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This article first appeared in The Edge Financial Daily on March 14, 2019

KESM Industries Bhd
(March 13, RM8.68)
Downgraded to underperform and a lower target price (TP) of RM7.60:
KESM Industries Bhd’s (KESM) first half for the financial year ended Jan 31, 2019 (1H19) core net profit (CNP) of RM 3.1 million (-86% year-on-year [y-o-y]) came in markedly below our forecast at 14% and consensus estimate at 13%. We attribute the earnings miss to the Chinese imposition of tariffs on US vehicles and the introduction of the Worldwide Harmonised Light Vehicle Test Procedure (WLTP) emission regulation, both of which affected vehicle sales in the regions during the quarter. No dividend was announced during the quarter, as expected.

Year-on-year, 1H19 revenue dropped 11% due to slower demand for its burn-in and testing services. We believe this could be a negative spillover from the US-China trade war and WLTP as noted, causing the utilisation rate to fall below 50% as the group’s customers instituted tighter inventory control measures. While earnings before interest, taxes, depreciation and amortisation declined 33% on higher raw material costs, operating profit dropped by a larger quantum of 82%, suggesting the ineffective charge-out of overhead cost on weaker topline. Coupled with a higher effective tax rate (ETR) of 43% (versus 15% in 1H18), CNP tumbled 86%. Quarter-on-quarter, despite flat 2Q19 revenue, CNP plummeted 82% to RM500,000 due to higher material costs (+42%) and a higher ETR of 71% (versus 30% in 1Q19). The increase in raw material purchases coincided with the provision of electronics manufacturing services to the group’s new customers.

Though earnings shortfall was observed in 1H19, we believe sales would pick up in second half of 2019 (2H19) once the adverse effect of WLTP and trade war subsides. Meanwhile, our check with management suggests that the slowdown is likely transitory as the long-term positive outlook of the business remains intact, especially vis-à-vis rising semiconductor content in automobiles. Note that the group is still in an investment phase with customers, though at a slower pace in FY19 (with capital expenditures [capex] of RM30-50 million versus a normal threshold of RM80 million). Beyond that, capex should normalise as the group is on the verge of shifting to “smart factories,” which spell better operational efficiency going forward due to automation.

Trim financial year ending 2019 and 2020 (FY19-20) CNPs by 6%-5% to RM21.6 million-RM32.4 million after lowering our earnings before interest and tax margin assumptions from 8%-10% to 7.5%-9.5%.

Downgrade to “underperform” with a lower TP of RM7.60 (from RM8), based on an unchanged FY19 price-earnings ratio (PER) of 15 times, in line with the Malaysian outsourced semiconductor assembly and test’s current two-year forward PER. Despite a potential recovery in 2H19, we believe trade war uncertainties will continue to cloud the group’s near-term earnings visibility, and valuation of the stock is currently expensive at FY19E PER of 18.8 times.

Risks to our call include: i) earlier-than-expected recovery in vehicle sales; and ii) faster-than-expected adoption of new semiconductor modules in automobiles. — Kenanga Research, March 13

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