Hoya: Japan's Quiet Tech Giant


By John Yang We believe Hoya ( HOCPY

; recent price: $131) is one of the best-kept secrets in the Japanese equities market. Founded in 1941 as an optical glassmaker, the Tokyo-based outfit transformed itself into one of the major semiconductor production-equipment companies in the world, creating key components crucial in the chip and liquid crystal display (LCD) panel production process.

Technology and high market share for its products have resulted in solid earnings and dividend growth in the past five years, and the share price has posted an average annual return of 24% since 2001.

Although the shares reached a historical high in August, we believe there's more room for upside after reviewing first-quarter earnings and have upgraded our recommendation to 5 STARS (strong buy), from 3 STARS (hold).

SIX PRODUCT SEGMENTS. Hoya's products can be divided into six segments: electro-optics, photonics, vision care, health care, crystal, and services. Electro-optics is the core business, accounting for 53% of revenues. Within this segment are five major products: Mask blanks, LSI photomasks, LCD photomasks, hard-disk drives (HDD), and lenses for digital cameras.

In general, semiconductor chip production can be divided into front end and back end. In the front end, a critical process called photolithography reproduces the chip's circuitry pattern on the wafer's surface by using ultraviolet light and a stencil coated with metallic film and light-sensitive material.

Once the ridges are made via a combination of light and chemicals on the wafer, metals such as copper and aluminum are laid out as pathways for electricity. The stencil in its untouched state is called mask blank. Once the chip's circuitry design is written on the mask blank, the stencil is called a photomask.

HIGH-MARGIN PRODUCTS. Hence, photolithography is very similar to developing a picture. The mask blank is the film, while the photomask is the negative, and the picture is the wafer with ridges.

Hoya is the largest producer of mask blanks, commanding an 80% market share worldwide. All major chipmakers are Hoya's clients. The barrier to entry for this market is high. Although Hoya doesn't disclose the margin of this product, we estimate it at 40%.

Such a high margin is justified, in our view, considering the complexity and difficulties involved in manufacturing mask blanks. Also, the technology involved in the production isn't easily duplicated.

WELL-POSITIONED. Moreover, due to the capital-intensive nature of the business, late entrants must spend a significant amount of money on R&D and capital spending just to be on par with Hoya, which is already moving towards next-generation mask blanks.

Hoya also produces photomasks for LSI and large-sized LCDs, with a world market share of 50% for the latter (management does not disclose the data for LSI photomasks). The same exact photolithography is applied to produce the LCD panel modules.

The design-rule cycle of LCD panel technology (which changes every 12 months) and the generation-shift to bigger mother glass plates should drive the photomask industry as a whole, and we think Hoya is in a good position to benefit from the trend.

SURGING DEMAND. It produces both glass substrate and media head disks for HDDs. About 80% of the iPod's (AAPL) HDD is made of Hoya's glass substrate. Naturally, one of its main customers is Seagate (STX

; ranked strong buy; $16).

Because of its shock resistance and reliability in data storage, the glass disk is slowly but surely replacing the aluminum disk. For example, all laptops made by Toshiba carry glass disks in their drives.

Managing a worldwide market share of 80%, Hoya, we expect, will continue to benefit from growing demand in portable music players, notebook PCs, and third-generation cell phones with disk drives.

GROWTH AREAS. Another business worth noting is lenses for digital-still cameras. Hoya has a market share among original equipment manufacturers of 50% worldwide.

An area of growth is the shift to glass lenses from plastic in digital cameras embedded in cell phones. Unlike plastic, glass lenses allow phone users to take pictures with more clarity.

Although the percentage of glass lenses in terms of revenues is small, we believe the shifting trend should gain momentum in fiscal year ending March, 2007, and boost Hoya's future earnings as European and American users upgrade their cell phones.

UNDERESTIMATED TREND. We were impressed with Hoya' latest earnings report. Its first-quarter diluted earnings per share of $1.66 rose 23% from a year ago, substantially beating our estimate of 96 cents.

We underestimated the revenue growth trend in Electronic Optics (EO), especially LCD photomasks and disks used in HDDs. In our previous assumption, we expected a slowdown in LCD photomasks due to a supply glut of LCD panels.

