We came away from a meeting with management feeling more CAUTIOUS in light of the gestation period for its product rationalisation exercise, rising material costs and weakening USD/MYR. Hence, we cut our FY18E/FY19E CNP by 11%/13%. With the de-rating catalysts in sight coupled with the industry’s unfavourable risk-reward ratio, we downgrade the stock to UNDERPERFORM. TP lowered to RM9.70 (based on 12.0x FY19E PER).

Further details on 2Q18 results. 2Q18 USD-denominated revenue showed improvement (+5% QoQ and +2% YoY); with the group’s product transformation programme gaining traction without major setback. Recall that this roadmap is to skew capacity towards Automotive sensor and Industrial (servers) copper clip packaging, which carry higher margins. In terms of products breakdown, improvement continued to be seen in Automotive electronics (+5% QoQ, +19% YoY) and Industrial segments (+5% QoQ, +12% YoY), offsetting the relatively weaker performance in Smartphone (+5% QoQ, -7% YoY) and PC/Notebook segments (+5% QoQ, -3% YoY). That said, net margin increment from the transformation programme was insufficient to offset the weakening USD/MYR and mounting costs from higher commodity prices; with CNP at RM43.3m (+17% QoQ, -21% YoY). Note that average USD/MYR in 4QCY17 was weaker at RM4.16/USD (-2% QoQ, -4% YoY) while Gold and Copper increased by 4-7% in just a quarter.

Short-term headwinds in sight. Management noted that it sees challenges in the next 1-2 quarters at the top-line and bottom-line levels, a view shared by us. While its portfolio realigning has been on track thus far, management currently is adopting a more aggressive approach - by way of phasing out legacy/low margin products (or going for higher ASP) and taking up more sensors-related packaging business on the Automotive side, all by FY18. Ultimately, the ideal contribution of Automotive segment is to be at 50% (vs current’s 28%) in two to three years. Meanwhile, this aggressive approach is also to allocate wafers to the more lucrative products given the lingering shortage issue. While we laud the strategy especially for the longer term, we prefer to be more conservative for now considering the nature of modest ramp-up (but orders are more sticky) in Automotive sensor business, wafer issues as well as the tight phase-out timeline for legacy products (which we believe is contributing >10% of total revenue). Hence, we only assume 4%/5% growth in FY18E/FY19E USD revenue (vs. management’s target of 5.5%/7.5%).

Profitability to be crimped by weaker USD/MYR and higher raw material prices. Note that nearly 100% of revenue of the group is 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 up to 50% hedging on the net receivables. Based on our sensitivity analysis, every 1% fluctuations in the USD and raw materials (copper and gold) from our new base case assumption of RM3.90/USD (from previously RM4.10/USD) will impact our 1-year Fwd./2-year Fwd. NP by c.2% each. All in, as the group finds it difficult to pass on the overall cost hike to customers, we see cost pressure continuing to suppress profitability, leading us to cut our FY18E/FY19E earnings by 11%/13%.

Downgrade to UP. We are turning more conservative on its FY18 and FY19 prospects. This is premised on mounting material costs as well as the limited top-line growth in FY18/FY19 which will be capped by the wafer constraints as well as the ongoing portfolio rationalisation exercises. All in, we reduce our TP to RM9.70 (from RM11.30), still based on a targeted 12.0x FY19E PER (which is the group’s 5-year average forward PER).

Source: Kenanga Research - 2 Feb 2018