Kenanga Research & Investment

Technology - Technically on Solid Ground

Publish date: Mon, 04 Apr 2022, 09:42 AM

We maintain our OVERWEIGHT call on the technology sector going into 2QCY22 but targeted on selective sub-segments. We turned neutral on consumer electronics but remain bullish on semiconductors for data centre, 5G base stations that are still seeing healthy demand as expansions need to continue to support 5G enabled consumer devices. We are also positive on automotive semiconductors that will continue to see elevated demand with the proliferation of electric vehicles. Therefore, we like D&O (OP; TP: RM5.60) being automotive LED-centric and MPI (OP; TP: RM48.10) for its healthy revenue exposure of c.68% to data centre and automotive markets. While Russia only accounts for 0.1% of global semiconductor demand, the halt to Ukraine’s neon gas production (c.50% of global supply) may pose a challenge to chip manufacturing if the war persists. Thankfully, wafer fabs have safety stock to last at least a quarter and can source from alternative producers in China which have an abundance of noble gasses. KGB (OP; TP: RM1.90) is identified as an indirect beneficiary given its trading of China-sourced semiconductor-grade gasses. With semiconductor demand remaining intact and local back-end players having more bargaining power to raise prices in recent years, we see little impact from rising inflation rate and the proposed increase in minimum wage. We are not overly concerned over the interest rate hike environment hindering expansion plans as tech companies are mostly in a net cash position. Overall, we still see attractive upside in the technology sector even after lowering our valuation to factor in the somewhat dampened sentiment.

Selectively bullish. We maintain our OVERWEIGHT call on the technology sector going into 2QCY22 but targeted on selective sub-segments. With the work-from-home (WFH) trend entering its third year and the upcoming iPhone 14 this September (which will be the third generation of 5G-enabled smart phone by Apple), we believe that most consumers that were in urgent need of upgrading their devices to adapt to the pandemic had already done so. This is evident by the stabilising demand as PC shipment inched up only 1% YoY in 4QCY21 while smart phone shipment slid 1.8% YoY in the same period.

Therefore, we have turned neutral on consumer electronics but remain bullish on semiconductors for back-end infrastructure (e.g. data centre, 5G base stations) that are still seeing healthy demand as expansions need to continue in order to support 5G-enabled consumer devices that have been sold in the past 2-3 years. In addition, we continue to favour the automotive semiconductors space, premised on the increased demand for electric vehicles that is accelerated by government’s legislation to curb down on carbon emission. The European Union (EU) has unveiled its blueprint under the European Green Deal last year to stop the sale of petrol and diesel cars by 2035. In 2021, the EU reported only 9.1% of the cars sold are purely electric powered (vs. 5.4% in 2020). This explains why car manufacturers are scrambling to fit in more EV models in their product portfolio. Having most of their manufacturing lines and design platforms built for petrol and diesel vehicles over the past decades, car manufacturers have a challenging task at hand to convert production fully to electric powered engines within the next 13 years.

Tech sanctions on Russia have little impact on global semiconductor demand... The Russian-Ukraine war that broke out since 24 February has further exacerbated the sell-down on technology stocks that started in early 2022. However, we believe a large portion of the sell-down is merely sentiment driven while fundamentals have mostly remained unchanged. To further illustrate, Apple’s decision to halt the sale of iPhones to Russia is estimated to reduce Apple’s annual revenue by a mere 2% and the void left by Apple could translate into opportunity for Chinese brands such as Xiaomi which has c.26% market share in Russia, followed by realme and Poco with 8% and 3%, respectively.

…but Ukraine’s semiconductor gas supply is crucial. However, the possibility of neon shortage for chip production is a valid concern. For the safety of the employees, neon gas producing companies in Ukraine such as Ingas and Cryoin which collectively supply c.50% of global semiconductor-grade (99.999% purity level) neon gas has stopped production. As a result, the price of neon has risen more than 500% since December 2021. Thankfully, large wafer fabs have experience such a scenario during the annexation of the Crimean Peninsula back in 2014 when neon supply was in shortage and prices rose 600%. Since then, chip giants with great buying power such as TSMC, Samsung and Intel have ensured that they have enough safety stock to weather through at least for a quarter year. TSMC even has its own in-house neon recycling facility underneath its wafer production facility to cater for its own needs.

