Under no circumstances is this investment advice. I cannot guaruntee accuracy of any information included. I am not a professional investor

Uchitec make the hardware and software required for electronic control modules in automated coffee machines. This niche product has provided them with highly impressive returns. They supply the highest quality auto-coffee makers- Jura, Siemens, Nestle, and others. Their ability to rapidly design new components means that these customers can release new products before their competitors. Uchi make other control systems, including those used for precision weighing, centrifuges, and deep freezers, but the coffee modules comprised 85% of revenue in 2020.

Control modules are far more basic than the high-speed chips used in devices and computers, yet still technically complex and difficult to produce. Uchitec are an Original Equipment and Original Design Manufacturer, owning the intellectual property in their products.

Uchi have an efficient attitude, with tight cost controls and a focus on research and development. Their primary aim is to exceed the expectations of their existing customers. Diversification into the wide range of other growing uses- medical devices, other home appliances, and pretty much any other form of automated machinery- has been limited, and this is the riskiest element of the company. It is also the key to their financial success.

Industry

Designing and manufacturing components requires a focus on efficiency and technical innovation. This can be culturally at odds with consumer product designers, who are more focused on branding, aesthetics, and user-centric innovation. Module manufacturing can be widely different in the parts and software used, the organization of the control module, and the manufacturing process. By devoting a large part of their energy toward refining these, manufacturers deliver significant value to customers.

Margins in the industry are variable. Access to IP and productive relationships with customers are key drivers of higher margins. The highest operating cost is typically raw materials, followed by labor. Maintenance, replacement, and reconfiguration of equipment are other major ongoing costs. Significant research and development are essential.

Demand trends are positive long-term. The auto-coffee machine and other automatic consumer appliance markets are expected to grow around 5%/yr. Automated instrument and machine use for tasks in industry is more rapidly increasing- for example, biotech instrument demand is expected to experience over 10% growth for at least the next 5 years.  

In response to the expected increase in demand, investment in manufacturing is growing. With thousands of participants engaged in creating circuit boards, fiercer competition for supply agreements is expected. However, the ability to create specific, high-quality components at a competitive price requires technical skill, expensive assets, and intimate knowledge of the customer that is difficult to replicate.

External Forces

Political/ Regulatory: China is the largest supplier of control modules, yet end-customers are aware of geopolitical tensions that may negatively impact supply lines in the future. Manufacturers in other locations are preferred. Regulations are favorable for Original Designers in many regions where tax advantages and grants are employed.

Economic: Auto-coffee machines and similar appliances are expensive, but a proven product for households with high wages in good economic situations. Higher wages also encourage businesses to invest in automation. So, demand for control modules is linked to strength in the consumer economy.    

Social: Coffee-drinking is an activity that has become increasingly refined. Consumers place high value on a consistent and well-balanced brew and providing this requires either an experienced barista or a well-functioning control module.

Social demographic trends toward a growing number of households are favorable for most kinds of automatic consumer products.

Technological: Making control modules is one of the more complex large-scale manufacturing processes and has attracted massive investment in research and development globally. The path of development should continue to follow a series of “S” curves that challenge market participants to adapt to new methods with optimal timing. On the other hand, control modules are essential for the ongoing automation of tools and appliances, which can often be achieved with older, non-cutting-edge control modules.  

Management

Management is well experienced, with many decades combined at the company and in fields relating to their activities. Mr. Ted Kao founded the company 40 years ago in Taiwan and remains an executive director. He and other directors have hands-on experience working with electronics, system administration, auto-manufacturing, and product engineering. The Managing Director, Mr. Chin Yau Meng, has been at Uchitec since 1990.

Across the board, directors are well aligned with the company’s success- they receive share-based compensation, and most individually own over RM1million worth of shares. Combined with their relatively modest salaries and fees, this indicates a significant degree of confidence in Uchitec’s future.

Communication with shareholders has improved over the years. Annual reports and Q&A transcripts from AGM’s contain straightforward reviews of operations, expectations for the future, and the rationale for strategic decisions. Management have been mostly correct in their predictions of earnings over the coming year.

