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Clayton Young
Clayton Young
Articles (6)  | Author's Website |

The Toyota of Chemical Companies

What Toyota did for manufacturing is what Daicel did for the process industry, and Daicel has the financials to prove it

According to Misaki Investments, 80%-plus of institutional investors in Japan hold investments for less than a year. Comparatively 62% of institutional investors in the U.S. hold investments for less than a year.

As you may have already guessed, value investing is not popular in Japan. This fact combined with the language barrier often presents me with “hidden” gems in plain sight. Daicel Corp. (TSE:4202) is an example of this.

Overview

Daicel is a chemical company based in Japan. Business segments include:

  • Cellulosic Derivatives: materials that go into cigarette filters and LCD displays.
  • Organic Chemicals: complicated chemical products that go into electronics, cosmetics, health supplements, etc.; also provides pharmaceuticals with specialized equipment that separate drug ingredients which cure stuff from those that cause side effects.
  • Plastics.
  • Pyrotechnic Devices: airbag inflators.
  • Other.

Cellulosic Derivatives is at the core of Daicel’s operations. In fact, Daicel’s founding came about when the Japanese government nudged eight distressed celluloid companies to merge in 1919. The celluloid business still accounts for 23% of total revenues and 39% of operating income.

Daicel’s annual report breaks out revenues and operating income by segment:

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Source: Daicel 2016 Annual Report (pg. 15)

Not the 'Toyota Way' but the 'Daicel Way'

For those who worked in operations or attended business school, Toyota’s (NYSE:TM) production system is probably a familiar concept. It’s a combination of just-in-time, automation, continuous improvement and various other supply chain concepts. The application of the Toyota Way works particularly well on the assembly line. The concept does not always translate well in process industries where raw materials are converted into intermediate goods (e.g., pulp, paper, glass, chemicals, etc.).

In many cases, bottlenecks are not visible in process industries. Imagine trying to create a just in time ingredient delivery system for making tomato soup in your kitchen. Your “bill of materials” will look something like this:

  1. 1 tablespoon olive oil.

  2. 1 tablespoon unsalted butter.

  3. 1 pinch of salt.

  4. 30 ounces of peeled tomato.

  5. Etc.

You get the drill. Now multiply your kitchen size by a million and you have a process plant of your own. In comparison, it’s easier to track inventory units in automotive manufacturing (four tires, one gas tank, one steering wheel and so on per car).

While the Toyota Way is largely focused on removing waste throughout the company, the Daicel way is more focused on enabling human creativity. To be sure, if we drew a Venn diagram of the Toyota Way and the Daicel Way, we would see plenty of overlapping concepts. Since information on the Toyota Way is widely available in English, I’ll keep the discussion focused on the Daicel Way.

In line with continuous improvement, Daicel’s strategy evolves over time. That said, human creativity has always been at the front and center of the Daicel Way. The company explains this on its English website.

The Daicel Way starts with organizational commitment, which can be summarized as:

  • Full commitment by top management.
  • Leadership by middle management.
  • Involvement of all employees.

In this environment, middle management is equivalent to the higher-ups of on-the-ground operations (e.g., plant managers, project managers, etc.). It’s not a clear cut linear process where you implement X and get Y. To an extent, middle management needs to start by making small but sure victories to gain No. 1 and No. 3 above. In order to obtain full organizational commitment, middle management starts by tackling small problems with the following approach:

  1. Mieru (visualize).

  2. Yameru (quit).

  3. Kaeru (change).

Put simply, visualization generally involves elaborate process mapping. Then, managers figure out whether a process is necessary or not. If the process is not necessary, it is eliminated. If the process is necessary and routine, it is automated. At least in theory, this is where the infamous “TPS Report” from the movie "Office Space" is eliminated. Finally, the change process is designed to set the glue so the changed processes stick. At this stage, operations management is categorized by functionality instead of plant location or product type. This is followed up by the development of a production, information and knowledge system that unifies and streamlines the whole company’s operations.

In essence, the elimination and automation of processes frees up people hours. Perhaps some companies may see this as an opportunity to reduce the workforce. Daicel takes this available time for employees to work on creative things (like product development, research, etc.).

What are some results?

So far, we’ve discussed the fluffy, qualitative side of the Daicel Way. Though Daicel’s system has not gained notable traction outside of Japan, it’s widely considered the equivalent of Toyota’s system even by some of the largest Japanese chemical companies. Companies that have implemented the Daicel Way include:

  1. Sumitomo Chemicals (TSE:4005).

  2. Daikin Industries (TSE:6367).

  3. Toyobo (TSE:3101).

  4. Zeon Corp. (TSE:4205).

  5. Mitsui Chemicals (TSE:4183).

Daicel’s Aboshi plant has over 8,000 visitors per year. Arguably, the Aboshi plant is one of the most advanced chemical plants on the planet. Plant operations can be run by a 20-man crew from one control room. As a reference, the Aboshi plant consists of multiple buildings sitting on 830,000 square meters (9 million square feet) of land.

At this point, it goes without saying that Daicel has one of the most efficient chemical plant operations in existence. Some investors may be tickled to know that Toyota Motor is one of the largest Daicel shareholders with a 4.29% stake.

Performance and quick valuation

What sort of business performance does the Daicel Way deliver?

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Here is a chart showing operating margin performance of the five companies that implemented the Daicel Way, excluding Daikin since it has major exposure outside of chemical operations. Daicel (green) and Zeon (light blue) are neck and neck for top performance.

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This one is a comparison of ROIC (Joel Greenblatt (Trades, Portfolio)) for the same companies. Again, Daicel (red) and Zeon (yellow) are neck and neck. Overall, Daicel’s performance seems most consistent, both for operating margins and ROIC.

Interestingly, Daicel is trading at just over 7x EV/EBIT. Historically, this figure has floated around the low teens, with the exception of 2009 (astronomically high!). To be sure, Daicel has marked record-level business performance in the past two years. Current dividend yield is just north of 2%, but historical payout ratios typically ranged between 20% and 30%. This means the record business performance in the past two years delivered healthier dividends compared to other years in recent history.

Enterprise value today (469 billion yen or $4.76 billion) is roughly the same as it was 10 years ago (468 billion yen). The pre-crisis Daicel delivered 36 billion yen in EBIT compared to 64 billion yen in fiscal 2017. Even with a steep decline in EBIT back to pre-crisis levels, EV/EBIT would come in at 13x but with a better balance sheet. Equity-asset ratio was at 0.41 10 years ago and is at 0.62 today. Assuming market cap remains flat (which is a terrible assumption), the 20% to 30% payout ratio means EV would decline with time, regardless of whether Daicel maintains record performance. They can reinvest the cash, further strengthen the balance sheet or deliver higher payouts (or some combination of all).

At least in theory, 13x EV/EBIT with a 0.62 equity-asset ratio is better than 13x EV/EBIT with 0.41 equity-asset ratio. A rational market ought to assign a higher EV/EBIT multiple to the former, but Mr. Market will probably have his swings anyway. With all that said, I don’t think investors with a long-term investment horizon (10-plus years) have anything to worry about. It’s hard to determine an accurate valuation, but a multiple expansion to 15x EV/EBIT generates a 15% gain using a rather conservative pre-crisis EBIT. Meanwhile, investors collect dividends delivered by actual, stellar performance.

Disclosure: I do not own shares in the companies mentioned in this article.

About the author:

Clayton Young
I grew up in Japan and completed an MBA in the U.S., but learned more from reading Howard Marks. I apply an American value investing approach to Japanese companies that are often inscrutable to outsiders who lack fluency in the unique cultural context.

Visit Clayton Young's Website


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