This scenario again presents an opportunity for China to gain market share as it possess an abundance of noble gasses thanks to its dominance in the steel industry which in the process allowed Chinese companies to develop technologies for purifying neon and other noble gasses to an acceptable purity level for chip production. Note that factories heavily rely on oxygen for manufacturing steel and neon is the by-product during the process of oxygen production. We have identified Kelington Group (OUTPERFORM; TP: RM1.90) as an indirect beneficiary as the group has ventured into industrial gasses since 2018 and has recently started trading semiconductor-grade noble gasses by sourcing from China and selling to western customers. Having a strong customer portfolio in China (e.g. SMIC, CXMT) and among western customers (e.g. Infineon, Micron etc) has helped Kelington Group bridged the trust gap and language barrier issue between western customers and Chinese suppliers.

Trade diversion to continue benefiting Malaysia. Building on the fact that Malaysia is a neutral zone in the US-China trade war and a multi--lingual country, we are optimistic that the trade diversion will continue to benefit local tech companies in Malaysia. This is evident by the recent announcement by Intel’s US$7b (RM30b) and Infineon’s €2b (RM9.5b) expansions in Penang and Kedah, respectively. In addition, China’s recent policies such as the ban of crypto-currency have pushed Bitmain to divert bulk of its manufacturing of mining equipment into Malaysia. China’s persistence on its zero-Covid policy will likely have companies, thinking twice before expanding in China, or diversifying out of China due to the disruptive impact of operating in an environment with sporadic lockdowns at this point of time when Malaysia has transitioned to the endemic phase of Covid-19.

Rising inflation, higher minimum wages, and rate hike. Traditionally in a rising inflation environment, front-end players are still able to continue enjoying their gains at the expense of back-end players (e.g. packaging and testing) facing margin compression, but things have changed in recent years and even back-end semiconductor processes have advanced and increased in complexity to complement growing demand for higher-powered chips in a smaller form factor. From our interactions with local tech players, corporates are indicating that customers are more understanding about the higher cost involved in packaging and testing these new chips and are willing to pay higher prices for their service. Therefore, we are sanguine that local tech companies will be able to maintain their margins. Despite the proposed increase in minimum wage to RM1,500 (from RM1,200) by the local government beginning 1 May, we see very little impact as many tech companies have already been paying their operators close to RM1,500.

As for the fear of rising interest rates that started the whole tech sell-down since early 2022, we are not overly concerned as most of the tech stocks under coverage are in a net cash position and have a strong balance sheet to fund necessary expansions in the near to medium term. Interestingly, in the past eight cycles of monetary tightening, it was pointed out by LPL Research and Bloomberg that the S&P 500 index showed positive returns over the next 12 months in all eight cycles. Back in Malaysia, we saw hints of such movement in the KLTEC index where it rose 10.7% in a week from 16 March 2022 after the first Fed rate hike was announced.

Mapping valuations. With that said, we still acknowledge the changes in macro factors such as: (i) reopening of international borders which has led to investors hunting for travel-related stocks, (ii) reduced liquidity in the stock market as trading activity among retailers are tapering, and (iii) dampened sentiment due to the on-going Russia-Ukraine war. Hence, we have accounted for these concerns by reducing our PER valuation across the board in the recent earnings reporting season. We applied a wider horizon PER multiple (see table below: “Mapping valuations”) of +1SD to 5-year average (Period 3) which we believe is ideal as it encompasses a balance between pre-Covid conservatism (Period 1) and the technological advancement that tech companies developed in recent years (Period 2). Comparing today’s valuation to Period 3 clearly shows that most of the tech names including those under our coverage are trading at a significant discount with sound fundamentals.

Maintain OVERWEIGHT stance on the technology sector. Our top picks are:

(i) Kelington Group (OUTPERFORM, TP: RM1.90). We continue to like Kelington Group owing to its unique exposure to the wafer fab expansion which is still seeing strong momentum. This is evident by its strong outstanding order-book of RM1.1b while its tender-book rose to a new high of RM1.9b. In addition, the group is committed to continue growing its industrial gas segment which yields double the gross margin compared to the ultra-high purity gas delivery systems for wafer fabs.

(ii) Malaysian Pacific Industries (OUTPERFORM, TP: RM48.10). MPI has a healthy portfolio with growing exposure in the data centre and electric vehicle segments (38% automotive; 32% data centre; 22% communication, 8% PC/laptop) which we continue to favour. By having a head start as the only OSAT in Malaysia capable of packaging wide bandgap (e.g. GaN and SiC) chips, MPI has futureproof the group’s prospects in the evolving semiconductor industry.

(iii) D&O Green Technologies (OUTPERFORM, TP: RM4.60). Being the only Malaysian company in the automotive LED space and Top 2 in the world capable of offering full range automotive LED solutions, D&O is expected to continue experiencing elevated growth in FY22, driven by a slew of electric vehicle models that are slated to launch in 2022 on top of the existing LED demand for fuel powered vehicles.

Source: Kenanga Research - 4 Apr 2022

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