We came away from VSI’s analyst briefing feeling reassured of its prospects moving forward. After a washout 3QFY18, VSI should stage a recovery in the subsequent quarters on improving operating leverage. It will take two or more quarters for margins to recover to 2017 levels. VSI is in talks with prospective new customers to fill up its new capacities coming on stream in 2H18. Maintain BUY and target price of RM1.85, based on a 13x 2019F EPS.

WHAT’S NEW

The worst is over. We attended VS Industry’s (VSI) analyst briefing and came away feeling reassured of its prospects moving forward. After a washout quarter in 3QFY18, we expect VSI to stage a recovery in the subsequent quarters driven by the operational commencement of more assembly lines for key customers. In addition, there were price adjustments since last month for selected models for key customers, whereby we estimate a cost pass-through of approximately RM12m p.a.

More new models coming up from US customer. To recap, VSI ceased production for two models that reached the end of their product lifecycles in 3QFY18, and has commenced production for a new replacement model for its US customer in May 18. There will be three more new models coming up in Aug 18, Mar 19 and Apr 19 respectively.

In talks with various parties to fill up new capacities coming on stream in 2H18. The acquired RM28m new factory of 120,000sf (capacity of 8 assembly lines) is under renovation and the first assembly line is slated to commence operations in Nov 18. Meanwhile, the construction of a RM70m new facility with warehouse space of 180,000sf (capacity of 12 lines) is scheduled for completion in Oct 18. VSI is currently in talks with potential customers to fill up these new capacities.

To improve current operating leverage with higher sales in subsequent quarters. The bulk of VSI’s earnings comes from its Malaysia operations which will have 9,000 workers by end-FY18, an increase of >3,000 workers from end-FY17. 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. We foresee that it will take two or more quarters before margins can recover back to 2017 levels, as it will take some time to ramp up its box-build assembly lines to optimal levels as well as to commence production of new models for key customers.

STOCK IMPACT

43.5%-owned VSIG may be back in the red in FY19. For 9MFY18, its China operations under VS International Group (VSIG) reported sales of RM547.1m and a PBT of RM7.8m (5.5% of overall group PBT for 9MFY18). Moving forward to FY19, VSIG may move back into the red on low plant utilisation from potentially lower sales. Unlike VSI’s Malaysia operations, VSIG’s China operations do not have a key customer.

Wholly-owned Skreen Fabric to break even by end-4QFY18. Skreen Fabric (M) Sdn Bhd (Skreen Fabric) is involved in the manufacture and supply of high-quality screen mesh, industrial filter fabrics and non-woven fabrics as well as precision filters. The subsidiary reported a net loss of approximately RM2m in 3QFY18. Moving forward, management expects the unit to breakeven by end-4QFY18 and to ramp up to its full capacity of 7m units per shift for one production line by end-FY19.

EARNINGS REVISION/RISK

No change to our earnings forecasts. Although guidance of VSIG to be loss-making for FY19 is not within our expectations as we expect the subsidiary to be profitable, we note that VSIG’s contribution to the overall group earnings is minimal (at 5.5% of group PBT for 9MFY18 and at 2.4% of PBT if based on VSI’s 43.5% stake in VSIG) and the maiden contribution from Skreen Fabric in FY19 should compensate for it.

Our FY19-20 earnings forecasts are 7% higher than consensus. Our FY19/20F sales growth assumptions are at +3/+6% vs consensus' sales assumptions and our FY19-20 net margin forecasts are at 4.6%/4.9% vs consensus' at 4.4%/4.9% as we expect higher utilisation of new facilities coming on stream in 2H18. Based on existing contracts at hand, we estimate FY19 sales at RM4.8b.

VALUATION/RECOMMENDATION

• Maintain BUY and target price of RM1.85, based on an unchanged 13x PE pegged to its 2019F fully-diluted EPS.
• VSI has a dividend policy of a minimum 40% payout. For the past four fiscal years, VSI has paid out 41-47% of headline profit to shareholders. Based on a payout of 45%, we estimate FY18-20 yields of 2.3-4.6% or 2.1-4.1% (fully-diluted basis).
• As at end-Jun 18, there was minimal change to institutional shareholding at 50% (end- Mar 18 at 51%). However, we note that local funds’ shareholding has increased to 39% from 36%, while foreign funds’ shareholding has dropped to 11% from 15%.

SHARE PRICE CATALYST

• Large contracts from existing/or new customers.
• Favourable forex.

Source: UOB Kay Hian Research - 16 Jul 2018