#787

Nippon Carbon – hidden black diamond

Nippon Carbon (5302) is a hidden gem. CM stumbled over this company in 2012. A decade prior to this, one of the commercial jet engine makers spoke of a new space age technology on the horizon. He mentioned there was a secret sauce that went in to make ceramic matrix composites (CMC). However, because of the secretive nature of R&D, the supplier wasn’t disclosed. So 12 years after that meeting and years of trying to hunt down this miracle ingredient, CM stumbled into meet Nippon Carbon to discuss its mainline graphite electrodes business. In the lobby, a dusty glass trophy cabinet revealed a mysterious cotton reel with black fibres wrapped around it (pic above).

Needless to say on application, the investor relations director told CM it was Hi-Nicalon which goes into CMC! Bingo. Forget the mainstay graphite electrodes! CM found the missing link. In the process, he told CM that the company had spent 40 (yes, forty) years developing it. Who does that? Only in Japan. What the material does is enable jet engines to burn hotter which means longer life, more efficiency with fewer emissions and lower weight. Win, win, win, win.

CFM International (GE/Safran JV) has 8,000 jets (16,000 engines) in the order book. Nippon Carbon’s JV to make Hi-Nicalon was lifted 10 fold in recent years to 10 tons (full capacity will be hit this year) and GE has licensed another 100% capacity increase from Nippon Carbon to produce locally in the US. It is black gold of another dimension.

What is often underestimated, is that passing new technology in commercial aerospace is way harder than seeking new drug approval in the pharmaceutical world. A new drug might have drowsiness as a side effect. A jet engine can’t have that level of failure risk. So now that this product is already flying in the B737 MAX and A320neo, the technology will be rolled out on all new commercial jets from this point. The next generation Boeing 777x will sport Hi-Nicalon in its GENx engines which will use about 5x the material than a B737. 340 orders for the B777x have already been placed by airlines. Deliveries begin in May 2020. GE will be the only engine choice on 777x.

Nippon Carbon is the sole CMC source ingredient producer for GE, the world’s largest jet-engine/turbine maker. The wonderful part about that is the fact that no substitutes will replace it. There are no competitors because in aerospace, quality of material matters. Only source suppliers get a look in. Nippon Carbon owns 50% of the NGS Advanced Fibers business where Hi Nicalon sits. GE & Safran own 25% each of the remainder. 

Ube Industries (4208) has Tyranno-fiber and is partnered with Rolls-Royce. Yet it is tiny part inside a business dominated by construction cement.

Nippon Carbon shares were hit hard the day before 1Q earnings on the back of a downward revision by competitor Tokai Carbon (5301). This is what happens when stocks have no official stockbroker coverage and get tarred by having “Carbon” in the name.

Nippon Carbon’s 1Q results came out after the close the following day, reporting a 46% increase in sales vs last year and a 168% increase in EPS. Full-year earnings were left unchanged.

Nippon Carbon mentioned tougher pricing position in graphite electrodes like Tokai Carbon, but the volume side appears healthier. It would not disclose customers but said demand was still healthy.

Sadly, disclosure is not a strong point of many Japanese companies and Nippon Carbon is no exception. Yet Japanese retail investors get hysterical over homegrown technology winding its way onto globally famous products. Toray (3402), the massive textile manufacturer, signed an exclusive supply contract with Boeing for the 787’s carbon fibre needs. The share price did the following. The slump came on the back of GFC.

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Toray’s stock trebled. Carbon fibre was only 12% of its earnings at the time. It is around 20% today. The rest of the Toray business was low margin textiles. Buying Toray to get exposure to 787 was like buying a fruitcake to get some raisins.

Osaka Titanium

Osaka Titanium Technologies (5726) had an even more bonkers reaction to the 787 which was loaded with titanium parts. Coupled with a global production shortage of titanium sponge and sharply higher contract prices, OTT shares jumped 28x! From relative obscurity, the stock became the most liquid stock in Japan. This is what happens when the small-cap retail lunatics are running the asylum.

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Based on Nippon Carbon’s FY2019 EPS forecast of ¥1,148 it trades on a 3.6x PE ratio. It trades below replacement cost and invested capital. CM thinks that if it manages to hit 20t of Hi-Nicalon by 2020 its EPS could approach ¥1353. That would put it on 3.05x.  Writing in an Armageddon scenario (literally nuking the core graphite electrode business) of ¥210 EPS the stock would be trading at a trough 19.6x. Normally industrials in a downturn would face losses or 50-100x multiples. 

