4202: Daicel Corporation’s Industry Leading Operations Paves Way for Long-Term Stability

Summary

• Who is cleaning up after Takata’s airbag recall mess?
• “The Daicel Way” is the chemical industry equivalent of the Toyota Production System.
• Daicel trades at a discount relative to its peers, despite its industry-leading operations.

The backdrop of this article on Daicel Corporation is that I was catching myself up on the Takata airbag recall and wondered which company would pick up after the mess. Autoliv (ALV), the world’s largest automotive safety parts manufacturer in the world, is the obvious answer. However, cleanup is a group effort for the largest automotive recall in history. That’s where I ran into Daicel Corporation, the #2 company in airbag inflators by market share, only behind Autoliv.

Background

Daicel Corporation was established in 1919 through a merger of 8 distressed Japanese celluloid companies. Over the years, Daicel expanded its operations outside of celluloid applications, including the development of photo films which marked the birth of Fujifilm (TYO: 4901) in 1934. In addition to expanding operations into different industries, the company expanded its international footprint as well. Here’s a map showing their facilities outside of Japan:

Source: Daicel Website

Daicel’s sales are still primarily focused in Japan, but with a growing presence in China:

Source: Daicel 2016 Annual Report (English)

In Japan, Daicel is most famous for what is called “The Daicel Way”, which is an internally developed production system that has recently been adopted by many large scale chemical processing companies in Japan such as: Mitsui Chemicals (TYO: 4183), Sumitomo Chemical Company (TYO: 4005), Zeon Corporation (TYO: 4205), Toyobo (TYO: 3101), and Daikin Industries (TYO: 6367).

Today, Daicel operates in 5 segments:

• Celluloid Applications
• Organic Chemicals
• Plastics
• Pyrotechnics
• Others

When I first looked into the operating segments, the only segments that sounded vaguely familiar to me was “Plastics” and “Others”. The rest went way above my head. After some reading, I got an idea of what the various segments actually produce. For people like me, here’s a brief description of each segment and what they mainly produce:

Celluloid Applications

This segment makes two primary products: Acetate celluloid films for LCD displays and acetate celluloid fibers for cigarette filter tow.

Organic Chemicals

This segment produces a variety of different complicated chemical products that go into electronics, cosmetic products, health supplements, paint, etc. Additionally, this segment offers chiral separation products. In normal human terms, that means Daicel provides pharmaceutical companies with special equipment that helps separate drug ingredients that cure symptoms from the ingredients that cause side effects.

Plastics

This segment provides engineered plastics, resin compounds, and high performance polymers. This is a confusing way of saying plastic coating, trays, packaging, machine parts, electronic components, etc.

Pyrotechnics

Explosive safety devices! This segment produces airbag inflators, initiators, propellants, etc. These are applied to things like airbags in cars, ejection systems in aircrafts, and missiles. Currently, Daicel holds the #2 market share in automotive airbag inflators, only behind Autoliv. Interestingly, Daicel just expanded their US operations by adding a facility in Arizona. It is probably worth noting that Toyota owns a little over 4% of Daicel as well. Finally, it’s been rumored that Daicel placed a bid on a buyout of Takata, along with other companies involved in automotive safety products.

Others

This segment contains water treatment systems, logistics services, household products, and miscellaneous other businesses.

Here’s a useful image straight from Daicel’s 2016 Annual Report highlighting some of the applications for Daicel products:

Source: Daicel 2016 Annual Report (English)

Sales and Operating Income by Segment:

Source: Daicel 2016 Annual Report (English)

The Daicel Way

The birth of the Daicel Way came from one chemical plant during challenging times. In the 1990s, when the Japanese bubble collapsed, the Aboshi plant was struggling with a large drop in sales and profits as well as a large loss in workforce. The loss in workforce was not due to the drop in sales, but because all the post-war hires reaching retirement age. For a chemical company, talent loss is a major risk since one mistake at the plant can result in an explosion. Unfortunately, the key advancements in manufacturing lead by Toyota Motors could not be easily applied in the chemical processing industry.

The Toyota Production System (TPS) is largely focused on continuous improvement (or Kaizen in Japanese). This means making incremental and continuous improvements, small steps. Fortunately for the manufacturing industry, plant layouts can be modified to some extent. In contrast, chemical plants generally consist of intertwining pipes and tanks that are fixed in position. What this means is that perfection in the production process is desired from day 1.

