Hamamatsu Photonics (6965) Part 2

Deeper dive into the business, management, and valuation/risks

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In this post, we continue our exploration of Hamamatsu Photonics. Here is a link to Part 1.

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Business model and competitive advantages

In Part 1, we’ve seen that Hamamatsu Photonics mainly supplies to advanced applications including medical equipment, industrials/semiconductor, and analytical instruments. Hamamatsu’s components are rarely used directly in consumer products.

This distinction is important in understanding the business model. Supplying to consumer end-markets typically require significant competitive advantages in volume and cost. But for Hamamatsu, these are less important since its customers are less price sensitive. Instead, Hamamatsu wins by working closely with customers to provide products that exactly meet their highly technical specifications.

To achieve this, Hamamatsu runs an operation that’s optimized for “high flexibility and low volume manufacturing”. With a large variety of SKUs, their products can be considered "semi-custom". For example, in photodiodes alone, they offer 3,000-4,000 SKUs, tailored to meet customer needs. Overall, the firm has 15,000 SKUs, generating 220 billion yen in revenue per year (which means each SKU averages just 15 million yen).

This model also involves more labor intensive operations, as human workers are needed to prepare production lines and perform parts of the manufacturing process that haven’t been automated due to low volume. For example, the photo below shows how the production of large-sized PMTs still relies heavily on manual labor.

It is also worth noting that ALL of Hamamatsu's production and R&D facilities are located in Japan. Because a large portion of their cost base is in Japan, Hamamatsu stands to benefit significantly from a weak yen, more so than other manufacturers. However, the concentration of production in Japan also presents a geographic risk factor, which we will elaborate on later.

Hamamatsu’s competitive advantages can be summarized as:

• Technology: Hamamatsu is the industry gold standard in high performance, especially within its sensor portfolio, including PMTs, APDs, and SPADs. These products are renowned for their high sensitivity, superior detection speed, and reliability.

• Reputation: Decades of providing industry-leading products have cemented Hamamatsu’s reputation. One industry expert mentioned, “Some Asian competitors offer slightly cheaper products, but I have seen companies choose Hamamatsu without looking too much into it.” Another key point is that the photonics industry is highly fragmented. Hamamatsu stands out as one of the few large, listed players. Supplier longevity is crucial, as customers need assurance that a company can support a component for a long time, particularly for products with long life like medical devices and scientific instruments.

• Comprehensive player: Hamamatsu boasts the industry’s most comprehensive sensors portfolio, which is a major advantage. The company is further deepening its moat by growing its light sources portfolio, becoming one of the very few in the industry that’s able to integrate both under one roof. Hamamatsu will continue to “fill in the missing pieces” in the portfolio through M&A, positioning it as a consolidator in the fragmented photonics industry.

Growth strategy

Hamamatsu’s management has outlined the following growth projections for its key end-markets:

• Healthcare: The company targets an 8% growth rate in the biology field, driven by fast growing products like digital slide scanners (used in R&D and clinical trials), which also come with services and software revenue. In the more mature segment of X-ray CT equipment for hospitals, the company sees a 5% CAGR in the end market (until 2028).

• Semiconductor: Targeting 10% growth, driven by AI chips (stealth dicing) and failure analysis (inspection light sources).

• Analytical instruments: Targeting 6% growth.

• Quantum computing: Targeting 30% growth (albeit from a very small base).

In addition to end-market growth, a key growth driver is to move down the value chain by producing semi-finished or finished products. Since Hamamatsu already manufactures key components and understands how the end product works, it’s natural progression to take the extra step and make the finished product. In recent years, this has increasingly been the focus. These include scientific camera products, pathology digital slide scanners, spectrometers, specialty imaging equipment used in the drug discovery field, and more (some of these are shown in the image below).

We can see below that these semi-finished/finished products have been the fastest growing segment (reflected in the “Imaging and Measurement” segment below, which utilizes components made in the other two segments).

There are two reasons why this business is attractive for Hamamatsu.

First, unlike components, finished products provide for recurring/aftersales revenue. I believe this is why device/equipment makers often command higher valuations than pure component makers, thanks to their maintenance and software revenues.

Second, Hamamatsu has a significant cost advantage since it is able to manufacture the key components in-house. For example, a key product for scientific cameras is the CMOS sensor, which is made in-house. This advantage is reflected in the high margin of the Imaging and Measurement segment. Despite a much smaller revenue base, the profit margin already equals that of Hamamatsu’s other two segments.

Finally, another component of growth is M&A. So far, Hamamatsu has used M&A to bolster its light sources portfolio.

In 2017, Hamamatsu paid 4.6 billion yen to purchase US-based Energetiq Technology, which supplies LDLS (Laser-Driven Light Sources) and EUV light sources for semiconductor mask inspection. In June 2024, Hamamatsu completed a much bigger purchase, acquiring the Danish player NKT Photonics for JPY 42 billion which we will examine further below.

NKT Photonics

“We expect very large synergy effects by combining this laser business with our other optical elements and optical technologies. My personal projection now is that our goal is to reach the JPY40 billion scale in 10 years. In this way, we will firmly build a fourth pillar.”

- President Tadashi Maruno