Since our first Trading Buy recommendation on the 9th Aug, KESM’s share price has gained 44% as FY16 Net Profit rose to a fresh all-time high of RM30.7m (+80.2% YoY). The recent 1Q17 earnings has been equally as impressive, accounting for 29.5% of our full-year estimate. We see exciting growth potential ahead, with prospects being driven chiefly by: (i) rising car production by global automakers and increased chip content, (ii) margin expansion due to greater economies of scale, and (iii) acceleration of CAPEX plans in the current financial year to meet the existing demand. We raise our Net Profit estimate by 11.9% for FY17 to RM38.0m and introduce FY18 Net Profit of RM43.7m. Maintain TRADING BUY call with an increased TP of RM12.18 (from RM7.90 previously) based on a PER of 12x FY18E EPS. Impressive start to FY17. KESM reported 1Q17 revenue of RM80.1m (+14.2% YoY), underpinned by higher demand for both the burn-in and testing services segments. A larger proportion of high-margin services and greater economies of scale was more than able to offset the increased operating expenses during the quarter, leading to net margins improving to 12.5% (+1.0ppt vis a vis 1Q16). Consequently, net profits rose to RM10.0m (+24.1% YoY, +24.4% QoQ).

Areas of high growth. We believe that KESM is uniquely positioned to benefit from massive USD21.5b automotive semiconductor market (expected to grow at a CAGR of 6.8% to USD 28b in 2019, according to KESM’s FY16 annual report) of which the company already serves 9 of the 10 largest automakers. Growth going forward will be driven by: (i) rising global automotive sales, and (ii) increased electronic chip content in making vehicles safer, cleaner, smarter and more comfortable. The automotive semiconductor segment represents an area of high growth potential for KESM, and currently accounts for 70-80% of KESM’s revenue base, up from 50-60 % (UNISEM: 17% and MPI: 24%, as at the latest quarter) with the remainder being derived from the commercial segment.

Better earnings visibility. KESM maintains a close working relationship with its clients - large automakers ahead of planned launches or new models. We understand RM70-RM80m in CAPEX has been earmarked for expansion in FY17 (FY16: RM29.6m) which we believe would increase production capacity by 10-15%. Given the longer product life cycles of 3-7 years for the automotive semiconductor segment (compared to 1-7 years for commercial segment) and recurring nature of the business, we believe that KESM will also benefit from better long-term earnings visibility and smoothened quarterly earnings delivery.

Achieving greater economies of scale. KESM’s EBIT margins have expanded from just 5.4% in FY12 to 12.9% in FY16 while its earnings have also increased at a CAGR of 64.8% for FY12-FY16. Going forward, we expect EBIT margins to expand further by 0.85ppt/0.39ppt to 13.7%/14.1% for FY17E/FY18E, owing to the increased contribution from the higher margin automotive semiconductor segment, cost efficiency from its proprietary Test during Burn-in (TDBI) techniques and also via greater economies of scale.

TRADING BUY with a TP RM12.18. We raise our FY17E earnings projections by 11.9% to RM38.0m and introduce FY18E net profit of RM43.7m, taking into account the increased revenue and margin assumptions. At the same time, we roll over our valuation base year to FY18E to derive a new TP of RM12.18 (from 7.90 previously) based on a targeted 12x Fwd. PER, in line with local OSAT players UNISEM and MPI.

Source: Kenanga Research - 17 Feb 2017