Description

We have always been intrigued by companies which manage to maintain high gross margins while operating in a very cyclical industry. We would like to present Yamaichi as a contrarian but prudent investment in the smart phone and telecommunication supply technology chain, which has experienced lower valuations across the board following the COVID-induced boom’s normalization. 

Yamaichi has two business units with very different economics:

-        Tech Solution unit: (52% of rev and 80+% of OP with 15-20% normalized OPM): maker of testing sockets (up to 13k types), the bulk of which is used in burn-in testing which subjects semiconductors to temperature and voltage stress at 125°C to 180°C for several hours to screen initial defects. They are used in smartphone, servers and auto-related industries

-        Connector solution unit (44% of rev and ~15% of OP with 6-8% normalized OPM): manufacturing connectors used for high-speed data transmission (optical transceivers, co-axial connectors for auto cameras, LCD, etc).

The Connector business is a lower margins business with a long-tail of legacy clients, some of which the company should probably drop to focus on the higher margins product lines. Their connectors for the telecommunication industry for instance dominate the high-end of that sector but they do not break up its contribution to this unit’s profits.

The rest of the write-up will focus on the high-margin Tech Solutions unit, which can itself be split further in two units:

 -          Burn-in testing sockets which are used to mimic operational conditions in automotive, health care and IOT products. The company has a 20 to 30% global share of a market which is shrinking because of the wider adoption of System Level Testing. That being said, growth has picked up again recently thanks to the demand in automotive and IOT products which are more likely to still use burn-in testing.

 -          Testing sockets are used by Apple and other high-end smartphone makers to test their Integrated Circuits (IC). Yamaichi dominates this market, which has been rapidly growing.

In terms of operating margin, burn-in sockets for analogue chips are the highest, followed by testing sockets (2nd highest) and burn-in sockets for memory devices (OPM half of the testing sockets). We will now focus on the testing sockets, which has seen high growth in the past two years and which  concentrates investors’ fear of a slowdown.

Let us first try to understand in layman terms how Yamaichi has managed stable 35% gross margins in what is a very competitive and fragmented market.

The key components of these testing sockets are the testing pins. The know-how to manufacture these pins, which can be used up to a million times, brings together the company’s niche manufacturing expertise, their use of special alloys and pre-production integration with its customers and their manufacturing outsourcing suppliers. On the last point, we understand that the integration lead time extends to one year, split evenly between sample production and evaluation/testing, translating into high switching costs.

Over the years, the number of these high-tech pins per testing socket has increased with the complexity of Integrated Circuits, taking its average selling price up with it.

These testing sockets have all the hallmarks of a low cost vs high value proposition, similar to the aviation precision parts market. We think that Yamaichi has deftly leveraged this position in a high-switching cost competitive moat.

The company has seen very high earnings growth since 2021, which has started to decelerate in the last quarter (Q3 FY2022). We think that earnings will mean-revert but the current valuation of 3 x EV/EBIT and 5 x PE based on the LTM earnings as well as the 30% of the market cap in cash gives us good downside protection. In fact, if earnings would normalize to Yen8B, valuation would only go up to 4x EV/EBIT and 7x PE, which we think is too low for such a quality business.

The company may even surprise us on the upside. It is expanding its manufacturing base North of Tokyo which bodes well for revenues and earnings growth over the next few years.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Risks:

Forex: The company’s manufacturing plant is located in Japan. Results are therefore impacted by the USDJPY rate. Management provides a useful forex sensitivity table in its earning results presentation. A weak yen has obviously been very good for earnings over the past 2 years, coinciding with a demand boom in testing sockets for smartphones. An assembly plant is being constructed in the Philippines, which will alleviate somewhat that dependency. 

Failed M&A: the company made a disastrous acquisition in 2011 which drove significant losses in the two subsequent years. We have been assured that lessons have been learnt and that diversification efforts have been abandoned for good.