This article first appeared in The Edge Financial Daily on April 19, 2018

KESM Industries Bhd
(April 18, RM16.50)
Downgrade to hold with a lower target price (TP) of RM19.60: KESM Industries Bhd’s revenue rose 11.6% year-on-year (y-o-y) in first half of financial year 2018 (1HFY18), driven by higher demand for burn-in and testing services, and capacity expansion. As a result of higher operating leverage, earnings before interest, taxes, depreciation and amortisation (Ebitda) margin expanded to 34.7% y-o-y in 1HFY18. However, depreciation expenses rose 27% y-o-y following the addition of machinery and test equipment to support the group’s capacity expansion, while effective tax rate increased to 14.8% (versus 12.2% in 1HFY17). Overall, 1HFY18 net profit increased 12.8% y-o-y to RM22.6 million.

We recently hosted a conference call with KESM executive director Kenneth Tan, together with nine domestic fund managers. During the call, the group shared its view on the likely minimal impact from the escalation in protectionist tariffs between China and the US. In addition, KESM is still facing wafer supply constraints as its customers face assembly and production yield issues. Wafer substrate is a key raw material for the fabrication of integrated circuit (IC) chips.

We expect KESM’s utilisation rate to fall from 80% in second quarter of FY18 (2QFY18) to 70% in 3QFY18 due to lower wafer supply. Nevertheless, we expect the group’s supply constraint issue to improve in 4QFY18 as its customers gradually improve their production yield. We expect KESM to deliver steady Ebitda margin expansion in FY18 to FY20, with a shift in product mix towards more advanced IC chip testing and better economies of scale. KESM expects to incur a lower capital expenditure of RM70 million in FY18 versus RM109 million in FY17.

We had earlier expected KESM to deliver higher earnings in 2HFY18 in view of the resilient demand in the automotive segment. However, we are now turning cautious about its near-term earnings outlook due to the wafer supply constraints at its customers. Hence, we cut FY18-FY20 earnings per share by 9%-15% to account for a lower-utilisation-rate assumption. Meanwhile, we do not expect the appreciation in the ringgit against the US dollar to have a material earnings impact on KESM, given that the majority of its transactions are denominated in ringgit.

Following our earnings revisions, we downgrade KESM from “add” to “hold” with a lower TP of RM19.60, still based on 13.5 times calendar year 2019 price-earnings ratio (PER) (at a 10% discount to our 15 times target PER for the Malaysian test and assembly sector). We think the discount is justified as KESM is a smaller test service provider by market capitalisation compared with its local peers. While we like the group’s product portfolio riding on rising semiconductor content adoption in automotive, we see limited near-term earnings upside due to constraints in supply chain. — CGSCIMB Research, April 17