Also, we anticipated that the introduction of the iPod Shuffle (which is flash-memory based) would slow down growth of HDD glass substrates since 80% of HDD-based iPods used Hoya's glass disks.

LOCATION, LOCATION. On the contrary, Hoya posted 20% and 42% revenue growth for LCD photomasks and HDD glass substrates, respectively. For the former, we had underestimated the utilization rate of the Hoya's newly started LCD photomask factory in Taiwan. In the latter, we didn't anticipate such firm demand for notebook PCs in the first quarter, which drove revenue growth of Hoya's 2.5-inch HDD glass disks.

Our company visit on Aug. 12 reinforced our view that the new plant which opened in Taiwan this year will put Hoya in a better position as a provider of LCD photomasks to Taiwanese LCD makers, given the proximity and their growing market share. Also, Asian LCD panel makers' (including Korean and Japanese) continuous effort to shift to 6G/7G will likely drive demand for LCD photomasks.

Furthermore, we share management's view that there's no sign of a slowdown for notebook PCs in the second half of fiscal year ending March, 2006, as consumers are shifting from desktop to notebook models. Toshiba (which uses only glass disks, not aluminum) confirmed that solid demand for notebook PCs would spill into the second half of fiscal 2006.

FORECASTS GET A BOOST. We expect Hoya's HDD business to benefit from such demand and post another double-digit revenue gain in the third and fourth quarters. We have upgraded fiscal 2006 EO revenue forecast to $1.58 billion from $1.56 billion.

We have also raised EO's margin assumption to 42% from 38%. We anticipate fiscal 2006 net income of $700 million, an increase of 20% year-over-year. We believe the shares are trading at discounted levels, considering what we see as firm earnings potential in fiscal 2006 and 2007.

We expect Hoya will continue to be a price-setter for rapidly growing LCD photomasks (we anticipate 20% revenue growth for fiscal 2006) for large-sized panels and hard disk glass substrates for notebook PCs, leveraging its global market shares of 50% and 80%, respectively.

JUSTIFIED MULTIPLE. Also, we project Hoya's gross margin will hover at the 49% level for fiscal 2006 and fiscal 2007, as the company's market position and cost-reduction efforts should offset any pricing pressure in semiconductor production equipment-related (such as mask blanks) products.

Although the current price-to-book (p-b) multiple is at 4.8, we believe that the future earnings growth justifies such a high multiple, as we expect a three-year annualized average EPS growth rate of 25.6% until fiscal 2007 (including fiscal 2005).

Also, Hoya President Hiroshi Suzuki confirmed in a Reuters interview that the company will use its cash balance for mergers and acquisitions by March, 2006. Moreover, the announced 4-for-1 stock split should add more liquidity to the market as the deadline nears.

POSSIBLE RISKS. The current p-b is at a 27.3% discount relative to the historical average. By applying a combination of p-b (6.6) and enterprise value to earnings before interest, taxes, depreciation, and amortization (EBITDA) (21.1) metrics, we derive our new 12-month target price of $181.

Risks to our recommendation and target price include a sudden downturn in capital spending by Asian LCD manufacturers and a continuous uptrend in oil prices. Also, given its high valuation, the share price may correct itself if Hoya doesn't meet our future earnings estimates.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index, in Asia the S&P Asia 50 Index, and in Malaysia the KLCI or KL Emas Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; in Sweden by Standard & Poor's AB ("S&P AB"), in Malaysia by Standard & Poor's Malaysia Sdn Bhd ("S&PM") which is regulated by the Securities Commission and in Australia by Standard & Poor's Information Services (Australia) Pty Ltd ("SPIS") which is regulated by the Australian Securities & Investments Commission.

The research and analytical services performed by SPIAS, S&P LLC, S&P AB, S&PM and SPIS are each conducted separately from any other analytical activity of Standard & Poor's.

Hoya, Seagate and Toshiba are not customers of S&P or its affiliates.

Disclaimers

This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

Analyst Yang follows technology stocks in Tokyo for Standard & Poor's Equity Research


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