Strategy

The business strategy is to focus on niche, high-return activities. This includes devotion to existing customers- “Total customer satisfaction is our purpose of existence”. This aim is quantified through a “customer satisfaction index”, on-time delivery rates, and customer reject rates, which are reported each year. Uchitec solidify these relationships with sole-supplier agreements, preventing them from selling some products to other customers. But because they own the IP, customers have a limited ability to source parts elsewhere.  

Management is aware of the apparent risk of such dependence but state the highest level of confidence in their customers.

Uchitec strategically view their research and development as “the soul” of the company. A consistent 7% of revenue is dedicated to R&D. By investing heavily in upgrading processes and completing new projects, Uchitec aim to empower customers to launch better products before their competitors and become indispensable.

Diversifying customers is an ongoing strategic issue. The company are committed to only pursuing projects with high returns on capital, and no significant projects have yet materialized. In 2014, management stated a target to make biotech 50% of revenue “in the long run”. This was never achieved, and the intention was not repeated.

The strategy to find new customers is “international exhibition” of their capabilities. It is difficult to know how much progress has been made, because the gestation of products, especially in biotech, can be several years. Projects are reportedly occurring under non-disclosure agreements.

Cost cutting is the final element of Uchitec’s competitive strategy. This involves constant investment in parts re-engineering, and operational refinement. The company have a strong competitive advantage in their cost-efficiency.

Quality of earnings

From a quantitative perspective, Uchitec’s earnings are excellent. Net profit margins were between 42% and 54% for the last 6 years and revenue grew from RM95m in 2014 to RM155m in 2020. The company were interrupted by shutdowns during COVID, yet no contraction in margins or material reduction in revenue occurred.

However, Uchitec are reliant on two major customers for the vast majority (77% and 9% FY20) of their revenue. This is the weakest element of the company, as these customers could reduce or withdraw purchases in the future.

Importantly, these customers are global leaders in the auto-coffee and broader home appliance markets and are extremely unlikely to fail. Uchitec have provided for these tier 1 customers for over a decade and maintained a high profit margin, which speaks to a level of competence and professionalism at the company.

Control modules are sold to Europe, where they are assembled into consumer products, and primarily sold in the USA.

The remaining revenue comes from a combination of deep freezer control modules, weighing modules, touchscreen display and light sensors, and centrifuge control modules. These products are based on precision weight and temperature components. The broad uses for their products support the idea that Uchitec can provide value beyond their major product but choose not to due to the lower returns involved.

Uchitec’s earnings are exposed to labor conditions in Malaysia, and a shortage may increase costs. 10% of the company’s workforce is from the currently stretched migrant worker pool. Raw material cost increases are also impactful, but Uchitec have historically controlled inventories well, and are reportedly prepared for supply chain disruptions.

Uchitec also operate in China, where 22% of their fixed assets are located. As such, customer action to divert manufacturing sources away from China due to geopolitical events could be negatively impactful.

Capital allocation

Uchitec’s capital allocation supports their strategy to satisfy their existing customers. They have a decent level of success in maintaining high returns on capital and providing value to shareholders.

Dividends are reliably the largest allocation each year, issued under a policy of 70% of profit after tax and yielding shareholders 5-7% annually. This is partially offset by the ongoing issuance of shares for employees, which caused an average dilution of (1.07%) per year for the last 7 years.

Uchitec increase the core capacity of the business with a major focus on research and development. They work on projects with customers, make internal improvements (manufacturing processes, power consumption, and waste management), and have pipeline of projects for new products.

Expansion of capacity is relatively modest. Uchitec replace and upgrade equipment sparingly, except for the purpose of R&D. They operate out of the same buildings in Penang and Dongguan as they have since the factories were opened in 1989 and 2006 respectively. Management state that they would prefer to outsource manufacturing rather than purchase new property, plants, and equipment.

Their conservative expansion and cost efficiency leave Uchitec with a substantial cash balance and no debt. Rather than investing in money markets, Uchitec keep their cash liquid, providing a degree of flexibility in their inventories.

