TOCALO: Japan’s #1 Leader In Indispensable Surface Modification Technology Centering on Thermal Spraying for Multiple Industries & Advanced Fields, Commands Over 90% Domestic Market Share In Semiconductor Equipment With Structural Growth in 3D NAND Memory
ROE 20%, EV/EBIT 10x, EV/EBITDA 8x, Net Cash 10% of MV
TOCALO (TSE: 6277) is Japan’s #1 leader in surface modification technology centering on thermal spraying applied on mission-critical parts, equipment and structure and the functional coating is indispensable for multiple key industries & advanced fields, such as advanced semiconductor and liquid crystal/flat panel display production equipment, industrial machinery, transport equipment, automobile parts and high-performance steel, power generation and petrochemical, medical equipment, aircraft parts. TOCALO develops a high performance coating that gives new properties and functions to the surface which include durability, strength, reliability, quality & production efficiency improvement, extension of life, excellent corrosion-resistance, strengthen against abrasion, improve conductivity, electrical insulation, anti-slippery, energy saving, and so on. Examples of its indispensability are evident in its dominance in coating for insulated bearings for shinkansen bullet trains and in advanced semiconductor production equipment, particularly the dry etching equipment in making hard-to-mass-produce 3D NAND flash memory. These “memory skyscraper” are enjoying tipping point structural growth due to a greater number of end markets driving demand for semiconductor for cloud servers used in data center, IoT (Internet of things), smart cars, big data, artificial intelligence. TOCALO has around 45-50% of the domestic market share, dominating with over 90% domestic market share in the semiconductor and flat panel display (FPD) equipment industry which contributes 35% of group sales (20% in Mar-2016), with Tokyo Electron (TSE: 8035) as its biggest customer (contributing around 23% of sales). Industrial machinery, energy & power generation, steel, others (medical, aerospace) and overseas thermal spray business contribute 14%, 12%, 16% and 10% of sales respectively. Non-thermal spraying business account for 13% of sales. Established in 1951 and headquartered in Kobe, TOCALO was a subsidiary of Nippon Steel Corporation (TSE: 5401). In 2001, there was a management buyout (MBO) and TOCALO re-listed in two years in Dec 2003 on Tokyo Stock Exchange Section 2, and was listed on the First Section in 2005. TOCALO management and ESOP owns 10.65% of the equity shareholding. Norway government and Norges Bank own a combined 10.93% stake.
- Sales by product segments: (1) Thermal spraying 87%: Semiconductor and FPD 35%, Industrial machinery eg insulated bearings of Shinkansen bullet trains and high-speed trains, gas turbines, energy and power generation 14%, steel 12%, Others 16%, (2) Non-thermal spraying 13%: PVD – Nippon Coating Center 7%, TD/ ZAC/ PTA 6%
- Sales by geography: Domestic 84.3%, Overseas 15.7%
- Shareholder structure: TOCALO management and ESOP 10.65%, Norway govt and Norges Bank 10.93%, Institutional shareholders 17.35% (Fidelity 5.67%), Public 61.08%
Industry Dynamics: TOCALO’s Thermal Spray Coating for Semiconductor & FPD (35% of Sales)
TOCALO Is The Low-Profile Company Behind the Success of Tokyo Electron’s Global Leadership in Dry Etching & Ashing Semiconductor Production Equipment Which Are Critical for the Mass Production of 3D NAND Flash Memory
- TOCALO is the low-profile company behind the success of Tokyo Electron’s global leadership in semiconductor production equipment (SPE): TOCALO is the low-profile company behind the success of Tokyo Electron’s (TSE: 8035, MV $31.2bn) global leadership in dry etching and photoresist processing (ashing) semiconductor production equipment (SPE) to produce insulating film, which is critical for the mass production of 3D NAND flash memory. Previously cyclical semiconductor investment now involves more than PCs and smartphones with a greater number of end markets driving demand for semiconductor for cloud servers used in data center, IoT (Internet of things), big data, electronification of smart cars, artificial intelligence, creating a shortage of 3D NAND flash memory chips. Special equipment needed for producing 3D NAND flash memory is in especially short supply, leading chipmakers to scramble for machinery from Tokyo Electron. Tokyo Electron also holds a near-monopoly on equipment for dry etching circuit patterns onto silicon wafers. In manufacturing processes for 3D NAND flash memory devices, four or five additional etching machines are required for each new layer. 64 layers, for example, adds up to 300 etching machines.
