When an uncommonly well-run company intersects with stronger than expected underlying end-markets, very good things can happen for the stock. Such has been the case for Shin-Etsu (OTCPK:SHECY), where strong results up and down the line have pushed the shares up another 25% or so from where they were when I last wrote about the company, even after a double-digit pullback from the January high.
I still lean positive on these shares. Although I fully expect the company’s growth rate to slow from its recent trajectory, I believe the company’s exposure to the strong PVC and wafer cycles as well as exposure to other growing specialty markets, biases the story in a favorable direction. Although the shares have enjoyed a very strong run since 2016, healthy end-markets should still support a high single-digit annual return at this point.
PVC Getting Stronger, And The Cycle Could Go Longer
Many chemical markets have reminded investors over the last year or so of a basic truth about cyclical industries – estimating the tops (both in terms of “altitude” and duration) is all but a fool’s errand where the best you can really hope for is to be approximately right. That has helped polyolefin companies like Braskem (NYSE:BAK) and it has also been the case for Shin-Etsu’s industry-leading PVC business.
The PVC/chlor-alkali business has seen revenue growth of 18%, 17%, and 21% in the last three quarters, with the most recent result (up 18%) driven by ongoing strength in PVC pricing, as well as caustic soda pricing. As is typically the case for process industries like PVC, there is significant fixed leverage and margins expand rapidly when operating rates (another term for capacity utilization) move into the 80%s and 90%s). To that end, the last quarter saw over six points of segment operating margin improvement for the PVC/chloro business, with margins closing in on 20%. Although Westlake (NYSE:WLK) and Olin (NYSE:OLN) aren’t as profitable as Shin-Etsu, both of this companies have likewise seen healthy growth and margin improvement trends in their respect vinyl and chlor-alkali businesses.
What’s more exciting is the prospect that this strength will continue. PVC resin demand is driven in large part by construction – about 80% of industry demand can be tied to applications in residential, commercial, and infrastructure construction – and construction markets are looking good. China’s construction markets appear to be improving, the U.S. is seeing strong housing growth and relatively healthy commercial construction, Europe is looking stronger, and even Japan’s numbers have shown strength.
At the same time, the supply situation is looking increasingly tight. Operating rates are already in the mid-to-high 80%s when you factor in maintenance-related downtime, and as the numbers from Shin-Etsu, Olin, and Westlake would suggest, these operating rates are already supporting healthy margins. More supply has gone offline in Europe than expected due to environmental regulations (mercury-cell production) and China has cracked down more than expected on coal-based supply. Producers are already flexing their muscle, with ongoing price increases for caustic soda and PVC resin after multiple increases in 2017.
This situation could possibly last a few years. Other than Shin-Etsu’s new ethane cracker in Louisiana, there’s not much new capacity coming online through 2020, and that could push operating rates well into the 90%s if demand stays healthy (and PVC demand correlates extremely closely with global GDP). Importantly, adding PVC capacity isn’t necessarily simple – it requires good, reliable supplies of inputs like ethylene and power and there aren’t all that many places in the world that can supply all of those needs at attractive prices.
Wafers Staying Strong
Arguably less controversial than the outlook for a PVC “super-cycle” is the ongoing strength in the silicon wafer business. Although there has been more fretting that the semiconductor cycle is about to turn, chip demand has remained very healthy. All told, the wafer market saw better than 10% volume growth in 2017, with high single-digit growth in 300mm wafers and blended ASP growth of around 20%.
Helping companies like Shin-Etsu and SUMCO (OTCPK:SUOPY) even more has been the drive toward miniaturization, where weak yields at the bleeding edge have helped stoke wafer volume growth – SUMCO’s chairman has publicly stated that he believes poor 3D NAND yields alone have led to an incremental 200K/month of 300mm wafer demand (around 4% of industry capacity). With robust demand for DRAM still in place, both Shin-Etsu and SUMCO expect tight market conditions to continue at least through 2018, with ongoing growth thereafter (likely at a slower rate).
There are multiple forward-looking drivers to consider. First, fabs continue to add capacity – an incremental 800K/mo through 2020 in fab capacity in China alone is already on the books. Between growing demand for high-end chips in communications (both mobile and networking) and memory and growth in demand for chips for automotive and IoT applications, I expect fab capacity growth to remain healthy, supporting mid-single-digit demand growth (annualized) for some time.
