#toray

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).

Trust in Japan? Strangled by sontaku 忖度

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Trust and Japan used to go hand in hand. It was a hard earned reputation.  A mining executive once told me that “when you sign a contract with the Japanese, that is the contract. When you sign a contract with the Chinese that is the beginning of the negotiations.” Hardly a subtle difference. Yet here we are in the last few years where a plethora of scandals from Japanese companies have come to light. Houeshold names too – Olympus, Toshiba, Kobe Steel, Subaru, Toray, Nissan, Mitsubishi Motors, Takata, Mitsubishi Materials, Asahi Kasei, Obayashi, JR Central, Nomura etc etc. It is almost as if there is a coming-out of sorts so the crimes are somewhat diluted in the midst of others. Syndicated scandals? Expect more to come out. Perhaps the worst part about it is the limp wristed approach by the regulators. ‘Sontaku’ (忖度) in Japanese is a word meaning ‘glossing over’ which is exactly what the regulator is doing over scandals involving household names. Hear no evil, see no evil, speak no evil.

In October I was invited to give a lecture to 70 bureaucrats at the Ministry of Finance’s attack dogs – the Financial Services Agency (FSA) and the Securities and Exchange Surveillance Commission (SESC) on foreign perceptions of Japan’s handling of corporate  crime. In the interests of objectivity the first slide pointed to how no corporate governance system is perfect citing the minefield of foreign corporations caught up in bad behaviour – VW, Petrobras, Parmalat, HealthSouth, Lehman Brothers etc etc. I also highlighted the sentencing of executives who commit crimes – many received lengthy jail sentences, personal fines while the corporates faced eye-watering penalties.

Ironically much of the crime committed by corporates here is at a relatively pithy level. Instead of billions being massaged into or from the books, Japanese corporates tend to commit the equivalent of falsely submitting a $20 taxi receipt to your boss as a business related expense. One almost could conjure up a scenario that if Toshiba was ever able to make back the money to cover the accounting fraud they’d have broken into corporate HQ in the dead of night to put it back in the safe.

I touched on Kobe Steel which conveniently broke the news that it had falsified the true contents of its products to customers. While pointing out such behaviour was regrettable a chart which showed a heavy shorting of the stock on the day it announced it to its duped clients displayed the bigger problem. A question was asked directly to the regulator – “do you intend to investigate the heavy short selling of Kobe Steel stock 3 weeks before the company announced this to market?” No answer.  The following slide showed that a person that was able to short the stock 3 weeks before the announcement would have cleaned up a tidy 60% profit. Again no plans to investigate the insider trading. Why bother having the FSA if it is a toothless tiger?

The following slide showed the types of fines dealt to both the broker (Nomura was a regular feature in the leaks) and the investor (at the time Chuo Mitsui Asset). The fines were the equivalent of $500 and no suspension of license was pursued by the regulator, When the following slide that compared it to the types of fines meted out to foreign banks – lengthy jail terms, lifetime suspensions and monster fines in the the millions and billions jaws didn’t so much drop but celebrate the idea “thank God we live in Japan”. Truth be told the FSA did punish one dying asset manager $150mn but that is an exception. That is the problem. It is too conditional where convenient.

Rolling onto the next slide the discussion looked at how ‘sontaku’ was a problem. Whereas the FSA & SESC heavily pushed for license revocation of foreign investment companies that it found to break rules, it let off all the domestic companies that had ‘brand names’ to protect. What message is the regulator sending if local corporations know they can pretty much get away with anything. In what way is that a fair system? If foreigners will be turfed on a whim then why do the locals get special protection?

When looking at agency funding, the FSA was put up against the US SEC and Australia’s ASIC equivalents. The US was there for illustrative purposes. Yet Australia was the market that made the point clearest. Despite having a total market cap 5x the size of Australia and 30% more listed companies, Japan spends 20% less than the antoipodeans. Even worse it had fewer numbers of staff and its budget was shrinking.

When analyzing market surveillance, in 2014 the Aussie market issued 36,000 speeding tickets (alerts to potentially suspicious trading). The sophisticated systems are designed to catch any wrong doing. The Japanese issued around 180 speeding tickets. I suggested the FSA go cap in hand to ASIC and the ASX and ask if they can buy the software off the shelf. Safe markets attract capital because all actors feel adequate protections are in place to prevent crime. Higher liquidity attracts more liquidity. It is a win win.

Several years ago the fanfare of the Corporate Governance Code was thrust into the faces of the intenational investment community that Japan Inc was changing. After visiting multiple staff inside the FSA and the TSE there is absolutely no pulse of proactively to be seen anywhere. Even my slight nudge to get the FSA to tap the shoulder of the TSE to suggest listed corporates provide English language materials to encourage more transparency for foreign investment met with the response, “it might help if you spoke directly to the Deputy PM & Minister of Finance Taro Aso.”Not a word of a lie.

How can the Japanese authorities look to appropriately handle a slew of corporate scandals if the encouragement of English language documents requires someone (a gaijin no less) outside the agency to ask the Deputy PM to suggest it back down to them. It is an embarrassment.

In closing perhaps we can look to these corporate scandals breaking out as endemic of a greater underlying problem. While the knowledge that the regulator is likely to do next to nothing provides mild comfort, the reality is that Japanese companies have been strangling themselves for decades. The corporate fabric is fraying. The world is far more competitive than it was. For Japan to assert its ‘quality and/or engineering gap’ dominance now means profits likely suffer. In order to  get around that hurdle it seems that to maintain profit margins, corporates now lie about specifications hoping a history of ‘trust’ and ‘time honoured’ traditions can keep the bluff going. As mentioned earlier the scale of the ‘cheating’ is pitiful yet the shame it brings is multiples larger.

Japan’s cultural rigidities are on full display. Unfortunately they couldn’t arrive at a worse time. Clumps of companies confessing crimes to soften the collective blow is only the start of many more. I suggested in my speech that the authorities introduce a 3 month amnesty period for companies to fess up to any wrong doing. That way they can clear the decks and make it clear that any wrong doing after that date will be met with harsh repercussions. Of course it won’t happen but expect the list of companies above to have many join them at the table of shame.