Toyo Gosei: Actions corrected but not yet a purchase (TYGIF)

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investment thesis

Shares of Toyo Gosei (OTCPK:TYGIF) have corrected 53% year to date, and we believe key negatives around cost inflation and currency risks have been discounted. Despite the company’s position as a supplier of key chemicals For the semiconductor industry, we believe it is not worth investing given the limited upside of a cash-burn profile and falling profitability that could lead to negative year-over-year growth. We are neutral on the stock.

quick primer

Established in 1954, Toyo Gosei is a Japanese specialty chemical manufacturer that operates two key business segments. The first is photosensitive materials used in the manufacture of semiconductors (for both logic and memory chips), which accounted for more than 60% of sales in fiscal year 3/2022. The second is chemicals for use in pharmaceuticals, fragrances, paints and solvents and their management and storage. The current CEO, Yujin Kimura, is a member of the family of founder and former president Masateru Kimura.

The company’s largest customer is Shin-Etsu Chemical (OTCPK: SHECY), Japan’s largest chemical company and the world’s leading manufacturer of PVC by volume. Shin-Etsu Chemical Compound 13.6% (page 12) of total sales in fiscal year 3/2022.

The company will announce the results of the second quarter of fiscal year 3/2023 on November 9, 2022.

Key financial data, including consensus forecasts

Key financial data, including consensus forecasts

Key financial data, including consensus forecasts (Enterprise, Refinitiv)

Our objectives

Toyo Gosei made headlines with Kamala Harris’s visit to japan in September 2022, who organized a roundtable with companies in the semiconductor supply chain. Though by no means a major industry heavyweight, Toyo Gosei has a role in supplying photosensitive material for use in semiconductor lithography.

In this article, we want to assess earnings prospects given major changes in exchange rates and inflationary pressures affecting raw material and freight costs.

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An uphill climb

While the company expected the depreciation of the Japanese yen against the US dollar in fiscal year 3/2023, no one could have anticipated its rapid real rate of decline. Toyo Gosei expected a fiscal year average exchange rate of JPY125 per US dollar for the current fiscal year, but it had already reached JPY136 in the first quarter of fiscal year 3/2023 and is currently trading at around JPY147, a depreciation. 31% year-on-year.

While this will result in a strong year-over-year boost in yen-denominated sales, it was already noticeable in the first quarter of FY3/2023 (page 4) that costs were increasing. Raw material, fuel and freight costs increased year-over-year, which squeezed margins, along with rising operating costs as the company spent on Capex and R&D. While trading appeared in line with the company’s interim guidance, we see the following challenges ahead.

First, the strength of the dollar will mean higher than expected costs. There is room for Toyo Gosei to raise prices, but we believe there will be limited selling power as end-user demand begins to dry up for flat panel display materials, as well as most notably in the memory market with ongoing inventory adjustments recently highlighted by Micron (MU), Western Digital (WDC) and Samsung Electronics (OTCPK:SSNLF). The logic market looks relatively healthier, but the overall outlook for the company’s photosensitive chemicals business is negative.

Costs will also play a role in reducing profitability in the chemical segment, which relies on demand for cars, cosmetics and high-purity solvents for electronics, which are experiencing a downturn in consumer confidence.

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Second, the company announced a medium-term plan in fiscal year 3/2022, which highlighted an investment commitment to improve its infrastructure and increase production capacity. While these should have benefits in the long term, in the short to medium term it seems to be a perfect storm where profitability is reduced by increased depreciation, while free cash flow is punished as costs are expected to fall. Capex levels remain historically high to boost capacity. The company’s free cash flow generation track record is not exactly stable, and as a result, we expect the company to be burning cash in FY3/2023 and FY3/2024 unless plans are revised, a difficult task given the long-term contract nature of these constructions.

Free Cash Flow Trend (in blue), with Capex planned for FY3/2023 (in yellow)

Free cash flow trend, with Capex planned for FY3/2023

Free Cash Flow Trend, with Capex Planned for FY3/2023 (Company)

Consensus forecasts look too bullish

Despite these significant challenges ahead, consensus forecasts look very positive with continued margin expansion combined with higher free cash flow generation (see chart above in Key Financials). We cannot anticipate such events to occur, given cost pressures and declining underlying demand. What seems relatively credible is the dividend forecast for fiscal year 3/2023, where the company has already forecast 40 yen per share. However, given the current business environment, we believe this will at best be a cap on dividends over the medium term, and at worst point to a year-over-year dividend cut. The company is not cash rich with a net debt balance of 14.1bn JPY/97m USD, which equates to 0.9x net debt to equity, which is not a major concern but highlights the limits on the company’s ability to serve shareholders increased. returns.

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Despite the company posting historically high operating margins of 14.3% in fiscal year 3/2022, it appears that this is a unique and unsustainable trend. To conclude, in our opinion, the consensus forecasts are misleading.

Ratings

Based on consensus forecasts, the stock is trading at P/E FY3/2024 12.6x. There is a risk that the company’s EPS will reach this level, but only through paper earnings (under non-operating income) as US dollar deposits are converted back to Japanese yen. The market does not generally reward temporary FX conversion gains. However, the projected free cash flow return of 2.4% seems too high given the potential for cash burn and therefore we do not think the stock looks undervalued.

risks

The company may be viewed as a key player in the semiconductor supply chain and consequently may be valued at a higher valuation multiple than historically assessed. After a major correction in the share price, investors can see that all the negatives have been priced in and the long-term outlook is attractive given Toyo Gosei’s exposure to structural growth in semiconductor manufacturing. .

Downside risks include weaker-than-expected second quarter FY3/2023 results, with the company’s guidance for the fiscal year being revised downward as cost pressures are quantified and the outlook is lowered. of earnings. Management may also limit proposals for future dividend increases, given the risks of increased financing costs.

conclusion

We believe recent trading is weak at Toyo Gosei and this will be highlighted in FY3/2023 Q2 results. Stocks have corrected 53% YTD and therefore we do not see a major downside risk. However, given the company’s relatively sketchy track record of generating free cash flow and its limited ability to boost prices to mitigate cost inflation, we don’t see the stock as attractive. We have a neutral rating on the stock.

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