Inter-Varsity Stock Research Challenge 2018 Building a ... · Capital who presented Keyence...

Inter-Varsity

StockResearchChallenge2018

BuildingaLeagueofHiddenChampions

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1. Thebookletanditscontentscontaintheopinions

and the ideas of its authors. It is not a

recommendationtopurchaseorsellthesecurities

of any of the companies or investments herein

discussed. The booklet is sold with the

understandingthattheauthorsandtheorganisers

are not engaged in rendering legal, accounting,

investment or other professional services. If the

readerofthisbookletrequiresexpertfinancialor

other assistance or legal advice, a competent

professional should be consulted. Neither the

authors nor the organisers can guarantee the

accuracyoftheinformationcontainedhereinthe

bookletanditscontents.

2. Theorganisersarenot inanywayrelatedtothe

companiesmentionedinthebooklet.

3. The authors and organisers specifically disclaim

any responsibility for any liability, loss or risk,

professional or otherwise, which is incurred as

consequence,directlyorindirectly,ortheuseand

applicationofanyofthecontentsofthebooklet.

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Preface

Impact.

Impactiscreatedwhenonestrivestobeofvalueto

craft insightful research reports on outstanding

companiestoleaveanindeliblemarkofbenefitto

thebusinessandinvestmentcommunity.

ImpactisdeliveredbyWarrenBuffett,longbefore

he was the billionaire Chairman of Berkshire

Hathawayandtheworld’sgreatestinvestor,when

he wrote his research article “The Security I Like

Best”onautoinsurerGEICOwhichwaspublishedin

TheCommercialandFinancialChronicle in1951–

when Buffett was only 20-years old. Buffett’s

comment that “the major portion of growth lies

ahead” for GEICO was audacious; GEICO had

already experienced supercharged growth since

1935inincreasingitsbaseofpolicyholdersbyover

38-foldto143,944andpremiumswrittenbyover

77-fold to $8 million. A trading or speculative

mindset would have resulted in one to sell the

sharesand takeprofit–andmissacritical lesson

aboutvalueinvestingandbusinessbuilding.GEICO

wentontocompoundgrowthevenfurther,to14

million policy-holders and premiums written to

$23.3billion.AsBuffett illuminates theevergreen

wisdom in value investing back then which still

holdstruetoday,“Ofcoursetheinvestoroftoday

doesnotprofitfromyesterday’sgrowth.”Andthe

research article proved instrumental in the years

aheadinimpactingthelong-termcareertrajectory

ofBuffett,whoappliedthebusinessandinvesting

approachoutlinedintheresearchtogoontobuild

the conglomerate Berkshire Hathaway with a

staggering market value of $500 billion, more

valuablethantheannualGDPoutputofSingapore.

Inourfirst inauguralstockresearchchallenge,we

had an uplifting experience assessing the well-

balanced presentations put forth by the

participating teams. The judges crowned Latent

Capital who presented Keyence Corporation

unanimouslyastheinauguralchampion.

They will be passing on the plaque to the next

champion which will be unveiled in our 2nd

IntervarsityStockResearchChallenge.Itwillbeheld

withinthe7th

ValueInvestingSummit(VIS),atwo-

dayeventwhichattractsa1,500-strongcommunity

oflike-mindedvalueinvestorstoparticipateandis

heldon27-28January2018attheSingaporeExpo.

TheChallenge’smissionistopromotethestudyof

value investing, to foster intelligent research on

HiddenChampionsinAsia,andtoallowstudentsto

cultivate the portable lifelong skill-set of critical

thinking ability. This booklet publication is a

culmination of the dedication put forth by the

students to applywhat they have learnt into the

messyworldofrealitybyformingqualityanalytical

research output that has timely relevance and

usefulnesstothewiderbusinesscommunity.

Who are Hidden Champions? Like GEICO and

BerkshireHathawaywhentheywereatanearlier

“Strive not to be a success, but rather to be of a value.”

- Albert Einstein

iii

undiscovered, overlooked and underappreciated

stage in their corporate lifecycle, Hidden

Champions are the indispensable companies

impactingthewell-beingofourdailylife.

Youwear them, the Crizal lens on your eyewear.

Essilor International is the world’s leading

ophthalmic optics company behind the Crizal,

Transition, Varilux lens and the company is

powered by a unique owner-oriented corporate

culture with its inclusive plan to enable 50% of

employees worldwide become shareholders,

compared to 20% currently. Its share price has

compounded2,000%since1986.

You touch them, theASSAAbloy system for your

door.ASSAAbloyAB,thegloballeaderininnovative

door opening solutions to improve our lives

through security, safety and convenience, is up

10,000%since1994.

You cookwith them – peep inside a professional

kitchen and you can find a Rational intelligent

cookingsystemonaNorwegiansubmarine,aSaudi

prince’s yacht, as well as in hospitals and

restaurants around the globe. Rational AG

commandsaglobal54%market leadership in the

world’s professional kitchens that include the

Buckingham Palace and theWhite House, and is

behindthesuccessofsuchfamousculinarynames

asGordonRamsay.RationalAGisup1,000%since

2000.

You may even use them in emergency care

situations,theAmbubagformanualresuscitation

inhospitals,byambulanceservices– in fact inall

kinds of emergency environments all over the

world.AmbuA/S, the companywhommillionsof

patients and healthcare professionals worldwide

dependuponthefunctionalityandperformanceof

itsproducts,isup6,000%since1992.

Essilor,ASSAAbloyAB,RationalAGandAmbuA/S

arethesuccessfulyetrelativelylow-profileHidden

Champions who are focused market leaders in

sophisticated, hard-to-imitate niche products and

valuablecriticalnichesthatare largely invisibleto

the average consumer yet are indispensable and

impactful to our well-being in daily life. From a

value investingperspective, investingatanearlier

stage in the long- termgrowth trajectory path of

theseHidden Champions - in Asia - should prove

rewarding. Entrepreneurs and thewider business

community could also find inspirations in the

Hidden Champions in scaling up their business

models.Thedifferencebetweenabusinessmanand

anentrepreneuristhatabusinessmancanalways

make money for himself but an entrepreneur

focusesonbuildingan idea larger thanhimself to

serveotherswithPurposeandcarrymorepeople

on board the bus. For Buffett-Munger, their idea

largerthanthemselvesismanifestedinthecreation

of a focused vehicle Berkshire Hathaway, which

compounds not onlywealth for shareholders but

moreimportantly,compoundsvaluesandvirtuesas

an exemplary role model in the way business is

conductedandhowthey livetheir life inasimple

andfrugalway.TheBerkshireHathawayBuscarries

morepassengersandsupporterswhogetpositively

energizedtowardstherightdirectioninthejourney

of Life in the increasingly harsh and pretentious

world.HiddenChampionsbelievecommerceisnot

merely about themeasurement of the weight of

profits collected inmultipleclever transactions to

build measurable wealth, fame and power, but

rather it should be defined by the immeasurable

integrity and virtue. Only in the endeavor to

perform first for customers, and serve themwith

the highest possible integrity and character, can

commercefinditsfoundationfordurablebusiness

successandcreatesociety’sabundance.

Afterarigorousselectionprocess,wehavepicked

nine teams toadvance into the semi-finals.Apart

fromit,wehavepickedupadditionalthreereports

fromothergroups.Together,theirresearchreports

areeditedandcompiledinthisbooklet.

WehopethattheunearthingofHiddenChampions

willbeanenduringendeavourforlifelonglearners

in value investing, entrepreneursand the student

community and that this booklet by these

promisingvarsitystudentshasmadeanimpactto

contributetothiscontinuouspursuit.

WarmRegards,

KeeKoonBoonChiefInvestmentOfficer&CEO

HiddenChampionsCapitalManagement

iv

TABLEOFCONTENTS

1. HAMAMATSUPHOTONICSK.K.(TSE:6965) 1

2. MASANGROUPHOLDINGS(HOSE:MSN) 7

3. RYOHINKEIKAKUCO.LTD(TSE:7453) 16

4. NCSOFTCORP(KRX:036570) 27

5. NIHONKOHDEN(TSE:6849) 37

6. BATASHOECOMPANY(BANGLADESH)LTD(DSE:BATASHOE) 48

7. TIMETECHNOPLASTLIMITED(BSE:532856) 55

8. AEROSPACEINDUSTRIALDEVELOPMENT(TSEC:2634) 67

9. XINYISOLARHOLDINGSLTD(SEHK:968) 75

10. TEIJINLIMITED(TSE:3401) 81

11. TOKYOELECTRON(TSE:8035) 88

12. TOTOLIMITED(TSE:5332) 113

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1. HamamatsuPhotonicsK.K.(TSE:6965)

CompanyResearch&Report

QuickStats

Date 15/12/17 EBIT/R&D(x) 1.94

FilingCurrency JPY

EBIT/EmployeeNo.

(USD/px) 40K

SharePrice ��3,730 EV/EBIT(x) 22.8

No.ofShares(Mil) 157.6 EV/EBITDA(x) 15.8

MarketCap(USDMil) 5,214.8 EV/CFO(x) 19.9

DailyValueTraded

(USDMil) 24.3 P/Sales(x) 4.5

GPM(%) 49.7% P/E(x) 25.7

EBIT(%) 17.5% P/B(x) 3.2

NetDebt(Cash)/

Equity(%) -36.25%

VQ1:EV/EBIT/ROE

(x) 1.9

ROA(%) 9.55%

VQ2:EV/EBIT/ROA

(x) 2.4

ROE(%) 12.22%

TeamMembers

Justin is a penultimate year student at Singapore Management

University, specializing in finance. He has experience in global

consumerbankingatCitibank.Heisinterestedincorporatefinance,

M&Aadvisoryandinvestmentbanking.Heiscurrentlythepresident

oftheSMURunTeam&YogiSMU.

Kim Chye is a second-year student at Singapore Management

Universityspecializinginfinance.Hehaspriorexperienceinfull-stack

developmentandasafinancialresearchanalyst.Heiscurrentlythe

vice-presidentoftheSMUEyeInvestmentClub.

Crystal is a final year studentat SingaporeManagementUniversity

specializinginfinance.Shehaspriorexperienceinprivateequityand

venturecapital.SheiscurrentlythepresidentoftheSMUAsiaPrivate

EquityClub.

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BusinessBackground&Overview

IntroductionHamamatsuPhotonics(Hamamatsu)manufacturesand

sells photomultiplier tubes, imaging devices, light

sources, opto-semiconductors, imaging and analyzing

systems.Theseelectronicpartsarethenusedinarange

of products such as medical equipment, test and

inspection systems, microscopes, automobiles, bank

note identification and even in baggage screening

detectorsattheairports.

Albeitthiswiderangeofproducttypes,itsexpertisein

thePhotomultipliertubesegmenthasbeenaffirmedby

the industry with its 90% market share. This market

leadershiphas sincecontributed to the largestbulkof

theirrevenuebyapplication.Medicalinstrumentssuch

as PET/CT scanners for brain research and cancer

detectionisoneexampleofthisapplicationamounting

toanincomeofUSD$332m.

RevenuebreakdownbyProduct&GeographyHamamatsuhas a broadproductmixwith threemain

businesssegmentsbyapplication.Theyare;i)Medical;

ii)Production&Industrial;iii)Imaging&Measuring.

RevenuebreakdownbyGeographyHeadquartered in Hamamatsu City, Japan, it also

operates in Europe, Asia and the US through its

subsidiaries. They include Hamamatsu Photonics

Deutschland Gmbh; Hamamatsu Photonics France

S.A.R.L.; Hamamatsu Photonics UK Limited; Beijing

Hamamatsu Photon Techniques, Inc.; Photonics

ManagementCorp.Theseoverseasventurehavesince

contributedtoUSD$815minrevenueinFY2017.

OverviewofBusinessPerformance2017Hamamatsu has experienced a consecutive 6 years of

profitability growth at a CAGR’11-17 of 4.88%. It is

currentlytradingat¥3805pershare(USD$33.51),with

a P/E ratio of 35.37x, a Market Capitalization of

USD$5,276mandanEnterpriseValueofUSD$4,620m.

InvestmentConsiderationsGlobalisationmeansa rapid sharingand replicationof

information and ideas that often includes business

strategyandproductofferings.Avaluableuniquetraitis

henceone that is able tomaintain its barrier of entry

amidtheintensecompetitionfromacrosstheborders.

Assuch,itisourbeliefthatHamamatsu’sapplicationof

innovativetechnologyhascreatedastrongformidable

competitiveadvantagethroughthefollowing;

- StrongreputationwithintheirhighlynicheindustryHamamatsuhasprovideditsdevicesandmodulesto

several Nobel Prize winning projects such as the

Super Kamiokande. Some of its products are

unrivalledsuchasitsMicroPMTwhichistheworld’s

smallestandlightestPMTwith1/7th

thevolumeand

1/9th

the weight of a conventional module. This

advancement of technology builds trust amongst

stakeholdersandpositionsthecompanytocapture

greatermarketshare.

- EffectiveuseofPatentsApart fromprotectingtheirproductswithpatents,

they have successfully patented a production

method in2015 forMicroPMTs thatcarriesahigh

level of functional accuracywhilemaintaining low

labour requirements. This patent serves two

purposes that is; i) to increase profits and reduce

costs;andii)maintainitsrelativepositionamongst

Hamamatsu’s competitors by eliminating any

imitationpossibility.

Hamamatsu’scomparativeadvantagefurtherescalates

withtheinternationalnetworkthatcomesalongwithits

extensive global footprint. With operations and

recognition built across Asia, Europe and the US,

Hamamatsu is able to effectively capture industry

tailwindswhilemaintainingahighbarrierofentry.

ManagementLeadershipThe company believes in the advancement of

technology–andespeciallyintheartofbeingonestep

aheadinseizingopportunitieswhentheyarise.Founder

Heihachiro Horiuchi pioneered this vision in 1926.

Hamamatsuhasbeenconsistentinworkingtowardsthis

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vision and they have even pursued photoelectric

conversion technology since the 1950s. Today, they

spendanaverageof9.8%(FY12-17)oftheirrevenueson

R&Dastheystrivetomanufacturehigh-valueproducts

thatarebackedbyhighadvancedtechnology.

However,whatcomplementsthisvisionexecutionisthe

current era’s Father-son pair who is the two most

currentCEOsofHamamatsu.

NikkeiBusinessPublicationsdescribedTeruoHirumato

beasocial-orientedleader.Thispersonalityhassteered

Hamamatsutowardsmanycollaborativeopportunities.

ThepartnershipwithToyotaMotorCorporationwasone

ofthemostnotable.HissonAkira,andthecurrentCEO,

places more emphasis on the firm’s technological

advancement. He graduatedwith a Computer Science

degree and led the firm to capture 40% of the global

PMT tubes in 2009, recording a positive profit even

duringtheglobalfinancialcrisiswhichallowedthemto

eventuallycapture90%ofthePMTworldmarketshare

withthefallofitscompetitors.

Thispairhasthuscreatedauniquesynergisticteamwork

thatprovidesHamamatsuanedgeoverothers.Forone,

theyhavelivedouttheirvisionofgoingonestepahead

intermsof technologyaswellasseizingopportunities

(through partnerships). More importantly, they have

successfullyavoided,andthrived,amajorobstacle for

most familybusinesses–effectivesuccessionplanning

andexecution.

Themanagementhasalsorevealedintheirlatest2017

December shareholders meeting that they are

increasing the firm’s transparency along with the

numberofindependentdirectors.Theseeffortscanbe

perceivedasanattempttoscaleupandmoveoutofa

familybusinessmould.Ahigherdegreeoftransparency

alsosuggestsasubstantialdegreeofconfidenceinthe

company’sprogress.

ShareholdingStructurei. Authorized:500,000,000shares

ii. Issued:167,529,968shares(including

10,728,486sharesoftreasuryshares)

iii. Numberofshareholders:24,254

StabilityinShareholdingStructureandfuelforinnovation

Toyota Motor Corporation, which holds 5.3% of

Hamamatsu’sshares,hasbeenactivelyinvolvedinR&D

project with Hamamatsu. There are several joint

researches conducted since 2015. Toyota Motor and

Hamamatsuhasbeenactively involved indiscoveryof

new technique in the field of laser and heating

mechanism for fusion fuelwhich bolsters Hamamatsu

R&D capabilities (Nishimura, Yoneyoshi & Yoshitaka

2015). Such collaborations also show that its major

shareholder, Toyota has vested interests in keeping a

goodworkingrelationshipwithHamamatsuandwillbe

unlikely to divest which brings stability to the

shareholdingstructure.Thisissupportedbytherecent

appointment of Ken Koibuchi, Executive General

Manager/Advanced R&D and Engineering Company of

Toyota,asanindependentdirectorofHamamatsu.

IncentivesformanagementthroughstockholdingsEmployeesofHamamatsuholdacombinedtotalof4.9m

shares (3.2%). This is more concentrated towards the

higher management with the President Akira Hiruma

andVice-PresidentHarujiOhsukaholding2.4mand2m

sharesrespectively,withatrendofthePresidenttaking

up more shares over the years. With higher vested

interests, there will be a greater incentive for better

managementandreducedlikelihoodofnegativeagency

behaviorthatthreatenfirmvalue.Retiringmanagement

suchasformerCEOHirumaTeruo,alsoseetheirshares

proportionatelyreducedovertheyearswhichindicates

a robust system of corporate governance in terms of

stock incentives to allow the focus of the vested

intereststoliewiththecurrentmanagement.

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InsightsintotheCorporateCultureAsaninnovator,R&DiscriticalforHamamatsuandthe

backbone of R&D is employees and knowledge.

Hamamatsuhencehasaverystrongcorporateculture

of taking care of its employee’s health and their

development. Hamamatsu being a company that

innovatestocreatenewproductstoimprovequalityof

life,hasaninteresttohavestrongtiestothesocietyand

being an environmentally safe and responsible

company. It embarks on several CSR projects such as

through education with the “Graduate School for the

Creation of New Photonics Industries” and medical

research with the “Hamamatsu Positron Medical

Centre”. This in turn would attract new talent from

societyandfurtherfosteritsR&Defforts.

BusinessModelQualityAnalysisHowScalableandsustainableisthegrowth?GlobalIndustryGrowthfavoringHamamatsuHamamatsu’sstrongR&Dandproductmixallows it to

be positioned to take advantage of global trends. In

terms of the global growth, the three main business

segments of Hamamatsu - Production Technology,

MedicalTechnology&LifeScience,andMeasurement&

ImageProcessing,hasaCAGRof7.0%,7.2%and4.2%

respectively (OpTech Consulting 2017). Below we

analysetwospecificglobaltrendsthatareinfavourof

Hamamatsu.

- GrowingDemandforHomecareMedicalEquipmentThehomecaremedicalequipmentmarket isestimated

tobeworth¥2,940billionby2020(Fujiwara2016),and

manufacturersaredemandingsmallerportabledevices

that still retain high functionality and reliabilitywhich

Hamamatsuispositionedtobethetopproviderthrough

itsMicroPMT’swhichistheworld’ssmallestandlightest

modules.

- GrowingDemandforRadiationdetection,MonitoringandSafetydevices

Due to growing incidence of cancer and number of

PET/CTscans,safetyconcernsfromthepostFukushima

Disaster and growing threat of security concerns (e.g.

terrorism), the market for global Radiation detection,

MonitoringandSafetydevicesisestimatedtogrowata

CAGRof5.6%(2016-2021)toreach¥246billionin2021

(MarketsAndMarkets 2016). This is in favor of

Hamamatsuasithasproductapplicationsinmonitoring

andsafetysuchasBaggagescreening,Cargo&Vehicle

screeningandMail&Parcel inspection.Moreover, for

diagnosis of cancer and other diseases, Hamamatsu’s

PMT modules is used in almost 100% of all Positron

Emission Tomography (PET) systems and hence will

further benefit from this growth with strong

performance,andHamamatsu’sexecutionofitsthree-

pronged approach as mentioned above. Moreover,

Hamamatsu had already declared ordinary cash

dividends on September 2017 and hence this share

repurchase is not necessary, but rather is a bonus to

theirpayoutpolicy.

Therefore, given the empirical evidence of expected

performancepostsharebuybacks,plus thesupporting

backgroundat the timeof the repurchase,webelieve

thatthisrepurchasecanbeseenasastrongsignalthat

themanagersofHamamatsubelievethatitssharesare

underpriced,whichmakesthisagoodcatalysttoinvest

inHamamatsunow.

EconomiesofScaleinR&DHamamatsuhasastrongtrackrecordforinnovationand

hasveryestablishedR&Dfacilitiestodoso.Ithasthree

research facilities, the Central Research Laboratory,

Tsukuba Research Centre and Industries Development

Centerandhasspenta5-yearaverageof¥11,425mper

year on R&D. In 2017 it has produced three ground-

breakinginnovativeproductsthisyearwhichisshownin

Table 10. Such differentiating products cannot be

replicatedeasilywithoutboththeknow-howandmeans

ofproductionsthatHamamatsupossesses.

CompetitiveAdvantageinUniqueProductOfferingsHamamatsu’s R&D has allowed it to capture market

share through product offerings that rivals cannot

follow.Hamamatsuhasauniquebusinesspropositionof

beingabletoofferacustomizedsupporttomatchthe

specific customer usage conditions and environments.

Forexample,Hamamatsuistheonlycompanythatcan

offerbothlightemittersandlightsensorsinGasAnalysis

applications and Light Detection and Ranging (LIDAR)

systems.Thisoffershugeadvantagestocustomerswho

bypurchasingthepackagedset,canbeensuredofthe

expectedperformanceduetonoincompatibilityissues

with different brands and troubleshooting is easier

which shortens the customer’s product development

period. This competitive advantage is difficult to

replicateduetothelargedevelopmentcostsandrisksin

investing inR&D inboth lightemissionandsensorsof

whichHamamatsualreadyhasawidemoatin.

Hamamatsu also has a large number of patents. Just

from2016todate,ithas229patentsfiledwhichallows

ittodefenditsuniqueproductpropositionandmarket

share.

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EconomiesofScaleinProductionandDistributionIn termsofproduction,Hamamatsuhasa competitive

edgeinusingitsin-houseinventionsallowittoimprove

thespeedandefficiencyofthemanufacturingprocesses

ofotherdevices.

Implicationsisthat,unlikeotherfirms,Hamamatsu’scan

easilymassproducecertainproductslikePMTswithits

exclusive know-how and support technologies. This

allowsittoremainasthemarketleaderbymeetingthe

demand for high-volume& cost-effectiveness from its

customers.

Moreover,thiscompetitiveedgeisamplifiedinthefact

that Hamamatsu has 7 factories and 6 sales offices

withinJapanalone.Offshore,ithastheLangfangfactory

inChina,and23foreignoffices.HenceHamamatsuhas

aneconomicwidemoatintermsofeconomiesofscales

forproductionanddistributionthatishardtomatchfor

any new entrants or even existing competition which

givesusconfidenceinexpectingcontinuedgrowthand

strongperformance.

Visiontoexpandthroughathree-prongedapproachHamamatsu is a technology firm that aims tobe “one

stepahead”. This is bynomeansemptywords as the

company has proven that it has the vision to expand

with a three-pronged approach through new

innovations, improved production capabilities, and

strategicacquisitions.

NewInnovationsIn2017alone,Hamamatsuhasreleasedfiveofitsown

in-housedevelopedproducts,ofwhichthreeofthem

areground-breakinginnovations.Thishighly

differentiatesitsproductsandallowsthefirmto

positionitselfforhigherprofitsduetothelargequality

gapanddifficultyinreplicationfromitscompetitors.

ImprovedProductionCapacityHamamatsu’s management has anticipated the

increased opportunities demands for opto-

semiconductors, imaging and light technology back in

2016andwillbenowabletoreapthebenefitsthrough

its completion of the construction of two factories at

ShingaiandMiyakodain2017.

StrategicInvestmentsIn September 2017, the Hamamatsu signed an

agreement to acquire Energetiq Technology Inc. This

provides expertise into light emission like extreme

ultraviolet (EUV) light sources. This not only allows

Hamamatsu to diversify its products and meet the

marketdemandforUVlightproducts,butalsoenables

it to combine its existing technologies to improve

efficiency indevelopingnewer innovativeproducts for

greaterfuturegrowth(Holton2017).

Hamamatsu also invested in Lagunita Bioscience, an

America Venture Capitalist firm, which will provide

synergies in Hamamatsu’s product offering in

biotechnology and medicine. With the medical

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instruments by application contributing the highest

revenues, investing in Lagunita Bioscience which

incubates and invests into early stage clinical solution

providers,willfacilitatethediscoveryofnewtechnology

applicationstomaintainitscompetitivenessinthelong

run.

Top3RisksRisk1:ErosionofmarketshareduetomedicaldemandtrendsHamamatsu biggest proportion of business by

application is intomodules for PET/CT technology for

medical screening of cancer and diseases whereby it

dominatesthemarketandgenerated¥37,538min2017.

However,thereisariseinMagneticResonanceImaging

(MRI)thatusesmagneticenergyinsteadanddonotemit

ionizing radiation unlike Computed Tomography (CT)

scanswhichmakes itasaferchoice forpatientsanda

threattoreplaceHamamatsu’smarketshare.However,

MRIhavehighercostsandlowpracticality,takingalong

timetocompleteascomparedtoCTscanstojustifythe

reductioninasmallrisk,andCTscansaremoreeffective

in scanning bone structures (William 2013). Hence in

comparison,CTscansareexpectedtogrowataCAGRof

7.5% (GIA 2016) while MRI at a CAGR of 5%

(ResearchAndMarkets2015).Moreover,bothCT scans

andMRI are usually used in conjuncture with PET to

improve imaging resolution and hence, Hamamatsu’s

PETdetectiontechnologywillstillbeindemand.

Risk2:CorporateGovernanceRisks

Hamamatsuhaslargelykeptalowdebt-to-capitalratio.

Thismaynotoptimizethefirm’svaluefrominteresttax

shields and the hoarding of cash increases the

probabilityof badagencybehaviour suchas excessive

executiveperksorempirebuilding.However,webelieve

that as Hamamatsu is a R&D and growth driven

company, having the debt capacity and availability of

cash, allows it to take on positive NPV projects or

investments in the futurewhentheopportunityarises

whichmight offset any resulting agency costs andwe

can expect to see a positive impact for Hamamatsu’s

growthinstead.

Moreover,withregardstotheacquisitionofEnergetiq

Technology that done using a Special PurposeVehicle

(SPV), there might be a concern of the possibility of

creativeaccountingsimilartothe2001scandalofEnron

transferringdebtstoitsSPV(Wharton2006).However,

webelievethisislargelymitigatedbythefactthatwith

Hamamatsu’s lowdebt ratio (3.72%)andstrongcredit

ratingof‘A+’,itisunlikelythatHamamatsuwouldneed

toabuseitsSPVtomanageitdebt.

Risk3:EconomicandTransactionExposure

Hamamatsu has vested interest in America, Asia and

Europe. It will face tremendous foreign currency

exchange risks when exporting goods and translating

profitsbackintoitsdomesticcurrency.Thisisespecially

the case should its currency pairs move in an

unfavorable direction against its position. To mitigate

this, Hamamatsu has entered into foreign forward

contractsandinthecurrentshort-term,Hamamatsuhas

largely benefited from foreign exchange, recording an

average annual positive FX adjustment gain of ¥658m

yenforthepast6years.

Economic exposure may also be mitigated as

Hamamatsuhasproductionanddistributionpresencein

its global regions through its subsidiaries, along with

strong R&D and product differentiation, with its

products having less elastic demand which may

translate into less exchange rate risks, and we can

expectmorestablecashflowsinstead.

(TSE:6965)HamamatsuPhotonicsk.k.FY2013 FY2014 FY2015 FY2016 FY2017 FY2018LTMSharePriceJPY 2,102.50 2,890.00 3,335.00 3,075.00 3,730.00 3,730.00NoofShares(mil) 160.8 160.8 161.1 157.3 157.6 157.6MCAP(mil)USD 3,218 3,892 4,454 4,143 5,215 5,215NetDebt(Cash)JPY (60,981) (70,112) (68,572) (59,140) (67,770) (67,770)EnterpriseValue(mil)USD 2,328 3,154 3,003 4,148 4,097 4,557Revenue(mil)JPY 102,156.0 112,092.0 120,691.0 121,852.0 130,495.0 130,495.0EBITDA(mil)JPY 25,455.0 29,618.0 33,114.0 31,092.0 32,893.0 32,893.0EBIT(mil)JPY 16,783.0 21,666.0 23,597.0 20,545.0 22,850.0 22,850.0NPAT(mil)JPY 11,529.0 15,155.0 16,598.0 14,419.0 17,777.0 17,777.0NPAT(Ex.Xtra+Dis.Ops)(mil)JPY 10,589.0 14,582.0 15,754.0 15,123.0 17,291.0 17,291.0CFO(mil)JPY 14,688.0 23,135.0 16,046.0 24,160.0 26,154.0 26,154.0CAPEX(mil)JPY (8,433.0) (15,036.0) (14,779.0) (9,144.0) (13,773.0) (13,773.0)EPSJPY 65.9 90.7 97.8 96.1 109.7 109.7Revenue(mil)USD 1,041.0 1,021.8 1,008.0 1,203.2 1,158.9 1,158.9EBITDA(mil)USD 259.4 270.0 276.6 307.0 292.1 292.1EBIT(mil)USD 171.0 197.5 197.1 202.9 202.9 202.9NPAT(mil)USD 117.5 138.1 138.6 142.4 157.9 157.9CFO(mil)USD 149.7 210.9 134.0 238.6 232.3 232.3CAPEX(mil)USD (85.9) (137.1) (123.4) (90.3) (122.3) (122.3)GPM(%) 50.1% 52.3% 52.3% 50.1% 49.7% 49.7%EBIT(%) 16.4% 19.3% 19.6% 16.9% 17.5% 17.5%NetDebt(Cash)/Equity(%) -39.6% -41.7% -38.1% -35.0% -36.3% -36.3%ROA(%) 8.5% 10.1% 10.4% 9.5% 9.5% 9.5%ROE(%) 10.9% 12.9% 13.1% 12.1% 12.2% 12.2%CFO/TA(%) 7.4% 10.7% 7.1% 11.1% 10.9% 10.9%EV/Sales(x) 2.7 3.5 3.9 3.5 4.0 4.0EV/EBIT(x) 16.5 18.2 19.9 20.7 22.8 22.8EV/EBITDA(x) 10.9 13.3 14.2 13.7 15.8 15.8EV/CFO(x) 18.9 17.1 29.2 17.6 19.9 19.9P/Sales(x) 3.3 4.1 4.5 4.0 4.5 4.5P/EBIT(x) 20.1 21.4 22.8 23.5 25.7 25.7P/B(x) 2.2 2.8 3.0 2.9 3.2 3.2VQ1:EV/EBIT/ROE(x) 1.5 1.4 1.5 1.7 1.9 1.9VQ2:EV/EBIT/ROA(x) 2.0 1.8 1.9 2.2 2.4 2.4

7

2. MasanGroupHoldings(HOSE:MSN)


QuickStats

Date 15/12/17 EBIT/R&D(x) 17.31

FilingCurrency VND

EBIT/Employee

No.(USD/px) 20K

SharePrice VND71,700 EV/EBIT(x) 22.6


MarketCap(USDMil) 3306.5 EV/CFO(x) 32.8

DailyValueTraded


GPM(%) 30.3% P/E(x) 15.8

EBIT(%) 11.7% P/B(x) 6.1

NetDebt(Cash)/

Equity(%) 139.8%

VQ1:

EV/EBIT/ROE(x) 0.9

ROA(%) 7.2%

VQ2:

EV/EBIT/ROA(x) 3.1

ROE(%) 24.9%

TeamMembers

JoelisajunioratNanyangBusinessSchoolmajoringinAccountancy

and Finance. He previously interned with the opportunistic credit

teamatApolloGlobalManagementandtheinvestmentbankingteam

atJ.P.Morgan.

Yu Xin is currently an undergraduate at Nanyang Technological

University taking a double degree in Accounting andBusiness. She

previously interned with the opportunistic credit team at Apollo

Global Management and the Real Estate Finance team at GIC.

Currently,sheisinterningwiththeAsianAffluenceFundatThirdrock.

8

InvestmentSummaryWeareoftheviewthatMSNhasawidemoatbusiness

and industry dynamics will act as a tailwind toMSN’s

success. The team has three key investment theses

whicharevariant fromcurrentmarketviewandhence

havenotbeenpricedin.

SelectionoftheVietnammarket:Vietnamwastheonly

frontiermarketwithinthelist.Frontiermarketstendto

bemore inefficientthantheirdevelopedandemerging

counterparts, and as such offer more compelling risk-

adjusted returns. Vietnam has extremely favourable

fundamentals – a young labour force, rapidly-growing

GDP, rising consumption levels, growing credit

penetration levels, and a trend towards urbanization.

These drivers bode well for a consumer-focused

company,andweselectedMSNaswebelieveitisbest

positionedtocapitalizeontheseacceleratingtailwinds.

Masan – A Wide-Moat Business: The Company’s

relentless focus has allowed it to establish itself as

Vietnam’sstrategicconsumergrowthproxyandbuildup

a wide moat, allowing it to sustain its edge over

competitors.Firstly,asabusinesswithhighoperational

leverage, MSN is able to derive value from scale.

Secondly, MSN’s exclusive distribution network is an

invaluable and difficult-to-replicate asset that has

enableditssuccess.Thirdly,MSN’sworkingenvironment

andreputationhasallowedittoattractthebestindustry

talents. Fourth, as a virtuous cycle, MSN’s size and

reputation has allowed it build strategic partnerships

withmarketleadersallowingittomaintainmarketshare

andcontinuetogrow.Lastly,stringentcapitalallocation

allows MSN to maintain a healthy capital structure,

resulting in the firm not just achieving fast but also

sustainablegrowth.

Quality Management – Steering MSN to Success: The“win-win” proposition that Masan has built into its

culture,andmanagement’s calibrewillallowMasan to

successfullyexecuteits2020ASEANexpansionplansand

achieve targeted revenue of USD 5bn. The quality of

MSN’smanagementissupportedbytheoversightfrom

major institutional investors, additional governance

committees apart fromwhat is prescribed by Vietnam

law, attainment of awards for MSN’s commitment to

sustainablebusinesspractices,aswellasManagement’s

increasedfocusonshareholderfriendlyinitiatives.

Investment Thesis #1 – 3F Model: Consolidation ofVietnam’sattractivemeatmarket: In1H17, theanimal

feedsegment(MasanNutri-Science,or“MNS”)suffered

fromthecollapseinporkprices(running27%below2016

levels).However,webelievethattherecentsell-downisattributed to short-term noise and provides a golden

opportunity for investors to buy into MNS long-termgrowthstoryoftheconsolidationofVietnam’sattractivemeatmarketatareasonablevaluation.

InvestmentThesis#2-Inventoryde-stocking:Shorttermpain, Long term gain: In 1H17, MCH’s inventory

rebalancingexercise resulted insacrificedsalesofVND

1,000bnandVND250bnofEBITDA,withSG&Aexpenses

increasingbyVND400bn.Thisresultedinasell-offasthe

inventory rebalancing exercise created a larger-than-

expected dent as compared to Street forecasts.

However, the team believes that the Street is beingmyopic and overly focused on the one-off expensesincurred while ignoring the long term benefits of theinventoryrebalancingexercise.Investment Thesis #3 – Geographical expansion:Accessingbothurbanandrural:On25December2015,

Masan Group announced the signing of a strategic

partnershipwithSinghaAsiaHoldingPteLtd(“Singha”).

ThestrategicpartnershipwithSinghaprovidesbothsides

exclusive rights to distribute each other’s products.Bytapping on Singha’s brewing expertise, there is hugeopportunities for geographical diversification, allowingMasan Group to unlock strong growth in the comingyears.ThepotentialhasnotbeenfullyappreciatedbytheStreet.MSN – Vietnam’s Strategic Consumer Growth Proxy, ATrueHiddenChampionOver the years,MSNhas achieved great successwhile

neverlosingsightofthebiggerpicturewhichresultedin

the Company continuously building up its competitive

advantage. The team believes that the sell-off which

resultedfromtheporkpricecollapseandinventoryde-

stockinghaspresentedanattractiveentry-pointtobuy

intoagreat,fast-growingbusinesswithvisiblecatalysts

forpositivere-ratings,presentingclearupsidepotential

makingitatruehiddenchampion.

BusinessOverviewMSN is a Vietnam-based diversified conglomerate

focused on the consumer, natural resources, and

financial services sectors. It operates in four key

segments:

• MasanConsumerHoldings (“MCH”)–56%of FY16revenue

- Leader in some of Vietnam’s largest consumer

staple categories such as seasonings and

conveniencefoods,withafastgrowingbeverage

business

- IncludesMasanConsumer andMasanBrewery

(partnershipwithSingha)

- ManufacturesarangeofF&Bproductsincluding

9

sauces, noodles, coffee, and mineral water,

amongothers

- KeybrandsincludeChin-Si,NamNgu,TamThai

Tu, Omachi, Kokomi, Komi, Wake-Up, Quang

Hanh,andSuTuTrang

• MasanNutriScience(“MNS”)–34%ofFY16revenue- One of the leading animal feed producers in

Vietnamthathasexpandedintopigfarmingand

branded meat to become a complete “3F”

platform

- Ownsthreekeybrands–ANCO,Proconco,and

Bio-Zeemwithcombinedsalesvolumereaching

morethan2.5Mt

• MasanResources(“MSR”)–9%ofFY16revenueo One of the largest private sector natural

resources companies in Vietnam, amongst

the leading producers of tungsten and

fluorspar

o Currentlydevelopingaworld-classNuiPhao

polymetallicprojectinNorthVietnam

• Techcombank(“TCB”)o One of the largest commercial banks in

Vietnam with a technology driven retail

strategy to capture the growth of financial

inclusion

o MSN owns a 36.4% stake in TCB and

accountsforitasanassociate

FavourableMacroDriversinVietnam

3rd-most populous nation in Southeast Asia: Vietnam

boasts the 3rd

-most populous nation within Southeast

Asia,withitscurrentpopulationof94.6mm.Accordingto

the World Bank, this figure is projected to grow to

103.5mm by 2026, indicating the huge and expanding

market opportunity for MSN’s consumer-focused and

bankingsegments.

Younglaborforce:Vietnamalsohasoneoftheyoungest

populationsinSoutheastAsia.Attheendof2016,48.5%

ofVietnam’spopulationwasbelow30,higherthanthe

SoutheastAsiaaverage.Ayoungpopulationindicatesa

potentially large workforce, which will drive

consumptioninthecountry.

Rapidlygrowingincomelevels:Euromonitordatashows

that the median disposable income per Vietnamese

householdgrewat12.5%CAGRfrom2006to2016,and

isexpectedtogrowat8.4%CAGRthrough2026.Asthe

Vietnamesepopulationbecomeswealthier,wewilllikely

see a shifting of dietary habits towards more animal

protein, and greater spending onmore premium food

products.MSN iswell-positioned to take advantage of

this trend through MNS and its market leadership in

manyofitsconsumerfoodproducts.

Risingconsumption:Vietnam’slevelofconsumption-to-

GDPstoodat74%in2016,placingitasoneofthehighest

intheworld.Movingforward,consumptionspendingis

expectedtotrackGDPandincomegrowth.Euromonitor

forecasts realGDP to growat 6%CAGR through2026,

while consumption-to-GDP isexpected to remain fairly

constantduringthesameperiod.

Low credit penetration: Consumer credit more than

doubled over the past 5 years, with gross lending

growingfromVND281tnin2012toVND637tnin2017.

Euromonitor forecasts suggest that gross lending will

growat6.0%CAGRtoreachVND853tnby2022.Through

itsstakeinTCB,MSNwillbeabletocapturegrowthfrom

thismassiveopportunity.

Urbanization: Even though Vietnam’s urbanization

levelhasincreasedfrom28.5%to34.2%inthepast10

years.ProjectionsfromEuromonitorsuggestthatthe

urbanpopulationwillcontinuetogrowfrom32.4mm

to 42.0mmbetween2016 and 2026, on the back of

rising urbanization levels (40.6% by 2026) and

population growth. Currently, the average urban

consumer spends 1.7x more than his/her rural

counterpart.This,coupledwiththehighdemandfor

convenience food by busy urbanites, will continue

increasingthemarketsizeforMCHanddrivegrowth

formanyyearstocome.MSN–AWideMoatBusinessByhavingaclearunderstandingofVietnam’sConsumer

Sector as one which is fragmented and overpriced,

MasanGrouphasidentifiedthewhitespaceinwhichit

can create its ownmarket, and shift themarket from

unbrandedtobrandedproducts.Thefocusonstructural

transformation to benefit consumers is evident in its

varioussegments.Foranimalprotein,theCompanyaims

to consolidate the fragmented value chain to achieve

bettersafetystandardization.ForFood&Beverage,the

Company aims to target the lack of innovation and to

providegoodqualityproductsatareasonableprice. In

thefinanciallife,theCompanyaimstoreachouttothe

underservedruralareas.TheCompany’srelentlessfocushasallowedittoestablishitselfasVietnam’sstrategicconsumer growth proxy and build up a wide moat,allowingittosustainitsedgeovercompetitors.

Deriving Value from Scale: As a business with highoperatingleverage,Masanbecomesmoreprofitableas

10

itscales,whichallowsthehugesizeofthebusinesstoact

as an advantage. This can be observed in its financial

resultsfrom2015to2016.AstheCompanyexperienced

41.4%growthinnetrevenuein2016,sellingexpensesas

apercentageofrevenuedeclinedfrom13.2%in2015to

11.5%while general and administrative expenses as a

percentage of revenue declined from 5.4% in 2015 to

4.5%.Masanisabletoexperienceimprovingmarginsas

itgrows,andhenceitsmarketsizeactsasanadvantage

thatisdifficulttoreplicate.

Exclusive Distribution Network: As Masan is aiming to

reach Vietnam’s consumers, it is important for the

Company to have a good distribution network. This is

because the points of sale are where consumers

purchasemostoftheirbasicdailyessentials,particularly

intheruralareas.Masanhasbuiltupitsnetworkfrom

the ground up over the course of 15 years, investing

through their banking and F&B platforms. This has

resulted in Masan having developed the most robust,

nationwideroutetothemarketcovering180,000points

ofsaleforfoodand110,000forbeveragedaily.

ThishasallowedMasantosimplyplugandplay,saving

time andmoney as they donot have to invest a huge

amountofcapitaltocreateseparatephysicalnetworks

to reach consumers and can instead rely on its strong

exclusive distribution network. To entrench its

competitive advantage, Masan has invested in

mobile/digitaltechnologytosupplementtheCompany’s

physicalpointsofsale,makingitcheapertoservemore

consumers. Masan’s exclusive distribution network is

difficulttoreplicate. ItnotonlyallowstheCompanyto

constantly interact with their end customers to gain

deeperinsightsonhowtobettermeettheirdailybasic

needs,butalsoallowstheCompanytofocuseffortson

marketingandR&D.

PartnershipwithIndustryLeaders:Masanhasbeenable

tomaintainmarketleadershipandstronggrowthowing

to its strategic partnershipswith industry leaders (e.g.

Singha,Vissan),allowingtheCompanytobuildupawell-

known portfolio of brands. This has allowedMasan to

achieve #1 position in soy sauce, fish sauce, instant

noodles, and animal feed. The mutually beneficial

partnerships with industry leaders are built up due to

trustinMasan’sreputation,anditishardforcompetitors

toreplicate.

Stringentcapitalallocationandcapitalstructure:Despitethe various ambitious growth initiatives that Masan

Grouphastakenon,theManagementiscognizanttonot

over-leverage and instead aim for sustainable growth.

The Company has historically had a negative interest

spread on interplay of investments and short-term

borrowing.With thatunderstanding, theCompanyhas

chosentomaketheoptimizationofthebalancesheeta

priority by reducing debt and swapping out expensive

debt.Prudentbalancesheetmanagementhas resulted

instrongercreditmetricsatyearend2016.Management

hascontinuedtoreducedebt,allowingdebtbalanceto

decline from VND 41,091bn in Dec 2016 to VND

33,148bn in Sep 2017. This has allowed for enhanced

profitabilitymargins.Management’sdisciplinegivesthe

team’scomfortthatbalancesheetmanagementwillnot

be sacrificed and Masan Group is well set for strong

growthahead.

ManagementExpertise:Masan’sfocusondoingwellby

doing good, and by making it a good working

environmenthasenabledtheCompanytoattractleaders

who are consumer-centric entrepreneurs. In order to

deliveronpromisestoconsumers,thepeoplemakeita

focustofindinnovativesolutions.Managementtendsto

be industry experts in their respective fields, allowing

themtonotonlygrowthebusinesseffectivelybutalso

manage the different risks present across each of the

Company’srespectivebusinesses.

ManagementQualityAnalysisTheteamhasconfidenceinthesuccessintheexecution

ofMasan Group’s 2020 ASEAN expansion plans and it

achieving the targeted revenue of USD 5bn. The team

believes in the “win-win” proposition that Masan has

builtintoitsculture,andthequalityofthemanagement

thatwillguideMasantogreaterheights.

Masan’s“Win-Win”Proposition“Ourgreatestachievementwillcomeonthedaywemakequality,innovativeandaffordabledailybasicgoodsandservicesuniversallyavailable.”-DrNgyuenDangQuang,Chairman

Masan Group believes in doing well by doing good,

exemplifyingtheCompany’scommitmenttosustainable

businesspracticesandhasunderpinnedMasan’ssuccess

over the years. For Masan, success is not only the

Company’s financial results but also from the positive

socialimpactcreated.TheCompany’sultimatemissionis

toprovidebetterproductsandservicestothe90million

people of Vietnam, so that they can pay less for their

daily basic needs. The Management believes in the

meaningfulpurposethatMasancanachieve,andthisis

reflected in the business’s future vision of achieving a

“win-win” proposition for their customers, employees,

shareholdersandVietnam.

ExperiencedandHighQualityLeadership MasanGroup’smember companies and associates are

industry leaders inmeat,packagedfoodandbeverage,

resources, and financial services, altogether

representing segments of Vietnam’s economy that are

11

experiencingthemosttransformationalgrowth.Masan

Grouphasdedicatedandexperiencedmanagementwith

extensive experience across global MNCs and strong

localexpertise.

MCHisledbyCEOTruongCongThang,whohasover17

years of experience in the F&B industry and served as

MarketingDirectorforP&GVietnamfor7years.

MNSis ledbyChairmanPhamPhuNgocTrai,whowas

President and CEO of PepsiCo Vietnam and Southeast

Asia,andPhamTrungLam,whowasMasanConsumer’s

HeadofSalespriortobecomingtheCEOofProconcoand

ANCO.

MSR is led by CEO Craig Bradshaw, who has over 23

years’ experience in the mining business, spanning

mining and processing operations, logistics, and sales

andmarketinginAustralia,ThailandandLaoPDR.

Management Quality supported by various otherfactorsOversightfromMajorInstitutionalInvestors:GICandKKRarethetwolargestforeignshareholdersinMasanGroup.

These companies are highly skilled andwell-resourced

andwouldmakeinformeduseoftheirrightsandproper

analysis of information, this promotes good corporate

governanceinMasan.Additional Governance Committees: Masan Group is

committedtogoodgovernance,best-in-classprocedures

andpoliciesandcorporatetransparency.Apartfromthe

governancecommitteesprescribedbyVietnamlaw,such

as the Board of Directors, Supervisory Board and

ManagementBoard,Masanhas additional committees

toensurehighergovernancestandards.

Awards:Masan’s commitment to sustainable business

practicesovertheyearshasallowedtheCompanytogain

third party recognition by both domestic and

internationalagencies.MasanGroupwonanawardfor

Investor Relations in 2016 for “Best Information

Disclosure,” as voted by the Vietnam Association of

FinancialExecutives.

Shareholder Friendly Initiatives: In 2016,Masan Group

notonlydidabuybackbutalsopaidout the first ever

dividendinMasan’s20yearhistory.Thisisbeneficialfor

shareholders, and management has guided for more

shareholderfriendlyinitiativesinthefuture.

InvestmentThesis#1 3F Model: Consolidation of Vietnam’s attractivemeatmarketIn1H17,theanimalfeedsegment(MasanNutri-Science)

suffered fromthecollapse inporkprices (running27%

below2016levels).Thetotalpigfeedmarketshrunkby

nearly35-40%assmallscalefarmersweresqueezedout

ofthemarketandminimal investmentsweremadefor

thenextpigherdcycle.WithMNSbeinghighlyrelianton

pork feed (c.60%of total animal feed), this resulted in

1H17NPATMIdropping52%yoyowingto10%yoylower

revenues,26%yoyhigherSG&Aexpensesandreduction

ininfinancialincome.

With the market expecting the deterioration in farm

economicstocontinuetocreateheadwindsforpigfeed

demand, it resulted in a sell-down of the share price.

However, we believe that the recent sell-down isattributed to short-term noise and provides a goldenopportunity for investors to buy into MNS attractivelong-termgrowthstoryatareasonablevaluation.

Collapse in pork prices allows MNS to strengthenfootholdinfeedmarketThecollapse inporkpriceshas resulted in theGroup’s

performance to be negatively impacted, however a

significant contributor to thepoor performance is also

attributed to the 26% yoy higher SG&A expenses. The

higherSG&Aspending isactuallyattributed to support

programstofarmersanddistributorsthatManagement

hasdeemedtobebetterpositionedtoemergefromthe

recovery asmarket consolidators. The additional price

supportandloyaltyprogramsresultedinsalesexpense

toincreasebyVND300bn.

This sets a firm foundation for MNS’s future

performance. Despite the short-term increase in

expenses,thefirmwasactuallybeinglong-termgreedy

astheywereabletolockupfuturefarmersanddealers

asaresult.Thisputstheminabetterpositiontoachieve

theirsettargetsof:

• 2017 target: Exit market share increased from

30% in FY2016 to 39% in 9M2017, on track to

achieveexitmarketshareof50%byyear-end

• 2018objective:Achieveaveragemarketshareof

51%forpigfeed;DominantChampion

Managementhasguidedthatoverthenext3years,meat

productswillcomprisealargerpercentageofMNS’net

revenue,resulting in improvedgrossmarginstoc.30%-

35%overthemediumterm.

Masan’s3FModelThe animal feed segment is just a piece that fits into

MNS’s bigger ambitions. MNS has ambitious goals to

take a bigger bite out of Vietnam’s attractive meat

market. Given the relatively fragmented nature of

Vietnam’s meat market, there are abundant

opportunitiesforF&Bcompaniestoredefinecategories

andbuildbrands.

12

• Feed:>60%feedmillshavecapacitybelow10k/year,

resultinginlowproductivity.

• Farm:90%of3millionpigfarminghouseholdswith

<50pigs,asaresultthereispoorhealthstandards.

• Food: 99% of meat consumed is unbranded,

unstandardized, and unsafe. This results in safe,

branded, and standardized meat being 2x more

expensive.

Lack of adherence to quality and health standards has

often created issues at the expense of smaller players

and can provide consolidation opportunities for larger

companies.MNS sees an untapped opportunity in this

spaceandexpectsfarmingtograduallyevolveintolarge

integrated farms,asopposedtotheprevailingpractice

ofdomesticfarmingbylowincomehouseholds.

Thefirm’svisionistobuildanintegratedanimalprotein

business, tohave auniqueplatform todirectly service

thesignificantdemandforsafeandtraceablemeat.MNS

expectstocompleteitsmeatproductioncomplexandpig

farm by 1H2018, establishing its 3F business model

(feed-farm-food)allowingittode-riskimpactoflivestock

commodity pricing and position itself to grow across

platforms. Apart from allowing MNS to strengthen its

footholdintheUSD6bnFeedmarket(grossmargins:20-

22%),MNSwillbeabletoventureintoalargerandmore

attractiveUSD9bnPorkmarket(grossmargins35-40%).

‘3F model’: Consists of feed, farming and food. The

longer term vision is to have a reliable source of raw

material for processed meat manufacturing. The 3F

model is a consumption-driven one and targets

Vietnam’smeatandproteinsegment.

MNS’s recent acquisitions marks another step in the

vision to become a vertically integrated player in the

animalproteinchain.In2016,therewasthepurchaseof

additional 30% stake in one of its feed subsidiaries

(ANCO) resulting in total holding to reach 100%, and

increase in stake of VISSAN to 24.9% from 14%. The

Group’seffective stake inotheranimal feed subsidiary

(Proconco)currentlystandsat72%.

SupportedbystrongstrategicpartnersIn 2017, KKR became one of the largest foreign

shareholders of Masan Group with the investment of

USD150 mn primary capital into MNS, resulting in an

implied valuation of USD$2 bn. KKR’s investment is a

strategic bet on Masan’s ability to build-out an

integratedmeatplatformtotransformMNSfromapure

commodity business into a branded consumer player

with direct access to Vietnam’s largest consumer

segment of USD18 bn. KKR will bring in international

expertise through its global network, and industry

expertise through its stake in PT Japfa Comfeed

Indonesia (one of the leading agri-food companies in

SoutheastAsia), toaccelerate theprocessandmanage

any potential operational risks. This reaffirms MNS’s

attractive long term growth story that has been

overshadowedbyshorttermvolatility.

#2 Inventory de-stocking: Short term pain, Long termgainIn1H17,MCHlostpotentialnetrevenueofVND1,055bn.

For 2Q17, revenues in MCH dropped to the lowest

quarterlyreadingsince2013.Theinventoryrebalancing

exerciseresultedinsacrificedsalesofVND1,000bnand

VND250bnofEBITDA,withSG&Aexpensesincreasingby

VND400bn. This resulted in a sell-off as the inventory

rebalancing exercise created a larger-than-expected

dent as compared to Street forecasts. However, theteambelievesthattheStreetisbeingmyopicandbeingoverly focused on the one-off expenses incurred andignoring the long term benefits of the inventoryrebalancingexercise.

ConcernsaboutmarketsharelossoverplayedMCH’s market share position remains intact across

categories, as sales from distributors to consumers

remained stable and only shrunk 7% yoy in 1H17,

suggesting that market share losses have been

restricted. Management has confirmed that the

inventory reduction exercise has been completed and

normalizationwilloccurfrom2H17onwards.

Improved distribution system with growth drivers forConsumersegmentPast the short termpain, theexercisehas allowed the

group to develop a more efficient and healthy

distributionnetwork tobetter serve consumersand to

prepare for its innovation pipeline across categories

where eight new products are in the pipeline. It will

betterallowforMasantoachieveitsaimtofocusonits

core, consumer-related business, and allow the

Company to disrupt the current market dynamics

throughinnovation,deepconsumerinsightsandmaking

products and services available to every Vietnamese

citizen.

Thisputstheminabetterpositiontoachievetheirset

targetsof:

• 2017target:Inventorydaysreducedfrom2months

to<4weeks;StocklevelreducedfromVND2,200bn

toVND900bn

• 2018objective:Maintainstocklevelunder30days;

Optimizeproductqualityofinnovationlaunches

13

Apart fromtheeightnewproducts in thepipeline, the

Management has opined that the Energy Drinks and

Processed Meat segment will emerge as long-term

growthdrivers,allowingMCHtocontinuetoexperience

stronggrowth.

EnergyDrinks:WithatotalmarketsizeofoverUSD1bn,

Management’sguidanceofnationwidemarketshareof

5%bytheendofFY17willmeanthatenergydrinkswill

beastrategicgrowthdriverforMasanlookingforward.

MCH’senergydrink,Wake-up247,hasbeenperforming

well,delivering72%netrevenuegrowthin1H17andis

ontracktobeaUSD45-50mnpowerbrandbyyearend.

ThisfallsinlinewithMasan’sstrategicvisiontodevelop

intoa50/50foodandbeveragebusinessandwillallow

MCH’sgrowthtoberejuvenated.

Processed Meat: Vietnam’s processed, value-added

meat market represents only 1% of total meat

consumption, similar to China 10-15 years ago.

Managementexpectsprocessedmeatpenetrationtobe

15-20%oftotalmeatconsumptionby2022,growinginto

a USD 1.5-2.0bn market which is on par with China’s

currentmeatmarketstructure.

#3Geographicalexpansion:AccessingbothurbanandruralOn25

th

December 2015,MasanGroup announced the

signing of a strategic partnership with Singha Asia

HoldingPteLtd(“Singha”),Thailand’s#2beercompany.

Accordingly, Singhawill invest a total of USD 1.1bn as

newcapitalinwhichUSD1.05bnistoown25%ofMasan

ConsumerHoldings(MCH)andUSD50mmtohold33.3%

of Masan Brewery (MB). This results in an implied

valuation forMCHofUSD 4.2bn (VND95.5tn), valuing

MCH at 2016 P/E ofmid 33-35x. This is a premium as

compared to the Vietnam market as a whole, which

reaffirmsMCH’ssuperiorbusinessmodel.Thestrategic

partnership with Singha provides both sides exclusive

rightstodistributeeachother’sproducts.BytappingonSingha’s brewing skills and expertise, there is hugeopportunitiesforgeographicaldiversification,allowingMasan Group to unlock strong growth in the comingyears.

VenturingintotheuntappedareasinVietnamTheaverageVietnamesehasastrongfondnessforbeer

andconsumptionhasbeenrisingat10%,touching60.1

litrespercapita in2015.MasanBrewery isable touse

Singha’sR&Dexpertise tostrengthen theirpresence in

the attractive beer market in Vietnam. Currently, the

beer(SuTuTrang)ofMasanBreweryisonlypresentin

theMekongDelta,averysmallfractionofVietnam.The

potential for geographic expansion has resulted in

Management’sguidance forBeer tomakeup21.7%of

consumersalesby2018E(from5%)andserveasakey

driverofgrowth.

