Description

Executive summary

Showa Denko is a misperceived Japanese chemical conglomerate.  We believe the financial community’s perception of Showa Denko is outdated and fails to recognize how the company’s 2020 acquisition of Hitachi Chemical has radically altered the company’s business and earnings mix.  Today, Showa Denko derives the majority of its earnings from its high quality, growing semiconductor and electronics materials segment.  However, most financial analysts are focused on the company’s highly cyclical graphite electrodes sub-segment despite its relatively small contribution to revenues and profits.  Complicating matters for analysts, the company’s earnings power is currently obfuscated by acquisition accounting and numerous one-off expenses related to the Hitachi Chemical acquisition.    

Showa Denko has a new senior management team which is in the early stages of implementing a multi-year plan to optimize the company’s business portfolio toward higher margin semiconductors and electronics materials, while deleveraging the balance sheet.  New management is aligned with shareholders with incentive compensation tied to financial targets and total shareholder returns. 

We expect reported EPS to quadruple from ~¥120 per share in 2022 to ~¥480 per share in 2024 as management executes against its medium-term plan, the company transitions to IFRS accounting, and one-off expenses and extraordinary losses abate.  If valuation multiples re-rate moderately toward semiconductor materials peers (e.g., JSR and Shin-Etsu) shares offer multi-bagger potential (3-5x from current levels).

Company Background

Showa Denko’s business portfolio includes semiconductor and electronic materials (the former Hitachi Chemical’s electronic materials business), specialty chemicals, commodity petrochemicals, and graphite electrodes (used for EAF steel manufacturing).  Among the generalist investor community, the company is probably best known for:  1/ its graphite electrodes business segment; and 2/ its acquisition of Hitachi Chemical which was announced in December 2019 and completed in June 2020.

Graphite Electrode segment

Graphite electrodes are consumed in electric arc furnaces (“EAF”) used in the steel production process.  Graphite electrodes experienced a “super-cycle” in 2017-18 and prices exploded from <$2,000/ton to over $25,000/ton spot pricing at the peak.  As one of the world’s largest producers of graphite electrodes, Showa Denko was a direct beneficiary of the super-cycle:  company- wide EBITDA nearly tripled from ¥81bn in 2016 to ¥220bn in 2018 and Showa Denko’s shares quintupled from ~¥1,000 per share to over ~¥5,000 per share.

Hitachi Chemical Acquisition

In late 2019 Showa Denko emerged as the surprise winner in a well-contested sale process of Hitachi Chemical.  In a shockingly bold move, Showa Denko out-bid a host of high-profile private equity players.  The company paid nearly ¥1tr for Hitachi Chemical, an amount more than double Showa Denko’s market capitalization at the time.  Investors were wary of the transaction which was viewed as expensive (~13x Trailing EV/EBITDA) and risky as it was financed entirely with debt.

Fast Forward to Today

Following the Hitachi Chemical acquisition and a normalization of graphite electrode prices, the graphite electrode segment today accounts for <10% of total revenues.  Meanwhile, the Hitachi Chemical portfolio includes multiple industry-leading semiconductor materials segments which are buoyed by the secular growth of the semiconductor industry.  Showa Denko claims to have the world’s largest portfolio of back-end semiconductor materials including die bonding film and paste, epoxy molding compounds, liquid encapsulants, copper clad laminates, high heat resistant coating materials, release sheet, and dicing film) as well as leading positions in certain front-end applications (global top share in ceria CMP slurry and photosensitive insulation coating materials). 

Over 70% of the company’s earnings come from businesses which are high ROIC, secularly growing, and operate in well-structured industries.  The semiconductor market is expected to grow 5-8% in the coming years with semiconductor materials expected to grow even faster at a 10% CAGR due to the increasing amount of materials content in final products (e.g., increase in 3-D NAND layers, and package sizes).  In turn, Showa Denko expects to realize higher-than-market growth for its semiconductor materials businesses.   

Multi-bagger potential

Valuation is attractive though partially obscured by financial statements complicated by the Hitatchi Chemical acquisition.  We estimate that in FY24 (December year-end), once one-off restructuring charges roll-off and the company completes its transition to IFRS accounting, Showa Denko’s EPS can reach ~¥480 per share, leaving the shares trading at ~4.6x 2024 P/E.  This compares to leading Japanese specialty materials companies like JSR and Shin-Etsu Chemical which have historically traded at low-to-mid-teens P/E multiples.

FCF yield offers another valuation lens.  We believe the current portfolio can ramp to ¥200bn of operating cash flow in 2024-25.  After annual net capex of ¥100bn, the company can generate ¥100bn of annual FCF representing a 25% FCF yield based on Showa Denko’s current ~¥400bn market cap.  The benefits of deleveraging are significant:  holding EV constant, if all FCF goes to paying down debt, equity value could accrete at 25% per year, from 2024 and onwards.

