Regular readers of my articles know that I’m not a “valuation doesn’t matter” sort of investor, but for every rule, there are exceptions, and Japan’s Shin-Etsu Chemical (OTCPK:SHECY) is one where I’m often tempted to relax my approach to valuation. Not only does Shin-Etsu have a strong track record where operational factors are concerned (margins, returns on capital, etc.), the shares have comfortably beat its sector peers and come close to beating the S&P 500 over the past 15 years, while handily beating the index over the last 20 years. What’s more, this is a company that continually reinvests in itself; it’s never the first to pursue the hot new thing, but it generally ends up being one of the best operators where it chooses to compete.
The PVC market is starting to look quite a bit stronger, and that should help offset some potential turbulence in the semiconductor silicon business. Longer term, I think Shin-Etsu will continue to grow revenue at around 3% to 4%, with healthy double-digit FCF margins driving mid-single-digit FCF growth. Shin-Etsu shares aren’t inarguably cheap here, but it’s a borderline “buy” call and definitely one to watch as meaningful pullbacks do occur from time to time.
Between a strong U.S. housing market and supply issues at two major U.S. producers, the U.S. PVC market is looking quite a bit better. PVC sales volume has been accelerating, rising 5% yoy in June, 8% in July, and 9% in August, while both Formosa Plastics and Westlake Chemical (WLK), representing about 44% of the U.S. market, have recently had significant production issues with their facilities.
As you might imagine, this is good for prices. Export prices have almost doubled from their March lows to around $1,000/t, and contract prices were already back to pre-COVID-19 levels in August, before going up another $160/t in September. The $0.08/lb price hike in September is an uncommonly large increase in a single month, and I don’t expect these conditions to persist, but it’s good news for companies with functional PVC capacity in the U.S. today. It’s also not just a U.S. phenomenon. As the low-cost producer, the U.S. generally sets export prices, and between stronger demand (in import markets like China) and more limited supply, it looks like Shin-Etsu will enjoy $1,000/t-plus pricing for its PVC exports from Japan for the first time in years.
There’s another positive kicker to the U.S. PVC story for Shin-Etsu. Earlier this year, the company saw its new ethane cracker go live in Louisiana, and this new plant allows the company to significantly enhance its profitability. Market prices for ethylene over the past three to five years have often been around $900/t, but the ethylene cash costs from this facility will almost certainly be below $500/t (and possibly far lower than that), so it should provide a very welcome boost to profits.
If there’s a near-term source of risk to Shin-Etsu, it’s probably the large and lucrative semiconductor wafer business. This is an exceptionally profitable business (recent operating margins around 40%), and it generates around 40% of Shin-Etsu’s operating profit, but I see a modest risk of lower wafer demand over the next couple of quarters. Chip demand is still quite strong, STMicro (STM) just upgraded guidance for the third quarter, but a lot of producers stocked up on wafers earlier in the year on fears that COVID-19 would create lasting supply interruptions. With that, I see some modest risk that inventory adjustments will lead to some volatility in near-term demand.
On a more positive note, demand for photomasks and photoresists used in semiconductor production should provide a boost for Electronics & Functional Materials, as should recovering auto production (rare earth magnets) and ongoing growth in 5G deployments (quartz cloth).
Looking ahead a bit, Shin-Etsu licensed technology to produce GaN-on-silicon from Qromis earlier this year, and GaN demand should continue to accelerate, given its power efficiency and other cost/performance criteria for high-end wireless applications (RF chips), as well as photonics, power, and sensing applications. Growing GaN crystals on top of silicon is an excellent way for Shin-Etsu to leverage/retrofit its existing 200mm wafer capacity, and management believes the technology is scalable to 300mm.
One question I do have is whether Shin-Etsu will create a presence for itself as a wafer provider for silicon carbide (or SiC). SiC is one of the most promising technologies for advanced power semiconductors, and companies like Infineon (OTCQX:IFNNY), ON Semi (ON), and STMicro have gone to great lengths to build up internal capabilities, likewise, II-VI (IIVI), which had already positioned itself as a substrate provider, has recently added capability to make SiC chips/devices themselves.
I know that Shin-Etsu already has some capabilities in SiC, as they make powdered silicon carbide meant for use as an abrasive. I also know they have IP pertaining to growing silicon carbide crystals. What I don’t know is if they have plans to expand into wafer production. I don’t see why they wouldn’t, but I haven’t seen any direct communication on this subject.
Recent strength in PVC should help offset any wobbles in the semiconductor wafer business, and I don’t really expect that volatility to last – I think the outlook for chip production in 2021 (logic and memory) is looking pretty good. I also think Shin-Etsu should see improving demand from a recovery in auto production and ongoing growth in electronics (including smartphones).
Looking at the long term, my year-by-year modeling assumptions work out to a long-term revenue growth rate of around 3% to 4%, with FCF margins in the mid-teens supporting a modestly higher mid-single-digit FCF growth rate.
Valuation is not quite as good as I could hope. On a cash flow basis, the shares look priced for a mid-to-high single-digit annualized return. I do see some upside on an EV/EBITDA basis, but the 10x multiple I use is well above the industry average (closer to 7.5x); I believe the premium is justified, given Shin-Etsu’s considerably superior margins, but investors do well to be skeptical of “it’s different this time” valuation arguments.
Closer to the mid-$20s, buying the Shin-Etsu ADRs would be a no-brainer for me. At today’s price, it’s more of a borderline call. I think the demonstrated excellence of execution argues for being a little more lenient on valuation, but I still do believe valuation matters, and with the shares within 5% of their all-time high, I can’t say the Street is exactly ignoring this name now.
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