Second, while I do expect Shin-Etsu will start looking at adding some capacity, 300mm capacity additions have been quite modest, with SUMCO’s expansion equal to about 2% of global 300mm capacity and Siltronics’ expansion closer to 1.5%. China and China-based wafer manufacturers would like to get into the game, but they are multiple generations behind the leaders and only Shin-Etsu, SUMCO, and Siltronics can supply wafers for 10nm and smaller chips.
Third, that supply-demand situation may actually lead to some changes in how the market operates. Shin-Etsu, SUMCO, and Siltronics have learned from past mistakes and have been very disciplined about capacity growth. At the same time, fab operators like TSMC (NYSE:TSM), Samsung (SSDIY), and Intel (NASDAQ:INTC) can’t be happy about the price increases they’re seeing and the risk of future 300mm capacity constraints. With that, I think you might see companies like Shin-Etsu try to tie greenfield expansions to long-term take-or-pay contracts that limit their downside risk exposure to overcapacity. This would represent a pretty big change, so it’s a speculative call, but it’s one I think makes sense given the industry dynamics.
Not Just PVC And Wafers
The PVC/Chlor-alkali and wafer segments account for around 50% to 60% of Shin-Etsu’s recent operating income, so they are clearly significant but not the only factors driving the company. Shin-Etsu also has very healthy operations in silicones, specialty chemicals, electronics, and other markets that are contributing meaningfully to the story.
The Silicones business has seen recent revenue growth of 20%, 14%, and 10%, with strong demand in a wide range of industries like cosmetics, autos, electronics, and construction. Silicone materials are used in a very wide range of industries/applications (Shin-Etsu sells over 5,000 products), but Shin-Etsu enjoys strong share and capacity in high-end products; Chinese producers supply about half of the world’s silicone products, but they are typically lower quality. With a strong focus on specialty products, Shin-Etsu not only enjoys much higher margins than most of its peers (historically in the 20%s and most recently climbing to 26%), but also higher growth with leading-edge applications.
The Specialty Chemical and Electronics/Functional Materials businesses are likewise looking at attractive futures. The company’s cellulose products are used extensively in construction and coatings (which is also driven by construction), but also offer leverage to recovery-driven growth in multiple industrial markets. With 30% global share, Shin-Etsu is unlikely to face serious competitive risk during what remains of this global construction upswing.
On the Electronics/Functional Materials side, the business is seeing strong demand today for magnets used in cars, and I expect the ongoing electric vehicle shift to drive even more growth for magnets needed to power EV motors, while I also expect growing demand from robotics applications. Elsewhere, the company’s strong share in ArF photoresists (used for producing chips at 10nm and below) should be a multiyear growth driver, and I expect the company to eventually introduce EUV photomasks at some point in the future.
Tight markets for wafers and PVC resin should support a strong outlook for CY2018, and though I expect some of that momentum to drain away, I believe Shin-Etsu has a good chance to generate mid-to-high single-digit annualized revenue growth over the next five years, as well as mid-single-digit growth over the longer term (the next 10 years).
Unlike many Japanese companies, Shin-Etsu has always been willing to proactively prune and restructure its operations. Coupled with a clear focus on achieving strong market share on the basis of technical capabilities and combining it with low-cost operations, I believe the margin outlook remains very attractive. I expect Shin-Etsu’s FCF margins to move into the mid-teens, supporting double-digit long-term FCF growth.
The biggest risk I see to those projections is the inherent cyclicality of its two largest markets. This 300mm cycle looks a lot different than what happened a decade ago, as suppliers like Shin-Etsu have been much more cautious about adding capacity, but the risk of a cyclical decline hasn’t vanished (and there are greater risks in the 200mm business, where Shin-Etsu also competes). With PVC, the pricing outlook for the next two to three years looks good, but demand could falter and/or China could decide to relax some of the supply-limiting environmental regulations.
The Bottom Line
Discounting Shin-Etsu’s cash flows back to today doesn’t suggest major undervaluation (not surprising, as the shares have doubled from early 2016 lows), but it does point to high single-digit annual total returns. That’s not spectacular, but I would argue it still keeps the arrow in the “buy” section of the dial. With the company reporting fiscal fourth-quarter results next month, and management likely taking that opportunity to once again re-frame expectations, this looks like a name that is still worth considering.
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