Description

LONG: Dai Nippon Printing (7912.JP)

Summary

Dai Nippon Printing in a longstanding Japanese industrial conglomerate that has transformed over its 150-year history and is now accelerating into its next phase as a capital-optimized owner of multiple near-monopoly niche growth businesses. What might appear to be an unfocused melting ice cube with no foreign broker coverage is actually a case study in successful R&D parlay.

The highly progressive pace of cross-shareholding sales and share repurchases, along with the company’s renewed focus on a few growth categories, puts the shares at 5-6x 3/28E P/E. Once the market realizes the dominant position the company holds in its overwhelming (80%+) earnings contributors, we believe the stock should conservatively trade at 15-20x forward P/E, providing upside of 2.5-4x in three years.

Company History

The company was founded in 1876 as Shueisha, merging with Nisshin Printing in the interwar period to form Dai Nippon Printing (DNP). As the company’s name suggests, DNP was for years a leading printing company, responsible for everything from books and magazines to official currency banknotes and posters for the 1964 Tokyo Olympics.

One of DNP’s early transformations leveraged the company’s printing technology to revolutionize the dominant medium of the late 20^th century: color television. DNP had refined its printing plate technology to become a leader in high-precision metal etching, and a major challenge of early color television researchers was to mass produce CRT shadow masks, the metal plates with finely drilled holes that allow electron beams to correctly reach RGB phosphors behind glass TV screens. DNP met the challenge and is still leveraging this capability in one of its key growth markets today.

Another adjacency for DNP was packaging, where the company developed systems for filling food and beverage containers, various coating and deposition technologies, and unique metal laminating techniques. This last capability has now turned into a second key growth business for the company.

DNP Today

One of the challenges in analyzing DNP is that it is diversified across many business lines, making it difficult to isolate earnings drivers. The company has identified this problem and is working to streamline its portfolio, shedding sub-scale product lines in competitive markets while doubling down on its strengths.

As it stands today the company reports three segments: Information Communication (or Smart Communication), Lifestyle and Industrial Supplies (or Life and Healthcare), and Electronics.

Information Communication – This segment currently represents just over half of revenues for the company and includes its historically core business lines, but it is the least relevant to the company’s near future. The segment includes photographic materials, media sublimation transfer technology, IC cards, etc. The segment generates ~3% operating margins and the company is consolidating capacity and discontinuing certain lines of business.

Lifestyle and Industrial Supplies – This segment currently represents roughly a third of revenues and includes residential and automotive decorative materials, medical and F&B packaging, and PV and other materials. The key driver of this segment is the EV battery pouch product, an undersupplied sub-segment of the EV market where the company’s product is the industry standard, explained further below.

Electronics – This is the smallest segment by revenue but currently the largest operating profit contributor, with operating margins in excess of 20%, having consistently risen over the past five years. The segment includes optical film and semiconductor capital equipment in more competitive markets, but the primary driver is the OLED fine metal mask business, in which, again, the company has a dominant position in a niche growth market, explained further below.

Earnings Drivers

As mentioned above the two products that will drive earnings for the next 3-5 years are 1) OLED fine metal masks and 2) Lithium-ion battery pouches.

OLED Fine Metal Masks – While OLED screens can be used in televisions, the process for manufacturing smartphone, tablet, and laptop OLED screens is different and uses fine metal masks instead of open masks. A smartphone OLED display is produced by evaporating organic material and depositing the vapor onto a glass substrate, and doing this requires a precision metal mask with finely drilled holes – the same technology the company has been working on since its CRT shadow mask days and even earlier.

While the company developed this business as an outgrowth of both its CRT shadow mask business and its metal plate “stretching and drilling” printing capability, it was not alone at the outset. Another printing company, Toppan, also entered the market based on similar capability. DNP, however, recognized the importance of the metal alloy and co-developed it with Hitachi Metals, patenting what is now the standard Invar alloy used in OLED fine metal masks. As the market grew DNP garnered 85-90% market share, leaving Toppan with a likely low-profitability 10% share business.

While one benefit of OLED screens is image quality, including better angle-viewing, the key driver, especially for larger screen sizes, is battery life. Unlike traditional LCD screens, only lit OLED pixels require meaningful energy, so for gaming and other applications with darker images, OLED displays consume a small fraction of battery life compared to LCD screens.