ExpansionintoThailandMasan’s strategic partnershipwith Singha has allowed

Masantogainentryintoawholenewmarket,Thailand.

Using the tried-and-tested strategy of spending on

brand-building activities which has succeeded in

Vietnam, Masan aims to gain success in the Thailand

marketaswell.

Masan’s initial venture with the introduction of fish

sauce is indicativeof its future success.Toprepare for

the launch, Singha setupa subsidiary inThailand, and

conductedproductformulationforthefishsauce.There

werestrongR&Defforts,withthemanagementgetting

pre-launch reviews. Masan Consumer has unveiled its

fishsauceproductinThailand,named‘Chin-SuYoThong’

whichisbeingstockedinBangkokandotherNortheast

areasofthecountryusingSingha’sdistributionnetwork.

Adedicatedsalesforcehasbeenestablished.Masanhas

demonstrateditsabilitytounderstandadapttodifferent

marketsasobservedbyitsstrategyfortheintroduction

of its fish sauce by targetingwetmarkets and smaller

shopsinselectedprovinces.

FinancialAnalysisRevenue growth: MSN has a history of driving growth

bothorganicallyand inorganically, in largesectorswith

extremely favorable industry dynamics. In 2011, it

acquired control of Vinacafe, Vietnam’s largest instant

coffeeproducer,andhasgrownitsbeveragesegmentto

becomeoneofthelargestlocalmineralwatercompanies

aswell. In2014,MSNmade its first appearance in the

local beer market by launching Su Tu Trang, which

becamethefastestgrowingbeerbrand inVietnamthe

following year. In 2015, it entered the animal feed

industrythroughitsacquisitionofProconcoandANCO,

and is today one of Vietnam’s largest local animal

nutritionbusiness.WeexpectMSNtocontinuegrowing

its revenuebothorganically and inorganically as it has

doneinthepast.

Profitability:MSN’sgrossmarginsdeclinedsignificantly

inFY15asaresultofMSN’sentryintothelowermargin

animal feed business. However, there was a less than

proportionate decline in EBITDA margins due to the

lower operating costs related to the feed business.

Moving forward,marginsareexpected to stabilizeand

improveasMNSbuildsoutitsfoodbusinessandwhichis

expectedtodeliverhigher,“FMCG-like”margins.

14

Return on capital: ROA improvement since FY13 has

beendrivenbyimprovementsinassetturnoverandnet

margin. A gradual increase in financial leverage

contributedtotherisingROE.

Leverage: MSN’s debt-to-assets ratio has increased

gradually throughout the years as it has optimized its

capital structure and taken on debt for acquisitions.

However, debt / EBITDA has improved as EBITDA has

grownmorequicklythantheadditionaldebttaken.

Catalysts,Events,TippingPointsThere are many potential positive catalysts that will

potentiallytriggertheStreettorecognizeMSN’sstrong

fundamentals and growth potential, resulting in a

positivere-rating.

Catalyst #1: As Vietnam is a frontier market, there is

potentialupsideifitgetsupgradedtoEmergingMarket

status,whichwilltriggerahugeamountofinternational

fundinflows.MSNwillbeanaturalbeneficiaryasitisone

ofthelargestlistedcompaniesinVietnam.

Catalyst #2: As management has guided on more

shareholder friendly initiatives, the introduction of a

payoutpolicycanactasatriggerforre-rating.Thisisnot

unlikelyespeciallysinceMSNdistributeditsfirstdividend

atthestartof2017.

Catalyst#3:Masan’s3Fmodelwillbeakeygrowthstory

thatshareholderswillbekeenlyobserving,thesuccessful

executionof itsmeatproductioncomplexandpigfarm

by 1H2018 will provide upside as investors are more

persuaded ofMasan’s ability to consolidate Vietnam’s

attractivemeatmarket.ApotentialliftingofChina’sban

onporkimportswillalsobeahugeboost,asporkprices

are c.60% higher in China than Vietnam. MNS’s

consolidationof thepork industryand implementation

ofstringentsafetystandardsmayacceleratetheliftingof

theban.

Catalyst #4: With the inventory de-stocking exercise

causing a larger-than-expected dent, Masan’s 4Q17

results will be important as investors would need to

observethattheexpensesincurredaretrulyone-offand

there will be normalization. This could result in the

overhang on the stock price to ease, as investors shift

their focus on the long term benefits of the inventory

rebalancingexercise.

Catalyst #5: Another concern from the inventory de-

stockingexercise is thedecline in revenue, resulting in

the Street being concerned thatMCH has lostmarket

sharepermanently.Hence,iftheeightnewproductsin

thepipeline,aswellasenergydrinksandprocessedmeat

segmentsaresuccessful,itwouldconvinceinvestorsthat

MCH’s growth is not stagnating and it can continue to

experiencestronggrowth.

Catalyst #6:Geographical expansion is also a way forMSN to continue to achieve strong growth, successful

execution will allow the Street to appreciate MSN’s

ability to tap on the potential presented to it in other

partsofVietnamandalsoinThailand.Thiswillresultina

positivere-ratingasitwillpresenthugegrowthpotential

forMSN.

KeyRisksDespitetheacknowledgementandunderstandingofthe

attractivenessofMSNasaninvestment,thereisaneed

tohaveathoroughunderstandingofpotentialrisksfaced

bythebusinesstoresultinamorerigoroustestingofour

investmentrecommendation.

Risk#1:Conglomeratediscountattributedbyinvestorsasaresultoffutureacquisitionsinunrelatedsegments.

This is commonly done by Management to allow for

empire-building,howeverMSNhasbeendisciplinedinits

acquisitions so far. Hence, we believe that this risk is

unlikelytoplayoutduetostrongmanagementdiscipline

thusfar.However,itisanareathatshouldbemonitored

and changes in management quality might call for a

reassessmentofthebuyrecommendation.

15

Risk#2:Foodsafety,bothintermsofdiseaseoutbreaks

among animals and health concerns regarding food

products, which can potentially tarnish MSN’s

reputation. This risk is mitigated by the stringent

requirementsMSNexpectsitssupplierstoadhereto,its

world-class facilities thatmanufactureproductsathigh

standards of hygiene and safety, and strong

management teamwith relevant industry expertise. In

addition,thefirm’sfocuson“doingwellbydoinggood”

alsoindicateshighpriorityonfoodsafety.

Risk #3: MNS margin volatility, as MNS is currently

heavily dependent on feed sales and is susceptible to

volatilityon inputaswellas feedprices.However, this

riskisexpectedtodeclineovertimeasthedevelopment

of the 3F model de-commoditizes MNS, thereby

improvingandstabilizingmargins.

(HOSE:MSN)MasanGroupCorporation FY2013 FY2014 FY2015 FY2016 FY2018LTM

SharePriceVND 64,666.67 50,000.00 47,333.33 47,050.00 71,700.00

NoofShares(mil) 1,102.4 1,103.7 1,120.1 1,133.6 1,047.5

MCAP(mil)USD 3,382 2,563 2,378 2,344 3,307

NetDebt(Cash)VND 9,717,443 14,350,585 26,954,451 26,157,165 26,677,597

EnterpriseValue(mil)USD 3,826 3,862 4,189 3,635 4,744

Revenue(mil)VND 11,942,533.0 16,119,894.0 30,628,410.0 43,297,064.0 40,600,292.0

EBITDA(mil)VND 2,616,802.0 3,817,052.0 5,914,676.0 8,358,272.0 7,246,714.0

EBIT(mil)VND 2,128,170.0 2,696,235.0 4,099,750.0 6,023,201.0 4,758,954.0

NPAT(mil)VND 451,200.0 1,080,169.0 1,478,292.0 2,791,444.0 2,156,630.0

NPAT(Ex.Xtra+Dis.Ops)(mil)VND 347,308.0 (76,157.0) 1,261,553.0 2,946,730.0 2,304,477.0

CFO(mil)VND (315,922.0) 333,147.0 3,822,772.0 4,118,601.0 3,285,859.0

CAPEX(mil)VND (3,840,386.0) (2,708,702.0) (3,856,825.0) (2,920,583.0) (2,364,707.0)

EPSVND 315.1 (69.0) 1,126.3 2,599.3 2,200.0

Revenue(mil)USD 566.5 753.8 1,364.0 1,901.2 1,786.7

EBITDA(mil)USD 124.1 178.5 263.4 367.0 318.9

EBIT(mil)USD 101.0 126.1 182.6 264.5 209.4

NPAT(mil)USD 21.4 50.5 65.8 122.6 94.9

CFO(mil)USD (15.0) 15.6 170.2 180.8 144.6

CAPEX(mil)USD (182.2) (126.7) (171.8) (128.2) (104.1)

GPM(%) 41.9% 39.8% 32.0% 29.9% 30.3%

EBIT(%) 17.8% 16.7% 13.4% 13.9% 11.7%

NetDebt(Cash)/Equity(%) 67.3% 95.6% 162.2% 171.2% 139.8%

ROA(%) 4.6% 5.1% 5.7% 8.2% 7.2%

ROE(%) 14.7% 18.0% 24.7% 39.4% 24.9%

CFO/TA(%) -0.7% 0.6% 5.3% 5.6% 5.0%

EV/Sales(x) 7.5 4.7 3.0 2.0 2.7

EV/EBIT(x) 42.2 28.4 22.1 14.0 22.6

EV/EBITDA(x) 34.3 20.0 15.3 10.1 14.9

EV/CFO(x) (284.3) 229.5 23.7 20.5 32.8

P/Sales(x) 6.0 3.4 1.7 1.2 1.8

P/EBIT(x) 33.5 20.5 12.9 8.9 15.8

P/B(x) 5.6 4.4 6.1 6.7 6.1

VQ1:EV/EBIT/ROE(x) 2.9 1.6 0.9 0.4 0.9

VQ2:EV/EBIT/ROA(x) 9.2 5.6 3.9 1.7 3.1

16

3. RyohinKeikakuCo.Ltd(TSE:7453)


QuickStats

Date 15/12/17 EBIT/R&D(x) 31.45

FilingCurrency JPY

EBIT/EmployeeNo.

(USD/px) 50K

SharePrice JPY35,550 EV/EBIT(x) 22.9



DailyValueTraded


GPM(%) 49.7% P/E(x) 23.6

EBIT(%) 11.2% P/B(x) 6.5

NetDebt(Cash)/

Equity(%) -19.1%

VQ1:EV/EBIT/ROE

(x) 0.9

ROA(%) 18.2%

VQ2:EV/EBIT/ROA

(x) 1.3

ROE(%) 25.2%

TeamMembers

Ye Ying is a second-yeardoubledegreeundergraduate atNanyang

BusinessSchool,specialisinginAccountancy&BusinessAnalytics.She

hasalsojoinedthelargestinvestingcommunityinschooltofurther

herinterest.

Xin Yi is a second-year double degree undergraduate at Nanyang

BusinessSchool,specialisinginAccountancy&BusinessAnalytics.She

iscurrentlydoinganinternshipintheCommercialBankingdivisionat

HSBCSingapore.PriortoHSBC,shehasdoneaninternshipatStarHub

implementingthenewFinancialReportingStandard.

Shan Shan is a penultimate business student in Nanyang

TechnologicalUniversity.Takingakeeninterestininvesting,shehas

joined the largest investing community in school to further her

interest.

VaniaisapenultimatestudentatNanyangBusinessSchool,planning

tomajorinBankingandFinance.Havingdevelopedakeeninterestin

markets,shestrivestolearnmoreaboutcapitalmarketinstruments

andiscurrentlyinterningatCitiMarkets.

17

HowDidYouOriginateThisIdeaandWhyDidYouChooseThisCompany?

Taking a top-down approach, the team first looked at

companies who are expanding in economies that are

fast-growing, suchasSoutheastAsia.Whennarrowing

down the list,MUJI stood out as a company that the

teamisfamiliarwith,whereits’businessisoneinwhich

the team understands. Its business also fulfilled our

initialanalysisthatitshouldbeabusinessthatisSelling,

ScalableandSustainable.

Moreimportantly,theteamfindsMUJIa“hiddengem”

in which MUJI is at a very interesting stage in its

business: even though MUJI is still seen as a regular

retailbusinessbymostinvestors,itisquietlyexpanding

itsbusinessbeyondretailintootherareassuchascafes

and hospitality by 2019 (Garfield, 2016). Moreover,

MUJIisvigorouslyexpandingitsbusinessbeyondJapan

andintofast-growingeconomiessuchasIndia(Marlow,

2017) and Southeast Asia, specifically Philippines and

Vietnamby2018(Tani,2017).

BusinessBackgroundandOverviewRyohin Keikaku Co., Ltd. is a Japanese company that

operatesintheretailindustry.Itmainlyengagesinthe

salesofitshousebrandgoodsunderthenameMUJIand

operates direct retail stores. ExcludingMUJI Cafe and

IDÉE,itcurrentlyhas418storesinJapanand403stores

overseas in US, Europe and Asia (Ryohin Keikaku Co.,

Ltd.,2017).AfteritssuccessfulentryintoChina,MUJIis

accelerating its pace for globalmarket expansion into

other economies such India, Philippines and Qatar

(Ryohin Keikaku Co., Ltd., 2017). It is also diversifying

into the hospitality industry with the launch of ultra-

minimalist hotels in Tokyo and Shenzhen by 2019

(Garfield,2016).

RevenueDrivers:

Womenswearandfurnitureareconsistentlywithinthe

top 3 best-selling product categories while health &

beauty overtook linens & interior goods in FY2014 in

terms of percentage of sales. Interestingly, sales of

health & beauty products have been consistently

increasing in the past 5 financial years indicating

potentialinthisproductline.

The domestic market remains the major source of

revenue for MUJI followed by the East Asia market.

MUJIisalsosteadilyexpandinginSouth&WestAsiaand

Oceania as indicated by the increase in percentage

sales.

OneSentenceInvestmentThesisMUJI’s diversified portfolio, strong retail strategy and

design-driven business allows MUJI to retain its

competitive advantage, further global expansion and

marketshareintheretailbusiness.

WhatMakesItaWide-MoatBusiness?To analyse whether MUJI possesses the competitive

advantagethatmakesitdifficultforcompetitorstorival,

weapproachedMUJI’sbusinessintermsof3“S”:

1. Saleability:CanMUJI’sproductssellwell?

2. Scalability:CanMUJI’sbusinessgrowwell?

3. Sustainability: Is MUJI’s business growth

sustainable?

18

Saleability:FocusonCustomerSatisfactionMUJIrecognisesthat“selling”isfundamentalinitsretail

business and customer satisfaction is at the core in

selling.Thus,MUJIhasputinmucheffortindeveloping

its sales capabilities. MUJI has enhanced its sales

capabilities through providing two “E”s - Expert and

Experience.

For“experts”aspect,MUJIhastraineditssalesstaffto

bespecializedinspecificareassuchasInteriorAdvisor

Consultation Service, Organizing Consultation Service,

Wall Storage, and Styling Advisor, offering detailed

lifestylesuggestionsforitscustomers.

By revamping its storeenvironmentand including the

Fragrance Studio, Stamp and Gifts Corner, Wood

EnvironmentPlayAreawithinitsstores,MUJIprovides

itscustomerswiththeexperienceofdiscovery.MUJI’s

customers are able to see, touch and feel to discover

theirown styleateachMUJI store.Collectively, these

haveenabledMUJItobettercatertoitscustomerswith

itswiderangeofproducts,therebyincreasingcustomer

satisfactionandhence,sales.

These initiatives have been rewarded with concrete

results. For example, after implementing its Interior

AdvisorConsultationServicein2013(Chen,2016),there

isanobviousincreaseinfurnituresalesfrom2013-2016

asshownbelow,contrastingwithitsrelativelystagnant

furnituresalesfrom2010-2012.

On top of these,MUJI’s extensive efforts in engaging

customers through its events, large social media

presence and app development have resulted in high

customer loyalty. It alsoemploysbigdataanalytics to

provideapersonalisedexperienceforcustomersonits

onlineplatform such as real-timeand context specific

recommendations.

MUJI’sOnlineandPassportMobileAppStrategyForinstance,MUJIPassportwascreatedtodriveinstore

traffic and to enableMUJI to be clear and consistent

with their communicationwith consumers through all

channels. Working like a loyalty card, it is a bridge

betweenMUJIanditsconsumers.

Despiteitsunderwhelmingsuccessduringitsinception,

MUJItookactiontounderstandtheirconsumerthought

process, enabling them to better serve them. By

understandingthatconsumerswereontheirsitetofind

out more about products before making an in-store

purchase, MUJI was able to garner interest by

introducinga free signupcredit incentiveandmaking

membership discount redemption a seamless

experience. The launch of push notifications that

informed consumers about discounted products also

resultedinasurgeinfoottraffictheduringsaledaysand

discounted items were wiped off the shelves within

hours(AppAnnie,2016).

Byofferingbonuspointstotheiralmost8millionMUJI

members,theywereabletoexponentiallyincreasefoot

traffictotheirstoresdespitetherecentconsumptiontax

hike (AppAnnie, 2016). Thiswasa testamentofMUJI

Passport’s ability to drive traffic to brick and mortar

stores and its capacity to be used as a channel to

maintaincustomerconnectionsandrelationships.

Today, MUJI Passport offer members personalised

discounts and product launch updates to keep

themselves relevant and up to date with their

consumers (Marian, 2015). In Japan, the app is

continually updated and expanded to increase

convenience and services. In other markets such as

Hong Kong and Korea, the app is awaiting revision in

terms of how it rewards shopping points and loyalty

programstructure(RyohinKeikakuCo.,Ltd.,2017).

Scalability:IntegratedSupplyChainManagementAsset-LightBusinessModelMUJI adopts the asset-light business model as it

outsources its manufacturing capability instead of

owning/controllinganymanufacturingfacilities.Thisnot

onlybringsaboutgreaterflexibility intermsofquicker

response to changes (such as changing demand,

technology advancements, newmarket opportunities,

and supply chain disruptions) but also allowsMUJI to

scaleatacheapercost (TheBostonConsultingGroup,

n.d.).Beingasset-light,MUJIisabletogrowitsbusiness

without incurring huge spending on capital assets,

allowingMUJItodomorewithless.

ComprehensiveSupplyChainOne major competitive advantage MUJI has over its

competitors is its comprehensive supply chain

management which allows it to manage its cost and

quality efficiently. MUJI has its own distribution and

procurement subsidiaries - RK TRUCKS Co., Ltd. and

MUJI Global Sourcing Private Limited handling Asia’s

supply chain; and a new distribution center in

Netherlands to manage its Europe supply chain. This

start-to-end supply chain management enables it to

reduce itsdelivery lead time to stores, ensuring items

are not out-of-season, particularly for apparels which

aresensitivetochangesintrends.

19

In 2013, MUJI has installed a global merchandising

system tomanage informationon sales and inventory

foritsproduct.InFY2014,thecompanybeganbuilding

a global supply chain management system (GSCM

system)toautomatemerchandiseorders,linkingstores,

regional distribution centres (DCs), global DCs and

factories.TheGSCMsystemaredividedinto3phasesas

showninthepicturebelow.AsofFY2016,MUJIfinished

introduction of the systems in all phases and is

beginningtoimprovesystemaccuracy.Thesystemhas

generatedresults,forexamplewhenitwasintroduced

inSouthKoreainApril2014,ithelpedreduceinventory

stockpile by 30%. Overall, MUJI has also managed to

reducethelogisticcostbyacumulativeof2.7billionyen

oralmost24millionUSD.AsMUJIcontinuestoimprove

on the GSCM system, therewill bemore cost-savings

andtightercontrolonsupplychain.

The team believes that with a sound and tightly

controlled supply chain management system, MUJI is

abletocontrolitsowncostandqualitywhileexpanding

atafastrate,withoutbeingsubjectedtoanyvolatilityor

lapsesbythirdpartiesinthesupplychain.

StandardisationofProcessesOntopoftheextensivetightcontrolonitssupplychain,

MUJI also employs standardisation of processes and

products,suchasthestandardisationofallbedlegs,to

drivedownproductioncostssuchthatitcanpassoncost

savings to increase customer basewithout hurting its

profitmargin.Thisisevidentfromitsmovetoslashprice

by14%on40%ofproductssoldinJapanin2018(Nikkei,

2017).

Sustainability:SustainableBusinessModelRetailStrategyMUJIbegun itshugesuccess inthe1990s.However, it

adopted an aggressive expansion strategy that

eventually outran the speed of its own product

development. Thiswas further exacerbated by a poor

overseasexpansionstrategy,whereMUJIcompetedfor

the hottest local spots to build its retail space. The

eventual consequence was that MUJI’s sales volume

simplycouldnotmatchuptothehighrentalcosts.For

example,aMUJIretailstorelocatedinanunderground

shoppingmallbeneaththeParisLouvreMuseumhada

rent-to-salesratioof40%.TheaverageratioinJapanis

10%,whilethetypicalfigureforEuropeisaround15%

(BeyondProxy,2015).

Learningfromitspastexperience,MUJInowadoptsthe

“second-bestspotinaprimelocation”retailstrategyto

lower rent expenses and to offset remodelling costs

(Horie,2015).Thisretailstrategyofsettlingfor“second-

best”enablesMUJItokeepitspricingcompetitiveand

operatingexpensesmanageable.

DiversifiedPortfolioThoughtheretailingofMUJIproductsstillmakesupbulk

of thebusiness,MUJIhostsawell-diversifiedportfolio

consisting of retail (MUJI), restaurants (The Cafe and

Meal MUJI), recreational activities (MUJI Campsite),

property(MUJIHouse)anddesign(IDÉE).

GlobalHRManagementAglobalHRsystemandaglobalincentivesystemwere

set up earlier this year as part of MUJI’s Mid-Term

Business Plan (FY17-FY20) to focus on employee

proficiency(RyohinKeikakuCo.,Ltd.,2017).MUJIstock

optionsandperformancebasedbonusareextendedto

thecompany’snon-Japanesedirectors,executives,and

employees (in the formofpoint system,wherepoints

willbeconvertedintoMUJIshares),motivatingthemto

actintheinterestofMUJIinoverseastenures(Rhyohin

KeikakuCo.,Ltd.,2017).Thiswillalsohelptoencourage

longtermrecruitmentoverseas,andachievesalesgoals

inviewofoverseasexpansion.

BrandEquityAlthoughMUJIproductsdonothavebrandlogowhich

isapsychologicaltooloftenusedbybusinessestohelp

promote strong affective associations (Association of

PsychologicalScience,2016)thisinturnhastheeffectof

shielding MUJI against the rise of anti-consumerism.

Furthermore,MUJIactuallysolicitsagrowingloyalcult-

like customer basewhere it is actually perceived as a

greatbrandwithsensibleandsimpleproductsthatare

continuouslyinnovating.

20

ThisbrandequityisbuiltwithMUJI’sdedicationtowards

coming up with new unique products continuously

whichcanbeseenfromitwinningmorethan100top-

tier design and innovation awards. This attitude is

reflected in its persistence in finding a way to mass-

manufacturethemoredurableandcomfortable“right-

angled 90-degree socks” instead of the conventional

socks at a 120-degree angle (Glader, 2014).MUJI also

adoptstheopen-innovationmethod,engagingexternal

designers who identify and pride themselves with

MUJI’sdesignvalue.Thesedesignsareevaluatedwitha

group panel to ensure consistency of style (Beyond

Proxy,2015).Thesetogethercontributetohighquality

MUJI-brandproducts,andallowMUJI toproducebest

sellersconsistently.

Collectively, thesehave laid the foundation forMUJI’s

brand equity which is: affordable, simple, sleek,

minimalist products designed well for a specific task

(Vulcan Post, 2017) which helps ensure MUJI’s

sustainability on the back of the rise of customers

conscious about waste reduction and eliminating

commercialism.

Environmentalism&CorporateSocialResponsibilityWithariseofglobalactivism,consumersarebecoming

moreawareandvocalabouttheirconsumptionchoices.

MUJI’slongestablishedfocusonenvironmentalismand

corporate social responsibilitywill safeguard it against

any potential consumer boycott. CSR is not a one-off

thingforMUJI,wherebyit incorporatesCSRintomany

aspectsofitsbusinessmodel.Inordertoincreasesthe

source of products for its supply chain management,

MUJIhastrained300womeninCambodiainsewingand

dyeing techniques, working towards empowering the

femalepopulation(AsianDevelopmentBank,2016).

MUJI’s programs such as ReMUJI (recycling of

consumers’unwantedclothes)(RyohinKeikakuCo.,Ltd.,

n.d.),investmentineco-friendlydyeingandsewingplant

in Cambodia, and sourcing products from Kenya and

Kyrgzystan instead of outsourcing to known

conglomerate of sweatshops all exemplify MUJI’s

centralvalueof“ConscienceandCreativity”,creatinga

sustainablebusiness(Quito,2016).

What are your top 3 dislikes? What are the toxicfactors?Internal:LimitedCostControlAbilityMUJIhasahighstockkeepingunit(SKU)countofover

7000 items but it does not own or control its own

manufacturing facilities.While thismakesMUJI asset-

light and avoids issues such as managing capacity

utilisation, italsomeans thatMUJIhas limitedcontrol

overitsproductcost.

As MUJI sells a wide variety of items in several

categories,thismeansthatdespiteexpandingoverseas,

the order lot size remains small. As such, it is

fundamentallydifficult forMUJItooptimise its lotsize

toreducecost.

Productlocalisationcateringtothediverseculturesand

bodytypesetcfundamentallyimpedesMUJI’seffortsto

cutcostsbecauseevensmallerlotsizeshavetobeused.

For instance, the flagship store in Singapore had to

source for Chinese strainers in efforts to localise

decorativeornaments(Lee,2017).

Inordertoovercomethis,MUJIoverhauleditslogistics

processestoreduceprocurementcostsandintroduced

simplifiedpackagingwhileincreasedsalesvolumeshave

helped to aid this reduction (Inside Retail Asia, 2017).

For instance in early 2017,MUJI cut costs by limiting

outsourcingfactoriesandmaterialsuppliersandbetter

productspecifications.ThisallowedMUJItolaunch200

itemsatdiscountedpricesandacampaign“Yutakana-

tei-kakaku (“rich life at lowprices”)” highlighting their

success.

MUJI’sreactiontothistoxicfactorhassofarenabledthe

company to add to its brand valueofminimalismand

generated new sales alongside repeat customers.

However, the team acknowledges that continual cost

reductionsarenotsustainableinthelongrunandthat

MUJI has to find other ways to continue to garner

renewedinterestandsales.

External:E-commerceSince2012, theglobal retail sectorhasseen lacklustre

performancerelativetoothersectorsduetotheriseof

ecommerce (Gjerstad & Papp, 2017). As such, in an

industrylandscapeoverrunbyconvenience,accessibility

andadvancedtechnologyofferedbyE-Commerce,brick

andmortarstorescannotsimplystillrelyonbeingaone-

stopshoptostaycompetitive.Instead,companiesneed

tofocusonthehowtogetcustomersexcitedwhenthey

walkintostoresviaanexperientialshoppingexperience

(The New Paper, 2016). True enough, the opening of

physicalstoresbyE-CommercegiantAmazoninabidto

provide a more personal shopping experience further

stressestheimportantroleexperiencesplayinshopping

(Team,2016).

MUJI’scentralfocushasalwaysbeenprovidingsuchan

experience as the company believes its physical store

experienceconveystheMUJIstoryof“MUJIisenough”,

“Without thought” and “Just right”. This experience

helps to build the brand value and heighten MUJI’s

emphasisonminimalismandtheideaofcompactliving

(Fukasawa, n.d.). Furthermore, the introduction of

21

interior consultants and styling consultants in stores

makeupthebrandexperiencethatsetsMUJIapart.

Despitetheirstrongbrandvalueandabilitytodelivera

goodexperientialshoppingexperience;MUJIdoes

recognisethethreatandopportunityduetorisinge-

commerce.AssuchMUJIhadlaunchedonlinestorein

2008andMUJIPassportin2013inordertodefendits

marketshareagainstrisinge-commercegiantsaswell

astodrivesalestophysicalstores.Asseenbelow,

onlinestoresalesrevenuehasbeenconsistently

increasingovertheyears,showingpositivegrowthover

theyears.

MUJI also increased its efforts in developing its omni-

channelsalesandmarketing.Forinstance,thecompany

constantlyengages theircustomersviacampaignsand

frequent, thoughtful updates on their social media

platformssuchas launchingfashionlookbooks,online

exclusiveoffersandpre-launchitemsetc.Thisnotonly

keeps theirconsumersengagedbutalsoenablesMUJI

to drive traffic to both their online and offline stores

(TheNewPaper,2016).

MUJI has also shown its commitment to continual

improvementofitsonlineexperience,forinstanceMUJI

has recently temporarily closed its online store in

SingaporeandwillberelaunchingitinJan2018witha

new enhanced site that will enable a more

comprehensiveandimmersiveshoppingexperiencefor

consumers (RhyohinKeikakuCo., Ltd., 2017). It is also

lookingtolaunchanecommercesiteinIndiaalongside

its plans to expand physically in the nation as it

recognisesitsappealespeciallyinsuchabigcountrylike

India(Shah,2016).

Movingforward,theteamrecognisesthatMUJIstillhas

alongwaytogointermsofitseffortstodrivesalesto

its ecommerce platform, however we feel that with

MUJI’s current efforts to combat this toxic factor, the

companyisnotinjeopardyinthemediumterm.

External:ErosionofMUJI’sUniqueBrandingMUJIpridesitselfas-“nobrand,goodquality”,whichis

theliteraltranslationfromitsJapanesenameMujirushi

Ryōhin.However,inthepast5years,therehasbeena

rise of “copycat” companieswhich erodes the unique

minimalismconceptMUJIstandsfor.

Themostnotableamongst them isMINISO,aChinese

companywhichemulatesMUJI’s(andUniqloandDaiso)

branding,wheretherearemanysimilarities-fromthe

focusontheconceptofminimalism,thewide-rangeof

products(fromappareltofurniture),toevensimilarred

logo and Japanese labels (Liu, 2017). Online reviews

have also found that the similarities are close enough

such thatsomecustomersmistakeMINISOasanother

brandunderMUJI(HongKongEconomicJournal,2016).

However, the close similarity of branding can only be

saidtobe“coincidental”inMINISO’sCEO’swords,and

thus is insufficient to amount to a legal pursuit (Liu,

2017).Therefore,thiscompetitioncannotbestifledand

willseeanevengreaterincrease,asMINISOexpandsat

afasterrate(1,800storessince2013)thanMUJIandin

placesMUJI is focusing on - China, India and US (Liu,

2017).

Furthermore, realising the appeal of minimalism to

consumers, many Chinese companies are jumping on

the minimalist bandwagon. Examples include Vancl

(apparelbusiness)andNetEaseYanXuan(lifestyleonline

retailer)which emulateMUJI’s style of simple designs

andhavegarneredahugebaseofconsumers(AllChina

Tech, 2016). This further dilutesMUJI’s unique selling

pointofminimalistdesigns.

Currently,MUJIhasbeenrelyingonitsbrandequityto

defendagainst the invasionof these competitors. The

inability to safeguard its unique minimalism branding

whichisthefundamentalbasisMUJIpridesitselfon,will

beasignificantriskfactorMUJIhastoaddress,inorder

toprotectitsmarketshareandprofitmargin.

ManagementQualityAnalysis

CorporateCultureJapanese companies have long been known for the

overworkculturewhichissoprevalentandentrenched

that the word “Karoshi” is created to describe the

common occurrence of occupational deaths due to

overwork.

ThetoxicoverworkingculturehascausedtheJapanese

advertisingfirmDentsutocomeunderfire in2015for

overworking its employees and subsequently it paid

S$29 million in overtime wages to its workers (Sim,

2017). In contrast, MUJI has been making efforts to

22

changetheoverworkculturesuchasconductingchecks

toensureemployeesdonotprolongworkingafterwork

hour(Nikkei,2016).ThishelpstoensureMUJIisableto

avoid possible backlash that could result from any

“Karoshi”controversy.

In addition, at MUJI, employees can raise problems

encountered and provide solutions to the company.

These inputs help to modify and refine Mujigram, a

comprehensivedirectivemanualthatprovidesguidance

covering various aspects of work processes from

productdisplaytocustomerservice(Kiuru,2016).This

creates an employee-focused corporate culture that

encourages participation and nurtures a sense of

belongingfortheemployees.

ManagementQuality&PhilosophyEarlier this year, MUJI announced organisational and

personalchanges.Onemajorchangeistheappointment

of more executive officers for RK’s large affiliates

outsideJapan(RyohinKeikakuCo.,Ltd.,2016).Thisisa

move by MUJI towards greater decentralisation of

management power and responsibility, in linewith its

goal towards global market expansion to facilitate

companygrowth.

These changes may potentially create difficulties for

MUJI to implement group policy uniformly due to

problems of coordination. However, this can be

mitigated by MUJI’s strong focus on internal

communication. Every manager in the Tokyo

headquarter will be seconded overseas to better

understand MUJI’s overseas operations. Similarly,

overseasmanagementstaffsaresenttoTokyotobetter

understand group policy decision-making process

(Rudlin,2013).

CurrentlyRyohinKeikakuis

helmedbySatoruMatsuzakiwho

tookoverasthePresidentand

CEOofthecompanyin2015.

SatoruMatsuzakiwasappointed

forhisdecadesofexperiences

overseeinginternational

operationsin25countries

(Takahashi&Katano,2015).Hisextensiveexperience

willbeparticularlyusefulatthisjuncture,asMUJIis

rapidlybuildingupitsglobalpresencebyexpanding

intovariouscountries.Intermsofmanagement

philosophy,SatoruMatsuzakisharesthesamebeliefas

hispredecesorTadamitsuMatsuithemanbehind

MUJI’sturnaroundintheearly2000s.Tadamitsu

MatsuiturnedaroundMUJIfromlossesbybringing

backtheMUJIway(thefocusonsimple,functionaland

innovativeproduct)andreducinginconsistencies

throughstandardisationofsupplychainmanagement

systemandstorelayout(Hiura,2013)SatoruMatsuzaki

alsostressesthatMUJIwillmaintaintheMUJIwayand

notrepeatthesamemistakeofdetractingfromMUJI

concepts(IESchoolofArchitecture&Design,2017).

SatoruMatsuzaki’smanagementphilosophyisalso

focusedonthelongtermvalueofitsbusiness,inwhich

forMUJI’sglobalexpansion,SatoruMatsuzakihas

statedthatMUJI’spriorityistosetupastrongbase

withitsjointventurepartnerReliancebeforerapid

expansioninIndia.Thisstrategyhasalreadyreceived

priorsuccessinexpansioninChina,inwhichMUJIonly

hadonestoreinChinaforthreeyearsfrom2005to

2007beforeembarkingonrapidexpansionofuptill

200storesby2017withatargetedincreaseof40

storesperyear(Shah,2016).AsMUJIisonlyinthe

initialstageofexpansionglobally,withonlylessthan

10storesinmanyofitsventuressuchasIndia,Saudi

Arabia,Bahrain,VietnamandPhilippines;thevalueof

itsglobalexpansionhasnotbeenreapedbutwilllikely

berealisedinthecomingfuture,asevidencedbyits

expansioninChina.

ShareholdingStructure• AuthorizedSharesIssued:112,312,000

• OutstandingShares:28,078,000

• NumberofShareholders:9,818

(RyohinKeikakuCo,.Ltd.,2017)

CorporateGovernanceJapanesecompaniesareknown for cross-shareholding

to cement business relationships. Cross-shareholding

oftencompromisescorporate-governanceascompanies

tend to take a hands-off approach on each other’s

management, weakening managers’ sense of

accountability(Kodaira,2015).MUJIismakingeffortto

dismantle this practice. In 2015, MUJI sold of its 1.7

million shares in apparel giant Onward Holdings, to

improveassetefficiency.MUJIalsohasitsowninternal

auditdepartmentthat isrecentlysplit intoStoreAudit

Office and Global Audit Office to reinforce corporate

governance and increase audit efficiency (Ryohin

KeikakuCo.,Ltd.,2016).

BusinessGroupStructure

23

FamilyMart’s investment in MUJI is reflected in its

business where there is a dedicated section forMUJI

productsinitsstoresandonlinesite.UponFamilyMart’s

merger with UNY Group, MUJI products are now

availableatFamilyMart,CircleKandSunkusstores.This

isawelcomedevelopmentforMUJIasit increasesthe

company’sreachby1.5timesandenablesMUJItotake

up greater consumer mindshare (Ryohin Keikaku Co.,

Ltd., 2016). Although this move might be seen as a

dilution of MUJI’s brand image, this move actually

enablesMUJItoreinforceitsimageofbeingfunctional

yetaffordable.

ChangesinDividend

Clear fromthe tableabove,dividendpayouthasbeen

consistently increasing. Year on year and excluding

extraordinary items,dividendper sharegrowthenjoys

anincreaseof19.11%(TheFinancialTimes,2017).The

consistentincreaseinthedividendpayoutsignalsMUJI’s

confidence in its future growth especially only some

companies in the Retail (Department & Discount)

industrypayadividend.Itsfive-yearannualiseddividend

per share also outperforms its peers in the industry.

Furthermore, there isa sharebuybackof4475million

yen in the fiscal year 2016 (Ryohin Keikaku Co., Ltd.,

2017),thismayimplythattheMUJImanagementthinks

thattheirshareisundervalued.

CatalystandEvents

We believe the following factors will helpMUJI in its

growth and potentially leading MUJI to double its

marketvalueinthenext3-5years

DiversificationMUJIhasdiversifieditsretailbusinessby:

• Openingupcafes-23inJapanand15overseas

• Sellingfreshproduce

• Venturingintohospitalitybyopening2hotelsin

TokyoandShenzhen(Garfield,2016).

AlthoughitmightseemthatMUJIisspreadingitselftoo

thin on the surface, MUJI has mitigated its potential

diversification to turn into “diworsification”, by

retainingfocusonitscoreretailstrategy.Ifonetakesa

closerlook,onecanobservethatMUJI’sdiversification

into foodandbeverage, freshproduceandhospitality

are all means to showcase and market MUJI’s iconic

minimalistbranding.For instance,MUJIhotel issimply

anotheravenueforgueststohavefirsthandexperience

usingMUJIproductsineverydaylife.

MUJI’s global flagship store “MUJI YURAKUCHO” is

another prime example of how MUJI has used

diversification to enhance the consumer’s experiential

shoppingexperienceaswell asmarket theirproducts.

Withinthestore,thereisfreshproduce,MUJICafeand

MUJIHut.(MUJIHutisalifesizedisplayofalivingspace

furnishedwithMUJIfittings)MUJIdrawsmoretrafficby

creating a comprehensive flow in the customer

experience (Ryohin Keikaku Co., Ltd., 2017). For

instance, the introduction of MUJI Cafe pushes more

traffictowardsitsfreshproducesection(freshproduce

is used in theMUJI Cafe) to entice consumers to stay

longeratMUJIstoresandhencemakemorepurchases.

MUJI also takes advantage of this increased traffic by

showcasingitsMUJIHutinthemiddleofthestore.Allof

theiractionsshowthatMUJIisactivelytryingtogarner

moremindshareinconsumersbycreatingopportunities

toenforcetheconceptof“MUJIisenough”andshowing

howMUJiseamlesslyintegratesintoone’slifestyle.

However, MUJI’s management time, energy and

resources are still concentrated on designing and

developingqualityproductswhichareshowcasedinits

diversification effort which minimises diversion from

MUJI’soreretailbusiness.

Though its diversification strategy is commendable, it

shouldbenotedthatthisstrategyhasnotyetprovenits

returnoninvestmentduetothehighinitialsetupcosts

andalongleadtimetobreakeven.

GlobalExpansionWithforeignoperationsaccountingformorethan40%

of total profit, MUJI continues to pursue its vision of

becomingaglobalbrandbyincreasingitsstorenetwork

andtakingupnewopportunities.(Nikkei,2017)

Even though both domestic and overseas sales have

beenincreasing,theincreaseinoverseassalesismore

instrumental tothe increase intotal revenue.Thiscan

beseenfromthegraphbelow,theincreaseintotalsales

is accompanied by the increase in the proportion of

overseassalesoutoftotalrevenue.

24

Todothat,MUJIisfocusingonaggressiveglobalmarket

expansionintoSouth/WestAsia,asseenfromthegraph

above. It targets to increase the number of its MUJI

stores from the current 821 to 1138 by FY2020.

(excluding MUJI Cafe and IDÉE) (Ryohin Keikaku Co.,

Ltd.,2017)

MUJI’sRegionalSegmentation• Japan

• EastAsia:China,Korea,Taiwan,HongKong

• West/South Asia & Oceania: Thailand, India,

Malaysia,Singapore,Australia

• Europe&Americas:USA,UK,France,Germany,

Italy,Canada,Spain,Portugal

MainlandChina,TaiwanandHongKongIn early 2014,MUJI convertedMUJI (Taiwan) Co., Ltd

into a subsidiary to further solidify its position in the

regionbydirectlyowningthestores inHongKongand

China. (RyohinKeikakuCo., Ltd., 2014)Afterdoing so,

MUJIhascontinuedtoaggressivelyopennewstoresin

these countries which has resulted in increased sales

andlocalprofits.(RyohinKeikakuCo.,Ltd.,2017)

MUJI’s focus has always largely been in China and

continues toexpand in themarket,aimingtoopen40

new stores annually, reaching 360 stores in China by

2021 in order to gain better name recognition among

thegrowingChinesemiddleclass.(Nikkei,2017)

The growing middle class has been fueled by lifted

Chineseincomesandrapideconomicgrowth.Thevalues

ofChinesecustomersarealsosettochangefromvanity

topracticalityastheChineseconsumermarketmatures

(Mishima,2016).Withapopulationsizeof1.37billion,

theChinesemarketstillshowsgreatpotentialforMUJI

totapondespiteitsincumbentpresenceinthemarket.

RegionalGeopoliticalTensionsMoreover, it is comforting that China-Japan relations

haveimprovedoverthepastfewyears.Morenotably,it

hasreachedanewhighinpositiverelations,whereboth

leaders have agreed theirmeeting in November 2017

marks a “fresh start of relations” (The Straits Times,

2017)andthatShinzoAbewasthefirstJapanesePMin

15 years to attend the Chinese embassy in Tokyo’s

NationalDaycelebration(Gao,2017).

This improvement in positive relations is reassured

through the continued governance by Shinzo Abe,

followinghissuccessfulre-electioninNovember2017.

Thisisespeciallyimportantbecauseconsumerspending

inMainland China can be greatly affected by national

issues,asnotedbytheboycottbyMainlandChinesedue

totheTHAADmissileissuewhichhasresultedinSouth

Korea’sLotteGrouphavingtoinjectUS$318millionand

subsequently sell all its stores in China in September

2017topreventfurtherlosses(TheStraitsTimes,2017)

IndiaThe company currently has three stores in Mumbai,

Bangalore and New Delhi and aims to open another

store in Noida (the national capital region) before

openingitsflagshipstoreinMumbaiin2018.President

and owner of MUJI - Satoru Matsuzaki-san has

expressed his high expectations for the Indianmarket

and cites the similarities between the Chinese and

Indian markets such as consumer demographics and

stronggrowthasthereasonforhisforecasts(Marlow,

2017).

India’s economy continues to be one of the fastest

growingintheregionwithaGDPgrowthof7%(Mishra,

2017) and its exploding middle class shows high

potentialforMUJItobuildcustomerloyaltyintheearly

stagesofthisgrowth(Keith,2016).Evidenceofthiscan

beseenfromitssalespershopperinIndiawhichalready

exceededthatofJapan.(Hayakawa,2017)

SingaporeMUJI recently opened of its flagship store Plaza

SingapuraOutlet - its 423rdoutletoutside Japan. This

movesignifiesthecompany’scommitmenttoexpansion

25

inSoutheastAsiaandSouthAsia,movingitsfocusaway

fromEastAsia.

MUJIsees itspresence inSingaporeasashowcase for

regional expansion and as a testbed to pique interest

fromoverseasinvestorsbyallowingthemtoexperience

thebrandinSingapore.Forinstance,thePlazaSingapura

outlet is only the second outlet to house the “MUJI

Cafe&Meal” concept and MUJI hopes to bring this

concept to other parts of Southeast Asia like Kuala

Lumpur.(TomomiKikuchi,2016)Apartfromthat,being

inSingaporehasalsoallowedMUJItolearnmoreother

countriessuchasIndiaandtheMiddleEast(Tani,2017).

OtherEmergingMarkets-VietnamandPhilippinesWith GDP growth of 6.2%, MUJI has also marked

Vietnamforexpansionandplanstoopenitsfirststore

inthecountryviaaJointVenturein2018(Nguyen,2017)

InthePhilippines,MUJIcurrentlyhas7outletsandhas

embarked on a similar Joint Venture with Stores

Specialists Inc.(SSIGroup)-a leadingFilipinospecialty

retailer that has an extensive portfolio of established

internationalbrands-underthename:MUJIPhilippines

Corp,tobuildupitsretailbusinessnetwork.Thisenables

MUJItodirectlyoperatelocationsinsteadoffranchising

them(Nikkei,2017).

In the partnership, SSI will provide the operational

knowledgeandapparelandretailsalesfortheFilipino

marketwhereasMUJIwillprovidebrandmanagement

expertise(Saulon,2017).Furthermore,thepartnership

will enable MUJI Philippines Corp to carry more

merchandiseandlowerpricingintheirstores(Gonzales,

2017)

IncreasingPopularityofMinimalismApple’sminimalistapproachhasledtonotjustitshuge

successtodaybutalsoadesignrevolution.Ithasproven

that simplicity appeals to customers and people are

buying into the design language. Similarly, with the

mottoof“nobrand,goodquality”,MUJIbasesitsentire

sellingpointonbeingminimalist.Itsproductsare“plain

without being forgettably genreic - special, and just

boringenough”(Sherwood,2014).Intherecent2years,

there has been increasing popularity of minimalism,

particularly amongst millennials, and as more

millennialsaged20-36todayentertheworkforceinthe

next 3-5 years, the increased purchasing power they

gain will have a positive impact on the sales ofMUJI

(Weinswig,2016).

Asfortheemergingmarket,agrowingmiddleclasshas

also spurred the trend towards minimalism as more

people steer towards owning simpler and more

functional products as their economic situations

improve.(Marlow,2017).

FinancialAnalysis

EvaluationofFinancialRatiosandFigures

RevenueCAGR=12.09%

NPATCAGR=18.71%

TheCAGRforrevenueandnetprofitarebothhealthyat

12.09% and 18.71% respectively. Revenue growth

slowed to 8.4% in FY 2016 due to strong yen which

depresses the overseas revenue. Furthermore, the

European & USAmarket has been creating losses for

MUJIandhasasluggishrevenuegrowth(revenueonly

increasedto17603millionyenfrom17124millionyen).

InFY2014, it isnotedthatthere isNAPTgrowthisat-

2.8%. This is due to a slightly lower NPAT in FY2014

despitehigherrevenueinFY2014.However,thisisdue

togainonstepacquisition(anextraordinaryincome)in

FY 2013, therefore if the extraordinary income is

disregarded,MUJIwasmoreprofitable inFY2014than

inFY2013.

EPSCAGR=19.03%

EPS has been generally increasing, indicating it is

profitableforshareholderstoholdontoMUJI’sstock.

MUJI’s gross profit margin has been consistently hit

above 45% in the past 5 financial years and is in the

increasing trend. This is an impressive number and

shows that MUJI most likely enjoys a market leader

positionoratleastapremiumspotintheindustry

Net debt has been consistently negative, indicating a

stableandhealthyfinancialstrength.

26

MUJI’s inventory turnover is rather low and inventory

numberofdaysarehigh.This ismostlydue toMUJI’s

strategy of expanding its product line-ups (staple

productsonly,excludingseasonalproducts)toprevent

opportunity loss such as stock-outs and rise in

production cost. But stocking inventory may lead to

issues such as higher storage expense as seen from

increasingleasehold&officerentsexpense.

High receivable turnover ratio and low days sales

outstanding.Thismeans thatMUJIhasa strongcredit

collection policy, collecting cash quickly, aiding in

healthycashflowforshorttermcapitalrequirements.

Owing to its asset-light business model, MUJI has a

moderatelyhighROA.Thisfarsurpassesitscompetitor

Isetan whose ROA hovers around 1-2% and is

comparable if not higher than Fast Retailing Co. Ltd

(whoseprimarysubsidiaryisUniqlo)asseenfromtable

above.

MUJIhasastrongROEwhichhavebeensustainedata

2-digit figure over the past 5 financial years. This far

surpassestheindustryaveragewheretheaverageROE

for retail industry in Japan is only 5.19% (Damodaran,

2017).

(TSE:7453)RyohinKeikakuCo.,Ltd.FY2013 FY2014 FY2015 FY2016 FY2017 FY2018LTMSharePriceJPY 8,000.00 11,160.00 20,330.00 24,850.00 28,330.00 35,550.00NoofShares(mil) 26.7 26.5 26.5 26.6 26.4 26.3MCAP(mil)USD 2,087 2,903 4,336 6,004 6,719 8,290NetDebt(Cash)JPY (31,070) (23,777) (16,238) (28,539) (27,643) (30,059)EnterpriseValue(mil)USD 1,516 2,192 3,400 5,271 5,492 8,057Revenue(mil)JPY 188,350.0 220,619.0 260,254.0 307,532.0 333,281.0 354,553.0EBITDA(mil)JPY 21,693.0 25,263.0 29,696.0 42,289.0 46,879.0 48,830.0EBIT(mil)JPY 18,352.0 20,915.0 23,847.0 34,440.0 38,278.0 39,655.0NPAT(mil)JPY 10,970.0 17,096.0 16,623.0 21,718.0 25,831.0 28,700.0NPAT(Ex.Xtra+Dis.Ops)(mil)JPY 11,759.0 12,782.0 14,313.0 23,001.0 25,922.0 25,941.0CFO(mil)JPY 13,176.0 15,117.0 14,619.0 26,133.0 19,742.0 28,863.0CAPEX(mil)JPY (3,856.0) (10,474.0) (16,490.0) (7,527.0) (8,468.0) (8,445.0)EPSJPY 441.0 482.8 540.0 866.0 982.4 986.9Revenue(mil)USD 2,039.2 2,161.1 2,174.9 2,724.5 2,975.9 3,218.2EBITDA(mil)USD 234.9 247.5 248.2 374.7 418.6 443.2EBIT(mil)USD 198.7 204.9 199.3 305.1 341.8 359.9NPAT(mil)USD 118.8 167.5 138.9 192.4 230.6 260.5CFO(mil)USD 142.7 148.1 122.2 231.5 176.3 262.0CAPEX(mil)USD (41.7) (102.6) (137.8) (66.7) (75.6) (76.7)GPM(%) 46.4% 46.1% 47.2% 48.9% 49.8% 49.7%EBIT(%) 9.7% 9.5% 9.2% 11.2% 11.5% 11.2%NetDebt(Cash)/Equity(%) -33.1% -22.0% -12.9% -20.4% -18.0% -19.1%ROA(%) 15.4% 14.9% 12.8% 17.1% 17.8% 18.2%ROE(%) 19.6% 19.3% 19.0% 24.6% 25.0% 25.2%CFO/TA(%) 11.0% 10.8% 7.8% 13.0% 9.2% 13.2%EV/Sales(x) 1.0 1.2 2.0 2.1 2.2 2.6EV/EBIT(x) 10.1 13.1 22.0 18.4 18.9 22.9EV/EBITDA(x) 8.5 10.9 17.7 15.0 15.4 18.6EV/CFO(x) 14.0 18.2 36.0 24.3 36.6 31.5P/Sales(x) 1.1 1.3 2.1 2.1 2.2 2.6P/EBIT(x) 11.6 14.1 22.6 19.2 19.5 23.6P/B(x) 2.4 3.1 4.8 5.2 5.3 6.5VQ1:EV/EBIT/ROE(x) 0.5 0.7 1.2 0.7 0.8 0.9VQ2:EV/EBIT/ROA(x) 0.7 0.9 1.7 1.1 1.1 1.3

27

4. NCSoftCorp(KRX:036570)


QuickStats

Date 15/12/17 EBIT/R&D(x) 2.79

FilingCurrency KRW

EBIT/Employee

No.(USD/px) 21K

SharePrice KRW482,000 EV/EBIT(x) 18.0



DailyValueTraded


GPM(%) 86.8% P/E(x) 20.6

EBIT(%) 32.9% P/B(x) 4.3

NetDebt(Cash)/

Equity(%) -53.0%

VQ1:

EV/EBIT/ROE(x) 0.9

ROA(%) 15.7%

VQ2:

EV/EBIT/ROA(x) 1.1

ROE(%) 20.3%

TeamMembers

AngKaiWeiisasecond-yearstudentfromNanyangBusinessSchool

enrolledinDoubleDegreeinAccountancyandBusiness,specializing

in Banking and Finance. He enjoys investing and aspires to be a

FinancialPlanningAnalystinthefuture.

Daryl is a second-year accountancy student at Nanyang Business

School, NTU. He enjoys investing and participated in POEMS Stock

ChallengeandCIMB-ASEANStockChallenge.

Benjaminisasecond-yearaccountancystudentatNanyangBusiness

School,NTU.HepreviouslyworkedatPricewaterhouseCoopersand

didaninternshipwithTauRxPharmaceuticalsasaFinanceIntern.

Yan Zhi is a second-year accountancy student atNanyangBusiness

School,NTU.HepreviouslyworkedattheInlandRevenueAuthority

ofSingaporeasaTaxOfficer.HehasparticipatedintheUOBNUSCase

Competition,POEMSStockChallenge,CIMB-ASEANStockChallenge

andtheUOBTopTradercompetition.

28

InvestmentThesis

NCSoft Corp (NCSoft)was selected by the teamwhile

researchingonstocksinKorea.Koreanstockscurrently

have one of the lowest P/E Ratio, with the average

stockstradingatjustaround10x2017PEcomparedto

13x-19xofmostothermajormarketsintheworld.The

teambelieves that therearepotentialgemswithhigh

ROEstobediscovered.

NarrowingdowntocompanieswithhighROEsandlow

Price-Earnings-Growth (PEG) ratios, the team chanced

uponNCSoft.ItisdeterminedtobeapotentialHidden

Championaftersubsequentanalysisof itsquantitative

andqualitativecharacteristics.

NCSofthasbeenenjoyingtremendousgrowthof>20%

perannuminsaleswhilemaintainingnetprofitmargins

over the past decade. The constant revenue growth

showsthatNCSoftisanextremelysuccessfulcompany.

Thecurrentbuzz is focusedoncompetitorNetmarble,

afteritsrecentIPOandannouncementonitsKRW4.8T

(USD4.4B) acquisitionplans this year,whileNCSoft is

leftoutofthespotlight.Takingintoaccountitsexpected

growthrate,NCSoft,beingoneofthetopthreemarket

leadersinKorea,enjoysstrongbrandrecognitioninits

domesticgamingmarket.

NCSoft’s IPoffersuniquegamedesigns thatappeal to

thededicatedgamerssegment.Theyplaceamplefocus

ononlya fewgame franchises,mostly inRole-Playing

Games (RPGs), and expands on them to preserve the

coregameconceptandplayers’interestintheirgames.

With their expertise in developing quality RPGs, they

have fortified their position as one of the top online

gamedevelopersinKorea.

Detailsonitscompetitiveadvantagesandvaluedrivers

willbeaddressedinsubsequentsections.Qualitatively,

thecompany’sabilitytomaintaintheprofitabilityofits

IPhasenabledittoenjoyhighROEandlowcostofsales.

An asset-light business model allows NCSoft to scale

while minimizing the increase in costs, giving it a

competitiveadvantage.

BusinessModelQualityAnalysisBusinessModel

NCSoft isaSouthKoreanvideogamedeveloperwhich

developsandpublishesonlinecomputer(PC)gamesas

well as mobile games. Its focus is on creating high-

quality, fun, persistent online gaming experience for

players to enjoy across different platforms and in a

variety of ways. The games in each platform are as

follows:

Their operating segment mainly includes Massively

Multiplayer Online Role Playing Games (MMORPGs).

NCSofthasdevelopedpopulargamessuchasLineage,

GuildWars2andBlade&Soul.Withtheincreaseinthe

online gaming market and mobile device gaming,

NCSoft’s maiden leap into themobile games industry

hasbeenasuccesswiththerecentreleaseofLineageM.

ThemainassetforNCSoftisitsIntellectualProperty(IP)

comprising its main game franchises. Apart from

developing games, NCSoft also partners with third

partiesforpublishing inothercountries.Thecompany

also licenses its IP to overseas developers. (Refer to

Section3.4forthelistoflicensepartners)

RevenueStreams

NCSoft’s main revenue streams come from in-game

sales of its PC and mobile games, with a small

contribution from royalties from licensing its IP. Its

revenuebreakdownisasfollows:

ItiscommendablethatseveralofitsIPfranchises,such

asLineageandLineage2,continuetobeprofitableand

generate cash flows,decadesafter their releasedates

(1998).Lookingforward,thecompany’smainenginefor

growthliesinextendingitsIPintomobileplatforms.

29

Currently,muchofNCSoft’s revenuesource is focused

on their domestic market in Korea with influence in

severalcountriessuchasTaiwan,Japan,US,Europe,and

China.Lookingforward,thecompanyintendstoextend

itsreachintootherregionsthroughtheirPCandmobile

games.

Market-provenIPAssetsAccumulatedoverthePast18Years

NCSoft’s market-proven IP assets serve as the

groundworkforfuturepipelineatbothplatforms.While

gamingIPsaremostlyintangible,theyaredesirabledue

to the positive free cash flows that they generate.

NCSoft's IP continues to generate cash flows for the

company decades after the franchise's debut. This is

evidencedbyitsLineagefranchise,whosefirstiteration

was in the late 1990s, andwhich still remain popular

today.

