We maintain our OVERWEIGHT stance on the sector as we believe that the earnings momentum of the semiconductor players would pick up substantially come 2H16 on capacity expansion and new componentsmass production for the incorporation into the next-generation smartphones. Our Top Picks are Globetronics and Inari. Outside the semiconductor space, we like Datasonic as we believe its recent passport chips job win, coupled with the likely renewal of its existing contracts over the next 3-9 months, would propel earnings to a new high in 2017.

Likely soft start. Nikkei Asian Review recently reported that Apple has reduced output of its latest iPhone models by 30% in 1Q16 to 40m-50m units. The reportsaid the leading smartphone maker had initially told component makers to maintain 1Q16 production of the iPhone 6s and 6s Plus at the same levels as with predecessors the iPhone 6 and 6 Plus launched a year earlier. Although there has been no official confirmation by management, we understand that the revised volume guidance took into account the slow-moving inventories as markets ranging from China and Japan right up to Europe have witnessed sales slowdowns. Concurrently, consumer sentiment was further aggravated by the steep USD appreciation against regional currencies in 4Q15. The unexpected cut in orders from Apple, in our view, could translate into a soft start to 2016 for the smartphone-centric packaging and testing players we cover, ie GlobetronicsTechnology (Globetronics) (GTB MK, BUY, TP: MYR6.66) and Inari Amertron(Inari) (INRI MK, BUY, TP: MYR3.96). This is because we expect the impact to spill over into the back-end services supply chain. We are expecting a 15-20% QoQ drop in 1Q16 earnings for the two. We note that Globetronics is set to release its 1Q16 results on 26 Apr while Inari is looking to announce its 3QFY16 (Jun) results by end-May.

Momentum to pick up in 2H16. That said, we expect production to normalise come 2Q16 as our channel checks indicate that inventory adjustments would be completed by April/May. Meanwhile, the components manufacturing for the nextgeneration smartphones is likely to commence at the very latest by June, with the commercial launch set to take place in September. Based on our conversations with local players, a large majority are waiting for the final confirmation of orders from their respective customers. We expect mass production to commence by April/May, with full volume loadings by June. The USD/MYR factor. The share prices of the semiconductor manufacturers under our coverage have retraced by 10-20% YTD. We believe the selling interest intensified in tandem with the rebound in MYR against USD, which last closed at MYR4.10 vis-à-vis the YTD average of MYR4.24. Given that our latest in-house USD/MYR forecast is at an average of MYR4.17 for 2016, we remain positive on the earnings momentum of our export-based manufacturers. That said, we highlight that every 1% appreciation in MYR against USD could translate into earnings downgrades of 2-5% for the technology manufacturers under our coverage, ceteris paribus.

Other key risks to our bullish stance on the sector include: i) a potential decline in the worldwide demand for semiconductor components should the global economic recovery falter, and ii) potential margins erosion upon product maturity. This is, given that packaging and testing services are at the lower-end of the semiconductor supply chain.

Buying Into 2H16 4Q15 a decent quarter 4Q15 was a mixed quarter for the technology sector, with one/four/two companies reporting earnings that were below/within/above our expectations respectively. On the semiconductor side, Unisem (UNI MK, BUY, TP: MYR2.83) reported an earnings surprise driven by a favourable forex environment, as USD averaged at MYR4.28 during the quarter. Meanwhile, Inari, Globetronics and Malaysian Pacific Industries’ (MPI MK, BUY, TP: MYR11.64) numbers came in within expectations. For the non-export players, Datasonic (DSON MK, BUY, TP: MYR1.87) reported a strong quarter due to higher-than-expected orders for delivery of its MyKad in 3QFY16 (Mar). GHL Systems (GHL) (GHLS MK, NEUTRAL, TP: MYR0.93) closed 2015 with a decent showing while Prestariang (PRES MK, NEUTRAL, TP: MYR2.70) reported a subdued quarter dragged by a slower-than-expected run-rate for its existing contracts and prolonged losses at its university.

