Post-analyst briefing, we are convinced that the worst is over for D&O. We are increasingly confident that the company will make a strong comeback in the 2H of the year on the back of sequential recovery in automotive LED sales and margins, led by the China market which contributes about 45%-50% to the Group’s revenue. The government has reportedly pledged more stimulus measures to boost car demand, amongst others. Overall, management retains its high single-digit sales growth for FY23. Maintain Outperform with unchanged TP of RM4.37, pegged at 35x FY24 EPS.

• Chinese government looking to shore up auto sector. Last Friday, the government of China rolled out new guidelines on the automotive (auto) industry, setting a target of 27m new vehicles this year or an increase of 3% YoY. It has also sets its sights on electric car sales of 9m units this year, up 30% YoY. It also identified three main domestic challenges that the auto industry is facing however, namely, i) shrinking demand, ii) supply disruption and iii) weakened expectations. The new plan also includes tax incentives that will be offered to boost sales of new energy vehicles, and more charging infrastructure to be installed. The central government is also calling on local authorities not to impose any further restrictions on car sales and is pushing regions to revise up their new car sales quotas. In addition, it will also support efforts to develop new technologies such as car chips, solid-state batteries, operating systems and high precision sensors. The action plan also sets out a goal for the auto industry to operate “within a reasonable range” next year with further improvements in quality and efficiency.

• Strong export growth ramping up China’s auto demand. While concerned over a demand slowdown domestically amid deepening price competition, China’s automobile players are now looking to bolster their sales in overseas markets. According to the China Passenger Car Association, China’s July passenger car exports soared 63% YoY to 310,000 vehicles, raising the total to 2.65m units in the first 7 months of the year. Local brands made up 248,000 units or 80% of July’s exports. China has also overtaken Japan as the top global car exporter. Led by a cost advantage in lithium-ion battery cell production and early-venture into Electric Vehicle (EV) technologies, China has now become the frontrunner in the EV race. It is forecasted that EV car prices in China are likely to drop below internal combustion engine car prices starting from next year.

• Loading volume expected to normalize in 2H. After seeing a historic low capacity utilization of 65% in 1H2023, management of D&O expects loading volume to be significantly higher at above 85% in 2H2023. Based on our rough estimates, we expect automotive LED sales to jump at least 37% in 2H vs 1H, with full-year sales breaking the RM1bn mark. Meanwhile, gross margin could potentially recover to the 23%-25% levels if capacity utilization hits above 80%. In contrast to last year, 4QFY23 sales are expected to hit the peak this year. Meanwhile, inventory levels are also expected to ease from the recent-high 6 months to below 5-month level in the subsequent quarters.

• Smart LED sales set to rise in strong momentum. Apart from securing an upbeat forecast from its key German customer, it is currently in talks with another established car maker from Korea. Smart LED sales volume is set to record an impressive CAGR of more than 200% from 2023 to 2025. In 2024, it is expected to register a 3-fold growth. In-short, smart LED sales are expected to contribute about 5%-6% of sales in 2023 before hitting 10%-15% in 2024 and 20% in 2025. It is worth noting that the current forecast only takes into account the projection for EV models such iX, i7, i5, X4 and Mini Cooper models. Models for X5, X7 and i3 are yet to be included, indicating the huge untapped potential in the future.

• A new milestone for smart projection application. The Group has recently bagged the first design win for smart projection LED in the global automotive LED industry with an estimated annual sale of more than RM15m for the new electric MINI Cooper. The Smart LED lighting, which is applied on the dash board, comes with 3 IC chips at an average selling price of at least 3x more expensive than the usual smart LED. It is expected to commence in 1QFY24 for monthly car production of 25,000 units. Meanwhile, acceleration in the move of adopting wider display panel applications and the adoption of car body lighting for sensing purposes by major automakers has advanced the technological shift from Edge-Lit to Direct Lit LEDs. A full screen of display panel application consists of more than 1,000 pieces of LEDs. The potential annual volume for the Direct-Lit Led market is more than 6bn pieces, which is a huge untapped market.

• Update on Plant 2. Following the recent site visit by BMW’s management, the floor space (1st floor) for Plant 2 will subsequently go through the i) qualification, ii) simulation run, iii) reliability test and iv) final approvals from Tier-1 module players and end-customers. Management has targeted full utilization of Plant 2 by 2026. Meantime, the existing floor space at Plant 1 can still cope with the ramp up in new capacity. It plans to free up more floor space for Plant 1 by converting the new automated casting line into triple-deck and new sorter line into double-deck sorters next year. This could potentially see space savings of 52%-60% with a doubling of yields per worker.

• Dominant Electronics on the mark. The Printed Circuit Board Assembly (PCBA) segment, which is part of the supplementary strategy to broaden the services for its clients, is almost ready for commercialization with 4 production lines installed, and an additional 2 lines next year. It has received its maiden project, which is an EV control unit from Hurain Beijing. The latter will occupy 50% of the top floor for the final testing. The estimated annual revenue is around RM12m-RM15m starting from FY25. We understand that there are a total of 5 projects in the pipeline.

• Capital expenditure (capex) guidance. D&O has spent a total of RM52.9m in the 1HFY23 on new production lines, machinery upgrade and plant automation. Management has set aside RM80m-RM100m capex this year with no major capacity expansion. About 80% of the budget will be allocated for new equipment. Current gearing level remains healthy, standing at net debt position of RM222m with a net gearing level of 24.6%.

• First physical integrated circuit (IC) chip to be unveiled soon. The first-of-its-kind physical chip, which has the functionality of analog, digital and memory, is in the final stage for package qualification. The physical IC is expected to be rolled out by end-Nov. One of the German leading automakers has given the greenlight for the IC application and they will undergo the stringent testing process in 2H 2024 before securing the qualification from end-customer by 2025. The design-in stage (initial success where customer considers and is involved in Dominant’s products) will only materialize by end-2025. The in-house chip design not only helps ease its chip supply concern by having a second source, it can also reduce its chip cost by up to 25%.

Source: PublicInvest Research - 6 Sept 2023