Kenanga Research & Investment

Technology - 1QCY23 Results Review: Missing a Low Bar

Publish date: Fri, 16 Jun 2023, 09:31 AM

The sector’s 1QCY23 results pointed to weakened earnings delivery vs. three months ago, despite significant earnings cuts during the previous results review season. The poor showing was largely due to the absence of a significant pick-up in orders despite China reopening, margin pressures on rising operating costs (particularly tariff hikes), and increased overheads from an expanded capacity and workforce (in anticipation of a pickup in orders that failed to materialise). Over the immediate term, players will focus primarily on cost rationalisation (including postponing expansion and reducing headcount) to align with the softer outlook. While we keep our NEUTRAL rating on the sector, we see bright spots in: (i) KGB (OP; TP: RM1.92) for its strong earnings visibility backed by RM1.9b order book, and (ii) LGMS (OP; TP: RM1.32) which operates in the cybersecurity space that offers a promising outlook.

Largely disappointing. The sector’s 1QCY23 results pointed to weakened earnings delivery vs. three months ago, despite significant earnings cuts during the previous results review season. Among the 13 companies under our coverage, 8%, 38%, and 54% came in above, within and below our forecasts vs. 33%, 34%, and 33% during the preceding quarter, respectively (see Exhibit 1).

No boost from China reopening. Most of the companies under our coverage experienced a seasonally weaker 1QCY23 earnings due to shorter working days associated with the Chinese New Year break. However, earnings were further depressed by a lack of meaningful order recovery despite the reopening of China’s economy. As such, companies such as D&O (UP; TP: RM2.65), UNISEM (MP; TP: RM2.75), and JHM (MP; TP: RM0.75) saw earnings plunging by >70% QoQ while MPI (UP; TP: RM15.26) dipped into the red due to unabsorbed overheads following sub-optimal utilisation rates. The impact was exacerbated by higher electricity costs for commercial usage that took effect earlier this year as well as lingering effects of the wage hike for foreign workers.

Elevated operating costs remain challenging. Despite corporates in the tech space labelling the reported 1QCY23 earnings as already the worst, which typically indicates a turning point in anticipation of an upswing, it is noteworthy that many companies are maintaining a cautious stance given the disparity between actual orders committed versus the optimistic forecast that was verbally indicated by customers. Consequently, earnings in the upcoming quarters are expected to remain subdued, with marginal improvements, and remedies to mitigate further margin erosion will remain the primary focus across all companies. For instance, MPI which is anticipating another quarter of net loss (albeit reduced), has decided to defer the completion of its new plant in China for the second time to January 2025 (previously, it was rescheduled from Dec 2023 to Apr 2024), incurring a fine of USD900k. D&O, with 50% of the revenue generated from China, warned of the slower-than-expected recovery in China, which may continue to weigh on earnings. As such, efforts to rationalise its workforce in alignment with the soft outlook will persist. SKPRES, which is set to complete its new c.650k sq ft plant (representing a c.50% increase in total floor space) next month, is still in search of an anchor customer. If unsuccessful, the company may choose not to renew the permits of a portion of its foreign workers due to the under-utilisation of its existing capacity caused by order cuts from key customers.

Maintain NEUTRAL. Our overall stance on the technology sector remains NEUTRAL, primarily due to the prolonged inventory rationalisation cycle. Product owners are still hesitant to commit to orders due to uncertainties surrounding the macro environment. Furthermore, the pace of China's recovery has fallen short of consensus expectations, leading to the need for further downward revisions in earnings forecasts. That being said, we still see value in selected companies that exhibit resilient earnings visibility. We hold a positive outlook on KGB (OP; TP: RM1.92) for: (i) it being a direct proxy to the front-end wafer fab expansion, (ii) its strong earnings visibility underpinned by its robust RM1.9b order book and RM1.4b tender book, and (iii) its strong foothold in multiple markets, i.e. Malaysia, Singapore and China. Additionally, we favour LGMS (OP; TP: RM1.32) for: (i) its involvement in the high-growth cybersecurity space, (ii) the deep moat around its business given the high entry barrier created by the tough qualification process as a vendor, and (iii) its new proprietary certification software which is expected to be the next earnings driver.

Source: Kenanga Research - 16 Jun 2023

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