PowerhouseoftheGamingIndustryinKorea

NCSoft is known to release highly popular and

revolutionary PC MMORPGs in Korea and have

expandeditsgamesacrosstheAsiaPacificaswellasthe

US. It also recently started to venture into Mobile

MMORPGs given the brighter future prospects of the

mobilegamingmarketandhassuccessfullycaptureda

largemarketshareofthemobileMMORPGindustry.

NCSoft mainly specialises in the development of

MMORPG genre type of games with 8 MMORPGs

developedup todate.Ofwhich, the Lineage,Blade&

Soul, Aion and Guild Wars franchises have remained

dominant in the market for a lengthy period of time

despite the conventional belief that online games

become obsolete within a few years. The success of

NCSoft’sMMORPGsisduetoitgreatsynergybetween

its business strategy, strong market penetration, and

unique game design which set itself apart from its

competitors.

ExistingBusinessStrategy

NCSoft’s business strategy focuses on quality over

quantityMMORPGstocreatea largefanbasetodrive

itsrevenue.Itdoessobyplacingamplefocusononlya

fewgamefranchisesandexpandingonthemtopreserve

the core game concept and players’ interest in their

games.NCSoft’squalitygamedesignbusinessstrategy

tackles the obsolescence issue mentioned above by

constantly updating their MMORPGs with major

expansions of their existing games to implement

significantnewcontent.Thisstrategyisoneofthebest

practicesadoptedbylargevideogamedeveloperssuch

asActivisionBlizzard,ontheirmostpopularMMORPGin

theworld,WorldofWarcraft(WOW).Thisensuresthat

existingplayerscouldcontinuetoexplorethegamesand

increase their playtime for the games instead of

switchingtoNCSoft’scompetitors.

However, unlike WOW and other popular MMORPGs

that still use a subscription-based or sales revenue

modeltogeneraterevenue,NCSoftsets itselfapartby

converting its MMORPGs from subscription-based to

free-to-play to attract more players at a faster rate.

Instead, NCSoft adopts two main recurring revenue

streams,royaltiesfromlicensingofgametitlestoother

developers and in-game purchases. Although free-to-

playgamesmayseemtodiminishplayerretentionrates

asplayersdonothaveanyobligationtostaywiththese

free-to-play games, NCSoft makes up for this with its

well-designed, expansiveMMORPGs to create a large

fanbaseasexplainedearlieron.Thus,thefree-to-play

MMORPGs allow NCSoft to rapidly increase its total

playerbasewitheverynewcontentorgamereleaseand

retainthematthesametime.Coupledwithsignificant

total-playtime from their MMORPGs and the lengthy

amount of time already invested in the games by

existing players, this also prevents competitors from

pullingawayitsplayers.

Furthermore, to complement its free-to-play game

business strategy,NCSoft alsoensures that thegames

are inclusive and fair to all players whereby their

philosophyistoensurethatnoplayerisableto“pay-to-

win”. This philosophy is advocated through “NCoins”

and “Premium Memberships”. Players are limited to

purchase only in-game cosmetics and convenience

items, which does not put any player in an unfair

competitive advantage over others. Furthermore, the

premiummembership is tiered in naturewhich scales

withtheamountofmoneyspent.Themorethemoney

spent,themoretheplayer isawardedwithcosmetics,

convenience items and privileges. This ensures that

NCSoft’s in-game purchase revenuemodel aligns well

with itsbusinessstrategyof implementingfree-to-play

games.

As such, with synergised business strategies

complementingeachother,NCSoftisabletogeneratea

steadyrevenueandnetincomestreamfromitsexisting

gamesandpromotesustainablegrowththroughoutthe

years. Furthermore, the powerful business strategy of

emphasising quality over quantity also established a

strongbrandrecognitioninitsgamefranchisesoverthe

years which facilitated its market penetration and

expansionstrategyexplainedbelow.

StrongandRapidMarketPenetration

Apartfrombeinganexcellentgamedeveloper,NCSoft

also sets itself apart from its competitors with their

gamepublishing expertise.NCSoft’smarket expansion

andpenetrationstrategyacrosstheAsiaPacific,Europe,

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andtheUSinvolvein-housedevelopmentofgamesand

licensingofitslegacygametitlestootherdevelopersto

expanditsgameseries.Thelicensingofitslegacygame

titles which include Lineage, Blade & Soul, Aion and

GuildWars is only possible owing to its strong brand

recognitionunique toNCSoft from its yearsofmarket

dominanceintheMMORPGmarket.

NCSoft also exercises precaution when it selects

developers to develop games that utilize their game

titles to avoid tarnishing their game franchise

reputation.LicenseddevelopersincludingTencent,Snail

games, Gameforge, Netmarble and Gamania are

established game developers within their own

geographicalregionsinChina,TaiwanandEurope.

By having a licensing strategy on top of its in-house

gamedevelopments,NCSoftisbetterabletoaccelerate

the spread of its game titles across the Asia Pacific,

EuropeandAmericatoraisebrandawarenesscompared

toitscompetitors.Moreover,thelicensingofgametitles

toestablisheddevelopersalignswellwiththeirquality

overquantitybusinessstrategywhichfurtherbuildson

their brand recognition. As a result, this licensing

strategy not only facilitates rapid expansion of game

titlesgloballybutalsocreatesanopportunityforNCSoft

to smoothly setup its in-housedevelopmententity in

theseregionssinceNCSofthassecuredastrongfoothold

in them in terms of its brand recognition established

throughthelicensees.

UniqueGameDesign

Lastly,NCSofthasthecapabilitytodevelopMMORPGs

with unique features to set itself apart from its

competitorsandenableNCSoft toexpand further into

the game industry. NCSoft is one of the pioneers

developing MMORPG presence in the Esports

competitive scenewhichmay be surprising given that

MMORPGslacktheelementofcompetitiveness.

NCSoftbrokeintoEsportsthroughBlade&Soul,which

possessesauniquecombatsystemthatisnotfoundin

most MMORPGs. This unique combat system created

opportunities for exciting Player-vs-Player (PVP)

matches between players which attracted many

competitiveplayersandaudiences.

Furthermore, NCSoft was able to sustain in the

competitive scene with its MMORPG while Activision

Blizzardhas failed todosowithWOWdue toWOW’s

lack of excitement in its PVP aspect. Their venture

turned out to be a big hitwith over KRW371m (USD

0.34m)raisedforits2017RegionalChampionshipprize

pool.

Peers

Headquartered in Tokyo, Japan, NEXON Co Ltd (TYO:

3659)(Nexon) isaclosecompetitortoNCSoft,beinga

developer of several free-to-play and online games as

well.Thecompanydevelopedthefirstgraphics-based

massively multiplayer online game (MMO) and

pioneered the concept of micro-transactions and the

free-to-playbusinessmodel.However,despitehavinga

first-mover advantage, its NPM and ROE fare worse

compared to that ofNCSoft. It is currently also facing

problemswithgrowingitsbottomline.

NetmarbleGamesCorp(KRX:251270)(Netmarble)isa

Korean game developer and distributor for online

mobile and computer games. Being a relatively new

company, its IP comprises mainly mobile games like

Magumagu, Modoo Marble, and L2R. Netmarble has

similarROEfigurestoNCSoft.However, it isunableto

achievethesameNPMfiguresasNCSoft,suggestingthat

NCSoftisabletomaintainfavourablemarginswithitsIP

franchise. Netmarble also follows a slightly different

business strategy. In 2017 it has unveiled its plans to

embarkonaKRW4.794T(USD4.4B)acquisitionplanin

the next few years, funded mainly from its 2017 IPO

proceeds.

NCSofthasbeeninapartnershipwithNetmarblesince

2015.In2015,NCSoftandNetmarbleacquiredsharesof

one another, to prevent facing a possible hostile

takeover by competitorNexon.Netmarble ismainly a

mobile game publishing company. Although the

partnership is not without its challenges, with NCSoft

suing its partner and ally Netmarble for infringing its

Lineage 2 IP in 2016, the relationship with NCSoft is

overall beneficial for NCSoft, with NCSoft gaining

exposureinthemobilegamessegment.

NCSoftalsobenefitsfromacceleratingIPvaluecoming

from its partner Netmarble’s global expansion. L2R

enjoyed decent positioning in Western markets, and

31

Blade&SoulRevolutionreceivedverypositivefeedback

from gamers on its gameplay at G-Star gameshow.

These bode well for NCsoft’s accelerating IP royalty

monetization in2018.Hence,NCSoft’sexpectedsurge

in royalty revenue in 2018 is also driven by royalty

revenuefromNetmarblenextyear.

Separately, Netmarble launched its newmobile game

offering, Tera M, 28 November 2017. This event is

expectedtohavelimitedimpactonNCSoft’sLineageM

’srevenuefiguresinDecember,duetoadifferenttarget

segment.

NCSoft is smaller compared to its larger international

peers. Furthermore, Activision Blizzard, Nintendo and

EAhavediversifiedgameofferings,unlikeNCSoftwhich

specializesinMMORPGs.WithaspecialfocusonRPGs,

thecompanyisabletogenerallyenjoyhigherNPMsand

ROEs than its peers which have ventured into other

businesses. One example is Nintendo which is

continuingtostrugglewithitsWiiUsales.EAhasbeen

enjoyingdecentmarginsandprofits,butitshighROEis

duetoitshighdebtlevels,withadebttoequityratioof

90.1%,comparedtoNCSoft’s24.5%.

Overall,NCSofthasmanagedtobuildastrongfollower

basewithitsIPbyfocusingontheRPGgenrespecifically.

ItsstrongmarketshareinKoreahasallowedittofortify

its position as one of the top 3 developers in Korea,

competing alongside its closest peers Nexon and

Netmarble.However,evenamong these3companies,

there are great differences in their IPs and game

offerings, which allow NCSoft to maintain a strong

followinginitsownIPandniche.

GlobalDevelopmentOpportunitiesonOnlineMobileGamesIndustryDemandforOnlineMobileGames

Themarketforonlinegaminghasseenanincreaseinthe

growth inrevenueofmobileonlinegamessince2015.

The market is expected to experience a Compound

AnnualGrowthRate(CAGR)of12%from2015to2019.

Figure6:CAGRofMobileGamesMarketRevenue.

Source:NCSoftIRMayPresentation

With the surge in the advancement of technology of

smart devices aswell as an increase in smart devices

penetration rate, NCSoft has tapped onto this

opportunityandplacedemphasisontheironlinemobile

games. The release of their new online mobile game

LineageMinJunelureda488%increaseintherevenue

oftheironlinemobilegamesin3Q2017from2Q2017.

Assuch,NCSoft’sfocusononlinemobilegameswillbe

abletogeneratemorerevenueapartfromitsonlinePC

games providing the company with a huge untapped

marketespeciallywhenRPGgenregamesarestartingto

dominatethemobilegamingplatform.

Figure7:Top10GrossingMobileGamesonAppStore

&GooglePlay.Source:NCSoftIRMayPresentation

Theonlinemobilegamesmarketdisplayedanincrease

inRPGwith8and6outof10gamesbeingRPGinthe

AppStoreandGooglePlayrespectively.NCSoft’sfocus

on MMORPGs not only gives them the comparative

advantage on the quality of the MMORPGs they

produce,butalsoallowsthemtorideonthetrendon

themobilemarketdemandforMMORPGs.

2.2.2OverseasPresence

NCSofthasestablishedastrongpresence intheglobal

mobile games market such as in Taiwan, Japan, US,

Europe and China. In the 3Q 2017, 13% of the online

mobile games revenue came from their overseas

presence.

Figure8:2016MobileGamesMarketRevenuePer

Country.Source:NCSoftIRMayPresentation

32

NCSoft’s revenue is largely derived from its domestic

market. Based on 2016 results, Korea’smobile games

marketrevenueonlymakesup5%oftheglobalmobile

gamesmarket revenue. This shows that NCSoft has a

great opportunity to venture and scale in overseas

market. Consequently, NCSoft has extensive plans in

expanding its market reach into the global market.

Lineage M was released in Taiwan, Hong Kong and

Macau on 11 December 2017 and the company has

futureplansforreleaseinChinaandJapanwhichmakes

up27%and18%respectivelyoftheglobalmobilegames

revenue.As such,NCSoft canpotentiallyenjoya large

andsteadyrevenuestreamfrombothitsdomesticand

overseasrevenuesgiventheirincreasingpresenceinthe

global market. It can enjoy large growth rates as it

carriesoutitsexpansionplans.

2.2.3GameDevelopmentVenture

To cater to the different overseas market segments,

NCSofthasalsoventuredintoVirtualReality(VR).They

havedemonstratedaVRbasedMassivelyOnlineBattle

Arena(MOBA)game,Blade&Soul:TableArena inthe

2017 Game Development Conference (GDC). This

venture captured the attention of the US and Europe

market inwhich there is strong interest inVR.TheVR

gameallows fora360-degreegamingexperiencewith

theuseoftheirOculusRiftandSamsungGearVR.This

venture intoVR is thecompany's firststep inreaching

outtotheVRmarketandcommunity.

Gaming preferences vary in different regions. For

instance,GuildWars2isfamousinUSandEuropebut

LineageisfamousinKorea,ChinaandTaiwan.Assuch,

NCSoft’sadaptationtocatertodifferentmarketswould

heightentheirrevenuestreamwithalargergraspofthe

market.NCSoft’swell-receivedgamedemoofBlade&

Soul:TableArenademonstratesstrongevidencethatit

will be able to sustain its revenue growth, via

adaptationsofitsgamesthroughtheirventureprojects.

2.3FinancialStabilitybackedbyStrongCashpositionandConstantRevenueGeneration

NCSoft has a history of being in a favourable cash

position over the years. This is attributable to

continuously profitable business as seen from the

constant growth in annual revenue over the past 18

years,amountingto25%CAGR.Capitalexpenditurealso

remainslowinthepastfewyears,atbelowKRW20B,

hovering at around 5% of 2016’s net income.

Maintaining a strong operating cash flow has allowed

NCSofttoprocureR&Dcapabilitiesandrepay its long-

termdebt.

Having excess cash on hand has also granted the

company the opportunity to acquire shares in

companies in the same industry. This implies that

NCSofthascapabilities formergersandacquisitions in

the future to increase its market share or expand its

business.

NCSoft holds a substantial amount of investments in

othercompaniesinthesameindustry.Thisisindicative

of its strategy to invest in such companies that have

growthpotential.WithNCSoft’sdecades-longexpertise

indevelopingandpublishinggames, theyhaveakeen

eyeforpromisinginvestments.(RefertoSection3.4for

a full list of NCSoft’s subsidiaries and associated

companies.)

Based on the nature of their acquisitions in

shareholdings intheseassociates,thetransactionsare

madeintheordinarycourseofbusiness.Theseholdings

areunlikelytoindicatepresenceoftunnellingofassets.

Figure9:NotableAcquisitionsbyNCSoftin2014to

2017.Source:NCSoft3Q17FactSheet

2.4Risks,ToxicFactors,Top3Dislikes2.4.1Piracy,ImitationsandRiskofLeaksofNCSoft’sIP

This is a risk factor specific to the gaming industry. In

some jurisdictions, there could be an increased

occurrence of piracy. If the jurisdiction has weak IP

enforcement, imitation games might surface as well

which replicate the game mechanics of NCSoft. The

replication of their gamesmay potentially erode their

sales. These are potential factors that NCSoft should

considerwhenexpandingintonewmarkets

Furthermore,in2007,thesourcecodeforLineage3,a

game in the pipeline, was leaked by ex-employees.

NCSoft may have won the legal suit, but this case

highlightedtheimportanceofNCSoft’sneedtoensure

proper internal controls are in place. Potential leaks

could undermine the marketing efforts dedicated to

building hype for the game, as well as dissipate the

competitiveadvantageofitsgames.

2.4.2IncreasingLaborCostsduetoIncreasingHeadcountofDeveloperstoSupportaLargerNumberofMobileProjectsNCSoft is planning to expand its offerings further,

especiallyinthemobilesegment.Thiscouldpotentially

33

requireincreasedspendingondevelopmentcosts,such

asincreasingtheheadcountofdevelopersspecializingin

mobile games. Development costs and expense has

been taking up a larger percentage of sales in recent

quarters. The largest concern is the uncertainty

associatedwith the development of its newer games.

The company runs the risk of incurring unexpected

development costs and going over budget if it

encounters roadblocks and delays in game

development.

2.4.3RelianceonConstantNewContent

In the gaming industry, there is a need to constantly

generate new content to keep their IP fresh and

interestingforitsexistingfanbase,aswellastoattract

newplayers.WhileNCSofthasexhibitedsuccessfulsigns

ofkeepingtheirIPfresh,theyneedtoensurethattheir

offerings are in line with current trends and not fall

behind the curve. Weaker-than-expected traction for

existing games is a potential downside risk. It was

highlighted that there was a faster-than-expected

revenuedropfromLineageM.AlthoughNCSoftenjoys

strongbrandrecognition,thisissomethingtheyalways

needtoconsiderastheinitialsuccessofagamerelease

isoftenlargelydeterminedbythehypegeneratedtothe

releaseaswellastheinitialreviews,andthesubsequent

success is determined by the company's ability to

maximizeretention.

NCSoft needs to ensure sufficient gaps between

subsequent releases of games and sequels.

Furthermore, its IP offerings must target different

segments of the markets which will minimize

cannibalizationofsales.

3ManagementQualityAnalysis

3.1CorporateCulture&ManagementPhilosophy

Vision:Strivetobringjoyandprovidefunforeveryone,

everywhere.

Mission:Tomakeeveryoneinthisworldhappier.

Format:Small,strong,substantive.

Spirit:Todotherightthing.

NCSoft’scorporatecultureliesfirmlyintheircorevalues

ofIntegrity,PassionandNever-endingChange.Sticking

closelytotheircorevaluesisparamounttothesuccess

of their company given the fierce competition from

other gaming companies. At the core of their values,

sticking to their principles (integrity) ensures that the

company continues to strive forward with minimal

hiccupsanddisruption.Havingthepassionforwhatthey

do emphasises on the quality of work produced.

Constantly trying to improve is tantamount to their

progress especially in the online gaming industry to

ensure that the company constantly innovate and

producequalityandefficientproducts.

3.2ManagementPhilosophy3.2.1GrowthSeekers

The management philosophy of NCSoft is seen to be

aggressive inseekinggrowth. In2000,despitethefact

that3Dgamesweredifficulttodevelopduetothelack

oftechnologyandexpertisebackthen,themanagement

teamwasstilldeterminedtopushforthedevelopment

of such games andwas one of the firstmovers in 3D

gamesdevelopment.Inaddition,themanagementteam

alsoseekgrowthinareasofthegamingindustrythatare

untappedwithroomtogrow.ThisincludesNCSoftbeing

one of the pioneers to venture into the MMORPG

Esportsscenewhichturnedouttobeabigsuccessforit.

Knowing that themobile gaming industry is booming,

themanagement teamwas alsoquick to venture into

thisareawiththeportingofitsPCMMORPGsovertothe

mobile gaming platforms which almost doubled its

revenue for the FY2017. Such hunger for growth and

ambition allows NCSoft to remain competitive and

relevant inthegamingindustryandsecureitsposition

asoneofthemarketleaders.

3.2.2AdaptiveOutlook

NCSoft has continued to portray its adaptive culture

with its swift and precise advancement in the

developmentoftheirnewgames.Forinstance,tomatch

upwiththefallinrevenueintheirUSmarketlargelydue

tothe lowpopularityofBlade&Soul inUS,theyhave

boldlyventuredintoVRtokeepupwiththetrendsand

likings of the different culture. On top of that, the

companywasabletoseizetheopportunityintherecent

increaseindemandforonlinemobilegamesandswiftly

innovatemobilegamestoadapttothecurrentmarket

trend.Inaddition,when,therecentlaunchofMasterX

MasterinJunedidnotachievethetargetrevenuethey

hadexpected,theywerequicktoadapttothecurrent

marketanddecidedtoshutdownthegameinJanuary

2018.Havinganadaptiveoutlookintheirmanagement

serves to ensure that the company continues to

innovateandstayuptodatewiththemarkettrendas

well as keep the company in check for any potential

downturn.

34

3.2.3ResilientinNature

NCSoft’s journey has not always been smooth sailing

with its survival largely attributed to their resilient

nature.Theexplosivegrowthofthe“PCbang”(internet

cafes)asaresultoftheextensivepopularityofStarCraft

andKingdomofWindscausedaplungeinNCSoftgames

duetotheirlackofuserimmersion.Inviewofthethreat

from opposing competitors, NCSoft’s introduction of

castlesiegeandguidesystemsconsequentlymaximizing

competitive and community experience attracted a

huge number of players. This allowed Lineage to

become the dominant game that replaced the

immenselypopularStarCraftastheleadingMMORPGin

Korea.Theimminentpiracyissueandstrictgovernment

policy in China also did not stop NCSoft from its

continuedeffortofventureintotheChinaMarkets.This

resilient management culture translates to a solid

groundforfutureimprovementinthelongterm.

3.3OwnershipStructure

Outstandingsharesissued:21,939,022

NCSoft isprimarilyownedbyretail investors including

its foreign counterparts. Notably, Netmarble Games

Corp(refertoSection2.1.7Peers)ownsaconsiderable

portionof8.90%.NCSoftalsoownsasizableportionof

Netmarble.

3.4BusinessGroupStructure

Figure12:NCSoft’sDeveloper,PublisherandLicensee

PartnerNetwork.Source:NCSoftIRMayPresentation

Figure13:ListofNCSoft’sSubsidiariesandAssociated

Companies.Source:NCSoft3Q17FactSheet

4Catalysts,Events&TippingPoints4.1CompanyDirection,GrowthPlansandRecentActivities

NCSoft is shifting its focus towards its online mobile

games such as the creation of new content and the

porting of their PC games into online mobile games.

Additionally,thecompanycontinuestodevelopfuture

expansionforboththeirmobileandPCgamesinorder

toretaintheirplayerbasebyreleasingnewandexciting

content.

Thecompanyhasalsosetitssightoncapturingalarger

globalmarket presence through their development of

gamesoverseasaswellasroyaltyrevenue.Someofits

futureplansincludetheirVRventureforBlade&Soul:

TableArenatocapturetheUSandEuropemarketwith

futureplanstoadaptVRintotheircurrentlineofgames

aswell,e.g.theLineageseries.

NCSoft has also announced Lineage Project TL for the

nextLineageflagshipreleasetocontinuetheirgrowthin

the online PC games. The long-anticipated release of

theironlinemobilegamesBlade&Soul2,Lineage2M,

AionTempestandAionLegionswillbethenextinlineof

theirexcitinglineofdevelopment.Thefutureplansfor

releaseofgamesarelargelykeptawayfromthepublic

and hence, growth plans are not visibly known.

However,thecompany’sdirectionoffocusandrelease

of trailers reveal plans to retain and capture more

players through expansions of their current line of

games.

35

Thecompanyhasundergonerecentactivitiesincluding

thereleaseofLineageMinKoreainJuneaswellas in

Taiwan,HongKong&MacauinDecemberwithplansto

continue to expand over in Japan and China. L2Rwas

progressively rolled out worldwide since December

2016 in Southeast Asia, Europe, North America and

Japan.

4.2Whyinvestnow?FromNCSoft’s existing business point of view, NCSoft

hasawell-establishedbrandrecognitionfromitsglobal

reachandhasbeenabletoretainandexpandmuchof

their player base from around theworld due to their

innovative game development over the years.

Furthermore, NCSoft’s strong cash position and

investmentinmanyfirmsshowanincreaseintheglobal

market influence in the industry and manifold

opportunitieswhich thecompanycangain from.With

thesetwobusinessstrengths,NCSoftisfundamentallyin

asolidpositiontopursue itsgrowthplanstocompete

withitscompetitors.

FromNCSoft’smanagementperspective,asmentioned

earlier, the management team possesses suitable

characteristics required to ensure the relevancy and

competitiveness of NCSoft in the rapidly-evolving

gaming industry. Moreover, since its incorporation in

1997,themanagementteamhasconstantlyprovenits

capabilityintakingcalculatedriskwithitsventuresinto

new areas of the gaming industry and overcoming

threatsposedbyitscompetitors.

Fromthe industryperspective, therecentsurge in the

market for mobile games and the shift in popularity

towardsmobileMMORPGs show promising prospects

forNCSoftsinceitspecialisesindevelopingMMORPGs.

Withthese3factorscomplementingeachother,itisthe

right time to invest in NCSoft. The company has

tremendousgrowthpotential.TheventureintotheVR

communityaswellastheirplansforfutureexpansion,

accompaniedby the company's ability to develop and

efficientlypublishqualitygameswillreelhugevolumes

ofrevenuewitheachrelease.

5FinancialAnalysis&Valuation

GrossProfitMarginhasimprovedconsiderablyoverthe

years, suggesting that thecompany isable togrow its

sales while minimizing its increase in cost of sales.

NCSoft managed to maintain its net profit margin

despiteincurringhigherdevelopmentcostsfor itsnew

games.

NCSofthasmanagedtoincreaseitsrevenueandprofits

overthepastfewyearswhilemaintainingadecentROE

percentageinthelow10s.

Asset turnover and equity ratios have remained

consistentovertheyears.

Overall,ROEandNPMareverydecentcomparedtoits

peers(RefertoSections2.1.7Peers).

5.1.1LargeIncreaseinAssetsandNetIncomein9MFY2017

There was a 33% spike in NCSoft’s asset levels, from

FY2016to9MFY2017ended30September2017.These

aremainlyduetofairvaluegains in its investments in

sharesandinvestmentsinassociatedcompanies.Other

contributingfactors includeprofitcontributionsduring

the 9 months ended 30 September 2017 and a large

increase in current liabilities. The large increase in

current liabilities ismainly due to increase in accrued

expenses,advancebillings,andcurrenttaxliabilities.

Thefairvaluegainsinmarketablesecuritiesarelikelyto

be within industrial norms. Netmarble’s investments

increasedover100%asat30September2017(including

new acquisitions funded by its recent share sale).

Netmarble has also announced in 2017 that it will be

settingasideKRW4.794T(USD4.4B)foracquisitions,in

lightofthepositiveoutlookinthegamingindustry.All

these indicatesignsofabrightoutlook in the industry

whichisreflectedbythefairvaluegainsofsecuritiesin

theindustry.

36

Thelargeincreaseinthenetincomeinthethirdquarter

ended30September2017 isduetothe initialsalesof

LineageM.Salesofthegameareexpectedtonormalize

andtaperoffaftertheinitialhype.Howevernetincome

is expected to continue to increase due to the

subsequentreleaseof3gamesin2018.

5.1.2IntercompanyLoans

NCSoft currently has provided intercompany loans of

KRW10BtoNCDinos,itswhollyownedbaseballteam,

forfranchisepurposes,andKRW200MtoArasoPandan,

an associate company which develops mobile games.

Thesizeoftheloansdoesnothaveasignificanteffect

on the company’s earnings, as since the company

receiving the loans are closely related to parent’s

business,theintercompanyareunlikelytobefraudulent

innature.

Changes in Korean tax laws which impose more

stringent requirements regarding intercompany loans,

effective7February2017,willminimizethechancesfor

NCSoft’sintercompanyloanstobequestionable.

5.2HistoricalGrowthRates

Historically,thecompanyhasenjoyed25%CAGRforits

revenues.

In2016,year-on-year:

1. Revenueincreased17%

2. OperatingProfitincreased38%

3. Pre-taxIncomeincreased44%

4. NetIncomeincreased66%

With ample catalysts in 2018 and beyond, NCSoft is

expected to continue to enjoy supernormal growth

rates.

5.3ProjectedGrowth

Revenue:ProjectionswilltakeintoaccountthelaunchofLineageMinTaiwan,aswellasnewgamesin2018.Thelaunchof LineageM inTaiwan isexpected tobring in

initialrevenuesof3to4billionKRW,assumingitslaunch

in Taiwan would track revenue momentum seen in

Korea.Thelistofprojectedgamereleaseschedulesdoes

nottakeintoaccountunannouncedgames.

Revenues are expected to grow faster than the usual

historical growth rates. In line with the market

expectationsofthethreeupcomingnewgamesin2018,

growthrateisestimatedtobe30%forthatyear.

In subsequent years, the growth rate is expected to

moderatetohistoricalratesat25%.Thisratecouldbe

conservative as it does not take into account any

unannouncedgamesinthepipeline.

NCSoft is expected to retain its dedicated customer

base, and recent launches from competitors, such as

Tera M from Netmarble, is not expected to affect

NCSoft’s revenues materially, due to different target

segments.Furthermore,LineageMinTaiwanattracted

morethan2.5millionpre-registrationsbeforeitsofficial

launchon11December2017, indicatinghigh levelsof

interestandhypeinthegame.

(KOSE:A036570)NCsoftCorporation FY2013 FY2014 FY2015 FY2016 FY2018LTMSharePriceKRW 218,000.00 181,500.00 253,500.00 305,000.00 482,000.00NoofShares(mil) 15.9 20.0 21.2 21.2 21.3MCAP(mil)USD 3,267 3,269 4,737 5,795 9,411NetDebt(Cash)KRW (627,533) (843,367) (888,437) (820,450) (1,296,163)EnterpriseValue(mil)USD 3,178 2,589 2,808 3,757 8,214Revenue(mil)KRW 756,655.7 838,718.2 838,297.6 983,556.9 1,510,015.5EBITDA(mil)KRW 239,365.0 312,596.8 272,446.6 361,307.6 528,217.1EBIT(mil)KRW 203,957.1 275,863.9 237,471.4 328,902.3 497,478.5NPAT(mil)KRW 158,755.9 229,958.4 165,393.4 272,268.8 390,051.7NPAT(Ex.Xtra+Dis.Ops)(mil)KRW 162,933.5 234,657.5 184,084.2 274,183.3 367,695.1CFO(mil)KRW 236,187.7 263,580.9 241,337.2 112,022.5 416,928.9CAPEX(mil)KRW (102,398.5) (19,493.5) (17,672.7) (16,632.2) (28,299.3)EPSKRW 10,231.9 11,757.3 8,666.7 12,908.5 17,302.9Revenue(mil)USD 716.7 768.4 712.4 817.0 1,320.3EBITDA(mil)USD 226.7 286.4 231.5 300.1 461.8EBIT(mil)USD 193.2 252.7 201.8 273.2 435.0NPAT(mil)USD 150.4 210.7 140.6 226.2 341.0CFO(mil)USD 223.7 241.5 205.1 93.1 364.5CAPEX(mil)USD (97.0) (17.9) (15.0) (13.8) (24.7)GPM(%) 70.8% 73.7% 75.8% 80.9% 86.8%EBIT(%) 27.0% 32.9% 28.3% 33.4% 32.9%NetDebt(Cash)/Equity(%) -55.0% -62.0% -50.2% -43.5% -53.0%ROA(%) 13.8% 16.2% 10.7% 13.9% 15.7%ROE(%) 17.9% 20.3% 13.4% 17.4% 20.3%CFO/TA(%) 16.0% 15.5% 10.9% 4.7% 13.2%EV/Sales(x) 3.8 3.3 5.4 5.8 5.9EV/EBIT(x) 14.0 10.1 19.0 17.2 18.0EV/EBITDA(x) 12.0 8.9 16.6 15.7 17.0EV/CFO(x) 12.1 10.6 18.7 50.6 21.5P/Sales(x) 4.6 4.3 6.4 6.6 6.8P/EBIT(x) 17.0 13.1 22.7 19.7 20.6P/B(x) 3.4 2.9 3.2 3.5 4.3VQ1:EV/EBIT/ROE(x) 0.8 0.5 1.4 1.0 0.9VQ2:EV/EBIT/ROA(x) 1.0 0.6 1.8 1.2 1.1

37

5. NihonKohden(TSE:6849)


QuickStats

Date 15/12/17 EBIT/R&D(x) 1.98

FilingCurrency JPY

EBIT/EmployeeNo.

(USD/px) 20K




DailyValueTraded


GPM(%) 47.4% P/E(x) 17.0

EBIT(%) 7.6% P/B(x) 2.2

NetDebt(Cash)/

Equity(%) -28.5%

VQ1:EV/EBIT/ROE

(x) 1.2

ROA(%) 8.9%

VQ2:EV/EBIT/ROA

(x) 1.7

ROE(%) 12.2%

TeamMembers

Pinzhang isa first-year Industrial&SystemsEngineeringstudentat

NUS.HeisalsodoinghisfinalpapersforanOxfordBrookesdegreein

AppliedAccounting.Hebeganinvestingat13andneverlookedback.

TingWei is a first-year double degree student at NUSmajoring in

Business Administration (Accountancy) and Industrial & Systems

Engineering. He has worked at EY and is a Vice-Team-Lead of

PredictiveAnalyticsteamintheBusinessAnalyticsSociety,NUS.

YiMingisafirst-yearstudentatYale-NUSCollegereadingtheliberal

arts&sciences.HeisalsoaStudentVentureCapitalistwithProtege

Ventures.

Jiong Yang is a first-year Chemical Engineering student at NUS.

RecipientoftheSingaporeIndustrialScholarship(GlobalFoundries).

38

BusinessbackgroundandoverviewTokyo-basedNihonKohdenwasfoundedin1951byDr.

YoshinoOginowhose goalwas to "combinemedicine

andengineering".Startingoffwiththeproductionand

marketingofhearingaids,thenotableachievementsof

Nihon Kohden over the years include developing the

world's first completely AC-powered direct-wiring

electroencephalogram (EEG), and also inventing the

world'sfirstpulseoximeter,contributingtoanaesthesia

safetyviathemonitoringofpatientbloodoxygenlevels.

Today, Nihon Kohden Japan's leading developer,

manufacturer and distributor of front-line medical

electronic monitoring equipment. Their ecosystem of

productsencompassestheentirecycleofahospitalvisit,

from pre-hospital, to the emergency room, the

operation room, the intensive care unit, the ward,

doctor's office, research laboratories and also home

healthcare. These include brain, muscle and heart

electricalactivitysensors(EEG,EMG,andECG),patient

monitors and clinical information systems, and other

treatmentequipmentlikedefibrillatorsandAEDs.

Outside of Japan, Nihon Kohden has an established

globalpresencewithsubsidiariesintheU.S.,Europeand

Asia. The company's products are now used in more

than 120 countries, is the largest supplier of EEG

productsworldwide, and is a recognised technological

leaderofwirelesspatientmonitoring.

Revenuebreakdownbyproduct

Thecompany’s revenuestreamof166,285millionyen

comesfrom4mainsegments:physiologicalmeasuring

equipment (EEGs, electrocardiographs, diagnostic

information systems, etc.) - 23%, patient monitors

(central, bedside, wireless monitors, etc.) - 34%,

treatmentequipment(defibrillators,AEDs,anaesthesia

machines etc.) - 18%, and other medical equipment

(analyzers, basic laboratory equipment and

consumables)-25%.

Revenuebreakdownbygeography

Domesticsalesmakeup73%ofnetsalescomparedto

27%ofoverseassales.Ofoverseassales,theAmericas

makesup46%,Europe17%,Asia30%,andotherareas

<1%.1

Overviewof2017BusinessPerformanceanditsconsistency

NihonKohden’ssalesperformancehasseenaconsistent

7yearsgrowthandithasremainedfirstinrankinginthe

salesofmonitoringequipmentinitsdomesticmarketas

wellassuccessful increaseinsalesinoverseasmarket.

The Japanese government has also worked on

healthcaresystemreformandeachprefecturedrewup

aregionalhealthvisionfortheenhancementofmedical

treatment systems by 2025. Given Nihon Kohden’s

strong dominance in the Japanesemedical electronics

systemmarket, it is likelytoride inwiththe increased

salesanddemandastheJapanswitchesovertobetter

healthcaresystems.

How did you originate this Idea and why did youchoose this company?Why is it fit to be a HiddenChampion?

We recognised the impending surge in demand for

healthcare products, and noticed that healthcare

equipment companies have generally stayed low-

profile.ThisisespeciallysoforNihonKohden,givenits

restructuringactivitiesinthelastfewyears,leadingto

lowerprofitpershareratio.Furtherresearchproved

tousthatNihonKohdencheckedallthekeyboxesfor

aHiddenChampion.

OneSentenceInvestmentThesis

The company’s existing advantage (via superior

technology & market dominance) and effective

businessstrategicplanputsitinpolepositiontoride

ontheuprisingglobalhealthcaredemandforarisein

profitinthenext3years.

39

Whatmakesitawide-moatbusiness?

Nihon Kohden's sustainable competitive advantage

that secures market share and profit is evidenced

throughseveralcharacteristics:

Dominant Market Leader in Domestic Patient

Monitoring&GlobalECG-EMGs

AsatFY2016,NihonKohdenisthelargestproviderof

patientmonitoringequipment in Japan (40%of total

companysales).AsseeninTable1below,thecompany

isthedomesticmarketleaderinseveralkeysegments

includingmulti-sign,wirelessmobile,heart,brainand

muscular activity monitors and diagnostics7

. Despite

recent headwinds in the domestic market, Nihon

Kohden has still managed to maintain its strong

position,evidencedfroma2.3%domesticmarketsales

increase. This success in adapting to changing

domesticmarketconditionssignalsitshealthyposition

tomaintainmarketshareinthecomingyears.

Additionally,NihonKohdenistheglobalmarketleader

in EEGs and EMGs9

,whichmarket size is expected to

nearlydoublefromUSD1.3billion in2015toUSD2.4

billion by 2024. Nihon Kohden's subsidiary in North

AmericaalsowonamajorUSD35milliondealwithUS

DepartmentofDefenseinprovidingpatientmonitoring

systemsonOctober2016,withpossible8more1-year

extensiontothecontract8

.

Enduring Product Differentiation through Quality &

Innovationintandemwithhealthcaretrends

Beyond guaranteeing top quality through life span

reliability, precision of data and accuracy of

measurements6

,NihonKohdenleadsthemarketwithits

commitment on innovation. Innovation has allowed

Nihon Kohden to develop very strong core

competenciesandproprietarytechnologiesthatarenot

easilyreplicable.Forexample,NihonKohdenhasstrong

proprietary sensor technology and led the world in

inventing theprincipleof thepulseoximetrysensor in

1974.Furthermore, Nihon Kohden's accumulated

industry know-how with the entire 'care cycle'

ecosystemofproductsmakesithardforcompetitorsto

matchitsbroad-basedexpertise.OnlyNihonKohdenhas

suchanextensiveproductlineincludestheCNS-9701™

and I™ for central monitoring, the I™ product line of

bedside monitors, I™,AirEEGWEE-1000™,

andNeurofax™ EEG product lines, which cater to the

high-end market, low-end market, and even mobile

transport.It’s broad range of products allow them to

develop their own proprietary hardware connectors

that simplify the synchronisation of different

equipment, simplifying the procurement process for

hospital, especially for emerging markets equipping

their hospital with more sophisticated monitoring

systems.AscomparedtotheircompetitorssuchasGE

Healthcare who develop their product lines through

acquisition of specific manufacturers, the greater

synergy and compatibility of Nihon Kohden’s product

servesasastrongcompetitiveadvantage,anddrawsa

greatervolumeofsalesduetotheeaseofprocurement

asapackage.

The commitment to innovation is evidenced in the

increase of research and development cost, which

currently stands at 6467million yen (3.9% of sales)13.

Nihon Kohden has focused on developing products in

linewiththecurrentmarkettrendsinthemedicaldevice

industry.Onesuchtrendistheadoptionofmonitoring

device configurations that emphasize on patient

comfortandmobilityacrossdifferentcaresetting.This

increased demand of non-invasive, portable medical

devicesisreflectedintheexpectedannualgrowthrate

of7.8%forthemarket15

.

Examples of innovations include proprietary

technologies focused on the development of non-

invasive, patient-orientedmonitoring technology such

as cap-ONE, the world's smallest and lightest

mainstream CO2 sensor6

, and esCCO, a continuous,noninvasive cardiac monitoring technology

16

. These

technologies have translated into more advanced

productsfocusedonmobility,aflagshipofwhichisthe

LifeScopeG3,amobilewearablevitalsigntelemeterto

support patient monitoring on-the-move. More

recently,2majormobileproductlaunchesinthepast4

monthsarethemobiletransmitterZS-640Ptotransmit

4typesofvitalsignsdatainAugust2017,andthenew

EEG Head Set AE-120A, a new simple-to-use and

wireless device for quick and easy EEG monitoring in

October17

StrongValue-addingServicesviaCreationofAdvanced

ITSolutions

Beyondmedicalequipment,NihonKohdencontinuedto

strengthenitsstrongrelationshipwiththehospitalsby

providingnotonlyhardwarebutalsothesoftware.

40

Prime Partner isa cloud-based software that stores

medical records on a secure cloud server.

Complemented with Lavita, a network system that

transmit data from synced-devices to the cloud

automatically, it allows hospitals to closely monitor

patientsremotelyevenwhentheyarealoneathome.It

allows hospitals to provide better homecare services

whichhasparticularrelevanceinthecontextofJapan’s

aging population.Nihon Kohden has also helped

hospitalsimprovementitsmanagementsystemwiththe

introductionof PrimeVitaPlus andPrimeGaia. Prime

Vita Plus is an award-winning software system that

centrally manages waveform and image information

generated from physiological or endoscopic

examinations. This enables the integration ofmultiple

types of ECGs, ultrasound, and various endoscopes

results for a more efficient and standardised work

process.PrimeGaia is a software systemdesigned for

patients under critical care. Through integration of

patient’s perioperative information and critical data

from other devices, it greatly enhances ease of

informationsharingallowinghospitalstoprovidequality

careespeciallyforpatientswithcriticalconditions.

Furthermore, these systems are compatible with

otherexternal devices like its Smart Cables and

Gateways.Thisstrongcompatibilityacrossitsownwide

rangeofproducts strengthensNihonKohden’smarket

dominanceviaaclosed-loopecosystem.

These have allowed Nihon Kohden to gain revenue,

and make its product become more “sticky” to its

customers, creating a sustainable demand of their

products regardlessofeconomicprospects.With the

entryof low-cost foreign products, Nihon Kohden

product system consolidation and service focused

approach serve a strong defence against mere unit

price competition in its home turf.Indeed, Nihon

Kohden'sstrengthinJapanhasbeenattributedtotheir

strong local sales force & healthy relationships with

hospitals7

.

Diversified&steadyincomesourcefromconsumables

&maintenanceservices

Therehasbeenanincreaseinpercentageofsalesfrom

consumables and servicessuch as finger probes and

electrodes, equipment servicing and maintenancefor

NihonKohdenfrom35%inFY2009to43%inFY2016.

Inallproductcategory,anydecreaseinsaleofhardware

iscounteredbyanincreaseinsalesofconsumablesand

information system associated with it. For instance,

thepatientmonitormarketsustainedmodestgrowthof

domestic sales of patient monitor segment despite a

decreaseinsalesofhardwareequipment,fortherewas

anincreaseinsalesofclinicalinformationsystemsand

consumablessuchassensorssuchasthecap-ONECO2

sensorsandpulseoximetryfingerprobes.Similarly,for

the treatment equipment category, overall sales

increasedintheAEDproductcategorythroughsalesof

consumables such as pads and batteries that are

required for regular maintenance, despite falling unit

sales of AED.This business model is made possible

because of the nature of themedical equipment that

Nihon Kohden specialise in; finger probes for patient

monitors are for one-time usage only, disposable

electrodes to for ECG, and AEDs require regular

replacement for the gel pads that will expire. In

comparison,medicaldiagnosticequipmentsuchasthe

MRIorCTscannerslacksimilarconsumableaftersale.

Thus,despiteincreasingbudgetconstraintsonhospitals

that results incutbackoncapitalspending, increasing

equipment upkeep spending such as

equipmentservicingandconsumables required for the

operation of these medical devices will allow Nihon

Kohden to achieve sustainable growth in sales and a

steadyincomestream.

LacklustreDomesticCompetition

FukudaDenshi isthesecond-leadingcompetitor inthe

Japanesepatientmonitoringmarket.Yet,NihonKohden

maintains a wide-moat advantage through superior

technologytranslatingintobetterproductfunctionality

offerings.Oneexamplewillbewirelesspatientvital-sign

transmitters, where Nihon Kohden's ZS-640P

transmitter is capable of measuring blood pressure,

whilst FukudaDenshi's offering the LX-7230 does not.

ThiswasaccomplishedviaNihonKohden'sproprietary

iNIBPLinearInflationTechnology.Also,NihonKohden's

producthas abattery lifespanof 4dayswhile Fukuda

Denshi'soperatesonlyfor2.5days.Thus,NihonKohden

differentiates itself through its integrated product

ecosystem, technological advantage, exclusive

proprietaryhardware,andalsoitsvalue-addingservices

andsalesplatforms.NihonKohdennotonlyhasPrime

Partner that consolidates data fromdifferent types of

devices of its brand, but also user-friendly viewing

software that allows for remote viewing (NetKonnect)

andviewingonmobiledevices(ViTrac).Incomparision,

FukudaDenshi develop separatesoftwaresfor viewing

information for different medical devices.There is a

41

relatively low threat of new entrants due to a high

barrier of entry to the domestic market for foreign

competitors, a key factor being the lengthy Japanese

regulatoryprocess14

,thusNihonKohden'spoleposition

isrelativelysecuredomestically.

Healthy Overseas Growth fromWidening Global

Research,Production&DistributionNetwork

The recently-concluded StrongGrowth2017mid-term

business plan expanded global operations to attain

sustainablegrowth.GlobalR&Dfacilitieswereenhanced

viaestablishingtheNihonKohdenInnovationCentrein

Boston,USA,which allows for collaborationwith elite

establishments like Harvard, MIT and other research

institutionsbasedinBoston.TheAdvancedTechnology

CenterinSaitama,Japanwaslaunchedtoo.Italsohas4

internationalmanufacturing bases outside of Japan in

Shanghai, Malaysia, Italy and India to ensure stable,

timelysupplyofproductat lowercost to the targeted

regions10

.

NihonKohdenhasawidedistributionnetworkaround

theglobewithsalesofficesstrategicallylocatedinmajor

citiesofAmerica,Europe,China,IndiaandAfrica,with5

new sales offices established in the past 4 years. For

instance,in2016itestablishedanewcallcentreinNew

Pennsylvania to strengthen its technical support call

centreintheUS13

.Besidestrongpresenceindeveloped

countries, Nihon Kohden has strengthened its service

operations in emerging markets through the

reorganizationof sales subsidiaries inCentral& South

America in 2016, and a new sales branch in Kenya in

November2017toentertheEastAfricaMarket11

.

This integrated approach to global distribution and

productionhasledoverseassalestogrowfrom17.9%of

totalsales in2010to25%in2016,representinga2.1x

growthinsalesfrom2010–2016,withstronggrowthin

majormarkets like China, Europe (15% increase), and

America (16% increase) on a local currency basis12.

Sales from Other (countries outside of Americas,

Europe, and Asia) increased by an impressive 38% in

FY2017Q1withlargeordersfromEgypt.Thesediversify

NihonKohden'srevenuebaseandpositionsittoridethe

globalhealthcaremodernisationwave,with thetarget

toincreasetheshareofoverseassalesto35%by2019,

reducingitsrelianceonastagnatingdomesticmarket.

Widening Global Research, Production & Distribution

Network

Therecently-concludedStrongGrowth2017mid-term

business plan expanded global operations to attain

sustainable growth. Global R&D facilities were

enhancedviaestablishingtheNihonKohdenInnovation

Centre inBoston,USA,whichallows for collaboration

with elite establishments likeHarvard,MIT andother

research institutions based in Boston. The Advanced

TechnologyCenterinSaitama,Japanwaslaunchedtoo.

Italsohas4internationalmanufacturingbasesoutside

ofJapaninShanghai,Malaysia,ItalyandIndiatoensure

stable, timely supply of product at lower cost to the

targetedregions10

.

NihonKohdenhasawidedistributionnetworkaround

the globe with sales offices strategically located in

majorcitiesofAmerica,Europe,China,IndiaandAfrica,

with5newsalesofficesestablishedinthepast4years.

Forinstance,in2016itestablishedanewcallcentrein

NewPennsylvania to strengthen its technical support

call centre in the US13

. Beside strong presence in

developedcountries,NihonKohdenhasstrengthened

itsserviceoperationsinemergingmarketsthroughthe

reorganizationofsalessubsidiariesinCentral&South

America in2016,andanewsalesbranch inKenya in

November2017toentertheEastAfricaMarket11

.

This integrated approach to global distribution and

productionhasledoverseassalestogrowfrom16.8%

of total sales in 2013 to 25% in 2017, with strong

growth in major markets, China, Europe (15%

increase), and America (16% increase) on a local

currencybasis12

.SalesfromOther(countriesoutside

of Americas, Europe, and Asia) increased by an

impressive38%inFY2017Q1withlargeordersfrom

Egypt. ThesediversifyNihonKohden's revenuebase

and positions it to ride the global healthcare

modernisationwave.

StrategicAcquisitionsofSubsidiaries

Over the past decade, Nihon Kohden has been

involvedinstrategicacquisitionsofcompaniesin-line

with expanding its wide-moat advantage in the

healthcareequipmentindustry.

To enhance vertical integration of manufacturing,

NihonKohdenacquiredLabnovaItaly in 200635

, and

full ownership of former joint-venture firm SPAN

Nihon Kohden Diagnostics India in 201536

, both of

which manufacturedhematologyanalyserreagents

for the company'shematologyanalysers.

Thisstrengthensitssupplysystembygivingfreedom

ofmanagementtoenforcedirectcontroloverquality

and quantity. To advance technological expertise,

NihonKohdenacquiredNeurotronicsin 2008 to

strengthen its position in the neurology business37

.

Finally, to capture market share overseas,

NihonKohdenacquiredDefibtechLLC in 2012 to

enter the U.S. resuscitation market

viaDefibtech'sAEDs38

.

42

StrongGrowthStrategy–AddressingSpecificDemands

ofDeveloped&DevelopingMarkets

MovingbeyondStrongGrowth2017,startingfromApril

2017, the Transform 2020 plan swung into action,transitioningfromthepreviousinvestmentphasetothe

phaseofprofitmaximising,targetingaROEof12.0%13

.

Thiswillbedonethroughtwobasicpolicies:

1. Creationofhighcustomervalueviadeveloping

new products by leveraging core Human-

MachineInterfacetechnologiesintandem,and

establishingaglobalsalesandservicenetwork

to create greater value for customers and

developnewbusinesses.

2. Strengthening the global supply chain and

improvingproduction& logistical efficiency to

achieve furthergrowth incorebusinessesand

byregion.

In addition, Nihon Kohden aims to increase market

sharebeyondhigh-endmarkets,inemergingeconomies

through differentiated regional strategies, by offering

bothhigh-end integratedproductsmade in Japanand

low-endvolume-basedmedicalinfrastructureproducts

madeinChinaandMalaysia.Forexample,forcountries

with less-developed medical infrastructure, Nihon

Kohden’sequipmentwasmorefocusedonconsumables

and on-sitemonitoring systems, providingmore basic

and practical equipment at a lower cost whilst

maintaininghigh-qualitystandards6

.

In summary, Nihon Kohden's existing strengths and

currentbusinessplansareverymuchin-syncwithglobal

healthcaremodernisationtrends,thusweareconfident

that Nihon Kohden is on the path tomeet this rising

demand.

Long-timeVeteranManagement

Nihon Kohden's executive management possess

tremendous internal experience in leading the

company.Mr.HirokazuOginohasbeenthePresidentof

NihonKohdenCorporationsinceJune25,2015andhas

beenitsChiefExecutiveOfficersinceJune28,2017.Mr.

Oginowasre-electedasadirectorinJune2017dueto

hisproventrackrecordsandhisvastexpertise.Hewas

akey figure in setting theagenda forNihonKohden’s

mid-termbusinessplan“stronggrowth2017”aswellas

thelongterm“thechange2020”.

Mostofthedirectorsarepromotedbasedonpastmerits

andexperiencewithinthecompany,withmostserving

atleast20yearsbeforereachingthedirectorshiprole.A

notablemention isTadashiHasegawa,who joined the

companyin2014andiscurrentlyholdingadirectorship

incorporaterole.MrTadashiHasegawahashelmedthe

roleofCorporatedirectorandsenioroperatingofficerin

Saitama Bank before moving to Nihon Kohden as an

Operating officer and finally Corporate director and

senior operating officer in 2017. Having managed

SaitamaBankoverseasoperation,MrTadashiHasegawa

will be a valuable asset for Nihon Kohden in their

overseaexpansion.

ManagementPhilosophy

The management philosophy is to contribute to the

globalbattleforhealthwhilstensuringagoodlifeforits

employees. It's internalgoal is three-fold, tobeat the

technological forefront, toachievethehighest levelof

quality,andtoattaintopmarketshare in therelevant

globalmarkets.Externally,NihonKohdenalsoadoptsa

uniquely Japanese customer service attitude termed

“Omotenashi”-Omotemeanspublicimageonewishto

present,and“Nashi”means“nothing”,combiningthem

meansthateveryserviceinteractionishonest,withno

hiding or pretence. Such whole-hearted service is

explainedwell by the President of Nihon Kohden,Mr

HirokazuOgino,aswequote:“Wearemeticulousinhow

weworkwith clients,which is innate to the Japanese

culture. While important, sales volume is not our

primary consideration. What matters most to us is

identifyingwhatpeopleneed,whetherweareworking

withdoctorsornursesorcaregiversandpatients.Once

wehaveidentifiedaneed,wediligentlyworktosatisfy

it.

Based on this approach, Nihon Kohden has not only

expanded its market share in major market but built

long-lastingrelationshipwiththestakeholders.Thiscan

be seen from Nihon Kohden America achievement of

number1rankingincustomersatisfactionbyforpatient

monitoring systems for 10 consecutive years.6

This is

made possible both infrastructure investment in new

service support centre in Pennsylvia to provide 24/7

service support, and the launch of Nihon Kohden

University,aglobaleducationandtrainingplatformto

provide training of healthcare professionals for their

customers.

NihonKohdenalsochangeditscorporatefundamentals

intoonethatismoreglobalised,efficientprofitableand

fast-pacedaswellasimplementCSRactivitiesaimedat

sustainablegrowthandstrengthenitshumanresource

development initiatives. Itsfocus includesestablishing

aglobalsupplychainto improveefficiencyandreduce

costaswellastoregionaliseheadofficeoperationsby

appointinglocalmanagementstaffanddevelopinglocal

employees, thereby speeding up decision making

process.

43

CorporateGovernance

Nihon Kohden places great emphasis on its corporate

governance to ensure transparency and fairness. Its

internal control system provides great assurance for

investorsthatthecompanyiswellpoisedandatrustable

company. In 2016, the addition of 2 independent

directorintotheAuditandSupervisoryactivitiesreduce

corruption and ensures that the director’s fees are

baseduponmerits.Alimitonthetotalfeesallocatedto

thedirectorsinoneyearisalsocappedbythecompany

policy. Meetings of the upper management is held 3

times a month to validate and ensure efficiency of

decisionmaking,aswellastocreateaflexiblebusiness

operation which can respond to changes and crisis

quickly. Nihon Kohden also introduced an operating

officer system that segregates managerial decision

making into a supervisory division and an operation

division, thereby reducing corporate corruption and

ensuringaccountability.

ShareholdingStructure

According to Mr Hirokazu Ogino (CEO), one of the

greatest limiting factors that the company face is the

limited understanding of consumer outside of Japan.

Quoted byMr Hirokazu Ogino (CEO), " After years of

expansion, we realized that true internationalization

couldonlybeachievedbyunderstandingourcustomer’s

needs and adapting our products to the demand.". A

diverse range of shareholders could provide valuable

feedbacks and suggestions on Nihon Kohden's

methodology at breaking the overseas market. Given

that Unites States is the second biggest market after

Japan, having State Street Corporation, an American

based financial holding company as the largest

shareholderwillproveinvaluableintheirunderstanding

oftheoverseasmarket.

The biggest groupof shareholders are the investment

advisors,wheremostofwhichareexperiencedtraders

whohavebuiltaportfolioaroundthecompanyandfind

itprofitablebeforeinvesting.Webelievethatthelarge

proportionofinvestmentadvisorsprovideagoodgauge

onthehealthandearningcapabilitiesofthecompany.

Creditratingofcompany

Nihon Kohden has consistently maintain a zero-debt

financingpolicy.Mostofitsfinancingaredonethrough

its past year profits instead of borrowing. The

company’s debt currently stands at 660 million yen

whileitscashisat28,753millionyen.Thisensuresthat

thecompanycanaccess to large liquidityquicklyand

easilyduetoitslowdebtservicingratio.

Whydoyouthinkthemarketvalueofthecompanycandoubleinthenext3-5years?

Overdue-growth and Profit-maximising Stage of

CompanyBusinessPlan

NihonKohdenhasjustcomeoffa3-yearstrategicplan

ofstronggrowthendinginApril2017,viainvestmentsin

technologyandoverseasexpansion.However,earnings

fell below predictions due to unfavourable market

headwinds, including prolonged healthcare reforms in

Japanandpoormarketconditionsinemergingmarkets.

Despitethat,NihonKohdenstilldidachieveitsgoalsof

enhancing its technological know-how and

strengthening its presence in overseasmarkets. Since

April2017,thecompanytransitionedfromthisprevious

investment stage to the current phase of improving

profitabilitybyfullyleveragingthebusinessfoundations

establishedinthepast3years.Thissetsituptoachieve

these previously unrealised growths in the coming

quarters.