For the blue blue sky scenario, we can look to Showa Denko’s MTP which envisions 2025 EBITDA of ¥320bn.  At 8x EV/EBITDA (the average of JSR and Shin-Etsu’s 5-year average forward EV/EBITDA), enterprise value would reach ¥2,520bn.  Backing out ¥500bn of net debt (assumes three years of annual debt paydown of ¥100bn) results in a ~¥2,000bn market cap or ~5x the current market cap.  In terms of P/E, we estimate the MTP’s 2025 EBITDA target of ¥320bn corresponds to ~¥850 of EPS.  At 12.5x P/E, shares could trade at ~¥10,625 per share, roughly 4.8x the current share price.

Current Earnings Power is Concealed by Acquisition Accounting and One-Offs

In 3Q22 the company downgraded its 2022 forecasts.  The revised guidance implies 2022 EPS of ¥121 per share, representing a 2022 P/E multiple of 18.0x.  Note that sell-side analysts have been slow to adjust their forecasts:  consensus 2022 EPS remains at ¥161 per share, ~10% below the company’s prior guidance. 

However, the revised forecast significantly understates Showa Denko’s true earnings power.  Net income and EPS are severely depressed by a combination of acquisition accounting (goodwill amortization expense required by J-GAAP), high financing costs associated with the Hitachi Chemical transaction, and one-off post-merger integration expenses and elevated extraordinary losses.  Below we show our pro forma 2022 EPS estimate adjusted for temporary items:  EPS more than doubles from ¥121 per share to ¥299 per share, representing a 2022 adjusted P/E multiple of 7.3x.

We believe these adjustments are sensible and provide a clearer picture of the company’s earnings.  In addition, there exists an identifiable path toward realizing them as the company implements a variety of self-help initiatives:

• Refinancing of Preferred Shares was completed in 2Q22 and will flow through in 2023
• Post-Merger Integration expenses are expected to roll-off in 2023
• The company intends to transition to IFRS accounting by 2024
• Extraordinary losses were elevated due to the disposal of non-core assets

In general, the sell-side doesn’t incorporate/understand the self-help.  Many sell-side projections assume:  1/ IFRS will never happen; 2/ the company will continue to take large restructuring charges forever.  Some do not even bake in the interest savings on the pref shares refinancing.  As a result, while our OP forecasts are slightly ahead of Street, the gap widens substantially at the net income/EPS level as Street estimates fail to reflect the company’s self-help measures.

New Management Team is Driving a Transformation of the Business Portfolio

Over the past year, Showa Denko has installed a new senior management team.  Namely:

• Hidehito Takahashi was appointed President and CEO in January 2022
• Hideki Somemiya was appointed Chief Financial Officer in October 2021
• Tomomitsu Maoko was appointed Chief Strategy Officer in January 2022
• Former CEO, Kohei Morikawa, transitioned to Chairman of the Board in January 2022

While Takahashi-san has been with the company since late 2015, he reportedly insisted on choosing his own management team consisting largely of outsiders.  Of the top 12 managers at Showa Denko, 8 are either outsiders or came from the Hitachi Chemical acquisition.  CFO Somemiya-san previously held multiple senior roles at Sony and its semiconductor division, while CSO Maoko-san joined the company from Renesas. 

New management has taken steps to delineate itself from prior management.  In Takahashi-san’s Feb. 2022 presentation, he highlights the company’s “New Management System” and “New Corporate Philosophy.”  Furthermore, the MTP outlines the company’s intention to promote strategies of Profitability, Portfolio Management, and Innovation on the back of “New Corporate Philosophy”, “New personnel system”, and “New management team that leads reformation”.

The company’s focus on portfolio management is particularly noteworthy.  Management intends to pursue portfolio optimization through continuous revision and replacement.  Each business segment will be viewed through the lenses of profitability/capital efficiency, fitness for strategy, and best owner.  Overall, the company targets ROIC of 10% or more. 

While this all sounds good on paper, actions speak louder than words.  To that end, new management has taken a number of steps which suggest a transformation is truly underway.  The company has changed to a holding company structure and is changing the company name to Resonac Holdings (effective January 1, 2023).  The company has changed its financial segment reporting to emphasize the semiconductor-related businesses.  Management has disposed of some non-core businesses (Isolite thermal insulation unit; a ceramics unit) and intends to dispose of others (FIAMM lead-acid battery business and auto brakes unit).  In addition, management has stated it intends to dispose of cross-shareholdings by 2024 (the value of the company’s listed holdings and treasury shares are equivalent to ~6% of the current market cap).  Management has also begun to discuss the transition to IFRS accounting and longer-term, the potential exit of the petrochemicals business.