- TOCALO dominates the domestic SPE industry with 90% local market share with unique high-performance thermal spraying coating solution: In semiconductor production equipment, TOCALO’s unique high performance coating contributes to substantial productivity improvement and has earned high praise from customers. For instance, in the semiconductor etching equipment, TOCALO has developed a new high-performance ceramic-based thermal spraying coating to protect the base material from the etching gas, improve the durability of the chamber and electrostatic absorption mechanism of the electrostatic chuck for holding and fixing the wafer in the plasma etching equipment. TOCALO dominates the domestic SPE and FPD equipment industry with 90% local market share which contributes 35% of group sales (20% in Mar-2016) and Tokyo Electron is TOCALO’s biggest customer who contributes 23% of its sales.
- NAND flash memory hits limitation: Since its introduction in the 1980s, NAND flash memory has radically changed how we store our digital data. NAND products store information in structures called “cells,” which are arranged in rows and columns. For more than 30 years, chipmakers were able to lower costs in accordance with Moore’s Law by shrinking line widths and increasing wafer size. Historically, memory density was increased by shrinking cell size and spacing. However, the transition to 450mm wafers has been a setback for equipment makers across the board. Once NAND cell dimensions shrink to a certain size, however, further reductions are hindered by technological barriers. Continued scaling using traditional lithography-intensive patterning also becomes extremely costly.
- 3D NAND memory skyscraper structure to increase memory density: As a result, different design concepts and manufacturing methods are needed to continue increasing memory density. The semiconductor industry is now transitioning to mass production of 3D NAND, in which the physical limits of line shrink are being approached. 3D NAND structures are the skyscrapers of the memory world. Instead of creating a string of memory cells that lies in the wafer plane, 3D NAND devices build the string vertically. Creating these three-dimensional structures requires developing new fabrication methods, which rely heavily on deposition and etch processes. For that reason, in recent years the film formation process and the etching process have become more important than the exposure process, and on a global level demand for the equipment made by Lam Research, Applied Materials, and Tokyo Electron has surpassed demand for the exposure equipment made by ASML. In manufacturing processes for 3D-NAND flash memory devices, four or five additional etching machines are required for each new layer. 64 layers, for example, adds up to 300 etching machines.
- As demand for greater amounts of digital information grows, 3D NAND and other advanced memory technologies will continue to play a key role in providing higher density storage solutions. TOCALO’s management believe that “in the world of semiconductors, miniaturization has progressed, and further improvement in performance is required for manufacturing equipment and parts thereof. In addition, new semiconductor technologies such as 3D stacking have been developed, and new functions that have never been seen are becoming required.” TOCALO management commented that in the future, “we will continue investing in China in the semiconductor industry and investing in large-scale liquid crystal panels and large-scale investments in organic EL panels, as well as global demand for semiconductors expansion in response to IoT and AI.” Management is targeting the increase in sales contribution from semiconductor to 50% from 35% (20% in Mar-2016).
1) What Makes It a Wide-Moat Business? Fundamental Dynamics Behind 20% ROE
(1) World-class technological superiority in thermal spraying
- Extreme precision and accuracy in processing at atomic level that requires deep technical know-how: Thermal spraying technology is an extremely precise processing technology that is required to process accuracy at the atomic level. There are various kinds of spraying materials such as metal, cermet, ceramics but they need to be dissolved with a certain energy, for example, by combustion flame, plasma flame, The substrate will also have metals and non-metals, plastics and glasses. When spraying and coating such a base material, the coating in melting and sticking is very simple, but how to control it requires deep technical know-how, and there is a value in our place where we live and do business. Not only is the selection of spraying material important but also the heating temperature and spraying speed, angle of thermal spraying from the melting gun to the base material, atmosphere of the space to be sprayed, pressure of atmosphere or gas is critical. In each spraying booth, TOCALO has automated operation using a robot, ensuring high reproducibility and high safety. Atmospheric plasma spraying and high-speed flame spraying are mostly used in its thermal spraying processes.
