Description

Toray Industries Inc. (3402 JP) – Long, ¥1,350/share 12-18 month target

Market Cap: ¥1.6t (Last Sale: ¥997; Shares Outstanding: 1,632mm)

TEV: ¥2.3t (¥701b Net Debt)

3-month Avg Daily Volume: 6.1mm shares/day (¥6.1b)

Investment Type: Medium term value

Investment Horizon: ~12-18 months

Summary

Bolstered by secular demand tailwinds related to several end markets, Toray Industries (3402 JP) screens an attractive medium term investment.  In particular, Toray is the world’s largest maker of carbon fibers, which are increasingly being used in a multitude of products, ranging from aircraft to automobiles.  Trading at ~12x my base case FY19 eps I view the stock as quite cheap.  Assuming the stock trades at ~16x FY19 eps the stock is worth ~¥1,350/share, about 35% above the last sale.

Why This Opportunity Exists

I believe a main reason the stock is trading at the current level is management credibility, as Toray has set aspirational goals for 2020 that consensus clearly does not view as realistic.  To wit, sell side consensus is calling for fiscal year 2019 operating profit of ¥186b, 26% below Toray’s formal guidance of ¥250b.  Additionally, I believe another key reason that the shares have lagged is concerns relating to the commercial aircraft cycle, given Toray’s carbon fiber exposure to next gen programs like the 787.

Valuation

-          Base Case: ¥1,350/share (+35%) – ~16x FY19 (March FY end) base case eps (~¥83).  Over the last 5 years Toray has traded in a p/e range of 12x-20, with a median mult of 16x.3x

-          Down Case: ¥850/share (-15%) – ~13x FY19 (March FY end) down case eps (¥65)

-          Bull Case: ¥1,600/share (+60%) – ~16x FY19 (March FY end) P/E assuming the company hits its FY 2019 target of ¥250mm operating profit

Thesis

The main tenets of my long case for Toray are:

-          Several of their business segments will benefit from secular demand tailwinds.  Notably, Toray is the global leader in carbon fiber manufacturing.  As has been written about extensively, next gen aircraft from Boeing (787) and Airbus (A350) are using exponentially more carbon fiber than their predecessors.  Boeing, for instance, is ramping production on the 787 to 12/month, and is currently studying whether to increase rates to 14/mo later this decade.  Additionally, Toray produce carbon fibers for automobiles, and views this as an area of growth over the next several years.  Toray competes with suppliers such as Hexcel (HXL) and Teijin in the carbon fiber market.  Toray aims to grow Carbon Fiber operating income at a high teens rate per annum through FY19.

-          Strong market position in core business such as their Fibers and Textiles business.  Toray enjoys dominant presence worldwide in textiles, with global operations.  Recently, they have signed a 3^rd strategic partnership with UNIQLO, and is aiming for the deal to entail ¥1.0t cumulatively in business over the 5 years of 2016-20.  Overall, Toray believes they can grow operating income at a ~10% per annum through FY19.

-          I believe consensus is setting a low bar for Toray.  Despite laying out an FY19 operating profit goal of ¥250b, the sell side consensus estimate remains at ¥186b, 26% below guidance.  Should management come anywhere near hitting their target, consensus estimates will need to go materially higher.

-          Toray’s Life Science business represents only <2% of operating profit, though clear long term upside optionality exists based on several products/initiatives.  For instance, Toray recently obtained approval from the US FDA to start phase 1 clinical trials in the US for cancer treatment TRK-950 that the company developed. TRK-950 is a monoclonal antibody preparation that binds to and attacks cancer cells, and the company said it is aiming to obtain approval for it as a revolutionary medical treatment for cancer.

-          I believe the stock is cheap – Toray trades at ~12x FY19 eps.  Over the last decade the stock has trade at a median multiple of ~18x 1 year fwd eps, and ~16x 2-year fwd eps.

Business Description

Some brief history on Toray per JP Morgan:  Mitsui & Co. established Toyo Rayon in 1926 to manufacture the synthetic fiber rayon, and the following year Toyo Rayon began spinning rayon yarn at a plant in Shiga. Toyo Rayon began making nylon in 1951 and polyester fiber in 1958 after signing technology licensing agreements with Du Pont and ICI, respectively.  Rayon production ended in 1963 and Toyo Rayon expanded into new products, including polypropylene film (1963), ABS resin (1964), artificial leather Ecsaine (1970), and carbon fiber (1971). Toray Medical was established in 1980 and the company entered the pharmaceuticals/medical products business.  In 1990, Boeing approved TORAYCA carbon fiber as the primary structural material for the B777. In 2006, Toray entered into an agreement with apparel retailer Fast Retailing to develop a strategic partnership. This led to the development of HEATTECH, AIRism, and other functional apparel materials that became the driving force of the textile business. The company name was changed to Toray in 1971.

Toray operates under five business segments.  Brief descriptions of each listed below:

1)       Fibers & Textiles – Key products include nylon, polyester, and acrylic yarn/thread/spun yarn and woven/knitted materials; non-woven fabrics; artificial leather; and apparel products.

2)       Performance Chemicals – Major products include acrylonitrile-butadiene-styrene (ABS) resin and molded products, polyolefin foam, polyester and polypropylene film, and precursor substances for pharmaceuticals and agrochemicals.

3)       Carbon Fiber Composite Materials – The main carbon fiber products are composite materials and molded products.  The two types of carbon fiber are polyacrylonitrile (PAN) and pitch, with the former made from polyacrylonitrile feedstock and the later from oil or coal pitch. PAN accounts for the bulk of carbon fiber manufactured, because of a good balance between performance, manufacturing cost, and ease of use. Toray manufactures PAN carbon fiber, and combined with the acquisition Zoltek, has the top share of the global market with some 40%.

4)       Environment & Engineering – This segment handles condominiums, industrial machinery, environmental equipment, water treatment membranes, and construction materials, as well as integrated engineering.

5)       Life Science – The two main businesses in the life science segment are pharmaceuticals and medical devices, and the main subsidiary in the segment is Toray Medical, which focuses on medical devices.

Risks

The most notable risks to Toray are:

-          Volatility in both f/x (¥1 rise against USD cuts annual operating profit by ~¥1.0b) and raw material prices

-          Deterioration in next gen aircraft demand, notably in Boeing 787 build rates

-          Degradation in carbon fiber prices

-          Execution of the company’s cost savings plan

-          A deterioration in LCD and related product demand

Financial Overview

Catalyst

- Earnings reports, as consensus remains well below management guidance

- Carbon fiber contract wins in auto

- Relatively resilient aircraft demand