StrongGlobalMarketTailwindsinPatientMonitoring&

EEGs

The healthcare market trends with regards to Nihon

Kohden's main specializations of patient monitoring

equipmentandEEGsareprojectedforasteadyupturn

inthenext5years,assummarizedinthislist:

44

As summarised above, down-trends in demand for

patientmonitoringdevicesareexpectedtobeovercome

byrisingdemandfromincreasedprevalenceofdiseases

and healthcare spending.Market research has shown

that the global patient monitoring device market is

expectedtohitUSD27.71billionby2020,growingata

CAGR of around 5.8% from 2016 through 202121

. The

Asia-Pacific Region is viewed as the most promising

region, with an ever higher forecasted growth CAGR

overthisperiod22

.Thishigherdemandisforecastedto

facilitateincreasedinvestmentintocapitalequipment&

disposables, enabling increased unit sales growth to

outpacepricingpressuresfromlow-costalternatives.

OfspecialrelevancetoNihonKohdenisthefast-growing

segment of mobile wireless ambulatory telemetry

monitoring. Hospitals are shifting to remote patient

monitoringplatformswithemphasisonpatientcomfort

and mobility, due to the increasing trend to transfer

patientsoutofhigh-acuityintensivewardsearliertofree

uphospitalcapacity.Demandisalsofuelledbythehome

patientmonitoringmarket,whichhasachievedaglobal

annualgrowth rateof15.5% from2011 to20162

Thus,

theexpansionofmid-acuitymonitoring,ofperforming

invasivemonitoringwhilemaintaining a transportable

size24

. This is the area where the Nihon Kohden has

focused its technological innovations,andthus iswell-

poisedtoofferaccurateandaffordablemobiledevices.

Theelectroencephalograph (EEG)market is forecasted

by similar growth. The global EEG market has a

forecastedgrowthof7.4%CAGRtoreachavaluationof

USD 1.8 billion in 20252

. Outside the United States,

Japanitselfisforecastedtobethelargestareaofgrowth

forEEGs,followedbythewiderAsia-Pacificregion,with

aforecastedgrowthof9.7%CAGR, from2014–2021,

nearlydoublinginvaluefromUSD$150milliontoUSD

$260 million5

. As seen in Table 2, this is fuelled by

increasing prevalence, awareness and action on

neurologicaldiseases,andtechnologicaladvancements

expanding the applications of brain monitoring in

medicineandtechnologyatlarge.

Thus, the convergence of Nihon Kohden's prior

technologicalandmarketexpansioninvestments,profit-

maximisingbusinessplan,andfavourablemarkettrends

leadsustobelievethatNihonKohdenisdueforauptick

ingrowthinthenext3-5years.

Growth Strategy mirroring a successful case study:

Sysmex

SysmexisalsoaJapanesecompanymainlyinvolvedwith

haematology analysers and consumables such as

reagents required for blood test. With share price

originallyatJPY3,160atJanuary2014,italmosttripled

invaluetoJPY8,870asofDecember2017.Thereisan

impressive increase of overseas sales from 67.5% in

2008to82.6%in201739

.

WeobservethatNihonKohdenhasthepotentialtobe

the next Sysmex from 2 key business decisions that

Nihon Kohden has adopted that mirrored Sysmex

successful growth strategy; firstly, a spike in capital

investmenttodriveoverseasgrowth,andsecondly,an

increase weightage of revenue from services and

consumablestocreateasustainable,recurringrevenue

business model.

Firstly, Nihon Kohden invested heavily to enhance its

global business activities similar to Sysmex. Sysmex

almost tripled its capital expenditure from JPY 4.54

billion in 2010 to JPY 13.10 billion in 2016 to further

enhance its global production and sale network, and

subsequentlysawsustainedgrowthinbothrevenueand

operatingincomeoverthesameperiodthatallowedfor

themore thanproportionate increase in valuation for

Sysmex.Inthesameperiod,NihonKohdenincreasedits

45

capital expendituremore than 4 times, from JPY 1.80

billion to JPY 7.71 billion, for project such as the new

R&DcentreatTokorozawa,SaitamaandBoston,USAas

well as establishing new sales office in places such as

Kenya to target emerging markets. The increase in

capital expenditures indicates Nihon Kohden

commitment towards itsoverseasexpansionand their

acknowledgement that they require more effort to

increasetheweightageofoverseassalestototalsales.

One might consider that Nihon Kohden is late in

implementation of their overseas expansion strategy

uponcomparisontoSysmex,butwemustalsoconsider

the difference in the nature of the products the two

company produces. Sysmex produce blood analysers

that are required as emergingmarkets build up basic

healthcare infrastructure,whereasNihonKohdencore

expertises,patientmonitors,ECGsandEEGsarepartof

healthcaresystemthat takecareofmorecomplicated

healthissuesthatarisesfromtheagingpopulation,and

also increasing prevalence of chronic diseases

worldwidethatarearesultofincreasingaffluenceinthe

recent decade. Nihon Kohden overseas expansion

shouldbeconsideredtimely;theirproductswillnotbe

indemandfrombothdevelopingmarket(whichhasyet

tobuildupbasicinfrastructure)anddevelopedmarket

(which have yet to feel the pressure from aging

population) if Nihon Kohden focused on overseas

expansionintheearly2000s.

Secondly, while Sysmex is a market leader in the

hematology analysers, 65% of its 2016 revenue are

recurring from the sale of maintenance services and

consumables such as their proprietary reagents, and

theyareventuringintohighvalueITsolutionservicesas

well. As discussed previously, Nihon Kohden has also

successfuldiscoveredthemarketforconsumablesand

servicesarounditsinstrumentsandreduceditsreliance

onunithardwaresales.

Top3ToxicFactors(Risks)

NegativeCurrencyTranslation

In2016,althoughthesalesgrewinregionssuchasUS,

Asia and Middle East, there was a decrease in

internationalsalesdueanappreciationoftheJapanese

Yen.Thisproblemwillbecomeevenmoreprominentas

NihonKohdenexpandsitsglobalmarketshareaspartof

The CHANGE 2020 business plan. In addition, the

Japanese currency is postulated to grow stronger as

inflation is set to return after decades of deflation

againstabackdropofagrowingeconomy.However,as

domesticsalesstillconstituteabout75%oftotalsales,

impact of negative currency translation isfairly

limitedgivenimprovementininternationalsales.

InternationalHealthcarePolicies

US constitutes the largestportionofNihonKohden's

internationalsales.However,theUSmarketisbeingmet

withuncertainty followinga revampof theAffordable

CareAct(ACA)underTrump'sAdministration.Someof

thechangestotheACAincludesshorter-terminsurance

plans,omissionofcertainbenefitsinthebasiccoverage,

and reductionofMedicaid. It iswidelybelieved that

thiswouldleavemanymorepeopleuninsuredanddrive

upcostsofcoverage25

.Ashealthcareisstillregardedas

anout-of-pocket expenseand insurance coverage is

paramount inhelpingpatients footmedicalbills, the

passing of the American Health Care Act would

adversely impact the affordability of in the US,

potentiallyaffectingthesalesrevenueforNihonKohden

InternationalCompetitioninITSolutions

ThoughNihonKohdencurrentlyholdsthebiggestshare

ofthepatientmonitoringsystemsintheworld32

ahead

ofbigplayerssuchasGEhealthcare,PhilipsHealthcare

andFukudaDenshi,itstillfacesstiffcompetitionsfrom

them in termsofotherplatforms suchas cloud-based

software. GE Health Cloud26

, Philips Healthcare's

Healthsuite27

are platforms that utilises cloud

technology to integratedevices andmonitors creating

anecosystemformoreefficientworkflow.WhileNihon

Kohdenmayleadtheindustryinadvanceddevicesand

systems,ithasonlyjustenteredtheCloudTechnology

with its Prime Partner earlier this year and it is only

limited to Japan.We foresee a steep barrier to entry

against such international players in terms of cloud-

based products given the additional regulatory

frameworks ithas tofulfil forproducts involving cyber

security.Assuch,NihonKohdenhastoplaycatchupto

its international competitors in this trending range of

product, which will shape its continued status as the

dominant global supplier of patient monitoring

systems.

FinancialAnalysis&ValuationGrossmarginincreasingwithoutadecreaseinworking

capital suggests a genuine upturn in the company’s

market performance, rather than a mere accounting

trick to inflate the financial balance sheet. Nihon

Kohden’s improvement in gross margin has been

accompaniedbyanimprovementinitsbalancesheetas

well.Thissuggeststhatgrossmarginimprovementsare

likely from operating decisions and not accounting

gimmicks.

46

Nihon Kohden's Gross Profit Margin has consistently

stayedabove47%overthepastfewyears.Grossprofit

margin is a key measure of profitability by which

investorsandanalystscomparesimilarcompaniesand

companies to their overall industry. The higher the

percentage, the more the company retains on each

dollarofsalestoserviceitsothercostsandobligations.

By comparingNihonKohden'sGPMwithother similar

competitors, we find that Nihon Kohden's ability to

reducethecostforeachdollarofsalesmuchhigherthan

its competitors. This gives us confidence that Nihon

Kohden's management has derived a holistic cost

formula that has allowed Nihon Kohden to lower its

directcostofproduction.

Nihon Kohden's R&D expense as a ratio of sales is

consistentlyaround3.9%,which ishigher thanmarket

average for healthcare. The company has also been

proppinguponitscapitalequipmentrecently,whichis

in tandemwith the CHANGE 2020 reformation of the

company. This provides sustainability in

itscompetitiveness.

Nihon Kohden’s current dividend is at JPY 35.02per

share, which is a dividend yield of 1.36%. Nihon

Kohden’spay-outonearningsiscurrently32.77%,which

ishigherthancompaniesofHealthCareindustry,which

is28.64%.Thecompanypolicyalsostipulates that the

dividend pay-out ratio is at least 30%or more. This

provides good investment value for long term

shareholders. This also ensures that the retained

earnings could be used for R&D investments, capital

investments, M&A and development of human

resources,thusreducingtherelianceonborrowingand

lowersthecostofcapital.

Thepay-outonearningswasanalysedtogetherwiththe

pay-outoncashflowsincethisislastamountwhichcan

bedistributed to shareholders.Cash flowper shareof

NihonKohden is JPY132.73pershare,which ishigher

thanthedividendpersharepaidbythecompanyofJPY

35.0219

. This signifies that the company generates

enough cash to maintain its dividend in the future,

ensuringastabledividendstructureofthecompany.

Givenhighupfrontinvestmentintotheoverseasmarket,

investmentreturnswillusuallybeslow.Thecompound

annualgrowthrate(CAGR) isthemeanannualgrowth

rateofaninvestmentoveraspecifiedperiodlongerthan

oneyear.NihonKohden'sCAGRshows that its annual

salesCAGRanditsoverseassalesCAGRisyieldinggood

investmentreturnsat6%and11%respectively,overa

periodof7years.OperatingincomeCAGRhasincreased

6%overthelast7years,withastagnationperiodsince

2013mostlikelyduetoitsreformpolicies.Overall,this

indicatesahealthyinvestmenttrendforNihonKohden

andensuresthatitsinvestmentyieldshighreturns.

Ascoveredearlier,NihonKohdenhasundergonearapid

expansion policy towards international market by

settingupoverseasfacilities.Itisalsoundergoingmajor

reforms in its supply chain management and its

corporate policies. Given that such expansion usually

takes huge investment capital with low investment

returnoverthefirstfewyears,therewasanotablefall

intheGrossandoperatingprofit.However,thisdropis

likely a short-term trend given the high CAGR

performanceintheoverseasmarket.

Conclusion

Our research indicates that Nihon Kohden's drop in

EBITDA is due to its rapid expansion policies towards

overseasmarketinsteadofafundamentalissuewithits

costoperation.WebelievethatNihonKohdenisinthe

phase of transiting towards internationalisation and

service-oriented sales structure. Nihon Kohden has

increased its sales consistently over 7 years despite

headwinds. With good corporate practice and

achievable development plan, coupled with its strong

abilitytoderivehighGPManddividendpay-outs,weare

confident that the companyis able togenerate higher

returnforshareholdersinthefuture.

47

(TSE:6849)NihonKohdenCorporationFY2013 FY2014 FY2015 FY2016 FY2017 FY2018LTMSharePriceJPY 1,895.00 2,540.00 3,030.00 2,865.00 2,594.00 2,543.00NoofShares(mil) 87.9 87.9 87.7 85.7 85.7 85.7MCAP(mil)USD 1,678 2,203 2,172 2,390 1,978 1,933NetDebt(Cash)JPY (23,982) (27,152) (32,452) (23,039) (25,561) (29,898)EnterpriseValue(mil)USD 1,309 1,517 2,144 1,887 1,709 1,644Revenue(mil)JPY 132,538.0 153,194.0 160,803.0 165,522.0 166,285.0 168,470.0EBITDA(mil)JPY 16,394.0 20,788.0 19,527.0 20,063.0 17,150.0 16,397.0EBIT(mil)JPY 13,485.0 17,548.0 15,922.0 16,439.0 13,586.0 12,810.0NPAT(mil)JPY 9,151.0 12,346.0 11,142.0 10,516.0 9,149.0 10,007.0NPAT(Ex.Xtra+Dis.Ops)(mil)JPY 8,224.0 10,966.0 9,739.0 11,097.0 8,967.0 8,022.0CFO(mil)JPY 13,189.0 9,383.0 12,505.0 10,765.0 11,356.0 12,202.0CAPEX(mil)JPY (2,131.0) (3,777.0) (3,174.0) (6,898.0) (6,304.0) (3,537.0)EPSJPY 93.6 124.8 111.1 129.6 104.7 93.7Revenue(mil)USD 1,407.1 1,488.0 1,340.1 1,473.1 1,491.3 1,496.1EBITDA(mil)USD 174.0 201.9 162.7 178.6 153.8 145.6EBIT(mil)USD 143.2 170.5 132.7 146.3 121.8 113.8NPAT(mil)USD 97.1 119.9 92.9 93.6 82.1 88.9CFO(mil)USD 140.0 91.1 104.2 95.8 101.8 108.4CAPEX(mil)USD (22.6) (36.7) (26.5) (61.4) (56.5) (31.4)GPM(%) 50.0% 50.0% 48.4% 48.8% 47.6% 47.4%EBIT(%) 10.2% 11.5% 9.9% 9.9% 8.2% 7.6%NetDebt(Cash)/Equity(%) -31.5% -30.7% -32.7% -23.6% -24.6% -28.5%ROA(%) 11.5% 13.4% 10.8% 11.4% 8.9% 8.9%ROE(%) 17.7% 19.8% 16.0% 16.8% 13.1% 12.2%CFO/TA(%) 11.3% 7.2% 8.5% 7.5% 7.4% 8.5%EV/Sales(x) 1.1 1.3 1.5 1.3 1.2 1.1EV/EBIT(x) 10.6 11.2 14.6 13.5 14.5 14.7EV/EBITDA(x) 8.7 9.4 11.9 11.1 11.5 11.5EV/CFO(x) 10.8 20.9 18.6 20.7 17.3 15.4P/Sales(x) 1.3 1.5 1.7 1.5 1.3 1.3P/EBIT(x) 12.3 12.7 16.7 14.9 16.4 17.0P/B(x) 2.4 2.7 2.9 2.7 2.3 2.2VQ1:EV/EBIT/ROE(x) 0.6 0.6 0.9 0.8 1.1 1.2VQ2:EV/EBIT/ROA(x) 0.9 0.8 1.4 1.2 1.6 1.7

48

6. BataShoeCompany(Bangladesh)Ltd(DSE:BATASHOE)


QuickStats

Date 15/12/17 EBIT/R&D(x) NA

FilingCurrency BDT

EBIT/EmployeeNo.

(USD/px) 10K

SharePrice BDT1,173 EV/EBIT(x) 9.8



DailyValueTraded


GPM(%) 41.4% P/E(x) 10.1

EBIT(%) 17.6% P/B(x) 3.8

NetDebt(Cash)/

Equity(%) -11.3%

VQ1:EV/EBIT/ROE

(x) 0.3

ROA(%) 21.4%

VQ2:EV/EBIT/ROA

(x) 0.5

ROE(%) 37.8%

TeamMembers

Andy is fromNanyangTechnologicalUniversity, reading Economics

withspecializationinFinance.Heisamemberoftheschool'sstudent

run investment club - Nanyang Capital. He is passionate

aboutinvestmentsandpreviouslydidaninternshipintheCorporate

Finance field. Moving forward, he islooking to venture into other

areasfrontofficeroles.

JunLeongisafinalyearstudentstudyingaccountinginNTU.Heisa

member of the school's student run investment club - Nanyang

Capital. He is interested in investments and previously did several

financedrelatedinternships.

49

Webelievethatthesuccessfactorsthatwehaveseen

currently and will see moving forward can be

summarizedasfollows(alsoknownas–MOAT):

SuccessFactor#1

Strong Management Team that have shown strong

loyalty and expertise, which will help Bata capture

market share throughout this transition from Third

worldtoFirstworldcountry.

SuccessFactor#2

Bata’s unparalleled network and resources when we

juxtapose it with its peers makes Bata an attractive

investment. Bata Bangladesh is able to receive help

from Bata International’s Bata Innovation Lab, which

provides themwithworld renowned R&D alongwith

strongandcloseworkingrelationshipswithsuppliers.

SuccessFactor#3

Bata,beingthefirstestablished internationallyknown

company to enter Bangladesh, enjoys first mover

advantage.Thisadvantageallowsthemtoenjoystrong

brand equity, which is why Bata is able to maintain

integrityevenwithentrantstothefootwearindustry.

Also, we believe that Bata presents high potential

upside while maintaining low downside risk. The

possibility of a ‘double-in-value’ can be derived from

thefollowingpropagation:

ValueFactor#1:DevelopmentofBangladeshEconomy

moving forward. We have been seeing positive

economic indicators in Bangladesh. Intuitive, the

footwear industry will growth along the economic

developmentthecountry.

Value Factor #2: Industry growth expectations. With

strong historical growth rates and future growth rate

expected,wefindthatBataispoisedtotakeupmarket

sharemovingforward.

ValueFactor#3:StrongBrandnamewithproventrack

recordsindifferentmarkets

Value Factor #4: Alignment of Business’s Goals with

thoseofEmployees

Value Factor #5: Strong Financials – Cash Flows and

BalanceSheetSituation

Some risk includes: (1) Frequent workers’ Strikes, (2)

PossiblerelianceonBrandNameand(3)Threatofnew

entrants.However,webelieveduetotheBata’sability

to stay rooted amongst these risk due to strong

fundamentalsthatthebusinesshas.

In the following report, the deeper analysis will be

conducted on these success factors and the

sustainabilitywillbeprovenusingfiguresandintuition.

BusinessDescriptionBata Shoe Company (Bangladesh) Ltd (BATA), as its

namesuggests,isheadquarteredinBangladeshandwas

foundedin1972.TheCompanyisoneoftheoperating

companiesofworldwideBataShoeOrganization(BSO).

BataShoeCompanymanufacturesandretails leather,

rubber, plastic, canvas footwear, hosiery and

accessories items for men, women, and children.

Currently, it operates c.250 stores across Bangladesh,

strategically managed to meet minimum IRR

requirements. In terms of production, it has two

manufacturingfacilities,locatedinTongiandDhamrai,

accountingfortheproductionofmorethan26.6million

pairs of shoe. In 2016, BATA restructured its

manufacturing operation so as to achieve synergistic

effects with the company objectives. The revamped

manufacturing model has a maximum production

capacityat45.46millionpairs,allowingittomeetthe

demandsurge.Apart from Bata’s own brands – Bata Comfit, B.first,

Power, North Star, Bubblegummers, Sandak, the

company forms strategic partnership with renowned

brands like – Adidas, Hush Puppies, Scholl, Nike,

Skechers,MarieClaireandWeinbrenner(Figure1).This

allows Bata to achieve its competitive position as a

marketleader.

Bata’srevenuecanbebrokendownfurtherintothree

segments(Figure2)–ShoesSales(95.62%),Hosiery&

Accessories (3.99%) and Exports of Shoes and other

items(0.40%).

Overviewof2016’sstellarperformance

Revenuegrowthisattributabletotop-linesalesgrowth

of3.11%,whichcanbebrokendownfurther intoASP

(average selling price) growth of 1.05% and volume

growthof 2.05% (Figure 3). Ifwe strip downonpure

retailperformance,Bata’srevenueseenagrowthof5%

over the year, contributed by successful strategic

marketinginitiatives.

50

Additionally, we witness margin expansion over the

past year, attributable to firm’s operation efficiency,

achieving COGS streamlining. Gross Profit Margin

increased from40.44%to43.45%,directlybenefitting

ProfitbeforeTax(PBT)margins(14.46%to16.19%)and

Net Incomemargin (10.08% to 11.87%) via spill-over

effect(Figure4).

Overall,thesefactors leadtothe21%increaseinEPS,

from$62.99to$76.24(Figure5).Worthnoticingisthe

consistentdividendpay-outthatBatamaintains.

Investment Origination and Hidden ChampionPropertiesInvestmentIdeaOrigination

We took a top-down approach, first looking atwhich

economic environment in Asia-Pacific is poised for

growth.Wethendrilleddowntotheindustrywhichwe

thinkisattractiveyetmissed,accordingtotheindustry

characteristics.Thisnarrowedittoconsumergoodsand

services.We chose footwear due to the fact that (1)

shoesareanecessity,assuringabaselevelofdemand

(2) able to capture upside as countries develop –we

considered developed countries and noticed that the

footwearindustryiscapableofevolvingalongwiththe

economy, with higher ASPs, better quality and

continuousinnovationabletodrivesales(3)footwear

in the emergingmarkets of Asia are generally at the

infantstageofdevelopment,providingsomebufferfor

downside.Finally,weshortlistedBATABangladeshdue

to its advantageous market position and capable

management.

WhyisitfittobeaHiddenChampion

HiddenChampionseeksalphawiththefollowingfilters,

namely (1) Entrepreneur providing valuable,

indispensableproductsthatpositionsforcompounded

growth,(2)Qualitiesbeyondprofitgeneration,guided

by higher purposes (3) Ability to stay rooted in

challengingtimes.After in-depthanalysis,Bataclearly

posses thesevaluesandproves tobea ‘hiddengem’,

especiallywhenitisunder-

covered and over-avoided due to its ‘perceived’

economicrisk.

ThemakingsofaWide-MoatBusiness

Contributing factors to this wide-moat business’s

29.33%ROE

#1 Management Analysis – Extremely Capable

Management Team Management and their business

philosophy

If we look at the BATA’s Board of Directions and

managementteam,wecanunderstandwhyBATAhas

beenable towitnessconsistentgrowth.Thecommon

characteristicoftheBoardmembersandmanagement

can be summarized in a few words and phrases –

Loyalty, Wide range of experienced individuals, each

with strong area of focus and expertise. Bata

BangladeshisheadedbyMrRajeevGopalkrishnanasits

Chairman – Mr Rajeev has had almost 3 decades of

experienceinthefootwearindustryandalsoexperience

in Batas of different regions and countries. Bata

Bangladesh’sManagingDirectorissimilarinprofile–Mr

CjitpanKanhasirihasalmost2decadesofexperiencein

the industry and experience in multiple Batas of

differentregionsandcountries(AppendixA).

All these culminated in recognition of Bata being the

leaderinthefootwearindustry.In2016,andinfactits

4th consecutive year, BATA was awarded the BEST

BRAND AWARD in footwear category. Additionally,

BATA was prized the Number 1 shoe brand in

Bangladesh.Thistiesinnicelywiththefactthatithold

51

c.25% market share in the footwear industry in

Bangladesh.BATABangladesh is ledbyan competent

teamwho are extremely experienced and have been

loyal to Bata formany years.With their international

experienceandexpertiseinthefootwearindustry,the

strong leadership at the helm gives us confidence of

BataBangladesh’sdirectionandmanagement’sability

tosteerthecompanytogreaterheights.

ShareholderStructure

Bata,withatotalof13,680,000shares,islargelyowned

byBafinNederland(70%),insignificantamountheldby

insiders(<0.01%)andtherestbyLocal(5.3%)andNon-

Resident Shareholders (24.7%) (Figure 6). With no

executivesholding sharesnoranymajor shareholders

holdingmore than 10%of total shares, this structure

preventsanypossibleconflictofinterest.

CorporateCultureandSocialResponsibility

Bata corporate culture can described in twowords –

‘accountability’ and ‘ownership’, in which they

implement performance management system,guided

byKPImeasuresand ‘pay-by-performance’ incentives.

Additionally, Bata is heavy on social involvement

programmes, namely – ‘Educational for the next

generation’, ‘Bata school adoption program’ and

‘Scholarshipprograms foremployees’children’.These

programreachedouttomanyschoolsallowingthemto

seekabetterlifemovingforward.

#2 Competitive Advantage & Sustainability – BATA’s

unparallelednetworktoleverageon

Bata Internationalperformsworld-renownedresearch

anddevelopment (R&D) inBata’s InnovationLab (BIL)

where they are constantly seeking the cutting-edge

technology.BATAaimstoimprovethelifeofconsumers

via consistent improvement in the quality of BATA

shoes,whichcanbeseenintheirR&Dprocess(Figure

7).Theirprogressivethinkinghascreatedsomeofthe

simplestyetelegantdesigns.Someoftheirinnovations

are as follows: Clarino (Material Tech – specialwater

and scuff-resistant material with premium durability

and feel) and Cosmo (Material Tech – strong and

durableinsolesmadeupof~70%recycledmaterial).

Thus,BataBangladeshhasaccesstothehighestquality

R&Ddoneatagrouplevel,whichprovidesalongpipe-

line that is both useable and tested inemerging and

growing markets. Amalgamating with Bata

Bangladesh’s ground-level understanding of

consumers’ preference and market trends, Bata

Bangladeshperfectlypositionedtonotonlycapturethe

growthinthefootwearindustryasawhole,butalsoto

increase their market share with such technological

advancementovertheircompetitors.

#3 Intangibles & Sustainability – Solid Brand Equity

justifyingpricingpremium

AglobalcompanylikeBataenjoysstrongbrandequity,

especially in a 3rd

world country, where brands are

scarce.Thisallowsittochargeapremiumasacompany

overitspeers(Figure8,AppendixB).

52

BataBangladeshhasachievedASPgrowthsteadilyover

theyears,withnodilutiontothevolumegrowth(Figure

9).Weclearlyseethatvolumedidnotgothroughade-

growth,stayingatabove0%overthepast5years.Bata

isabletochargeareasonablepremiumwhilecapturing

strongvolumegrowth,representativeofthepremium

thatBataBangladesh is able to command.Thisbrand

equity is continuously being solidified by strong

marketingandadvertisingfees(Figure10).Additional,

Bata Bangladesh was the first international company

with to enter the Bangladesh shoe market in 1972,

whilepeerscameinonlyafter2006,meaningtheyhave

hadalongerrun-waybuildingtheirbrandname.These

initiatives by Bata Bangladesh are help to ingrain the

brand perception and customer awareness of their

brandandfortifiestheirfootholdovertheshoemarket

inBangladesh.

KeyInvestmentRisk(ToxicFactors)

ThekeyinvestmentrisksaresummarizedinFigure13,

showingthatmostofitsrisks,evenwhenmaterialized,

posesmalltomoderateimpactonthefirm.

[KI1]KeyInvestmentRisk#1–FrequencyofStrikes

Bangladesh, as mentioned previously, has frequent

workers’ strikes, demanding better wages and/or

better working conditions. [High Probability, Small

Impact]

Mitigation:Bata enforces strong labour relationship,evidentfromthecomprehensiveemployeebenefitsby

Bata.Bataplacesstrongemphasisonloyal,longterm

workers,providingthemmultiplepackagesthatcovers

both employment period and post-employment

period. Additionally, Bata understand that the ST

workers also plays a huge part, and therefore, they

cater to them as well (Figure 14).

[KI2]KeyInvestmentRisk#2–RelianceonBrandName

As its business is concentrated on consumer goods,

theremightbeover-relianceonconsumerperception

and branding perception. [Moderate Probability,

ModerateImpact]

Mitigation:Bataisaninternationalcompanythat

provenitssuccessinothercountriescurrently

transitingfromthirdworldtofirstworldcountry.

53

[KI3]KeyInvestmentRisk#3–Newentrantscoming

intotheFootwearIndustry

Weacknowledgethefactthatnewentrantswilltake

attempttotakeawayBata’smarketshare.[Moderate

Probability,Small-ModerateImpact].

Mitigation:Beingabrandwithlong-history,Bataisestablisheditselfasthetrusted/go-tobrand.

Additionally,thesheersizeofBataissomethingthat

entrantscannotreplicateon,allowingittomaintaina

highermarginascomparedtothesmallerplayers.Also,

astheindustrygrowsbigger,theimpactonrevenue

willbeminimized.

ValuationandFinancialAnalysis

Thepossibilityofupsideisexplained:

Factor #1 – Development of Bangladesh economy to

drivetop-linesalesgrowth

AsBangladeshtransitfromathirdworldtofirstworld

country, we expect a natural expansion of the

footwearindustryfuelledbygoodeconomicdynamics

(Figure 15). Theexpansion canbebrokendown into

twoareas–(1)Volume,fuelledbyRealGDPGrowth,

boostinggeneralconsumptionand(2)ASP,fuelledby

inflation,boostingpurchasingpower(Figure28).

We expect ASP to grow along the same trend as

inflationrate/GDPincrement.However,wepriceina

lowergrowthrateascomparedtotheinflationrateas

weacknowledgethefactthatpeggingASPgrowthto

inflationrate/GDPgrowthrateisnotsustainableinthe

longrun.

Factor#2–GrowingFootwearIndustry

ThefootwearindustryinBangladeshalsoseenstrong

growth over the past 5 years, as awhole grew at a

CAGRof12%asmentionedbyBata’sseniormanager

(Figure 16). Moving forward, Orion Group’s CEO

(Orion is a local footwear retailer) projects a c.15%

growth in the footwear industry, boosting top-line

salesgrowth(Figure16).Intuitivelythismakessense,

becauseBangladeshisauntappedmarket,beinga….

Particularly,weseehighergrowthinconsumptionof

leather products, favouring footwear retailers with

leatherproductlines.Notably,Bataproducesawide

rangeof leatherfootwear,allowing it torideonthis

waveofleatherconsumptionexpansion.

Factor #3 – Strong Brand name with proven track

recordsindifferentmarkets

There are arguments circling around the influx of

independent (local) stores and international

competitors. However, Bata differentiates itself on

threeareas.

(1) StrongDistributionnetwork:Bata is the leadingfootwearcompany,withthemostphysicalstoresas

companyto itspeers,allowingthemtoreachout in

an effectivemanner. Also, Bata is able to tap on it

supply chain network, allowing it to derive better

margins.

(2) ExcellenceR&D,togetherwithexpertise:With

BIL’sR&D,Bata’sstrongproductlinewillbeableto

coverthewholespectrumofthemarket,fromlowto

highendconsumers,asevidentfromthe900product

releasesin2016.

(3) Solid Brand Equity:Having a long history of 45yearsandhugemarketshare,Batahasthefirstmover

advantage,thuscreatingstrongbrandequity(Figure

17). Boutiques and international players who has a

small presence will find it hard to competemarket

sharewithBata.

Additionally, we wish to emphasise Bata’s

competitive advantage of having ‘International’

expertise.Theyhavethetechnicalknow-howandvast

experience toeffectively capturea larger cutof the

footwear industry pie over this third world to first

world country transition.

54

Factor#4–AlignmentofCompany’sgoalswiththoseof

Employees

Batarecognizesthefactthatitspeopleareitsgreatest

asset, and they clearly proved to provide strong

employee benefits via employment and post-

employment benefits and bonus program (Figure 18,

also shown previously). Additionally, the bonus

packages pegged to bonus packages will further

incentivizeworkerstoworkinBata’sinterestsaswell.

Atfulleffectoftheseincentivesandwelfareprograms,

revenueshouldgrowthwhensynergyeffectisattained

betweenBataanditsemployees.

Bataalsoconsistentlycomesupwithplanstoenhance

employees’ loyalty.Oneexample isBata’sScholarship

away,awardedtomorethan7employee’schildrenin

recognition of academic excellence.

Factor#5–ExcellenceBalanceSheet

Looking at Bata’s balance sheet, we understand the

strongcashpositionthatBataisabletomaintain(Figure

19).Thisstrongcashflowsandbalancesheetposition

allows three important possibilities. During (1) Time

withgood investmentopportunities,Batawillbeable

touseitsownFCFor,(2)Takeondebteasily,andduring

(3)Periodsofbusinesscyclecontraction,Batacanuse

thethickcashcushionthroughanyrevenuedecline.

(DSE:BATASHOE)BataShoeCompany(Bangladesh)LimitedFY2013 FY2014 FY2015 FY2016 FY2018LTMSharePriceBDT 880.20 1,354.90 1,170.40 1,115.60 1,172.60NoofShares(mil) 13.7 13.7 13.7 13.7 13.7MCAP(mil)USD 155 238 204 190 194NetDebt(Cash)BDT (123) (130) (174) (632) (475)EnterpriseValue(mil)USD 120 203 227 189 185Revenue(mil)BDT 7,879.0 8,077.0 8,522.8 8,784.6 9,009.8EBITDA(mil)BDT 1,240.6 1,116.4 1,295.1 1,545.9 1,727.4EBIT(mil)BDT 1,140.9 1,003.2 1,170.9 1,397.0 1,582.6NPAT(mil)BDT 813.1 700.7 831.7 1,043.0 1,163.9NPAT(Ex.Xtra+Dis.Ops)(mil)BDT 808.0 694.8 820.1 1,041.8 1,168.7CFO(mil)BDT 563.5 644.1 591.9 1,076.5 638.8CAPEX(mil)BDT (150.6) (238.5) (123.0) (92.4) (186.9)EPSBDT 59.1 50.8 59.9 76.2 85.4Revenue(mil)USD 101.9 103.7 108.9 111.2 109.6EBITDA(mil)USD 16.1 14.3 16.6 19.6 21.0EBIT(mil)USD 14.8 12.9 15.0 17.7 19.2NPAT(mil)USD 10.5 9.0 10.6 13.2 14.2CFO(mil)USD 7.3 8.3 7.6 13.6 7.8CAPEX(mil)USD (1.9) (3.1) (1.6) (1.2) (2.3)GPM(%) 35.1% 35.6% 37.1% 40.1% 41.4%EBIT(%) 14.5% 12.4% 13.7% 15.9% 17.6%NetDebt(Cash)/Equity(%) -5.4% -5.1% -5.9% -17.8% -11.3%ROA(%) 24.7% 21.5% 22.4% 21.3% 21.4%ROE(%) 50.6% 39.0% 39.5% 39.3% 37.8%CFO/TA(%) 12.2% 13.8% 11.3% 16.4% 8.7%EV/Sales(x) 1.5 2.3 1.9 1.7 1.7EV/EBIT(x) 10.4 18.3 13.5 10.5 9.8EV/EBITDA(x) 9.6 16.5 12.2 9.5 9.0EV/CFO(x) 21.2 28.6 26.8 13.6 24.4P/Sales(x) 1.5 2.3 1.9 1.7 1.8P/EBIT(x) 10.6 18.5 13.7 10.9 10.1P/B(x) 5.3 7.2 5.4 4.3 3.8VQ1:EV/EBIT/ROE(x) 0.2 0.5 0.3 0.3 0.3VQ2:EV/EBIT/ROA(x) 0.4 0.9 0.6 0.5 0.5

55

7. TimeTechnoplastLimited(BSE:532856)


QuickStats

Date 15/12/17 EBIT/R&D(x) 274.21

FilingCurrency INR

EBIT/EmployeeNo.

(USD/px) 10K

SharePrice INR204 EV/EBIT(x) 17.6



DailyValueTraded


GPM(%) 26.1% P/E(x) 15.3

EBIT(%) 10.4% P/B(x) 3.3

NetDebt(Cash)/

Equity(%) 46.8%

VQ1:EV/EBIT/ROE

(x) 0.8

ROA(%) 11.4%

VQ2:EV/EBIT/ROA

(x) 1.6

ROE(%) 21.7%

TeamMembers

AngChiHernisanundergraduatefromtheSchoolofAccountancyin

SingaporeManagementUniversitywhohasaninterestincorporate

financeandanalysisofstocks.Heiscurrentlydoinganinternshipin

ExcidePteLtd,a financialmanagementconsultancyfirm,wherehe

supportsthemanagementteaminprovidingservicestoclients.

Yim Yi Xiang is an undergraduate pursuing a Degree in Business

Management in Singapore Management University. He is an avid

readerofbooksrelatedtovalueinvestingandfinancialanalysisand

isactive inanalysingcompanies listed inSingapore.He is currently

interningatCredencePartners,aprivateequityfirmasaninvestment

analyst.

LimMingSheng isanundergraduatepursuingaDegree inBusiness

ManagementinSingaporeManagementUniversity.Hispassionliesin

corporate finance and valuation and has done internships in

CreditsightsandTiroCapital.

Louis Quek Yi Fu is an undergraduate at Singapore Management

UniversitypursuingaDoubleDegreeprogramme inEconomicsand

Business.Hisinterestliesincorporatefinanceandvalueinvesting.He

hasinternedatPrincipalGlobalInvestorsandExcidePteLtdwhichare

assetmanagementandfinancialconsultancyfirmsrespectively.

56

Howdidyouoriginatethisideaandwhydidyouchoosethiscompany?Our team has approached the stock search by first

screeningfilteringdowntheuniverseofsticksviaafew

metrics mainly: (1) ROE, (2) ROA, (3) Market

Capitalization.Subsequently,ourteamwilllookateach

company in our screen list and look for potentially

interestingandgoodbusinesses.Wenarrowdownour

targetlistfurtherbyaskingafewquestions:

(1)Canweunderstandthebusiness?

(2)Doesthebusinesshaveaneconomicmoat?

(3)Dothemacroeconomicfactorsallowthecompanyto

growfurther?

(4)Isthedemandforthebusinessinelasticandfirm?

After answering these questions, our team narrowed

down to a few businesses which includes

manufacturing, tobacco, waste management and

pharmaceutical.We further funneledour target list to

our final decision by looking out for growth

opportunities.

TimeTechnoplast(TT)wasselectedduetoafewmacro

reasonsandspecificcompanycompetitiveadvantages.

Firstly, the macro growth of industrial packaging and

stable projected growth of the industry with lack of

penetration in areas TT operate thrilled us. Secondly,

with their introduction of the new composite cylinder

whichcouldpotentiallydisruptsteelcylindersmadethe

companypoisedfor futureexponentialgrowth if take-

uprateaccelerates.

Hence,withagoodmixofmarketgrowthstabilityand

specific growth catalyst, our team selected TT as our

researchcompany.

CompanyOverview:TimeTechnoplast(TT)isamanufacturingcompanythat

producespolymerbasedindustrialpackagingproducts.

They operate mainly in the B2B business focusing on

industrialproducts.Theirproductlinesaredividedinto

2maincategoriesknownasEstablishedProducts(EPs)

andValue-AddedProducts(VAPs)whereEPsareold

successful brands and VAPs are the company’s latest

products.Afewexamplesofshownbelow

57

.

TT is the largest polymer based industrial packaging

producerinIndiawithanapproximatemarketshareof

70%.Thecompany’srevenueissplit intooverseasand

domestic shown in Figure 1 and their product line

revenue contribution is shown in Figure 2. It is also

important to note that the company serves over 900

institutional customers with no single client owning

morethan4%ofitsrevenue.

Additionally, TT has a global presence through

subsidiaries and joint ventures. Below is a table that

summarizesthecompany’svariousglobalpresences.

Whatisyourone-sentenceinvestmentthesis?Strong market leader in polymer based industrial

packaging products with high growth potential from

compositecylindersegment.

Whatmakesitawide-moatbusiness?TT’sbusinesshasawidemoatwith4reasons:(1)Highinitial CAPEX, (2) Position of factories, (3) Costlycertifications and product testing (4) Thinmargins forexploitation.The4pointsareelaboratedbelow:

(1) Formanufacturingcompanies,theinitialCapital

Expenditure (CAPEX) of production plants is

extremely high which deters introduction of

competitionduetothehighinvestmentcost.

(2) Additionally,thepositionofplantsisessentialtocutdowntransportationcostwhichwillcutinto

thethinmarginsofthisindustry.TThasplaced

18plantsinIndiawhicharewithin300kmrange

58

reducing transport cost. Since incumbentswill

alreadypositionthemselvesinvitalgeographic

locations, it limits new entrants geographic

spacetoplantheirfactoriesexpansion.

(3) Furthermore,productionof industrialproducts

such as Composite Cylinders, DWC pipes and

otherindustrialproductsrequirealongprocess

ofproducttestingandcertificationwhichistime

consuming,difficulttoobtainandcostlyfornew

entrantstoinvestin.

(4) Finally, the company’s profit margins range

around 5-7% means the potential financial

incentivesfornewentrantstocoverinitialcost

is very thin making entrance trying. These

factorsmakeamanufacturingcompanylikeTT

gainaneconomicmoat.

Whydoyouthinkthebusinessmodelisunique,scalableandthatitgetseasierasitgetsbigger?Unique:ThebusinessmodelofTTisuniqueinthesense

thatitproducesawiderangeofproductsrangingfrom

plastic containers, pipes to composite cylinders.

Furthermore,theircustomersarefromawiderangeof

industries such as chemicals, paints, household, hotel,

automotive, sewage,powerplantandagriculture.The

beautyofthisbusinessmodelisthatTT’sproductsare

essentialpartsofeachcustomers’businessresultingin

aratherinelasticdemandacrossvariousindustries.

Scalability:Intermsofscalability,TTcanexpandfurther

due to its diversified product offerings. For instance,

polymerdrumsareunderpenetratedinAsiaatonly10%

whileIndiaspecificallyisat55%.Furthermore,TT’sdebt-

to-equity ratio has dropped significantly from

approximately0.8inFY15toapproximately0.45inFY17.

The reduced leverage allows further CAPEX expansion

onceTTfindsfurtherexpansionopportunities.

Easieras itgetsbigger:AsTTexpandsoperations, thebusiness will experience greater efficiency such as

EconomiesofScaleastheirfactoriesareproducingmore

andincreasingtheirutilizationrates.Asamanufacturing

company,thegreaterorderbookitreceivesthegreater

theefficiencyoftheirbusinessastheywillbemilkingthe

most out of their sunk cost of their factory CAPEX.

Furthermore, with an increased demand for new

products such as their composite cylinder, ~2.5 times

currentcapacity,businessoperationswillbenefit from

expansion as top line improves from greater demand

and bottom line improves from better operational

efficiencyandutilizationoffactories.

Whatisthecorporateculture,managementqualityandshareholdingstructurelike?TT is managed by key management with decades of

experience in their respective roles. Table 3 below

elaborates management team and their respective

experienceandcapabilitiesfortheirroles.

59

Additionally,theboardofdirectorsareshownbelow.

Thetableshowsthelistofdirectorsandthespecific

categoryofeach.Furthermore,itexplainsthenumbers

ofdirectorshipsandcrossdirectorshipsinotherboard

committees.

TT’sboard,asshownabove,isgovernedby9members.

TheboardischairedbyMrVenkatasubramanianwhois

independent and non-executive. With regards to

requirementsunderSEBI’slistingguidelines,TT’sboard

structuremeetsthemwhichcanbefoundinClause49

of the guidelines. TT also has ironed out essential

businessescommitteessuchas

(1) Audit(2) Remuneration

(3) Investorgrievance(forcorporategovernance)

TheauditdepartmentischairedbyMKWadhwawhois

a Chartered Accountant and an independent director.

Withregardstogoodpractices,ourteambelievesthat

regular board meetings with specific agendas and

transparent meetings reports make the company

forthcoming in sharing information and increasing

credibility of the company’s business directions and

practices.

The following table breakdown TT’s shareholding

structure. Majority of the shares are held by

“Promoters”which consist of 9members and takes a

52.59%of total shares.Thedetailsof“Promoters”are

foundinfurtherdown.

Thenext tablementions themain shareholders in the

“Promoters” portion of the company ownership. The

majorityshareholder isTimeSecuritiesServicesPrivateLimitedat18.65%.

InvestmentSummary:(1)FavourableMacroMakeinIndiaInitiative

This movement is targeted at the few sectors:

Chemicals, Construction, Foodprocessing,Oil&Gas

andPharmaceuticals. Thebenefits for the industries

areassuch:

1. Simplificationofregulatoryenvironments

2. Technology acquisition and development of

fund set up by the government to acquire

60

necessary technologies to develop domestic

manufacturingcapabilities

3. Governmenttoproviderelevantvocationaland

skilltrainingthroughestablishmentofIndustrial

Training Institute (ITI) via Public Private

Partnerships

ThedirectbenefitTTenjoysisthattheircustomersare

fromthesesectorsandanincreaseofactivitiesofthese

sectors in India will lead to increase demand for TT’s

products.Specifically,industrialpackagingandpipesas

these are essential items needed for the initiative. In

essence, “Make in India” will increase the activity of

theseindustrieswhichareservedbyTTinwhichleads

toanincreaseindemandforTT’sproducts.

RawMaterialPricesCatalyst

There is currently a global oversupply of polyethylene

(PE) and polypropylene (PP). According to HISMarkit,

more than 24 million metric tons (MMT) of new PE

capacitywill be added globally from 2015 to 2020. In

India specifically, ONGC Petro additions Ltd (OPaL)

started two 360 KTA LLDPE/HDPE swing lines and

Reliance Industries Ltd starteda550KTALLDPE/HDPE

swinglineinFY17.TheoversupplyinHDPEputspressure

onpriceswhichwillbenefitTTasHDPEisamajorraw

materialusedinmanyofTT’sproducts.

Nowconsidering the steelprices in India, government

recently imposed an additional duty on steel imports.

TherulewasimplementedinSeptember2017andadds

ona18.95%countervailingdutyonsomehot-rolledand

cold-rolledstainlesssteelflatproductsfromChina,US,

South Korea and the EuropeanUnion. This is done to

curb the influx of cheaper imports and help local

producers.AsmostofTT’ssubstituteproductsaremade

ofsteel,an increaseinsteelpriceswillresult inhigher

costs for competitors and reducing ability to compete

withTT.

In essence, favourable raw material price for the

productionofTT’sproductsandunderpressureprices

ofmaincompetitors’rawmaterial,steel,makestheout-

lookofTTpositive.

IncreasedInfrastructureSpending

Firstly, the Indian government announced that they

wouldinvestUSD1TNintheinfrastructuresectorinthe

12th

FiveYearPlan.Investmentswillbefocusedinwater

and sanitation management, irrigation, building &

construction, power, transport and retail sectors.

Specifically, investments in water and sanitation

managementandirrigationwillbenefitTTasHDPEpipes

are likely to be demanded in these 2 sectors. A liTTe

overview of HDPE pipes is that they are flexible and

ductile and100% leakproofmaking themapreferred

choiceofproduct forwaterand sanitarymanagement

andirrigationprojects.Secondly,theIndiangovernment

planstoprovidehomesthroughthe“HousingforAllby

2022” plan. It aims to provide 18 million houses for

households in urban India and nearly 30 million

households in rural India by 2020. As such, the

governmentwill construct new homes and encourage

individuals to upgrade their homes by providing a

securityoftenure.Again,thiswillaffectTT’stoplineas

newhome constructionswill demand forHDPE pipes.

SinceHDPEpipesarerelativelylowerinpricescompared

to its substitutes and also its ability to carry portable

water,thedemandforTT’sproductsislikelytoincrease

withsuchinitiatives.

(2)DrumandPipesTimeTechnoplast’sSolidFoundation—PolymerDrums

Industrial packaging is TT’s most valuable segment,

contributing USD290M or 77% of its sales revenue in

FY16. TT’s industrial packaging (IP) segment, which

primarily consists of polymer drums and intermediate

bulk containers (IBCs), has a combined 70% of the

market share in the polymer industrial packaging

market.

Polymerindustrialpackagingmarketsharebreakdown

End-User IndustriestoDriveGrowthforTT’s Industrial

PackagingSegment

TT’s industrial packaging segment is mainly driven by

demandfromitsend-userindustries,whicharemainly

in the chemical industry. Plastic products such as

polymer drums and IBCs are crucial for storage and

transportationpurposes,while jerrycansandpailsare

61

requiredforthepackagingofthechemicalproductsfor

sale or usage. Hence, the growth of the end-user

industriesiskeytotheperformanceofTT’sIPsegment

as it will determine the future demand of plastic

productsintheseindustries’operations.

GrowingEnd-UserIndustries—APositiveOutlookforTT

IndustrialPackagingSegment

India’schemicalindustry,whichincludessectorssuchas

paints,petrochemicals,&pharmaceuticals,isontherise

as the urbanisation continues to occur across the

country. Over a 6-year period, the total production

volumeofmajorchemicals in IndiagrewataCAGRof

1.65%. Within this chemical industry, the specialty

chemicalssectorisasectorthatwillseehighgrowthin

thecomingfuture,especiallyinthefollowingmajorsub-

segments: Paints and Coatings, and Construction

Chemicals.

ThepaintindustryinIndiahasbeenforecastedtogrow

at a CAGR of 14% from 2015 to 2020 due to rapid

urbanisationandgrowinginfrastructurecontributingto

high demand for paint products. Since industrial

packaging products will be needed for storage and

packagingpurposesinthepaintindustry,thispotential

growth in the paint industry will generate additional

demandforIPproducts.

Similarly,forconstructionchemicals,IPproductswillbe

necessaryforstorageandtransportationpurposes.With

theconstructionchemicalsindustryexpectedtogrowat

aCAGRof12%from2015to2019,itwillhelpdrivethe

growth of IP products as demand for these essential

productsrises.

Since TT is a major player in the IP market with a

substantial market share, these trends paint a very

positive outlook for its IP segment as the end-user

industries will require the type of products that are

availableinTT’sproductportfolio.CoupledwithIPbeing

TT’s largestbusinesssegment, thispotentialgrowth in

the market may have a huge positive impact on TT’s

financialperformanceinthefuture,shouldTTbeableto

capturethislucrativeopportunityinthemarket.

1

CRISILResearch

The forecasted growth in the end-user industries is

definitelyapositivesignforTTasitwillbenefitfromthe

potential increase in demand for IP products.

Nevertheless,withvariousindustrialpackagingproducts

and solutions available in the market, the main

determinantofwhetherTTwillbeabletocapturethis

incremental growth is the preference and usage of

polymer products over their steel counterparts. Our

teambelievesthatTTwillbeabletoedgeouttheirsteel

competitors in the market as polymer drums have

penetrateddeeplyintothemarketovertheyears,and

displaced steel drums as the preferred packaging

productasof2016.

Polymerdrumsareverymuchmorewidelyusedinthe

domestic Indian market,as compared to the global

market, where steel drums are still more heavily

favouredat84%ofthetotalvolumeinthemarket.This

discrepancyislargelyduetotheunavailabilityofcheap

steel materials in India due to anti-dumping duties

placed on imported steel, which results in higher

production costs and consequently selling prices for

steel drums in India. As such, despite polymer drums

beingconventionallymoreexpensivethansteeldrums

duetoitshigherrawmaterialcost(polymerresin),the

prices of steel drums and polymer drums differ by a

minutemargin.Moreover,polymerdrumsalsohavea

longerlifeexpectancythansteeldrumsastheydonot

corrodeorrustovertime,andevenhaveahigherresale

value1

than steel drums. With better material

characteristics and higher resale value, this eventually

ledtothecurrentmarketsituationinIndia,whichisvery

beneficial to TT’s core polymer IP segment going

forward.

While a 55% market penetration is already rather

positive for TT, our team is of the opinion that this

market situationwillpersist toapointwherepolymer

drums have an even more substantial share of the

market from recent development and benefit TT. In

September 2017, India has imposed an additional

18.95% import duty on hot-rolled and cold-rolled

A Different Base in The Drum Market — Plastic

TriumphedwithTime

SteelBarredfromCapturingGrowth

62

stainlesssteelflatproductsfromChina,theUSA,South

Korea, and the EU to curb the influx of cheaper steel

imports. This is very likely to keep the prices of steel

drumshigh,whilethepricesofpolymerdrumscontinue

to dwindle from downward pressure on polyethylene

pricesasaresultofaglobaloversupply.Withthelocal

marketalreadygraduallyflockingtopolymerdrumsdue

toitscompetitiveprice,thisimportdutyplacedonthese

key steel products may enable further market

penetrationbypolymerdrums,ascenariowhereTTwill

stand to gain evenmore. Furthermore, as TT’s largest

competitorinthepolymerIPmarket,BalmerLawrie,is

stillmorefocusedongrowingitssteeldrumssegment,

TT is unlikely to face intense competition in capturing

the future growth. Hence, our team strongly believes

that TT’s IP segment will perform excellently in the

futureasthecurrentIndianmarketsituationandmarket

forcescontinuetodrumupmorecustomersforpolymer

drums.

ValueAddedProducts(VAP)drivenbycompositecylindersCompositeCylinderThesisLiquefiedPetroleumGas(LPG)Marketsegments

In 2016, usage of LPG in India is split into 4 main

segments – Domestic (92.3%), Commercial (3.4%),

Automotive LPG (2.4%) and Industry (1.9%). The

Domesticsegment,whichistheuseofLPGforcooking,

isalargelyregulatedmarketasitisheavilysubsidizedby

the government and state-ownedpublic oilmarketing

companies(OMCs)topromotetheuseofLPGoverother

dirtiesfuels(kerosene,drieddungcakeetc).Duetothe

subsidiesandpricecaps,95%ofLPGsaleintheDomestic

segment is conducted by the 3 main public OMCs -

IndianOilCorp.Ltd(IOCL),BharatPetroleumCorp.Ltd

(BPCL)andHindustanPetroleumCorp.Ltd(HPCL).

Retailanddistribution

IntheDomesticsector,LPGisfilledincylindersandsold

through independent dealers to end-consumers. LPG

cylinders are sold bymanufacturers directly toOMCs.

The cylinders are owned by the OMCs and rented to

consumers free-of-charge for LPG distribution.

Consumersneed topaydeposits on the LPG cylinders

thattheyuse,whichstandsatUSD23persteelcylinder

andUSD46per composite cylinder (not in commercial

useyet).WhentheLPGcylinderisemptied,itisreplaced

bythelocaloperatingdealeratthecustomers’location.

Dealer sends the empty cylinders to the required

boTTingstationsviatruck,whicharethenrefilledtobe

sentbacktothedealer.

CompositecylindersinIndia

The Indian government has been seeking local

manufacturers to produce composite cylinders since

2009.In2009,the3publicOMCsfloatedaglobaltender

for 200,000 cylinders, which garnered interest from

HexagonRagascoandCompositeScandavian(beforeit

was acquired by Ragasco in 2010). Subsequently, the

tender conditions were modified which only local

manufacturers could participate in the tender.Due to

thesubstantialcapitalexpenditurerequiredtoestablish

the factory to initiate production and the low order

quantity,manufacturersfelt itwouldbeunwisetoput

up a shop to manufacture just these many cylinders.

Hence, thetenderwasunsuccessful.Atonestage, the

Petroleum and Explosives Safety Organisation (PESO),

which is in-charged of domestic LPG cylinder

certification, thoughtof importing suchcylinders from

European countrieswhere they arepopular. The then

PESO chief had visited Denmark and inspected these

cylinders.However,thegovernmentdecidedtoexplore

the possibility of identifying a local company to

manufacture the composite cylinders instead. This is

also in line with Narendra Modi “Made in India”

campaign in2014toencouragenationalcompaniesto

manufacturetheirproductsinIndia.

TT obtained its technology to produce composite

cylinders throughtheacquisitionofKompositPraha,a

struggling European composite cylindermanufacturer,

in 2010. In the same year, TT set up a factory (1m

capacity) in Maharashtra to manufacture composite

cylindersandbecamethefirstcompanytomanufacture

compositecylindersinIndia.

Currently,onlysteelcylindersareusedtodistributeLPG

as India’s government has not issue license for

compositecylinderstobeuseddomestically.However,

TT (in2013)andSupreme Industries (in2015)are the

onlycompanieslicensedtoproducecompositecylinders

in India. Nearly 95% of TT’s composite cylinder

productionarebeingexported,mainlytoAfrica,Middle

East Russia, Egypt and South Asia. TT’s current order

book(2016)standsat2.5xitsannualcapacityof700,000

cylinders. In May 2017, TT increased its production

capacityto1.4mcylinders,justbehindthatofRagasco,

the leading manufacturer of composite LPG cylinders

whichstandsat2mbutlargerthanSupreme’s500,000

cylinders.

63

PilottestofcompositecylindersinIndia

InOct2016,the3publicOMCsbeganthepilottestof

the composite cylinders with the sales of 30,000

cylinders initially in the states Ahmedabad and Pune.

These cylinders will be obtained from both TT and

Supreme, the only 2 companies producing composite

cylinders domestically. Upon completion of the pilot

study,whichisproposedforaperiodoftwoyearsand

basisthefindings,otherOMCs—BharatPetroleumand

IndianOil—willfinalizetherollouttootherpartsofthe

country.

Thisdevelopmentcomesatatimewhenthenumberof

LPG users has spiked thanks to the government's

PradhanMantriUjjwalaYojana(PMUY)whichenvisages

toprovideLPGconnectionsto50mwomenbelongingto

thebelow-poverty-linecategory.Sincethelaunchofthe

scheme inMay2016, thenumberof beneficiarieshas

alreadycrossed25m.

Sub-thesis #1: Larger adoption of LPG among Indian

householdsexpected

Favorablegovernmentpolicies

GovernmentpoliciespromotingLPGconsumptionhave

propelled Indiatothesecond largestLPGconsumer in

theworld at 19million tonneper year. The growth is

largely driven by the government’s push to increase

householdLPGpenetrationthroughthePradhanMantri

UjjwalaYojana(PMUY),whichaimstoprovidefreeLPG

connections to below-poverty-line households. This

programwasenlistedundertheGuinnessBookofWorld

RecordforitslargestcashtransferatUSD6.5billionand

is targeted toprovide50mpoorhouseholdswith free

LPG connections. Since its launch in 2016, PMUY has

helped21.7mhouseholds receive LPGconnections.At

present,thereare198.8mactiveconsumers,according

to an official statement, which works out to an

estimated 72.8 per cent national LPG coverage. The

government target is nearly 84 per cent. Customers

retention on their LPG connections have been strong,

withatleast85percentapproachingdealersforarefill

ofLPGcylinders.

