Despite the market noises, Malaysia’s OSAT companies’ and equipment makers’ growth remains promising, led by sector leaders. Companies with high earnings quality and clear strategies for multiple-year growth will sustain their above-mean valuations. The valuation gap between these track record-proven companies vs the rest could widen in a highly volatile market. Maintain OVERWEIGHT. Top pick: Inari.

WHAT’S NEW

• Outperformed KLCI post-general election. 1H18 was a volatile period for the technology sector’s outsourced semiconductor assebly and test (OSAT) companies and equipment makers. Despite falling 5.8% ytd, the technology sector (only for stocks under our coverage) outperformed the FMBKLCI post the 14th general election (GE14) held on 9 May. Since GE 14, the sector has risen 11%, vs the FBMKLCI’s 9% contraction. Despite the still promising outlook, the sector’s sentiment has been affected by various factors, which include the ongoing US-China trade talks, newsflow on the weaker orders for Apple’s supply chain and the pre- and post-election selloff and rally.
• Outlook still promising. Despite the market noises, the technology sector’s growth remains promising, led by sector leaders. Essentially, we see: a) OSAT sales growth remaining healthy at 8% and 10%, and the equipment sector’s sales growing 12% and 18% in 2018-19 respectively; b) 2H18 earnings possibly growing hoh, benefitting from new smartphone cycle and a weaker ringgit; c) massive capacity expansion for selected companies suggest new business opportunities; and d) local companies getting more entrenched in the global supply chain.

ACTION

• Maintain OVERWEIGHT. The sector was in an upcycle in 2017 and aided by a strong US dollar, essentially benefitting all industry players. Coming from 2017’s high sales base, investors should focus on high earnings quality sector leaders with clear strategies for multiple-year growth, which could sustain their above-mean valuations. In our view, Inari and vision inspection maker Vitrox meet these criteria. Moreover, looking at the broader picture post GE14, the technology sector’s valuation could be upheld as it is one of the handful of sectors that are apolitical and supported by strong earnings growth.
• Top pick: Inari, with a higher target price of RM2.68. Maintain BUY with a higher target price of RM2.68 (previously RM2.45), pegged to 22x 2019F PE (previously 20x). The higher valuation is in view of strong revenue prospects (CAGR of 21% in FY17-20) and high earnings quality, with potential upside from new contracts, particularly from OSRAM in 4Q18. Also, Inari’s new plant under construction in Batu Kawan (first block to be ready in Oct 18) is set for the next phase of growth in 2019-20, with the new floor space possibly earmarked for OSRAM’s automobile-related products. Meanwhile, Inari could still see solid sales growth from Broadcom, which includes the RF segment (due to the commercialisation of 5G networks) and more in-house job transfers to Inari.
• Maintain BUY on Globetronics with a higher target price of RM2.52 (previously RM2.36), pegged to 15.5x 2019F PE (previously 14.5x PE), which is 1x higher than the mean PE. Despite expecting a weak 2Q18, Globetronics’ revenue visibility has improved. With mass production of new-generation light sensors that started in June, production volume is expected to hit 40m units in August (4x and 2x higher than in May and June). Early indication suggests that the monthly production volume could sustain at 40m units in SepOct 18. Moreover, mass production of laser headlamps (for one car model) is poised to start in Oct 18 after more than two year’s stringent qualification process. Laser headlamps could be a catalyst in 2019 once volume ramps up and also pave the way for Globetronics to seek growth beyond mobile device-related products.
• Vitrox: Getting ready for next growth phase… Vitrox will be moving into its new plant (3x larger than existing premises) later this month, which will solve its floor space constraint problem. Despite a strong five-year net profit CAGR of 31% in 2012-17, earnings growth could be sustained on capacity scale-up, a more favourable product mix (demand for advanced 3D inspection systems is on the uptrend due to miniaturisation of semiconductor components and more sophisticated PCBA) and introduction of inspection systems for new segments (such as precision mechanical parts) to increase its total addressable market.
• …to double headcount by 2020. Valuation still attractive. By moving into the new plant, Vitrox aims to double its current’s 500 headcount to 1,000 by 2020. We note that 2017’s headcount was doubled that of 2012’s but sales and net profit grew much stronger at 269% and 282%. Vitrox currently trades at 22.1x 2019F PE and 18.4x 2020F PE with consensus forecast of 3-year net profit CAGR of 20% in 2017-20, or 73% net profit growth from 2017 to 2020. Given the scale that Vitrox is ramping up, consistent new product introduction to the market and the mega trends in the semiconductor sector, there could be upside to consensus’ earnings forecasts which implies PEG ratio of <1x, suggesting undemanding valuation.

ESSENTIALS

• Rising trade tensions weigh on sector sentiment but sensitivity lessens. The US-China trade tension has been intensifying since early-April. However, we note that Malaysia’s technology sector is getting less sensitive to the trade war newsflow despite the tension is exacerbating (see graph below). We assess that Malaysia’s technology sector has marginal direct impact from the tariff battle, based on the developments thus far. Over the longer term, should the tension between the US and China persist, Malaysia may benefit as US MNCs may relocate their production facilities to Southeast Asia. Having said that, the potential indirect impact could be an underlying threat to the sector. If the relationship between the US and China worsens (for example, Chinese consumers boycotting US products), US companies with significant China exposure will be impacted. We estimate that Inari’s and Globetronics’ earnings would decline 5-6% and 7-8% respectively should their US-smartphone end client’s sales in China drop by 50%.
• Minimum wage hike would not have prominent impact. The new government’s election manifesto has pledged to increase the monthly minimum wage to RM1,500 (from RM1,000) by the first term with the government to bear RM250 increment. Overall, we opine the minimum wage hike will not have a significant impact on the sector as the increment is likely to be implemented gradually over five years as the new government needs to consider the country's fiscal conditions. In any case, we estimate every RM100 hike will reduce Inari’s and Globetronics’ FY19 earnings by 0.5%-1.0%.

Source: UOB Kay Hian Research - 5 Jul 2018