We downgrade our sector call to NEUTRAL in view of: (i) the industry’s moderating growth, (ii) less favourable risk-to-reward ratio in most of the tech names following valuations expansion, and (iii) the weakening of USD/MYR which will negatively impact most of the net exporters’ profitability. Global semiconductor sales (GSS) extended its 15th YoY consecutive growth at +21.9% as of Oct 2017. While 2018 GSS growth is still forecasted to be positive at +7%, we noticed that the momentum is already moderating, which mimicked the movement of the last up-cycle which lasted for 26 months back then from May 2013 to Jun 2015. Back home, though earnings growths of most local tech players would still be positive in 2018 (to be driven by new smartphone launching as well as rising adoption of automotive semiconductor), we believe the positives have mostly been priced-in at this level. Note that the Bursa Malaysia Technology Index has advanced by 83% (as of our time of writing, which is also its highest level since 2005; with most stocks trading at +1SD to +2SD above their forward average PER band). This significantly outperformed the FBMKLCI Index which only increased by 7%. Additionally, the weakening of USD/MYR and rising raw material cost are also detrimental to most of the local semiconductor exporters. Based on our sensitivity analysis, every 1% fluctuation in our base case assumption of RM4.10/USD will impact the earnings by 1-3% of our stocks coverage. Post sector updates, we have revised our previous valuation benchmark from up-cycle valuation to midcycle valuation to reflect the moderating GSS growth momentum, alongside the imputation of weaker USD/MYR assumption. We continue to prefer the BOTTOM-FISHING approach which is especially apt for the sector; with our preference skewed towards undervalued laggard with good growth prospect and sound financial fundamentals. Our only top pick is PIE (OP, TP: RM2.65 @ 15.0x FY18 P/E).

Still growing; but at a slower pace. According to the latest SIA data, October GSS extended its 15th consecutive YoY growth (at +21.9%), prompting WSTS to revise up its 2017/2018 growth forecasts from 17.0%/4.3% to 20.6%/7.0%. Higher growth forecasts have been made mainly for better sales in Optoelectronics and ICs. While 2018 GSS is still forecasted to be positive at +7%, we noticed the growth momentum is already moderating, which mimicked the movement of last up-cycle which had lasted for 26 months back then from May 2013 to Jun 2015. On another observation from SEMI, the semiconductor equipment billings for North American headquartered equipment manufacturers marked the 14th consecutive YoY growth, with billings of 27% recorded in Nov 2017, although at a slower pace after the strong surge in 1H17.

Growth in 2018 to be supported by Smartphones and Automotives. From our channel checks with the local semiconductor players, the main growth drivers for 2018 would still be from the Smartphone as well as the Automotive segments. Data from Gartner suggested that the overall smartphone shipments will reach 1.66b units, which is an increase of 6% YoY. Thus far, 3Q17 sales of smartphones grew by 3% to 383m units YoY, bringing 9M17 smartphone sales growth to 6%. Growth drivers were Emerging Asia/Pacific and North America markets that offset the weakness in China, which was due to consolidation of local and lesser-known brands. In terms of vendors, top brands i.e. Samsung, Apple, Huawei, Oppo and Xiaomi continue to see decent growth vis-à-vis the budget smartphones. Going forward, with the positive spill-over from newly launched flagship premium phones namely iPhone 8/iPhone X/Samsung Note8 that were launched in Sept 2017/Nov 2017/Sept 2017 as well as the anticipation of newer generation smartphones from the top vendors, we believe local semiconductor players would still see the Smartphone segment being supported from these new launching. As of our 4Q17 data collection, volume for IC packaging (MLP, wlCSP, foCSP later) are still decent for which we have already accounted in our earnings assumptions. This is accompanied by high capex after 2016. Meanwhile for Automotive, our discussion with the OSAT players in Malaysia revealed that their respective Automotive segments are still seeing resilient sales thanks to the increasing semiconductor content per vehicle as well as growing demand for advanced vehicle safety and comfort systems.

Valuations are no longer attractive for most of the tech names. Note that Bursa Malaysia Technology Index has advanced by 83% (also its highest level since 2005; with most stocks trading at +1SD to +2SD above their forward average PER band) which significantly outperformed the FBMKLCI Index which only increased by 7%. From the global perspective, a glance on the overleaf table showed that our major tech names have been trading at premium vis-à-vis other global names which have bigger scale of operations, better positioning in terms of supply chains as well as better margins. Meanwhile in terms of PEG, both global as well as local tech players under our radar are trading on par at 0.9x-1.2x for its 1 year – 2 year Fwd. PEG; implying that there is not much room left for local tech players against the global players in terms of valuation.

Adverse currency fluctuation to negatively impact earnings. Recall that nearly 100% of revenue of semiconductor players under our coverage are denoted in USD, with natural forex hedging 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). Our team of economists has recently come out with a new set of projection for USD/MYR at an average of RM4.10/USD for 2018. We were previously assuming currency base rates of RM4.20-RM4.25/USD (different FY) for the companies under our coverage. Hence, to be in-line with our in-house forecasts, we have imputed similar assumption of an average of RM4.10/USD for 2018 for the Tech companies under our coverage which led to 2-8% earnings revision (please refer to overleaf for further details). Based on our sensitivity analysis, every 1% fluctuations in the USD from our base case assumption of RM4.10/USD will impact our 1-year Fwd./2-year Fwd. NP for the tech companies under our coverage by c.1-3%.

Downgrade to NEUTRAL; stick to stocks with solid fundamentals. Given the stretched valuations in most stocks across the sector coupled with the industry’s tapering growth momentum as well as the weakening of USD/MYR, we downgrade the sector to NEUTRAL. From our coverage, we see no appealing names in the OSAT spaces as well as Precision Manufacturer. While EMS players also saw waves of re-rating, we see an underappreciated gem with good growth prospect and sound financial fundamentals. From both quantitative and qualitative perspectives, we prefer PIE for exposure in the whole sector with investment merits anchored by; (i) its earnings recovery story with sustainable growth prospects (2-year NP CAGR of 32%) and is only trading at 0.3x 2-year fwd PEG vs peers’ 0.4x-0.5x 2-year PEG, (ii) state-of-the-art manufacturing capabilities underpinned by constant vertical integration (more capabilities than the other EMS players), which provides higher value-added services (thus higher margins of 8-9% vs. other EMS players’ 5-6%) and hence higher chances of winning other contracts in the near to medium term, and (iii) 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.

Source: Kenanga Research - 5 Jan 2018