- TOCALO to expand in areas dominated by Japan: Japan is very strong in the industrial field, including high-performance tensile steel, secondary battery separator films, optical films, nonwoven fabric, insulated bearings at high speed train, aircraft parts, medical equipment. According to TOCALO’s CEO Dr. Noriyuki Mifuni, “We will expand in areas dominated by Japan such as semiconductors, flat panel, batteries, energy, new materials. Although the market for thermal spray technology has expanded rapidly over the past decade, we are confident that its field of application is still infinite.”
(2) Development-driven and market-creation company to innovate new products: TOCALO is a ‘market-creation’ type of company that tackles the development of new products mainly in accordance with market needs for thermal spraying. When major companies and customers are considering application of thermal spraying technology to their own products, they consult TOCALO, who is a pioneer of thermal spraying, which often triggers joint development and even joint patents, such as with Tokyo Electron.
(3) Business expansion of the Trinity type: Sales, manufacturing, and development have become a trinity at TOCALO. 70% of TOCALO’s ‘sales engineers’ are from science and engineering background, and they propose consultative solution-driven sales focused on individual customer needs. The challenges and problems that customers face are diverse. That is why TOCALO is committed to solution-driven consultative sales based on close contact with the customers in the field, with the support by its R&D team that constantly examines the possibilities of new coatings and continues to challenge new technologies. TOCALO provides solutions better suited for each customer with multidimensional approach. The solution is developed by integrated efforts of sales staff, production staff and R&D staff. TOCALO also actively work on the joint development of new applications in addition to the technology support of surface treatment services. TOCALO’s service and technology is highly evaluated and selected as an excellent coating supplier by many customers around the world.
(4) High earnings structure focused on high-end products: TOCALO maintains a high profitable structure by differentiating ourselves from other companies by concentrating management resources on projects that are high in technology requirements and that other companies do not allow. TOCALO is the only thermal spray technology company in the world with a strong and growing business franchise in providing high-end, high-margin solution to the semiconductor and FPD industry, which contributes 35% of its sales (20% in Mar-2016) and management targets 50% in the next few years as a result of healthy structural demand from its customers.
2) Why It Is Actionable Now
- Share price has corrected 20% from recent peak in 1 Feb 2018: The short-term correction in share price by 20% since 1 Feb 2018, from JPY 1,628 back to JPY 1,267, from pessimism surrounding the overall market correction from rate hike concerns, presents a mispricing opportunity for long-term investors.
- Latest 3Q results a positive catalyst confirming tipping point growth expansion on track: On 31 Jan 2018, TOCALO announced strong 3Q results: Sales, operating profit and net profit increased 17.9%, 31.8% and 31.9% yoy respectively and the operating income margin rose from 21.5% to 22.2%, driven by strong orders from semiconductors and FPD equipment industry, high-performance steel and industrial machinery sector. Non-thermal PVD coating business (Nippon Coating Center) for cutting tools and automotive parts also made steady progress with operating profit increasing 26.5%
- Shareholder-friendly exercises: On January 31, TOCALO announced that it will implement a 1:4 stock split for shareholders as at Feb 28 to improve stock liquidity, and annual dividend share is revised upwards to ¥90, a 11.1% increase in real terms due to the stock split.
- Capex expansion: TOCALO also announced a new factory expansion to be completed in Kitakyushu factory in the summer of 2018 in response to increasing orders for semiconductor manufacturing equipment and bearings. This disciplined capex expansion plan is a positive signal of confidence that bodes well to support sales growth and profit margin expansion in areas of higher profitability.
- Why mispriced in the first place?: While share price has jumped 300% in nearly five years since Jun 2013 when CEO Noriyuki became CEO, we believe that the stock is mispriced with its underappreciated wide-moat dominance in the semiconductor and FPD equipment business, particularly in coating for etching and ashing equipment by Tokyo Electron which are critical for the mass-production of 3D NAND flash memory and these “memory skyscraper” are enjoying tipping point structural growth in demand due to the greater number of end markets driving demand for semiconductor for cloud servers used in data center, IoT (Internet of things), big data, electronification of smart cars, artificial intelligence, creating a shortage of 3D NAND flash memory chips and the special equipment making them. With an ROE 20% and healthy balance sheet of net cash at 10% of market value, and decent valuation at EV/EBIT 10x, EV/EBITDA 8x, EV/CFO 11.4x, as well as a strong and stable institutional shareholder base in the Norway government and Norges Bank having a combined 10.93% stake, we believe that the low-profile TOCALO is mispriced.