BenefitsofLPGvsothercookingfuels

DespitethehighercostofLPG,theenergyproducedper

kg of LPG is the highest among all other fossil fuels.

However,costhasbeenthemostsignificantobstaclein

the adoption of LPG among poor Indian households.

WiththehelpofthePMUYscheme,itwillhelpremove

thehighcostbarrierforthesehouseholdsandincrease

LPGconnectionsinIndia.

Additionally,theteambelievesthatPMUYschemewill

notbeatemporaryinitiativebythegovernmentasLPG

isseenasthepermanentfixtureincookingfueldueto

its low pollution and harmful effects to people.

AccordingtoaWorldHealthOrganisationreport,smoke

from such fuels inhaled by women is equivalent to

burning 400 cigarettes in an hour and causes several

respitoryandotherdiseases.

Sub-thesis#2:Successofpilottestwillcatalysedomestic

compositecylindergrowth

As the LPG consumption among Domestic segment is

heavilysubsidizedbytheIndiangovernment,onlythe3

public OMCs (IOCL, BPCL and HPCL) undertake the

distribution of LPG among domestic household.

Currently,these3OMCsareundergoingthepilotteston

the commercial viability of composite cylinders. If the

pilot is a success (in 2H19), the 3 OMCs will start

distributing LPG using composite cylinders due to its

lighter weight, which decreases logistical costs

significantly,anditssafetyasitdoesnotexplodewhen

exposed to high heat. Since 93% of India’s LPG

consumption isderived from theDomestic sector, the

successofthepilottestaccompaniedbythebackingof

the 3 state-owned OMCs and their vast distribution

networkwillallowTLL’scompositecylinderstocapture

asignificantbulkoftheLPGdistributionmarket.

The made-in-India campaign will favour composite

cylinders manufactured by TLL and Supreme over

foreign imports. Between them, TLL is expanding its

productioncapacity to1.4mcylindersperannum, just

behind that of theworld leaderHexagonRagasco but

wayaheadof Supreme’s450,000cylinders. The larger

production capacity will allow TLL to capture a larger

marketshareofIndia’scompositecylindermarket.

Sub-thesis #3: Increasing regional demand for

composite cylinders, large order backlog and stronger

margins

TLLhas license toexport itscompositecylinders to48

countriesandhasbeenexportingthesecylindersto26

64

ofthesecountries.Despitehavingmostofitscylinders

being exported and not domestically (due to ongoing

pilot test), TLL’s utilization rate has been running at

100%, with large order book at 2.5x of annual

productioncapacityof700,000cylindersperannumas

of2017.

With the following regulatory certification TLL’s

composite cylinders have obtained (listed below),

management is expecting increasing exports to 55/56

countriesinthenearfuture.

- Approved by TUV Rhineland, Germany under the

most stringent European Standards

(EN12245:20002and14427:2004)andinternational

standards(ISO11119-3:2002)).

- Emirates Authority for Standardization and

Metrology (ESMA) for use in Gulf Cooperation

Council(GCC)countries.

- LiquefiedPetroleumGasSafetyAssociationofSouth

Africa (LPGSASA) to service South African market

anditsadjoiningcountries.

Of theproduct segments TLLhas, composite cylinders

offerthehigherEBITDAmarginat20%,comparedtoits

plasticdrums,jerrycans,pailssegmentat14.2to14.4%

and Intermediate Bulk Container at 18 to 20%. The

increasingregionaldemandforcompositecylindersand

a successful pilot test in India will help boost TLL’s

compositecylindersaleandimproveitsEBITDAmargin

assalesofthesecylinderstakesupalargerproportion.

Sub-thesis#4:Compositevssteelcylinders

Prior to TT’s entry with Techpaulin in 2017, Supreme

IndustriesLtd(SIL)hasacompletemonopolyinthecross

laminated film market with its multi layer cross

laminated U.V stabilized film (under the brand

‘Silpaulin’).AsofFY2016,SILcommanded100%ofthe

marketwithUSD70bninsalesrevenuefromitsSilpaulin,

and a silpaulin manufacturing capacity of 45,000MT.

However,with the introductionofTechpaulin into the

market,TTislookingtobreakuptheexistingmonopoly,

aswellascapturethegrowththatawaitsitastheend-

userindustriesgrow.

MOXFilmsThesisLiningUpTT’sToplinewithMOXFilms

Multi layermulti axis oriented cross laminated (MOX)

filmsisanewproductlaunchedbyTTunderthebrand

‘Techpaulin’, on 1 April 2017, and is a whole new

productsegmentinTT’sproductportfolio.TheseMOX

films are similar in nature to tarpaulin (“tarp”),which

has widespread usage across several critical sectors,

particularlyinagriculture,andinfrastructure,butareof

higher quality and versatility than conventional tarp.

Moreover, theseMOX filmsalso yield amorepositive

EBITDAmarginforTT,makingitoneofthevalueadded

products that can drive the expansion of TT’s profit

margins in the future. Nevertheless, the success of

Techpaulin is not a given, and hinges on the

performance of its main competitor, Silpaulin; the

growth of the agricultural industry in India; and the

possible applications of Techpaulin that justifies its

sellingprice.Fromourresearch,ourteambelievesthat

Techpaulinispoisedtoperformwellinthemarketdue

to3mainfactors:

1. Swiftdevelopmenttomaximiseayear’sworth

oftimetocapturemarketsharefromitspeer

2. A growing agriculture industry that recognizes

thelogisticalbenefitoftarps

3. Techpaulin being able to uphold its premium

price despite the existence of cheaper

alternatives

WhenSilMeetsTech

65

Moving ahead, TT’smanagement has targeted a sales

revenue of USD31bn by 2019, and has already taken

action by expanding its production capacity to

12,000MT.Thisexpansioninitsmanufacturingcapacity

is slated to be ready for utilization by end 2017.

Meanwhile,SIL ismoreheavily invested ingrowing its

plasticpipingsegment,asevidentfromitsstrategicplan.

This effectivelyprovides room for TT tobuild itsMOX

film segment and encroach into SIL’smarket share by

leveraging on its additional 6,000MT manufacturing

capacity,anditswiderdistributionnetwork.

Plasticproductshavewidespreadapplicationsthatcan

benefit agricultureon thewhole, suchasplasticpipes

thatcanbeusedforirrigation,plasticsheetsorfilmsin

greenhouses, and as a lining to formwater reservoirs

thatareacheaperalternativetowatertanks.Neelkamal

Darbari, Principal Secretary of Agriculture under the

Government of Rajasthan, has stated that the use of

plastic is imperative in achievingefficientwaterusage

andhigherproductivity.Withplasticulture,theusageof

plasticsinagriculture,graduallybeingrecognisedasthe

way forward for farmers, there are immense

opportunitiesforTTtoleverageontogrowitsMOXfilms

segment.

Tarpaulinisgenerallyusedforlininginpondsorwater

reservoirs,protectingcropproducepost-harvest,aswell

asaprotectiveshelter ingreenhouses.Assuch,plastic

filmsusedinsuchapplicationssimplycannotbeoflow

orcheapqualitythatareoftenunabletowithstandU.V

raysandhaveshortusefullives.TT’sTechpaulinpossess

the necessary characteristics that make them a good

choiceforuseintheagricultureindustryas ithashigh

durability, resistant to U.V rays, and is waterproof.

Hence,Techpaulin,asacrosslaminatedfilmmadefrom

HDPE,islikelytobeselectedforuseandprotectedfrom

cheaperalternatives suchasPVC filmsas farmersand

agricultural companies start to incorporate the use of

plasticsinagriculture.

ChallengingtheMonopoly

TTenteredthemarketinthefirstquarterof2017witha

significantly lowermanufacturingcapacityof6,000MT,

in comparison toSIL’s45,000MT.However,TT initially

aimed to achieve growth through 2means: offering a

product of equal or better quality, and focus on

establishing a wide-reaching distribution network.

Based on the claims made by both parties, TT’s

Techpaulin is comparable to Silpaulin in terms of its

featuresandquality.BothfilmsaremadeusingHDPEvia

their own respective proprietary cross-laminated

process,which confers favourable qualities thatmake

theseplasticsheetshighlysuitable foragriculturaland

packaging applications. The outcome of TT’s wider

distribution network lends credence to the fact the

Techpaulin is a serious competitor to Silpaulin in the

market. In introducing Techpaulin into themarket, TT

wentontheoffensebyappointingover27distributors

acrossIndia,asopposedtoSIL’s18distributionunitsin

India. At that moment, due to SIL only having 18

distributionunits,itwasunabletoadequatelymeetthe

demand for cross laminated films throughout India,

which effectively helped TT in capturing SIL’s

underservedcustomersinthemarket.Thisculminated

in the achievement of USD1.4M in cash sales for TT

withinonequarterofitslaunch.

SeedingtheGrowthOfTechpaulin

ThesuccessofTechpaulininIndiaisdependentonthe

futuregrowthofitsend-userindustries,oneofwhichis

thelocalagricultureindustry.India’sagricultureindustry

hasrecentlyrecoveredfromasluggishdrought-induced

growth of 1.2% in 2016 to a possible 4.1% growth in

2017,andisexpectedtoremainat4%for2018aswell2

.

For the industry to continue on its current track of

furthergrowthandthegovernmenthasrecognisedthe

potentialofplasticusageinagriculture,particularlyfor

duringandpost-harvestaspectsofagriculture.

TheRiseofPlasticulture

66

Besidescontributingtotheexpansionofthecompany’s

profitmargins,thisproductsegmentalsoimprovesTT’s

workingcapitalduetothecurrentsalespolicyadopted

bythemanagementwithregardtoMOXfilms.TT’sMOX

filmsdonotcaterforsalesmadeoncredit,andrequire

paymentonsupplyor inadvancefor thegoods.AsTT

continues to expand this segment, it may effectively

shorten its cash conversion cycle, and utilize its

improved working capital to develop the business

furtheratanearliertimeperiod.

InvestmentRisks:Risk#1:Failedpilot testor lowadoptionofcomposite

cylindersinIndia

Ifthepilottestfailstoprovethecommercialviabilityand

demandofcompositecylinders, the3OMCswillmost

likely not increase their purchase of TT’s composite

cylinders. Even though this might dent the growth

potential for TT in the domestic market, the export

regionalmarketprovestoberesilientenoughforTTto

achieve strong cylinder sales growth,which is evident

fromits2.5xorderbook.

India’shouseholdsarerequiredtopayadepositforeach

LPGcylindertheyuse.Currently,thecompositecylinder

standsatUSD46ascomparedtosteelcylinder’sUSD23.

The start-up deposit required and cash outlay (which

cannot be broken up into installments) when using a

composite cylinder presents a serious barrier to its

uptakebylow-incomehouseholds

Risk#2:ContractorsoptingforcheaperPVCalternatives

insteadofHDPE

WhileHDPEpipesaregenerallymoresuitableforpiping

systemsduetoitsdurabilityandcapabilitytowithstand

high stress, they are more expensive than its PVC

counterpart which is more prone to damage over

extendedperiodofuse.AsTTenjoysmorecostsavings

from manufacturing and selling HDPE pipes due to

economiesofscalefromitsotherproductsmainlybeing

made from HDPE as well, a situation where PVC is

selected for use in infrastructure projects may not

benefitTTasmuch.Furthermore,asSILhasaverystrong

footholdinthePVCpipesmarket,TTmaynotbeableto

capture as much growth as its PVC pipes segment is

considerablysmaller.

Risk#3:GrowthofMOXfilmsslowerthanexpecteddue

toresponsefromSIL

SIL, as the market leader who has been enjoying a

completemonopoly,isunlikelytoallowTTtoencroach

toofarintotheirmarketsharewithTT’sMOXfilms.SIL

hasinitiatedplanstowidentheirdistributionnetwork,

and increase their production capacity for their

protective plastic packaging segment which includes

silpaulin. As such, TTmay face resistance in its bid to

build up its MOX films segment further and have its

competitive edge in the form of a wider distribution

networkbeingeroded.

BesidesSIL’sresponse,thesheerlengthoftimeSILhas

beeninthisspecialtytarpmarketmayhavecontributed

significantly in building up brand loyalty and trust in

silpaulin. While TT’s MOX films may be of equal or

superior quality, customers may still prefer silpaulin

simplyduetopastexperiencesandpurchasesoverthe

years. Hence, it may be difficult for TT to cannibalize

salesfromSIL’scustomersegmentsthatareadequately

served.

(BSE:532856)TimeTechnoplastLimited FY2014 FY2015 FY2016 FY2017 FY2018LTM

SharePriceINR 46.80 51.60 49.20 159.55 204.15

NoofShares(mil) 210.1 210.1 210.1 226.1 226.1

MCAP(mil)USD 164 170 153 558 720

NetDebt(Cash)INR 7,911 7,352 6,759 6,565 6,489

EnterpriseValue(mil)USD 280 301 271 530 828

Revenue(mil)INR 21,911.2 24,796.3 24,242.7 27,566.3 28,886.4

EBITDA(mil)INR 3,131.1 3,420.7 3,493.8 4,062.5 4,246.2

EBIT(mil)INR 2,261.8 2,546.0 2,505.4 2,907.6 3,007.8

NPAT(mil)INR 954.3 1,096.1 1,381.3 1,471.0 1,578.8

NPAT(Ex.Xtra+Dis.Ops)(mil)INR 1,001.2 1,167.8 1,255.6 1,555.8 1,663.6

CFO(mil)INR 2,140.7 2,694.6 2,886.0 1,879.8 1,879.8

CAPEX(mil)INR (1,361.7) (1,051.7) (1,699.2) (2,123.6) (2,123.6)

EPSINR 4.8 5.6 6.0 6.9 7.4

Revenue(mil)USD 365.7 396.6 365.8 425.4 442.3

EBITDA(mil)USD 52.3 54.7 52.7 62.7 65.0

EBIT(mil)USD 37.7 40.7 37.8 44.9 46.1

NPAT(mil)USD 15.9 17.5 20.8 22.7 24.2

CFO(mil)USD 35.7 43.1 43.5 29.0 29.0

CAPEX(mil)USD (22.7) (16.8) (25.6) (32.8) (32.8)

GPM(%) 27.0% 25.8% 25.0% 25.6% 26.1%

EBIT(%) 10.3% 10.3% 10.3% 10.5% 10.4%

NetDebt(Cash)/Equity(%) 85.2% 70.9% 57.9% 49.5% 46.8%

ROA(%) 10.1% 10.9% 10.4% 11.3% 11.4%

ROE(%) 24.4% 24.5% 21.4% 21.9% 21.7%

CFO/TA(%) 9.5% 11.5% 11.9% 7.3% 0.0%

EV/Sales(x) 0.8 0.8 0.7 1.6 1.8

EV/EBIT(x) 8.2 7.4 7.1 14.8 17.6

EV/EBITDA(x) 5.9 5.5 5.1 10.6 12.5

EV/CFO(x) 8.6 7.0 6.2 22.9 28.2

P/Sales(x) 0.4 0.4 0.4 1.3 1.6

P/EBIT(x) 4.3 4.3 4.1 12.4 15.3

P/B(x) 1.2 1.2 1.0 2.7 3.3

VQ1:EV/EBIT/ROE(x) 0.3 0.3 0.3 0.7 0.8

VQ2:EV/EBIT/ROA(x) 0.8 0.7 0.7 1.3 1.6

MadeBetterwithTech

DuetothefeaturesofTT’sTechpaulinderivedfromits

technology that makes it a suitable and desirable

material foruse inend-user industries,TTcanactually

charge a higher price for its product in the market.

Presently, the average EBITDAmargin ofMOX films is

21%, and is estimated to have a sustainable EBITDA

marginof16%inthelongrun,whichishigherthanthose

in TT’s regular business segments (14%). Thus, the

continualdevelopmentofthisproduct linewillhelpto

boostthecompany’soverallmarginsovertheyearsas

improvement of these MOX films can continue to

differentiate it from lower quality alternatives and

justifythembeingpricedatapremium.

67

8. AerospaceIndustrialDevelopment(TSEC:2634)


QuickStats

Date 15/12/17 EBIT/R&D(x) 4.58

FilingCurrency NTD

EBIT/EmployeeNo.

(USD/px) 20K

SharePrice NTD38 EV/EBIT(x) 20.2



DailyValueTraded


GPM(%) 14.0% P/E(x) 15.0

EBIT(%) 9.0% P/B(x) 2.9

NetDebt(Cash)/

Equity(%) 98.5%

VQ1:EV/EBIT/ROE

(x) 1.1

ROA(%) 6.9%

VQ2:EV/EBIT/ROA

(x) 3.0

ROE(%) 18.8%

TeamMembers

TanShuaiZhuangDarren isasecondyearfinancemajorstudentat

Singapore Management University, pursuing a degree in Business

Management. He is a senior analyst in SMU StudentManagement

Investment Fund, a student led investment club focused on stock

researchandmarketanalysis.HeiscurrentlyananalystinNorthRidge

Partners,anindependentmerchantbankthatinvestsinandadvises

technologycompanieswithintheAsiaPacificregion.

Ng Jia Wei is a second-year undergraduate student at Singapore

ManagementUniversity,pursuingadegreeinBusinessManagement.

He is currentlyananalyst in SMUEmergingMarkets, a student-led

businessclubfocusedonresearchofindustriesandcompanieswithin

theemergingmarketsinSouth-EastAsia.PriortoSMU,hehasworked

at Mizuho Bank, undertaking audit duties under the Operations

PlanningDepartment.

Teo En Quan is a second year finance major at Singapore

Management University, currently pursuing a double degree in

BusinessandEconomics.

68

BusinessBackgroundandOverview

Aerospace Industrial Development Corporation

(AIDC),previously knownas theAerospace Industry

DevelopmentCentre,wasfoundedonMarch1st,

1969

fortheTaiwanAirforce.AsofJuly,1st

1996,AIDCwas

transformed from a military establishment into a

government-owned company, before achieving

privatization in early 2013, and subsequently going

publiconAugust25th

2014.

AIDCdeveloped itsCarbonFiberReinforcedPolymer

(CFRP) technology several decades agowhen it was

buildingIDF,amilitaryaircraftmadeinTaiwan.After

adoptingtheCFRPtechnologytocommercialaircraft,

AIDCbuiltacompositematerialplantin4Q10,Taiwan

Advanced Composite Centre (TACC). The new

composite material production plant will increase

AIDC production capacity of aircraft components.

Productionrateisexpectedtodoubleto20unitsper

monthin1Q18andincreasedfurtherto30unitsper

monthtomeetAirbusorderrate.Despiteincreasein

output, the TACC would only be operating at 50%

capacity (Macquarie Research). This would enable

AIDC to increase TACC production even further to

meetanyriseinfuturedemand.

AIDC operates in both themilitary and commercial

aircraftindustry.Theiroperationsincludedeveloping,

manufacturing,distributingaswellastheassemblyof

aircraft parts. Having a global outreach, AIDC also

markets its products to commercial and military

entitiesworldwide.Havingpartnershipswithmultiple

leaders in the industry, such as Airbus and Boeing,

AIDC is an undiscovered gem that is primed for

success.

AerospaceIndustryStructure&BreakdownTier1-SystemsIntegrators

Firms in this tier research, develop, manufacture,

modify, and market completed aircraft with their

ownbrands.Duetoeconomiesofscaleandtechnical

barriers to entry built by the minority of aircraft

manufacturers,theaerospacemarketinthistierisin

an oligopoly situation. Main players in this tier

include–Boeing,Airbus,Bombardier

Tier2-SystemsComponentSuppliers

Tier2firmsprovidekeyaircraftcomponentstotier1

companies.Thisincludecomponentsthatarecritical

toanaircraftfunctionality–avionicsandengines.

This segment is seeing increasing consolidation

where firms are merging and integrating their

manufacturingnetworkswithtier1firms.

Tier3-Sub-AssemblySupplier

Tier 2 firms would outsource some of their

manufacturingproductiontotier3firms.Tier3firms

would manufacture less advanced components of

the aircraft. This includes aircraft instruments,

compositematerials,interiors,andlandinggears.

Tier4-StandardComponentSupplier

Thesefirmssupplystandardpartsandrawmaterials

outsourced by their upper tier clients. Products

manufacturedbythese firmsmaynotbeuniqueto

theaerospaceindustry.

AIDC’sBusinessUnits

Aircraft/vehicleMaintenanceMilitaryAIDC has a significant amount of experience

maintaining military aircraft for the Taiwanese

Military.Thisencompassesallaspectsofmaintenance

requiredbyanaircraft,fromaircraftinstrumentsand

avionics to hardware maintenance. The wealth of

experienceAIDChasputsitatasignificantadvantage

in maintaining its business relationship with the

TaiwaneseMilitary.

CivilianAstherearemanycommonalitiesbetweencivilianand

militaryavionicsandlogisticsupportsystems,AIDCis

also able to supply avionics and logistics systems to

thecivilianmarket.

69

Theglobaldemandforcivilianairtrafficisexpected

togrowataCAGRof4.7%between2017and2036.

Theincreaseindemandforairtrafficwouldresultin

the increase in aircraft orders by airliners to meet

passengerdemand.Currently,thereisahugeexisting

backlog of commercial aircraft from aircraft

manufacturersasBoeingandAirbusstruggletomeet

demand (Figure4). Subsequently, as theseaircrafts

are introduced into service, they would require

regular maintenance as the hardware ages with

sustainedused.Hence,AIDCupstreampositionasan

aircraftpartssupplierenablesittotakeadvantageof

the increase in global demand for avionics and

logistics systems needed to support these new

aircrafts.

Aero/IndustrialEngine

AIDC iswell recognized by enginemakers for their

engine case design, with quality approvals and

accreditations from notable manufacturers. The

world’stop5enginemakershaveAIDCastheirmajor

supplier, with AIDC being a key partner with CFM

International in themanufacturing of LEAP aircraft

engines.WithAIDCso integratedwiththeseengine

manufacturers, some parts its supply chain have

enteredtherealmoftier-2aerospace.

The earnings of AIDC’s engine manufacturing

segmentiscorrelatedtothenumberofLEAPengines

that are ordered globally. With the component

shortage holding the production LEAP engine

productionsettoclearin2018,thetransitionofCFM-

56toLEAPin2017,andtherecord12200ordersfor

LEAP engines in 2017, LEAP engine production is

expectedtoincreaseexponentiallyinthenearfuture.

IndustrialTechnologyServices

Usingitsexpertiseinproductdesign,manufacturing,

maintenance,installation,andsystemintegration,it

manufacturerscommercialauxiliarypowerunitsfor

civiliancommercialaircraft.Producedproductsareof

highqualitywithmanufacturedpartsbeingcertified

by the FAA and global commercial aircraft

companies.

AIDC also steadily diversified from aerospace

engineering to include the rail and automotive

industry. It successfully produced rail simulators for

Taiwan,Hong Kong, and Bangkokmetro companies.

Usingitsexperienceindevelopingelectronicsforthe

aerospace industry, it ventured into the automotive

industrytoproduceelectronicsthatarecriticalinthe

modernautomobile.

Armed with experience of manufacturing aircraft

engines, it broke in to the local alternative power

generationmarketwiththemanufacturingofhighly

efficient gas turbine engines as well as wind-

poweredelectricalsystems.

ClientConcentrationRisk

From2012to2016,proportionofrevenuefrommajor

clients have been steadily increasing. This suggest an

increaseintheclientconcentrationrisktakenbyAIDC.

Although AIDC’s client concentration risk looks

significantlyhigh,webelievethatthis isdue inpartto

70

thenatureoftheindustry,withfewerclientsaccounting

foralargerproportionofrevenue.Despitethenamesof

itsmajorcustomersarenotmadepublic,wecansafely

assumethat its largestclient is theTaiwaneseMilitary

(CustomerA)asasignificantproportionofitsrevenueis

derivedfromtheisland’sdefencebudget.Additionally,

ithasjustclinchedahugecontracttodevelopthefighter

trainer aircraft for the Taiwanese Airforce, making it

unlikelythatitwouldloseTaiwan’sAirforceasaclientin

thenearterm.

ProductionSitesTaiwanAdvancedCompositeCentre(TACC)

Location:Taichung

Area:4.1Hectares

DescriptionTACC started production late 2010. Itmanufacturers

aircraftgradecompositematerialstomeetthedemand

ofthesematerialsinaircrafts.

ShaLu/CCKLocation:TaichungArea:74.7Hectares

DescriptionThis facility focuses on Avionics & Flight Control

Engineering, Harness Fabrication & Installation, Flight

Test&Maintenance,andAircraftAssembly&Testing.It

is AIDC’s largest facility and its aircraft vehicle

maintenancefunctionsarebeingconductedhere.

ItsMilitaryAircrafttestingandproductionfacilityisalso

locatedhere.

Taichung Complex Location: Taichung Area: 29.2

Hectares

DescriptionThisisthehomeofAIDC’sheadquarters,itsEngineering

Unit, Industrial Technology Services, which include

Aircraft Parts Fabrication and Avionics Assembly &

Testing.

Kang-Shan Complex Location: Kaohsiung Area: 19.2

Hectares

DescriptionAIDC’s aero/industrialenginemanufacturing,

assembly,andtestingunitsarelocatedhere.

HowdidyouoriginatethisIdeaandwhydidyouchoosethiscompany?Startingwithatop-downapproach,welookedthrough

industries that we believe will see an accelerated

growth in the next 3 to 5 years.With the Taiwanese

governmentexpressinggreatinterestinincreasingtheir

militarycapabilities,wesawpotentialintheaerospace

defense industry. Moreover, Taiwan was ranked 6th

globally in terms of Aerospace Manufacturing

attractivenessin2017,accordingtoareportbyPwC.

Inaddition,strongrecoverywasshownintheglobal

commercialaviation.Thus,wenarrowedourscopeto

Taiwanese aerospace companies which could best

leverageonthistrend.Followingastringentscreening

process,AIDCwasfinallychosenduetoitsstrongteam

ofexperiencedexecutives,deepconnectionswiththe

Taiwanese government and a well-developed

relationship with global companies. Furthermore,

recent headways in increasing their production

capabilitieswillallowAIDCtohavealargerappetiteto

take on more and increase their profitability.With

suchdevelopments,AIDCispoisedtocapitalizedona

growingmarket andwas thus chosen as our hidden

champion.

OnesentenceinvestmentthesisBacked by a growing local defense industry and an

expanding commercial market, AIDC is well-

positioned for extraordinary growth through

considerableadvancementsinproductioncapabilities

and by leveraging on well-established relationships

withgrowingcustomers,giving themadistinctedge

overtheircompetitors.

Whatmakesitawide-moatbusiness?LeadsTaiwan’sAerospaceDefenseIndustry

AIDC has been in the defense industry for over 40

years, and has significant experience in the

production ofmilitary aircraft. Due tomultiple key

partnershipswithotherglobalindustryleaders,AIDC

was able to develop their own unique production

capabilitiesandaccumulatevaluableindustryknow-

how. One notable example includes Taiwan’s

indigenousdefensivefighter,the‘ChingKuoFighter’

(F-CK fighter), a local variant of the F16 fighter jet

developed in a key partnership with Lockheed

Martin.AIDC’swealthofknowledgeandexperience

inmanufacturingqualitygoodsthusservesasakey

71

competitive advantage, allow them to erect high

barriers to entry and assert their position as an

industry leader. This prevents competitors from

achievingstablegrowthandreduces theirability to

consistentlybringinorders.

Strongconnectionswithgovernment

AIDC’s top executives, including current Chairman

Liao Jung Hsin, previously held high positions in

Taiwan’smilitarypriorto joiningAIDC.Thisensures

thatAIDCwouldhavestrongconnectionstocurrent

membersofthegovernment.GiventhattheTaiwan

military is AIDC’s biggest customer, such strong

governmental connections would ensure that AIDC

willbeabletobringinmoreordersandhenceprofit.

Moreover, as other competitors do not possess

similar ties, the connectionswould thus serve as a

significantcompetitiveadvantage,asstrongtieswill

able to facilitate negotiations which could be in

AIDC’sfavor.

Possesshighcompetency inuniquecapabilitiesAIDC

isoneofthefewaerospacemanufacturersinAsiato

have achieved a certain level of competence in

providing a full range of service covering aerospace

R&D,systemintegration,testing,andmanufacturing.

AIDCalsoboastastrongcorecompetencyofairplane

body,advancedcompositematerials,andtheworld-

classengineeringdesignofavionicssystems.AIDCalso

has strong downstream advantage due to their

capabilities in carbon fibre capacity. Their

competitors, Toray and Toho Japan are upstream

materialproducers,withanestimated33%and12%

of market share of global carbon fibre capacity.

Formosa plastics in Taiwan has 7%market share of

global carbon fibre capacity but it does not have

certificationfortheaerospaceindustryyet.Thus,AIDC

withitsfocusondownstreamservicesandonaircraft

structure parts, prove to give AIDC a competitive

advantageovertheirpeers.

Taiwan’s advantageous position boosts ADIC’s

competitiveadvantage

There is a strong industry cluster support from

Taiwan’sprecisionmetalindustry.Formedfromtwo

major collaboration systems with 112 outsourcing

partnersinairplanebodyandengine.ItenablesAIDC

to offer better flexibilities when facing order

volatilities,andalsoenhancesthecompany’sROEvia

higher asset turnover. AIDC will have better cost

control, goodmanagement efficiency, better timely

delivery,andhighproductquality.ThiswillallowAIDC

to stand out amongst a competitive global

environment.

Highbarrierstoentry

Duetothetediousandstringentcertificationprocess

fortheaerospaceindustry,itactsasahighbarrierto

entry for potential competitors for AIDC. This will

allow AIDC to continue tomaintain their dominant

positionandprevent theirmarket share frombeing

diluted.Forexample,Boeing’sBAC5578qualification

forcompositematerialtapelaying,hasonlyqualified

10companiesthusfar.

Howscalableandsustainableisthegrowth?50%ofTaiwan'smilitarybudgetgoestoAIDCannually.

TheTaiwanesemilitarybudgetisexpectedtoincrease

4%y-o-ytoNT$321billionin2018.Hence,weforecast

a 4% y-o-y increase in AIDC's defense revenue.

Forecastedgrowthforcommercialaircraftrevenueis

expectedtobeabout10%in2018and7%in2019.This

isduetotheincreaseinproductionratesandalikely

marketsharegainoveranAustriansupplierinAirbus

orders. If market share gain is successful, Austrian

suppliercandoublemonthlyordersto60unitsforits

new composite material plants, the TACC plants.

CurrentTACCproductionrateis10units/monthwith

targetsofreaching20units/monthin2018.Moreover,

AIDC’sOperation Expenditure is expected to remain

flattill2019duetodecliningR&Dexpense,indirectly

contributingtobottom-linegrowth.Theconsiderable

of length of such projects will ergo provide

sustainabilityinAIDC’sgrowthforthecomingyears.

MilitaryArmSetforMoreGrowth

AIDC has taken up the Advance Jet Trainer (AJT)

Program which is spearheaded by the Taiwanese

government. The project, valued at NT$65 billion,

begun in 2017 and is set to last till 2026. AIDC is

targeting for the first jet flight in June2020.At the

sametime,thedeliveryofthe66trainingaircraftwill

bespreadoutbetween2020-26.AIDCisexpectedto

earnNT$0.5billionin2017fordesign,NT$3billionin

2018/19 and NT$10 billion after delivery of all the

aircrafts. AIDC is improving their productivity to

increase their margins. This will allow AIDC to

leverage on these new projects to increase their

bottomline.(Macquaire,24thNov)

HugeCivilianContractsDrivingupRevenue

Globaldemandforpassengerairtrafficisexpectedto

growatCAGR4.7%between2017and2036globally

(Boeing).Thiswillleadtoanincreaseindemandfor

newpassengeraircraft.Inaddition,thereisalreadya

largeorderbacklogof commercial aircraft frombig

aircraft manufacturers like Boeing and Airbus in

addition to the substantial number of new orders.

Orderbacklogwasreportedtohavegrownby250%

72

for Airbus and Boeing alone. Being an upstream

provider of aircraft components for major aircraft

and engine manufacturers, it will certainly see an

increase in demand for its commercial aircraft

manufacturing business, allowing AIDC to convert

thatbacklogintorevenue

GreaterCapacityforProductionPlantTACC19

CompositematerialproductionplantTACC19issetto

increaseproductioncapacityfrom10to20unitsper

monthasofSpring2018.AIDCthenaimsto further

increaseitscapacityto30,toproducethenecessary

componentstomeetthecurrentrateofdemandof

ordersfromAirbus.AIDChasthepotentiallytodouble

TACC19’soutputto60unitspermonth, should they

becomethesolesupplierforAirbus.AIDCisprojected

tohaveamarketsharegainasasupplier forAirbus.

Thus, TACC19 presents a breakthrough for AIDC to

bringinmorerevenue.Bybeingabletoconsistently

supplymorecomponentstoairbus,AIDCwillbeable

toboostprofits.

EmergenceofLEAPEnginesinIndustry

The LEAP engine is a high-bypass turbofan engine.

DesignedbyCFMInternationalforuseonsingle-aislecommercial aircraft, it is themodern replacementof

thesuccessfulCFM56engine.Withthegreateruseof

compositematerialsandahigherbypassratioof10:1,

the LEAP engine is expected to deliver up to15%

reductioninoilconsumptioncomparedtotheprevious

generationCFM56.

With3variants,theLEAPenginewouldbeabletobe

installed on the Boeing 737MAX, Airbus A320neo,

and COMAC C919. This would enable the LEAP

enginetotargetmajorityofthenarrowbodyaircraft

market. Despite the current component shortage

holding back the production LEAP engines, the

shortage is expected to be resolved in 2018.With

aircraftmanufacturerstransitioningfromCFM56to

LEAPin2017,andtherecord12,200ordersforLEAP

enginesin2017,LEAPengineproductionisexpected

toincreaseexponentiallyinthenearfuture.

CostManagement

With increasing competition in the global aircraft

partsmarket,companieslikeBoeingandAirbushave

announcedtosupplierstheir intentionsof lowering

pricesoffuturecontracts.Thisputshugepressureon

companieslikeAIDCastheyhavetocompeteagainst

manufacturing firmsbased in lower cost, emerging

marketeconomies.Thepricereductionsquotedare

in the range of 10-25%, severely cutting profit

margins.To remain competitive, AIDC consolidated

the Taiwanese aerospace industry by creating

alliancesandpartnershipswithitslocalcompetitors.

By leveraging on their respective comparative

advantages,aswellasintegratingtheisland’ssupply

chain. This job-sharing and joint price quotations

wouldenableAIDCtostaycompetitiveandcontinue

tocaptureoverseasmarketorders.

RevenueDrivers

ReplacementDemandforFuel-EfficientAircraft

Oil prices play a huge role in an airline decision to

upgradetheirfleettoincludenewer,moreefficient

aircraft.Currentoilpricesareexpectedtomaintain

current prices above US$60/barrel with Morgan

StanleyraisingtheiroilpricetargetsbyUS$7toUS$9.

Additionally, an agreement between OPEC and

Russiatorestrictoilsupplyisexpectedtoberenewed

for another year, thus driving up the price of oil.

Furthermore,oilpricesarealsoexpectedtoremain

highduetoafallingsupplyofshaleoil,asaresultof

thecurrentshortageoffrackingcrewintheUS.With

demandforoilgrowingfasterthanUSshaleproducers

areable toexpandoutput,US is seeing their crude

inventoriesfallingmuchfasterthanexpected.Hence,

crudepricesarenotexpected to fallbelowcurrent

levelsinthenearterm.

At thecurrentoilpriceofaround$60/barrel,many

airlinesareincentivisedtoswitchtoanewerfleetto

loweroperatingcosts.Thishasledtoahugebacklog

ofnewaircraftordersforbothAirbusandBoeing.

FleetExpansionsinEmergingMarketsThe Asia-Pacific Region share of global GDP is

forecasted to rise from33%today to40%by2036.

Theincreaseinaffluenceintheregiongivesrisetoan

increase in demand for air travel. As a result, it is

expected that the region would demand for over

16,000newaircraftsoverthecomingyears.

StrongOrdersfromLowCostCarriers64%of theworld’s jet fleet is comprised of single-

aisle aircraft and is set to increase to over 75% by

2036(Boeing).Thisismainlyduetotheexpansionof

LowCostCarriers(LCC),whichprimarilyusessingle-

aisle aircrafts. The fleet share of LCC in the single-

aislemarketisexpectedtogrowfromaquartertoa

thirdgloballyin2036,totalling11,000aircraftinthe

category.

These 3 factors combined showed that there is a

huge demand for aircraft in the short to medium

term.With AIDC positioned as a tier 2 supplier, it

would benefit greatly from this future expected

growth.

73

ExpandingTaiwaneseDefenceBudget

Taiwan'sdefenseexpenditureisexpectedtoincrease

ataCAGRof4.41%between2015to2020and6.75%

between2021and2026(BMIResearch).Thisincrease

inMilitaryexpenditureislargelyaresponsetoChina's

double-digitgrowthindefenseinvestments.Withthe

Chinese military actively improving their hardware,

Taiwan is hard pressed to rejuvenate their ageing

military,with its frontline F16 jets pushing 20 years

old. With majority of arms exporting countries

unwillingtosellmilitaryequipmenttoTaiwan inthe

face of China’s diplomatic pressure, the Taiwan is

shifting its focus to developing its local defense

industry to meet its military needs. This is positive

newsforAIDCas50%ofitsrevenuederivesfromthe

state’sdefensebudget.Agrowingdefensebudgetand

the shift to indigenous arms producers will benefit

AIDCinthelongrunintheformofsustainablegrowth.

Long Term Engagement for Maintenance of Fighter

Trainers

Fighter jets require a comprehensive maintenance

schedule to ensure its combat readiness.WithAIDC

beingthesoleproducerofthetrainerjets,itwouldbe

engagedinthejetsmaintenanceoverthelongterm.

Thus, a proportion of its revenue related to aircraft

maintenancewouldbesecured.

ManagementQualityShareholdingStructure

AuthorizedSharesIssued:1,500,000,000

OutstandingShares:947,870,000Number

ofShareholders:23,402

CorporateGovernance

Underitscorporategovernancestructure,AIDChasits

own audit committee to eliminate any fraud and to

ensure reliability in its financial reporting. AIDC also

hascompensationcommitteetoevaluateandexecute

compensationpolicies,aswellastheremunerationof

directors.Withcurrentlythreeindependentdirectors

inthecommittee,thisensuresthatthesalariesofthe

executivesarefairandnotexcessive.

Additionally, AIDC was ranked top 20% in the

Corporate Governance Evaluation TWSE listed

companiesby the Securities and Futures Institute in

April2016.AIDCwasalsoawardedthe12th

term“CSR

AwardinTraditionalManufacturersCategory”bythe

GlobalViewsMagazineinMay2016.Theseaccolades

serve as testaments to the reliability of AIDC’s

management.

InsightsintotheCorporateculture

President&actingCEO–Lin,Nan-Juh

Lin Nan-Juh has been with the company since 1995.

Started as a Senior Engineer, before moving up to

Director of Technology and Services Department in

2007.Subsequently,hemovedontobecometheSenior

Vice President of AIDC in 2009, before being finally

promoted to President in 2017. Lin’s long- term ties

with the company reflect his dedication to the

betterment of AIDC. Furthermore, his continued

presenceinthecompanynotonlyproveshisknowledge

ofthecompanyworkings,butalsotheknow-howinthe

industry.Respectedbyhisemployees,webelieveAIDC

will prosper under Lin’s leadership, experience and

guidance.


AIDC’s vision to be a world class aerospace and

technology provider. Their corporate philosophy and

culture revolves mainly around accountability,

continued innovation, dedication and customer

orientation, with the goal of achieving efficiency,

quality and customer satisfaction. Under its ‘Good

Faith and Integrity Policy’, AIDC declared their

commitment to engage solely in ethical business

practices,aswellastoprovidegoodsandservicesof

highstandards.

As a result of their QualityManagement and sound

corporate values, AIDC was able to earn multiple

accreditationsfromnumerousthirdparties,certifying

AIDC’s quality of goods. Notable parties include

Boeing,AirbusandRolls-Royce.AIDCalsoreceivedthe

International Organization for Standardization

(ISO9001) accreditation. Therefore, validation from

both internal and external parties leads our team to

believethatAIDCisunderreliablemanagement.

Whatareyourtop3dislikes?HighDependenceonTaiwaneseDefenceSpending

48% of AIDC’s revenue comes from the Taiwanese

governmentintheformofdefensecontracts.Withsuch

ahighdependenceonthegovernment,itwouldbemore

susceptiblecomparedtoitspeersasaslowdowninthe

Taiwanese economy would significantly hamper the

government toprovidedefense contracts thatAIDC is

relyingheavilyupon.However,ourteambelievesitisa

double-edged sword. Given the long-term nature of

projects AIDC has undertaken, such as theAJT, there

exists stability in its cash flows, which is largely

independentfromgovernmentspendingforthenext5

to10years.

Moreover, partnerships with other companies inthe

74

commercialsectorserveasaformofdiversificationfor

AIDC, reducing its reliance on its defense sector and

ensuringrevenue.

SusceptibilitytoOilPrices

Demandfornewaircraftisalsocloselytiedtooilprices.

Ahigheroilpricewould increasetheattractivenessof

newer,moreefficientaircraftforairliners.Incontrast,a

loweroilpricewoulddissuadeairlinerstoupgradetheir

fleetascostoffinancinganewaircraftwouldnotjustify

thefuelsavingsreapedfromthemoreefficientaircrafts.

As AIDC’s revenue from its civilian aviation arm is

positively correlatedwith oil prices, a fall in crude oil

priceswouldnegatively impactthecompany'sbottom

line.

Fortunately,currentoilpricesareexpectedtomaintain

currentpricesaboveUS$60/barrelwithMorganStanley

raising their oil price targets by US$7 to US$9.

Additionally,anagreementbetweenOPECandRussiato

restrictoilsupplyisexpectedtoberenewedforanother

year,thusdrivingupthepriceofoil.

Furthermore,oilpricesarealsoexpectedtoremainhigh

due to a falling supply of shale oil, as a result of the

current shortage of fracking crew in the US. With

demandforoilgrowingfasterthanUSshaleproducers

are able to expand output, US is seeing their crude

inventoriesfallingmuchfasterthanexpected.

Hence, crude prices are not expected to fall below

currentlevelsinthenearterm(MorganStanley).

Overrelianceonasinglerevenuestream

60%ofAIDC’srevenuecomesfromcommercialaircraft

parts,deliveryscheduleofwhichisinfluencedbymacro

condition. For example, during the financial crisis in

2008-09, therewas a significant drop of aircraft new

ordersanddelayofdelivery.ThiscausedAIDC’sshares

to fall drastically due to reported losses.

Furthermore,thebulkoftheirclientsarecivilianaircraft

carriersthatdonothaveastrongabilitytoraiseticket

prices.Giventhenatureoftheairlineindustry,firmsare

unable to raise prices given that casual travellers

consider air tickets a luxury good that can be easily

forgone.This isespeciallytrueshouldafinancialcrisis

hit.ThisputspressureonAIDC,becausecivilianairlines

would be unable to generate sufficient earnings to

maintainthepurchaseofcomponents.

This also mean that their clients will most probably

pressureAIDCtolowertheirprices.AIDCwillalsofind

itdifficultforthemtoincreasepricesontheproducts

sold to clients.

CompanydirectionThe increase in orders from both the defense and

commercialaerospaceindustrywillboostAIDC’stop-

line growth. AIDC has also seek to improve their

production capabilities by launching automated

warehousingand increasingplantefficiency.Thiswill

allowAIDC to improve theirmargins.Thus,AIDCcan

leverageontheirtop-linegrowthwithwidermarginsto

increasetheirbottom-line.Aboostinprofitabilitywill

actasacatalysttoincreasethecompany’svalue

ReasonsforinvestingnowWiththeonsetofaplethoraofprojectsthatAIDCwill

addintotheirportfolio,theteamispositivethatAIDC’s

4Q17quarterlyreportthatisreleasedin1Q18willhave

astrongshowing.Investingnowwillallowinvestorsto

leverage on the low valuations currently to make a

largerprofit later.Furthermore,aswemovetowards

the holiday season the commercial aviation industry

will enjoy a stronger demand for their services. This

meansthatsuppliersofairplanesandrelatedservices

willalsoseeaboostinrevenue.

(TSEC:2634)AerospaceIndustrialDevelopmentCorporationFY2014 FY2015 FY2016 FY2018LTMSharePriceTWD 34.76 40.69 37.03 37.70NoofShares(mil) 941.9 941.9 941.9 941.9MCAP(mil)USD 1,047 1,192 1,147 1,185NetDebt(Cash)TWD 6,484 8,637 8,506 12,375EnterpriseValue(mil)USD 1,281 1,433 1,401 1,598Revenue(mil)TWD 24,924.0 26,878.2 27,325.5 26,255.9EBITDA(mil)TWD 2,243.4 2,779.4 3,422.7 3,219.5EBIT(mil)TWD 1,454.4 2,153.7 2,725.9 2,367.1NPAT(mil)TWD 1,871.5 2,029.2 2,082.7 1,735.9NPAT(Ex.Xtra+Dis.Ops)(mil)TWD 1,694.5 1,891.4 2,298.4 1,996.6CFO(mil)TWD (5,749.7) 2,405.0 4,533.6 2,770.8CAPEX(mil)TWD (726.2) (362.2) (689.8) (161.1)EPSTWD 1.8 2.0 2.4 2.1Revenue(mil)USD 785.3 815.1 843.2 865.2EBITDA(mil)USD 70.7 84.3 105.6 106.1EBIT(mil)USD 45.8 65.3 84.1 78.0NPAT(mil)USD 59.0 61.5 64.3 57.2CFO(mil)USD (181.2) 72.9 139.9 91.3CAPEX(mil)USD (22.9) (11.0) (21.3) (5.3)GPM(%) 11.1% 12.1% 15.1% 14.0%EBIT(%) 5.8% 8.0% 10.0% 9.0%NetDebt(Cash)/Equity(%) 63.0% 74.9% 68.8% 98.5%ROA(%) 5.7% 7.5% 8.8% 6.9%ROE(%) 14.1% 18.7% 22.1% 18.8%CFO/TA(%) -22.7% 8.4% 14.6% 8.0%EV/Sales(x) 1.6 1.7 1.6 1.8EV/EBIT(x) 27.0 21.8 15.9 20.2EV/EBITDA(x) 17.5 16.9 12.7 14.9EV/CFO(x) (6.8) 19.5 9.6 17.3P/Sales(x) 1.3 1.4 1.3 1.4P/EBIT(x) 22.5 17.8 12.8 15.0P/B(x) 3.2 3.3 2.9 2.9VQ1:EV/EBIT/ROE(x) 1.9 1.2 0.7 1.1VQ2:EV/EBIT/ROA(x) 4.7 2.9 1.8 3.0

75

9. XinyiSolarHoldingsLtd(SEHK:968)


QuickStats

Date 15/12/17 EBIT/R&D(x) 17.84

FilingCurrency HKD

EBIT/EmployeeNo.

(USD/px) 100K

SharePrice HKD3.0 EV/EBIT(x) 9.9

No.ofShares(Mil) 7,423.9 EV/EBITDA(x) 8.5


DailyValueTraded


GPM(%) 36.8% P/E(x) 7.5

EBIT(%) 32.5% P/B(x) 2.3

NetDebt(Cash)/

Equity(%) 55.4%

VQ1:EV/EBIT/ROE

(x) 0.3

ROA(%) 11.8%

VQ2:EV/EBIT/ROA

(x) 0.8

ROE(%) 29.5%

TeamMembers

Huang Hao is a second-year business student pursuing a major in

Finance atNUS Business School. He is highly passionate about the

financialmarketsandisalsoaglobalmacroresearchanalystinNUS’s

InvestmentSociety.

Nicholasisasecond-yearundergraduateattheNUSBusinessSchool

majoring in finance. He is an equity research analyst in the NUS

InvestmentSocietyandhasundertakenvariousinternshipstobetter

groundhisknowledgeofthemarkets.

Yuchong is a first-year undergraduate at NUS Business School,

planningtospecializeinfinance.Heisalsoanequityresearchanalyst

inNUSInvestmentSociety.Hedidaninternshipasanequityresearch

analystatIntegerAlpha,aproprietarytradingfirm.

Nicklaus is a first-year undergraduate at the School of Computing

majoringinBusinessAnalytics.Hehasakeeninterestinfinanceand

isanEquityResearchAnalystintheNUSInvestmentSociety.

76

CompanyBackgroundXinyiSolar(XYS)isaHongKongbasedcompanywhich

principallyengagesinthemanufacturingandsalesof

solarglassproducts.Ithascapturedanestimated30%

oftheglobalmarketshareforsolarglass.XYSwasspun

offbyparentcompanyXinyiGlass(XYG)in2013,which

retainsasignificant26.4%equityinterestinXYS.

XinyiSolarhas3operatingsegments:

(1) SalesofSolarPhotovoltaic(PV)glass

(2) Solar Farm Business, which includes Solar

Farm Development and Solar Power

Generation

(3) EPC(Engineering,Procurement,Construction)

services

Figure 1: FY16 Revenue Breakdown by BusinessSegments(Source:CompanyFinancials)

Of the HK$6,007m of revenue generated in 1H17,

HK$2,447m came from the sales of solar glass,

HK$735mwas from thegenerationofelectricity from

solar power, and HK$2,128m was from EPC services.

EPCprojectsaremostlyone-offorad-hocinnature,and

therefore is considered to be supplementary income

sourcebutnotakeygrowthdriverofthegroup.

Figure 2: FY16 Revenue Breakdown by Geography(Source:CompanyFinancials)China is themainmarket for Xinyi Solar, comprising

HK$2,090mofrevenue.Othercountries,includingthe

EuropeanUnion, make up the remaining HK$357m.

XYSalsoaimstobroadenoverseasopportunities-- it

acquireda60%stakeinPolaronSolartechCorporation

inApril2016,andalsoconductedafeasibilitystudyon

asolarfarmprojectinCambodia.

PVGlass

ThePVglass segmentboastsa stableanddiversified

client base, with more than 100 customers such as

YingliSolarandTrinaSolar,amongtheworld’slargest

solarpanelmanufacturers.XYShasmanylongstanding

and stable relationships with its customers. XYS’s

domesticmarketChinaaccountsformorethan80%of

salesfromthissegment,withChinaaloneaccounting

formorethan70%ofglobalsolarmoduleproduction.

Major solar glass products include: fully finished

tempered anti-reflective coated pattern solar glass,

ultra-clearphotovoltaic (PV) rawglass, ultra-clear PV

processed glass and back glass. These products are

usuallysoldfurtherdownstreaminthevaluechain,to

bemanufacturedintosolarpanels.

XYShas3manufacturingbases,with2inChina(Tianjin

and Anhui) and one inMalaysia (Malacca). Aggregate

daily production capacity of its facilities amounts to

6,800tons,meeting40%ofglobaldemandforPVglass.

SolarFarms

Figure3:AsolarfarmownedbyXYS(Source:Company)

XYS entered the solar farm business in 2014,

commencingwith2solarfarmsofaggregatecapacity

of 250MW in 4Q14. Since then, the total approved

grid-connectioncapacityhasgrownataCAGRof85%

to 1,584MW at present, with about half the plants

having a weighted average feed-in tariff (FiT) of 1.0

RMB/kWh (see Appendix 1). XYS currently owns 22

solarfarms,ofwhich19aregrid-connectedand17are

inoperation.

77

EPCServices

XYSisengagedtoprovideEPCservicesforsolarfarms

in China. It also constructs the solar farms that it

operates.XYSconsidersEPCservicestobeone-offor

adhocinnature,ratherthanasasourceofpredictable

andstable revenue,owing to the short construction

period for distributed solar projects and the

unpredictability of government tenders. While XYS

focuses mainly on solar glass manufacturing and

constructing and operating solar farms, it takes on

opportunisticEPCcontractswhenavailable.

1YearStockPriceChart

UnwarrantedUnderperformanceVSHangSengIndex

onLTMbasis

IndustryBackground

UndertheChinesegovernment’s13thFive-YearPlan,a

2.4 trillion-yuan package for renewable energy was

unveiled,which includes a significant 1 trillion yuan

investment for solar energy. Based on the latest

guidance from the National Energy Administration

(NEA),newly installedsolarcapacity is likelytoreach

86.5GW over the next few years, implying overall

nationwidecapacityofcloseto200GWin2020.Thisis

likely to incite continuous demand across the solar

powervaluechain.

According to SolarPower Europe, the global PV

installation was 76.6 gigawatts (“GW”) in 2016, up

from 51.2GW in 2015, representing a year-on-year

growthof50%.Theworld’stwolargestmarkets,China

and the United States, both saw unprecedented

installation levels. China added 34.5GW of grid-

connected installations in 2016, a 128% annual

increase. Annual installation in the US also grew

significantly,from7.5GWin2015to14.8GWin2016,

anincreaseof97%.

InvestmentThesis–OriginalityandRelevanceTheteamwantedtochooseacompanybasedonafew

factors:

1. Top-downapproach:Exploreagrowthtrends

andnarrowdowngeographically

2. Companieswithawideeconomicmoatand

significantgrowthopportunitiesinhigh

growtheconomies

3. Stronginsiderownershipandmanagement

expertise

We explored underlying growth trends in the world

economy today to decideon the sector to focus on,

beforenarrowingdowngeographically.Oneofthekey

themes in today’s world is the topic of renewable

energy, the market for which has been growing

exponentially over thepast 2 decades and has good

long-term prospects. We decided to focus on

renewableenergyinahigh-growthAsianmarketwith

increasingenergyneeds--China.

TherenewableenergysectorinChinahastakenoffthe

past decade, spurred by the support of the Chinese

governmenttowardrenewableenergyinitiatives.This

bodeswell for companies linked to the solar energy

valuechain,fromthemanufactureofcomponentsto

thegenerationofenergy.

Xinyi Solar encompassed all of the qualities listed

above, strategicallypositioned fromtheupstreamto

the downstream in the solar value chain. It boasts

market-leading technology and is poised to reap the

benefitsofChina’srenewablesdrive,leveragingonthe

expertiseofitsmanagementanditsabilitytobenefit

fromeconomiesofscaleduetoitssize.

78

BusinessModelQualityAnalysisWebelievethatacommittedmanagementteam,loyal

customer base, prudent emphasis onR&D capabilities

and growth prospects in the long run provides the

impetusforXYStostayaheadandbeattheforefrontof

therapidlygrowingsolarpowerindustry.

AStrongEconomicMoat

AccordingtoJPMorgan,XYSisthelargestsolarglass

manufacturer in the world, with a market share of

about 30% and boasting an aggregate daily melting

capacity of 6,800 tonnes. In comparison, the second

largestsolarglassmanufacturerintheworld,FlatGlass

group has a market share of about 15%. Xinyi’s

industry-leading production lines are highly

automatedandfullyintegrated,enablingeconomiesof

scale and production efficiencies to be realized,

translating into cost-efficient operations. Regular

maintenance programs ensure production facilities

functionatoptimalefficiencyandachieveconsistent

outputquality.

XinyialsoconsidersR&Dasoneofitsmainprioritiesto

stay ahead of the competition, investing heavily in

research to build and maintain the competitive

advantageinproductsandsolutions,suchasthrough

cooperation with various scientific research

institutionstobuildresearchplatforms.

Thesolarglass industryhashighbarrierstoentry as a

result ofmaturity of existing companies and the high

costs of R&D to gain an initial competitive advantage.

Coupled with the seamless manufacturing processes

and continuous improvementXYShasundergone, this

hasbuiltalargeeconomicmoatforXYS,thusenablingit

to thrive in an increasingly competitive environment

while ensuring its long-term competitiveness.

Longstanding customer relationships with the world’s

largest solar panel manufacturers also improve

customer loyalty and retention, giving XYS the

unparalleled edge in the industry

AnalysisofBusiness&GrowthOpportunities

RidingtheSolarEnergyWave

China’s 13th Five year plan continues to emphasize

greendevelopment,apotentialboon forXYSasChina

aims to advance the energy revolutionby rampingup

the exploration of clean, safe resources such as solar

energy. Also, China’s National Energy Administration

(NEA) has set targets for 150GW of solar power

installation by 2020, which will incite continuous

demandacross thesolarpowervaluechain.Being the

marketleaderinsolarglassmanufacturingandPVglass

technology,Xinyiispoisedtobeamajorbeneficiaryof

China’srenewablepush.

Vertical integration of upstream (solar glass) and

downstream (solar farms) businesses also unlocks

uniquesynergiesforXYS,enablingittocapturegrowth

opportunities inabroaderspectrumofthesolarvalue

chain.Itbenefitsfrombothincreaseddemandforsolar

energy products, while also tapping into the lucrative

solarpowergenerationmarket.

HighIRRSolarFarmOperations

XYSboastsauniqueintegrationofsolarglassproduction

and solar power generating operations, which highly

complement each other, while simultaneously

capitalizingontheindustry’stronggrowth.Thecurrent

industry average internal rateof return (IRR) for solar

projectsisaround8-12%,butwebelievethatXYS’solar

farms IRR will increase over the coming years. This

higher average IRR is a result of low financing and

constructioncosts.Theformerisattributedtoitsability

to secure offshore debt and strong backing from its

parent,whilethelatterismainlyattributedtoitsstrong

in-house EPC team becoming increasingly efficient as

comparedtohiredthird-partyEPCserviceproviders.

