Japan’s Nippon Electric Glass (NEG) is set to emerge from a long winter, with structurally higher returns, top line growth and a valuation which reflects these changed circumstances. We see a significant arbitrage between NEG’s historic poor operating performance and something that resembles a high barrier to entry oligopoly going forward. The LCD glass industry is today dominated by 3 players, Corning (50%), Asahi Glass (25%) and NEG (20%). In late 2013 Corning gained full control of their LCD joint venture with Samsung to cement their dominant position. Smaller players like LG Chemical (Schott) and Saint Gobain (exited) have struggled to keep pace with falling prices and rising technical hurdles.
An unusual quirk of the LCD glass industry is having the world market denominated in Yen, while the final goods (TV’s, notebook PC’s) are largely priced in US dollars. This left Japanese suppliers at a competitive disadvantage during the period of Yen strength up until 2013. And coupled with rising energy costs which followed the Fukushima nuclear shut down, NEG suffered through a bleak winter from which we think they’re now emerging. The recent policy-induced weakness in the Japanese Yen has meant that glass costs have fallen from 12% of the cost of panel production to an historic low of 7% today. We think this sets the stage for a more rational pricing environment amongst the glass manufacturers and for some claw back of lost economics through better pricing. The pricing environment should be further reinforced by Corning’s decision to offer customers guaranteed best price, in return for guaranteed fixed supply, removing the incentive for Asahi and NEG to discount to win share. In point of fact, Asahi and NEG have scope to raise prices knowing a) Corning will not undercut them and b) the cost of glass in Yen terms is at an historically low level. This will very likely driving improving financial returns for the Japanese glass companies. At the same time China Inc. is embarking on the next wave of panel production build out, and will represent a strong new source of demand. At the same time, the trajectory of technology driven cost reductions in the glass industry has slowed due to physical limitations. Coupled with a now consolidated supplier base, the scene is set for a price squeeze.
Trading at just 0.6x book value with net cash on their balance sheet, NEG carries the type of asymmetric risk-reward profile that we’re generally in search of. NEG’s recent surprise revision to their margin outlook we think provides evidence of the changed industry circumstances we’ve been describing. And although the shares have moved up in recent months, on our inspection they capture only a transitory, not the structural uplift to industry conditions we believe is underway. We have as a result elevated NEG to one of the larger positions in our funds, and see share price upside well beyond book value. As investors get comfortable with the idea of sustainably higher industry returns, similar to the transformation witnessed in the DRAM and Hard Disk Drive industries, valuations can and should expand accordingly – a mid-cycle earnings based valuation would equate to 1.2-1.5x book (ex-cash PE of 12-15x).