Outperformed the broader index after a remarkable recovery from Mar’s plunge. For strategic and security reasons, many heavy investments are earmarked to for frontend subsector which will likely lead to robust capex in near to mid-term. However, we do not see such catalyst for OSAT and view frontend’s forward integration as a threat and will erode its market share. While semiconductor sales forecast remains lacklustre, capital spending projection is encouraging reinforcing our position of favouring frontend over backend players. Maintain NEUTRAL on the sector with Frontken and UWC as our top picks.

Outperformed in 1H20. After a rapid recovery from Mar’s plunge, KLTEC gained 8% vs KLCI’s 6% decline (see Figure #1). Our earlier bearish view was proven right and share prices of our 3 SELL calls nosedived beyond our TP. Our only regret was not able to upgrade the sector timely enough when market sentiment turned around.

Blessing in disguise. Following the spark of US-China/Huawei tech war, many have rushed to develop their semiconductor capabilities, especially in leading edge (≤7nm) frontend fabrication (foundry) to be self-sufficient on the back of national strategic and security interests. As a result, this has led to huge investment commitments such as China IC Fund (USD29bn), American Foundries Act (USD20bn), CHIPS for America Act (USD10bn), TSMC’s Arizona foundry (USD12bn), SMIC’s Shanghai share sale (USD6.6bn), Taiwan subsidies (USD260m) and more. Coupled with the undersupply situation for advance node in the market, we opine that frontend subsector capex will be robust in the near to mid-term, benefiting companies such as Frontken, UWC and SAM Engineering (not rated).

How about OSAT? The solid frontend orders should trickle-down, benefiting backend players. However, heavy investment is not expected to be a catalyst or ploughed into this low-value segment which only contribute circa 10% of the value of an IC. As such, frontend’s gradual forward integration will eventually erode pure OSAT’s market share by providing one-stop and superior solutions (2.5/3D heterogeneous integration, HBM, chiplets and etc).

Global semiconductor sales. Despite achieving 6% growth to USD137bn in 4M20 (see Figure #2), the latest industry average growth projection is slashed from initial 7% to merely 2% (see Figure #3), this is even lower than our earlier conservative estimate of circa 5%. The growth is chiefly driven by memory (+15%) followed by logic and micro (+3%), offsetting the weaknesses in discrete (-7%), analog (-6%), opto (- 5%) and sensors (-2%) (see Figure #4). If memory prices continue to head south (see Figure #5), we do not discount another downward revision in global sales estimate. As for 2021, the sector is expected to pick up the slack in 2020 with an average growth of 11% (see Figure #6).

Equipment spending. Capital investment was strong in 5M20 with 21% gain in 3MA billings to USD12bn (see Figure #7). Based on SEMI’s latest forecast, there will be 13 new fab constructions (China×4, Taiwan×4, Americas×2, SEA×2 and Others×1) in 2020 with a total investment of USD38bn yielding additional installed capacity of 473kwpm (200mm equivalent). For 2021, 7 new fabs will be developed (Americas×2, China×2, Taiwan×1, Korea×1 and Others×1) with total capex of USD37bn with a total capacity of 289kwpm. This projection validates our view on frontend’s vigorous capex ahead and reinforces our bullishness on this sub segment.

Stronger greenback. HLIB expects USD to be stronger in 2020 averaging RM4.23- 4.28/USD compared to 2019’s average of RM4.14/USD (see Figure #8). As such, we expect tech firms to be marginally boosted thanks to their USD-denominated sales while partly offset by the USD cost items.

High input cost. Gold and copper prices are on the upward trajectories (see Figure #9) and may spell bad news for OSATs. Compounded by stronger USD projection, pricier commodities will exert pressures on margins for packagers. On the contrary, steel and aluminium prices have retraced materially from the elevated levels during 2018-19 which will benefit equipment players such as UWC and ViTrox.

Segmental view. Recovery in smartphone along with communication segments are expected to be the major growth driver on the back of 5G proliferation. Next would be high-performance computing (HPC) supported by the robust cloud investments by global tech giants. Although IoT device generally has lower IC content, the sheer forecasted volume suggests that this market is too big to ignore. Lastly, automotive is still stuck in the low gear as global car sales has yet to see any material uptick.

Maintain NEUTRAL. However, we tactically position ourselves in favour of frontend over backend players based on the thesis above. As such, our top picks for the sector are Frontken and UWC. In line with our upbeat outlook on the subsector, we rerate frontend players to 35x PE (previously 28x) which is more reflective to global peers’ valuations (see Figure #10) with a slight premium. We adjust Frontken FY21-22 earnings forecasts by +16% and +15%, respectively while keeping FY20 unchanged taking into consideration of the pandemic impact on its O&G segment. In turn, Frontken TP is raised from RM2.40 to

RM3.47 (35x of FY21 EPS) and we upgrade its rating to BUY from Hold. As for UWC, we adjust FY21-22 EPS by +11% and +17%, respectively taking into consideration of the potential contribution from new frontend client commencing FY21. After the upward earnings revision, our TP is lifted from RM3.45 to RM4.90, pegged to 35x of CY21 EPS. Maintain BUY. We strongly believe that Frontken and UWC will continue to chart record high earnings in coming quarter and for FY20.

A hidden gem? Under-researched SAM Engineering and Equipment (not rated)

has morphed into a sizable semiconductor contract manufacturer after successful diversification strategy from aerospace market. Its equipment business has outgrown aerospace in FY20 with revenue and PBT accounted for 52% and 63% of overall. Supported by strong parents (SAM Group and Accuron Technologies), SAM has exposure in semiconductor frontend and storage devices with reputable customers (Agilent, Teradyne, KLA Tencor, Bosch, P&G and etc) in telecommunication, medical and automotive sectors. Conservatively, assuming that any slack from aerospace will be compensated by equipment’s strength and yield a flattish bottom line for FY21 (RM80m), SAM is currently trading at undemanding 13.6x PE. However, we do note the concerns of liquidity and severe-than-expected slump in aerospace segment which should be mitigated by its initiatives to divert capacity to equipment business. As for OSATs, we left their earnings untouched but increased their TP after pegging to higher PE multiples. Inari Amertron TP is now RM1.57 from RM1.28, pegged to 25x (previously 20x) of CY21 FD EPS while Unisem TP is now RM2.32 from RM1.74, valued at 20x (previously 15x) of FY21 EPS. HOLD calls for both are unchanged.

SELL call on ViTrox is maintained even after we bump up its TP from RM6.74 to RM8.43 with a higher valuation of 30x of FY21 EPS (previously 24x).

Source: Hong Leong Investment Bank Research - 20 Jul 2020