3) Why Is It Undervalued? Why Can It Double Over 3-5 Years?
- TOCALO vs global process equipment comparable: Since Dr. Noriyuki Mifuni took over in Jun 2013 to focus on areas with high profitability, particularly in the advanced thermal spray coating solution in semiconductor equipment, it has achieved strong financial results, and its commands the highest profit margin in the industry (EBIT margin 21.2%, Net margin 15.1%) and the highest ROA at 14% which are at least 50% superior than its peers. Yet, its valuation at EV/EBIT 11.4x, EV/EBITDA 9x is trading at a discount.
- Resilient growth with upside surprise: Buoyed by strong demand for its thermal spray coating solution and strong operating cashflow generation ability (~US$57m in Dec 2017) backed by a healthy net-cash balance sheet (US$73m), TOCALO announced a new factory expansion to be completed in Kitakyushu factory in the summer of 2018 in response to increasing orders for semiconductor manufacturing equipment and bearings. This disciplined capex expansion plan is a positive signal of confidence that bodes well to support sales growth and profit margin expansion in areas of higher profitability. Since FY2014 when Dr. Noriyuki Mifuni took over in Jun 2013, TOCALO’s overall financial performance has improved significantly: Sales has grown 45% from ¥22.6bn in FY2014 (YE Mar 2014) to ¥32.8bn in LTM Dec 2017 with the steady improvement in gross margin from 33.5% to 37.7%, operating profit has doubled from ¥3.48bn to nearly ¥7bn, net income rose 128% from ¥2.17bn to ¥4.97bn, and operating cashflow increased over 70% from ¥3.46bn to over ¥6bn (estimated). We believe TOCALO can build on the momentum to generate over 50-70% growth in operating profits in the next 3-5 years to $98-110m, and spur an upward valuation re-rating based on EV/EBIT 15-17x towards a 102-160% rise in market cap from its present $741m to cross $1.5-2bn, or a share price of JPY 2,580-3,310 from its present JPY 1,276.
4) Summary Investment Thesis
TOCALO’s performance-driven culture and DNA rooted in its MBO in 2001 has contributed to its strong management foundation and deep sense of responsibility to improve performance by active investment and to continuously innovate in new technologies, new markets, and new products by leveraging off its proprietary world-class technological knowhow in its specialty niche in surface modification centering on thermal spraying. TOCALO’s indispensability and dominance in mission-critical parts and equipment in our daily life from insulated bearings in bullet trains and advanced semiconductor equipment ensures its longevity and resilience as an all-weather company even in difficult times. Since CEO Dr. Noriyuki Mifuni took over in June 2013, overall financial performance has improved significantly: Sales has grown 45% from FY2014 (YE Mar 2014) to Dec 2017 with the steady improvement in gross margin from 33.5% to 37.7%, operating profit has doubled, net income rose 128%, and operating cashflow increased over 70%. Dr. Mifuni has made structural improvements in the business model which are taking off, including shareholder-friendly exercises. We are impressed with and inspired by the determination of Dr. Mifuni and his team in rebuilding TOCALO since the MBO for staying power and we believe that the market is severely underappreciating its market dominance in high-end applications, its unique consultative solution-driven business model and long-term growth trajectory path and we think that TOCALO deserves a valuation premium.
- Forex risk: TOCALO earns over 84% of its revenue in Japan and around 16% from overseas markets in China, Taiwan, JVs from Thailand and Indonesia and licensing fees in America and Europe, and it is less susceptible to forex risks in the fluctuations of the yen.
- Possible downturn semiconductor and liquid crystal & flat panel display (FPD) manufacturing equipment industry: With the growing sales contribution from the semiconductor and FPD equipment industry, TOCALO results could take a hit should a downturn in the industry happen. However, we believe this risk is mitigated given that the previously cyclical semiconductor investment now involves more than PCs and smartphones; there is also now a greater number of end markets driving demand for semiconductor for cloud servers used in data center, IoT (Internet of things), big data, electronification of smart cars, artificial intelligence, creating a shortage of 3D NAND flash memory chips. Special equipment needed for producing 3D NAND flash memory is in especially short supply, leading chipmakers to scramble for machinery from Tokyo Electron who is TOCALO’s biggest customer accounting for 23% of its sales. TOCALO’s unique high performance coating contributes to substantial productivity improvement and has earned high praise from customers. For instance, in the semiconductor etching equipment, TOCALO has developed a new high-performance ceramic-based thermal spraying coating to protect the base material from the etching gas, improve the durability of the chamber and electrostatic absorption mechanism of the electrostatic chuck for holding and fixing the wafer in the plasma etching equipment.
