SHECY - Cycle Worries Have Opened A Window Of Opportunity At Shin-Etsu Chemical

Summary

• Shin-Etsu shares have lagged on worries about the housing-driven PVC business and the impact of weaker electronics demand on the semiconductor and silicone products businesses.
• PVC prices have corrected sharply and Shin-Etsu will see a significant decline in profits in the coming quarters, but the business will likely stay profitable and remains the global cost-leader.
• A brief downturn in the semiconductor industry is unlikely to lead to a significant decline in wafer demand; 300mm inventories and supplies remain limited.
• Shin-Etsu has proven itself over many cycles and remains well-leveraged to longer-term growth in housing and semiconductor demand; today's price looks attractive for long-term investors willing to accept short-term cyclical risk.

Even the best companies aren’t immune to macro challenges, and that’s certainly the case these days at Shin-Etsu Chemical ( SHECY ) (4063.T) (“Shin-Etsu”). One of the best-run companies I know in the broader chemical space (and perhaps irrespective of industry grouping), Shin-Etsu shares have come under pressure on worries about the impact of weaker housing on polyvinyl chloride (or PVC) prices/margins, as well as concerns about weakness in the semiconductor and electronics markets.

Concern is appropriate, and Shin-Etsu is very likely to see weaker profits over the next 12-18 months, but I think the downturn needs to be kept in context. Namely, this remains the world leader in PVC cost structure and North American capacity, and the U.S. housing market should resume growing after this upcoming correction. Likewise, while I do see some risk to semiconductor demand, demand for leading-edge chips is unlikely to weaken substantially for long. Even with some risk to earnings expectations over the next 12 months, I believe the shares are priced for attractive long-term returns.

PVC Prices Have Already Plunged

There’s really not much left to fear in terms of a decline in the PVC market – it has already happened, and in pretty dramatic fashion. Houston spot prices nearly reached $2,100/mt back in the summer (against pre-pandemic prices that ranged from around $600/mt to $1,000/mt), but have since fallen below $700/mt, with an exceptionally sharp decline over the last two months alone.

While pricing isn’t completely uniform across all grades (pipe-grade PVC still trades at a relative premium), the reality is that the market has seen a sharp correction. Likewise, while Shin-Etsu has the advantage of the lowest cost structure in the business, there’s simply no escaping the short-term impact on the business. I would expect to see at least four straight quarters of sequential profit declines in the business, with profits likely dropping by at least 50% from peak (FQ2’23) to trough. Quarterly margins in the PVC business have fallen into the single-digits during troughs in past cycles, and while I don’t think that will happen this time (at least not on a sustained basis), there will be a sharp deceleration from the mid-40% operating margins seen recently.

I’m not worried about this business beyond the next 12 to 18 months. While the housing market is seeing a correction in the wake of significantly higher interest rates, the reality is that the U.S. is still under-supplied with housing and I don’t see any meaningful long-term demand destruction. Likewise, while there has been supply growth in recent years (2.9% in 2020, 2.5% in 2021, and around 0.7% in 2022), it has been relatively restrained, and I expect industry operating rates to stay in the mid-to-high-70%’s. While I don’t expect a return to the sort of prices that the market saw in 2021 and 2022, Shin-Etsu has amply demonstrated that it can make good profits in this business with prices in line with historical norms.

Semiconductor Wafer Demand Remains At Risk, But Likely Not A Severe Risk

There’s no longer any real question about a correction in the semiconductor market, and the questions have shifted more to the depth and duration of the correction. As a leading supplier of wafers, this is clearly of interest and concern to Shin-Etsu.

I actually don’t see all that much risk to the business at this point. Barring a severe global recession, it seems unlikely that semiconductor lead-times are going to correct back to prior cyclical lows, suggesting a higher bottom for this downturn. Along those lines, demand for leading-edge chips (used in applications like high-speed networking, AI, and so on) has stayed fairly strong despite weaker demand for smartphones, and that should continue to support demand for 300mm wafers, as supply is still relatively tight, inventories are still low, and chip producers are wary of being caught short of capacity again when demand improves.

I think it is plausible that Shin-Etsu could go through this correction without actually seeing a decline in wafer volumes (at least in the 300mm business). Semiconductor downcycles are almost always driven by price, not volume, and it’s actually rare to see meaningful year-over-year declines in volumes for any sustained time. I do think wafer volume growth will drop into the low single-digits, and possibly hit zero, but I don’t believe they will turn negative. Likewise, between limited supply/capacity, a need to rebuild inventories, and long-term supply agreements, I don’t think Shin-Etsu is likely to see meaningful price erosion and should, in fact, see pricing gains over the next 12-24 months.

Silicones Still Need Work, And Further Investments Into EV Materials Seem Likely

Shin-Etsu’s silicones business (part of Functional Materials) has long been a relative laggard, and I do think that “relative” is an important caveat, as margins well in the 20%’s are hardly bad for a chemical company. Management has been working on developing more value-added products here (in collaboration with established customers), but there’s still a lot of room for improvement. In the near term, the company’s strong position in electronics (around 10% of segment sales) and industrial (around 20% of sales) is probably a weakness, but one that is partly offset by healthy positions in personal care (around 20% of sales) and autos.

Shin-Etsu has a well-earned reputation for being methodical about its expansion plans, and the company’s strong return on capital track record reflects that cautious and value-conscious approach. Still, management has noted that the growth of electric vehicle production is a significant opportunity, and one where they intend to participate. The company already has a sizable rare earth magnet business (the magnets are used in EV traction motors), and the company is looking to expand its capabilities in magnets that require less (or no) rare earth elements. Likewise, the company is exploring opportunities in areas like battery materials and related products like sealants, thermal materials, and shielding materials.

The Outlook

Between weaker housing, industrial, and personal electronics end-markets, I believe Shin-Etsu will likely see a high-single-digit revenue decline in FY’24 (around 8%), which is about double the decline reflected now in the average sell-side estimate. I expect a sluggish rebound in the following year, but still expect mid-single-digit growth over the longer term. I do see some downside risk from a sharper decline in the electronics/semiconductor end-markets, but I don’t expect either the housing or electronics/semiconductor downturns to be long-lasting.

This current fiscal year will likely be a peak year for EBITDA and free cash flow margins, but I do believe that while there is a risk of a decline in EBITDA margin to the mid-to-high 30%’s in FY’24, margins will likely quickly recover to the high-30%’s/low-40%’s. Longer term, I believe Shin-Etsu could achieve mid-to-high-teens FCF margins, though capex investment cycles could lead to some year-to-year volatility.

Discounting those cash flows back, I believe the shares are priced for a long-term annualized total return in the double-digits. The shares likewise look undervalued on the basis of multiples (EV/EBITDA and ROE-driven price/book), but these are trickier to use. Shin-Etsu’s EV/EBITDA multiple has swung from around 4x to over 12x over the years, and while I believe 7.25x is a fair forward multiple at this point, there’s a lot of subjectivity there.

The Bottom Line

I believe Shin-Etsu is likely around 15% to 20% undervalued today, but I don’t want to ignore the risk that company guidance and sell-side estimates could come down over the next couple of quarters due to weaker PVC pricing and weaker industrial and electronics end-markets. I think this is “noise” over the long term, but that noise can still have a painful impact on the share price in the short term.

For investors who are willing to take on some near-term cycle risk to own the shares of a very well-run company with multiple positive long-term drivers, I think this is a good time to consider Shin-Etsu.

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