With headwinds from the trade war having subsided, we are now more convinced on Elsoft’s ability to deliver improved performance in FY20 and as such we ascribe a higher target PE of 19.0x (previously 15.0x), which is in line with its 5-year mean and correspondingly arrive at a higher TP of RM0.89/share (previously RM0.72/share). Alongside the improved risk reward potential, we also upgrade our recommendation from Sell to Buy. Drivers for the group include its new series of automated test equipment catered to the smart devices (LED flash tester) and automotive (headlamp tester) segments. Key downside risks include single customer concentration and poor acceptance of new products.

Expect 4QFY19 Results to Remain Weak

Elsoft is scheduled to release its 4QFY19 results towards end-February 2020. We expect the quarter’s results to remain weak with revenue and core net profit estimated to come in the range of RM7mn to RM11mn and RM3mn to RM5mn (supported by order book of RM11mn as at end-3QFY19). If so, this will represent the 4th consecutive quarter of top and bottom line decline on a YoY basis. To recap, akin to most peers in the semiconductor industry, 2019 was a challenging year for Elsoft. Its 9MFY19 revenue and core net profit declined 58.1% and 57.9% to RM27.3mn and RM13.9mn as: i) the absence of significant upgrades to a major end-customer’s smartphone flash module, ii) the slowdown in the global automotive market, and iii) the uncertainty on the trajectory of the trade war between the USA and China, altogether led to lower demand for the group’s automated test equipment with weakness observed across all segments including smart devices, automotive, and general lighting.

Looking Forward to a Better Year in FY20

Notwithstanding, we expect FY20 to be a better year for Elsoft with revenue and core net profit forecasted to grow 67.0% and 67.9% to RM60.3mn and RM30.7mn, driven by: i) its new series of automated test equipment catered to the smart devices (LED flash tester) and automotive (headlamp tester) segments, and ii) the improved sentiment on the global economic backdrop following the phase one trade deal between the USA and China, which could see customers move forward with earlier capex plans that were placed on the back burner.

We note that the group’s new series of automated test equipment are currently undergoing qualification by customers, and we view bright prospects for acceptance given their relevance to emerging trends i.e., with the smart devices segment’s LED flash tester designed for the next evolution of smartphone flash module, and the automotive segment’s headlamp tester catered to multibeam LED headlamps which are still in a nascent stage. Attesting to its research and development capabilities, note that both the smart devices and automotive segments were the group’s key drivers over the years as they consistently contributed to over 80% of revenue.

Medical Devices Segment, a Wildcard.

Meanwhile, we continue to see the medical devices segment as a wildcard. While contributions from the medical devices segment are smallish, which we estimate to be <5% of 9MFY19 revenue, we note that Elsoft is now improving on the first generation of embedded controllers for peritoneal dialysis machines it introduced in 2018. Peritoneal dialysis is an alternative to haemodialysis, which among others, offers patients of chronic kidney disease the advantage and convenience of having dialysis at home. We believe that alongside the prevalence of chronic kidney disease, the market potential for the group’s upcoming generation will increase as it is expected to be more cost effective, compact, and portable. From 2018 to 2025, Fortune Business Insights projects the peritoneal dialysis market to grow at a CAGR of 5.8% to US$5.0bn.

Impact

We make no changes to our earnings estimates.

Valuation and Recommendation

With headwinds from the trade war having subsided, we are now more convinced on Elsoft’s ability to deliver improved performance in FY20 and as such we ascribe a higher target PE of 19.0x (previously 15.0x), which is in line with its 5-year mean and correspondingly arrive at a higher TP of RM0.89/share (previously RM0.72/share). Alongside the improved risk reward potential, we also upgrade our recommendation from Sell to Buy. Key downside risks include single customer concentration and poor acceptance of new products.

Source: TA Research - 7 Feb 2020