The result of Uchitec’s capital allocation activities has been remarkable growth in their return on invested capital. They made gains in this figure every year since 2014 (20.89%), and the return in 2020 was 49.09%.

Risks

Strategy: Their narrow revenue source strategy is the highest risk. Major customers could end or reduce their purchasing from Uchitec, and they may not have the connections or IP necessary to re-build revenue elsewhere.

Customer: Uchitec are dependent on customers to perform well and make payments on time. Making sales of the end-product is mostly out of their control. Additionally, relationships between sole-suppliers and customers can go poorly, resulting in illegal behavior, litigation, or simply an unbalanced and eventually unproductive relationship.  

Obsolescence: Uchitec must constantly develop new products to meet customer needs, reduce power consumption, and remain cost-efficient. It is possible that new solutions outside of Uchitec’s capabilities could emerge.

Demand: The demand for high-quality auto-coffee machines in the USA may fall, limiting sales growth.

Geopolitical and regulatory risk: Uchitec are exposed to trade conditions in China, Malaysia, USA, and several European countries where the end-product is assembled. Currency exchange rates, tariffs, and political differences are all potentially negative.

Cost risk: Uchitec depend on external supply chains for raw materials and some components, which could become more expensive. Labor costs are also susceptible to increases.  

Hazards: Standard hazard risks of manufacturing apply- internal or external disasters could occur, and poor or illegal working conditions could be revealed. Destruction of property and reputation could result. This is especially true with the high standards required by their quality customers.

Valuation

The value of Uchitec’s cash, equivalents and property minus liabilities is around RM110m. Total net assets are RM180m. These are well below their market cap of RM1.4b- the underlying assets do not provide much support. Earning a 100% return from dividends would require Uchitec to maintain their current payout for the next 11 years at the present growth rate.

The market has indicated an expectation of continued growth, assigning the company an average PE of between 13 and 18 (currently 14) in recent years.

For a company with a ROIC of well over 30%, profit margin of nearly 50%, no debt, and growing revenue, this is visibly cheap.

If the share price increased in line with earnings at 10% per annum, it would double in 7 years. Furthermore, if the company can find another source of high-return revenue, the earnings multiple should expand to reward the lower risk.

However, if Uchitec do not continue to grow, their multiple may contract to the mid-single digits, possibly cutting the share price down to a third of its present value. And if earnings were to decline, perhaps due to a major customer withdrawal, the price could fall to the value of Uchitec’s tangible assets, at about 1/10^th the current price.  

Of course, each of these scenarios is unlikely, and the most probable future is somewhere in the middle. Uchitec should be able to partially diversify their revenue without disrupting their current relationships- the possible uses for their products are growing, and the company have a proven ability to satisfy customers. But they will probably remain reliant on their existing customers for most of their income.

Management appears confident that they can maintain these relationships, supported by their behavior and their high level of shareholding. Growth in auto-coffee seems inevitable- the product is valuable, replacing significant cost of labor and providing a desirable beverage for the consumer. It is highly probable that Uchitec’s customers will continue to lead this market.

Conclusion

I think that an investment in Uchitec is worthwhile. The company have a proven ability to engage in a win-win relationship with their major customers, and to employ a refined R&D process to drive success in their final products.

The company managers appear to be highly skilled investors, only undertaking projects that provide the highest returns, and avoiding anything that does not appear to be worth the effort. They have controlled costs very well but invested significantly to build valuable IP.

Concentration is not always a bad thing, but it appears risky to anyone viewing from the outside. While Uchitec have agreed not to take on other auto-coffee customers, I think they could find another high-return source of revenue in time. The double impact of increased income and de-risking would be highly desirable.

If they cannot achieve more diverse revenue but retain their current customers, the share price should still provide a worthwhile return.

Investors are dismayed by the reliance on just two customers but may not appreciate the evidence of confidence and strength in these relationships. Other risks are either highly unlikely, or easily absorbed by Uchitec’s financial strength.

Of course, if their existing relationships fail, Uchi will be forced to serve alternative customers. Due to their competence, I think Uchi would be able to find new customers and continue manufacturing at high capacity but are less likely to earn returns at today’s level. The possibility of complete company failure appears very low.