- ASP risk: A potential risk is the possible price reduction on thermal spray processing cost, although this is mitigated by its domestic market leadership and that its thermal spray coating solution are applied on mission-critical parts, equipment and structure of its customers.
- Too low-profile with no sell-side analyst coverage: Since Marusan Securities wrote a brief 4-page research report on TOCALO in March 2015 with a target price of ¥3,000 (share price was ¥2,344 then), there were few recent coverage on this low-profile world-class company by the investment community. The last coverage was by Tokai Tokyo Research Institute from Nov 2011 to May 2012, and JP Morgan from Dec 2004 to Feb 2006. However, the adage “so good that they can’t ignore you” remains true and as TOCALO continues to deliver outstanding results and shared more on how its thermal spray coating solution is indispensable in enabling customers like Tokyo Electron to become global leader in semiconductor equipment, there were a greater number of online coverage, such as SBI Securities in May 2017 and TOCALO was also invited to exhibit at the 12th Nikkei IR/Investment Fair in Aug 2017 sponsored by Nihon Keizai Shimbun. As the unique global leader in its surface modification technology field of thermal spraying, TOCALO has few direct listed comparable, and sell-side analysts will find it difficult to assess the valuation of the company. We believe TOCALO, with its strong ROE and healthy balance sheet yet trading at an attractive valuation at EV/EBIT 10x and EV/EBITDA 8x, is at the tipping point of the re-rating trend and fundamental growth.
Hosokawa Micron (MV US$568m): World’s #1 Powder & Particle Processing Equipment Manufacturer At Tipping Point Growth & Expanding Into Nano-Level Advanced Grinding Technology for Lithium Battery in Electric Vehicles (EV), Cosmetics, Haircare & Pharmaceuticals
ROE 14.9%, EV/EBIT 8.7x, EV/EBITDA 7.2x, EV/CFO 6.1x, P/Sales 1.2x, Net Cash 26.1% of MV
Hosokawa Micron (TSE: 6277) is the global leader in powder and particle processing equipment and high-performance plastics thin-film blowing manufacturing equipment with a wide range of clients in the pharmaceutical & cosmetics, food & beverage, auto, electronic materials & chemicals, and other industries. Renowned world-class brand names owned by the Group include Alpine, Stott, Vitalair, Rietz, Mikro, Micron, and Vrieco-Nauta. Hosokawa Micron has a strong reputation for world-class technology and advanced technical capabilities, possesses nano-level advanced grinding technology, including the capability to pulverize magnetic materials such as neodymium, iron, boron used in lithium batteries for electric vehicles (EVs), which enabled the increasing miniaturization of the lithium batteries with the surface modification; increased magnetic strength and performance improvement which brings about motor miniaturization; and improved performance and safety of secondary batteries for in-vehicle use for increase in cruise distance. Hosokawa acquired in and after 1980 U.S. Filter Systems Inc and Alpine AG of the former West Germany, both the largest powder processing equipment manufacturers in respective countries, as well as Nauta Mix Inc. (Netherlands) which is globally renowned for mixers. These acquisitions resulted in stronger capacity for technological development that meets wide-ranging customer needs and ability to respond to requirements on a global basis. Overseas markets contributed over 75% of group sales. Established over a hundred years ago in 1916 in Osaka by Eiichi Hosokawa, the founder went on to develop in 1930 the Micron mill, a grinding machine capable of making powder of micron (μm) unit for the first time in the world, which also contributed greatly to the industry of Japan. Hosokawa Micron was listed on the Tokyo Stock Exchange in Jan 1992. Masahiro Hosokawa, son of founder, took over in 1951 and passed away in March 2008. The company was led since 2003 by former CEO Kiyomi Miyata. Since current Chairman and CEO Yoshio Hosokawa, grandson of the founder, took over in Oct 2014, overall financial performance has dipped initially before improving significantly: Operating profit has increased nearly 50% from ¥3.37bn to ¥5.05bn with the steady improvement in gross margin from 34.1% to 36.4%, net income rose 55.9% from ¥2.29bn to ¥3.57bn, operating cashflow doubled from ¥3.57bn to ¥7.26bn, bank debt was reduced from ¥4.05bn in FY2014 to ¥1.95bn in FY2017 while gross cash position rose from ¥9.91bn in FY2014 to ¥17.45bn in FY2017, and share price has jumped 125% as compared to a rise of 35% for the Nikkei. Yoshio has made a number of difficult and bold business decisions, such as the divestment of its loss-making confectionery equipment in Oct 2015 to focus on core business and lithium battery expansion, that has led to structural improvement in the business model.
