Resilient macro indicators for E&E manufacturing growth (+13.6% YoY), strong export trends to US and EU markets coupled with encouraging numbers from semiconductor sales provide a promising outlook for our electronic manufactures. We remain optimistic that outsourcing trend will persist with the combination of trade diversion and WFH that will continue to benefit our manufacturing players. We view that the shortage of foreign labour as a near term hiccup for our EMS players. We applaud VSI’s proactive effort in conducting open discussion to improve labour welfare following the recent conundrum. We have an OVERWEIGHT stance on the sector with VSI (BUY, TP RM1.78) as our top pick.

Robust macro indicators. Based on DOSM Oct 2021 IPI data (Figure #1), manufacturing index accelerated to 8.0% YoY (Sept: +4.0% YoY) amid stronger growths in export-oriented and domestic-oriented sectors. In the export-oriented sector, broad-based improvement across industries was seen. E&E production grew +13.6% YoY (Figure #2), mainly on higher computers & peripheral equipment and consumer electronics productions. Similarly, trade data in Nov 2021 remained in expansionary mode at +32.4% YoY. Manufactured exports grew +27.4% YoY, contributing +21.8ppt to overall growth. This was led by E&E products (+17.4% YoY), in line with stronger semiconductor billings growth (+50.6% YoY) (Figure #4). Exports to US and EU in Nov 2021 (Figure #3) recorded double digit YoY increase of +33.5% and +30.9%, respectively. Note that both of these regions are the main revenue contributors for VSI (US contributed 42% of FY21 revenue) and Uchi (Europe dominates with 97% of FY21 turnover).

Capacity expansion to support demand. We gather that PMM SA2 plant is currently fully operational with the target to increase the in-house production of injection parts. We note the possible delay in reaching its target due to the recent flood that affected its SA2 plant but we opine that production will start ramp up once condition normalizes. Similarly, VSI’s new 300k sqft facility (secured in Oct 2020) at i Park Senai Airport City has commenced operation and we expect the utilization to pick up steadily. We gather that full utilization for the dedicated facility could garner RM1.5bn revenue from Customer Y. Furthermore, VSI secured two additional factories early this year in anticipation of robust demand from pool cleaner customer. We gather that the additional space could garner RM600-800m sales. Note that pool cleaner contributes the highest margin.

Strong semiconductor sales and US-China trade diversion. Based on Semiconductor Industry Association (SIA), Oct 2021 global semiconductor sales gained 24.0% YoY to USD48.8bn. Semiconductors or integrated circuits are usually not useful on the standalone basis instead almost all are eventually assembled into end user products. On the back of this strong correlation, EMS market is expected to remain robust, taking cue from the strong YTD semiconductor market growth registered and we expect even more upbeat prospect moving forward (Figure #4). Furthermore, with the still frosty relations between US and China, companies continue to hedge their risks by diversifying supply chain. From our channel checks, our local EMS players have been getting requests for quotations buoyed by increasing order diversions. We expect discussions to gather speed with borders reopening, and these should serve as growth catalysts over the longer term.

Foreign labour woes. We view that the shortage of foreign labour as a near-term hiccup for our EMS players. VSI is ramping up effort in hiring local workers to tackle the foreign labour shortage. Should government announce to allow the entry of foreign worker this year, we opine that the sector would be able to mitigate this shortage. We also applaud the VSI’s proactive effort in conducting open discussion to improve labour welfare following the recent conundrum. On the greener side, VSI expects strong outlook from Customer X with order diversion from another contract manufacture following the recent labour issue. Management expects to start production for the diverted 4 models in 3QFY22. With the availability of floor space following Victory’s exit, potentially there could be additional RM1bn revenue from the conversion of space.

We reiterate our OVERWEIGHT stance on the sector. We remain optimistic that outsourcing trend will persist with the combination of trade war and WFH that will continue to benefit our manufacturing players. Despite some headwinds from prolonged supply chain disruptions, the lifting of restrictions domestically and abroad is expected to further improve demand conditions and support manufacturing activity in Malaysia. Maintain BUY calls for both VSI (TP: RM1.78) and Uchi (TP: RM3.83). We maintain our HOLD call for PMM with unchanged TP of RM25.70. Our preferred pick for the sector is VSI given its (i) healthy order outlook brought by the steady demand of consumer electronic products; and (ii) margin expansion from customer diversification efforts. As the biggest EMS player in Malaysia with solid track record, we opine that VSI is a prime beneficiary from the intensifying trade diversion theme.

Source: Hong Leong Investment Bank Research - 5 Jan 2022