We upgrade our sector call to OVERWEIGHT given the outweighing of OUTPERFORM ratings in the total market capitalization of our stocks coverage universe alongside improving industry prospect. Global semiconductor sales in January 2017 increased by 13.9%, marking the sixth consecutive YoY growth which is the largest YoY growth since November 2010. With better numbers concluded in 2016, drastic revisions have been made to WSTS’s 2017/2018 growth forecasts from 3.3%/2.3% to 6.5%/2.3%; with higher growth forecasts mainly from Sensors and ICs. Smartphone segment which has been the key driver for the semiconductor industry over the past three years is expected to see better growth again in conjunction with the launching of flagship models by world’s largest vendors this year. On top of that, Automotive semiconductor market is seeing higher growth from the increasing semiconductor content per vehicle for safety features and comfort systems. We are more positive on the OSAT players under our coverage given their improving earnings profile with meaningful exposure to the abovementioned segments. Beyond industry growth, the earnings of Malaysian semiconductor export players will also be augmented by favourable currency translations. We have imputed an average of RM4.40/USD, a 2-year forward MYR/USD assumption for the Tech companies under our coverage to be in-line with our team of economists’ forecasts. With the industry seeing meaningful recovery, we are now assigning up-cycle valuations to most of the semiconductor players under our coverage. Of all, our top picks are PIE (OP, TP: RM2.87) and NOTION (OP, TP: RM1.62).

More visibility. Global semiconductor sales closed the year 2016 with its highest-ever annual sales (+1.1% YoY). Recall that 2016 sales started with a slow pace and picked up steam mid-year on the back of better macroeconomic factors and increasing amount of semiconductor technology in various devices. From the latest SIA data, global semiconductor sales in January 2017 increased by 13.9%, marking the sixth consecutive YoY growth which is the largest YoY growth since November 2010. With the latest reported positive numbers, WSTS’s conservative forecasts for 2017/2018 of +3.3%/+2.3% have been revised up to +6.5%/+2.3%; with higher growth forecasts mainly from Sensors and ICs.

Automotive gaining better traction; Smartphone still the lion share contributor. According to WSTS 2016 Semiconductor End-Use report, in terms of end users products, Communications and PCs/Computers remained the top semiconductor markets. However, in terms of market share, while Communication marked the third consecutive year’s growth as the largest end-users application for semiconductor, its share decreased by 2.6ppts with Automotive and Industrial’s gaining better traction. Notably, these trends are also reflected in the Malaysian OSAT players’ CY2016 results. Outlook-wise, for Mobile phones, we noticed that Gartner is forecasting positive growth (albeit a marginal one) from 2017 onwards which is also our belief that the growth will be driven mainly by the launching of flagship smartphone models by world’s largest vendors this year. We expect higher volume ramp-up for MLP and wlCSP amidst the launching of new flagship smartphones in 2H17, alongside the resolution of the inventory overstock issue. Meanwhile for Automotive, the global automotive semiconductor market is forecasted by Lucintel to grow at a CAGR of 6.4% from 2017 to 2022 with the major growth drivers being increasing vehicle production, increasing semiconductor content per vehicle, growing demand for advanced vehicle safety and comfort systems, and growing government regulations regarding CO2 emissions. We see MPI as a better proxy in the OSAT space as we gather that the group’s leading Automotive technologies that are used for safety features (such as advanced package for pressures, magnetic, acceleration sensors), have already passed the stringent qualification stage and will see more meaningful earnings fruition in the next two/three quarters. Meanwhile, we also like NOTION for its near-term earning driver, being the stack-up orders of Automotive EBS components, which could see a 2-year revenue CAGR of 30%.

Earnings further augmented by favourable currency translation. Note that USD/MYR exchange rate strengthened further (+7%) to average RM4.45/USD (YTD17) from RM4.14/USD (2016); as of our date of writing. Based on our sensitivity analysis, every 1% fluctuations in the USD will impact our 1-year/2-year forward NPs estimates for USD sales oriented companies by 1%- 3%. Recall that nearly 100% of their revenue are denoted in USD, with natural hedge from raw materials purchases (mainly in USD) which constitute about c.40% of total costs as well as the 50% hedging on the net receivables (in some companies). We have imputed an average of RM4.40/USD, a 2-year forward USD/MYR assumption for the Tech companies under our coverage to be in-line with our team of economists’ forecasts.

Upgrade to OVERWEIGHT. All in, with the industry’s recovery as well as other favourable macro factors, we are now assigning up-cycle valuations alongside rollover of valuation base year to capitalise on the growth of the technology players under our coverage. For the OSAT players, we ascribed 15.0x PER to both MPI and UNISEM’s 2-year forward EPS (representing +1SD above both average PER). As a result, our ratings and TPs on MPI and UNISEM are now at RM12.75, OP ↔ (from RM10.20) and RM3.55, MP ↔ (from RM2.80). Meanwhile, for EMS players and precision manufacturers under our coverage, we roll over the valuation base year of PIE to FY18E, but still based on an unchanged 15.0x PER (+1SD above its average PER) which led to a higher TP of RM2.87 (from RM2.60). We made no changes to SKPRES and NOTION as our recent notes have already reflected the abovementioned matrix.

From both quantitative and qualitative perspectives, PIE is our top pick for the sector anchored by: (i) its earnings recovery story with sustainable growth prospects (2-year NP CAGR of 12%) alongside generous dividend pay-out ratio (DPR) of at least 40% from its PATAMI (translating into decent dividend yield of c.4%), (ii) its state-of-the-art manufacturing capabilities underpinned by constant vertical integration, which provides higher value-added services (thus higher margins) and higher chances of winning other contracts in the near to medium term, (ii) strong parentage support from the world’s largest EMS group, Hon Hai/Foxconn Technology Group, which allows PIE to tap on its parent’s first class engineering and manufacturing capabilities.

We also like NOTION for its superior earnings prospect (2-year NP CAGR of >100% from low base) as well as potential warrants conversion, which could inject cash of up to RM38.6m to the group for further expansion. Besides the better products portfolio to anchor growth, the group also been working towards enhancing the efficiency of its operations with new CNC machines that could lead to further margin expansions. Beyond that, management has also committed to reward its investors by forming dividend policy of minimum 30% of PATAMI, to be paid out quarterly (at dividend yield of 4% assuming minimum payout of 30%).

Source: Kenanga Research - 28 Mar 2017