- Sales (EBIT) by product segments: Powder & particle 74.6% (72.2%), Plastics thin-film 25.4% (27.8%)
- Sales by geography: Domestic 24.5%, Overseas 75.5% (Germany 11.8%, Europe ex-Germany 24.2%, America 18.7%, Asia 16.7%, America ex US 4.1%)
- Shareholder structure: Hosokawa family & mgmt. 2.96%, Nisshin Seifun (TSE: 2002), Japan’s largest flour miller, is both a strategic shareholder and customer with 8.63% stake; Hosokawa suppliers association 2.39%; Toho Sangyo 3.34% since Oct 2014, Institutional investors 35.86% (Sumitomo Mitsui Trust AM 12.1%, JP Morgan AM 4.9% since Jun 2013, Asset Mgmt One 3.9%, Norway 3.4%)
1) What Makes It a Wide-Moat Business? Fundamental Dynamics Behind 14.9% ROE
(1) Technological superiority in powder & particle processing: Hosokawa Micron has a strong reputation for world-class technology and advanced technical capabilities and possesses nano-level advanced grinding technology, including the capability to pulverize magnetic materials such as neodymium, iron, boron used in lithium batteries for electric vehicles (EVs).
(2) Unique business model in providing total engineering services
- Custom-made equipment system: Hosokawa Micron work with their customers to develop custom-made equipment and then manufactures the equipment in small volumes with high production technology. According to Yoshio Hosokawa, “We are doing ‘manufacturing’ which can not be imitated by manufacturing methods focused solely on cost.”
- Toll processing or turnkey solution business and aftersales services generating higher-margin service income: Hosokawa Micron provides their major machines in their product line-up at the toll center to meet the various requirement of the customers, from lab type of new products to production model. Hosokawa service team helps their customers to ensure their equipment is running in tip top condition-for extended life benefits, including avoiding emergency breakdown by periodic maintenance, minimizing lost revenue through unexpected downtime, speedy delivery of sophisticated spare parts to meet production requirement.
(3) Global R&D & test center network to get closer to market and customers needs and enable new product innovation: Hosokawa Micron takes advantage of its global R&D structure that has five R&D centers and 8 test centers to observe the market needs that are closely tied to customers needs. This has enabled Hosokawa to launch new products that meet customer needs quickly, achieving sales ratio of new products of 20% with a target of 30%.
(4) Leveraging deep intangible know-how in powder processing technology to create new categories of growth in nano-materials
- Hosokawa Micron leverages upon its accumulated deep intangible know-how in nano-level advanced powder & particle grinding technology to develop quasi-drugs in skin-care cosmetics (NanoCrysphere) and hair tonic/scalp care agents (NanoImpact) using its proprietary-developed DDS (drug delivery system) technology. Hosokawa Micron’s nano-materials business generates ¥1.7bn in sales and ¥376m in operating profit (OP margin 21.4%) in FY2017 from cosmetics, haircare, R&D for nano-capsule, contract R&D and some contract manufacturing OEM work using its nano-level technological capabilities (selling PLGA nanoparticles in bulk for large and medium-sized cosmetic companies and OEM sales of finished products to cosmetic planning companies).
2) Why It Is Actionable Now
- Share price has corrected 15% to 18% from recent peak in 23 Jan 2018: The short-term correction in share price by 15-18% since 23 Jan 2018, from JPY 8,530 (or intraday high of JPY 8,690) back to the JPY 7,090-7,250 level in Feb-Mar 2018, from pessimism surrounding the overall market correction from rate hike concerns, presents a mispricing opportunity for long-term investors.