We believe senior management is well-aligned with shareholders.  President and CEO Takahashi-san’s compensation consists of basic, short-term, and mid-to-long-term components in the proportion of 40%/30%/30%.  Short-term compensation will be tied to Consolidated EBITDA (20% weighting), EBITDA Margin (30%), ROIC (20%) and Personal Performance Evaluation (30%).  Medium-to-long-term stock-based compensation will depend on Total Shareholder Returns relative to competitors in the chemical/textile industries.  Specifically:

• 20% percentile relative TSR rank:  zero mid-to-long-term incentive payout
• 60% percentile relative TSR rank:  100% mid-to-long-term incentive payout
• 100% percentile relative TSR rank:  200% mid-to-long-term incentive payout

Business Portfolio Revenue and EBITDA Mix

Starting in 2022, the company reclassified its segments for financial reporting purposes.  In the appendix, we provide a brief description of Showa Denko’s business portfolio based on the previous, more granular segment classifications.

Below are management’s revised segment forecasts for 2022.  Of note, while the Semiconductor & Electronic Materials segment only accounts for 34% of revenue (before Others/Adjustments), it accounts for 56% of EBITDA (before Others/Adjustments).  Including the Innovation Enabling segment and certain sub-segments of the Mobility segment, we estimate over 70% of EBITDA is derived from businesses which are high ROIC, secularly growing, and operate in well-structured industries.  As discussed above, many investors focus on Showa Denko’s graphite electrodes business.  We think this attention is misplaced as through the first three quarters of 2022, graphite electrodes only accounted for 22% of the Chemicals segments revenues (18% in YTD-3Q21), which in turn accounts for 41% of total revenues before others.

Valuation and Upside

We believe there is a straightforward path to nearly triple the share price.

• Business segments grow with their end markets and achieve margins in-line with historical levels
• Refinancing expensive Mizuho Preference shares with lower cost subordinated debt (completed in 2Q-2022 with impact seen in 2023)
• Transition to IFRS accounting (Targeting 2024)
• Extraordinary expenses return to normal levels as one-off post-merger integration expenses roll-off (2023)
• Valuation re-rates slightly to reflect improving company narrative and business mix

Here are our forecasts through FY-2025.  We expect EPS to quadruple by 2024 on the back of IFRS transition, refinancing of preference shares and subordinated debt, and rolling-off of post-merger integration expenses and elevated extraordinary losses.

At 12.5x 2022 EPS of ~¥480 per share, our base case target price is ~¥6,000 per share or +170% upside from the current share price.  Our base case 12.5x P/E multiple represents a ~20% discount to the average 5-year median forward P/E of a group of Japanese semiconductor and electronics materials companies (JSR, Shin-Etsu, and Tokyo Ohka Kogyo).

As mentioned, we can envision more bullish scenarios which offer significantly higher upside through some combination of higher earnings, higher multiples, and/or spin-out of the petrochemicals and graphite electrodes segments.

For example, the company’s MTP targets 2025 EBITDA of ¥320bn.  We estimate this translates into an EPS of ~¥850 per share.  At 13.5-16x P/E (peers have all traded over 25x forward P/E at some point over the past five year), Showa Denko would be a 5-6-bagger from current levels.

Risks

• Company transformation fails to take hold.  We believe this is largely mitigated by executive buy-in for many of the key drivers, including IFRS adoption, refinancing the preference shares, and minimizing exceptional losses. 
• Shares continue to trade with the graphite electrode cycle.  Though Showa Denko maintains a strong market position in graphite electrodes which enjoy secular growth tailwinds (ongoing shift toward EAF production process), the sector is volatile and has an outsized impact on the share price.
• Delays to IFRS implementation
• The company is highly levered and de-leveraging does not occur as rapidly as we anticipate.
• The company experiences continuous exceptional losses as it continues to restructure its business portfolio.
• The company pursues non-accretive acquisitions.