OLED penetration has reached just over 50% for smartphones, and the metal mask is roughly 10% of the total OLED display cost; e.g., for a $20 OLED display, a metal mask might cost $20 and be used for 10 displays before being discarded (these numbers vary depending on OEM requirements). Smartphone OLED penetration is continuing ahead, with the entry-level iPhone SE receiving an OLED display in 2025. As a small yet critical component, we believe the company has pricing power in excess of inflation.

The larger driver is the laptop and tablet market, where penetration is in the low-single digits, and the high-end iPad Pro is just now receiving an OLED screen in its next iteration. While there is a higher technology hurdle, DNP is this month opening a dedicated manufacturing facility to focus on this market, and pricing on a per-square-inch basis is expected to be higher than in the smartphone OLED metal mask market. This means the company will more than double its current revenue, and likely OP, from this business by the time tablet and laptop penetration reaches current smartphone OLED penetration, even if smartphone OLED penetration remains flat.

Lithium-ion Battery Pouches – This is an unusual-sounding element of the EV supply chain that gets little press but is mission-critical. An aluminum-polypropylene-nylon laminate pouch is one of three form-factors currently used in EV batteries, the other two being cylinder and prismatic. Each of these form factors holds ~1/3 of the market, but the pouch market is expected to gain share as it is better-suited to next-generation batteries, including lithium-sulfur and solid-state.

Tesla was an early adopter of the cylinder form-factor, and CATL primarily uses the prismatic form-factor, while BYD has started using the pouch form-factor in ~30% of its batteries. The two key customers for DNP are LG (Energy Solutions / Chem) and SK, while many smaller battery manufacturers in China and globally also skew toward the pouch form-factor. The key advantage of the cylinder form-factor is stability, and the prismatic form-factor allows stability at a lighter weight. The advantage of a pouch is it can easily be formed as the end-customer wants, with higher or lower capacity, since it is basically a film; it is also lightweight, and stability is becoming less of a concern with newer generations of batteries.

While DNP has 50-60% market share, it gained that share as an early mover with key customers like LG. Some of DNP’s patents have expired, allowing competitors like Resonac and Youlchon Chemical, who were active in the small-battery pouch market, to enter. However, the key expertise arises from making sure the film is not separated from the aluminum, which could cause an explosion. As DNP pouches have the longest road-time, and exploding EVs are bad for business, we believe the 3-7% cost as a percentage of total battery cost is immaterial to most OEMs, and we see room for DNP to raise pricing in excess of inflation as the industry standard.

There is legitimate concern over the current state of the EV market, but based on our discussions with industry experts, the pouch market is actually under-supplied, meaning pouch penetration would have been higher if DNP could have produced more – as things currently stand, LG takes up most of the company’s production, and when LG demand is lower there is other standby demand.

Capital Efficiency

While this has been a major topic in Japan for more than a year, DNP has been one of the most progressive among diversified industrials. There has been activist interest from Elliott Investment Management and others, but the company insists it was organically on the path of capital efficiency before the activists showed up.

In January 2023 the Financial Times reported that Elliott had taken a stake of just under 5% in the company, which the company confirmed. The following month, at the 12/22 earnings release, the company announced they were formulating a new plan with a “record” buyback and a boiler-plate RoE target of over 10% and P/B target of “more than” 1x.

In March 2023 the company announced it would repurchase 40 million shares within a year for a maximum of JPY 100 billion. The company also announced a cancellation of 25 million treasury shares and a five-year buyback of JPY 300 billion, or more than 30% of the company at the time.

The company has been on pace to exceed its five-year buyback plan in just over a year, as it completed the JPY 100 billion buyback by February 2024 and last month announced an additional JPY 50 billion buyback to be completed by September 2024 (IR has said this should be completed by May 2024).

What is funding the buybacks is the company’s massive portfolio of cross-shareholdings, primarily in liquid large-caps. The company sold half of its stake in Recruit in May 2023 and last week announced it would have another large gain this quarter from cross-shareholding sales. The remaining cross-shareholdings still represent nearly 40% of the company’s market cap, and the company has openly discussed taking advantage of the strong move higher in Japan equities since it announced its plan last year.

In the Price?

DNP’s rapid share price appreciation in the first quarter of 2023, as news of activist interest and a series of capital efficiency measures hit the market, might cause investors to wonder whether the catalysts have already passed. It might have caused other investors to deprioritize a deeper look at the business.

Consider DNP’s historic peer (with an adjacent ticker) Toppan Holdings, which has actually outperformed DNP by nearly 20% since the end of 2022; Toppan was another under-analyzed printing business with a high-growth electronics segment, which accounted for only 18% of OP in FY 3/20 but 63% in FY 3/23; in recent quarters the electronics segment has accounted for 81-116% of OP.