- Latest 1Q2018 results a positive catalyst confirming tipping point growth expansion on track: On 9 Feb 2018, Hosokawa Micron announced strong 1Q2018 results: Sales, EBIT and net income are up 17.4%, 101.7% and 23.3% to ¥12.7bn, ¥1.5bn and ¥767m respectively. EBIT margin for 1Q2018 improved significantly to 11.7% as compared to 6.8% in 1Q2017 and 13.9% in 4Q2017, driven by strong growth in food-related equipment, electronic materials such as magnets and lithium-ion battery, chemicals, and mineral products.
- Shareholder-friendly capital program: Hosokawa Micron implemented a series of shareholder-friendly capital program in 2017 that include share buyback. We believe that such shareholder-friendly moves will be a positive catalyst for the stock to re-rate, especially as it continues to deliver strong fundamentals.
3) Why Is It Undervalued? Why Can It Double Over 3-5 Years?
- Hosokawa Micron vs global process equipment comparable: Since Yoshio Hosokawa returned in 2014 to rationalize the business to focus on areas with high profitability that generate healthy operating cashflow and does not tie up working capital, including strengthening product planning and development capabilities and accelerating the introduction of new products into the market, it has achieved strong results in operating cashflow efficiency, and its CFROA (operating cashflow divide total assets) at 12.8% is interestingly one of the best in the industry (vs Alfa Laval 8.5%, GEA 5.1%, John Bean 7.6%, IDEX 12.7%, Marel hf 13.6%). Yet, its valuation at EV/CFO 6.1x, EV/EBIT 8.7x, EV/EBITDA 7.2x is trading at a steep discount to niche specialty comparable at 21x, 19.3x, 14.5x respectively, indicating a doubling in share price to close the unjustified valuation gap.
- Resilient growth with upside surprise: Buoyed by strong demand for its powder processing products and strong operating cashflow generation ability (US$67m in FY2017) backed by a healthy net-cash balance sheet (US$142m in FY2017), Hosokawa announced in Sept 2017 that it is investing ¥3.6bn (US$33m) to expand its present 50-year-old plant in Hirakata, Osaka in two phases, which will potentially double its domestic production capacity in around three years by 2020. This disciplined capex expansion plan is a positive signal of confidence that bodes well to support sales growth and profit margin expansion in areas of higher profitability, sustained plans for innovative development in powder processing and materials science technologies and a long term commitment to their global customer base. Since FY2014, Hosokawa operating profit grew 50% with the steady improvement in gross margin from 34.1% to 36.4%. By applying its accumulated intangible knowhow in powder technologies innovation to solve customer business problems and to capture the tipping point growth in structural demand from lithium-ion batteries, magnetic materials, electronic materials, functional food, nano-materials in cosmetics, haircare, pharmaceuticals, Hosokawa has the potential to build on the momentum to generate over 50-80% growth in operating profits in the next 3-5 years to $70-83m, and spur an upward valuation re-rating based on EV/EBIT 15x towards a 90-120% rise in market cap from its present $568m to cross $1.08-1.25bn in the next 3-5 years, or a share price of JPY 13,800 to 16,600 from its present JPY 7,250.
4) Summary Investment Thesis
Hosokawa Micron is one of the rare Japanese companies with global #1 leadership and proprietary world-class technology in its specialty niche in powder processing and a global-oriented business model achieving worldwide success in sales with over 75% of revenue contributed from overseas markets. However since the listing of this centennial champion in Jan 1992 on TSE which coincided with the burst of the Japanese asset price bubble (late 1991-early 1992), Hosokawa has struggled in a lost 20-years, entropized into contentment, conservatism and reluctance to embrace relevant change, due to “stability” in its customer base or industry. Since the return of Yoshio Hosokawa, the grandson of the founder, in Oct 2014, after a hiatus in consulting work for 11 years following his unsuccessful first term as president from 1995 to 2003, his second act is akin to Steve Job who returned to Apple after 12 years. In four years, Yoshio has made a number of difficult and bold business decisions that led to structural improvement in the business model, which resulted in a substantial improvement in the financial performance. Yoshio re-focused the purpose of Hosokawa Micron back to applying its accumulated intangible knowhow in powder technologies innovation to solve customer business problems and to contribute to society, capturing the tipping point growth in structural demand from lithium-ion batteries, magnetic materials, electronic materials, functional food, nano-materials in cosmetics, haircare, pharmaceuticals. We are impressed with and inspired by the determination of Yoshio and his team in rebuilding Hosokawa Micron for staying power and we believe that the market is severely underappreciating its unique total engineering solution business model and long-term growth trajectory path and we think that Hosokawa Micron deserves a valuation premium.
