• Downgrade to NEUTRAL from Buy, with new TP of MYR0.86 from MYR1.49, 4% upside. We came away from VS Industry’s visit feeling more uncertain and cautious on the company’s prospects, and wary of potential further order cuts depending on the global economic outlook. Its saving grace is the rising demand from Customer X mitigating the shortfall. All in, we believe the share price weakness has largely priced in the slowdown risks but the risk-reward profile is no longer compelling.

• Signs of weakening demand. We understand that VSI has been guided for softer sets of order demand by all key customers, baring Customer X, with some of them also delaying new product launches. This is likely due to the more cautious sentiment amongst the customers in view of a challenging global economic outlook going forward. On top of that, we believe customers could also be making adjustments to the high inventory levels built earlier due to supply chain disruptions. Nonetheless, we caution a significant earnings impact arising from further order cuts should the macroeconomic environment deteriorate – taking into account the high fixed costs and the resulting negative operating leverage.

• Customer X singing a different tune. On a brighter note, VSI is expecting a sharp volume ramp-up for Customer X – on the back of robust demand for existing production lines and contribution from new production lines. This will be sufficient to drive 20% topline growth in FY23F (Jul), offsetting the lower volume we assume for other key customers. Essentially, we believe Customer X’s product innovation, affluent end customer profile and loss of a key supplier are the key factors sustaining the demand notwithstanding macroeconomic headwinds – this should offer relatively better order visibility to the company.

• Risks outweighing reward. Following the sequential earnings recovery since dipping to a low in 1QFY22, VSI’s immediate term earnings should remain steady – in light of the peak seasonality and commencement of new production lines. The orders will be fulfilled by the arrival of new foreign labour intake and easing of component shortage. That said, we believe the cautiousness on the macroeconomic picture, rising interest rate environment and earnings downside risk from further order cuts will negate the immediate term earnings prospects. Post-visit, we cut our FY23F-25F earnings by 10-20%. We also peg the stock with a lower P/E multiple of 13x (closer to its 5-year mean) from 18x to reflect our more cautious stance, in line with our recent valuation downgrade for the technology sector.

• Risks to our recommendation include better/worse-than-expected global economy growth and supply chain disruption.

Source: RHB Research - 18 Oct 2022