Also consider DNP’s largest cross-shareholding, Recruit, which has returned nearly 60% since the end of 2022; the TOPIX Index has returned nearly 50%, while the relevant sub-indices have also returned 50-60%+.

Despite the sale of more than JPY 60bn of Recruit shares in May 2023, the value of DNP’s cross-shareholdings has increased by 17% from 12/22 (pre-activist) through 3/24:



Forecast and Valuation

While the company gives little detail on the contribution of its key products above, we believe OLED fine metal masks account for roughly 65% of Electronics segment revenues and 75% of segment OP, while battery pouches account for roughly 15% of Lifestyle and Industrial Supplies segment revenues and more than 100% of segment OP.

DNP has identified longer-term opportunities in healthcare and semiconductors, but we assume the remaining businesses stay roughly flat over the coming years as the company shuts down underperforming business lines. This leaves the two key product lines above generating ~80%+ of OP by FY 3/28E.

We also assume the company continues to sell down cross-shareholdings and repurchase shares, at increasingly higher share prices over the next three years. Accordingly our base and bull case estimates have different share counts:



As mentioned at the outset, once the market realizes 80%+ of profits are generated by two near-monopoly businesses, with option value from ongoing R&D, we believe 15-20x forward P/E will be a conservative multiple in a Japan rate context, providing a 35-55% IRR with downside protection via meaningful buyback activity.

For reference the TOPIX Electric Appliances Index, which is the closest peer group to DNP’s earnings drivers, has traded between 13-22x forward P/E over the past two years and currently trades at 19x forward P/E. See comparable valuations below, DNP’s forward EPS growth from 3/28E should be above the average:

Reality Check

With the opaque reporting segments, it is important to avoid false precision in our estimates, but we can apply a reality check to our base case.

In the OLED fine metal mask business, using OLED smartphone penetration, DNP’s market share, and the pricing mentioned above, we get to ~65% segment revenue share and ~75% segment OP share (based on IR comments). If we assume the remaining segment revenue and OP stays flat through FY 3/28E, our estimates imply this product grows by ~40%, meaning ~20% penetration of the tablet and laptop market by 3/28 if OLED smartphone penetration and pricing remains flat. Our estimates also imply OP margins for the product increase from ~28% currently to ~37% in FY 3/28E – we would note the company’s current JPY 20 billion capacity expansion in Kitakyushu, which is actually a retrofit, should achieve ROICs well into the double-digits, and the company will maintain a near-monopoly position with low cost-impact to the display makers (Samsung Display, BOE, TCL, etc.).

In the battery pouch business, we believe the product currently accounts for ~15% segment revenue share and just over 100% segment OP share, based on rough IR comments. Our 3/28E estimates imply product OP margins stay flat at ~25-26%, while revenues grow in-line with EV/hybrid market volume projections, leaving an additional <5% CAGR for pricing and pouch share gains within EV/hybrid. DNP is in the process of acquiring land in the U.S. to significantly ramp up production capacity.

Our overall base case FY 3/28E OP estimate is 9% ahead of the company’s own undated projection, which we believe is reasonable considering how conservative the company’s buyback forecast was compared to its actual results.

The company has also provided cash flow guidance from FY 3/24 to 3/28, including JPY 440bn of OCF and another JPY 90 billion from idle asset sales, etc. (excluding cross-shareholding sales). JPY 260 billion of this will be reinvested in focus areas, and considering the high ROIC the company should achieve in near-monopoly capacity expansions, we are less concerned with free cash flow generation in the near-term; cross-shareholding sales and remaining FCF will be deployed in share buybacks and a less meaningful dividend.

Risks

• While the company appears to have found religion with respect to capital and operational efficiency, as judged by its actions, it has a long history and could slide back into being a sprawling conglomerate. There could be minor landmines in other business lines, but the company is taking a progressive stance on scrapping underperformers.
  
• The company has made high profile mistakes in the past, including unrealistic forays into e-books, photo-sharing, and other consumer-oriented services. Any future impulse to pursue competitive growth markets would likely be met with skepticism.
  
• The OLED metal mask business is likely to see more competition, especially from Chinese vendors, in the future. We like the market structure of both of DNP’s key businesses, where there are credible second and third vendors to put customers at ease, but DNP maintains ~100% profit share.

Catalyst

Annual results and medium-term plan update on May 13.