1Q16 could see some softness Nikkei Asian Review recently reported that Apple has reduced the output of its latest iPhone models by 30% in 1Q16 to 40m-50m units. According to the report, the leading smartphone maker had initially told component makers to maintain production of the iPhone 6s and 6s Plus for 1Q16 at the same levels as their predecessors, ie the iPhone and 6 Plus launched a year earlier. Although there has been no official confirmation by management, we understand that the revised volume guidance took into account the slowmoving inventories. This is because markets ranging from China and Japan right up to Europe have all witnessed a slowdown in sales while consumer sentiment was further aggravated by the steep USD appreciation against regional currencies in 4Q15.Short-term impact on local players

The unexpected cut in orders from Apple, in our view, could translate into a soft start to 2016 for smartphone-centric packaging and testing players under our coverage, ie Globetronics and Inari, as we expect the impact to spill over into the back-end services supply chain. Taking that into account, we are expecting a 15-20% QoQ drop in 1Q16 earnings for the two firms. We note that Globetronics is set to release its 1Q16 results on 26 Apr while Inari is looking to announce its 3QFY16 results by end-May. That said, we expect production to normalise come 2Q16 as our channel checks indicate that inventory adjustment would be completed by April/May while the components manufacturing for the next-generation iPhone 7 series are likely to commence latest by June. This new phone’s commercial launch is set to take place in September.

All eyes on the iPhone 7… While there have been various rumours and speculations over the technical specifications of the iPhone 7 series, we gather that the final versions have yet to be confirmed at this point of time. We believe this could be due to the escalating competition from the Androidbased sartphone brands, which – in our view – compels Apple to go back to the drawing board on the designs of its next-generation flagship models. Based on our conversations with local components suppliers, a large majority are waiting for the final confirmation of orders from their respective customers. We expect mass production to commence by April/May, with full volume loadings by June.…as well as USD/MYR

Share prices of the semiconductor manufacturers under our coverage have retraced by 10-20% YTD. We believe the selling interests intensified in tandem with the rebound in MYR against USD, which last closed at MYR4.10 vis-à-vis the YTD average of MYR4.24. Given that our latest in-house USD/MYR forecast is at an average of MYR4.17 for 2016, we remain positive on the earnings momentum of our export-based manufacturers. That said, we highlight that every 1% appreciation in MYR against USD could translate into earnings downgrades of 2-5% for the technology manufacturers under our coverage, ceteris paribus. In the event of a prolonged appreciation of the local currency against the USD, we believe that most manufacturers would have to embark on pricing renegotiations with their direct customers to help mitigate the forex impact to their respective bottomlines

OVERWEIGHT stance reaffirmed All in, we maintain our OVERWEIGHT stance on the technology sector. This is because we continue to believe that: i) capacity expansion, ii) the introduction of new products, and iii) the current favourable USD/MYR rate ought to propel earnings of the semiconductor testing and packaging players under our coverage.

Our Top Picks are Globetronics and Inari. Notably, Globetronics is set to ride on the introduction of its 3D imaging sensor, which we suspect would be used in the next generation smartphones that are slated for launch in 2H16. The group has set aside capex of MYR50m for 2016, a large portion of which is to be dedicated for its new 3D imaging sensor production lines. Management targets full volume loadings of 30m-35m units per month under this new product by June, pending a final volume indication from its endcustomer. Based on our calculations, the imaging sensor segment could potentially translate into an additional revenue contribution of MYR200m -250m pa on a full-year basis.

On the other hand, Inari’s radio-frequency integrated chip division currently houses over 600 units of testers. Although there have been some slight delays in its full ramp-up to 800 units of testers due to slower volume guidance from Avago Technologies (Avago) (AVGO US, NR) for 1H16, we are adamant that a slew of launches within the premium smartphone segment over the next 3-6 months – coupled with the increasing radiofrequency content per device – are likely to help to propel demand growth over the medium term. In addition, the group is also working closely with Avago to grow its fibreoptic products division by offering value-added services on the latter’s existing fibre-optics connector offerings. It plans to subsequently market these products to Tier-2 and Tier-3 customers that Avago currently does not serve.

Outside the semiconductor space, we continue to like Datasonic. This is because we believe that its recent passport chips job win, coupled with the likely renewal of its existing contracts over the next 3-9 months, would propel earnings to a new high in 2017. Management is currently working on the potential renewal of its MyKad contract, which we understand would involve a new version with 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 MYR250m-300m. In addition, the company is trying to secure a 5-yer extension to its existing passport photo-page contract, given the better-than-expected current run-rate. This could be worth MYR300m-350m and, in our view, could materialise by 2H16. Datasonic is also 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 with a total value of MYR200m-230m. The official award likely to be by end-March.

Source: RHB Research - 9 Mar 2016