We like KESM for its prudent management, solid balance sheet and ability to tap into the growing need for burn-in and test services catering to automotive semiconductor segment. We have a Not Rated call on the stock, deriving a MYR4.16 TP (6% upside) by ascribing a 12x FY16F P/E. The group is still trading below its BV/share of MYR5.88 as at end-Apr 2015.

• The largest independent burn-in and test services provider locally.KESM Industries (KESM) is the largest independent player in Malaysia that specialises in the burn-in and test processes of semiconductor devices. The group has two plants in Penang and Selangor (Malaysia), and one in China. In May, KESM completed the acquisition of the remaining stake (of 34.62%) in its 65.38%-owned subsidiary KESM Test (M) SB (KESM Test), a move to further strengthen its commitment as a fully independent testing services group.
• Riding on strong demand growth for automotive electronics. The automotive sector contributed approximately 70% of KESM’s total burnin and test sales. Over the years, the group has built a strong business relationship with its customers who are supplying specialised semiconductor devices to world’s reputable automotive manufacturers.
• Uninterrupted profit track record with a solid balance sheet.KESM’s track record has been respectable despite the technology sector’s boom and bust cycles. It has recorded an uninterrupted earnings trend since 1997. As at end-April, the group had total net cash of MYR46.5m, or net cash per share of MYR1.08.
• Investment case. We have a Not Rated call on the stock, deriving a MYR4.16 TP (6% upside) based on a 12x FY16F (Jul) P/E. This is in line with its 12.4x, 6-year average P/E and represents a 23% discount to the technology industry’s average FY16F P/E of 14.8x. The group is stilltrading below its BV/share of MYR5.88 as at end-April.
• Key risks. i) any downturns in the semiconductor industry, ii) a hike in direct costs, and iii) unfavourable forex movements.

Investment Thesis Strong track record with a solid balance sheet. KESM is the largest independent player in Malaysia that specialises in the burn-in and test processes of semiconductor devices. Over the years, the group has delivered a respectable set of results, with uninterrupted net earnings since 1997. With the accumulation of wealth over the years, it has managed to build a solid balance sheet, with total net cash of MYR46.5m as at end-April.

An experienced and prudent management team. The semiconductor industry is a highly cyclical sector, with periods of major upswings and downturns. Thanks to its prudent management and insightful decisions, the management team has been able to navigate KESM through the industry’s up- and down-cycles. Management has done this by concentrating on high-growth areas such as providing burn-in and test services for the automotive industry, as well as for the smartphones and tablets subsector.

To capitalise on growth in global automotive market. The automotive sector contributed approximately 70% of KESM’s total burn-in and test sales. Over the years, the group has built a strong profile of customers who supply specialised semiconductor devices that are used in the vehicles of the world’s reputable automotive manufacturers. These higher-end vehicles require greater electronic content to fulfil functions such as wireless connectivity, infotainment, global positioning system (GPS), advanced driver assistance systems, air bag systems, battery management, and safety systems, among others. Acquired remaining stake in KESM Test. In May, KESM completed the acquisition of the remaining 34.62% stake it did not own in subsidiary KESM Test from its major shareholder Sunright (SUNR SP, NR) for MYR35m, funded through internallygenerated funds. This move allows KESM to gain full control over KESM Test’s business development and further strengthen its commitment of being a fully independent test services group. In addition, this coincides with its intention to focus on testing services for microchips that are used in the automotive sector. KESMTest’s PAT grew to MYR15.8m in FY14 from MYR9.3m in FY12. This was mainly contributed by the growing demand for automotive electronic parts and lower tax expenses as a result of reinvestment allowances. The acquisition is earnings accretive due to the consolidation of KESM Test’s financial results. The acquisition cost implies 6.4x P/E and is based on KESM Test’s FY14 (Jul) PAT, which was lower than KESM’s 15.4x FY15F P/E.