With the goal of building a next generation chemical plant where people’s work are more creativity-focused vs. task-focused, Daicel set out to develop their own system. The outline of the system has 3 main steps:

1. Mieru (Visibility)
2. Yameru (Quit)
3. Kawaru (Change)

Step 1 is the relentless pursuit of visibility. The typical process improvement approach in manufacturing revolves around focusing on a specific process in production. The Daicel Way approaches process improvement from an entire business segment’s view. Every process from the production floor technicians to sales departments are laid out in detail – frequently using employee activity journals as a reference. As you might imagine, the process map is generally large.

Step 2 is waste removal. Every process that does not add any value is removed. Now, that’s a vague criteria, but the waste removal process revolves around whether a process actually works towards solving a problem. Generally, there are 3 patterns in information flow between the middle manager and plant operations:

1. Manager instructs the plant to do something -> plant performs as instructed -> plant reports results to manager.
2. Plant discovers a problem in daily operations -> plant reports problem to manager -> manager instructs plant on problem resolution.
3. Plant reports manager with updates or Manager updates plant

The 1st and 2nd patterns generally accomplish something. If you’ve ever worked in the corporate world, the 3rd pattern is the weekly meeting that requires 3 cups of coffee, takes a whole hour of your time, and gets next to nothing accomplished.

Step 3 is change. This should be more familiar for those with experience in operations management. After the team is done removing useless processes, it’s time to evaluate the surviving processes for improvement areas. The benefit of having the “change” step after the “quit” step is that employees tend to get burned out if this is done in reverse. Removing the useless processes reduces the workload for employees, offering more time to be spent on change.

Now, this is a simplified explanation of the Daicel Way. In practice, the Daicel Way involves the systemization of processes, a knowledge database, a full on-boarding program to acquaint the new employees to the company’s lingo, etc. Overall, the Daicel Way frees its employees from mundane tasks and helps keep the focus on creative, innovative, developmental work. As a reference, Daicel’s Aboshi facility, which consists of multiple buildings sitting on 10 million square feet of land, can be operated with 20 people from one control room (Japanese reference).

Valuation

To start, here are a few data points:

It is safe to say that even if all of Takata’s airbag inflator business landed in Daicel’s hands, it is not likely that Daicel’s core business would see a dramatic change. Having said that, increased long-term share in the airbag inflator market would be a nice side dish. Compared to its peers of similar size, Daicel maintains a rather normal total debt to total equity ratio of 0.21 (Peers: 0.1~0.3). However, Daicel’s ROE (11.8%) and ROA (8.4%) are higher than its peers (ROE: 5% – 8.2% ROA: 1.6% – 5.6%). Additionally, Daicel trades at 11.3x P/E compared to 11~16x for its peers.

Peers include: Kuraray Co (TYO: 3405), JSR Corp (TYO: 4185), Nippon Shokubai (TYO: 4114), and Zeon Corp (TYO: 4205).

Daicel management is expecting revenues and earnings to be lower in FY 2017 compared to FY 2016. Projected sales is 444,000M yen with a projected operating profit of 61,000M yen in FY 2017 compared to 449,878M  yen in sales and 69,479M yen in operating profit for FY 2016. Daicel has been building out their factories and it’s a little difficult to gauge just how much of capex is for maintenance and how much is for growth, which makes it a little difficult to gauge what their free cash flow looks like. I decided to make this real simple – I’ll have 3 scenarios:

1. Maintenance capex at 25%
2. Maintenance capex at 50%
3. Maintenance capex at 75%

Blanket assumptions include: 11% discount rate, FCF starts at FY 2014 levels (since FY 2016 marked record highs and I want to be a little conservative), then increases 3% per year (Daicel has a sales CAGR of 6% over the past 11 years), current price is closing price on 9/30/2016:

1. Maintenance capex at 25%:

2. Maintenance capex at 50%

3. Maintenance capex at 75%

As a reference, Daicel has a tangible book value per share of 915 yen. What comes to my mind is a quote from the Oracle of Omaha: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Daicel Corporation isn’t cheap, but they are at the forefront of chemical plant operations. It’s hard to say what that is worth, but it’s valuable enough for me to keep an eye on Daicel’s price.