Investment Highlights

• Since the coronavirus disease 2019 (Covid-19) outbreak, China’s role in global supply chain and the virus’ impact on multiple industries have been in the spotlight as the country shuts down factories and business, restricted transportation, and other measures to curb the spread of the virus. From our channel checks, we have gathered that the companies under our coverage would be impacted by Covid-19 in differing ways: (i) companies with operations in China as V.S. Industry and Malaysian Pacific Industries have risks of potential delays in production directly impacting earnings, (ii) companies who partially import raw materials from China such as V.S. Industry and ATA IMS have materials sourcing risk, and (iii) indirect impact on demand of products in the telecommunications and automotive industry which impacts the sector as a whole.
   
• Various news sources indicate that business is far from back to usual as provinces and cities were instructed to resume work at their own discretion, despite initially being scheduled to resume work after 10 February 2020. According to news reports, even though a significant share of China’s plants have resumed operations, many are operating at far below capacity due to labour shortages as many migrant workers were unable to return to work due to lockdowns on some cities and quarantines on workers travelling across towns. Although the majority (~76%) of the Covid-19 laboratory-confirmed cases were in the Hubei province, efforts to contain the spread of the disease in nearby provinces would cause delays in other parts of the supply chain as well e.g. raw materials sourcing, assembly, test, and shipping, etc.

Technology

• Apple ecosystem updates:

• Production sites near Wuhan (Hubei province) not spared: Foxconn and Pegatron, which are key suppliers to Apple, were amongst many businesses shut down their plants and delayed resuming operations. Industry sources revealed that Foxconn’s Zhengzhou and Shenzhen plants are critical production sites of the iPhone 11 and upcoming iPhone 9 (or SE 2), and 2020 iPhones respectively while Pegatron’s Shanghai and Kushan plants are in charge of iPhone 11 and new 2020 iPhones, and iPhone 9 production respectively. Since the outbreak, Foxconn had issued a statement that it is waiting for local government recommendations before moving ahead with production. To note, the production for the low-cost iPhone 9 was rumoured for a March 2020 release while the new 5G-enabled 2020 iPhones are set for its usual September release. However, concerns regarding products set to be released in 1H 2020 persist due to supply constraints relating to production amid the Covid-19 outbreak.

• Worries not limited to production concerns, but also on smartphone sales demand: Apple released a statement on 1 February 2020 regarding the temporary closure of 42 of its retail stores in China due to the virus outbreak and has scheduled to reopen them on 10 February 2020, but most have extended closures to at least 14 February 2020. A few stores have since opened but with limited opening hours, and there is no indication on when the other retail stores in China would reopen. Apple’s 1QFY20 (Sep–Dec 2019) China sales made up 15% of its total revenue, its 3rd largest market behind the Americas and Europe. On 18 February 2020, Apple CEO Tim Cook said in a statement that Apple would be missing its revenue guidance for the current March 2020 quarter, citing slowed production and weakened demand in China as a result of the Covid-19 outbreak.

• As such, we believe that INARI (HOLD, FV RM1.76) might face a weaker 2HFY20 due to uncertainties related to one of its major end customers (Apple), which is tied to its radio frequency (RF) segment, representing ~49% of the group’s revenue. If the Covid-19 impact does not extend beyond 2QCY20 and 5G smartphones scheduled for 2HCY20 release go out according to plan i.e. Apple’s iPhones scheduled for fall release, Inari’s RF demand for FY21F is anticipated to be strong due to the transition to 5G as RF chip content per phone increases with every model produced and as users who held back purchases earlier begin purchasing 5G-enabled phones. We make no changes to our forecasts as our FY21F forecasts have already factored in growth relating to 5G but do not discount a potential downgrade in earnings, particularly FY20F (1H2020), pending a conference call with management in early March.

• Global automotive industry and supply chain also impacted:

• China: According to the China Association of Automobile Manufacturers (CAAM), vehicle sales fell 18% YoY to 1.94mil units in January 2020 (Exhibit 1) amid fewer working days due to the Lunar New Year Holidays as well as the Covid-19 impact and the group said that declines could be even steeper in February. Meanwhile sales of newenergy vehicle (NEV) declined by 54% YoY.
   
• According to S&P Global Ratings, Wuhan and the rest of the Hubei province account for ~9% of total Chinese auto production as it is houses some of General Motors, Nissan, Renault, Honda and Peugeot’s large factories. Hubei is reportedly China’s 4th largest auto-making hub. Covid-19 caused carmakers and dealerships to close over the extended holiday, with several carmakers such as General Motors, Fiat Chrysler and Toyota Motor began restarting production in China as at 18 February 2020. Besides closure of automaker factories and dealerships impacting car sales, the whole supply chain is at risk as many countries rely on China for auto component imports (Exhibit 2).

• Europe and USA: The European Automobile Manufacturers Association (ACEA) reported that the EU passenger car market contracted by 7.5% YoY to 957K units due to the following factors: (i) taxation changes by some EU member states for 2020; (ii) weakening global economic conditions; and (iii) uncertainty due to Brexit. Meanwhile, US vehicle sales rose by 1% to 16.8 million in January 2020 amid positive economic indicators such as healthy consumer sentiment, low unemployment and available credit.

• Malaysian Pacific Industries (BUY, FV RM12.45) shared that its exposure to China is about 30% of its revenue. Meanwhile, the group’s revenue tied to automotive products in 1QFY20 was 32%. During the Lunar New Year period, its Carsem Suzhou factory was running at 75–80% utilization rate, expecting to maintain that utilization up till 8 February 2020. Since then, the group has yet to share an update on its Suzhou operations but we expect to gain more insight in an upcoming investor briefing on 27 February 2020. We do not rule out the possibility of a downwards revision on earnings pending more details.

EMS

• As for the electronics manufacturing services (EMS) sector, V.S. Industry (BUY, FV RM1.50) which has operations in Malaysia, Indonesia and China, has shared the following update relating to Covid-19: (i) the Malaysia segment is expected to undergo business as usual. However, if the outbreak persists, there may be disruption to the supply of raw materials from China as the segment imports 30% of its raw materials from China; (ii) the China segment is expected to resume production on 17 February 2020 but if further delays in production occur, the group’s production schedule would be impacted. The latest update is that China operations has resumed production but only partially and current raw material inventory is sufficient up till early March 2020. To recap, Malaysia, Indonesia and China operations contribute 86%, 7% and 7% of group revenue respectively. Meanwhile, ATA IMS (BUY, FV RM2.02) said that its raw material inventory is sufficient up till mid-March 2020 and similarly imports 30% of its raw materials from China. The group has not seen any decline in orders from its key customer nor disruptions in production currently. We do not see the need to revise earnings for EMS players yet, as both players have enough inventory for another month.

NEUTRAL on Tech, OVERWEIGHT on EMS

• To summarize, most if not all of the companies under our coverage are adopting a wait-and-see approach and have not yet guided for any earnings impact, depending on whether the Covid-19 outbreak impact extends beyond March 2020 or 1Q. Companies with operations in China and those with a heavier dependency on end customers which have factories in China would be affected the most, while others such as EMS players are indirectly impacted through supply chain risks.

• We maintain our NEUTRAL recommendation on the technology sector and OVERWEIGHT on the EMS sector as even though long-term prospects remain intact, short-term risks related to the global supply chain due to the Covid - 19 outbreak cause uncertainties on the performance of semiconductor players.

Source: AmInvest Research - 20 Feb 2020