Large chemical companies with mid-teens operating margins aren't very common, but Japan's Shin-Etsu (OTCPK:SHECY) has managed it for some time and that has helped the stock outperform both the Nikkei and the S&P 500 over the last five years. With leading positions in PVC, silicones, and multiple markets serving the semiconductor space, I believe Shin-Etsu is looking at a relatively favorable revenue and margin outlook for at least the next few years.
With both the Tokyo-traded shares and the ADRs up around 70% over the last year, a lot of the positives about this company are in the stock. That said, the shares don't look particularly expensive on a DCF basis and improving conditions in the wafer market could drive some near-term upside. I'd rather see a better entry price, but Shin-Etsu's all-around quality argues for a spot on a watch list, and I wouldn't be in a rush to sell if I owned the shares.
A Diverse Set Of Businesses With A Common Thread Of Leadership
Shin-Etsu is involved in a wide range of chemical businesses and markets, but across those platforms, there are a few common threads. Shin-Etsu is often at or near the top in terms of market share, and even when they're not the top in share, they're typically the best in terms of margins.
Shin-Etsu is also uncommonly committed to running its businesses along similar principles, with a focus on recruiting and retaining good workers that allows the company to operate with lower staffing levels than many of its peers. Shin-Etsu is also disciplined, eschewing growth for its own sake, prioritizing margins, and trusting that it can afford to wait for markets to develop before entering and gain share later through execution.
The largest contributor to revenue is the PVC/chlor-alkali business. Contributing about one-third of the company's revenue, Shin-Etsu's PVC business is also the largest in the world, with roughly one-third more capacity than its next-largest rival (Formosa Group). More than two-thirds of the company's capacity is located in the U.S., where it takes advantage of access to cheaper natural gas inputs (a meaningful amount of global capacity is based on naphtha), and the company is building a large ethane cracker in Louisiana that will support better margins.
Shin-Etsu is also a leader in its next-largest business (close to 20% of revenue), silicon wafers used in the production of semiconductors. Shin-Etsu is basically neck-and-neck with SUMCO in market share terms, and the two control about 60% of the industry's capacity, with Shin-Etsu holding an edge in 300mm capacity.
The electronics and functional materials business generates around 15% of revenue, but at above-average margins (contributing over 20% of total operating income). In some ways, I think you could argue this business is a good microcosm of Shin-Etsu's overall philosophy - prioritize leadership in markets that reward innovation, allow for moats, and can support healthy margins and growth.
Shin-Etsu has only been in the semiconductor photomask market for about a decade, but the company has been steadily chipping away at Hoya's (OTCPK:HOCPY) market share and it generates about 4% of overall operating income. In the interest of preserving margins, the company has no current plans to enter the EUVL market, but will re-evaluate if and when that market develops - arguably saving the company a lot of R&D for a market that may not live up to initial hopes.
Shin-Etsu also enjoys good share in specialized markets like semiconductor photoresists (7% of op inc), rare earth magnets (6% of op inc), electronics packaging (3% of op inc), and synthetic quartz (2% of op inc) - all of which are niche markets where newcomers would have a hard time gaining traction and where the products are basically "mission critical" for customers, but not particularly large parts of the final bill of goods - meaning they're often willing to pay up for Shin-Etsu's products rather than risk downtime/product quality.
The remaining quarter or so of Shin-Etsu's revenue comes from its silicones business (15%) and specialty chemicals (9%). The silicones business is an interesting one - although Shin-Etsu is a very distant #4 behind Dow (DOW) (Dow Corning), which has almost one-third market share) and is slightly smaller than #2 and 3 (Momentive and Wacker Chemie), the company's margins are roughly double the second best player's, as the company specializes in high-quality products and works closely with customers to meet their particular product performance needs.
While the specialty chemical business is the smallest, the margins are solid, and the company enjoys strong share in markets like methylcellulose, hydroxyethyl cellulose, polyvinyl alcohols, and synthetic hormones (often used in pest control).
Pricing Power In Wafers?
Pricing leverage has been hard to come by in the wafer business for the last decade, but that seems to be changing. Shin-Etsu management has basically said that they're booked up and already starting to allocate capacity to customers, and SUMCO is in a similar situation. At the same time, semiconductor manufacturers are offering higher prices to ensure their supply. That could ultimately lead to double-digit price increases for 2017 and at least some momentum continuing into 2018.
While higher prices are good news for Shin-Etsu (and will produce strong incremental margins), Shin-Etsu and SUMCO have a vested interest in keeping price hikes from getting out of hand, lest "tier 2" suppliers start adding too much capacity. Should Shin-Etsu decide to add capacity, it should have a relative advantage; it often takes its rivals up to two years to add capacity, but Shin-Etsu has done it in under a year in the past.
Leverage In PVC And Silicones Should Be Durable
Shin-Etsu's PVC business generates margins below the company average, but it's still a well-run business relative to its peers in the sector. That new ethane cracker should improve the company's supply costs, and the ongoing recovery in the housing market is a positive underlying driver given that about 80% of PVC production finds its way into construction. Stimulus to infrastructure could help this business further, but weak oil prices are a threat as it reduces the cost advantage to those producers in North America that can take advantage of abundant low-cost natural gas supplies.
As is the case in many chemical markets, Chinese manufacturers are making inroads into the silicones industry, with BlueStar already closing in on 10% share. While more Chinese competition is not great news for much of the industry, Chinese production tends to be lower-quality and simply isn't up to snuff to replace Shin-Etsu's products in most applications. With diverse market demand across electronics (including possible adoption in OLEDs), cosmetics, healthcare, construction, transport, and other chemicals, Shin-Etsu should be in a position to grow this business at the global GDP rate (or above) while preserving strong margins.
The biggest threat I see to Shin-Etsu is a sharp slowdown in the electronics sector, and handsets in particular, as about one-third of its wafers ultimately find their way into smartphones and that market likewise drives demand for photomasks, photoresists, and other products. Excess capacity growth in the PVC business and/or a reversal in the housing market are likewise potential threats. While pricing has been strong for over a year, there has been more resistance of late to price increases.
On balance, I'm comfortable with Shin-Etsu's outlook. Higher wafer prices should help an already-very profitable business, and I like the near to mid-term outlook for PVC and silicones. I'm looking for long-term growth from Shin-Etsu of around 4%, with margin leverage and more limited capital reinvestment needs driving high single-digit FCF growth. All of that more or less supports today's price and an outlook for high single-digit annual returns.
The Bottom Line
I do believe that Shin-Etsu is an uncommonly well-run chemical company, but the price largely reflects that. I wouldn't be in a rush to sell if I already owned the shares, but I'd like to see a better price before starting a new position.
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