Solarpowergenerationalsoimprovesthepredictability

of XYS’ revenue stream. While feed-in tariffs may be

changed by the government, solar irradiation and

irradiation hours are approximately constant

throughouttheyear.

LowLeverageLeavesRoomforM&A

InApril2016, theacquisitionof60%equity interest in

Polaron Solartech Corporation, a solar power system

providerinCanada,hasmarkedasuccessfulstartofthe

Groupinthisaspect.TheGroupiscontinuingitseffort

to explore other downstream solar opportunities in

overseas countries and it has just been granted the

permissiontoconductafeasibilitystudyonasolarfarm

project with a capacity of 100MW in Cambodia, to

further achieve strategic overseas expansion.

Furthermore, the company has been sitting on excess

cashwith 843M in 2016 and 2,449M in 30 June 2017

accordingtotheXinyi’s InterimReport2017.Thisputs

the company in a favourable position to engage in

capital projects or capture acquisitions opportunities

movingforwardwhichwillcementXYS’positionasthe

leadingsolarglassmanufacturerinChina.

79

Managementqualityanalysis

1) IndustryExperienceandExpertise

Thechairman,DatukLeeYinYeejoinedthegroupsince

2006 and has 27 years of experience in the glass

industry. He is also the founder of parent company

Xinyi Glass, which has a 26.4% stake in XYS. Vice

chairman Tung Ching Sai joined the group in 2006.

Priortohisposition,heworkedinXYGfor27yearsever

sinceitsinception.Heiscurrentlyanexecutivedirector

andtheCEOofXYG.

CurrentCEOLeeYauChing,sonofDatukLee,hasbeen

theCEOofXinyiSolarHoldingssinceJan2011.MrLee

startedhiscareerinXYGandservedasitsCOOpriorto

hisappointmentasXYS’sCEO.Hebringswithhim18

years of experience in the solar Industry, and a

thorough understanding of XYS’s operations.Mr Lee

alsohasa3.7%stake --given thenatureofXYSasa

familybusiness,weexpectMrLeetoremaininvested

forthelongrun.

2) Largeinsiderownership

Parent company Xinyi Glass (XYG) is XYS’ largest

shareholder.XYGisitself20.9%ownedbyDatukLee,

and 9.2% owned by Tung Ching Sai. Large insider

ownership represents a strong alignment of

management’sinterestswithitsshareholders,andis

a further reflection of the Lee family’s dedication

towardtheirbusiness.

3) InsiderBuying-AVoteofConfidence

Membersofmanagement,inparticulartheDatukLee

andVice-chairTung,havebeenincreasingtheirstakes

inthecompany formuch 2H17. Datuk Leemade a

significantpurchaseof475msharesinApril,bringing

histotalstaketoto12.6%.Thisspeakswellaboutthe

confidencethatthemanagementhasinthesuccess

ofthecompany.

(refertoAppendix2)

4) RemunerationStructure

ReferringtoAppendix3,XYS’remunerationstructure

ties management interests with shareholders’

interests.Management’s compensation is basedon

responsibility, and a discretionary bonus is issued

based on performance. This incentivizes

management to focus on long term sustainable

growth, while also reducing agency risk from

occurringinthefirm.

Catalysts,Events,TippingPointIntheRightPlaceattheRightTime

Therefore,XYS’smarketpositionasthelargestsolar

glass manufacturer, and its timely foray into solar

power generation, allows it tocapitalizeonChina’s

13th5-yearplan,astheChinesegovernmentpushes

formorecleanenergy.Well integrated in the solar

value chain, and a trusted supplier to the world’s

largest solar equipment firms, combined with an

established track record in China, XYS’ competitive

advantage will be well manifested when demand

acrossthesolarvaluechaintakesoff.

As the world shifts to more sustainable means of

energy production, XYS looks poised to continue

capturingnewgrowthopportunitiesbeyonditshome

market by further expanding production, achieving

evengreatereconomiesofscaleintheprocess.XYS

planstoaddtwomore1,000-tonneproductionlines

in Malaysia, which are scheduled for production

launch in4Q18andmid-2019respectively.Thenew

linesareprojectedtobeaccretivetorevenuein1Q19

and3Q19respectively.

Hence,webelievethatthemarkethasoverlookedXYS’

strongpositionandcapablemanagement,aswellasits

capabilitiestomaintainitsleadingpositioninthisperiod

ofindustrytransformation.Webelievethatitsvaluewill

be unlocked over the coming 3-5 years as the solar

industryinChinaandacrosstheworldshiftsintohigher

gear.

RisksIncreasedCostofProductionXYSishighlyreliantonenergyandrawmaterialsforits

solar glass production. One of the main resources

requiredisnaturalgas,accountingforabout40%ofthe

cost of production -- the rising cost of which poses a

short-termrisk.Aspikeinthecostofnaturalgascould

hurtXYS’bottomline.

80

IntensifiedCompetition

WhileweexpectXYStoretainitsmarket leadershipin

solarglass,thepossibilityofnewcompetitorsentering

this lucrative space cannot be ruled out. Incumbent

players are likely to capitalise on the government’s 5-

yearplantoexpandcapacityandsales.Weforeseethat

competition is likely to intensifyasaresult.Thiscould

potentiallyputpressureonindustry-widemarginsanda

dilutionofXYS’growthandmarketshare.

ReductioninGovernmentSubsidies

GridcurtailmentanddelaysinFeed-intariff(FIT)subsidy

payments could negatively affect the cash flow and

liquidityoftheXYS.Subsidiescouldalsofallasaresultof

solarpowerapproachinggridparityin2020.Significant

reductionsinsubsidieswillalsolowersolarfarmproject

IRR.

ForeignExchangeRisk

Asthemainbulkoftherevenue(92%of1H17revenues)

isderivedfrommainlandChina,andalsowithamajority

oftradebillsandreceivablesdenotedinRMB,XYSfaces

considerablecurrencyrisk.SincetheHKDisitsreporting

currency, depreciationof RMBagainst theHKDwould

resultincurrencytranslationlosses.Thisriskispartially

mitigated by the XYS’ policyofentering intocurrency

hedges as it deems fit. Furthermore, XYS also has a

factory in Malaysia, making it susceptible to foreign

exchangeriskagainsttheMYR.

(SEHK:968)XinyiSolarHoldingsLimited FY2013 FY2014 FY2015 FY2016 FY2018LTMSharePriceHKD 2.32 2.41 2.76 2.48 2.67NoofShares(mil) 5,700.0 6,580.0 6,748.8 6,748.8 7,423.9MCAP(mil)USD 1,705 2,045 2,401 2,154 2,537NetDebt(Cash)HKD (279) 710 631 5,672 4,964EnterpriseValue(mil)USD 1,171 1,668 2,798 2,760 3,349Revenue(mil)HKD 1,967.5 2,410.0 4,750.4 6,007.1 8,141.8EBITDA(mil)HKD 465.9 681.9 1,570.4 2,836.4 3,094.2EBIT(mil)HKD 368.5 589.8 1,348.9 2,440.1 2,645.9NPAT(mil)HKD 303.8 493.0 1,205.6 1,985.6 2,124.7NPAT(Ex.Xtra+Dis.Ops)(mil)HKD 303.6 506.1 1,144.0 1,977.4 2,117.9CFO(mil)HKD 653.7 715.0 851.1 680.8 446.1CAPEX(mil)HKD (239.7) (2,321.7) (3,531.7) (4,621.9) (2,640.4)EPSHKD 0.1 0.1 0.2 0.3 0.3Revenue(mil)USD 253.7 310.8 612.9 774.7 1,043.0EBITDA(mil)USD 60.1 87.9 202.6 365.8 396.4EBIT(mil)USD 47.5 76.1 174.0 314.7 338.9NPAT(mil)USD 39.2 63.6 155.6 256.1 272.2CFO(mil)USD 84.3 92.2 109.8 87.8 57.2CAPEX(mil)USD (30.9) (299.4) (455.7) (596.1) (338.2)GPM(%) 30.1% 31.6% 36.0% 45.8% 36.8%EBIT(%) 18.7% 24.5% 28.4% 40.6% 32.5%NetDebt(Cash)/Equity(%) -12.1% 21.5% 11.0% 91.2% 55.4%ROA(%) 13.7% 10.2% 10.6% 14.5% 11.8%ROE(%) 16.0% 17.8% 23.5% 39.3% 29.5%CFO/TA(%) 24.3% 12.4% 6.7% 4.1% 2.0%EV/Sales(x) 6.6 6.9 4.3 3.9 3.2EV/EBIT(x) 35.1 28.1 15.1 9.7 9.9EV/EBITDA(x) 27.8 24.3 13.0 8.3 8.5EV/CFO(x) 19.8 23.2 24.0 34.7 58.7P/Sales(x) 6.7 6.6 3.9 2.8 2.4P/EBIT(x) 35.9 26.9 13.8 6.9 7.5P/B(x) 6.2 5.1 3.3 2.8 2.3VQ1:EV/EBIT/ROE(x) 2.2 1.6 0.6 0.2 0.3VQ2:EV/EBIT/ROA(x) 2.6 2.7 1.4 0.7 0.8

81

10. TeijinLimited(TSE:3401)


QuickStats

Date 15/12/17 EBIT/R&D(x) 1.89

FilingCurrency JPY

EBIT/EmployeeNo.

(USD/px) 30K




DailyValueTraded


GPM(%) 32.8% P/E(x) 7.0

EBIT(%) 8.5% P/B(x) 1.5

NetDebt(Cash)/

Equity(%) 75.2%

VQ1:EV/EBIT/ROE

(x) 0.7

ROA(%) 7.0%

VQ2:EV/EBIT/ROA

(x) 1.6

ROE(%) 17.5%

TeamMembers

JiaJunisafirst-yearAccountancyandBusinessdoubledegreestudent

atNanyangBusinessSchool.HeintendstospecialiseinBankingand

Finance.HeisamemberofNTU’sNanyangCapital.

Joby is a first-year Business student at Nanyang Business School,

intending to specialise in Banking and Finance. He is amember of

NTU’sNanyangCapital.

YiYanisafirst-yearBusinessstudentatNanyangBusinessSchool.He

intends to pursue a specialisation in Banking and Finance. He is a

memberofNTU’sNanyangCapital.

Jian Rong is a first-year Accountancy student at Nanyang Business

School.HeisalsoamemberofNTU’sNanyangCapital.

82

Howdidyouoriginatethisidea?

We first researched on the sectors that we felt had

strong potential growth as well as looking at growing

trendsintheAPACregion.Afterthoroughresearch,our

team has chosen to focus on the growing sector of

Electric Vehicles (EV). We studied the value chain in

detail tosearch forcompanieswhichwillbenefit from

theincreasingdemandforEVswhilstconsideringifthe

stock has already priced in the existing information.

Aftershortlistingafewpotentialcompanies,wefurther

analysed the company’s fundamentals and their

businessmodelandfinallysettledonTeijinLtd.

CompanyOverview&BusinessBackground

Established in 1918, Teijin Ltd is a Japanese company

operatinginthecommoditychemicalsindustryandisa

constituentoftheNikkei225stockindex.Thecompany's

brand statement is "Human Chemistry, Human

Solutions", where it strives to enhance the quality of

people's lives globally. Currently, Teijin Ltd sells its

productsin83countries.

Teijin Ltd'smain business ismaterials,which provides

high-performance fibers such as Aramid and Carbon

Fibers,ResinandPlasticsprocessingaswellasPolyester

andPolycarbonatefilmsandsheets.Today,italsohasa

healthcare segment providing products such as

therapeuticoxygenconcentratorsandpharmaceuticals,

aswellasanInformationTechnologysegmentproviding

e-comicsservices.

ForFY2017,revenuedecreased6.3%year-on-year(yoy)

from JPY790.75 billion to JPY741.3 billion, largely

attributabletothehaltofSingapore'sresinproduction

plant. However, gross profit margin and net profit

marginimprovedfrom32.2%to33.5%and3.9%to6.8%

respectivelyasaresultoflowercostofgoodssoldand

fixedexpensesfromrestructuringinitiatives.

Whyisthiscompanyahiddenchampion?

1. StrongBusinessModelandSustainableGrowth

In the materials and healthcare industry, Teijin Ltd

remains asoneof the topmarket leader. It hasmany

patented and differentiated market-leading products

within the industry. With the management's clear

objectives,theyhaveacquiredCSP,whichistheworld's

largest sheet molding compound manufacturer for

automakers.TeijinLtdiscontinuouslyseekingtofurther

enhance their businessmodel to ensure a sustainable

growth.

2. StrongManagementandESGInitiatives

What differentiates Teijin Ltd from its competitors is

that Teijin Ltd has a strongmanagement system that

perpetually strives to achieve their goals tagged with

their intensiveESG initiatives.Hence,TeijinLtdwillbe

abletomaintainitspositionasamarketleaderandstay

ahead of its competitors. Teijin Ltd believes in

sustainabledevelopmentandhasaheartforthesociety

and the environment. By including diverse workstyle,

while reducing environmental impacts through their

intensive ESG initiatives, Teijin Ltd aims to be an

enterprise of tomorrow. With a better organization

culture,theywillbeabletoattractabettertalentpool

andaimforgreaterheights.

3. PositioningtoCapturetheGrowingIndustry

Backedby the strongmanagement,our teambelieves

thatTeijinLtdwillbestronglypositionedtocapturethe

potentials in fast-growing industries throughplans set

out by management. We reckon that the market is

currently still uncertain whether Teijin Ltd will be

successful in their expansion plans into multiple new

industries while concurrently focusing on their non-

financials.However,westronglybelievethatTeijinLtd

willbeabletoachievegreatsuccesswithitswidemoat

businessmodelanditisundoubtedlyahiddenchampion

withhighgrowthpotential.

BusinessModelQualityAnalysis

SustainableLeadingMarketPosition

TeijinLtdisamarketleaderinitsownfieldswithinthe

commodity chemicals industry. Itsproductionofpara-

aramidfibres--TechnoraandTwarocommands50%of

themarketshareforhighperformancematerials.Teijin

Ltdalsohasthetopshareinthemarketformeta-aramid

fibres, textiles, resins and plastics processing. The

company is also one of the world's top three

manufacturers for carbon fibres. Recently, it has also

acquired CSP, the world's largest sheet molding

compoundmanufacturer forautomakers.Thedemand

foritsdifferentiatedproductsisexpectedtogrowinlieu

of the increasing need for higher-performance,

lightweight automobile components due to tighter

environmentalregulations.

With over 40 years of expertise, Teijin Ltd is also

successfulinitshealthcarebusiness.Currently,itholds

the largest customer base in Japan for home oxygen

therapy, with market share over 50%. Another

successfulproductithasunderitsbeltistheContinuous

PositiveAirwayPressure (CPAP) ventilatorSLEEPMATEforsleepapneasyndrome,withamarketshareof40%.

In addition, it has also established a top share in themarketforhyperuricemiaandgouttreatments,inwhich

83

ithasfurthersecuredexclusivedistributionagreements

foritspharmaceuticaldivisioncovering117countries.

Our team believes that Teijin Ltd's superior product

offeringshavenotonlysecurelycementeditsfoothold

inthemarket,italsoenablesthecompanytoleverage

on its bargaining position for a better and continuing

relationship with its key stakeholders, particularly

suppliers. The diversity of its product offerings also

enhancesthestabilityandqualityofthefirm'searnings

and cash flows by reducing the interdependency and

concentrationofsupplierandcustomerbase,infaceof

changingandcyclicalmarketconditions.

StrongR&DandTechnologicalCapabilities

OurteambelieveswhatdistinguishesTeijinLtdfromits

competitors lies in itscutting-edgetechnologies in the

research and development of its products. It has also

beenat the forefront intherevolutionofkey industry

segments.AnexampleofTeijinLtd'ssuccessistheuse

ofthermoplasticresinincarbon-fiberreinforcedplastic

(CFRP). The company was able to outsmart its

competitorstomassproducetheproductbysimplifying

and reducing the manufacturing time to one minute.

This is evident in its role as the manufacturer of the

world’s firstpolycarbonate-resinpillar-lessautomotive

frontwindowoftheTommykairaZZ,anelectricvehicle

designedbyGreenLordMotors.Othersuccessesarethe

developmentofNANOFRONT®technology,theworld'sfirst, ultra-fine nanofiber and miraim, a high-

performance membrane for vapor-liquid separation

usageintheautomotiveindustrysuchasfuelcells.

Withitsstrongtechnologicalexpertise,TeijinLtdhasnot

onlypositioneditselfstrongly inanichemarketwhere

barrierstoentryarehigh,itssheersizeenablesTeijinLtd

to enjoy economies of scale to keep costs low amidst

volatile periods and better customer retention to

sustainrevenuestreams.

RevenueBreakdownbySegments:

ManagementQualityAnalysisShareholdingandBusinessGroupStructure

I. AuthorizednumberofSharesL600,000,000

shares

II. Number of Shares Issued: 196,951,733

shares

III. NumberofShareholders:83,726

CorporatePhilosophy

Teijin Ltd’s brand statement is “Human Chemistry,

Human Solutions”. Its long-term vision is “Teijin will

become an enterprise that is essential to tomorrow’s

society by continuously creating value”. It strongly

believes in growing in a sustainable manner with the

progress of society by solving social issues through

innovative means and anticipating changes in the

externalenvironment. Ithas identified“Environmental

Value Solutions”, “Safety, Security and Disaster

Mitigation” as well as “Demographic Change and

Increased Health Consciousness” as its core priority

fields.

The company places huge emphasis on the

Environmental, Social and Governance (ESG) aspect.

UndertheleadershipoftheirChiefSocialResponsibility

Officer,TeijinLtdpromisestokeepdeliveringrealvalue

throughthedevelopmentofchemicaltechnologiesthat

are friendly tobothpeopleand theenvironmentwith

84

theirownCSRManagementSystem.Teijinisamember

oftheUnitedNationsGlobalImpactandtheyadhereto

internationalstandardsliketheParisAgreementtolimit

their carbon footprint and provide assurances to the

safetyoftheirconsumersontopofprovidingquality.As

of2012, theyhave reducedgreenhousegasemissions

from manufacturing operations and total water

discharge by approximately 20% and chemical

substanceemissionsbyalmost40%.

CEO

Mr.JunSuzukihasbeentheChiefExecutiveOfficerand

PresidentofTeijinLimitedsinceApril2014andservesas

amember of the advisory board.Mr. Suzukiwas also

previously General Manager of Advanced Fibers &

CompositesBusinessGroupsinceApril2013andChief

MarketingOfficerofTeijinLtdsinceApril2012.Sincehis

appointment, Teijin Ltd’s gross profit and EBITDA

margins has grown from 24.8% to 33.5% and 8.1% to

12.9% respectively. Identifying and anticipating

potential market growth, Mr. Suzuki recently

announcedanewmedium-termmanagementplanthat

clearlyarticulateshisaspirationsandactionstobetaken

to ensure Teijin Ltd’s future success. Our team is

optimistic that Teijin Ltd will achieve even higher

performance results under Mr. Suzuki’s strong

leadershipandvisions.

RemunerationStructure

Teijin Ltd adopts a performance-based remuneration

system to compensate its directors. The amount of

remuneration is determined according to the

consolidated ROA and additionally based on the

consolidated ROE, improvement of operating income,

achievementsrelativetobudgetsandanevaluationof

the director’s performance. The Advisory Board

evaluates the CEO and deliberates on the specific

remunerationfortheCEO,whichisthendecidedbythe

Board of Directors. The remuneration structure aligns

management interests with shareholder’s interests

sincemanagementisrewardedbasedonthecompany’s

performance and ratios, reducing agency risks from

occurring in the firm. By rewarding directors on long

term improvements to the company’s operations, it

preventsmanagementfromforegoingstablelong-term

growthtoachieveshorttermgains.

Whyisthestockmispriced?

Despite having higher gross margins and ROE as

comparedtoitspeers,TeijinLtdispricedcheaperata

TEV/EBITDAmultipleof6.8xthantheindustryaverage

of 8.9x. We reckon that this mispricing is due to

increased investor cautiousness towards Teijin Ltd's

recent ability to grow its revenues in the commodity

chemicals industry, having decreased by 6.25%

comparedtothesector's3.47%,aswellasitsabilityto

finance the announced JPY300 billion in capital

expendituresoverthenext3years.

Wedifferfromthemarketconsensusaswebelievethat

the lower revenue growthwas attributable to one-off

eventssuchastherecenthaltofSingapore'sproduction

plant, and not from deteriorating operations.

Furthermore, our team feels that not only would

revenuegrowoverthenextfewyears,TeijinLtdwillalso

be able to fund its capital expenditures from the

potentialincreaseinoperatingcashflowsbasedonour

investmenttheses.

Top3Dislikes

1. HighCashConversionCycle

Teijin Ltd’s CashConversionCycle (CCC)has increased

drastically,uptoacurrentCCCof110.94 from78.0 in

2014.ThegrowingincreaseinCCCismainlyattributable

toanincreasedDaysInventoryOutstanding(DIO).This

was largely caused by a downturn in spending on

apparelandsalesofautomotive interiormaterialsand

equipment.However, Teijin Ltd'sCCC is slightlybelow

theindustryaverageof112.46anditisnotacausefor

alarm.Ourteambelievesthatthatthischaracteristicis

duetothecurrentmarketconditionandit isnotlikely

topersistoverthelongterm.

2. TooAmbitious

Under the new medium-term management plan for

FY2017-FY2019,TeijinLtdaimstoachievemanytargets

in the short period of time. While trying to improve

profitability with their growth and transformational

strategies, they are concurrently aiming for corporate

governance, diversity and reduction of environmental

impacts.OurteamfeelsthatTeijinLtdshouldfocuson

prioritising the success of their plan in growth and

transformationalstrategiesbeforefocusingontheother

targets.

3. HighFinancialLeverage

Teijin Ltd has a higher Net Debt/EBITDA ratio of 2.3

comparedtotheindustryaverageof1.49.Thisimpacts

the company's creditworthiness and ability to takeon

moredebt in the future,whichwouldaffect its future

interestcostsandaccesstodebt.Wefeelthatthisisan

importantfactortoconsiderasnotonlywoulditwould

affectTeijinLtd'scompetitiveness,lessaccesstocapital

wouldpotentiallyhinderitsdailyactivities.

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However,thisratiohasbeendecreasingfromitspeakof

3.9 in 2014. Furthermore, Teijin Ltd's current Interest

CoverageRatiois44.4.Thissuggeststhatthecompany

doesnothavean issuepayingoff its short-termdebts

despite it being lower than the industry average of

65.87. Though it is not ideal to have a high Net

Debt/EBITDAratio,ourteamisconfidentthatitcanbe

repaid with a projected increase in earnings over the

longterm.Inaddition,wealsofeelthatitisessentialfor

TeijinLtdtotakeupmorefinancialleverageandinvest

moreinitsfutureinordertostayaheadinthishighly-

competitiveindustry.

Catalyst,EventsandTippingPoint

1. Meeting company earnings target and key

performance index (KPI) in FY2018. Teijin Ltd has

announced its 2 years management plan which

includes the transformation and growth strategy.

Management has given their guidance and

estimatesonKPItobeachievedbyFY2018.Hitting

estimates and KPIs will indicate that Teijin Ltd is

heading in the rightdirection andwill continue to

experience strong growth under management’s

guidance.

2. ApprovalofregulationsforFEBURICtobesoldto

othercountriesandlaunchofnewdrugsby2018.

InvestmentThesis

1. GrowthindemandforElectricVehicleswilldriverevenueforTeijinLtd

One of the global fastest growing markets is Electric

Vehicles (EVs).Unlike conventional vehicles thatusea

gasolineordiesel-poweredengine,electricvehiclesuse

an electric motor powered by electricity from

rechargeablebatteries.

The compounded annual growth rate (CAGR) of EVs

globally is estimated to be 42%. One of the largest

consumerofEVsisintheChineseeconomy,whichtakes

upapproximately35%oftheentireglobalEVsales.Due

tostronggovernmentinitiatives,thetrendofswitching

from conventional vehicles to EVs in China is likely to

continueinthefuture,wheretheCAGRofEVsinChina

isestimatedtobeat30%.

TostrengthensupplychainintheChinesemarket,Teijin

Ltd acquired Continental Structural Plastics (CSP), a

globalleaderinlightweightcompositesolutionsin2016,

toleverageonitsexistingextensiveproductionfacilities

inChina.

TeijinLtdplanstocapturethepotentialprofitsfromthe

growthoftheEVmarketthroughtwostrategies:

a) ExpandingUsesofCurrentProducts

TeijinLtdisaglobalmarketleaderintheproductionof

high-performancecarbonfiberswhichhavebeenmainly

used in aircrafts.With thegrowthof EVs, demand for

various complement components used in its

manufacturing process will increase as well. As

automobiles are becoming lighter, manufacturers are

looking to incorporate high-performance lightweight

materialsforthevehicle.Themarketdemandforsuch

automobilelightweightmaterialsisexpectedtogrowat

13.06%. Teijin Ltd plans to expand uses of its existing

productstoincludeautomobiles.Forexample,itspara-

aramid fibers will be used as a tire reinforcement

material and polycarbonate resins as a lightweight

alternativeforglass.

b) Diversifyingproductlinestoincrease

competitiveness

Secondly, Teijin Ltd is entering the automobile

compositematerialsmarket.ByacquiringCSP,TeijinLtd

can easily enter the Chinese market for automobile

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compositematerialssinceCSPisalreadyastrongmarket

player. A core component of an EV is the lithium-ion

battery (LiB) engine. The CAGR for the demand of LiB

separator inautomobiles isexpectedtobe22%.Teijin

Ltd plans to increase its capital expenditure in LiB

separators, the underlying technology behind a LiB

engine to capture the increased demand. Despite

existing competitors, we believe that Teijin Ltd will

capture the most growth due to its proprietary

technology -- LIELSORT, the world's first coating

technology for battery separators which enhances a

battery’senergyefficiencyandlifespan,providingTeijin

Ltdthecompetitiveedgeoveritspeers.

By diversifying the product lines, Teijin Ltd has

positioned itself strongly as a multi-material

manufacturer to increase its competitiveness over its

peersasasolution-orientedsupplier.Ourteambelieves

thatTeijinLtdwillcontinuetostrengthenitsdominance

torealisethepotentialsfromincreasingdemandforEV

automobile components alongside the growth of EVs.

Furthermore,itisunlikelythatcompetitorswillbeable

to compete with Teijin Ltd in this field due to its

established competitive advantage with patented

technologyandexpertise.

2. TeijinLtdisstrengtheningexistingrevenuedriverswhilelookingtoexpanditsproductsandservicestonewfieldsinHealthcare

HealthcarePillar

Under the healthcare pillar, Teijin provides home

healthcareservicestoover300,000patientsinsideand

outsideofJapanandhavesecuredthetopshareinJapan

for therapidlygrowingmarket forcontinuouspositive

airwaypressure(CPAP)ventilators,forthetreatmentof

sleep apnoea syndrome, the same as with its home

oxygen therapy (HOT) services. In therapeutic oxygen

concentrators for HOT, Teijin Ltd will further boost

rentalvolumebyenhancingandexpandingtheline-up

of portable oxygen concentrators aswell as achieving

thesamefornon-portableoxygenconcentrators.Teijin

LtdwillbeenhancingthefunctionsofCPAPventilators

to respond to patient needs by capitalizing on their

homehealthcarecallcentres.

Moving forward. Teijin Ltd is also looking to improve

leverage on its IT services to enable IoT and AI in its

homehealthcaresystems.VitalLink,amultidisciplinary

collaboration and information sharing system was

establishedin2015toserveasaplatformfortheabove-

mentionedhealthcareservices,therebyintroducingand

linking more players into the home healthcare field.

Essentially,TeijinLtdisplanningtoprovidethesoftware

platformforintegratedhomehealthcaresystemandis

marketing the system to the government and other

market players in the industry. Although sales of

VitalLinkisstillinitsinfancystages,webelievethatithashugepotential forgrowthandTeijinLtdcanexpect to

provide even higher quality of services to distinguish

itselffromcompetitors.

PharmaceuticalPillar

Under the pharmaceutical pillar, Teijin Ltd developed

FEBURIC, the first global hyperuricemia and gout

treatment febuxostatandhasalreadysecured the top

shareinthedomesticmarket(about50%).TeijinLtdis

securing exclusive distributorship agreements for the

febuxostat drug covering 117 countries and regions

overseas, with plans to expand the sales area

progressively.In2014,thedrugwassoldin42ofthese

countries and currently, it is sold in 67 of these

countries. We believe that increased health

consciousness and awareness of early prevention of

diseases through targeted treatment globallywill help

FEBURIC to grow to become a substantial revenue

source for business growth under Teijin Ltd’s

pharmaceuticalpillar.

Teijin Ltd has made plans to provide consumers with

healthmonitoring products and services in new areas

such as the cranial nervous system. This market is

expectedtoincreaseby5timesfromJPY100millionin

2015toJPY550millionin2020.InOctober2017,Teijin

Ltd announced that they are partnering withMerz, a

globalleaderinaestheticsandneurotoxinsandentered

intoastrategiclicenseandco-developmentagreement

for the commercialization of Xeomin. Teijin Ltdwants

Xeomintobecomeacoreproductwhichaimstoprovide

atotalsolutionforstrokepatientswiththesynergistic

effectsoftheirstrokerelatedproductsandpipelinesuch

as rehabilitation devices and regenerative medical

products.

3. GreatersynergiesexpectedtobederivedthroughInformationTechnology

Tomaintainitscompetitiveedgeintheindustry,Teijin

Ltdmustembracerapidcommoditization,rawmaterial

price volatility and an increasingly regulatory

environment. Recently, it has announced plans to

allocateJPY10billionfrom2017to2019toestablishan

integrated informationplatformthrough IoTandAI to

support their growth and transformation strategies.

Examplesincludeconstructinganinformation-platform,

automating production process as well as digitizing

businessprocessesanddatabases.

ThisprovidesTeijinLtdbettervisibilityofthecompany’s

progress with regards to external conditions such as

real-time pricing quotes. For example, The Dow

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ChemicalCompany,aUS$49billionconglomerate,was

able to optimize its procurement strategy by

collaboratingwithsupplierstocombatpriceandsupply

volatility. This has reduced their cost of goods sold,

especiallycrudeoilwhichiswidelyexpectedtoincrease

overthenextfewyears.

Ourteambelievesthatthisisastepintherightdirection

forTeijinLtdasoperationalexcellenceiskeytosuccess

in this industry.Givenmanagement's track record,we

expect that it would likely be able to successfully

restructure its business model. Upon completion, the

strategic shift would be difficult for competitors to

replicateandcatchupwith.This isduetohighcapital

expenditures and cultural problems which historically

were the main reasons to its slow adoption among

chemical companies.According toDeloitte,more than

50% of chemical enterprises do not have a digital

transformationstrategyyet,whichputsthematriskof

losingtheircompetitiveedge.

ThroughtheenablingofIoTandAI,TeijinLtdcandeliver

more tangible customer results by sensing and

integratingend-userconsumptionpatternswithsupply

chain activities. This leads to a leaner supply chain,

thereby reducing inventory storage costs, wastage of

raw materials through increased operational

efficiencies. Management would be able to make

decisions faster and reduce risks of product quality,

reliabilityandsafety.Withlessneedtoforecast,manage

and satisfy future demand, more resources can be

allocated for research and development purposes to

furtherstrengthenTeijinLtd’sbusinessmodel.(Deloitte,

2017). Following IHS Chemical Week 2016, we also

expecttosee improvementofprofitmarginsby8%to

13%fromthisinitiative.

Risk/ToxicityFactors

1. ProductQualityRisk

Teijin Ltd has been positioning themselves to be an

enterprise thatprovidesproductquality and reliability

assurance. As they are venturing into the Chinese EV

markettobecomeamulti-materialmanufacturer,Teijin

Ltdmust ensure that their products are able tomeet

specifications. Any product defects could negatively

affect customer relations since their deals are greatly

basedontheirproductqualityandreliabilityassurance.

Teijin Ltd has to increase quality control regulations

whilstdecreasingoperationalcostsandbeabletosatisfy

demandsontime.

2. Commoditypricerisk

Thedemandforoil isgrowingatanunexpectedlyhigh

rate,causingU.Scrudeoilinventoriestodepletefaster

thanexpected.Moreover,OPECandotheroilexporters

areexpectedtoreserve1.8millionbarrelswhichwillnot

be sold in themarket next year.With the reliance on

shale that is growing, the limits are becoming more

apparent. Companies are facing issues with hydraulic

fracturing as the crews and equipment are frequently

bookedalongwiththerisingcostforoilfieldservices.

TeijinLtd'sCarbonFiberaremadefromPolyacrylonitrile

(PAN) precursor, which is a product of crude oil. The

increase in crude oil prices will increase the cost of

manufacturingforTeijinLtdbutourteambelievesthat

TeijinLtdwouldbeabletomanagetheriskandactearly

tohedgeit.Inthepast,TeijinLtd'sECO-CIRCLEsystem

uses oil to produce polyestermaterial. To date, Teijin

Ltd'sECO-CIRCLEsystem is theworld-first, closed-loop

recycling system for polyester products. This has

reducedoil dependency andwith continuedR&D,our

team believes that Teijin Ltd will be able to manage

commoditypricerisk.

3. ForeignExchangeRisk

Teijin Ltd has diversified operations across the world

namelyChina,SoutheastAsia,EuropeandUS.Withthe

acquisitionofCSP,salesinChinaandUSisexpectedto

expand.TeijinLtd’sbasecurrencyisJapaneseYen.With

the increase in global operations, there will be an

increaseinforeignexchangeriskasTeijinLtd’searnings

willbemoreaffectedbyanymovement intheforeign

exchangemarket.

(TSE:3401)TeijinLimited FY2013 FY2014 FY2015 FY2016 FY2017 FY2018LTMSharePriceJPY 1,090.00 1,270.00 2,375.00 1,685.00 2,161.00 2,401.00NoofShares(mil) 196.6 196.6 196.6 196.7 196.7 196.8MCAP(mil)USD 2,159 2,465 3,817 3,227 3,785 4,191NetDebt(Cash)JPY 242,257 278,593 266,450 231,133 292,128 288,794EnterpriseValue(mil)USD 4,980 5,143 5,740 5,507 5,369 6,552Revenue(mil)JPY 745,713.0 784,425.0 786,171.0 790,748.0 741,291.0 792,896.0EBITDA(mil)JPY 59,235.0 63,742.0 82,116.0 106,024.0 95,843.0 110,305.0EBIT(mil)JPY 12,358.0 18,078.0 39,086.0 67,130.0 56,512.0 67,048.0NPAT(mil)JPY (29,131.0) 8,356.0 (8,086.0) 31,090.0 50,133.0 57,946.0NPAT(Ex.Xtra+Dis.Ops)(mil)JPY 3,839.0 14,202.0 39,226.0 49,587.0 75,082.0 72,920.0CFO(mil)JPY 64,305.0 38,587.0 76,030.0 80,641.0 79,040.0 73,325.0CAPEX(mil)JPY (31,031.0) (30,863.0) (26,528.0) (31,895.0) (37,662.0) (40,859.0)EPSJPY 19.5 72.3 199.5 252.2 381.6 370.6Revenue(mil)USD 7,916.7 7,619.5 6,552.0 7,037.6 6,648.3 7,041.4EBITDA(mil)USD 628.9 619.2 684.4 943.6 859.6 979.6EBIT(mil)USD 131.2 175.6 325.7 597.5 506.8 595.4NPAT(mil)USD (309.3) 81.2 (67.4) 276.7 449.6 514.6CFO(mil)USD 682.7 374.8 633.6 717.7 708.9 651.2CAPEX(mil)USD (329.4) (299.8) (221.1) (283.9) (337.8) (362.9)GPM(%) 25.5% 24.8% 27.6% 32.2% 33.5% 32.8%EBIT(%) 1.7% 2.3% 5.0% 8.5% 7.6% 8.5%NetDebt(Cash)/Equity(%) 89.1% 98.6% 92.5% 76.8% 86.1% 75.2%ROA(%) 1.6% 2.4% 4.7% 8.2% 5.9% 7.0%ROE(%) 4.5% 6.4% 13.6% 22.3% 16.7% 17.5%CFO/TA(%) 8.4% 5.0% 9.2% 9.8% 8.2% 7.7%EV/Sales(x) 0.6 0.7 1.0 0.7 1.0 1.0EV/EBIT(x) 38.6 30.2 19.2 8.6 12.9 11.6EV/EBITDA(x) 8.0 8.6 9.1 5.4 7.6 7.0EV/CFO(x) 7.4 14.1 9.9 7.1 9.2 10.6P/Sales(x) 0.3 0.3 0.6 0.4 0.6 0.6P/EBIT(x) 17.3 13.8 11.9 4.9 7.5 7.0P/B(x) 0.9 1.0 1.7 1.2 1.6 1.5VQ1:EV/EBIT/ROE(x) 8.5 4.7 1.4 0.4 0.8 0.7VQ2:EV/EBIT/ROA(x) 23.8 12.8 4.0 1.1 2.2 1.6

88

11. TokyoElectron(TSE:8035)


QuickStats

Date 15/12/17 EBIT/R&D(x) 2.43

FilingCurrency JPY

EBIT/EmployeeNo.

(USD/px) 170K




DailyValueTraded


GPM(%) 41.4% P/E(x) 15.7

EBIT(%) 22.7% P/B(x) 5.0

NetDebt(Cash)/

Equity(%) -38.6%

VQ1:EV/EBIT/ROE

(x) 0.5

ROA(%) 21.2%

VQ2:EV/EBIT/ROA

(x) 0.7

ROE(%) 30.9%

TeamMembers

Darren Ong is in his second year pursuing a degree in Business

Management at Singapore Management University. As a finance

major, he has done internships with asset management and

proprietary trading firms. He has experiences in the field of Data

Analytics,InvestmentOperationsandInvestmentResearch.

YiChang is inhis secondyearpursuingadegree inAccountancyat

Singapore Management University. With a passion for the capital

markets,hehasdoneinternshipsinfieldsrelatedtoAudit,Corporate

FinanceandMergersandAcquisitions.Heiscurrentlyinterningasa

CorporateRestructuringAnalyst.

JaylenisinhisthirdyearpursuingadegreeinEconomicsatSingapore

ManagementUniversity.Withapassionforfinanceandtechnology,

he has done internships in fields related to Data Analytics,

InvestmentsandInvestmentResearch.Asatechentrepreneur,hehas

goneontowinseveralFinTechcompetitionsaswellasfoundedhis

ownstart-upcompanies.

89

SUMMARY:Tokyo Electron (TSE:8035) is one of theworld-leading

suppliersofsemiconductorproductionequipment(SPE)

which manufactures and sells industrial electronics

products, suchas fabricate integratedcircuits (IC), flat

panel displays (FPD) and photovoltaic cells (PV). The

company sells its products in theUS, Taiwan, Europe,

KoreaandJapan.

InvestmentThesisTokyo Electron, a dominant semiconductor giant with

bestinclassproducts,strongbalancesheetandearnings

potential to ride industry trends and propel itself

towardsanewgrowthera.

Highlights- Strongleadingmarketpositionswithprovenrecords

across business cycles as this enhances pricing

power and creates the foundation for sustainable

goodprofitability,aswellasanattractivepositionin

thevaluechainwithoutbeingdependentonspecific

suppliersorcustomers.

- Continuous innovation and R&D to achieve and

ensure strong market positions, create new

categories of growth and profitability over time;

Longrunwayandaddressablemarkettocompound

growth from solving pressing problems for their

customers.

- - Exposure to service and after-market sales toimprove the understanding of customer needs,

build customer loyalty, and offers attractive

profitability, additional growth opportunities and

increasedproductpenetration;

- Prudent stewardship and allocation of capital;

Strong balance sheet and robust cash flow

generationthatcanbeusedforreinvestmentsinto

the business for example in the R&D and market

expansion,lastlytocaptureattractiveopportunities,

aswellassteadycashdistributiontotheinvestor.

TheSelectionProcessWe employed a 3 stage process at the industry level,

sub-sector level and finally narrowing it down to our

chosenhiddenchampion.

DisruptiveTechnologies

Firstly, at the industry level, the team went on to

researchonkeytrendsthatareoccurringacrossvarious

industries.Wewouldavoidindustriesthatarepresently

facingheadwindsanda lackof futurepotential in the

nearterm.Asaresultofourfindings,wehaveidentified

theriseofFinTechandtheinternetofthings(IoT)aredisruptive technologies thatwill have adrastic impact

across many industries. Disruptive technologies are

expected to change the way traditional industries

operate and change the landscape of how businesses

willbeconducted inthe imminentfuture.Assuch,we

90

narrowed down our industry to the semiconductorsindustry for the main reason being, all these

technologies need chips to function and perform

complextasks.

GoingBacktoTheSource

Oncewehadidentifiedthesemiconductorsindustry,we

proceeded to narrow it down at the sub-sector level.

Interconnectivity have been on a rise in tandemwith

internetadoptionratesacrossdevelopedandemerging

economies.Asmentioned,alloftheserequirespowerful

chips for them to work. Chips can be found almost

everywhere in our everyday lives (PCs, smartphones,

TVs etc.). Hence, the team decided to focus on

semiconductors equipment (SPE)manufacturerswhoprovide tools and machines to create these powerful

chipsbychipmakerssuchasSamsung,Inteletc.

OurHiddenChampionIn our stock screening process,we assessed each SPE

manufacturer’s earnings potential, scalability of their

business, historical track record and management’s

ability.Thesewillbeelaboratedindetaillateroninthe

report. Finally the teamchoseTokyoElectronLimited(TSE.8035)asourhiddenchampion.Thecompany isa

debt-less SPE giant and global player in providingsemiconductortoolsandequipment.Inthepast,theSPE

industry was highly cyclical, however, the range of

applications where semiconductors and chips can be

usedhaveexpandeddrasticallywhichhavelessenedthecyclicalityoftheindustry.Assuch,theteamisconfident

that our pick – Tokyo Electron iswell positioned now

withtheperfecttimingtoenterastageofnewgrowth

where disruptive technologies are set to change the

traditional landscape of multiple industries in which

they operate to yield higher profits and achieve

operationalefficiency.

Introduction–EnteringIndustry4.0

AsweenterIndustry4.0,wheretheconceptofInternet

ofThingsstartstoemerge,manyopportunitieslieahead

for companies in the manufacturing industry.

Automationisstartingtotakeovermanuallabour,self-

learningrobotsarebeinginventedtoincreaseefficiency

and high speed 5G data networks are being

implementedtoenable fastdata transfer.Withsilicon

waferchipsembeddedinalmostallelectronicaldevices,

from memory chips to CPUs in smartphones to

computers,thesemiconductorindustryisdefinitelythe

industry that will experience a boom in business

activities.

SemiconductorIndustryOverview

With the advent of the Internet of Things, many

governments of the world are increasing their

investment in IoT services and digitalisation. For

example, the Thailand government is implementing

Thailand4.0,anation-widedigitalisationplan.TheLow

PowerWideAreaNetwork (LoRaWAN),whichenables

long-rangecommunicationswithlittlepower,arebeing

implementedincountriesallaroundtheworld,turning

cities into smart cities. Smaller, faster and cheaper

semiconductors are also in demand to meet the

upcomingIoTsolutionsandinfrastructuredevelopment

aswellasindemandbybusinessesthatareconstantly

developingnewelectronicaldevices.

Therefore, the governments’ initiatives to be in sync

with the Internet of Things trend and the increased

business applications drive the demand of

semiconductors, causing the industry toboom.Within

the semiconductor industry, there are two important

players, mainly the Semiconductor Equipment (SPE)

Provider, whom produces equipment to manufacture

silicon wafer chips and the semiconductor

manufacturers (SM), whom produces silicon wafer

chips.

WoesofSemiconductorManufacturers

SM companies have the need for high capital

expenditure to upgrade its semiconductor production

equipment, meet ever-changing specification of

electronic products as well as juggle with pricing

pressures. SM have to constantly invest in new

semiconductor equipment that are able to produce

newer semiconductors that are smaller and faster to

meet end consumers’ demand. In addition, electronic

products’ specifications are constantly changing, with

consumers looking out for smaller and faster devices,

whichSMcompanieshavetokeepupwithinorderto

stay competitive. Lastly, although tech products are

constantly being improved with higher specifications,

thepricesofnewdevicesaregettingcheaper,causing

SMtofacepricingpressures.

SemiconductorProductionEquipmentProvider– TheDirectorBehindtheScenes3DNAND

91

PE companies also foresaw the demand of higher

performancesemiconductorfromthetrendof IoTand

the issues SM companies face, which led them to

investing heavily in R&D to create better SPE. For

example, the industry is moving from regular straight

lineetchingto3DNANDstacking,anewtypeofmethod

inthesemiconproductionprocess,whichincreasesthe

processingpowerofthesemicon.

RecurringRevenueStreams

SPEsuppliersarealsolessexposedtopricepressuresasshownfromtheirprofitmargins,ontopofthat,theyare

able toobtain recurring revenue from thewater fab’s

constant need to upgrade wafer capacity and

technologyandafter-salesservice.

HighBarriersofEntry

TheSPEindustryhasalsohighbarriersofentry,asSPE

companies must possess technical know-hows and

specialised manufacturing tools, allowing the current

playersintheindustrytothrive.

LowCyclicality

Lastly, the SPE producing business is less cyclical

comparedtointhepast,whichiswhollydependenton

PC and the smartphone industry. Presently, SM

companies are moving towards cloud computing and

data centres, which creates new revenue streams for

SPEcompanies.TheHealthcare,Automotive,Oil&Gas

and even Augmented Reality industry is currently

openedforSPEcompaniestotapon,thus,reducingthe

cyclicality of the business. The market value of data

centers and cloud market are projected to grow

significantly by 14.9% and 15.4% CAGR respectively,

provingthattheSPEindustryisveryprofitable.

InvestmentCase:Thus,wefeelthatthecurrentmarketisdiscountingand

mispricingcompaniesintheSPEindustryastheymight

not recognise the potential profit generating

opportunitiesandstructuralshiftsofcompaniesmoving

towards industry 4.0, which pose as a good investing

opportunityforinvestorscomparedtoSMcompanies.

TokyoElectronIndustryResearch

GlobalSemiconductorIndustry

In2016,theglobalsemiconductorsmarketgrew3%to

reachavalueofUS$387.6billionfromUS$376.4billion

inthepreviousyear.Thisrepresentsa5.3%CAGRfrom

2012through2016.TheAsiaPacificregionisthelargest

market for semiconductors manufacturing accounting

for72.4%oftheglobalmarketvalueatUS$280.7billion

andfollowedbytheUnitedStateswhichmakesup12.8%

ofthepieatUS$49.4billion.Europeandtherestofthe

world accounts for 8.7% (US$33.6 billion) and 6.1%

(US$23.9billion)oftheglobalmarketvaluerespectively.

Theindustrysawastabilizationofgrowthin2016after

aglobalslowdownin2014and2015duetoaslowdown

inthePCandsmartphonemarketsaswellasanindustry

wide consolidation. During this time, many

semiconductor companies underwent restructuring to

refocus their portfolios on core and innovative

technologies (Tanner, 2017). At the same time,

semiconductorcompaniesalsosoldawaytheirnon-core

92

businesswhich are dragging down the overall bottom

lineresultinginmassivejobcuts.

GlobalSemiconductorOutlook

Growth is expected to accelerate from 2017 onwards

fuelledby the increasinguseof semiconductors in the

InternetofThings(IoT)andintheautomotiveindustry

of autonomous cars which will offset the declining

demand for PCs. The global semiconductor industry is

expected to grow at a stable rate of 5% CAGR in the

periodof2016–2021toreachatotalmarketvalueof

US$495.2 billion. This represents a 22.2% growth in

marketvaluefromUS$405.4billionbyend2017.

APACSemiconductorIndustry

Theindustrybegantogarnerstrengthandacceleratein

2016fromthepreviousyearduetotheglobalslowdown

inthePCandsmartphonesmarketthatcauseddemand

toshrink.TheAPACsemiconductorsmarketrecordeda

total revenue of US$280.7 billion in 2016 which

representeda6%CAGRsince2012.Chinaaccountsfor

40.5% of the APAC semiconductors market value at

US$113.6 billion, followed by South Korea at 10.3%

(US$28.9billion)andJapanat9.9%(US$27.9billion).On

theotherhand,IndiaandtherestofAPACaccountsfor

theremaining39.3%(US$110.2billion)oftheindustry.

In APAC, themarket is heavily concentrated in China,

Taiwan,SouthKoreaandJapan.Chinaisexpectedtobe

thenewdrivingforcetodriveglobalgrowthinthenext

fewyears tobethe leadingsemiconductorcountry. In

2016alone,theChinesemarketrecordedrobustgrowth

of9.3%CAGRinmarketvaluetoreachUS$113.6billon

(Marketline,2017).Themarket inAPACisexpectedto

continue growing at a stable rate of 5.3% CAGR from

2016to2021.Thisrepresentsatotalgrowthof29.6%in

marketvaluetoUS$363.7fromUS$280.7billioninthe

projected 5 years which are primarily driven by

innovationsintechnologyandthedemandfromChina.

JapaneseSemiconductorIndustryAlthoughtheJapaneseSemiconductorsindustrystarted

toshowsignsofgrowthafterasharpcontractionin2015,

thegainswerenotenoughtooffsetlossesfromprevious

years.In2016,theJapanesesemiconductorsmarkethad

total revenues of US$27.9 billion which was a 2.2%

increasefrom2015.Thisrepresenteda-3%CAGRover

theperiodfrom2012to2016.Thedeclinewasprimarily

duetointensecompetitioninDRAM(DynamicRandom-

Access Memory) from big manufacturing players in

South Korea and Taiwan in electronics. The computer

boominthe2000splacedtheUnitedStatespositioned

Inteltobecomethemarketleaderinthesemiconductor

spacewithitsmicroprocessors.Furthermore,from2000

to2014,theindustryvaluechainshiftedtowardsfabless

companies like Qualcomm started to dominate the

market. This affected Japan’s IDM (integrated device

manufacturers)whichhadtraditionallyhandledallchip

makingprocesses.Theoutlookfortheindustryremains

bleakasitisexpectedtocontractatarateof2.7%CAGR

toreachatotalmarketvalueofUS$22.4billionby2021

from US$27.9 billion in 2016. This represents an

expected decline of 12.5% in the next 5 years. In

comparison, the Taiwanese and Chinese markets will

continue to post stable growth at 4.1% CAGR and 6%

CAGR respectively over the next 5 years. The total

marketvaluefortheTaiwanesesemiconductorsmarket

willreachUS$67.3billionandChinawillrecordatotalof

US$152.4 billion by 2021.

GlobalSemiconductorEquipmentIndustryThe global semiconductor equipment market is

expectedtogrow66.5%toUS$64billionby2019from

US$38.4billion in2014.Thisrepresentsa10.7%CAGR

over the period. Global sales of new semiconductor

equipmentareforecastedtogrowby19.8%toatotalof

US$49.4billionbytheendof2017(SEMI,2017).A7.7%

growth is expected for 2018 to reach a new high of

US$53.2billionfortheglobalsemiconductorequipment

market.

Inthewaferprocessingequipmentsegment,growthis

estimatedtoriseby21.7%toUS$39.8billionbytheend

of 2017. On the other end, fab facilities equipment,

wafermanufacturing andmask/reticle equipment will

growby25.6%toUS$2.3billion(Shen,2017).Despite,a

contracting semiconductors industry in Japan, the

country remains one of the leading suppliers of

semiconductor equipment and material globally. The

Japanese supplies over 50% of materials and around

35%ofnewequipmentusedworldwide(Tanner,2015).

Thesemiconductorequipmentindustryisdominatedby

several big players globally. Japan’s Tokyo Electron

Limited is the industry leaderwith the largestmarket

shareat18.5%,followedbyNetherlands’sASMLHolding

N.V.at17.1%,UnitedStates’AppliedMaterialsInc.and

LAM Research Corporation at 16.0% and 13.2%

respectively.

Bytheendof2017,SouthKoreawillbecomethelargest

market for semiconductors equipmentmanufacturers,

followedbyTaiwanandChina.SEMIalsoindicatedthat

while most regions will experience growth, Southeast

Asia will be the exception. South Korea will lead the

industry with a growth of 68.7%, followed by Europe

with58.6%andNorthAmericaat16.3% (SEMI,2017).

Equipmentsalesareforecastedtoacceleratethemost

inChinawithagrowthof61.4%reachingatotalvalueof

US$11billionby2018.SouthKorea,TaiwanandChina

will remain the top 3 markets globally for

semiconductorsequipmentsales

93

IndustryCatalyst

StrongDemandfromChina

Chinawillcontinuetobethemajordriverofgrowthfor

themarket.Consumerdemandforproductscontaining

semiconductorsproductsarelargelyresponsibleforthe

increase. This is further supported by the Chinese

government’s efforts to reduce reliance on foreign

technology and create domestic replacements

(Marketline, 2017). Most leading semiconductors

companies have been directly involved in the

development of the Chinese semiconductors. The

Chinese market is especially flourishing due to an

increasingdemand for sophisticated technologywhich

requires high levels of computing power (Marketline,

2017).Thus,demandforsemiconductorsspecialtyand

servicesareexpectedtoriseasChinaseekstoincrease

capitalexpendituresintheindustrytoproduceitsown

modernelectronicproductsandwaferfabricationplants

in the coming quarters .

InternetofThings

TheInternetofThings(IoT)referstotheconnectionof

devices other than the typical computer and

smartphonestotheInternet(Meola,2016).By2020,the

number of IoT devices connected to the Internet will

growmorethan3-foldfrom10billionto34billion.Of

this amount, only 30.4% will comprise of traditional

computing devices such as smartphones and tablets

while 70.6% will comprise of new and upcoming IoT

devices.IoTwillbecomeatrillion-dollarindustrywhich

US$6 trillion is expected to be spent on IoT solutions

overthenext5years(Meola,2016).Astheindustryof

IoT is set to explode within the upcoming years,

businesseswillbe the topadoptersof IoT solutions in

whichtheywillemploy in3areas:raisingproductivity,

lowering operating expenses and expansion towards

newmarketsordevelopingnewproducts.Ontheother

hand,governmentsaroundtheworldwillbethesecond

largest adopters primarily focused on increasing

productivity,reducingcostsandraisingthequalityoflife

for citizens. Lastly, consumers are expected to lag

behindbusinessesandgovernments inadoptionrates,

however,theyareexpectedtocatchupandpurchasea

largenumberofdevicesaswellasinvestsignificantlyin

IoT ecosystems.With the rise in IoT, this serves as a

catalyst igniting growth for the global semiconductors

industry. Semiconductors are the fundamental

technologywhichenablestheuseofmoderntechnology

possibleincludingIoT.

94

NatureofIoTdevices

All IoT devices requires semiconductors such as

transistors, microcontrollers, sensors, and memory to

connect to each other for them to perform their

functions(SemiconductorIndustryAssociation,n.d.).As

such, semiconductors create an infrastructure that

enables connectivity to all these devices. This would

drive innovation in the semiconductors industry as

manufacturers compete to come up with higher

performing and efficient semiconductors to meet

variousneedsofconsumersinmanyinfdustries.Hence,

the rise in IoT serves as a driving force for the

semiconductors industry fuelling demand for

semiconductors that can aid In the development of

sensorsthatcaninstantlyanalysedata.

AutomotiveIndustry&SmartMobility

Driving growth for the global semiconductor industry

will come from automotive as more cars and light

vehicles are being produced in emerging economies

than in developed markets (PwC, 2017). The BRIC

nations(Brazil,Russia,IndiaandChina)willremainthe

most important growth driver for demand in the

automotiveindustryrepresentinga5-yearCAGRof9.4%

from2012–2017.Theuseofelectronicsinautomobiles

will be the single largest driver of change in both the

automotive and semiconductors industry.

Semiconductorcontentpercarisexpectedtogrowfrom

US$315 in 2012 to US$385 by the end of 2017 (PwC,

2017) and trends have revealed that innovation in

automotive are in electronics rather thanmechanical.

These innovations are being introduced into cars at a

fast rate as costs continue to decrease as continued

innovationincreasesandbyintegratingitwiththeIoT,

auto makers seek to achieve “smart mobility”. To

achievesmartmobility,automakersarerequiredtouse

evermore sophisticated semiconductors tobeable to

establish connectivitybetweenvehicles and the smart

devices inwhich theyoperate. These “smart vehicles”

have to be able recognise traffic, manage safety and

perform many other functions better than a human

driver.

GlobalFlatPanelDisplayIndustry

Theglobalflatpaneldisplay(FPD)industryisprojected

toreachamarketvalueofUS$110billionbyendof2017.

This represents a year-on-year growth of 9.3% (IHS

Markit, 2016). This demand is fuelled by a booming

consumerelectronicsmarketforsmartdevicesandflat

screenmonitors. This growthalso spursademand for

Human Machine Interface (HMI) technology in the

automotiveindustrywhichisexpectedtodrivefurther

demandforflatpaneldisplays.TheFPDindustryismost

concentrated within the APAC region and emerging

Asian economies where many consumer electronics

manufacturers can be found. Liquid crystal displays

(LCD) segment will remain the most dominant in the

industrywithsalesexpectedtoexceedUS$116million

by 2020 and accounts formore than75%of the total

market (Persistence Market Research, 2017).