Appendix:  Description of Business Portfolio

Showa Denko Materials (former Hitachi Chemical)

• Semiconductor Materials:  world’s largest portfolio of back-end semiconductor materials, including die bonding film and paste, epoxy molding compounds, liquid encapsulants, high heat resistant coating materials, release sheet, and dicing film.  Leading CMP slurry and photosensitive insulation coating front end business.  We believe this is an excellent business.
• Display Materials:  specialty connecting film (anisotropic conductive film) which connects driver chips to display panels.  One of two players in the space.  Strong market position in an ok end market.
• Materials for Printed Wiring Boards: base materials and photosensitive materials for printed wiring boards.  Excellent market position, reasonable growth in the space. 
• Functional Films:  variety of specialized films used in electronic manufacturing processes.  Good market position and reasonable growth.
• Resins:  portfolio of resins for a variety of electronics and automotive uses.  Specialized and differentiated materials, not huge growth.
• Carbon Products / Ceramics:  leading position in anode materials for lithium ion batteries.  Good growth prospects but hard to achieve high margins.  Remainder of portfolio is carbon brushes and sliding materials for industrial motors, which are well positioned but a GDP grower.
• Automotive Products:  molded plastics to help automotive companies lightweight their vehicles.  Very high quality, extremely cyclical end market, a few competitors in each product category.
• Powder Metal Products:  high end powder metal structural parts, bearings, and assembled parts.  Reliant on auto cycle but very reasonable margins.

Electronics

• Device Solutions:  manufactures hard-disk media and SiC epitaxial wafers for power semiconductors.  Though the HD media business is no longer growing, it is the only independent HD media supplier and generates good profitability.  The SiC business is highly differentiated and should grow dramatically as SiC based power semiconductors gain adoption across a variety of applications, with particular focus on electric vehicles and charging stations.
• Electronic Materials:  supplies materials for compound semiconductors, high-output LEDs, rare earth magnet alloys, and PD epitaxial wafers.  Generally high quality, high margin, growing businesses.
• Advanced Battery Materials:  manufactures anode and cathode materials and films for use in lithium ion batteries.  Highly regarded technically but a difficult end market to make big margins in.

Chemicals

• Industrial Gases:  operates an air separation gas business focused on Kawasaki and supplies compressed hydrogen, carbonic acid, dry ice, and other industrial gases.  This business competes with Nippon Sanso.
• Electronic Chemicals:  manufactures specialty gases and specialty gas equipment for use in semiconductor, panel, and solar cell manufacturing, with production bases in Japan, S. Korea, Taiwan, Shanghai, and Singapore.  This is an excellent business.
• Basic Chemicals:  manufacturers a variety of industrial chemicals, including ammonia, caustic soda, hydrochloric acid, acrylonitrile, amino acid, and elastomers products.  These are slightly more complex materials but relatively commoditized.
• Functional Chemicals:  provides various plastic and molding compounds and emulsions.  These are fairly specialized, high value add products that generate reasonable but not semiconductor material level margins.

Petrochemicals

• The company operates a single petrochemical complex in Oita, Kyushu.  The site manufacturers Olefins (ethylene, propylene, C4 fraction, and cracked fuel oil) in its Naptha cracker, as well as Organic Chemicals, including acetaldehyde, acetic acid, vinyl acetate, ethyl acetate, and allyl ester resin.
• The company’s facility is part of a broader chemical complex in Oita.  As a result, it has a host of dedicated off-takers for its products and is substantially less volatile in earnings than stand-alone petrochemical assets.

Inorganics

• Carbon:  supplies graphite electrodes for electric steelmaking furnaces.  One of three major ex-China, ex-India players in the world, and generally regarded as one of the leaders in quality.  Large electrical currents are passed through the low conductivity electrodes, which causes electric arcs between the tips of the electrodes and across the liquid steel, which is the core process to EAF steel manufacturing.
• Ceramics:  manufactures polish, abrasives, and refractories, as well as ultrafine titanium oxide for MLCCs.  These are relatively differentiated materials.

Aluminum

• Extruded, forged, and cast products for a variety of end-markets, with automotive and mechatronics being the two end markets.
• Showa Denko used to have a number of commoditized aluminum businesses but has exited them.  The remaining businesses are relatively differentiated and generate reasonable margins.

Life Sciences (Minaris)

• Regenerative Medicine:  CDMO for cell and gene therapy products.  This is a promising but immature segment of Life Sciences.  If it succeeds, it promises the ability to develop patient-specific cell therapies.  Currently losing money or breaking even, but if this segment takes off, they are one of the global leaders and this business could be valuable.  We don’t have any upside from this baked into our financial models as it is too early to assess reasonable outcomes.
• In-Vitro Diagnostics:  provides panel tests for environmental and food allergens.  This business is fine but not likely to turn into anything big.

Catalyst

• Business segments grow with their end markets and achieve margins in-line with historical levels
• Refinancing expensive Mizuho Preference shares with lower cost subordinated debt (completed in 2Q-2022 with impact seen in 2023)
• Transition to IFRS accounting (targeting 2024)
• Extraordinary expenses return to normal levels as one-off post-merger integration expenses roll-off (2023)
• Valuation re-rates slightly to reflect improving company narrative and business mix