The general semiconductor sector is besieged by several challenges in 2Q19, particularly: (i) lacklustre smartphone sales given minimal feature upgrades in recent models and the high price point of recent Korean flagship smartphone models, (ii) muted vehicle sales in China amid trade war and in the EU due to the introduction of the Worldwide Harmonised Light Vehicle Test Procedure (WLTP). The recent profit warnings issued by Samsung and OSRAM serve as a good precursor to the worse-than-expected slowdown in both the subindustries. Meanwhile, despite the general excitement for 5G, we believe major deployments will only take place from 2020 onwards. In the EMS space, prospects remain promising as SKPRES continues to see awards of new products from its key customer, while PIE recently saw an influx of enquiries from companies that are looking to shift their supply chain out of China due to the US-China trade war. Given unexciting near-term developments in the semiconductor industry, we maintain NEUTRAL on the Technology sector. However, we still like: (i) MPI (OP, TP:RM13.00) as a value play given that it is only trading at an FY19E ex-cash PER of 8.2x and its profit margins are expected to improve after legacy products have been weeded out and replaced with higher-growth/margin sensor packages; and (ii) SKPRES (OP; RM1.45) due to potential margins enhancement and new contracts in the pipeline post PCBA-line commencement (a re-rating catalyst), while the company only trades at FY20E PER of 12.7x. Currently, technology companies under our coverage are on average trading at -0.7SD (range: -1.1 to -0.3SD) from their respective mean PER, which is consistent with the unexciting immediate-term outlook but lacks comfortable margin of error for us to turn positive on the sector at this juncture.

Uninspiring smartphone market. We believe the smartphone market will continue to be a drag for the technology sector in 2Q19, as the market has reached a saturation point in major markets with 2-3% annual growth expected. In addition, minimal feature upgrades and high price point of recent smartphone models further discourage sales. Just last week, Samsung issued a profit warning for its 1QCY19 results due to slumping demand for the memory chips and display panels it makes for electronic devices, which we believe is mainly tied to slow down in the smartphone industry. This further strengthens our view that 1HCY19 will likely be unexciting for the sector. Therefore, semiconductor players exposed to the industry have to rely on growth in dollar/semiconductor content per device. From our channel checks, we gather that generic components in smartphones such as RF chips – used for wireless communications – are facing a slowdown in orders as content growth plateaus, whereas modules used for new applications such as pay-wave and augmented reality continue to see bright prospects. Within our coverage, companies with meaningful smartphone exposure are MPI and UNISEM (33% and 24% as of 4QCY18, respectively). Unfortunately, both players are primarily in the RF space of the smartphone industry.

5G only a teaser in 2019, major deployments likely from 2020. Recently, various reports, from the likes of The Verge and Forbes, have suggested that most carriers will start launching 5G in 2019. However, we believe major deployments are not expected until 2020 as necessary network infrastructure is still limited geographically and data-hungry applications that call for the use of 5G such as virtual reality remain scarce. During our recent visit to Penang, while the technology companies are generally excited about 5G as it will not only drive offtake of existing products (especially those relating to data infrastructure, radio frequency and sensors) but also lead to the creation of new products; the consensus was that more clarity and meaningful positive impact could only be seen in 4QCY19-1QCY20, consistent with our view. Additionally, Bloomberg reported that a major North American smartphone maker, which has great influence over the prospects of semiconductor companies in Malaysia, is planning to sit out 5G until at least 2020. In essence, we believe that a “soft launch” of 5G in 2019 will be of little help to RF content growth for Malaysian semiconductor companies, while rapid adoption of the new technology from 2020 onwards should reinvigorate the semiconductor industry.

Automotive market no good either. Similarly, short-term prospects of automotive-centric semiconductor players are dampened by the recent introduction of new emission standards under the worldwide light vehicles test procedure (WLTP), which caused a 23% slump in passenger car registrations in Sep 2018 as automakers struggled with the tougher testing methods, according to Bloomberg. Additionally, vehicle sales in China have been lacklustre, no thanks to the US-China trade war. These have repercussions for our local automotive-centric semiconductor companies such as KESM, which indicated that its utilisation rate has fallen below 50% (vs. 70-80% normally) as its key German customer reduced orders. Therefore, we are unexcited about automotive-centric semiconductor players in the near term, especially KESM. For D&O, however, we believe earnings should remain stable as the company continues to gain market share in the automotive LED space. Nevertheless, for full-year 2019, we expect sales of automobiles to recover as the European automakers resolve the delays caused by the new emission standards. Market research firm IC Insights forecasts automotive semiconductor market to be the strongest end-market for electronic chips through 2021, with 5-year CAGR of 5.4%, underpinned by: (i) rising demand for electronic systems in vehicles to power autonomous driving, vehicle-to-vehicle and vehicle-to-infrastructure communications; as well as (ii) on-board safety, convenience and environmental features. Back home, our OSATs have already been realigning their portfolios in the past 1-2 years with capex skewing towards the automotive segment (e.g. sensors packaging, advanced vehicle safety systems). MPI has already shown increased contribution from automotive sensor-related packaging products with 32% share in 4QCY18 vs. 24-25% in FY17, and it targets to grow this to 50% in 2-3 years. For UNISEM, its contribution from the automotive segment has been stable at 15-18% in the past few years, but is set to grow larger going forward given its ties with one of the key players in tyre pressure monitoring system (TPMS). TPMS should see increasing market penetration over the next few years as China has made it compulsory for all new M1 vehicles to carry TPMS by 2019. For KESM and D&O, automotive-related revenue already constitutes c.100% and c.97% of their portfolios, respectively.

