VSI’s 3QFY18 results missed expectations due to weaker-than-expected gross margin owing to: a) reduced operating leverage given the large labour base, b) setup and testing costs of new assembly lines, and c) existing box-built assembly lines yet to achieve optimal efficiency. We cut our FY18-20 earnings forecasts by 17-22%. We opine it will take two or more quarters for margins to recover to 2017’s level. Maintain BUY. Target price: RM1.85.

RESULTS

3QFY18 results were below expectations, with 9MFY18 accounting for only 59% and 57% of our and consensus full-year earnings forecasts respectively. The underperformance in VS Industry’s (VSI) 3QFY18 results was due to the weaker-thanexpected gross margin at 8.4% (3QFY17: 15.2%) owing to: a) reduced operating leverage from sharp fall in sales from a US customer given VSI’s large base of workers, b) set-up and testing costs of new production lines, and c) existing box-built assembly lines yet to achieve optimal efficiency. An interim DPS of 0.5 sen (3QFY17: 1.2 sen) was declared, bringing 9MFY18 DPS to 2.9 sen (9MFY17: 3.1 sen).

Sharp fall in sales from a US customer impacted Malaysia sales in 3QFY18. Despite additional new box-built assembly lines being built to cater to orders from a key customer since end-17, 3QFY18 sales rose only 13.2% yoy due to minimal sales contribution from a US customer following the end of product lifecycle for certain models. Note that in 2QFY18, Malaysia sales rose 74% yoy. 3QFY18 PBT declined 56.9% yoy given: a) the cessation of certain models for a US customer and existing labour base, which resulted in reduced operating leverage; b) set-up and testing costs associated with new production lines; and c) existing box-built assembly lines yet to achieve optimal efficiency. Note that 3QFY17 was a high base given the commencement of production of a new model for a US customer back then.

Lacklustre performance from 43.5%-owned VSIG expected. After a strong comeback in 2QFY18, VSIG reported a 35.9% yoy reduction in sales, and PBT consequently declined by a higher quantum of 72.9% yoy on an increase in raw material costs and labour costs, coupled with the competitive environment which reduced VSI’s ability to pass through costs to customers.

STOCK IMPACT

Needs to achieve higher sales to improve current operating leverage. The bulk of its earnings comes from its Malaysia operations, which has about 8,000 workers. Given the large base of workers which is part of its COGS, VSI needs to achieve higher sales to increase its operating leverage, which will in turn improve its margins. As VSI is in the midst of negotiating for more contracts from existing or new customers, we believe the large pool of labour force is in anticipation of potential contract wins although we note there is nothing firm yet at this juncture. We foresee that it will take two or more quarters before margins can recover back to 2017’s level, as it will take some time to ramp up its box-built assembly lines to optimal level, as well as to commence production of new models for its key customers.

More new models coming up from its US customer. VSI has commenced production of a new replacement model for its US customer since May 18. We gather that there will be three more new models coming up in 2H18 and 1H19.

Price adjustments by key customers from Jun 18 onwards. We note that pricings of selected products have been revised up by its key customers to alleviate cost pressure notably from labour. We estimate cost pass-through impact at RM15m p.a.

Focusing on filling up new capacities coming on stream in mid-18 over the next 3-5 years. VSI recently acquired a new plant (up to eight assembly lines) near its current headquarters in Jalan Murni, Johor Bahru, for about RM30m. This is in addition to a new facility with a warehouse (up to 12 assembly lines) that is currently under construction that should be ready by next month. Besides vying to get new contracts from its key customers, VSI is looking to diversify by seeking contracts from new customers.

EARNINGS REVISION/RISK

In view of the weaker-than-expected results, we cut our FY18-20 earnings forecasts by 22%/21%/17% to RM148m/RM234m/RM287m after updating our key assumptions (see RHS chart).

VALUATION/RECOMMENDATION

Given the significant retracement in share price in the past one month, we maintain our BUY rating with a lower target price of RM1.85 (from RM2.30), based on a 13x PE pegged to its 2019F fully diluted EPS.

SHARE PRICE CATALYST

Large contracts from existing/or new customers.

Favourable forex.

Source: UOB Kay Hian Research - 29 Jun 2018