We came away from a meeting with Mr. Kenneth Tan (its Executive Director) maintaining our cautious outlook on KESM’s near-term prospects. The group’s burn-in facilities are currently running at 40-45% capacity (vs. 50% in 2Q19), signaling weak 3Q19 results. Management also remains cautious on capex amid possible general semiconductor slowdown. Trim FY19-20E CNPs by 40-36% to RM12.9-20.6m. Maintain UNDERPERFORM with a lower TP of RM7.20.

Still getting burnt. YTD, KESM Industries (KESM)’s burn-in facilities have been running at 40-45% capacity (vs. 50% in 2Q19) as customers remain cautious with tighter inventory controls. Weak car sales in the Europe due to the introduction of the Worldwide Harmonised Light Vehicle Test Procedure (WLTP) emission regulation as well as in China amid trade war have been the main culprit of the problem. This signals weak results come 3Q19 (to be reported in June), although we believe the group would remain slightly profitable due to higher orders/contribution from its electronics manufacturing services (EMS) division. Revenue from the EMS segment has spiked up to c.20% from c.15% normally.

Lacking near-term catalysts... For 2HCY19, management prefers to remain cautious and avoid overspending as it believes automotive demand will remain sluggish and observes that the World Semiconductor Trade Statistics (WSTS) has recently toned down its forecast for worldwide semiconductor sales from 3% growth to a 3% decline. Management believes the next semiconductor upturn will only be seen in end-2019 earliest when the deployment of 5G technology takes off. We concur with management’s view, as we see no major catalyst in the automotive sub-segment for the near term and note that a slowdown in global semiconductor sales typically lasts 12-13 months based on historical observation.

…but the tough get going. However, management believes the longterm growth prospects of the automotive sub-segment remains positive as semiconductor content in vehicles continues to rise over the years. We also draw some comfort from KESM’s sturdy balance sheet with net cash standing at RM116m as at end-2Q19, positioning the group well to weather through the momentary market softness. The group is currently working on new product qualifications for end-products such as car cameras and sensors for park-assist.

Trim FY19-20E CNPs by 40-36% to RM12.9-20.6m after lowering our EBIT margin assumptions from 7.5-9.5% to 4.5-6.0% mainly to account for increased contribution from EMS, which incurs higher raw material costs.

Maintain UNDERPERFORM with a lower TP of RM7.20 (from RM7.60), based on an unchanged PER of 15.0x (implying -0.5SD) applied to FY20E EPS of 47.8 sen. We have rolled forward to FY20E (from FY19E) and even then the TP still reinforces our UNDERPERFORM call, indicating that FY20E earnings growth is insufficient. Despite its long-term positive outlook, we believe current weakness in the automotive market will continue to cloud the group’s near-term earnings visibility, while valuation of the stock remains unattractive at this juncture at 16.4x FY20E PER.

Risks to our call include: (i) earlier-than-expected recovery in vehicle sales and (ii) faster-than-expected adoption of new semiconductor modules in automobiles.

Source: Kenanga Research - 26 Apr 2019