We  visited  VS  Industry  recently  and  were  pleasantly  surprised  by  the substantial  ramp-up  in  production  from  the  preceding  quarter. Management  guided  for  double-digit  growth  in  production  volume  for FY14/FY15,  although  subsidiary  VSIG’s  outlook  remains  challenging. We  raise  our  FV  to  MYR2.00  (from  MYR1.75)  after  upgrading  our estimates but retain our NEUTRAL call. 

• A better quarter ahead. 4QFY14 is expected  be a better quarter for VS Industry. This is not  only due to seasonal factors  but  from the  increased utilisation rate  brought about by the production  ramp-up of a new coffee machine  model  that  started  at  end-May.  We  expect  to  see  fullcontribution  from  the  production  of  these  machines  in  FY15  –management  expects  their  contribution  to  group  revenue  to  grow  to approximately  40%  by  then  (FY13:  20%),  which  is  part  of  the  group’s initiative  to  diversify  away  from  Dyson  products.  Net  margins  are  also expected  to  improve  slightly  on  the  higher  utilisation  rate  and  product mix.  However,  we  continue to  forecast    FY14-15  net  margins  of  about 2%,  as  the  group  will continue to be  dragged down  by its  loss-making subsidiary,    VS International Group (VSIG),  which makes up more than one-third of the group’s total sales 
•  VSIG’s  prospects  remain  bleak.  The  outlook  for  VSIG  remainschallenging,  as  the  bulk  of  its  sales  comprises  low-margin  products, coupled  with mounting pressure from  a  hike in wages. We reaffirm our view that it will take some time before we see  positive contributions from VSIG after its consolidation in July 2013. 
• Stay  NEUTRAL,  FV MYR2.00 (vs  MYR1.75).  We raise  our  FY14/FY15 earnings  estimate  by  11.2%/20.8%  respectively,  after  taking  into consideration:  i)  higher  sales  assumption  for  Keurig  coffee  machine orders,  and  ii)  slightly  better  margins  due  to  improved  utilisation  and product mix. We maintain NEUTRAL with higher  FV of  MYR2.00,  based on  9.5x  FY15F  earnings  P/E  (from 10x), broadly in line with its closest peer,  SKP  Resources  (SKP  MK,  BUY,  FV:  MYR0.75)’s  11x  valuation. We ascribe a lower P/E due to VS Industry’s gearing level, as well as our lower forecast earnings growth in the coming years vs its peer.

Earnings Recovery On The Way

A better quarter ahead.  We believe the coming quarter, 4QFY14,  will be the best quarter of the financial year. This is because  production has ramped up substantially since  the  commissioning  of  the  assembly  of  a  new  coffee  machine  model  back  in  end-May.  This  is  the  third  model  in  VS  Industry’s  production  line-up.  Management stated that production of this model reached 100,000 units in June and figures should double  that in  July.  By  FY15,  we  will  see  ~40%  (FY13:  20%)  of  the  group’s  sales  consisting of coffee machines, diversifying away from Dyson products.Net margins stood at 1.5% as at 9MFY14. VS Industry continued to record declinesin its net margins in each of the last four quarters. This decline was attributed to: (i)  Minimum wage policy . The national minimum wage (MYR900 in WestMalaysia,  and MYR800  in  Sabah and Sarawak) came into effect on 1 Jan 2013. Its China  operation suffered the same fate as well,  as labour costs  increased to  CNY1,400 as of now  from  CNY1,100 in 2012. We also  understand  from  management  that  wage  pressure  is  still  a challenge  to  its China  operations,  which we believe ought to  materially impact its margins, moving forward.(ii)  Decreased utilisation rate.  VS Industry’s utilisation rates  declined,  as we understand that its key customer,  Dyson,  cut orders in anticipation of  new  models  for  2014. We  also  note  that  its  peer,  SKP  Resources (SKP MK, BUY, FV: MYR0.75),  also received  fewer  orders from Dysonduring the period. (iii)  Forex  loss.  We  note  that,  in  3QFY14,  VS  Industry  recorded  a MYR4.4m  derivative  loss  on  its  currency  forward  contracts.  As  more than  one-third  of  the  group’s  sales  comprised  sales  from  its  China operations, it is exposed to the fluctuation of the CNY against the USD.(iv)  Loss-making  subsidiary  VSIG.  VSIG’s  outlook  remains  challenging,as most of  its sales consist  of low-margin products. We also note that the  group’s  interest  expenses  also  rose  considerably  after  VSIG’s consolidation back in July 2013.

But we expect net margins to  improve slightly,  moving forward. Looking ahead, we believe net margins will improve slightly to ~2% each for FY14/FY15 on the back of  the  increased  utilisation  rate  and  improved  product  mix.  Production  of  its 
NextWindow  touch  screens  and  the  new  coffee  machine  model  ought  to  generate better  margins.  We  deem  our  estimates  conservative,  as  we  understand  that  the business typically generates low margins and it will take some time before we see  positive  effect  of  the  group’s  cost  rationalisation  after  consolidating  VSIG  and  its subsidiaries.

Key risks. Key risks include: i) a weaker-than-expected global macroeconomic environment that could dampen consumer demand for electrical items, and ii) dependence on orders from key customers. Maintain  NEUTRAL  with  a  new  FV  of  MYR2.00  (from  MYR1.75).  We  raise  our earnings  estimates  for  FY14/FY15  by  11.2%/20.8%  respectively  after  taking  into consideration: i) higher sales assumption for coffee machine orders,  and  ii) slightly better margins due to improved utilisation as well as product mix. We maintain our NEUTRAL call with a higher FV of MYR2.00, based on FY15F P/E of 9.5x (from 10x). This  is  broadly  in  line  with  its  closest  peer,  SKP  Resources  (SKP  MK,  BUY,  FV: MYR0.75)’s valuation of 11x. In our opinion, VS Industry deserves a lower target P/Eas we forecast lower earnings growth in the coming years vs its peer.

Source: RHB