Furthermore,FPDhavefoundotherusesinthemedical

field, advertising and education etc. These will all be

futuregrowthdriversfortheindustryandpotentialfor

theFPDmarkettoexpand.TheAPAC(includingJapan)

regionisthemostdominantintheglobalFPDindustry

andisprojectedtoachieveatotalmarketshareof85%

by2020(PersistenceMarketResearch).InAPAC,China

is expected to lead the industry as it is a top

manufacturer of consumer electronics (mostly where

FPDsareused).Ontheotherhand,Japanisthesecond

largestFPDmarketandwillbeexpectedtogrowat1.2%

95

CAGR over the period of 2015 – 2020 (Persistence

MarketResearch,2017).

GlobalFlatPanelEquipmentIndustry

TheglobalFPDequipmentmarketisexpectedtoachieve

over US$13 billion by 2021 fuelled by the growing

demand for high performance displays (Technavio,

2016).Ascustomersareincreasinglydemandinghigher

display resolution, it has become one of their key

considerationfactorsduringtheirpurchaseofelectronic

goods.TheAPACregionhas thehighestconcentration

ofdisplaydevice,LCDandorganic light-emittingdiode

(OLED)panelmanufacturersglobally.Inaddition,major

consumerelectronicgiantssuchasSamsung,Sonyand

ApplewhohastheiroperationsinSouthKorea,Taiwan,

Japan and China will help propel growth for the FPD

equipmentmarket for the region. Industry trends are

showing that there is an increasing adoption and

demand for consumer electronics with active-matrix

organic light-emitting diode (AMOLED). The AMOLED

segment is expected to become one of the biggest

segments intheindustryasdecreasingdemandofPCs

will reduce the demand for LCD monitors. Hence,

AMOLEDs are expected tobe fuel growth for the FPD

equipmentmarketoverthenextfewyearsaswellasa

rising demand for high resolution and rich quality

displaysforLCDTVs(Technavio,2016).rep

CyclicalIllsofSPEIndustryThesemiconductorequipmentindustryischaracterised

ashighlycyclicaldueasitsresultsaredependentonthe

primaryendmarket–chipsector.Thechipsectorisin

turn influenced by chip companies based on their

projections for future demands. If companies expect

higher demand they will order more equipment.

Traditionally, demand tracks end-market consumer

electronics (PCs, Smartphones etc.) Now,

semiconductors are demanded in other fast-growing

areas. Currently, the market has been discounting

semiconductorscompaniesastheybelievedtheirprofits

areexpectedtodeclineduetothecyclicalitynatureof

theindustry.Assuch,theteamfeelsthatcompaniesin

this spacearepresentlyundervaluedas themarket is

ignoring structural shifts (IoT, AI and autonomous

driving) and expansion of various semiconductors

applications that will drive profit growth via higher

demand and lesser cyclicality going forward (Trainer,

2017).

BeyondPCsandSmartphones:Thedataservicesmarket

is booming. The PC and smartphones markets have

witnessedaslowdownindemandinrecentyears.This

haveledtoanindustryshifttowardshighgrowthareas

suchasdatacentres(Tanner,2016).Thedatacentreisa

large group of networked computer services typically

usedbyorganisationsforremotestorage,processingor

distributingcopiousamountsofdata.Acorporationwill

alwaysattempttooptimisecosttodeliverahigherprofit.

Hence,datastorageandcomputationalcapacityshould

beminimisedtoalevelthatisabletosupportabusiness

moreefficiently.Thedemandformoredatastorage is

also rising in tandem with a rapidly increasing data

traffic.Allofwhichrequires leadingcutting-edgetools

and advanced semiconductors equipment to make

complex semiconductors and chips.

Source:GrandViewResearch

Theglobaldata centre servicesmarket isprojected to

reach US$17.3 billion by 2025 from US$5.1 billion in

2016. This represents a robust growthof 14.9%CAGR

over the forecast period.

Over the same forecasted period, the APAC region is

expected to enjoy the fastest growth at 18.4% CAGR.

Thetotalmarketvaluefordatacentreservicesmarket

inAPACisexpectedtoreachUS$4.2billionby2025from

US$0.9 billion in 2016. Important Trends for the

Intermediate Term: Continuing shift towards larger

wafers (larger wafers lower manufacturing costs),

Development of smaller geometry chip design (allows

more transistors in each integrated circuit for high

performance), Transition from aluminium to copper

interconnections (copper yields better device

performanceduetohighelectricalconductivity).

The cloud managed services market recorded a total

valueofUS$23.2billionin2016andisprojectedtoreach

96

US$82.3billionby2025.Thisrepresentsarobustgrowth

of 15.4% CAGR over the forecast period. The rising

adoptionofcloudservicesgloballybysmallandmedium

enterpriseswillbeattributabletobenefitssuchascost

reductionandhigherITfunctionalityoverall.

Over the same period, the North American region is

expected to record a total value ofUS$22.5 billion by

2025.Thisisagrowthof12.5%CAGRfrom2016where

themarketisvaluedatUS$8billion.TheAPACregionis

projectedtobethefastestgrowingmarketby2025.Itis

estimatedthatAPACwillseegrowthof19.9%CAGRover

the forecast period to reach a total value of US20.8

billion. This growth is driven by investmentsmade by

techgiantssuchasIBMandGoogleintheAsianmarket

aswell as governmentpoliciesare contributing to the

riseincloudadoption.

ExpansionofApplications

Asmentioned,theprimarycauseofthecyclicalillsinthe

semiconductor equipment industry was due to the

dependenceofdemandfromconsumersforelectronics

devices.However, this cyclicality has been reduced as

the number of applications for semiconductors have

increased.

In the coming future, semiconductorswill find itsway

into various industries and uses. Some of these will

include:- AutonomousVehicles- ArtificialIntelligenceandAugmentedReality- CloudComputing- IoT (5G, small cells, Software Defined Network,

NetworkFunctionVisualisation)- E-payment Systems (Visa Paywave, Apple Pay,

AndroidPayetc.)- Drones(Military,mediaandproductionuses)- Fintech- OilandGas(Tolowercoststhroughefficiency)- Healthcare (Rising interconnectivity of medical

devices)Source:BMIResearch

Assuch,thelandscapeforsemiconductorsapplications

havechangeddrasticallyandno longeraredependent

on the electronics industry, PC and smartphones

marketstodrivetheirtopline.Moreandmoreusesof

semiconductorsarerisingduetoIoTtrendsanddemand

forevermoresophisticatedsemiconductorstoperform

various functions for different uses would require

semiconductorequipmenttoolstocreatethem.

Hence, the team concludes that semiconductors

equipment companies can be expected to ride on an

upcyclecausedbystructuralshiftsthathavestartedto

disruptmany industriestoday.Asaresult,wefeel the

market is presently discounting semiconductor

equipment companies due to their cyclical nature.

However, as we can see from present trends and

structural shifts in the industry, companies with

capabilities to meet end market demands for high

performancechipsandsemiconductorswillbeable to

successfullyenteranewgrowthera.

97

TheWaferMakingProcessHere are 7 key steps in the chip making process to

manufacture semiconductors. Eachof theseprocesses

requiressemiconductorequipmenttoperform.

Step1:NitrideFilmDepositionFirstly,aplainwaferwillbeplacedinahotfurnaceunder

watertogothroughtheprocessofoxidation.Thisforces

thevapour(oxygen)todiffuseintothewatersurfaceat

high temperatures (800 and 1200°C) to create a

protectivelayerofsilicondioxide.Thislayerprotectsthe

waferfromcontaminantsthatcandamageitselectrical

properties.

Step 2: Imprinting Circuit Patterns (PhotoresistCoating)Thenextstepofcreatingawafer fab is imprintingthe

circuit pattern on the protected wafer. This process

allows numerous densely packed electronic

components such as transistors, diodes, resistors and

capacitorstobefixedonthewaferfabitselfwhichare

crucialastheyprocessandstoreelectricsignals.Inthis

processtherearevarioussubprocessesfromcoatingto

cleaning.

FunctionsofEach:§ Transistors:Actsasapowerswitch

§ Capacitors:Storeelectricenergy

§ Resistors: Control current flow to other

components

§ Diodes:Managedirectionofcurrentflow

PhotoresistCoating(Photolithography)This process allows electronic circuit patterns to be

printedontothewaferviathephotolithography.Think

of the process as printing a picture (circuit patterns/

design)ontoapieceofpaper(wafer).

ExposureandDevelopment:Thewafer isnowcoatedwith theadditivephotoresist

(PR)whichishighlysensitivetolight.PRcanbepositive

ornegative.WhenthewaferisexposedtoUVlight,the

positive PR will be removed while negative PR stays

leavingthewaferwiththedesiredcircuitpatterns.

Step3:EtchingAfter the wafer is imprinted with the desired circuit

design,itnowhastogothroughtheetchingprocessto

have unnecessarymaterials removed so that only the

patterns remain on the exterior. In art, etching is a

processwhere lines are carved (etched) onto ametal

plate and dipped into an anti-corrosive material

(etchants).

Intheetchingprocessofsemiconductors,aliquid(wet)

or gas (dry) etchants areused to removeunnecessary

parts.Similarly to the process used in art, an anti-corrosive

layeriscoatedonthewafer.Thentheetchantsremove

the undesired portion of the wafer while the circuit

patternsarecoatedwithananti-corrosivelayerformed

during the photo process remains. The portion

protected by the PR remains intact while the rest is

etchedawaytopreservethepatternstructureunderthe

resist.

DryEtchingThis process uses plasma or etchant gases to remove

undesiredmaterialsthroughionisation.

WetEtchingThisprocessusesliquidchemicalstoremovematerials

fromthewafer.

DryVSWetAlthough dry etching is more costly and complicated,

withconstantinnovationinsemiconductortechnology,

thisprocessiswidelyusedasitprovidesahigheryield.

98

Step4:ThinFilm(Deposition)ProcessThisistheprocesswherethewafergetsappliedwitha

very thin film of material (few nanometres to 100

micrometres) with electrical properties. The cross

sectionofasemiconductorchipisconstructedbypiling

layersandlayersofmaterialstogetherlikeaskyscraper.

This is done by repeating the photolithography and

etchingprocessafewhundredtimesover.Theprocess

is important as contaminants on thewafer will affect

performanceandelectricalconductivity.

In order for the semiconductors to get its electricalproperties, it has to go through the thin film

process.Materials at the atomic level with electrical

propertiesaredeposited asa thin layeron thewafer.Thislayerswouldeventuallyallowelectricalconnections

between circuits and dielectric (insulating) layers

protect the wafers from contaminants. For the

semiconductors to be able to conduct electricity, ions

are implanted onto the layers.

Step5:MetalContactFormationInthisprocess, itensuresthattheelectricalproperties

are well-connected and “powered” so that electrical

signalsareabletopassthroughthewafersuccessfully.

Thinkofitasbuildingapoweroutletinforelectricityto

pass through to “power” the wafer. This is achieved

throughthemetalinterconnectprocess.

Interconnectsserveasthestreetsandhighwaysofthe

integratedcircuit(IC),connectingelementsoftheICinto

afunctioningwholeandtotheoutsideworld.Themetal

interconnect process creates metal circuits along the

circuitpatternsalreadyprintedonthewafer.Metalfilms

arefilledintothetrenchandexcessmetalsarepolished.

Copperisthemorepreferredmetalfortheprocessdue

to its cost effectiveness and better conductivity

properties.

Step6:ProveTestingThe semiconductor chips will then be subjected to

several tests before it is shipped to customers. These

testsincludeelectricaldiesorting(EDS),packagingtest

andafinalqualitytest.TheEDStestverifiesthateach

chipthatleavesthefacilitymeetsthestandardsofthe

manufacturer.

EDS uses electrical testing to check if chips meet the

processing centre’s required quality level. Things that

are typically checked are semiconductor elements

(transistors, diodes etc.) for their functionality.

Functionalor repairablechipswill continueprocessing

while defective chips are marked with ink dots.

Defectivechipswillbediscarded.

5StagesofEDS:

- Testingofelectricalproperties

- Useofelectricalsignalstoidentifydiscrepancies

- Using laser to repair discrepancies identified

earlier

- Laminating to protect wafer from dust and

particles

- Inkingtodistinguishdefectivechipseasily

Step7:PackagingandPackageTestingThe last process involves enclosing the integrated

circuitsinaformfactorthatcanfitintoaspecificdevice.

99

Usingadiamondcutter,thesemiconductorswillbecut

intoaformthatfitsintothedevicesocalled“packaging”thewaferintothedesiredshapeanddesign.Finally,the

packagedsemiconductorisputintoadevicetobetested

fortheirperformanceandfunctions.

BusinessdescriptionTokyo Electron Limited (Tokyo Electron or "the

company") is engaged in themanufacture and sale of

semiconductorproductionand flatpaneldisplay (FPD)

productionequipment.Thecompanyprimarilyoperates

in Taiwan, Korea, Japan, the US, and Europe. The

company operates through three business segments:

semiconductorproductionequipment(94%),flatpanel

display production equipment (6%), and other. After

servicesalesandmaintenancemakeup26%ofoverall

netsaleswhichmakesupaslight increaseof5%from

the previous year. This is a result of Tokyo Electron

focusingmoreCRMservicesaswellasamoremodular

approach towards selling theirmachines.After service

salesandmaintenancemakesupasignificantportionof

TokyoElectron’soverallnetsalesanditisimportantas

these is a source of stable recurring revenue for the

company.Products&services

TokyoElectron’sSPEsegmentsprovidesequipmentfor

manufacturing semiconductor devices used in mobile

devices, such as smartphones and tablets. The

company’sproductportfolioincludescoater/developers,

plasmaetchsystems,thermalprocessingsystems,single

waferdepositionsystemsandcleaningsystemsusedin

wafer processing. In addition, the company provides

wafer probers used in the wafer testing process,

electrochemical deposition systems and wafer

bonders/debonders used in advanced packaging

processes. The company’s FPD segment offers

coater/developersandplasmaetch/ashsystemsusedin

themanufactureof FPDs. The segment’s offerings are

usedinvariousproducts,rangingfromtelevisions(TVs)

andmobiledevices,includingsmartphonesandtablets

to digital signage for advertising. The segment also

offers inkjetprintingsystemformanufacturingorganic

light-emitting diode (OLED) panels using large-sized

substrates. The company’s other segment includes

includephotovoltaicpanelproductionequipmentused

in the manufacture of thin-film silicon photovoltaic

panels,aswellasgroup-wide logistics services, facility

maintenanceandinsurance.

MarketPositioning

Strong leading market positions with proven records

across business cycles as this enhances pricing power

and creates the foundation for sustainable good

profitability,aswellasanattractivepositioninthevalue

chainwithoutbeingdependentonspecificsuppliersor

customers.Exposuretoserviceandafter-marketsalesto

improve the understanding of customer needs, build

customer loyalty, and offers attractive profitability,

additionalgrowthopportunitiesandincreasedproduct

penetration.

ModularUpgrades

Themanagement is shifting Tokyo electron’s business

model from the sale of heavy machinery to that of

modular part upgrades. This move will allow the

company to keep its customer base and increase

customerstickinessasitwillallowbothTokyoElectron

and itscustomers tocutcost.Theequipmentthat the

companyproducesisalsopartofthewaferfabprocess

which goes into all IoT technologies. Since Tokyo

Electron is APAC focus, the strong customer base

capturedovertheyears,dueto firstmoveradvantage

thatthecompanyhaswillallow it tostaydominant in

theSPEindustry.Shiftingthebusinessmodeltothatof

amodularapproachwillalsohelptoretaincustomersas

it increases theswitchingcost for itscustomersat the

sametimedecreasingthedevelopmentcost forTokyo

Electronaswellnewequipmentcostforitsconsumers.

DominantPositionintheAsiaPacificTokyoElectronwasincorporatedin1963,beingoneof

thefirstsemiconductorequipmentsuppliersintheAPAC

region.Duetoitsfirstmoveradvantage,TokyoElectron

100

has amassed awealth of key institutional clients over

the last five decades. Semiconductor manufacturing

equipmentprovidedbyTokyoElectronrunsintheblood

ofhugeclients likeSamsung, LG,PanasonicandTexas

Instruments and has been instrumental in their

development over the years. As the number of

customersofTokyoElectronsgrew,sodidthedemand

fortheirproductsformorecomplexSPEequipmentto

cater to the ever-changing requirements of consumer

electronics. This network effect contributed to Tokyo

Electronsgrowthof its complexarsenalofproprietary

productionequipment,whichposesashugebarriersto

entry for new incumbents trying to enter the SPE

industry.

Withitssuperiormanufacturingproductsinfourcrucial

semiconductor production processes mainly wafer

washing, photo-resistive coating, etching as well as

contact probing, Tokyo Electron managed to secure

dominantmarketsharesintheseprocessesandwiththe

backing of mammoth clients, became a global

powerhouse. Going forward, Tokyo Electron will

continuetofocusitseffortsontheAPACregionasthey

currently have a loyal installed based which can be

extractmorevaluefrom.

ShareholderStructureOut of its total outstanding shares listed, 53.22% is

ownedbyFinancialInstitutionsand42.01%bythepublic.

TopHoldersofitspublicsharesincludes:NomuraAsset

Management (8.2%), Mitsubishi UFG Kokusai Asset

Management – 6.93% and Asset Management One –

5.58%.

PrivateOwners

TEL isalsoownedbyavarietyofbigprivate investors,

with notable institutions from Tokyo Broadcasting

System Holdings, Mizuho Asset Management, The

MasterTrustBankofJapan,Ltd,FILInvestments(Japan)

Limited,MitsubishiUFJKokusaiAssetManagementCo.,

Ltd,JapanTrusteeServicesBankLtd,BNYMellonaswell

asStateStreetBankandTrustCompany.

OwnershipStructure&Analysis

Fromthewiderangeofprivateandpublic investors, it

shows that investors are confident in TEL producing

positivereturnsontheirinvestments.Thiscanbeseen

from the heavy investments made into TEL by big

financial institutions such as Nomura Asset

Management.

CorporateGovernanceTokyoElectron’sBoardofDirectorsiscomposedofthree

types of directors, namely outside directors, non-

executivedirectorsandexecutivedirectors.Inaddition,

TokyoElectronhasanAudit&SupervisoryBoard,which

auditstheappropriatenessandfairnessoftheexecutive

directors’ decision-making processes and business

execution,aswellastheauditingmethodsandresultsof

the independent auditors. The Audit & Supervisory

Boardcurrentlyhas fivemembers, threeofwhomare

outside members. The composition of the Board of

Directors enables aggressive management – allowing

appropriate risk taking in order to increase corporate

value – as well as effective defensive governance by

monitoringtherisksbeingtaken.

101

ManagementAnalysis

ManagementAnalysisTokyo Electron possesses strong management with

manyyearsofexperienceinthecompany,thusknowing

whatworksandwhatdoesnotworkforthecompany.

InvestmentsandR&Darecarefullythoughtoutusingthe

experience the management have gained throughout

theyears theyhavebeenwith thecompanyandhave

generatedpositivereturns.

ProvenTrackRecord

Also, since the inception of their current positions in

2014, the 3 C-suites officers have stewarding the

companytogreaterheights,bringingtherevenueofthe

company from ¥612 billion in 2014 to ¥799 billion in

2017atacompoundedCAGRof6.97%.

SupportingMetrics

Using theTotalRevenue/Totalno.ofEmployeematric

as a gauge of management performance, we can see

that the number of revenue generated per employee

has increased throughout the years by 30%, from

¥49,754/employee in 2014 to ¥71,143/ employee in

FY2017, highlighting the effectivemanagement of the

trioandtheboardofTokyoElectron.

NotStuckbyStickyCostsTodetermine if the company still has thepotential to

scale, the team looked at 2metrics tomeasure sticky

costs.Fromour findings,wediscoveredthatSGA%of

Saleshavebeendecliningyear-on-yearasthecompany

recorded higher sales each year. The ratio fell from

29.4% in 2013 to 20.8% in 2017 as the company

recorded an increase of JPY302,420 million over the

same period. Similarly, over the same period, this

downwardtrendcanbeobservedwiththeSGA%Total

Assetsratio.Wecanseethatdespiterisingassetvalues,

SGAexpensesaregenerallydeclining.In2013,theratio

was18.85%andfellto17.40%in2017.Hence,theteam

can conclude that the Tokyo Electron can continuescaling and overcome sticky variable overheads to

expand their business as SGA expense have

demonstratedadownward trendwith rising salesand

assetvalues.andassetvalues.

StrongCorporateCultureandGuidingPrinciplesTEL’smanagementalsosetoutasetofstrong

corporateprinciples,whereemployeesandthe

companywillhavetoadhereto,arelaidoutasa

pyramidbelow:

CorporatePhilosophy–TELstrivestocontributetothe

developmentofadream-inspiringsocietythrough

leading-edgetechnologiesandreliableserviceand

support.

StrongCorporateCulturethroughManagementPolicies

1. ProfitisEssential–TELaimstocontributetothe

developmentofsocietyandindustryaswellas

itscorporatevaluewhilepursingprofit

2. ScopeofBusiness–TELwantstoleadmarkets

by providing high-quality products in leading

edgetechnologyfields,focusingonelectronics

3. GrowthPhilosophy–TELwillcontinuetotakeon challenges of technological innovation to

achieve continuous growth through business

expansionandmarketcreation

4. QualityandService–TELstrivestounderstandneedsof customers andgain consumers’ trust

whileimprovingqualityandservice

5. Employees – TEL employees create and fulfil

company values, performing work with

creativity and sense of responsibility and a

commitmenttoteamwork

6. Organisation–TELwillbeanorganisationthatmaximizescorporatevaluewhereallemployee

canrealizetheirfullpotential

7. Safety,HealthandtheEnvironment–TELgivesthehighestconsiderationtosafetyandhealthof

everystakeholder,beitinternalorexternal

8. Social Responsibility – TEL strive to gainsociety’ssupportbyadoptingastrongcorporate

socialresponsibilityaswellastobeacompany

whereemployeesareproudtoworkat.

TELValuesTEL Values was implemented in April 2006, where all

employeeshavetoadhereto:1. Pride – to take pride in providing high-value

productsandservices

102

2. Challenges – to accept challenge of goingbeyond what others are doing to pursue the

goalofbeingnumberoneglobally

3. Ownership – keep ownership in mind while

implementingstrategiestoachieveTEL’sgoals

4. Teamwork – to respect each other’s

individuality and place high priority on

teamwork

5. Awareness – to be aware and accept

responsibilityforone’sbehaviourasarespectful

memberofsociety

Mid-TermManagementPlan

Themedium-termmanagementplanaimstopushTEL

intobecomingtheultimatesupplierforallIoTproviders

by2030.

Thecurrentstepsthemanagementhaveputinplacefor

theplanincludes:

1. InfrastructureExpansionAnewMiyagiPlantisalsocurrentlyinconstructionand

issettobecompletedbyendofAugust2018.Thisnew

plant will enable TEL to conduct joint R&D with SM

companies, which will lead to product improvements

and joint partnerships in the future. In addition, the

Miyagi plant is able to develop and produce etching

equipment,cateringtothedemandofadvancedetching

processesfromthe3DNANDtrend.

Furthermore,TokyoElectronKyushuCo.,Ltd.,whichis

engagedincoatinganddevelopingequipment,willalso

beexpandingitsCleaningRoomby1.3x,adding1350m²

of development floor, completing in January 2018,

whichincreasestheproductioncapacityabilityofTEL

2. FocusonFieldSupport(After-Sales)ServicesontopofSaleofEquipment

Themanagementhasalsorecognisedthatwhilethesale

ofSPEbringsinalargeproportionofrevenue,thefocus

should also be on after-sales service (field support),

consistingofremodeling,refurbishing,partssupply,etc.

This is essential as in the IoT field, there is a growing

need for legacy technology, i.e. Sensors, rather than

advanced processes. The application of such legacy

technology is the installation of LoRaWan in various

cities.With the LoRaWanmarket share to reach 3.97

103

billion USD by 2021, it’s definitely a lucrative area in

whichTELcancapitaliseon.

3. IntensiveResearchandDevelopment

Within TEL, there is also a Technology Strategy

Division, which focuses on developing new

technologyandprocessesforTEL’sSPEbusiness.

TELVentureCapital–TEL’sVCArm

InJuly2006,TELestablishedTELVentureCapital,

Inc.tocapitaliseonupcomingtechnologiesona

global scale. Based in California,USA, it aims to

gather together venture capital companies and

start-upsinSiliconValley,tocaptureanddevelop

new technologies. Thisalsoallows the company

tobeattheforefrontofleadingnewtechnologies.

ProcessIntegrationCenter(PIC)TELalsohasaPICfunction,whichstrengthens

worldwide development of technology.

Currently,TELisfocusingondevelopingnew

process tools for its Cleaning, Lithography,

EtchingandDepositionprocesses.Inaddition,

it’s also developing new analytical tools for

analysispurposes.

Currently, Extreme Ultraviolet (EUV) Lithography

methods is close to being commercialised, which will

increase production efficiency of wafers. As such, TEL

hasbeencollaboratingwithleadingmanufacturerslike

imec,SRC,AISTanditsmajorcustomerstocomeupwith

technologiesthatwilladoptEUVlithographymethods.

Themanagement’s aggressive R&D spending to churn

growth can be seen from the past 5 year’s R&D

spending, which grew at a 2.74% CAGR from 2013 to

2017,reaching¥83.8bin2017

MeasuringEffectivenessofBusinessStrategyTokyo Electron possesses strong management with

manyyearsofexperienceinthecompany,thusknowing

whatworksandwhatdoesnotworkforthecompany.

InvestmentsandR&Darecarefullythoughtoutusingthe

experience the management have gained throughout

theyears theyhavebeenwith thecompanyandhave

generated positive returns. Themanagement has also

led the company while sticking to TEL’s Corporate

Principles.

Using theTotalRevenue/Totalno.ofEmployeematric

as a gauge of management performance, we can see

that the number of revenue generated per employee

has increased throughout the years by 30%, from

¥49,754/employee in 2014 to ¥71,143/ employee in

FY2017, highlighting the effectivemanagement of the

trioandtheboardofTokyoElectron.

Incremental EBIT/Capex have also grown by 0.59% to

2.06%inFY17,meaningthecompanyisgeneratingmore

incrementalEBITwitheverydollarofcapex.

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ImpactofCorporateActionsonTokyoElectron

Mr.ToshikiKawai,whomrecentlytookoverthebaton

from Mr. Toshitoshi Torito on 1 January 2016,

spearheadedamedium-termmanagementplanwhich

wasannouncedinJuly2015.Theplanwasforecastedto

helpTELhitsalesof900byenandoperatingmarginof

25%withinfiveyears.

ConsolidationofResources toFocusonMainBusiness

Segments

Soldoffnon-corebusinessunitsTo tiebusinessoperationswith InternetofThingsand

rising SPE demand, TEL sold off its other businesses

(mainly Photovoltaic Panel Production Equipment

business)in2015toconcentrateontwomainbusiness

segments, SemiconductorProductionEquipment (SPE)

andFlatPanelDisplay(FPD).CurrentlytheSPEsegment

contributes to 93.8% and FPD segment contributes to

6.2%oftotalrevenue.

ReorganisationofBusinessUnits-TELalsoreorganisedits6businessunitsintofourin2017,mainly:

1. DepositionSystems

2. EtchingandDryCleaningSystems

3. Coaters,DevelopersandWetCleaningSystems

4. TestSystemsandFPDDrySystems

DoingsoallowedTELtofocusonEtching,Cleaningand

ALDbasedCoater&Developersegments,whichboasts

high market share in the wafer fab production

process.Currently,within theEtchingprocess,TELhas

over60%marketshare.

FocusonEtchingtobe in linewith3DNANDTrend–Withtheindustryshiftingtowards3DNAND,wherethe

etching process is becoming increasingly more

important, TEL is focusing on trying to dominate the

Etchingprocessasitiscurrentlythe2ndwithamarket

shareof21%.

MergingofSubsidiaries– InJuly2017,TokyoElectronYamanashiCo.,Ltd.andTokyoElectronTohokuCo.,Ltd.

Merged and established Tokyo Electron Technology

SolutionsCo.,Ltd.(TTS).Doingso,itallowsTELtopool

itstechnologyandresourcestonarrowitsfocusonthe

productionofcoreSPEproductsaswellas toconduct

advancedR&Dfortheitsfutureproduction.

Theeffectivenessoftheconsolidationofresourcescan

beseenfromtherisingnetsales,bringingtherevenue

ofthecompanyfrom¥612billionin2014to¥799billion

in2017atacompoundedCAGRof6.91%.

AGlobalCompanyTokyo Electron is a global companywith international

presence in key semiconductors and manufacturing

markets.Aswecansee,theamountofsalesrecorded

frominternationalmarketshavebeenonarisingtrend

whiletheproportionofdomesticsalestototalrevenues

are getting smaller. This shows that the company has

been successful in replicating its business model in

overseasmarketsafterbeingthemarketleaderinJapan.

Theteamexpects,thecompanytogrowitsdominance

in international markets particularly Asia with the

company’s expertise and intangible know-howsof the

businesstoridethetidesofcurrentindustrytrends.

FlexibilitytoPivot&ZERODebtTokyo Electron has a diverse portfolio of production

equipmentthatallows ittopivoteasilyandexpanding

intoitssurroundingindustries.Thisleanbusinessmodel

allowsthecompanytoadaptandchangerapidlyinthe

volatile, uncertain, ambiguous and complex

environments,atthesametimediversifyingtherisksof

thecompany.Thecompanyalsohaszerodebtwhichis

unique in the manufacturing industry with most

companies saddled with high debts. Hence, TEL has

plentyofcapacitytoleverageandcapitalizeonanynew

growthopportunitiesthatarises.

RevenueChannelsNetsalesinfiscal2017rose20.4%yearonyeartoyen

799.7 billion. This reflected the favourable market

environment, expanding demand for cutting-edge

semiconductor production equipment and increased

demand for parts and used equipment sales,

modifications and maintenance services. By segment,

105

netsalesintheSPEsegmentgrew22.3%yearonyearto

yen 749.8 billion. Net sales in the FPD production

equipment grew 10.5% YOY to 49.3 billion yen.

Furthermore, net sales in the field solutions business

(encompassing sales of parts and used equipment,

modificationsandmaintenanceservices)rose12%year

onyeartoapproximately208billion-yen,accountingfor

26%ofoverallnetsales.SPEequipmentsalesmadeup

93.8%ofoverallsaleswhereastherestcamefromFPD

and other products. Gross profit, SG&A expenses and

operating income gross profit in fiscal 2017 was up

20.6%yearonyear to322.2billionyen, reflecting the

growthinnetsales.However,thegrossmarginroseonly

0.1of percentagepoint to 40.3%as profitability gains

from increased factory utilizationwere partially offset

by investment in growth aimed at reinforcing product

competitiveness.

CostChannelsR&Dexpenseswereup9.8%yearonyearto83.8billion

yen.Themaincauseofthisrisewasthereinforcement

of R&D in the fields of etch, deposition and cleaning

systems,inwhichthecompanyisworkingtoexpandits

market share under the medium-term management

plan. TSE focused on R&D aimed at enhancing the

competitiveness of future products. This included

developinginnovativetechnologiestonotonlyenhance

the performance of individual products but optimize

entire processes as well as making products more

intelligent,allofwhichareespeciallyimportantinterms

of differentiating the company’s products going

forward. TSE regards advanced tech prowess as the

sourceofitsgrowth.Accordingly,thecompanyactively

investsingrowthtoproducenextgenerationproducts,

mainly focusing on fields in which market growth is

forecast.

Inthefiscalyearunderreview,TSEreleasedanewsingle

waferdepositionsystemandincreaseditsmarketshare

inallofitskeyproductareas,makingtangibleprogress

toward the goals of the medium -term management

plan. IN FPD production equipment, TSE primarily

advanceddevelopmentofproductsfornewgeneration

10.5/11panels,whichareexpectedtoseerapidmarket

growthgoingforward.

KeyResources&DistributionChannelsTELhasapowerfulnetworkofglobalsalesandcustomer

service channels and distribution centres as well as 4

strong R&D plants, which allows TEL to grow its

corporatenamegloballyaswellastaponlocaltalents

andtechnologiesincountriesitoperatesitsR&Dplants

in.

KeyCustomersSegmentsSomeofthenotablecustomersthatTELhasincludes:

AdvancedSemiconductorengineering,Inc.(TSEC:2311)

– Taiwan based manufacturers that manufactures

semiconductor packaging, electronic chips, computer

parts, automotive electrics, computer storage and

servers.

IntelCorporation (Nasdaq:INTC)–UnitedStatesbased

company that manufactures and sells computer,

networking and communications platform worldwide.

Its platform is used in notebooks, desktops, services,

smartphone,tabletsandwiredconnectivityproducts.It

createsmicroprocessorsandflashmemoryproductsas

well asmachine learning based products. Intel serves

theautomotive,communications,computing,industrial

andconsumerelectronicsindustryworldwide.Itserves

the automotive, industrial, home and consumer

applicationsindustryworldwide.

Micron Technology (TSE:8035) – United States based

company that provides semiconductor systems

worldwide.Itproducesbusinessstorageunits,servers,

networking decides,DRAMproducts for smartphones,

NAND products and SSDs for computers. It also

manufactures products sold under other NAND flash

suppliers’ name andprovides 3Dmemory products. It

servestheautomotive, industrial,homeandconsumer

applicationsindustryworldwide.

Renesas Easton Co. (TSE:8035) – Japan based

semiconductortechnologicaltradingcompanythatsells

integrated circuits, display devices and other electric

parts. It also sells lasers, LED, Bluetooth and COMS

sensormodulesandpanelPCs.Thecompanyalsodoes

ASIC development and browser software, on top of

infraredtransmissionsystems.Itservestheautomotive,

manufacturing,industrialandconsumerentertainment

industryworldwide.

SamsungElectronicsCo.,Ltd.(KOSE:A005930)–SouthKorea based electronics company that produces

consumer electronics, information technology and

mobilecommunications forbusinessesandconsumers

worldwide. It produces TVs, monitors, printers and

106

mobilephonesaswellasLCDandOLEDpanels.Samsung

alsoproducescomputerpartssuchasSSDsandmemory

cards. Samsung recently started to manufacture

semiconductorequipment,repairservicesofelectronic

devicesandevenAItechnology.Thecompanyoperates

in the consumer electronics, industrials and medical

industry.

Siliconware Precision Industries Co., Ltd (TSEC:2325)–Taiwan based company that produces semiconductor

packaging and testing services worldwide. It products

testingservicesforlogicmixedsignalsandRFintegrated

circuits and services customers in the personal

computer, communications and memory

semiconductorsmarket.

TaiwanSemiconductorManufacturingCompanyLimited

(TSEC:2330) –Taiwan based company that engages in

the computer-aided design, manufacture, packaging,

testingandsaleofintegratedcircuits,colourfiltersand

semiconductordevices,primarilyinTaiwan.Itoperates

inthesemiconductorandcomputerpartsindustry.

DiverseCustomerPortfolioAlthough being primarily a SPE supplier, TEL’s has a

diverse and large portfolio of customers from various

industry, whom are also leaders in their individual

industry itself. TEL’s customers are mostly in the

SemiconductorManufacturing (SM) industry, followed

byConsumerElectronics.TELalsosuppliesSPEto2ofits

competitors,AppliedMaterialsandNaigaiTecCorp.

TEL’s customers are industry leaders of individual

industry,withthetop3customersbeingthe1stor2nd

intheirindividualindustry.Thisshowsthatmanystrong

companies depend on TEL to provide them with the

necessary tools and equipment to create advanced

waferchips.

Thetop5customersinitsportfolioincludes:

StayingRelevantwithR&DTostaycompetitiveandtoalignitselfwiththeindustry

trend, TEL has several R&D Partnership with its

CustomersaswellasGlobalResearchInstitutessuchas

imec, SRC, AIST, EIDEC, A*Star Singapore, EIDEC and

CollegeofNanoscaleScienceandEngineering.

In order to be aligned with the upcoming Internet of

Things, TEL has also partnered several firms that

produces such technologies and manufacturing

capabilitiessuchasMilpitasandProcketNetworksInc.

TEL mostly invents proprietary technology through

intensiveR&Dwithitspartnersbutalsoacquiredsome

from various companies throughout the years. For

example, in 2005, TEL and IMEC extended their

Lithography Collaboration to EUV. TEL installed two

coaters/developers systemsat Imec in2006 toenable

researchonthecommercialuseofEUV.

In2015,TELandImecalsodemonstratedR&Dresultsof

anewdiscoveryofetchingschemeforpatterningofCU

interconnects at the IEEE IITC conference. The

collaboration was part of imec’s GLOBALFOUNDARIES

programwithvarioussemiconductorcompaniessuchas

Fujitsu,Sony,Panasonic,MicronTechnology,IntelCorp,

TaiwanSemiconductorandTEL.

With such strong R&D capabilities and research

partners, TEL is always at the forefront of new

innovationsandtechnologies,towhichitcanimplement

initsproductsfasterthanitscompetitors.

107

KeySuppliersTELhasalistofsuppliersthatsuppliesthecompanyits

rawmaterialsforproductionof itsgoodsandservices.

Withanexhaustivelist,TELcanenjoyeconomicsofscale

andare lessaffectedbyrawmaterialpricechanges.A

summaryofitssupplierscanbeseenbelow:

KeyPartnershipsIn order to be aligned with the upcoming Internet of

Things, TEL has partnered several firms that produces

such technologies andmanufacturing capabilities such

asMilpitasandProcketNetworksInc.

KeyCompetitorsAppliedMaterials

LamResearch

Hanergy

KLATencor ASMLHoldings

AdvantestCorporation

WideBusinessMoatsIn order to be aligned with the upcoming Internet of

Things, TEL has partnered several firms that produces

such technologies andmanufacturing capabilities such

asMilpitasandProcketNetworksInc.TokyoElectronis

also amarket leaderwith intangible knowhow in the

developmentofnon-lithiumsemiconductorequipment.

Thecompanyalsohasanagilebusinessmodelwhereby

they have a diverse portfolio of complex proprietary

productiontoolsthatarehardtoreplicate.Thisallows

themtobrancheasilyintothesurroundingindustriesif

thereisaneedtopivot.TokyoElectronhascompetitive

advantageindevelopingSPEequipmentgloballywhich

is needed to develop semiconductors in all electronic

productsacrosstheglobe.TELcreatedanewdivisionto

analyzeitsolderinstalledbaseand,accordingtoChasey,

discoverhowtobestsupportit.Thebusinessunit,called

Field Solutions (FSBU), found a potentially immense

opportunity:Customerswerelookingforhelpwithnew

configurationstomeetemergentneedsforIoTdevices,

and replacement parts that might not be readily

available.

As semiconductor devices become smaller, avoiding

pattern collapseof high aspect ratio structures during

thepostcleandryingprocess isaseriouschallenge. In

placeoftheexistingIPA*dryingmethod,theCELLESTA

-iMDuses anewdrying technology calledMonolayer

Dry. This proprietarymethod successfully reduces the

incidenceofcollapseofcircuitpatternstolessthanone-

tenth of those observed using conventional methods

which can help to save unnecessary cost spending.

CELLESTA -i was chosen from 34 products and

technologies nominated for the Grand Prize in the

semiconductor manufacturing equipment category

across the globe. In the photoresist coating machine

segment,TokyoElectronwithitsCleanTrackserieshas

grabbed an as high as 90% market share worldwide.

RevenuesgeneratedfromtheCleanTrackproductline

accountfor30%ofthecompany'stotalrevenues.Indry

etch equipment, Tokyo Electron also has the second

largestmarketshareat21%,anditalsohasthelargest

marketshareforcontactprobers(asofCY2013),atype

ofequipmentthatexamineswaferquality

ValueChainAnalysisofSemiconductorProductionEquipmentTokyo Electron is a world leader in the production of

etchingequipmenttoproduce insulatingfilm,which is

critical for the mass production of 3D NAND flash

memory.TokyoElectronisalsoaubiquitousequipment

supplierofchoiceasthesemiconductorchipsthatthe

company’s equipment can produce is being used in

almostallelectronicproducts.FromHPcomputer,Texas

instrument calculators, Panasonic home appliances as

wellasSamsunghandphones,Tokyoelectronplaysan

indirectintegralroleinourdailylives.

ProcessforManufacturingSemiconductors.

SegmentLeadersTheleadersineachoftheprocessesareasfollowswafer

washing (Screen 54%, Tokyo Electron 23%), Photo-

resistivecoating(TokyoElectron90%),Etching(dryetch

- Lam research 47%, Tokyo Electron 21%), Thin film

formation (Applied materials 50%), Metal Contact

formation (Teradyne 53%, Advantest 44%), Prove

testing(TokyoElectron55%)andPackaging(Disco84%).

In the process of making a semiconductor, TEL is

dominant in 4 of the keys steps and commands 23%

market share in wafer washing, 90% market share in

108

photo-resistivecoating,21%marketshareindryetching

aswellas55%marketshareinprovetesting.

Front End Process: The semiconductormanufacturing

process comprises front-end processes (wafer

fabrication) and back-end processes (semiconductor

assembly). The front-end processes start with silicon

waferwashing.Screenhada54%shareof themarket

forautowetstations(atypeofwashingequipment)and

Tokyo Electron had a 23% share. Next is thin-film

formation.Formationmethodsincludephysicalvapour

deposition(PVD)sputtering,chemicalvapourdeposition

(CVD),andthermaloxidation.AppliedMaterialshasthe

top share of the market for thin-film formation

equipment,dominating itsrivalswithsharesof50% in

RTP and oxidation/diffusion equipment, 35% in CVD

(including TSV) equipment, and 74% in sputtering

(includingTSV)equipment.

Inthewaferwashingprocess,someoftheproductsthat

allow Tokyo Electron to stand out are the Cellesta – i

whichusesanewdrying technology calledMonolayer

Dry.Thismethodsuccessfullyreducestheincidenceof

collapse of circuit patterns to less than one-tenth of

those observed using conventional methods.It also

allows wafers to be produced at 300% the speed of

regularproductionmethods.

PhotoresistProcess:Intheresistcoatingprocess(whichfollows formation and washing), the wafer surface is

coated with resist (photosensitive liquid). In

coater/developers (thetypeofequipmentused in this

process),TokyoElectronhasbyfartheworld’stopshare

inphotoresistprocessing(track)equipment,at90%.In

the exposure process, infrared rays are exposed onto

the resist-coated wafer through a photomask (onto

whichthecircuitpatternhasbeendrawn),causingthe

circuit pattern to be transferred to the resist. In

exposure equipment, ASML has an 82% share of the

marketforsteppers(includingEUV),followedbyNikon

at12%andCanonat6%.Overthepast10years,ASML,

which achieved high throughput through twin-stage

equipment,hassurpassedthetwoJapanesecompanies.

Next, developer is applied to the resist, dissolving the

portion of the resist thatwas irradiatedwith infrared

rays,completingtheprocessofexposingthesurfaceof

the thin film.The remainingunexposedportionof the

resistnextactsasamaskfortheetchingprocess.Etching

involvesformingapatternbyusingaliquidtoetchaway

andthenremovetheexposedthinfilm.Thereisalsoa

dryetchingprocess,whichinvolvesbombardmentwith

ionstoachievethesameends. Indryetchequipment,

LamResearchhasthetopmarketshareat47%,followed

byTokyoElectronat21%.Inconductoretchequipment,

Lam Research has a 53% share, followed by Applied

Materialsat32%,HitachiHigh-Technologiesat10%,and

Tokyo Electron at 4%. After the etching process,

phosphorusandotherforeignmatterareionizedonthe

silicon substrateand infused into thewafer. Since the

infused ions are electrically conductive, it is activated

throughheattreatmentusingRTPequipment.Insulating

layers are then formed and thewafer surface is then

mademoreeventhroughthepolishingprocess.

Tokyo Electron had a firstmover advantage in photo-

resistive coating when scanner-type steppers using a

deepUVlightsource,usageofwhichgrewrapidlyduring

the early 2000s. Responding to this demand, Tokyo

Electron launched a reduced-footprint, reduced resist

versionoftheCLEANTRACKACT™8aheadofothers.This

productisnowusedbymostmajorchipmakersaround

theworld.SuccessinraisingmarketshareintheUnited

States helped Tokyo Electron further strengthen its

leadingpositionintheglobalcoater/developermarket.

Demand for photoresist processing equipment is

associatedwithunitgrowthof lithographyequipment,

as each photoresist coater/developer usually supports

one lithography tool. As Tokyo Electron continues to

innovateandprovideuptodatecuttingtechnologysuch

asextremeultravioletlithography(EUV),itispoisedto

remaindominantinthisprocess.

Etching Process: Tokyo Electron is strong at

Globalfoundries in etching. Hence, it has significant

marketshare intheetchingprocess.Thistrendshould

continue over the next few years, driven by new chip

manufacturing processes including double patterning

(DP) and FinFET in logic/foundry, and 3D NAND in

memory. Fromaprocesspointof view,DPusesmore

siliconetchingstepsthansinglepatterning(SP),asdoes

FinFET. The memory chip manufacturing process

currentlyrequiresthat55%ofetchingstepsarecarried

outusingsiliconetchingtechnology,andthispercentage

isexpectedtoriseto60%for3DNAND.Asaresult,TEL’s

iswellpositionedtocapitalisedonthisshiftingmarket

trendsandreapmorerevenues.

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VersatileEquipment:TokyoElectronalsohasaleanandagilebusinessmodel that allows it topivot easily into

surrounding industries. This is made possible by their

arsenalof complexproprietaryproductionequipment.

Furthermore, Tokyo Electron also practices open

innovation as seen with their partnerships with spin

technologies todevelopmentthe latestMRAMaswell

as YOGOKAWA to develop stem cells for regenerative

medicine.TokyoElectronwasalsoacknowledgedbythe

guinness book of world records for its newspaper ad

presentingaperiodictableofelementswithaugmented

reality(AR)features.

Back End Process: The back-end processes comprise

wafer inspection, assembly, and package testing. In

waferinspectionequipment,TokyoElectronhasa55%

shareofthemarketforcontactprobers(asofCY2013),

atypeofequipmentthatexamineswaferquality.Inthe

market for SoC test equipment (used in pre-wafer

testing,orthetestingofachip’selectricalproperties),

Teradyne has a 53% share and Advantest has a 44%

share.

Inassemblyequipment,Discohasan84%shareofthe

market for wafer dicing saws, used in back grinding.

Package testing processes include pre-burn-in testing,

test burn-in, and high/low temperature testing, all of

whicharemethodsforeliminatinginitialdefects.Finally,

packagetestingprocessesalsoincludesvisualinspection

and shipping.

IntangibleKnowHow:Foroverthirtyyears,chipmakers

were able to lower costs in accordance withMoore’s

Lawbyshrinkinglinewidthsandincreasingwafersize.

However, the transition to 450mmwafers has been a

setback for equipment makers across the board. The

semiconductor industry is now transitioning to mass

productionof3DNAND,inwhichthephysical limitsof

line shrink are being approached. For that reason, in

recentyearsthefilmformationprocessandtheetching

process have become more important than the

exposureprocess,andonagloballeveldemandforthe

equipmentmadeby LamResearch,AppliedMaterials,

and Tokyo Electron has surpassed demand for the

exposureequipmentmadebyASML,Nikon,andCanon.

In logic production, line shrink through EUVL is just

beginning.ASMLandTokyoElectron,keyplayersinthe

industry, have a combined 100% share in such

equipment, are likely to reap the benefits. Going

forward,TokyoElectron’siswellpositionedtocapitalize

on the shifting market trends as film formation and

etchingequipmentincreaseindemandduetoarisein

the usage of 3D NAND amongst semiconductor

companies.

FuturePipelinesA.I.MachinesforSPETheR&DteamatTELiscurrentlyresearchingoncreating

Artificial Intelligence (AI) Semiconductor Production

Equipmentthatis:abletoself-diagnoseerrors,ableto

learnonitsownandautonomouscontrolabilityinthe

productionoftheproducts.Thiswillbeinlinewiththe

SPEindustrytrend,wherefor:3DNAND(FlashMemory)

Higheraccuracyandspeed.DRAM(RAM):Morestorage,

Higher aspect ratio etching, Logic (Motherboard),

Develop smaller logic boards using newmaterials and

New patterning technology for scaling. With the AI

technology being researched to create a self-learning

SPEmanufacturingequipment,wecanexpectTELtobe

abletoadaptquicklytothegrowingdemandofSPE,as

seen from the on-going growth of global

semiconductorsequipmentmarket,whichisforecasted

togrowataCAGRof10.7%from2014to2019,reaching

a total market value of US$64 billion by 2019.

Nanotechnology–NanowirefieldeffecttransistorsWith its research partners, TEL is trying to utilize

Nanotechnology to create Nanowire Field Effect

Transistors(FET),whichwillallowproductionofbetter

SPEandFPDparts,reapingthebenefitsinparticular:For

SPE: increased density of memory chips and reduced

size of transistors in circuits, to put more power in a

smaller circuit board. Thiswill be in linewith the FPD

industrytrendssameasabove.ForFPD:reducedpower

consumption on display screens, reduced weight and

thickness of screens, nanowire will enable FPD to be

moreflexible.ThiswillbeinlinewiththeFPDindustry

trends,where: consumersare looking for screens that

arebigger,industryisleaningtowardstheproductionof

OLEDfromLCDandincreasedscreenresolutionfrom4K

to8Kfrom300ppito700ppi.ThisisinlinewiththeFPD

industry,whichisforecastedtogrow15.8%from2016

to2020reachingUS$117b

Tokyo ElectronSuppliers

End Consumers

(Govt, Businesses,

Society)

Customer 1

R&D Partners

Customer 2

Customer 3

Customer…

3

2 1

Faster, Smaller, Cheaper Chips

4

Supply Demand

Require advanced

SPE

Procure raw materials

Conducts intensive

R&D

PC Industry

Smartphone Industry

Healthcare Industry

Others

5

Upgraded modular SPE

+After-sales service

Feedback and

collaboration

6

110

Launched in 2005, TEL’s Plasma Etching Equipment

‘Tactras’ has gone through several upgrades, in 2006

and 2010.With the latest Tactras RLSA Etch in 2010,

customersareabletofabricateeventhemostadvanced

product lines. Using the newest system, production

damages is minimized and it allows superior profile,

uniformityandselectivity.Withsuchadvancedetching

technology,TELisabletodominatetheetchingprocess.

ExclusiveTechnicalModelThatIsHighlyScalableUsingitscurrentbusinessmodel,TELisabletotailorto

all types of customers that requires SPE. The SPE

industryisdrivenbythedemandofsemiconductorsby

end consumers, such as government, businesses and

society, who requires faster, smaller and cheaper

electronical devices and applications. This in turn,

creates pressure on semiconductor manufacturers as

theywillhavetoprocureadvancedSPEtocreatemore

efficientwaferchipstocatertothedemand.

To meet the demand of its customers, TEL will then

procure rawmaterials aswell as through its intensive

R&D,comeupwithupgradedversionsofitsmodularSPE

toselltoitscustomers.Inaddition,SPEprovidesafter-

salesservicesuchasmaintenancetocustomers.

Lastly,TELalsocollaborateswith its customers,whom

becomesitsR&Dpartners.ThisallowsTELtoobtainreal-

time feedback from its customers on areas for

improvement, to create products that are more

customer-centric.

FinancialPerformanceIn 2013 and 2014, net profits for the company were

considerably low with a reported net loss of JPY19.4

billionin2014.Thiswasduetotheeconomicslowdown

globallyaswellasintheelectronicsindustry.Duringthis

period, the PC and smartphones market started to

decline which affected the company’s bottom line as

well.TokyoElectronalsounderwentrestructuringofits

businessbywithdrawingfromtheirphotovoltaicpanel

(PV)productionequipmentbusiness(TELSolarHolding

AG(formerlyOerlikonSolarHoldingAG)),whichlacked

futurepotentialaswellasdivestingfromitselectronic

components and computer network business. This

resulted in a JPY47 billion loss inwrite-downs for the

company as management have decided to focus its

resourcesintheSPEandFPDbusinesssegmentswhich

were set to boom with the overall marketplace

demandingforbettersemiconductorsasindustrytrends

were leaning towards IoT and greater demand from

China,TaiwanandSouthKorea. In2013, thecompany

made3acquisitions forTELNEXX, Inc. (formerlyNEXX

Systems, Inc.),TELFSI, Inc. (formerlyFSI International,

Inc)andTELMagneticSolutionsLtd(formerlyMagnetic

SolutionsLtd.).Thesebuyoutswerepartmanagement’s

strategytostrengthenandfocusitsbusinessintheSPE

marketforthecomingexpansioninthissegmentofthe

semiconductor industry. The strategy paid off as the

companysawitsrevenuesgrowfromJPY497.3billionto

JPY799.7 billion. This represented a 12.6% CAGR in

revenues over the 5 years. Net profits also saw an

impressive 1,788% growth from 2013 to 2017. Net

profitsalsoenjoyedstronggrowthof26.5%CAGRfrom

2015 to 2017 which was another testament of the

management’sforesightanddedicationinbringingthe

companythroughadversity.

111

SPE&FPDOrderBacklogsThe total SPE orders rose tremendously from JPY342

billionin2013toJPY951billionin2017.Thisrepresents

arobustgrowthwithCAGR29.1%overtheperiodthe5-

year period. Similarly, the FPD business segment also

reported robustgrowth ratesof25.1%CAGRover the

sameperiod.SalesofFPDequipment rose fromJPY20

billion in 2013 to JPY49 billion in 2017.Tokyo Electron

alsosawthenumberofitssaleswaitingtobefulfilledin

fiscal year 2018 increasing from its 2 key business

segments.SPEordersbacklogincreasedby83.2%from

2015to2017toreachatotalvalueofJPY464billion.On

theother hand, FPDbacklogs also grew29%over the

sameperiodtoJPY37billion

.

OperatingExpensesIn 2014, operating expenses rose 16.1% from2013 to

¥169.7 billion was due to increased R&D expenses in

fieldsrelatedtothefouroverseassubsidiariesacquired

infiscal2013.TheywereTELNEXX,Inc.(formerlyNEXX

Systems, Inc.),TELFSI, Inc. (formerlyFSI International,

Inc.), TEL Solar Holding AG (formerly Oerlikon Solar

HoldingAG),andTELMagneticSolutionsLtd(formerly

Magnetic Solutions Ltd.). These costs also include

amortization of goodwill, related to the acquired

companiesandlossesfromdepreciationoftheJPY.The

dropinoperatingcostsby16.5%in2015wasduetothe

withdrawal from the PVbusiness.However, operating

costsstartedtoincreaseyearlyfrom2015onwardsbut

the sales growth outpaced the increase in operating

expenses.ThiscanbeseenfromtheratioofOperating

Expenses to Net Sales dropping steadily from 29% in

2013to21%in2017whichdemonstratesthecompany

is incurring lesser costs for products in proportion to

sales generated year on year.

EfficiencyRatiosTokyo Electron has made considerable efforts to

improveitsoperationalefficiency.Thiscanbeseenfrom

a gradual decline in days sales in receivables from 74

daysin2013to61daysin2017.Thisdemonstratesthat

the company is able to convert credit sales in to cash

faster. At the same time, the payable period of the

company has also seen a gradual increase from44.88

days in2013to51.32days in2017.Thisdemonstrates

that the company has been able to form strong

relationships with its suppliers as seen from a higher

credit period given to them. The inventory turnover

periodhasbeenrisinggraduallybutthis is in linewith

theriseinSPEandFPDorderbacklogsthecompanyhas

yettofulfil.

LiquidityMeasuresThecurrentratioofTokyoElectronhasbeendeclining

yearly from a high of 4.89x in 2013 to 2.84x in 2017.

Similarly,thequickratioofthecompanyfellfromahigh

of 3.19x to 1.81x over the same period. This was

primarilydue tohighercustomeradvancesandhigher

inventoriesthatthecompanyhasasaresultofgreater

salesandarisingorderbacklogsfrombothitsbusiness

segments. However, the both the company’s current

ratioandquickratioareaboveitsindustrypeersof2.49x

and1.76x.Thisdemonstrates that thecompany is still

able to maintain its liquidity above industry average.

CompanyLeverageTokyoElectronhasanextremelyminimalriskofcreditdefault as seen from its times interest ratio.The ratio

was354.3xin2013andgrewto16,989.3xin2017.This

showsthatthecompanycanpayitsinterestsfromdebt

obligations16,989.3timesover.Thecompanycurrently

haszeroleverageasseenfromitsDebt/Equityratioof0.Thecompanyhasrepaidallinterest-bearingdebtsin

2015 to make way for spare capacity.

ProfitabilityTokyoElectron is ahighprofitability companyas seen

fromitsROEandROA.Thecompanyrecordedahighof

19.1%ROEand17.9%ROAin2017.Therisingtrendsin

bothratiosasobservedare indicatorsof thecompany

gettingmoreprofitable.TheAPACindustryaveragefor

ROEis18.7%andROAis11.8%.Thisgoestoshowthat

thecompanyisgenerallymoreprofitablethanitspeers

in the Asia Pacific region. Globally, its US peers are

recording impressive growth as well. LAM Research

(ROE: 30.1%, ROA: 16.2%), Applied Materials (ROE:

41.5%,ROA:20.2%)andKLA-Tencor(ROE:91.6%,ROA:

19.3%).ThisdemonstratesthattheglobalSPEindustry

is in an upcycle now.

NetProfitMarginAs the business began to pick up after restructuring

effortsbythemanagementtopropelthecompanyinto

a new growth era, the company saw its net profit

marginscompoundedata rateof10.9%from2015to

2015. This represents a growthof 23%over the same

period.ThedemonstratesthatTokyoElectronisgetting

112

more profitable with higher net profit margins being

recorded on a year on year basis.

