We hosted Datasonic in a group meeting yesterday that was attended by 12 clients. We believe the group’s recent passport chips job contract win, coupled with the potential renewal of its existing contracts, maylikely propel earnings to a new high in 2017. Upgrade to BUY, with our TP revised up to MYR1.87 (from MYR1.51, 25% upside).

Renewals in the works. With its existing MyKad contract set to expire by mid-2016, management is currently working on a potential renewal by proposing the next generation of MyKad to contain enhanced security features. Based on our channel checks, the official award is likely take place by mid-2016, at an estimated total contract value of MYR250mMYR300m. In addition, the company is trying to secure a 5-year extension to its existing passport photo-page contract, given the betterthan-expected current run-rate. This could be worth MYR300mMYR350m and, in our view, could materialize by 2H16.

More passport jobs likely. Recall that Datasonic had, earlier on,secured a MYR319m 5-year contract for the provision of smart chips to be embedded in Malaysian national passports. While the 1 Dec 2016 commencement date came in later than we initially thought, we are positive on this latest contract win, which will propel earnings to new high come FY18 (Mar). In addition, the group is in active discussions with the Government for the provision of the passport booklet. Our checks with sources indicate that the contract would cover 12.5m-13.5m copies of booklets to be procured over a 5-year tenure, at a total value of MYR200m-MYR230m with an official award likely by Mar 2016.

Earnings revision and risks. Although we trim our FY17F EPS by 13.0% (we had earlier anticipated both its passport chip and booklet contracts to commence in Apr 2016), we upgrade FY18F EPS by 12.7% after factoring in higher profit margins from the two new contracts – in line with management’s latest guidance. Key risks to our forecasts include potential delays in renewals of its existing MyKad and passport photo-page contract and further delays in finalising the long-awaited passport booklet contract.

Upgrade to BUY. Given that the full-year earnings accretion from the new passport chip contract will only be felt in 2017, we are rolling forward our valuation to 2017. Based on an unchanged target P/E of 25x, our TP now stands at MYR1.87 (from MYR1.51). Given the appealing upside of over 20%, we upgrade our call to BUY.

Eyeing New Jobs Next-generation MyKad in the works. We estimate that Datasonic currently enjoysan outstanding orderbook of 4.2m/3.6m copies of MyKad/MyKad consumablesrespectively, as of Sep 2015. With the contracts set to expire by mid-2016, management is currently working on potential renewal of the contracts by proposingthe next generation of MyKad, which contains enhanced security features on the national identification card. Based on our channel checks, the technical evaluation process is currently ongoing – with an official award likely to take place by mid-2016 before the existing contracts expire to ensure continuity of supply.

Potential renewal of passport data-page contract. Management highlighted that the run-rate for its existing provision of photo-pages for Malaysian passports is clocking in at 2.5m-2.8m pa vis-à-vis the initial projection of 2.0m-2.5m pa. In view of the pent-up demand, the company is currently trying to secure a 5-year extension to its existing contract. This is in line with our previous expectations, as the group looks to cement its position as a leading national security solutions provider. Should the extension materialise, we expect a potential improvement in its overall profitability margins as we understand that most of the equipment and hardware have been provided for under its current contract.

Passport chip supply to commence in Dec 2016. Recall that Datasonic had, earlier on, secured a 5-year contract for the provision of smart chips to be embedded in Malaysian national passports. The contract is valued at MYR318.8m, which translates into an average selling price of MYR25.50 per chip. While the commencement date of 1 Dec 2016 is later than expected, we are positive on the earnings accretion over the long run as this latest contract win will likely propel its earnings to new high come FY18.

Passport book supply contract coming. To complete its national passport offerings, Datasonic is in active discussions with the Government for the provision of the passport book. Management indicated that negotiations are crrently ongoing,with an official award to take place as soon as 1Q16. We believe the official commencement date will likely coincide with its passport chip contract, ie on 1 Dec 2016. Our checks with sources indicate that the contract would cover 12.5m-13.5m copies to be procured over tenure of five years at a total value of MYR200mMYR230m

New jobs ahead. Beyond its existing focus on MyKad and national passports, management reiterated its intention to penetrate into other national security-related projects. Recall that the group was previously involved in the installation of security camera systems in Penang. Datasonic is currently exploring opportunities to replicate this model in other parts of Malaysia to help combat crime – in line with the Government’s aim to reduce house break-ins by 5% annually in 2013-2015, and to tackle vehicle theft, which made up 43% of total index crime in 2011. On top of that, management intends to play a significant role in the country’s migration towards pin based payment cards by Jan 2017. Recall that Bank Negara Malaysia has mandated the migration towards chip-and-pin based payment cards by Jan 2017. This would require the re-issuance of existing payment cards, which are currently based on the chip-and-sign platform.

3QFY16 results preview. On a side note, the group is set to release its 3QFY16 results by end-Feb. We believe core earnings would come within our expectations at MYR11m-13m. Based on our channel checks, its MyKad delivery registered at 1.0-1.3m copies, with additional 1.0m units of MyKad consumables delivered during the quarter.

Earnings revision. While we leave our FY16 EPS unchanged, we trim our FY17 EPS by 13.0% as we had earlier on anticipated both its passport chip and booklet contracts to commence in Apr 2016. That said, we are turning more bullish on its FY18 EPS (upgrade by 12.7%) as we factor in higher profitability margins under the two contracts in accordance with management’s latest guidance.

Risks. Key risks to our forecasts include potential delays in the delivery of its existing MyKad and passport photo-page, further delays in finalising the long-awaited passport booklet contract as well as competitive pressure from local peers. Upgrade to BUY. Given that the full-year earnings accretion from its recently-won passport chips contract will only be felt in 2017, we arerolling forward our valuation to CY2017. Based on an unchanged target P/E of 25x, our TP now stands at MYR1.87 (from MYR1.51). Given the appealing upside of over 20%, we are upgrading our call to BUY. Our P/E-based TP is supported by our DCF-derived fair value of MYR1.47-MYR2.17 (see below).

Base-case DCF valuation. Under our base-case scenario, we assume Datasonic would provide the full set of solutions for both MyKad and national passports in the foreseeable future. We expect its capex to amount to MYR20m pa , as its investment in new equipment would be minimal. This is given that the existing equipment is sufficient to handle annual recurring demand of approximately 2. 5m copies of MyKadand 3.0m copies of national passports. We derive a fair value of MYR1.47.

Best-case DCF valuation. Under our blue-sky scenario, we assume that Datasonic would secure an additional revenue stream of MYR200m pa by FY19F with a target EBIT margin of 37.5%, on top of providing the full set of solutions for both MyKad and national passports in the foreseeable future. Under this scenario, we expect its capex to be sustained at MYR20m-25m pa on the replacement of existing equipment and procurement of new machinery. Under these assumptions, we derive a fair value of MYR1.47.