KESM registered a CNL of RM0.5m in 3Q19, pulling back 9M19 CNP to RM2.6m (-91% YoY), markedly below our forecast at 20% and consensus estimate at 23% due to the trade war and WLTP. YoY, 9M19 revenue dropped 11% while 3Q19 revenue fell 9% due to slower demand for its burn-in and testing services. No dividend, as expected. Trim FY19- 20E CNPs by 11-3% to RM11.5-20.1m. Upgrade to MP with a lower TP of RM7.00.

Markedly below expectations. KESM Industries (KESM) registered a Core Net Loss (CNL) of RM0.5m in 3Q19, pulling back 9M19 Core Net Profit (CNP) to RM2.6m (-91% YoY). This was markedly below our forecast at 20% and consensus estimate at 23%. We attribute the earnings miss to the Chinese imposition of tariffs on US vehicles and the introduction of the Worldwide Harmonised Light Vehicle Test Procedure (WLTP) emission regulation, both of which affected vehicle sales in the regions during the quarter. No dividend was announced during the quarter, as expected.

YoY, 9M19 revenue dropped 11% due to slower demand for its burn-in and testing services. We believe this could be a negative spillover from the US-China trade war and WLTP as noted, causing its utilization rate to fall below 50% as the group’s customers instituted tighter inventory control measures. While EBITDA declined 31% on higher raw material costs (+45%), operating profit dropped by a larger quantum of 82%, suggesting the ineffective charge-out of overhead cost on weaker top line. Coupled with a higher effective tax rate (ETR) of 43% (vs.17% in 9M18), CNP tumbled 91%. QoQ, 3Q19 revenue fell 9%, while the bottom-line reversed a CNP of RM0.5m to a CNL of RM0.5m due to higher material costs (+75%). The increase in raw material purchases coincided with the provision of electronics manufacturing services (EMS) to the group’s new customers.

Lacking near-term catalysts. For 2HCY19, management prefers to remain cautious and avoid overspending as it believes automotive demand will remain sluggish and the next semiconductor upturn will only be seen at end-2019 earliest. We concur with management’s view, as we see no major catalyst in the automotive sub-segment for the near term. However, long-term growth prospects of the group remain positive due to rising semiconductor content in vehicles. We also draw some comfort from KESM’s sturdy balance sheet with net cash standing at RM118m as at end-3Q19 (up from RM116m 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 CNP by 11-3% to RM11.5-20.1m after lowering our EBIT margin assumptions from 4.5-6.0% to 4.0-5.9%.

Upgrade to MARKET PERFORM with a lower Target Price of RM7.00 (from RM7.20), based on FY20E PER of 15.0x, implying -0.5SD. While the weakness in the automotive market continues to dampen KESM’s near-term prospects, the group’s long-term outlook remains promising. Additionally, we believe most negatives have been priced-in at the current price levels.

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

Source: Kenanga Research - 7 Jun 2019