Seven & I’s shares have underperformed due to ongoing malinvestments into its struggling domestic department store and food retail segments. 

We believe Topcon shares many similarities with the Olympus, JSR, and Seven & I cases.  The company has a history of R&D and technology innovation which has resulted in top tier market share in both the Positioning and Eye Care segments.  While neither segment is dramatically underperforming, Topcon’s operating margins significantly lag peers.  We think this reflects the challenges of running a far-flung global operation in two very different business segments with limited overlap and synergies.  While these were likely factors which attracted ValueAct’s interest, we think ValueAct hopes to guide Topcon through a more transformational change. 

Namely, Topcon for many years now, has published ambitious Mid-Term Plans which revolve around the digitalization of its fields.  By investing in software, the company aims to turn its solutions into more useful platforms which are mission critical to its customers’ workflow.  One upside of this strategy is the creation of a larger stream of high-margin, recurring subscription software revenue.  Many companies have navigated this shift from on-premise, software to a cloud-based, subscription model.  Indeed, it is transition which ValueAct is very familiar with given its investments in Adobe, Microsoft and numerous other software companies.

Admittedly, Topcon has a much bigger mountain to climb on the software side.  At present, Topcon’s software offering and contributions from recurring revenues are much lower than Positioning peers Trimble and Hexagon, both of which invest heavily in software R&D and M&A.  However, this is precisely the type of business transformation that ValueAct prides itself on effecting. 

In any case, we believe that ValueAct’s investment in Topcon is positive on multiple levels.  Firstly, it provides a measure of validation regarding the quality of Topcon’s Positioning business.  It likely also signals the potential for significant investment returns from here (recall, ValueAct’s cost basis is ~1705 JPY per share).  Finally, we believe ValueAct’s involvement has the potential to lead to improvements in Topcon’s profit margins, capital allocation, and shareholder returns policy.  A more transformative change in Topcon’s corporate structure (e.g., a spin-off and US-listing of the Positioning business) and business strategy may also be in the cards.

Clearly, none of this would be possible if Topcon’s management is unreceptive to ValueAct’s involvement.  To that end, we were very pleasantly surprised to hear from Topcon management that the company has a good relationship with ValueAct (as well as with another Japan-focused activist investor, Taiyo Pacific) and believes ValueAct and Topcon share the same goal of increasing corporate value.  Unlike management at Seven & I, Topcon management is open to the idea of more transformative change and not tied to heritage business units.  When asked directly about the possibility of spinning-off the Positioning segment, Topcon told us that “if we think a separation maximizes corporate value, we would be open to exploring.”

Mid-Term Plan (FY-Mar23 through FY-Mar26)

Below are financial forecasts which tie to Topcon’s Mid-Term Plan FY-Mar26 sales and operating profit targets.  For FY-Mar24, our numbers are ~5% ahead of guidance which we think are conservative.  Topcon management agreed that this year’s guidance is conservative and includes a larger buffer based on a JPY:USD assumption of 130. 

Sum-of-the-Parts Valuation

Below is a bear/base/bull case sum-of-the-parts framework which utilizes these forecasts and a range of EV/EBITDA multiples.  Risk:reward looks very attractive, with limited downside and significant upside.  Key assumptions:

• Positioning bear/base/bull EV/EBITDA of 7/10/12.5x compares to Hexagon/Trimble at ~13x in ’24 EV/EBITDA

• Eye Care bear/base/bull EV/EBITDA of 6/8/10x compares to comps at ~11x 2024 EV/EBITDA

• Unallocated corporate opex and losses from Topcon’s minor “Others” segment have been capitalized at the blended Positioning + Eyecare multiple.

• We’ve given Topcon credit for its treasury shares and other listed stakes (~86 JPY per share)

Near-term results should show sequential improvement:

Topcon shares fell -17% in the two days following the release of its June quarter results.  Positioning sales were weaker-than-expected, the impact of which cascaded through the income statement and resulted in a big operating profit miss.  The OP miss was magnified as it occurred in Topcon’s seasonally lowest revenue quarter, while opex increased as budgeted.  The quarter also included one-off FX losses which hurt reported operating profits and a large one-off loss related to closing the company’s Russian R&D group which hurt reported net income.

