KESM kicked-off 1Q18 with an 11th consecutive quarterly increase in revenue and a commendable earnings performance (+13.6 YoY, -15.1% QoQ) which met expectations. Although we like KESM for its unique position in the high growth automotive semiconductor business, valuations have become rich – necessitating a rating revision to UNDERPERFORM while maintaining our TP at RM18.40 based on 15x CY18.

1Q18 earnings meet expectations. At 22.8%/22.2% of house/ street’s estimates, we deem the 1Q18 net profit of RM11.4m to be in-line with expectations as earnings should pick up in the quarters ahead amid a gradual ramp-up in testing capacities from FY17 blowout expansion year. No dividend was declared for the quarter as expected, although we expect a full-year dividend of 14.0 sen.

11th consecutive quarterly improvement in revenue. 1Q18 revenue grew 1.1% to RM90.7m while net profit declined 15.1% QoQ from RM13.4m to RM11.4m. We believe the stronger top-line was due to the addition of testing machinery in the previous quarters which allowed the Group to capitalise on the higher demand of burn-in and testing services. Notably, PBT grew 5.0% QoQ, aided by a lower proportion of low margin EMS services and increased operational efficiency. However, KESM’s bottom-line was lower due to the absence of a tax benefit of RM0.6m which was recorded last quarter.

On a YoY comparison, revenue grew by 13.2% while net profit improved by a similar quantum of 13.6% from RM10.0m in 1Q17. The stronger top-line performance was due to higher demand for burn-in and testing capacities and capabilities mentioned above. Greater economies of scale arising from a lower proportion of employee benefits expense (+3.2%) was, however, offset by a higher depreciation charge (+31.6%) as well as a higher effective tax rate of 15.5% (+5.1ppt) which resulted in flattish NP margins of 12.5%.

CAPEX takes a breather in 1Q18 but set to resume. Although the 1Q18 financial statement indicates that CAPEX has taken a breather during the quarter (1Q18: RM13.5m; FY17: RM140.2m), we expect expansion plans to resume in the quarters ahead with focus remaining towards growing the testing business, primarily the automotive semiconductor industry. Among the initiatives taken to capitalise on the increased demand include a massive CAPEX plan, in addition to developing proprietary technologies to process high-volume automotive devices. As an indication, more than 1.7b semiconductors were processed in KESM’s factories in Malaysia and China in FY17 (+19% YoY).

Maintain TP of RM18.40, revise call to UNDERPEROFM. Post earnings release, we keep our forward estimates and Target Price unchanged. We continue to like KESM given its unique position in the high growth automotive semiconductor business and believe that the company will benefit from two salient trends; (i) Rising car production by global automakers, and (ii) increased chip content within vehicles. Nevertheless, the share price has risen +107% YTD, and is currently trading at a rich valuations of 16.7x CY18 PER vs. our targeted PER of 15x. As such, we revise our call to UNDERPERFORM in accordance to our ratings definition.

Risks to earnings include: (i) lower-than-expected sales and margins, and (ii) longer-than expected gestation periods.

Source: Kenanga Research - 24 Nov 2017