Valuation We derive a MYR4.16 TP which represents a 6% potential upside return. We are valuing the stock based on a FY16F P/E of 12.0x, which is in line with its 6-year average P/E of 12.4x and it is at a 23% discount to the technology industry’s average FY16F P/E of 14.8x. We consider a lower valuation relative to the industry average is reasonable in view of the group’s smaller market capitalisation, lower ROE and dividend yield.

Peer comparison. There are no truly comparable listed peers on Bursa Malaysia that provide independent burn-in and test services to the semiconductor industry. However, some bigger players such as Malaysian Pacific Industries (MPI MK, BUY, TP: MYR7.69) and Unisem M (UNI MK, NEUTRAL, TP: MYR2.42) provide test services as part of their turn-key services while Elsoft Research (ELSR MK, NR) engages in the research, design and development of test and burn-in systems for its customers. With the group’s efforts to strengthen its earnings growth by expanding its core burn-in and testing services, its P/E multiples will likely compress further to approximately 11.4x in FY16F and 10.8x in FY17F. KESM is the only companyamong the peers that is trading below its book value as at end-Apr 2015.

Key Risks Any downturns in the semiconductor industry. KESM’s business is susceptible to the cyclical nature of the semiconductor industry and the changes in macroeconomic environment. Nevertheless, we believe that its management is experienced, and has the ability to improve efficiency and manage costs in the event of a downturn . This is evident in its performance track record.

Hike in direct costs. Any upward pressure in utility costs and minimum wage rates in Malaysia and China will adversely impact KESM’s profit margins. This is because it is quite unlikely for the group to pass on the cost increases to its clients. Nevertheless, any downward risks attributable to higher operating costs could be in the short term only, considering that KESM can work towards utilising its resources more efficiently to further improve its performance.

Unfavourable forex movements. We believe that the downside risk of unfavourable forex movements will likely be manageable. This is because KESM’s export sales account for less than 10% of its Malaysian operations while the output from its China plant only caters to domestic customers. Furthermore, the bulk of the group’s operating expenses are denominated in local currencies, which provides a natural hedge against any unfavourable forex movements.Having said that, the weakness of the MYR against the USD is deemed a n added bonus for KESM in terms of earnings gained from the components it does export.

Financial Overview Uninterrupted profit. KESM has been posting an uninterrupted profit track record since 1997, with its performance mainly tracking the global economic performance. The group has managed to survive various crises that impacted the world economy,including the Asian Financial Crisis (1997), the Technology Bubble (2000-2002), the severe acute respiratory syndrome (SARS) outbreak (2003) and the Global Financial Crisis (2008-2009). KESM recovered from each crisis and emerged stronger. Having said that, however, its net profit margin has been staying at single-digit levels since2009 and we believe this trend may continue going forward because the semiconductor manufacturers are constantly trying to make their chips smaller, cheaper and with more features. This means KESM has to constantly improve operational efficiency in order to maintain its profit margins. As such, any earnings growth potential, going forward, has to be driven by growing demand for its services

Cash rich. Despite low net profit levels, KESM has been generating healthy operating cash flow, as its net profit is partly discounted by high depreciation costs. With the exception of FY03 and FY04, the group has been in a net cash position since 1997. As at end-April, KESM has a total net cash of MYR46.5m, or net cash per share of MYR1.08.

Stable dividend. KESM has been paying DPS of 3 sen since FY06. For FY15, the group has already paid a special interim dividend of 3 sen. With a higher earningsbase going forward, following the consolidation of KESM Test, there is a possibility for the group to declare a higher dividend payment. However, its dividend payout ratio has never been more than 35% of net profit, as KESM has been conserving cash for its debt repayment and capex requirements. Assuming a flat DPS of 3 sen going forward, the dividend yield would be around 1%.

9M15 Results. KESM posted a good set of 9M15 results, with net profit up by 56.5% YoY to MYR6.6m on the back of a 4.6% YoY increase in revenue to MYR194.2m. These results were due to higher demand from burn-in and testing services, and an exchange gain of MYR800,000 arising from the appreciation of the USD against the MYR.

Source: RHB Research - 15 Jun 2015