Description

Our hunt for value continues to unearth interesting long-term investment opportunities in the more developed markets of East Asia.  While corporate governance issues and subpar capital allocation are quite common in these markets, it is still possible to find exceptional businesses that are well managed, yet trading at a large discount to intrinsic value.  We believe that investors can achieve attractive long-term returns in these situations even if this discount were to persist indefinitely, but as these “hidden champions” compound earnings at such a rate that they become large enough to appear on more institutional screens, there is also the potential for a valuation rerating.

Elite Material Corporation (EMC) is a dominant leader in a growing global market with significant tailwinds for both the industry and the company, with the potential for 20% annualized profit growth over the next 3-5 years and a trailing P/E multiple of less than 14x.  We believe the stock should continue to attract more institutional interest given its substantial size ($1B+ market cap, $10m+ daily liquidity) and growing dividend (4.5% est. 2017 yield with room for a higher payout ratio), which could support a higher P/E multiple in the long run.

The Company was founded in 1992 and listed in Taiwan in 1998.  In 2002, the Company became a subcontractor for Hitachi Chemical, supplying halogen-free (HF) PCB laminate for the iPod.  The Company has since grown to become the largest supplier of green PCB laminate worldwide and the world’s fifth largest overall laminate supplier.  

ITEQ, Nan Ya Plastics, and TUC are based in Taiwan, Panasonic and Hitachi Chemical are based in Japan, SYTECH is based in China, and Doosan is based in South Korea.  There is not much overlap in the customer base for these competitors; for instance, EMC is dominant in mobile devices, while ITEQ focuses on notebooks and Nan Ya focuses on PCs.  In recent years, Taiwanese suppliers have been gaining market share against the Japanese suppliers, as much of their cost base in Japan and electricity costs have risen in the wake of the Fukushima nuclear meltdown.

The Company only produces HF laminate, which accounts for 16% of the total PCB laminate market. This is expected to increase by a CAGR of 20% from 2015 to 2020 due to the ongoing EU implementation of RoHS (Restriction of Hazardous Substances in Electrical and Electronic Equipment Directive).

Halogen includes chlorine, fluorine, bromine, iodine and astatine elements which have been commonly used in the production of electronics, particularly bromine and chlorine. During the traditional manufacturing process, halogens are added to components to make them withstand high temperatures and to be flame-retardant.  

Increasing awareness of environmental protection issues has prompted governments to institute national compliance codes for the use of HF electronics in an effort to reduce the amount of hazardous substances released into the atmosphere, as most electronics are burned up at the end of their life.  Handheld devices were targeted first given their relatively short product lives.

Handheld Segment

EMC is the leading supplier of HF laminates to the global smartphone giants in the US, Korea and Japan.  Chinese smartphone manufacturers are also transitioning to HF laminates as they make a push into global markets.  They are a priority source for Apple, but their customer concentration is much lower than the typical Apple supplier, as every competing smartphone manufacturer needs to use them as well.

This business segment accounted for 48% of revenues in H1 2016, down from 75% in 2014.  The segment generates gross margins as high as 29%, but each customer contract will be different.  Each customer is buying a unique “recipe” from Elite, as the number of layers and make-up varies depending on the end product’s design and function.

The mobile phone market is expected to slow significantly to a CAGR of 2.3% through 2020.  EMC is not planning any additional capacity expansion for this segment; their strategy is to use their dominant position to keep their higher margin customers and cycle out their lower margin business to make room for the rapidly growing infrastructure segment, which generates higher margins.

Infrastructure Segment

The global server and data storage market is expected to grow at a CAGR of 5.3% in the coming years, but the penetration of HF laminates in this market is still quite low.  This is rapidly changing now that IBM, Cisco, and Intel are moving from designating HF laminates from “preferred” to required components in their servers.  While these companies have had environmental policies in place for decades and the government directives have been in place for more than a decade as well, it was only in the past several years ago that EMC developed HF laminates that are of comparable quality and cost to the traditional alternatives.  Quality standards at these companies have resulted in a high barrier to entry and products must go through a two year testing period (compared with two months for consumer electronics).  For example, Panasonic is the only other HF laminate supplier to Cisco.

In H1 2016, this segment accounted for 23% of revenue with 50% annualized growth at significantly higher than average gross margins of 31%.  EMC is currently the fifth largest provider of laminates consumed by high speed networking infrastructure, but an industry shift toward HF laminates plays directly into their hands.  At the current rate of growth, the infrastructure segment could become EMC’s largest source of revenue and profits in 2 to 3 years.

Large-scale internet firms are continuing to invest heavily in building out datacenters globally; datacenter capex likely grew 10-15% in 2016, which supports demand for more servers and thus more laminates.  Global data center traffic is growing at a CAGR north of 20%, driven by booming cloud IP traffic.

5G networks will start to launch commercially around the world in 2020, enabling 10x-100x user data rates and 5x lower latency.  These speeds will require further upgrades of materials consumed by PCB makers for base stations and datacenters and presents further opportunity for EMC to win new business.

Automotive Segment

EMC has one contract in this segment as the largest provider of laminates for the largest auto parts OEM in Germany.  This contributes 15% of overall revenue at a lower than average gross margin of 20%.  The recipe for automotive applications is currently less complex (fewer layers), but self-driving cars will require far more computing hardware and more complex recipes.

5G infrastructure is needed first to handle the data demands of self-driving cars.  Intel estimates that by 2020, the average person will consume 1.5GB daily, while an autonomous vehicle will need 4,000GB daily.  

In the meantime, EMC’s commercial focus will be on building the networking infrastructure that will make this possible, but they should be well positioned to supply the automotive market once the conditions are ideal.  Even lengthier supplier approval times in the automotive industry of 5 years should create an additional barrier to entry for EMC in this segment.

Capital Allocation and Corporate Governance

Growth capex has been fully funded by operating cash flow and debt.  Average net debt to EBITDA prior to 2014 was 2.8x, but the company reached a net cash position for the first time in corporate history in 2015, at the same time growth capex needs are slowing.  Management has historically focused on generating high ROE and may consider increasing the current payout ratio of 50% to return excess cash to shareholders.  The Company stopped paying share dividends in 2011 and has only paid cash dividends since.  The Company no longer issues stock options to employees, only cash bonuses.

The Company is expanding capacity at their Hsinchu site; they will spend approximately NT$900m for expected incremental revenue of NT$3B, to be finished by July 2017.  We believe that the company’s incremental returns on capital should be very attractive, especially for capacity dedicated to the infrastructure segment.

It’s our understanding that EMC only just recently started to beef up their investor communication efforts, which could help attract a more stable investor base.  The Company has published IR materials in English and is planning to attend more investor conferences in Taiwan and Hong Kong, which will save potential investors the trip to the industrial outskirts of Taipei.

Valuation

While the stock is trading at the high end of its historical valuation range at 14x P/E and 8x EV/EBIT, we believe this is an attractive valuation in the context of the Company’s growth prospects.  As the rapidly growing infrastructure segment drives earnings growth at about 20% annually over the next several years and dividends increase at a similar or higher rate, we think the stock should at least maintain the current valuation or possibly rerate to a more appropriate growth stock multiple.  

Catalyst

• Increased adoption of halogen-free PCB laminates in new data center and base station contruction
• Improved product mix driving increase in gross margins
• Increased investor awareness from improved investor relations efforts
• Increased capital return to shareholders