Growth streak ended. After 29 consecutive months of YoY growth (the longest streak in a decade), the semiconductor industry finally came to an end with January’s global semiconductor sales (GSS) registering a YoY/MoM decline of 5.7%/7.2%. Furthermore, notably, the World Semiconductor Trade Statistics (WSTS) has recently revised its 2019 growth forecasts downwards from 2.6% to -3.0% as it now expects Memory to register a larger decline at 14.2% (vs. 0.3% previously) after enjoying extraordinary growth over the past two years, and probably also due the lacklustre smartphone subsegment. In addition, the statistics provider now projects Optoelectronics (e.g. LED, optocoupler) to register 1.5% growth (vs. 6.8% previously) possibly due to the muted automotive market. Overall, the general observation of the GSS data signals a slowdown in the semiconductor industry.

In the EMS space, prospects for SKPRES remain promising as it continues to see awards of new products from its key customer. Meanwhile, for PIE, its telecommunication, industrial printing, medical and raw cable customers should continue to see growth in sales volume in FY19. In addition, both the companies recently saw an influx of enquiries from companies that are looking to shift their supply chain out of China due to the US-China trade war, which could translate into business opportunities in the near term. In fact, PIE has already secured a new contract for a telecommunication device which offers huge volume potential (1.1m units in FY19, with potential to scale up to 5.8m units). Revenue contribution from the new product is expected to be meaningful from end-3Q19 onwards, although its margins could be low initially due to external material/parts sourcing. Meanwhile, while SKPRES has received multiple enquiries for its PCBA and box-build capabilities, the group remained selective and has decided to focus on existing swarming orders from its key customers.

Maintain NEUTRAL. To sum up, the general Technology sector is besieged by several challenges in 2Q19, particularly: (i) lacklustre smartphone sales given minimal feature upgrades in recent models and the high price point of recent Korean flagship smartphone models, (ii) muted vehicle sales in China amid trade war and in the EU due to the introduction of the Worldwide Harmonised Light Vehicle Test Procedure (WLTP). The recent profit warnings issued by Samsung and OSRAM serve as a good precursor to the worse-than-expected slowdown in both the sub-industries. As such, we maintain our NEUTRAL call on the Technology sector, while continuing to favour: (i) MPI (OP, TP:RM13.00) as a value play given that it is only trading at an FY19E ex-cash PER of 8.2x and its profit margins are expected to improve after legacy products have been weeded out and replaced with higher-growth/margin sensor packages; and (ii) SKPRES (OP; RM1.45) due to potential margins enhancement and new contracts in the pipeline post PCBA-line commencement (a rerating catalyst), while the company only trades at FY20E PER of 12.7x. Currently, technology companies under our coverage are on average trading at -0.7SD (range: -1.1 to -0.3SD) from their respective mean PER, which is consistent with the unexciting immediate-term outlook but lacks comfortable margin of error for us to turn positive on the sector at this juncture.

Share price performance. Among our previous preferred picks (SKPRES, PIE and MPI) for 1Q19, SKPRES and PIE’s share price performances were within expectations with YTD (till our report cut-off date of 22 Mar 2019) gains of 34% and 8%, respectively. On the other hand, MPI’s share price was flat YTD (+0.6%) likely due to a slowdown in the semiconductor industry, but we are nonetheless keeping our OUTPERFORM call given its deep value with an FY19E ex-cash PER of 8.2x. For our only MARKET PERFORM call, namely D&O, the minimal change (-0.7%) in share price was also consistent with our expectation. Lastly, for our UNDERPERFORM calls, UNISEM’s -19% YTD decline aligned with our recommendation while KESM’s +12% YTD rebound was an uncalled-for surprise. However, we are maintaining our UNDERPERFORM call on KESM as its share price is likely to retrace amid the challenging automotive market.

Source: Kenanga Research - 5 Apr 2019