Model Portfolio rmcduff:RMG1

Canon Inc. (CAJ-NYSE $46.50): 6.5X estimated 2008 EV/EBITDA

Shares outstanding (fully diluted) 1.33 billion
Total liabilities cash & equivalents (est. on December 31, 2007): -$5.4 billion
Estimated 2007 Revenue: $39.9 billion US

Estimated 2007 exit EV: $67.2 billion.
Estimated 2007 EBITDA: $9.4 billion

Estimated 2008 exit EV: $64.8 billion.
Estimated 2008 EBITDA: $10.1 billion.

Estimated 2009 exit EV: $61.5 billion.
Estimated 2009 EBITDA: $10.7 billion.

Canon is a nimble giant in several important industries

Canon is one of the world's leading manufacturers of plain paper copying machines, digital multifunction devices, laser printers, bubble jet printers & cameras. The company also makes semiconductor equipment. Canon is THE world leader in the production of high definition television broadcast lenses. A medical products division manufactures
X-ray cameras, retinal cameras, autofractmeters and image-processing equipment for diagnostic systems. Canon pioneered digital radiography.

The stated corporate objective is for Canon to achieve #1 status in each of its core businesses.

Canon has a technological edge over many competitors in core industries

Canon has been consistently ranked as the 2nd or 3rd leading company in North America for patenting its technology. Accordingly, many competitors license out Canon patents. This produces a long lived royalty stream, which largely funds research and development expenses. Licensees include:

As well, Canon also has significant cross licensing agreements with the following companies:

Management feels that new products protected by seminal patents will not easily allow competitors to catch up with it. This should provide Canon with lasting advantages in establishing standards for these markets.

An impressive balance sheet contains many "little recognized" strengths

My financial analysis excludes more than $6 billion of marketable securities held by Canon. The firm also has a portfolio of long term investments in public and privately traded Japanese securities. These are held for strategic purposes. As such they are not marked to market.

Canon produces its products at 40 plants globally. The company owns all of the land and buildings where production is located. In Japan alone, Canon holds over 37 million square feet of commercial property. Outside of Japan, Canon also owns 10.6 million square feet of commercial property. Many of these properties have been depreciated to nominal values. In addition, Canon has recently opted to increase its depreciation charges, for the purpose of reducing taxable earnings.

Revenues are growing at a pace much faster than global GDP

In 2006, revenues exceeded $36.36 billion, and are forecast to exceed $39.9 billion for 2007. For 2008, revenues could exceed $43 billion. A modest growth assumption in 2009 produces a revenue estimate of $46 billion.

EBITDA growth has historically outstripped revenue growth. Accordingly, Canon has the potential to generate EBITDA of $10.1 billion in 2008, and as much as $10.7 billion in 2009.

Free cash flow appears to be substantial

Annual capital expenditures for 2008 are estimated to be $5 billion. Recently, Canon has applied surplus cash towards repurchasing more than 5% of the outstanding shares. This appears to be a highly productive use of funds at the current share price.

The capital generating capabilities of Canon are such, that the firm could increase its annual dividends by more than 10% per annum for the next 2 years, increase capital spending by more than 10% annually, and still produce more than $6.3 billion of surplus cash through fiscal 2009. Funds could be used towards additional share repurchases or debt retirement. Either use could accelerate EPS growth over the next 24 months.

Canon shares appear to be very inexpensive; both on a relative as well as an absolute basis

At the current price of $46.97, Canon shares are selling for roughly the price that investors paid back in April 2006. Since that time, the company has raised its dividend and retired $3.9 billion of stock. The firm has grown revenues, EBITDA and earnings since that time, by rates well above global GDP.

In light of Canon's global diversification, the discount may be unjustified

Perhaps investors are concerned about a US economic slowdown. If that is true, they could be selling shares in anticipation of a negative earnings impact for Canon. Tempering this view is the fact that Canon generates less than 30% of revenues from North America and South America. The percentage of revenue generated from the United States has been falling for several years now, while growth in other regions has accelerated. European revenues now make up more than 1/3 of the total, and have increased by almost 14% in 2007.

Consequently, as Canada, South American and European economies appear to be quite strong, a US led slowdown might have surprising little impact upon Canon's top and bottom lines.

Alternatively, investors in 2006 may have simply overpaid for their holdings, are unhappy with negative returns and are selling for tax losses. Should that be the case, their untimely loss could be driving Canon down to bargain prices. This should delight new investors.

I am now adding shares of Canon to my Marketocracy RMG1 mFOLIO as a core position

Irregardless of the reason(s) for the decline; Canon is selling for less than 6.5x my estimated 2008 year end EV/EBITDA. This seems an unduly large discount for a world class firm.

Management's conservative approach to financial accounting provides me with great comfort, with respect to the quality of Canon as a business. Based upon my forecast, I estimate that fair value could be $71 per share by the end of 2009. This would price the company at just 9X my estimated 2009 EV/EBITDA.

Should the dividend rise to my expectations, the total potential return could exceed 55% over the forecast period. If Canon can recapture the imagination of growth oriented investors, my total return forecast may prove to be conservative.