As a very loose rule of thumb, when I see a company with a solid history of returns on capital, good market share, and a clean balance sheet trading for mid-single digit multiples to EBITDA, I take a closer look. In the case of Hoya Corporation (OTCPK:HOCPY), the debate is pretty simple - will this company ever really grow again or not? Nobody really seems to doubt that the company's traditional technology businesses have likely peaked (at least from a growth perspective), but there's ample doubt as to whether the company can (or will) reallocate its assets and build itself into a growth story once again.
From Healthcare To Tech And Back Again
Hoya has an interesting history. The company's business has long been built around or based on specialty glass, with the company producing optical glass from Day One. In the 1970s, the company took a turn towards technology and that would play a major role over the next three decades.
Hoya built a solid business in electronics and imaging by producing photomask substrates - basically very specialized pieces of glass used in the manufacturing process of semiconductors and LCD screens - and HDD substrates (the glass platters in hard disk drives). While the company does have competitors like Shin-Etsu (OTCPK:SHECY), Asahi Glass, and internal capabilities of large chip and fab companies like Taiwan Semiconductor (NYSE:TSM) and Intel (NASDAQ:INTC), Hoya has generally enjoyed the status of high-margin oligopolist.
At the same time, the company had (and still has) a healthy and growing healthcare/medical business. Hoya is one of the largest manufacturers of eyeglass lenses in the world (#3 behind Essilor (OTCPK:ESLOY)), the leading contact lens company in Japan, and a growing player in intraocular lenses.
The company tried to supplement its business with a deal in 2007 that did not work out so well. Hoya bought Pentax for about $1 billion in 2007, adding the company's digital camera (and related components) and medical device business (endoscopes) to its own. Unfortunately, the company found minimal traction in cameras before selling most of the business to Ricoh in 2011. Likewise, the company's foray into endoscopes hasn't been a tremendous success so far. Even still, the company gets nearly 50% of its revenue from healthcare and medical products today.
Can Tech Come Back? Management Doesn't Seem To Think So
One of the unusual aspects of Hoya is that management is pretty conservative, if not outright dour in some respects. CEO Hiroshi Suzuki is not given to rosy outlooks or bold predictions of future growth. To that end, investors expecting a big turnaround in Hoya's tech businesses should realize that management doesn't seem to share that confidence.
The biggest threat to the company is in its HDD substrate business - a business that produces about one-sixth of the company's revenue and more than 20% of profits. The problem here is a familiar one - PC demand has significantly tapered off. Whether or not phones and tablets from Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF) are the primary reason for the decline, the reality is that new ultrabooks don't seem to be stimulating a big rebound. At the same time, traditional hard drives from Western Digital (NYSE:WDC) and Seagate (NASDAQ:STX) are seeing more and more pressure from solid state drives.
On the photomask side, any investor in an LCD-exposed company like Corning (NYSE:GLW), AU Optronics (NYSE:AUO), or Sharp knows all about how bad that business has gotten. Likewise, the chip sector has seen a meaningful downturn of its own. While other players at different points of the LCD manufacturing cycle are a bit more optimistic about a recovery (including DuPont (DD) and 3M (NYSE:MMM)), Hoya doesn't share that optimism. While acknowledging that chip demand should recover and the increasing sophistication of the chip-making process create some opportunities, management seems to believe that this business will recover and then plateau around 2014. With the photomask and substrate business (as a whole) making up nearly 40% of profits, that's not a trivial issue.
Where Can The Healthcare Business Go?
Hoya Corp. is hardly the first or last Japanese company to see healthcare and medical technology as a key growth market for the future. Whereas Fujifilm and Asahi Kasei have looked to build through M&A, quite a lot of Hoya's business was internally developed. That's not to say, though, that there aren't ample opportunities for the company to use M&A to grow or get more aggressive with its own marketing.
In the eye care area, Hoya has about 10% global share, but considerably higher share in Asian markets (40% or more in many cases). While the market for eyeglasses isn't a major growth opportunity on the whole, better access to healthcare in markets like India and China still represents incremental opportunity here. As for the contact lens business, Hoya is #1 in Japan, but has made minimal efforts to penetrate other markets - I'm not sure taking on Novartis (NYSE:NVS), Johnson & Johnson (NYSE:JNJ), or Cooper (NYSE:COO) in North America is a great idea, but I would think China and India could offer growth.
Management does seem more aggressive with its plans for intraocular lenses and endoscopes. Hoya is #4 globally in IOLs (and number one in Japan with 33% share) and management wants to become the world's number two player (behind Novartis) by 2018. While that's an ambitious and worthwhile goal, it wouldn't represent a huge delta to the company's bottom line numbers (about 5% or so).
As for the endoscopes, Hoya is a sizable player within Japan, but little threat to Johnson & Johnson, Olympus, or Covidien (COV) on the global stage. Management seems focused on changing that - mentioning not only the above-average market growth potential (high single digits to low double-digits for some markets), but also asserting that the company's history in optics makes this a natural area of focus and product development. The opportunity is certainly there - it's a question of whether the company wants to sacrifice the margin for accelerated R&D and really make the sales effort to gain more share in North America and Europe (not to mention emerging markets).
Growth May Be Hard To Find
I like Hoya and it's an uncommonly shareholder-friendly Japanese company (it's relatively easy for investors to get what they need in English). Even so, none of that changes the relatively moderate growth outlook here.
I do believe that recoveries in LCD, chips, and HDDs could improve sales growth in the next year or two, but I have a hard time seeing how the company grows its top line by more than 3-5% over the long term - I see a lot of the company's gains in endoscopes and intraocular lenses being offset by longer-term declines in HDD substrates and some of its photomask businesses. Absent a real leap forward in R&D (or a sizable acquisition), revenue growth looks pretty sedate.
Where I'm less concerned about Hoya is on the operating and cash flow lines. I believe the company will continue to produce free cash flow at a low-to-mid teens clip for the future, with some potential upside if the company can harvest more cash flow by reducing operating costs or capital reinvestments in less-promising tech units.
Couple the low revenue growth and steady free cash flow generation, and free cash flow growth would seem to be on the order of 3-4%. At a slightly better-than-market discount rate (to reward the company's market share and historical returns on capital), that works out to about $22 per share in fair value. Give the company a little more credit for maintaining growth in tech and/or generating better growth in healthcare/med-tech, use a 5% revenue growth estimate, and the fair value moves up to about $24.50.
The Bottom Line
Hoya Corp. is one of those dangerous companies/stocks to me - liking the company (and its management), it's tempting to want to give the company "the benefit of the doubt" and goose up some of the numbers in the model. And to a certain extent, it's easy to spin a supportive story - more advanced chips will require more advanced photomasks and substrates, while aging populations in North America and Western Europe should combine with growing affluence in emerging markets to boost healthcare spending.
That said, I think investors have to be cognizant of the cyclical aspects of the business, the risks of technological change/obsolescence, and the threats to key markets like hard disk drives. What's more, even with a high-end (and in my view, fairly aggressive) estimate of $24.50, it's hard to argue that the stock would be cheap enough to buy today, though that 3.7% yield certainly helps.
I'm keeping Hoya Corp. on my watch list, but I'd need to see a pullback on the ADRs into the teens to get really excited about owning these shares today. On a more positive note, though, I believe most of the risks are to the upside at this point, particularly if consumer tech markets recover more quickly.
Disclosure: I am long MMM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.