We believe management’s explanation of the quarter and expectations of a near-term improvement are credible.  Namely, management attributed the sales miss on a buildup of inventory at the distributor level.  According to management, distributors had pulled forward orders at the end of last year amidst supply chain shortages.  This coupled with distributor cautiousness about the economic outlook led to a slowdown in orders.

Management believes the June quarter miss is temporary and end demand remains stable.  The company cited internal analysis and tracking which suggests sell-through from distributors to end customers has been healthy.  As a result, Topcon claims inventory levels are normalizing and should be back to a typical three months by October, down from a peak of five months.  Note that this implies the September quarter is likely still impacted by higher-than-normal inventory levels.  We think OP should still see a sequential improvement as the September quarter is seasonally stronger and management adjusted its expense plans following the June quarter. 

Key risks

• Another quarterly results miss as inventory destocking takes longer than expected due to customer concerns about the economic outlook. 

• Economic downturn impacts construction activity

• Topcon does not engage with ValueAct.

Appendix A:  Segment Descriptions and Product Portfolios

Positioning Segment

Topcon’s Positioning segment designs and manufactures precision positioning products and solutions for the global surveying, construction, agriculture, and civil engineering segments, among others.  Topcon reclassified its business segments last year and the Positioning segment now includes Topcon’s former “Smart IT” segment which includes a portfolio of surveying instruments primarily used in the construction and civil engineering sectors.  A significant piece of the Positioning segment is hardware and software solutions which is integrated into construction and agricultural machinery and enables this equipment to operate more precisely and efficiently. 

In the construction industry, Topcon offers a wide range of solutions including which enable precise measurement and control of construction activities such as site preparation, grading, levelling, and building layout.  Topcon’s GNSS/GPS and machine control technologies are integrated with heavy machinery (excavators, bulldozers, graders, and pavers) to enable automated control and guidance.  On the surveying side, Topcon sells Total Stations and 3D laser scanners which capture high-resolution data of existing structures and construction sites.  The use of these systems can significantly reduce construction times.  In addition, systems are designed so that even relatively unskilled personnel can use them effectively.

In the agricultural sector, Topcon’s precision agriculture solutions encompass a range of technologies which utilize GNSS/GPS and machine technology to guide tractors, sprayers and other equipment.  The company has developed variable rate application technology which helps farmers apply fertilizers/pesticides optimally.  Yield monitoring and mapping systems utilize sensors and onboard data collection devices to collect real-time data on crop yield variability.  Remote sensing, imagery technologies, and data management/analysis platforms provide farmers with additional insights.  Overall, Topcon’s technologies are used by farmers to increase productivity and yields, reduce waste, and promote sustainable farming. 

In addition to construction and agriculture, Topcon offers various geospatial solutions for mapping, surveying and geographic information systems.  Products such as GNSS receivers, stations, and software applications enable accurate data collection, analysis, and visualization with applications in land surveying, urban planning, infrastructure management, and environmental monitoring. 

Eyecare segment

In the eye care segment, Topcon offers a portfolio of ophthalmic instruments and diagnostic equipment which are utilized by ophthalmologists, optometrists, and eye-glass chains in eye examinations and disease diagnosis.  Topcon’s product line-up includes optical coherence tomography (OCT) system (company claims its ~28% market share is #1), fundus cameras, slit lamps, vison testers, refractometers, tonometers, corneal analyzers, etc.  The company sells to major eyewear chains (LensCrafters, Wal-Mart, SpecSavers) and individual optometrist and ophthalmologist practices.

Here is an exhibit from Topcon’s 2022 Integrated Report which breaks down the company’s business segments and major products.  Note that starting this fiscal year, the “Smart Infrastructure” has been consolidated into the Positioning segment.

Catalyst

- Topcon works with ValueAct to increase shareholder value (e.g., the company adds a new director at the behest of ValueAct)

- Near-term improvement in quarterly results