- Forex risk: Hosokawa Micron earns over 75% of its revenue and profit from overseas markets in USD and Euro. As a result, a weaker (stronger) yen is positive (negative) on its short-term financial results. However, the rate hike cycle should result in a strengthening USD over time, which bodes well for Hosokawa Micron.
- Succession risk: Chairman and CEO Yoshio Hosokawa is 66 years old and while he has not named a successor, Yoshio has two key generals: Hitoshi Kihara (62), the managing director since 2010; and Haruo Shiraya, the managing executive officer, CTO and also the Director at the Hosokawa Power Technology Research Institute since 2005. Tetsuya Inoue is the CFO. There is also a capable management team in place which comprises of Shinsuke Nohara (powder processing – sales), Takeshi Baba (toll processing division), Atsutoshi Hino (aftersales service division), Masahiro Inoki (Powder Technology Research Institute), Hiroyuki Tsujimoto (Materials division), Eiichi Tateyama (Osaka plant manager), Sakae Mukaigawara (Shanghai), Yoshinori Uchida (Malaysia).
- Product innovation or/and strategic business alliances that fail to commercialize in a meaningful way: In Jan 2010, Hosokawa Micron and Teijin (TSE: 3401) jointly developed and launched advanced nano-tech firefighting clothing of the world’s highest standard. The fiber material composed of synthetic nanostructured fibers, and by using this material, fire-fighting clothes achieved significant weight reduction and suppression of burn injury. Both companies had high hopes of promoting the establishment of mass production technology of this nanostructured aramid-fiber textile material and aim for practical applications beyond firefighter clothing. However, there was not much business development after the initial product launch. Hosokawa Micron also developed an initial strategic alliance with Suntory Wellness in 2009 in marketing its cosmetics and haircare products but Hosokawa Micron decided to develop the business themselves. We believe that these past experiences over the years have shaped Hosokawa Micron to know clearer what it wants to do in terms of developing new businesses and products, and how to go about doing it. As a result, after making the decision to integrate the manufacturing and marketing/selling business in cosmetics and haircare, the nano-materials business has performed rather well and generated ¥1.7bn in sales and ¥376m in operating profit (OP margin 21.4%) in FY2017, a near-tripling from ¥600m in sales from cosmetics and haircare in FY2014.
- Too low-profile with no sell-side analyst coverage: Since JP Morgan wrote a brief company memo on Hosokawa Micron in Aug 2007 and a credit rating report by Japan Credit Rating Agency (JCR) in Sept 2015, there were few coverage on the company by the investment community. As the unique global leader in its field of powder processing, Hosokawa Micron has no direct listed comparable, and sell-side analysts will find it difficult to assess the valuation of the company. Unlike other relatively similar unique specialty niche companies such as IDEX Corp and John Bean Technologies who are able to articulate its end markets and customers and how their products serve them, Hosokawa Micron has much to learn in its IR communication. Interestingly, after the Jun-Aug 2017 shareholder-friendly capital program in share buyback and the media coverage in Aug 2017 that Hosokawa Micron is an important technological provider in lithium-ion batteries, coupled with the delivery of continued good financial results, there is a upward re-rating in valuation of the company and we believe Hosokawa Micron, with an attractive valuation at EV/EBIT 8.7x, EV/EBITDA 7.2x, EV/CFO 6.1x, is at the tipping point of the re-rating trend and fundamental growth.
- M&A risk: Hosokawa Micron has been very conservative in its M&A strategy with Schott as their last prominent acquisition in 1996, before Yoshio restarted the engine to acquire Anton Kolb in Jan 2015, a small German blown-film take-off device maker with ¥1.2bn in sales in FY2014, to integrate into its high-performance blown-film Hosokawa Alpine business to increase its competitive edge. Yoshio commented that he will not chase to acquire targets if the price, valuation and fit is not right. We believe Hosokawa Micron can be more active in its acquisition strategy, given its healthy cashflow generation ability with US$67m in operating cashflow in FY2017 and strong balance sheet with US$142m in net cash and in excess of US$100m even after accounting for its US$33m two-phase capex expansion.