Investment Highlights

• We are downgrading the sector to NEUTRAL (from OVERWEIGHT). Despite the broad-based decline in share price, we believe semiconductors’ near-term earnings growth potential could be further capped by the potential slowdown of economic activities and sustained global inflation which is affecting demand for end-products, especially within the consumer-driven markets. Strengthening MYR against the US$ also may cause further earnings vulnerability. 

• Demand downcycle to drag earnings. With rising interest rate and inflation cutting into consumer purchasing power globally, demand for consumer electronic products, particularly personal computers (PC) and smartphones, is slowing down. Coupled with enterprises delaying their purchases due to macroeconomic uncertainties and geopolitical concerns, the industry is facing risk of a sharp inventory correction. During the cyclical correction, competition is also likely to intensify amid the inventory de-stocking and this could lead to the double whammy of lower sales and margin compression for semiconductor firms. In line with this view, Gartner is forecasting worldwide semiconductor revenue growth to decline by 3.6% in 2023 while the World Semiconductor Trade Statistics projects the global semiconductor market to contract by 4.1% to US$557bil. 
  Note that worldwide PC shipments experienced the steepest decline in over 2 decades after falling 20% in 3Q2022, according to Gartner. Separately, International Data Corporation reported that global smartphone shipments dropped 10% in the same quarter, its fifth consecutive quarter of decline.
• Bright spots to bolster earnings. Nevertheless, local outsourced semiconductor assembly & test players (OSAT) and automated test equipment (ATE) makers are still seeing healthy demand from selected sub-segments such as the automotive sector and wearables segment – stemming from secular trends of electrification of vehicle, autonomous driving and healthcare-related devices. A pocket of opportunities within these areas is expected to support the sector’s 2023 earnings and circumvent negative earnings growth, in our view. In 2023, we are forecasting semiconductor-related stocks under our universe to report earnings growth of 13% on the back of revenue increase of 24%.
• Unattractive valuations, not ruling out further derating. The Bursa Malaysia Technology Index’s current FY23F PE of 22.5x implies that the sector’s broad-based valuations remain pricey compared to its 10-year average of 17x or prepandemic level of 14x (2015-2019), despite the recent share price pullback. Due to this, any negative earnings surprise or turn of events may potentially lead to further derating.
• China’s recovery will not be a straight line. The easing of China’s stringent zero-Covid-19 policy is the sector’s 2023 wild card, which would help alleviate supply chain disruptions and spur a pickup in economic activities, translating into higher demand for end-market products. However, the transition likely will be on a staggered basis – any missteps may lead to a spike in the number of Covid-19 cases and the country could reinforce the strict movement control orders again while the sudden surge in demand also could risk further prolonged global inflationary pressures.
• We remain selective with our BUY calls due to uncertainties in the macroeconomic environment, focusing on quality names with good order book levels and lower risk of further valuation derating. However, we may upgrade the sector if the global recession is shallower-than-expected with signs of softening inflation. Prolonged lockdown in China and worsethan-expected global economic slowdown are catalysts to further downgrade the sector.
  We like Pentamaster Corp’s (FV: RM4.64) robust outlook which continues to be supported by portfolio diversification efforts across market segments and expanding customer base. The group’s strategy to ride on global automotive electrification through robust offerings is also bearing fruit with a comfortable order book at a book-to-bill ratio of 1.4x. 
  We also have a BUY call on Inari Amertron (FV: RM3.72) is premised on the stock’s attractive valuation of ex-cash FY23F PE of 17x vs its 5-year mean of 30x. The group’s healthy net cash position of RM2bil as at September 2022 translates to 20% of market capitalisation. The group’s long-term prospects stem from the resilience of its radio frequency earnings and margin due to higher chip complexity in 5G devices with plans to enhance and diversify revenue streams via joint ventures in China. 
  On the electronic manufacturing services (EMS) front, we have a BUY call on VS Industry (FV: RM1.05), the sole stock under our coverage within the sub-sector. We expect the group’s earnings recovery trajectory to continue in FY23F following the alleviation of labour shortages and supply chain disruptions.
• Environment, social, and governance (ESG). The local semiconductor sector is facing a shortage of skilled employees and this pose a key challenge if the industry would like continue innovating and staying ahead of regional competitors. Nevertheless, the companies have been taking proactive measures such collaborating with local academic institutions and running its own training academy to combat this problem. Besides ensuring a healthy pipeline of human capital to the industry, this will have positive economic spillover effect to the community at large. 
  The EMS sector previously suffered from negative publicity of forced/unethical labour practices. However, we believe local players are more cautious towards this issue and pay great attention to any potential breach. For instance, to ensure supply chain partners adhere to standards set by Malaysian labour laws and the International Labour Organisation, VS Industry imposes Ethical and Environmental Code of Conduct on its suppliers. The code of conduct outline that suppliers must adhere to minimum legal working age and policies on the prevention of forced labour. This include terms that work must not be performed under the threat of punishment or confiscation of belongings, employment should be freely chosen and to never force workers to lodge deposits or identity papers with the company.

Source: AmInvest Research - 20 Dec 2022