2023-09-21 12:02:57 ET
Summary
- Shin-Etsu Chemical has shown resilience during challenging conditions in 2023, with strong margins and longer-term leverage to growth in housing, semiconductor demand, and emerging markets like EVs.
- As expected, weak construction markets have driven weakness in the chlor-alkali business, but Shin-Etsu has a superior cost position and leverage to long-term housing growth.
- The semiconductor space is still correcting, with a sharper potential inventory correction in the third quarter, but volumes will recover, and Shin-Etsu has innovation-driven opportunities elsewhere.
- With Shin-Etsu's major markets likely near their bottoms and an appealing valuation on long-term growth in the mid-single-digits, Shin-Etsu is worth consideration today.
Tough times are when the best companies really show their qualities, and such has been true for Shin-Etsu Chemical ("Shin-Etsu") (SHECY) (4063.T) during a 2023 that has seen significantly more challenging conditions for all of its major business lines. Although quarterly operating profits are down about a third from the recent peak, margins are still very strong and Shin-Etsu is likely closer to the bottom of the cycle than not. Looking beyond this period of correction, the company is leveraged to ongoing growth in housing (with a very strong cost advantage), semiconductor demand, and emerging opportunities like EVs, and has shown many times over the years that it can and will innovate into new and attractive growth markets.
Shin-Etsu's ADRs are up about 25% since my last update on the company, easily outperforming the S&P as well as other chemical comps like Olin (OLN), Sika (SXYAY), SUMCO (SUOPY), Wacker Chemie (WKCMF), and Westlake (WLK). At this point, I still see more upside. I do think there is some downside risk to estimates and sentiment over the next six to nine months as most of the major global economies are looking soft now, but I think business will start turning up in 2024, and I think Shin-Etsu has years of profitable growth to look forward to after this correction.
As Expected, Housing Has Driven Weakness In the Chlor-Alkali Business
When I last wrote about Shin-Etsu, the foremost concern in the market was how the company would manage what would likely be a tough market for its Infrastructure Materials segment (largely PVC). Although the U.S. housing market has held up a little better than expected, there have been some increased signs of weakness in non-residential construction and China's weakness (China is a major global consumer of PVC) remains a risk.
PVC margins are down about 50% year over year, driven by a 20%-plus decline in prices in North America (down more than 40% from the peak). While export prices have been more stable, domestic prices are more than 40% higher than export prices, so the mix really does matter.
This weakness has definitely shown up in the reported results - the last quarter (the fiscal first quarter) saw Infrastructure revenue down 17% as reported, with a 38% decline in operating profit (with margin down about 11pts to 33%). While this could well be as bad as it gets, and Shin-Etsu still has the advantage of the lowest cash production costs in the world, Shin-Etsu is a price-taker and it is notoriously difficult to call bottoms in cyclical, economically-sensitive commodity markets like PVC, particularly with China stumbling.
Long term, I still like this business. The PVC segment of the petrochemicals industry has seen less capacity growth than other segments and supply growth is looking pretty limited over the next four or five years. Keep in mind, too, that it's likely to be harder to add greenfield capacity in the cost-advantaged U.S. market (few communities are eager to host new chlorine plants) and it takes around three to four years to get a new plant up and running. On the demand side, the U.S. still has a housing deficit and I likewise do expect growth in markets like China and India over the longer term.
The Semiconductor Space Is Correcting, But Not Quite Done Yet
Relative to the PVC market, I'm less confident that Shin-Etsu has seen the bottom for the semiconductor cycle. Demand has held up as customers have had to honor long-term supply/purchase agreements, but lead-times continue to shrink across the industry and more and more companies are reporting that customers are asking to push out orders.
Given a 7% sequential increase in 300mm wafer volumes for the industry in the second quarter, I think it's reasonable to expect a sharper inventory correction in the third quarter/second half of 2023. That should be the end of it, though. While I do think Shin-Etsu will likely see a year-over-year decline in wafer volume (quite rare in the history of the semiconductor industry, as most corrections are more weighted to price), I think customers are going to be cautious about working inventories down too far and risking another supply shortage situation like we saw recently.
There's also more in Shin-Etsu's Electronic Materials business than wafers. The company should be ramping commercial production of EUV photomask blanks this year, and this should be a worthwhile opportunity given the long-term growth potential of EUV (basically essential for sub-5nm chip production).
Shin-Etsu has also continued to invest in innovation, including new substrate and magnet materials. On the substrate side, the company has developed a propriety new substrate for gallium-nitride (or GaN) chip production; GaN chips are attractive in a range of power and RF applications, but they're especially easy to manufacture and a better substrate could prove to be an important innovation. On the magnet side, Shin-Etsu remains attractively-leveraged to growth in magnets used in applications like electric vehicles and factory automation, and the company continues to innovate in the area of replacing rare earth elements in its magnet designs (an important consideration for customers, as China has threatened the stability of supply for these materials).
The Outlook
Although I'm now looking for a steeper revenue decline in FY'24 than I was before, that has more to do with a higher starting point, as Shin-Etsu has continued to outperform my expectations. I do still see some downside risk to the numbers over the next six to nine months on global macro weakness, but I think business will start improving in the second half of calendar 2024 and I expect long-term growth in the neighborhood of 4%.
Margins will correct some in FY'24, but I see no reason why Shin-Etsu won't generate EBITDA margins comfortably in the 40%'s over the next three to five years with attractive free cash flow margins and FCF growth in the neighborhood of 5%. I will note that capex spending can be "lumpy" here, and I would expect that the company will have to reinvest in expansion at different points over the next decade.
Between discounted cash flow and an EV/EBITDA approach, I believe Shin-Etsu remains undervalued. I believe the ADRs should trade closer to $18 today and I see a double-digit long-term annualized total return potential. The EV/EBITDA approach is a little more challenging now given what is likely to be a modest year-over-year decline in FY'24, but a 7.5x multiple (slightly above the average long-term multiple of 7.25x) on my FY'24 number still gets me to around $17 today.
The Bottom Line
Shin-Etsu operates in multiple commodity or commodity-like markets and they're not a leader everywhere they compete (there are segments of the silicones business, for instance, that aren't quite as strong), but they have shown an ability to establish and hold cost leadership, strong margins, and decent capital returns to shareholders over a long period of time. On top of that, the company is more innovative than I think it often gets credited for, and I like the combination of high-margin, cash-generating base businesses and underrated growth opportunities in areas like back-end semiconductor materials, magnets, and functional chemicals.
Given the discount, and the fact that Shin-Etsu has often traded at a premium, I think these shares deserve a closer look today. I realize trying to time a bottom in cyclical businesses like PVC can be a fool's errand, but even if the outlook for the next 12 months is too high, I think this will work out over time and I think the shares offer a good long-term potential return now.
For further details see:
Shin-Etsu Chemical Outperforming While Others Struggle