We met with KESM’s management recently. Given the likely prolonged inventory correction, we cut our FY19-20 EPS estimates by 20-44%. While we understand that inventory in the supply chain is already lean, demand remains weak impacted by the ongoing trade tensions. In this soft period, management is taking on more EMS work, also reaffirming the recent trend of a shift in EMS activities to this region. However, this is unlikely to be a long-term solution given the relative low margins. Maintain HOLD with a lower TP of RM8.

3QFY19 Likely to be Another Soft Quarter

Current utilisation levels for its burn-in and test business remains low at under 50%, similar to the quarter before. The burn-in business for its automotive and commercial segments remains impacted by the ongoing trade tensions. To mitigate the softness in this business, KESM undertook more EMS work and secured new short-term customers, potentially resulting in this business contributing up to 15% of its topline for FY19.

Visibility still weak, but cautiously optimistic of a recovery in 2HCY19

While management guided that visibility remains weak, KESM’s customers are, however, pointing to a demand recovery in 2HCY19. We remain cautiously optimistic that a quick resolution between the US and China would be a major catalyst for a demand recovery. Meanwhile, new product development will likely support revenue growth, especially as adoption of electronic content in automotives increases.

Maintain HOLD, 12-month Target Price Lowered to RM8

We cut our margin assumptions and hence FY19-20E EPS by 20-44% as the revenue mix tilts increasingly towards the lower-margin EMS business. This is likely to be a short-term solution before a recovery in the automotive semiconductor space. We lower our target price to RM8 based on the stock’s long-term (c.20 years) mean PE of 12x on our FY20E EPS (previously 17x on CY19E EPS), to reflect the current earnings weakness. Nevertheless, we maintain our HOLD rating as we believe that KESM remains well positioned to benefit from a structural increase in automotive semiconductor demand, which could be imminent as we understand that inventory within the supply chain is already lean. Key risks include a loss/gain of customers and a reduction/gain in outsourcing opportunities as customers increase/lower their in-house burn-in and test function.

Source: Affin Hwang Research - 21 Mar 2019