DividendTokyoElectronhasadividendpolicytopayout50%of

earningsandissueanannualdividendpershareofnot

less than JPY150 as well as conduct share buyback

exercises.Thisshowsthatthemanagementisconfident

of the company’s future performance to generate

enoughprofits to issuehighdividends.Dividendshave

rose590%since2013whichdemonstratesthestrength

ofthebusinesstogenerateprofits.Sharebuybacksalso

createsapositivesignallingeffecttothemarketbecause

the management believes that their shares are

undervalued. This will create wealth and value forshareholders.

Top3DislikesandToxicFactors

A. SteepCompetitionCompetitionbetweenSPEmakersarestiffasthepoolof

buyers of SPE machines are typically small and large

companieslikeSamsungandIntel.Asmentionedinthe

valuechainanalysis,eachSPEmakersarespecialisedin

certainprocessesofthesemiconductorsvaluechainand

each maintains a dominant position in their own

regions.TELisdominantintheAPACregionand4ofthe

processes. Furthermore, the company is expanding its

proprietarytechnologiestowardsotherapplicationsand

future pipelines can be expected to increase market

shareandallowTELtobeahighlycompetitivecompany

in the global arena.

B. DecliningOrdersDownside risks to the business may be caused by a

decline in SPE and FPD equipment orders due to a

slowdownintheglobaleconomyorsteepercompetition

within SPE makers. For a ratio of more than 1.0, it

indicatesthatthecompanyhasmoreordersthanitcan

deliverwhichsignifieshigherdemandandthatitneeds

toinvestinspeedingupproduction.TEL’scurrentbook-

to-billratiois1.19xwhichtellsusthatthereisastrong

demand for the company’s machines and TEL is

expectingtofillmoreordersinthecomingquarters.The

riseinordersandbacklogsarealsoinlinewitharising

book-to-billratioforTEL.Assuch,weareconfidentthat

thecompanywillnotbeexperiencingadeclineinorders

in the imminent future.

C. DropinCapitalSpendingTheglobaleconomyaffectshowmuchsemiconductors

manufacturers spend on their capital expenditures. A

downturnintheeconomywillresultinsteeperdeclines

of equipment orders. However, with TEL’s diversified

revenuestreams,thecompanyisnolongerdependent

ontheelectronicsmarketforwhichsemiconductorsare

widely used. Due to the emergence of IoT, TEL’s

portfoliooftoolsandmachineshavefounditswayinto

new industries where the applications of

semiconductors have expanded (AR, AI, Regenerative

Medicineetc).Assuch,theindustryisnowlesscyclical

as compared to before. Furthermore, key markets in

Asia such as China, South Korea and Taiwan are all

projected to experience GDP growth in the coming

years,wecanexpecthigherconsumerspendingandthe

manufacturing industries in these key economies to

expand(Appendix).

WhyInvestNow?Tokyo Electron is well positioned based on current

industry trends to be the number one leading

semiconductorequipmentmanufacturer.Withgrowing

demand from China as well as the trends of IoT, the

companyisabletoinnovatewithitsexpertisetocreate

the necessary equipment to produce high performing

semiconductors to meet the increasing needs of

consumersforhighperformanceandhighfunctionality

products. With its strong balance sheet as well as

backlogsandearningabilities,wefeelthatthecompany

stillhashighpotentialupsidefortheimminentfuture.

(TSE:8035)TokyoElectronLimitedFY2013 FY2014 FY2015 FY2016 FY2017 FY2018LTMSharePriceJPY 5,020.00 6,848.00 7,747.00 8,575.00 15,160.00 20,955.00NoofShares(mil) 179.2 179.2 178.2 164.0 164.1 164.1MCAP(mil)USD 9,064 12,116 11,287 13,697 22,143 30,505NetDebt(Cash)JPY (179,730) (203,166) (266,810) (181,371) (259,541) (273,323)EnterpriseValue(mil)USD 5,549 9,165 10,146 8,708 15,401 27,580Revenue(mil)JPY 497,299.0 612,170.0 613,124.0 663,948.0 799,719.0 963,973.0EBITDA(mil)JPY 40,320.0 61,358.0 110,141.0 137,017.0 174,201.0 238,350.0EBIT(mil)JPY 12,549.0 32,208.0 88,113.0 116,790.0 155,698.0 219,003.0NPAT(mil)JPY 6,076.0 (19,408.0) 71,888.0 77,891.0 115,208.0 163,910.0NPAT(Ex.Xtra+Dis.Ops)(mil)JPY 2,519.0 27,717.0 74,076.0 88,763.0 123,166.0 167,282.0CFO(mil)JPY 84,266.0 44,449.0 71,806.0 69,398.0 136,948.0 152,888.0CAPEX(mil)JPY (19,012.0) (9,451.0) (11,898.0) (11,294.0) (17,557.0) (24,603.0)EPSJPY 14.1 154.7 415.7 541.1 750.7 1,019.5Revenue(mil)USD 5,279.5 5,946.3 5,109.8 5,909.1 7,172.4 8,560.7EBITDA(mil)USD 428.0 596.0 917.9 1,219.4 1,562.3 2,116.7EBIT(mil)USD 133.2 312.9 734.3 1,039.4 1,396.4 1,944.9NPAT(mil)USD 64.5 (188.5) 599.1 693.2 1,033.3 1,455.6CFO(mil)USD 894.6 431.8 598.4 617.6 1,228.2 1,357.7CAPEX(mil)USD (201.8) (91.8) (99.2) (100.5) (157.5) (218.5)GPM(%) 31.9% 33.0% 39.6% 40.2% 40.3% 41.4%EBIT(%) 2.5% 5.3% 14.4% 17.6% 19.5% 22.7%NetDebt(Cash)/Equity(%) -30.2% -35.0% -41.6% -32.2% -40.2% -38.6%ROA(%) 1.6% 3.9% 10.1% 14.7% 16.3% 21.2%ROE(%) 2.1% 5.6% 13.7% 20.7% 24.1% 30.9%CFO/TA(%) 10.9% 5.4% 8.2% 8.7% 14.3% 14.8%EV/Sales(x) 1.5 1.7 1.8 1.8 2.8 3.3EV/EBIT(x) 58.2 32.1 12.6 10.5 14.3 14.5EV/EBITDA(x) 18.1 16.9 10.1 8.9 12.8 13.3EV/CFO(x) 8.7 23.3 15.5 17.7 16.3 20.7P/Sales(x) 1.8 2.0 2.3 2.1 3.1 3.6P/EBIT(x) 71.7 38.1 15.7 12.0 16.0 15.7P/B(x) 1.7 2.2 2.3 2.6 3.9 5.0VQ1:EV/EBIT/ROE(x) 27.6 5.8 0.9 0.5 0.6 0.5VQ2:EV/EBIT/ROA(x) 36.0 8.3 1.3 0.7 0.9 0.7

113

12. TOTOLimited(TSE:5332)


QuickStats

Date 15/12/17 EBIT/R&D(x) 2.65

FilingCurrency JPY

EBIT/EmployeeNo.

(USD/px) 20K




DailyValueTraded


GPM(%) 38.1% P/E(x) 20.4

EBIT(%) 8.7% P/B(x) 3.6

NetDebt(Cash)/

Equity(%) -5.4%

VQ1:EV/EBIT/ROE

(x) 1.2

ROA(%) 9.4%

VQ2:EV/EBIT/ROA

(x) 2.1

ROE(%) 16.7%

TeamMembers

LawWeiSiangisathirdyearAccountingstudentatUniversiti

UtaraMalaysia. With his interest in investment, he founded

Bursa Young Investor Club and started to gain investment

knowledgeinthatplatform.

Alvin Lim is a second year International Affairs student at

Univerisiti UtaraMalaysia. He started his investment journey

sincehewastwelveandcurrentlyleadingaresearchteaminan

investmentclub.

Lee Ke Qi is a third year Accounting (Information System)

studentatUniversitiUtaraMalaysia.Asanaccountingstudent,

she took interest in investment and began to learn value

investing.

114

CompanyOverviewTheTOTOGroupwasmanufacturingseatedflushtoilets

at a time when public sewage systems were not yet

widespread in Japan, and it has been instrumental in

promoting healthy lifestyles. The TOTO Group has

openedthedoortonewlifestylesbycreatingproducts

such as the WASHLET™, the prefabricated bathroom

module, and other bathroom and kitchen plumbing

products.

The TOTO Group is pursuing the development of

beautiful products, focussing on design and

functionality.Emphasizingdesigncharacteristicsmeans

rising to the challenges of increasingly complex

manufacturing demands by overcoming production

issues one by one. Beauty is the crystallization of

enthusiasm and ingenuity in the design of individual

partsandproductiontechnology.

The TOTO Group pioneered development of the

remodellingmarket in Japanand continues to lead its

advancement by actively providing remodelling

solutionsthatpromisenewlifestylesbeyondcustomer

expectations.Tohelpcustomersgainaclearersenseof

their options, we have established throughout Japan

showroomsthatletcustomerssee,feel,andexperience

remodelling possibilities. Together with contractors,

whichareindirectcontactwithcustomers,westriveto

show customers how bathroom and kitchen

environmentscanbemademorecomfortable.

Thecompanywastryingtoentertheglobalmarketto

ensurethecompany’srevenuegrowhealthyeveryyear.

This shows that the management team have been

intentionalonglobalisingtheirproducts.Thecompany

first entered the world largest economy which is the

UnitedStates.Insuccession,after5yearsthecompany

enteredthe2nd

largesteconomy,China.Thisshowsthat

the company has the insights in assumption of the

potential growth market for the sales of toilet. Thus,

sales fromUnited States and China had increased the

company’s revenue consistently even till today.

Currently, their domesticmarket accounts for roughly

70%oftheTOTOGroup'snetsales.

The company’s flagship product which is “Washlets”.

This creative design utilises a warm-water washing

feature.“Washlets”hasachieved40millionsshipment

in 2015. This shows that the innovative nature of the

company is the hidden value that drives revenues

forward.

The second flagship product which is “Neorest”. This

product is a Hybrid Series equipped with toilet bowl

cleaning function. This product created new revenues

forthecompanyas2millionunitsweresoldinaquick

spanof3years.Itshowstheirproductsarewellreceived

bothdomesticallyandinternationally.Movingforward,

“Washlets”and“Neorest”aretwocriticalengines.

OriginationoftheIdeaToilet is an inseparable and important component in

every house or building. Without a toilet, it creates

inconveniencesforthehumanpopulationanditcauses

potential pollutionof theenvironment.A comfortable

and user-friendly restroom must be equipped with a

goodsanitarysystemtoensuregoodhygieneinourdaily

life.

Today, a clean toilet reflects the personality and the

imageofthebuilding’sownerorcountry.Besidesthat,

a comfortable toilet provides better hospitality to

travellers or visitors. Therefore, modern buildings,

shopping malls and hotels begun to pay attention to

such details, as more installation of smart sanitary

systeminordertoimpresstheirvisitors.Besidesthat,it

alsoreflectshighstandardofcleanliness.

Behindeverycleantoiletisanefficientsanitarysystem.

Therefore, our team had chosen TOTO, the leading

Japanesesanitarysystemmanufacturerasourresearch

company, because as living standard and cleanliness

improved,thedemandofamodernsanitarysystemwill

continuetogrowinfuture.

115

Besides that, TOTO Washlet product had established

highmarketpresenceinupscalemarketinbothUSand

Asia,we believe TOTO’s smart bathroom solutionwill

continue to attract high net-worth buyers which

prioritize comfort and luxury in China and ASEAN

market. TOTO’s products are innovative, high

technologyanditsergonomicdesignshowcasedJapan’s

designphilosophy.

WebelieveTOTO’splanistoexpandintotheirexpertise

into other segments such as green building materials

and prefabricated bathrooms will essentially reduce

TOTO’sdependentononlyoneproduct.Therefore,we

recommendTOTOashiddenchampionaswe saw the

TOTO potential to benefit in future smart technology

sanitary system and the adoption of prefabrication

toiletsinAsiacountries.

WhyTOTO?GrowingprospectonChinasanitarymarkets

According to Frost & Sullivan report, rapid economic

growthinChinahadledtoanacceleratingurbanization

processwithaninfluxofruralinhabitantstotheurban

areainChina.TheurbanpopulationinChinaincreased

by18.5% fromapproximately582.9million in2006 to

approximately 690.8 million in 2011. Hence, rapid

urbanization has substantial impact in consumer

patternsandhabitsofChineseconsumers.

Driven by the growth of newhousing development in

China and home renovation activities, sanitary ware

market is expected to grow toRMB144,848by 2015,

representingCAGRof14.4%growthfrom2011to2015.

The target market of TOTO product segment, mid to

highendceramicwaremarket,accounted47.1% total

marketshareofChina’sceramicmarket.From2011to

2015, the mid to high segment recorded the highest

growth of market share compare to low-end and

premiummarketswithCAGR18.5%annually.Hence,the

midtohighendmarketwasthelargestmarketinoverall

Chinaceramicmarket.

Therefore, we expect TOTO to benefit from China

growing sanitary equipment market based on three

criteria, market share, and brand awareness and

consumerpreference.

InFrost&Sullivansurvey,TOTOrankedNo.3intop10

brands in Chinamid to high end sanitary and ceramic

marketswarein2011.Intermsofmarketshare,TOTO

rankedNo.2amongtop10brandsinChinasanitaryand

ceramicswaremarket,withaverageretailsalesof1,510

millionRMB,approximately8.3%oftotalmarketshare.

Furthermore, TOTO also ranked No. 3 in brand

awarenessinChinaandalsoinconsumerpreferencesin

China trailingbehindKohlerandArrow.Therefore,we

were able to project TOTO future earnings in Asia

markettocontinuegrowinginthenext10yearsbased

oncurrentmarketdata.

116

EnvironmentalfriendlysanitaryproductsTOTO’s latest product, Neorest, consumed 3.8L water

comparetopreviousmodelswhichconsumedaverage

14L.Aswaterresourcesarebecomingmorescarceand

precious, water-saving products began to gain

popularity in countrieswhich lack of consistentwater

supply. Besides that, more countries are more

environmentally conscious, which offer incentive and

tax rebate to reduce wastage of water and carbon

footprint.

Besides that, TOTO management are committed in

environment conservation in their corporate mission

charter.IntheirmanagementV-Plan,TOTOplannedto

contribute to environment conservation through their

business activities. We viewed TOTO’s environment

initiativesandTOTOproduct’scompetitivenessgohand-

in-hand to meet the environment standards of

internationalorganization, suchEuropeanUnion. Such

advantageprovidesTOTOtheopportunitytopenetrate

markets in Europe which are more environmentally

conscious.

Growing market trend of prefabricated bathroommodulesThe adoption of IBS (Integrated Building System) in

modernconstructionfieldhadincreasedtheutilization

of prefabricated bathroom modules. Therefore, the

demand of pre-fabricated bathroom modules will

continuetoincreasetocatertheneedofIBSbuildings.

Currently, TOTO has proprietary technology of

bathroommodules,consistsofuniqueceramicsdesign.

TOTO’sspecializationinbathroomfloormaterialknown

asKararifloor,whichfeaturesofttexturewhichprovides

greatercomforttoitsusers.Inbathtubsegment,TOTO

has theMahobin bathtub that are highly insulated. It

allows no more than a 2.5C decline in water

temperatureoveraspanofhours.

Furthermore, to further strengthen their remodelling

business,TOTOhadformedalliancewithDaikenandYKK

AP, leadingmanufacturerofkeyhousingmaterials like

metal bearing, interior door, lumber and aluminium

windows,which formed theTDYalliance.BothDaiken

andYKKhasinternationalpresenceinbuildingmaterial

manufacturingmarketandnumerousjoint-venturewith

localcompanyinAsia.

The integration with buildingmaterials company, had

givenTOTOadvantageinsecuringmorecontractsinIBS

construction projects in Japan or overseas. As Japan

Olympics’ official plumbing and sanitary equipment

supplier, theboost in infrastructureprojectswouldbe

seen.

EfficientMarketingStrategyInordertostrengthenmarketingavenuesandbusiness

strategy, TOTO management adopted a three-stage

strategytoenhancecommunicationsbetweencustomer

andTOTOproductsdealers.Firststageisbuildingbrand

awareness by approaching notable properties. Second

stage is to increase market penetration in domestic

market. TOTO opened numerous showroom and

lifestyle experience centres in worldwide, including

establishing direct showroom in developing countries

likeVietnam.

Weare favourableof this strategysincecustomercan

get better insight of TOTO products rather than

traditional retail model which depend on authorized

dealers. Besides that, customers can get better after-

sales service and support directly from manufacturer

warranty, it could increase customer satisfaction and

alsoreducetheriskofparallelimport.

Thethirdstageofimplementationistoestablishaluxury

brand. TOTO management’s approached numerous

upscalehotelchains,topromoteTOTOtoiletbranding

to be installed, in order to create strong brand

awarenessamongconsumer.SinceTOTOproductswere

engineeredtoprovidecomfortandsophisticated,TOTO

iscreatingtheirownnichemarketamongitsownfans.

Besides that, TOTO also worked actively with

government authority to promote their marketing

strategy.Forexample,TOTOestablishedaTOTOgallery

insideJapan’sbusiestinternationalairport,Narita.This

strategiclocationwithhighhumantrafficbenefitsTOTO

marketingthroughpublicawareness.

117

FutureProspectsCompanyfuturedirection

The management of TOTO formulated a long-term

businessplanknownasTOTOV-Plan2017management

plansinceJuly2009.

The plan reorganised TOTO strategic framework into

two business segment - housing equipment business

and developing new business domains consists of

advanced ceramics business and Green Building

materialsbusiness.

The development of housing equipment business in

China,IndiaandASEANcountriescontinuebecomethe

main driver of TOTO growth for the next decades. As

household income continues to grow rapidly in Asia

countries, demand for higher and better qualities

standardsanitarywareshassoaredrapidly.Theamount

ofresidentsinChinaandIndiawillgeneratehigherlevel

ofsalestoTOTOastheyareaimingtowardsbeingthe

most trusted brand in China.One of the initiatives by

TOTO to build strong sales network tomeet changing

marketandcustomerneedsisbyharnessingstrengthof

existing buildingmaterials route in rapidly growing e-

commerceroute.

Inabletocopethesurgingdemandofsanitaryproducts

in Asia markets, TOTO increased productions lines in

both Thailand and Vietnam. This strategy was in-line

withTOTOmanagement’saimtoincreaseTOTObrand

exposure in ASEAN countries. Currently, TOTO has

plantsinVietnamandThailandwhichwillbeoperational

in2018.Weestimatedbothproductionplantswillable

to contribute higher earnings on TOTO’s net sales.

Besides continue development of Washlet flagship

product, TOTO also actively expanding into other

bathroom components such as bathtub and advanced

ceramicwares.InMarch2017,StraitsTimesSingapore

reportedthatTOTOlaunchedacradledshapedbathtub,

named “Floatation Tub” which bring user ultimate

relaxation by inducing a trance-like state. We viewed

thisproductasapositivemoveofTOTOtoexpandtheir

portfolioinglobalhousingequipmentbusiness.

TheofficialshoppageofTOTOonthebiggestonlineshoppingplatforminChina,TMALL.

KeypointsinMid-TermManagementPlan-WILL2022“Anshin”RemodellingStrategy

The domestic housing equipment business underpins

TOTO,accountingforabout80%ofallsales.Following

theglobalfinancialandeconomiccrisis,thenumberof

new housing starts in Japan plummeted, TOTO’s

remodelling strategy plays amajor role in this severe

issue. Inoneof theTOTOglobalenvironmentalvision,

Japanhousingequipmentbusiness,TOTOmakesanew

declarationon their remodelling strategywhich called

“Anshin” remodelling strategy. TOTOhas been always

targeting in proposing new lifestyles to its customers.

The latest declaration encapsulates TOTO’s desires to

helpcustomerssothattheycanembarkonremodelling

with peace of mind. TOTO will consider about their

customers’concernstomakesuretheycanvisualizeand

understand.

In able to ensure continued growth, TOTO started

wholesales product to the public. This is another

marketing strategy to prevent the company’s reliance

on the retailer sales. This strategy will enhance the

profitability and consistency of the revenue growth in

future. TOTO also started approaching construction

companies.Forexample,TOTOThailandsignedcontract

with V.M.P.C to use TOTO’s innovative toilets. This

company has launched Atara Hotel Sriracha which

consistsof460rooms.AtaraHotelchosetouseTOTO’s

sanitary ware both toilets with revolutionary flushing

system and Washelt, automatic sear and cover with

adjustableheatedseat system,self-cleansing function,

air dryer and deodorizer, suitable for all ages and

genders.

Developing“OnlyOne”Technologies

OneofthebusinessdomainsthatproposedbyTOTOis

advanced ceramics business. TOTO creates value

throughcollaborationwithcustomersandsuppliersby

introducing high- performance semiconductor

manufacturing technology and next generation high-

speed optical communication devices. TOTO builds a

production structure that meets new demand and

replacementdemand.This technology isdevelopedby

activelyexpandinginvestmentinnext-generationR&D.

Super-hydrophilic photo catalyst can be applied to

variousmaterialsandfieldsasmentionedabove.TOTO

isgoingtoapplythistechnologytoexteriortiles,siding

boards, and mirrors. From our analysis of TOTO

corporate report since 2009, advanced ceramics

businessrecordedthehighestgrowthinnetsales,with

an increase of 135% compare to other segments.

Generally, advanced ceramics business consists were

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materials that canwithstandhighchemical resistance,

abrasionresistanceandstable.Therefore,ahighersales

ofadvancedceramicssuggestthegrowingmarketshare

of sophisticated bathroom equipment or component,

whichbringpositiveimpactonnewbusinessdomain.

LeadershipBoardCorporatecultureofTOTO

TOTO emphasizes on work life balance culture, by

creating a sustainable working environment for

employees. Under TOTO’s work life balance culture,

employees were encouraged to take paid leaves and

alsosettingupvariousfacilitiessuchasnurseryandchild

day-carecentre toease theburdenofemployees.We

canconcludeTOTO’scorporateculturewasmuchdiffer

with traditional Japanese company which mandate

employeestospendmoretimeinoffice.Besides,TOTO

alsoencourageitsemployeestostrengthentheirfamily

ties because family is foundational support for its

employees.

Besides that, TOTO also advocate for more women

participation in thecompany,which target to increase

thepercentageoffemalemanagersby10%in2017.We

canalsoviewTOTO’smovetoincreasefemalemanagers

incompanytopmanagementbodewellwiththeirwork

life balance culture. In typical Japan, females tend to

encountermorecareerobstaclesinthecorporateworld

compared to men. Hence, TOTO’s work life balance

culturerelievestheburdenoffemaleemployees.

Such corporate culture could inspire more female

employeeswithgreatcapabilitiestomoveaheadTOTO

corporateladder.

TOTOalsoprovidesmanagementtrainingforemployees

toenhancetheirlanguageskillandknowledgewiththe

introduction of Open School. The purpose of Open

Schoolistoletindividualstochoosewhattheywantto

learn. Under TOTO management school (Keiei-Juku),

employees can learn extra knowledge of other

industriesfieldandalsodevelopingthenextgeneration

leadersofthecompany.WewelcomeTOTO’seffortof

emphasizing the importance of knowledge as it will

benefit the futureof companywhile in the journeyof

expanding their overseas operations. Besides that,

employees also have the opportunity to learn foreign

cultures through language class, which helps them to

assimilateintodomesticcommunity.

TOTO’smotto:tobringJapanesetoiletculturetotheworld

TOTOtracesitsrootsbackin1912,andstartitshumble

beginningsasasanitaryceramicmaker.Today,TOTO’s

brand,WashletsispartoftheiconiccultureofJapanese

cleanliness and hospitalitywith the touch of futuristic

technology.

TOTO’spresident,MadokaKitamuramentioned thata

country’shospitalityimageisbasedonthecleanlinessof

publictoilets.ThisgivesTOTO’sproductsanimportant

role inshapingthemindsandimpressionofvisitorsto

Japan.Furthermore,italsoreflectsthehighstandardsof

TOTOsanitarydesignsandspiritofincorporatingthree

elementsintosanitaryproducts,modern,comfortable,

andquality.

SincethelaunchofWashletbrandin1980s,thespecial

functiontoilethadgainedpopularityaroundtheworld.

Dubbing “the Apple of Toilet Tech” by the Fortune

magazinein2013,TOTOWashletbrandsissynonymous

with Japanese culture that outline beauty is the new

comfort.TheWashletredefinedthesanitarymarketand

successfullycreatetheirownniche.

Duetoitshightechspecificationsandergonomicdesign,

TOTO toilets became the cult culture for smart toilet

today. In2017,CNN’shomedesign journalistAmanda

Sealy,notedthatsmarttoiletstodayissimplyreferred

asTOTO,suchlikeavacuumcleaneriscalledHooverand

thehottubaJacuzzi.TOTO’sWashlet’spioneerstatus

earnedaconstantmarketshareinbathroomappliances

intheworld.

Frombriefanalysisofthegeneralperceptionofmedia

andpublictowardsTOTOflagshipproduct,Washlet.We

canconcludethemanagementofTOTOtookmeticulous

effort in designing their product to ensure high

standardsweremaintainedineveryWashlettheysold.

The management strives to promote the unique

experienceof Japanese toilet culture toeveryone,not

because it is a leader in the industry, but more

importantly,itisTOTO’sstrongspirittoupholdJapan’s

image as the world most cleanliness and civilized

country.

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TOTOShareholdingStructureShareholdingAnalysisTOTO largest shareholders are mostly of financial

holding companies, holding up to 44.6% of the

shareholdings. Such shareholding structure and

ownershippatternarecommoninJapaneseKabushiki-

Gaisha,Japanesejoint-stockcompany.Asmostfinancial

holding company in Japan likeMitsubisihi USJ, Mitsui

were Zaibatsu (conglomerate), financial company

typically hold interlocking horizontal or vertical

shareholdingpatterns.However,TOTOdidnotbelongto

any leagueofkeiretsufamily.ButoneofJapan largest

homebuilder,SekisuiHousehaveasubstantialstakein

TOTO.

TOTO’sCorporatestructure

CorporateGovernanceTOTO’s management emphasize on the fairness,

objectivity and independence by appointing three

Outside Directors who are independent of the TOTO

Group.Thenumberofoutsidedirectorsincreasedfrom

2to3intheyearof2016.TheOutsideDirectorswillgive

various advice and make proposals on our overall

management. This kind of practice is rarely seen in

Japan.Threeof themwillprovidedifferentopinionon

theTOTOGroup’sactivities.Thefirstoutsidedirectoris

HirokiOgawa,heprovidedawidevarietyofopinionon

sales activities in Japan and overseas. The second

director,KazuhikoMasuda,heprovidedawidevariety

of opinions on distribution ofmanagement resources,

businessmanagementandsoon.MasatsuguShimono,

thethirdoutsidedirectorofthecompany,heprovideda

wide variety of opinions on reinforcement of the

company’s management base. Three of the directors

havethevotingrightinthemeeting,thistypeofculture

is rarely seen in the world. In other companies,

independent directors haveno voting right. Theyonly

willprovideadvicetotheboardduringthemeeting.

The cross shareholdings in TOTO has declined

significantly, that’s only one bank be the major

shareholdings of the company which is The Bank of

Tokyo-MitsubishiUFJwithonly1.74%.Thetotalofthe

shareholdings combines with bank, trust bank and

insurance company does not exceed 31.12%. Thiswill

break the traditional Japanese practice of cross-

shareholdings,which theZaibatsuwillholdmore than

51%shareineverysinglecompany.Noneofthemajor

shareholdersholdmorethan10%oftheTOTOGroup’s

shares.Thus,thiswilldecreasetheaccountingfraudand

relatedpartytransactionbetweentheshareholdersand

noneoftheshareholdershavethemajorpowertoalter

andcontrolthecompany’sdecisionthatwillaffectthe

companyfutureplan.

TOTO Group’s established nominating advisory

committeetoensurethetransparencyandobjectivityof

TOTO’s management through activities such as

deliberating on and confirming the appointment of

TOTO’s Directors and Audit & Supervisory Board

Members.ThispositionwillbeappointedbytheBoard

ofDirectorofthecompany.TheCommitteeshallreport

totheBoardofDirectorsonproposalssubmittedtothe

General Meeting of Shareholders related to the

appointment and dismissal of the candidates of

Directors and Audit & Supervisory Board Members,

includingOutsideDirectorsandOutsideMembersofthe

Audit & Supervisory Board. The company has two

outside members of the audit & supervisory board,

which areMasamichi Takemoto andAkira Katayanagi.

Masamichi Rakemoto provided a wide variety of

opinionsfromaglobalviewpointonqualitycontrol,risk

management and business strategies whereas Akira

Katayanagiprovidedawidevarietyofopinions froma

global viewpoint on financial aspect, human

development and management on the group

companies.


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TOTO’sgroupmanagementphilosophywasformulated

accordingtotheir founder’s letter,KazuchikaOkurato

hissuccessor,SaburoMomoki.Thecontentoftheletter

istreasuredastheWordsofourfounder.Thewordsof

founderhadbecomethefoundationofTOTOmotto.

TOTO’sfounders,similartootherprestigioustraditional

Japanese firm, took pride in their craftsmanship to

deliver the best qualities product. While quality

productsmaycostabitmore,thecompanyfocuseson

providing product satisfaction to its customers.

Therefore,wecanconcludeTOTOmanagementisstrict

onproductqualitytoensurethatonlygoodproductsare

delivered.TheformationofTOTOcorporatecorevalues

canbeseenbelow;

KeyManagementAnalysis

Mr Madoka Kitamura- the current president and

representativeDirectorofTOTOLtd.Heisin-chargedof

global business promotion, management planning

design and the secretary’s office. Born in 1957, Mr

Madoka Kitamura graduated from University of

Nagasaki with a Bachelor of Economics. Madoka

KitamurawasappointedPresidentandRepresentative

DirectorofTOTOLtd.inApril2014.

In May, immediately following his appointment, he

announced the TOTOGroup'sMid-TermManagement

Plan. To achieve the TOTO V-Plan 2017, TOTO's long-

termmanagementplanthatwasannouncedin2009,he

presented strategies for the domestic (Japanese)

housing equipment business, the overseas housing

equipmentbusinessandnewbusinessdomainsinJapan

andoverseas.He joined thecompany in1981,andhe

has held key management positions in subsidiary

companiesoftheTOTOGroup.

AfterservingasSectionManagerofTOTO'sAccounting

& Finance Division, Deputy Manager of the

ManagementPlanningDivision,andGeneralManagerof

theManagement PlanningDivision, hewas appointed

GeneralManagerof theBathroomDivision in2008. In

2011hewasappointedDirector.WhilehewasGeneral

Manager of the Bathroom Division, he worked on

developing platforms for modular bathroom for the

domesticmarket,andreleasedtheproductsin2012.

MrKunioHarimoto-thecurrentrepresentativedirector,

and chairman of the board. Born in 1951, Mr Kunio

obtained his degree of Commerce in University of

Waseda.Mr.KunioHarimotoservedasthePresidentof

TOTOLtduntilApril1,2014anditsExecutiveOfficer.Mr.

HarimotohasbeenChairmanoftheBoardatTOTOLtd

April1,2014andservesas itsRepresentativeDirector

since June 2003. He has been an Outside Director of

Nishi-NipponRailroadCo.,LtdsinceJune2014.Besides

that,hewasalsoappointedasthehonoraryconsulate

ofFinlandinKitakyusuJapan.

GrowthStockAssessmentIncomeStatement

BalanceSheet

The factories in Vietnam and Thailand will start to

commencebusinessandprocessforthetoiletproduct

in the year 2018. The future sales will be increased

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because TOTO Group will strengthen the market of

SoutheastAsia.Otherthanthat,thefactoryinThailand

andVietnamwillcontributetohighprofitmargindueto

thelowercostandtaxexpensesinbothcountries.This

willincreasethenetincomeofthecompanyaswellas

theprofitmargin.

Otherwise, theirnewbusiness,advancedceramicswill

alsocontributetothesalesofTOTOGroupinthefuture.

As there is relatively lack of strong competitors in

sanitary ware technology, we believe that TOTO will

comeoutwithamoreadvancedanduniquetechnology

in this business to compete in themarket. Eventually,

the future sales of the advanced ceramic products is

believed togrow faster than themainbusinessof the

companywhichissalesoftoiletproduct.

CompetitiveAdvantagesCompetitors of TOTO are analyzed based upon two

categoriestodeterminehowhighofathreattheyareto

TOTO’smarketshareasrivals.

TOTO is theworld's largestmanufacturer of plumbing

fixtures.Thecompanyoffersawidearrayofproducts,

ranging from restroom products to high-tech ceramic

products.Fewofitstopcompetitorsareabletomatch

TOTO's wide scope of products. For example, Grohe,

alsoalargemanufacturerofbathroomproductsfocuses

on a nichemarket thatmainly sells faucets. American

Standards,awidely-knownAmericanbrandalsooffersa

wide range of products, but they don't have ceramic

products like TOTO. Besides its diversified product

categories, TOTO also listens to their customers to

determine the needs of the market. TOTO’s products

provides affordable solutions without sacrificing

performance.TOTOinvestsalotofmoneyintoR&Dto

make products that are innovative and good for the

environment. They understand that true value comes

fromcustomersatisfaction.

TheBiggestCompetitor:GeberitTheGeberitGroupisaSwitzerland-basedmultinational

specialized in the manufacturing and supplying of

sanitary parts and related systems throughout Europe

and the world. As TOTO and Geberit having similar

product line, we will deeply discuss about the

comparison between TOTO and Geberit in few

important aspect which are marketing strategy,

business model, product differentiation and future

prospect.

Marketingstrategy

TOTOappliesadirectshowroomstrategytoattractnew

customers,withmore than13showroomsaround the

world. Inside TOTO well-furnished showroom, each

customer will have first-hand experience of TOTO

productsandservedbyappointedsalespersonnel.The

aim of TOTO’s marketing strategy is to shape TOTO

brandawarenessasthepremiumbrandoftoilet.

Besides,maintaining a lifestyle experience showroom,

TOTO established relationship with network of

authorizeddealerand jointventuresacross theworld,

notablyinAsia.ThisgrantTOTOasolidfootholdinAsia

sanitaryandceramicsmarket.Besidesthat,mostTOTO

overseassubsidiaryoperatesindependently,thisallows

moreflexibilityinmarketingstrategytoaccommodate

differentsanitarycultureindifferentcountries.

IncontrastwithGeberit,Geberitpursuemoreproactive

marketing strategywhich they deploy amoving toilet

showroomtotravelaroundareasoftargetedcustomer.

ComparetoTOTO’spassivemarketingstrategy,Geberit

embraceapushandpullstrategyapproach.

Under the” push and pull” strategy, plumbers were

educated to ‘pull” the product through wholesale

channel,andcompanysalesrepresentatives“push”the

products to wholesalers. In exchange for plumbers’

promotion, Geberit pays commission to the plumbers

fortheirtoiletinstallations.

Such alliance between suppliers and Geberit brings

attractive profit margin for Geberit, Geberit achieved

greateroperatingmarginupto15%comparetoTOTO’s

operating margin of 8%. Besides that, such business

model also allows Geberit to secure up to 70% of

Europeansanitarymarketshare.

Geberit also employed amoving showroom tactics to

display their products to their targeted customers. In

promoting their Aquaclean shower toilets, Geberit

moved showrooms to provide greater exposure to

customers by travelling around Europe using moving

truck. Besides that, Geberit alsomade amobile toilet

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showroom available in selected concerts, sporting

eventsandothermajorevents.

In addition of traditional marketing strategy, Geberit

also focus more on middlemen or target group

relationship to enhance sales by providing them

technicalassistanceandeducation.Hence,bynurturing

friendlyrelationshipwithdealerorplumbers,plumbers

canhelptoboostGeberitsales,aswellindirectlymarket

theirproductstotheircustomers.Itcouldhelptofoster

brand loyalty, during economic downturn when

renovation and construction slowing down, plumbers

become themain supportofGeberit business.Hence,

plumbers become the main pillar of Geberit business

when consumer scale down on spending. In contrast

with TOTO, during 2009, TOTO sales suffered major

lossesastheirproductpricingwasexpensiveandlackof

effective contingency plans to weather economic

downturn.

Therefore, in contrast with both Geberit and TOTO

marketing strategy, our team concluded that due to

difference in target customer groups, TOTO putmore

concentration on creating a luxury brand image by

building direct managed showroom, in order for

customerstoexperiencetheirhightechnologyproduct,

while Geberit focus on minor detail by cultivating

relationship with plumbers because most Geberit

products focuson itsdurability than luxury.Hence,an

easy and durable products will be recommended to

customerwhich look for valueofmoney compared to

valueofcomfort.

ProductOfferingDifferentiation

TOTOandGeberitproductofferingwashomogeneous

whichrangefromsanitarysolutions,bathroom,faucets

and ceramics. However, TOTO and Geberit product

offering differentiate in both patterns as TOTO only

focus more on engineering a high function toilet or

bathroomequipment,whileGeberit focusonmoreon

basicoutdoorbathroomsuppliessuchashighlysound

insulating building drainage plunging system, cistern

mechanism,customizedurinalsystemforbuildings,and

pipesandbrassfittings.

TOTOputsmoreconcentrationonproductdesignand

proprietary technology of Washlet technology, while

Geberit focuses more on engineering of external

bathroomequipment.TOTOWashletseriesestablished

solid market presence than Geberit Aquaclean series,

whichwasonlyintroducedin2015.However, interms

of external equipment engineering, Geberit has more

experience inpiping system,whichwasanareaTOTO

did not have any expertise or existing product

development.

In both analyses of both companies’ product offering,

ourteamdiscoveredthatTOTOandGeberithaveboth

work closely with construction companies to provide

endtoendsanitaryequipmentintegration.WhileTOTO

established alliance with construction companies for

promotionofitsremodellingbusiness,Geberitfocuson

construction of customized urinal system for hotels,

stadiumandbuildingsandalsowastetrapmanagement

system.Our teamanalysis conclude thatGeberithave

more expertise on sanitary infrastructure such as

pipings,cisterns, installationssystems,whileTOTOhas

great experience in bathroom interior design, friendly

user interface and high technology bathroom

accessories.

However, both companies can learn each other to

improvebothproductsandservice.TOTOdespitebeing

re-owned manufacturer of cutting edge bathroom

technology, TOTO’s product still lack of Geberit

engineeringtouchonwaterpipesanddrainagesystems,

and precise plumbing technical details on bathroom

internal installation system behind the wall. While,

Geberit bathroom ceramics segment and smart toilet

functionsstillbehindTOTOtechnologyuntiltheirrecent

acquisition of Sanitec in 2014, their flagship product

AquacleanseriesstilllackofTOTOinfluenceinAsiaand

US markets. However, Geberit proved a strong

competitorwithotherbathroomequipmentmakerafter

theirintegrationwiththeirpipingsystems.

Businessmodel

Intermsofcorporateexpansion,TOTOandGeberittook

different approach in expanding their company, TOTO

tookanorganicgrowthapproach,whileGeberitpursue

M&Aapproachbyverticalintegration.Currently,TOTO

didnotacquireanycompetitor,butinsteadfocusingin

expandingproductionlineinAsiaregion.

However, Geberit had undertaken numerous vertical

expansion by takeover of bathroom ceramics maker

Sanitecin2014,ChicagoFaucets in2002,andCaradon

TerrainandFAEFluidsystemin1999.Incomparisonof

both companies’ business model, we expect Geberit

marketshareexpandinfasterpacecomparedtoTOTO

organicgrowth.However,TOTOin-houseresearchand

developmentprovedmoresophisticatedthanGeberit.

Unlike Geberit which need to acquire companies to

expand technology know-how, TOTO research

department had amassedmore proprietary bathroom

technology such as water consumption management,

smartceramicsmaterialssuchasHYDROTECTtilesand

heatinsulatedbathtub.ThesetechnologyplacedTOTO

as the world leader in sanitary technology,as a result

TOTOproductsweremorepreferbyluxuryandupscale

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marketforsuchsophisticateddetail , indirectlyhelped

toincreasedTOTOoperatingmarginfrom3%to8%.In

contrast, Geberit only have relative technology on

installationsystemandpiping,whilesmarttechnologies

bathroomappliancesstillingrowthstages.

Futureprospect

Besidesthanmainstreambusinessofsanitarywaresand

bathroom equipment, both companies have also

developed new products as new sales catalyst. For

TOTO,asidefromtheirflagshipWashletproduct,TOTO

developed new business domains that focus on

advancedceramicsbusinessandgreenbuildingmaterial

products. The advanced ceramics business consists

range of high quality ceramics produced for the

semiconductorindustries.

TOTO was involved in development and research of

advanced ceramics since 1984, hence TOTO has the

specialization on air bearings, electrostatic chunks,

optical components, AD ceramic film, bonding

capillaries, and precision ceramic components. Our

team found out that the huge growth in TOTO’s

advancedceramicssegmentwasfueledbythesurgeof

demandinelectronicandsemiconductorindustry.

Our team isconfidentwithTOTO’sadvancedceramics

product especially as most of those components like

optical and precision ceramics were largely utilized in

communicationsectorandinspectionandfabricationof

semiconductor mould and tooling those components

were designed to withstand high thermal resistant,

superiordurability,andhighspecification.Forexample,

TOTO’s silicon infiltrated silicon carbide-SiSic was

normally used for manufacturing of FPD (flat panel

display) and processing and conveyance system of

semiconductor,while TOTO’s optical receptacleswere

installinwiderangeoftransceivers,likecommunication

networkandmobilephones.

Besides that, in order to understand and customized

customerneeds,TOTOhadadopted3Dtechnologyfor

leadingedgesemiconductordevice.Hence,weestimate

as global semiconductor demand continued to move

uptrend, more specialized ceramics component is

neededtoensurehighsafetypriorityandinspectionof

semiconductor. Therefore, our team projected that

TOTO’sadvancedceramicssegmentwouldcontinueto

grow and contribute larger profit in TOTO Group

revenue. We noted that the growing of global

semiconductor production and fibre optic

communicationwasbehindthegrowingprofitabilityof

TOTOadvancedceramicsdepartment.

Geberitfuturegrowthprospectwerelargelydictateby

their new launch of Aquaclean series, which was just

launched in 2015. Despite being the new kid of the

block,GeberitAquacleanserieshadmadenewinroads

inshowertoiletmarketwhichwaspresentlydominated

by luxury bathroom equipment maker such as TOTO,

GroheandKohler.However,accordingtoGeberitlatest

business report, due to overwhelming demand of

Aquaclean, existing facilities line unable to cater such

strong demand, resulted slower growth in Aquaclean

series.

Despite facing currentobstacle inproduction line,our

team still positive with Geberit future prospect to

feature an integrated bathroom solution which

comprise installation system, cisterns, water taps and

their Aquaclean shower toilet. Besides that, we were

alsopositivewithGeberitnewinnovationoftheirpiping

systemfeaturingahightechnology,heatinsulatedand

soundproofpipingsystem.

WeexpectGeberitpipingsystemwillcontinuedbethe

main growth driver, as demand of efficient piping

system needed to discharge water at a higher rate,

especially during harsh weather condition when the

volume ofwater increased tremendously.We foresee

thedemandofhighlysophisticatedpipingsystemswill

surge in future, as risk of unusual weather or natural

phenomenaincreased.

In comparison growth prospect of both sanitary

companies, our team concluded that TOTO new

businessdomainadvancedceramicsandgreenbuilding

materialswillcontinuedtobefuturecatalystgrowthof

TOTO.While forGeberit,Geberitnewdevelopmentof

showertoilet,Aquacleanseries,propelledGeberit into

anintegratedplayerofthesanitarymarketfromsystem

behind thewall and in front of thewall. However, in

currentsituation,bothcompanies’growthprospectstill

ingrowingstageandlargelydependentonsentimentof

consumer market. We hope both companies’

managementwill have long termplan to execute and

implementineconomicalscale.

BusinessRiskFactorsPricefluctuationofforeigncurrencyandrawmaterial

suchCopperandaluminium.

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Asakeyrawmaterialformanufacturingthe“Washlets”

and “Neorest”, the copper and aluminium price keep

changingeverydayfollowbytheindexboard.Thismay

adversely affect the TOTO Group's business, financial

condition and operating results. For example, if the

demand in one of the quarter perform very well, the

priceofthis2rawmaterialwillbeincreasedsteeplyin

the particular quarter. On the other way, when the

demanddecreasesatthesamequarterinthefollowing

year, the pricewill be decreased steeply and thiswill

make thecompany financialperformancesurge in the

period. If this thing happens frequently, the financial

performanceofcompanywillgetaffectedandthepublic

confidenceforthecompanywilldropinthefuture.

Secondly,TOTOGroup’sconductsinternationalbusiness

transactions, while production, sales and other

operating activities overseas are handled in foreign

currencies.Inbetweencurrencytranslations,thereare

foreigncurrencyrisk forthecompany. Inaddition, the

assets and liabilities of overseas consolidated

subsidiariesaretranslatedintoyenontheconsolidated

balancesheets.Thus,iftheJapaneseYenperformwell

comparewithothercountries,theprofitofthecompany

willbedecreasedduetotheweak foreigncurrencyof

overseascountry.

Highpricingof“Washlets”and“Neorest”

BothofthesearetheflagshipproductsofTOTOGroup’s.

Duetothehighqualityoftheproducts,itmayboostthe

revenues during good times, it may also reduce

revenues during bad times. Even TOTO Group’s have

exportedtheirproductto India,butthecountrymight

need such high quality for toilet facilities. Themarket

demand for such products is not visible as such

companiesarefightingtohavetheleastandmostbasic

toiletfacilitiesatthemoment.

Bothof theseproductswill be installed inplaceswith

high disposable incomes. Thus, the companywill face

this problem due to the poor demand and lack of

interestforthehighqualitytoiletproducts.Ontheother

hand,mostof thecompanywillnot invest to increase

thequalityof toilet facilities. Theymight focuson the

development of property, public transport and so on.

Thus, the budget allocation for every country on

improvethequalityoftoiletfacilitiesisverylimited.

BarrierenterintoEuropemarket

AsweknowthatTOTOGroup’srevenueismorereliant

on Asia instead of western country such as Europe.

Europe is a huge and potentialmarket that is able to

helpTOTOtogeneratemorerevenues.However,TOTO

GroupfacesstiffcompetitionwithbrandsinEuropesuch

as“Grohe”and“Kohler”.Bothofthesebrandrepresent

theflagshiptoiletproductinEurope,sothere’sabarrier

for TOTO Group to join and compete in the Europe

market.Thus, to remain thecompetitive,TOTOGroup

mustconstantlyinvestinresearchanddevelopmentto

buildwideanddeepmoatintheEuropemarket.

WhyTOTO’spricewillbedoubledupin5years?

IncreaseinCapexleadtohighergrowthoffuture

revenue

TOTOcurrentlyhavemorethan20manufacturingsites,

36salesofficesand13showroomsacrosstheglobe.In

TOTOFY14-17midtermmanagementplanwhichaims

to establish a global supply chain network, TOTO has

subsequently increased capex on existing plant in

VietnamandThailandtodoubleitspresentproduction

capacity.

AccordingtoTOTOprojection,uponcompletionofnew

Vietnam Plant No. 3, will be able to export 600,000

piecesofsanitaryperyeartootherAsiancountries. In

Thailand, TOTO planned to invest approximately 2.88

billionbahttoexpandlocaloperationsbyconstruction

ofasecondplanttobecompletedinApril2019.Thenew

plantwillbeableproduce420,000unitsperyearplus

another450,000units from theadjacentplant,witha

totalcombinationof900,000unitsexpected.

The new facilities will be installed with state of art

technologiestoreduceenvironmentalpollution,aswell

labour cost. TOTO has collaborated with Fujitsu to

developasmartfactorysystem,whichprovidegreater

quality management by using IC tags and barcodes

attached in products in progress and all sorts of

equipment to collect information, not only including

qualityandprogressinformation,butalsohumidityand

temperaturewhenrawmaterialsweremixandtypeof

glazeappliedonsanitarywares.Thus,useoftechnology

innewplantcanreduceproductmalfunctionandreduce

costofhumanlabourusingautomation.

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Leaderofsanitarytechnologydevelopment

TOTO first developed the bidet toilet seat device,

Washlet, which equipped with smart technology like

heat warming seat, tornado flushing patterns and

electriccontroldevice.Sincethe inventionofWashlet,

TOTO invented and developed numerous ground-

breakingsanitarysystemsandbathroomequipmentand

most of these technologies were unique intangible

know-how of TOTO. From medium range Washlet to

luxuryNeorest and smart bathtub that equippedwith

smartsensors,TOTOisleadingamongallcompetitorsin

termsofresearchanddevelopment.

Besides than its beautiful and futuristic appearance,

TOTO has advantage in cutting-edge technology of

water-savingandcontrolpanelsthatcanadjusttosuit

your own comfort. TOTO also invented the Tornado

flush,whichsavesmorewaterthantraditionalflushby

installing threewater jetswhich flushes the rim in an

innovativeway.SuchprecisedetailsofTOTOproducts

hasattractedhighurbanmiddleclass fromdeveloping

countries to embrace TOTO Japanese toilet style of

hospitality.

Furthermore,TOTO isalso the leader indevelopingof

environmentfriendlytechnology,whichwasthescience

behindeveryTOTOproduct.Recently,TOTOdeveloped

the Hydrotect technology, which is a unique self-

cleaningprotective coating forbuildingmaterials such

as ceramic tiles when used on outdoor surfaces and

exposed to ultraviolet light either from the sun or an

artificial source. Hydrotect active surface generates a

reaction that cleans the material surface by

decomposingorganicandbyoxidizingnitricoxide into

less harmful substance. Hence, Hydrotect technology

helps to purify the air surrounding and reduce the

spread of bacteria and eliminate the bad odours in

bathroom.

With strong research and development together with

solidtechnologyfoothold,TOTOhasstrongcompetitive

advantageaheadothercompetitorsonsmartbathroom

technology.

Stablefinancialpositionwithpositivegrowthtrajectory

Despitefacingheavycapexthatcouldimpactcompany

retained earnings and borrowings, TOTO managed to

achieve average 6.48% of annual retained earnings

growthfrom2010to2017,inthesametimeoperating

expensesonlygrowat2%annually,whichtranslateinto

2timesofexpensescreate6timesofvalue.Weviewed

TOTOasacompanywithsolidfinancialbackgroundto

supportitselfandpaydividendtoshareholders.

Inworking capital, TOTOhas 2.53bil yen total current

asset and 1.611 bil yen of current liabilities. Thus,we

concludeTOTOhasenoughcapitaltoservicetheirlong

termandshort-termdebt.Intheirlatestfinancialreport

2017,TOTOhasacombinedof956.67milinbothcash

andshortterminvestment,whichissufficienttorepay

current debt obligation and capital leases obligation

worth269.3milyen.Besidesthat,withcashreserveup

to 956 mil yen, TOTO was able to finance or pursue

mergerandacquisitionsofrivalcompetitors,whichrival

LixilGrouphadtaken.

Alternativedistributionchannelsviajointventure

TOTOpresenceinAsiamarketiswellestablishedsince

their first 1997 opening of overseas manufacturing

facilityinIndonesia.Sincethen,TOTOIndonesiaSuryais

the largesttoiletmanufacturer intheworldwitheight

productionlinesandalsoalistedcompanyinIndonesia

StockExchange.

TOTO also formed a joint venturewith Thailand Siam

SanitaryWareCo, subsidiaryofSiamCementgroup in

1984 to manufacture and distribute of high quality

sanitarywares,faucetsandceramics.Thus,COTTOwas

the leading distributor of local brands and TOTO

products.

(TSE:5332)TotoLtd. FY2013 FY2014 FY2015 FY2016 FY2017 FY2018LTMSharePriceJPY 2,018.00 2,730.00 4,412.00 4,060.00 4,290.00 6,220.00NoofShares(mil) 171.6 168.0 168.2 169.1 169.2 169.2MCAP(mil)USD 3,490 4,527 6,070 6,687 6,460 9,335NetDebt(Cash)JPY 29,495 (1,221) 13,209 8,296 (11,462) (16,689)EnterpriseValue(mil)USD 3,062 4,387 4,715 4,886 5,954 8,813Revenue(mil)JPY 476,275.0 553,448.0 544,509.0 567,889.0 573,819.0 589,310.0EBITDA(mil)JPY 42,885.0 62,105.0 54,655.0 64,535.0 67,781.0 71,890.0EBIT(mil)JPY 23,377.0 47,183.0 37,428.0 46,138.0 48,572.0 51,520.0NPAT(mil)JPY 16,956.0 44,122.0 24,813.0 35,723.0 33,839.0 36,578.0NPAT(Ex.Xtra+Dis.Ops)(mil)JPY 20,955.0 37,525.0 26,611.0 34,423.0 36,917.0 37,542.0CFO(mil)JPY 44,498.0 48,015.0 34,713.0 58,695.0 63,738.0 55,115.0CAPEX(mil)JPY (21,252.0) (19,217.0) (25,534.0) (27,320.0) (32,023.0) (36,800.0)EPSJPY 122.1 223.4 158.2 203.5 218.2 221.9Revenue(mil)USD 5,056.3 5,375.9 4,538.0 5,054.2 5,146.4 5,233.4EBITDA(mil)USD 455.3 603.3 455.5 574.4 607.9 638.4EBIT(mil)USD 248.2 458.3 311.9 410.6 435.6 457.5NPAT(mil)USD 180.0 428.6 206.8 317.9 303.5 324.8CFO(mil)USD 472.4 466.4 289.3 522.4 571.6 489.5CAPEX(mil)USD (225.6) (186.7) (212.8) (243.1) (287.2) (326.8)GPM(%) 36.3% 38.2% 38.1% 38.1% 38.5% 38.1%EBIT(%) 4.9% 8.5% 6.9% 8.1% 8.5% 8.7%NetDebt(Cash)/Equity(%) 14.2% -0.5% 4.9% 3.0% -3.9% -5.4%ROA(%) 5.7% 9.9% 7.2% 8.6% 8.8% 9.4%ROE(%) 11.3% 19.0% 13.8% 16.7% 16.3% 16.7%CFO/TA(%) 10.9% 10.1% 6.7% 10.9% 11.5% 10.1%EV/Sales(x) 0.8 0.8 1.4 1.2 1.3 1.8EV/EBIT(x) 16.3 9.9 20.4 15.3 14.9 20.2EV/EBITDA(x) 8.9 7.5 14.0 10.9 10.7 14.5EV/CFO(x) 8.6 9.7 22.0 12.0 11.3 18.9P/Sales(x) 0.7 0.8 1.4 1.2 1.3 1.8P/EBIT(x) 14.8 9.7 19.8 14.9 14.9 20.4P/B(x) 1.8 2.0 2.9 2.6 2.6 3.6VQ1:EV/EBIT/ROE(x) 1.4 0.5 1.5 0.9 0.9 1.2VQ2:EV/EBIT/ROA(x) 2.9 1.0 2.8 1.8 1.7 2.1

126

Acknowledgements

Onbehalfof8VIC,IwouldliketoexpressourheartfeltgratitudetoourInter-VarsityStockResearch

Challengejudges!

Withouttheirexpertise,thecompetitionwouldnothaverunsosmoothly.

Judge:ProfessorDr.HermannSimon• Honorarychairmanandfounderofglobalconsultancy,Simon-

Kucher&Partners.

• AnExpertinstrategy,marketingandpricing.IntheGerman

languagearea,hewasvotedthemostinfluentialmanagement

thinkerafterthelatePeterDrucker.

• BestSellingAuthorwithover35booksin26languages-

Worldwidebestsellers"HiddenChampions"and"PowerPricing",

aswellas"ManageforProfit,NotforMarketShare".

Judge:FrançoisBadelon

• FounderandChairmanofAmiralGestion,anindependentasset

managementfirmwithanAUMof€3bnofassetsunder

management.

• Over25yearsofinvestmentexperienceandhissinglegoalis

sustainedperformancewithminimumriskbasedonthefirm’s

valueinvestingapproach.

Judge:HemantAmin• Founder,ManagingDirectorandChiefInvestmentOfficerof

AsiaminCapital.

• ThecompanyistheAsiaminFamilyOffice&Investmentadvisor

forallocatingproprietarycapitalbelongingtotheAsiaminGroup.

• Fundsaremanagedinthestyleofafocused,20stocks,longonly,

equityportfolioviaabottoms-upcompanyspecificresearch

process.

Judge:VishalKhandelwal• FounderofSafalNiveshak.com,acommunityofover38,000

dedicatedreadersacrossover100countries.

• Hehasoveradecadeworthofexperienceinstockanalysis.

• Vishalisafirmbelieverandpractitioneroftheprinciplesofvalue

investingasoutlinedbythelikesofBenGraham,WarrenBuffett,

andCharlieMunger,andtheseareexactlywhatheteachesothers

tobeabletomakewell-thought-outinvestmentdecisions.�

127

Judge:KeeKoonBoon• ChiefInvestmentOfficer&CEO,HiddenChampionsCapital

Management.

• Aninternationallyfeaturedinvestor,hehasoveradecadeworth

ofexperienceasafundmanager.

• HewasalsoalectureratSingaporeManagementUniversity

wherehepioneeredthefirst-of-its-kindcourseonAccounting

FraudinAsia,whichisnowanofficialcourseintheSMU

curriculum.

• Expertiseincludesinvestmentresearch,riskmanagementand

accountingfrauddetection.

Thankyouforcomingforwardandvolunteeringyourtimetomentorandprovideinsightfuladviceto

thestudents.Itisameaningfulcausetoprovidestudentsaplatformforexposureandgrowth.

Lastly,IwouldliketospeciallythankourorganisingcommitteeconsistingofKelvinSeetoh,KlaraLye,

Joshua Zhang, Jinliang Tho and Joyce Pang Qin for working together to bring this stock research

challengetofruition.

WarmestRegards

MrSeanSeahChiefExecutiveOfficer

8VICGlobal

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