To be honest its biggest problem is that the Nippon Carbon has such woeful marketing of itself. A visit to its Tokyo HQ reveals a 1950s lobby. It doesn’t spend a lick on itself which is also a relief. No frills. It is a proper engineering company. Unlike Toray and Osaka Titanium (at the time), Nippon Carbon has no official broker coverage meaning it remains in obscurity.

Hi-Nicalon is truly revolutionary. It is a once in half-a-century product. It will become the defacto standard jet engine material. At the moment it stands at around 5% of revenue and minimal profit as it ramps up but by next year it could be as high as 15-16% in a few years, which maybe conservative. Depending on the demand for aircraft, it may head higher. It is worth noting at the time of GFC, airlines many upgraded to more efficient aircraft to lower operating costs. Leasing companies obliged. That isn’t to say that Nippon Carbon is isolated by any means but the product itself is unique which provides relative stability.

Worth taking a long hard look at the story. This is a game changer material. We only need for the retail investor to cotton on to this story and let the Pride of Nippon push it to absurd valuations. We have the history of Toray and Osaka Titanium. At 3.6x it is already at absurd valuations (just at the opposite end).

Boeing 737 MAX-8 piñatas

The loss of life through any accident is tragic. Make no mistake. Yet if aviation authorities (AA) across the world were truly worried about the safety of the Boeing 737 MAX-8 they’d have grounded it after accident #1 when they’d learnt about the faulty AOA sensor issue. They could have issued Boeing with an immediate action to fix it. They didn’t. Just let the FAA do its work and adopted its resolutions. Now it appears they’ve merely followed the followers. It is as if they’ve felt social media pressure to cover their behind so as not be the last AA do so. It’s irrational. Think of it as aviation piñatas. Bashing with a blindfold.

China was the first to ground the plane. The stunt was in part a trade related issue because the FAA airworthiness directive wasn’t just issued inside a cornflakes packet and as the strictest aviation authority should carry weight. The FAA has said the evidence is not broad enough to justify a ban.

Having been a former aerospace analyst, this is the first time in a very long time CM can remember that a virtual global ban was put on any aircraft type. When Qantas flight QF32 (an Airbus A380) had an uncontained engine failure which ruptured the wing tanks and severing hydraulics, the airlines grounded their own planes as a safety measure, not the authorities. Singapore Airlines suspended its A380 flights for one day before resuming operations.

When AA587 crashed in Queens after the tail and engines sheared off, Airbus A300s weren’t summarily grounded. When AF447 crashed into the ocean off Brazil, A330s weren’t grounded as a precaution.

The Boeing 737-400 series had inert fuel tank issues where near empty scenarios could cause the vapor to ignite in the centre tank and lead to a deadly explosion. Several did explode. Some in the air. Some on the tarmac. These planes weren’t grounded. World aviation authorities, like Australia, issued advisories on how to ensure it doesn’t happen. Not knee jerk copy thy neighbor responses.

The list of 787 airworthiness directives (from fire issues, wings, flight controls to landing gear) stands at 52. FIFTY TWO. Sure a 787 has not crashed yet but where have the authorities been trying to ground the type until it has no ailments at all? Do they need a crash to rally into action? Or do they look at the issue on its individual merits? The 737 can fly without this AOA safely, which is why the FAA still allows its operation.

This seems to be follow the pattern of board governance today. Aviation authorities reacting with emotion, not data. Seemingly acting for fear of a twitter backlash rather than applying common sense to a problem and shutting out noise. Are social media trolls experts on aviation matters? Yet another “it’s better to be morally right than factually so” argument it would seem.

Maybe the biggest qualification is whether airlines ground them because passenger refuse to board 737 MAX-8s where they’re allowed to operate. However most passengers don’t look at the “registration plate” affixed to the top of the front left hand door jam as they board to see what type of plane they’re on. They don’t look at the safety placard in the seat pocket. Most certainly don’t pay attention to the cabin attendants during the pre flight safety instruction.

By the way, flight AA293 from Miami to Washington DC is scheduled to land 11 minutes early today. It’s a MAX-8. Passengers in America are prepared to put their faith in the FAA not the whims of social media activism led policy to unnecessarily ban something to appear virtuous.