Stock Review: Showa Denko

Kevin Smith, of Delft Partners and portfolio manager of the TAMIM Asia Small Companies fund, highlights one of the stocks in the Asia Small Companies portfolio.  Showa Denko K.K. (SDK) is one of the largest chemical groups in Japan with history that dates back to 1908, the group also manufactures and markets electronic and aluminium products.

Net sales break down by products is as follows: petrochemicals 30.8%, chemical products 16.8%, electronic components 15.4%, aluminium products 12.4, inorganic products 8.3%. In recent years SDK has taken steps to diversify away from the chemicals and metal fabrication business into the field of electronics.  SDK has a market leading product in the form of silicon carbide epitaxial wafers, a business segment that is expected to grow at a compound annual rate in excess of 30%, this business makes SDK an exciting and undervalued investment opportunity.

6 Business Segments

Accounting, Strategy and Governance Comments

Accounting

1. Full compliance with local standards and moving towards IFRS via membership of the Financial Accounting Standards Foundation in Japan which is a body that is adjusting the local practices in Japan in accord with international standards.
2. The Company has a policy of good transparency with investors an excellent Annual Report which from 2017 was combined with their corporate social responsibility reporting.  The documentation provided to investors is among the highest standard of any company in Japan.
3. The local entity of KPMG undertakes the auditing function at SDK, there have been no qualifications issued with respect to audited accounts.

Strategy

• The development of silicon carbide (SiC) epitaxial wafers is a transforming event for SDK, they can move away from highly cyclical earnings generated by their traditional chemical and metal fabrication businesses and generate an earnings stream underpinned by strong compound growth.  Operating income from SiC epitaxial wafers increased by 357% in 2018.  SDK has provided forecast growth for SiC Epitaxial Wafers in excess of 30% per annum compound out to the year 2025 and expect to become the largest independent producer in this field with global market share of 30%.  This is a bold target which appears to be within the reach of SDK and makes the company look outstanding value on 5.3x current and 4.3x prospective earnings.  SDK is an excellent example of hidden technology residing in a traditional cyclical business. When compared with mainstream silicon based semiconductors, SiC-based power semiconductors can operate at higher temperatures, higher voltage and high current conditions while conserving energy.  These attributes allow device manufacturers to produce smaller, lighter and more energy efficient power control modules. ​

• ​The year 2018 was a difficult year for SDK’s traditional businesses, the company was able grow revenues by 27.1% and has a (probably conservative) forecast in place for the current year of 10.8% revenue growth.  In 2018 operating income increased by 131%, the company forecast for 2019 is a modest 8.2% earnings per share growth.  The management of SDK have a clear strategy for managing the various segments of the business in the form of “Enhance, Grow and Change”.  The “Enhance” category are segments that should demonstrate improved profitability, specifically petrochemicals, industrial gases and basic chemicals.  The “Grow” segment is based around SiC epitaxial wafers, a business with high growth and high profitability.  The “Change” segment applies to aluminium and ceramics, where speciality high value added products will be developed against a backdrop of stable profitability in those categories. 
• Geographic strategy.  SDK plans to develop more production bases in the Asian region, they currently have aluminium production in Vietnam and Thailand.  SDK has signaled a plan to be acquisitive in Europe, in the field of automotive design and weight reduction. 

Governance

1. Since 2016 SDK has been included in ESG indices operated by FTSE and MSCI, in particular the FTSE Blossom Japan Index and MSCI Japan ESG Select Leaders for companies demonstrating strong ESG practices. SDK is also included in the MSCI Japan Empowering Women Index which includes the companies that best demonstrate gender diversity. In October 2018 SDK was included in the S&P/JPX Carbon Efficient Index, the company has been diligent in reducing carbon footprint in recent years and inclusion in that index is a recognition of those achievements.
2. In December 2018, the company announced a share repurchase programme with the aim of enhancing returns to shareholders and improving capital efficiency. SDK made early repayment of ¥24 billion in subordinated loans in a review of the capital structure of the business.
3. Full compliance with the Governance Code in Japan.  The Company has three outside directors on the Board comprising nine Directors in total. The Company holds fourteen Board Meetings per year and has applied term limits for the Directors.

Value, Momentum and Quality Comments

​SDK has consistently scored exceptionally well in the value category of our scores and is currently in the top 3% of all companies in the region assessed for value.  SDK has gradually improved in the quality element of our scoring, the company has ambitious and achievable targets for return on equity which should see the quality scores continue to improve. 

During the past eighteen months, the 2020 eps forecast has increased from ¥480 to ¥900, the wave of upgrades by analysts peaked in November 2018 when the 2020 eps forecast reached ¥1,100.  The subsequent downward adjustment in eps expectations is responsible for the decline in the momentum and overall VMQ scores, however, that still leaves SDK comfortably in our top quintile of companies in the region. 

Conclusion
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SDK is a good example of hidden technology by developing the market leading SiC epitaxial wafers within a traditional petrochemicals and aluminium fabrication business they have been overlooked by the market and trades on a forward multiple of 4.3x earnings.  The management of SDK have set themselves an ambitious target for return on equity and have defined the business into three types of management “Enhance, Grow and Change” that should see them achieve that goal and achieve substantial positive returns for shareholders.