Hi-P International - DBS Research 2017-11-08: Strong Earnings Momentum

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HI-P INTERNATIONAL LIMITED H17.SI

Hi-P International - Strong Earnings Momentum

• Expect strong earnings momentum to continue.
• Addressing succession planning, a key concern to the market.
• Raised FY17F and FY18F earnings by 16% and 18% respectively.
• Maintain BUY; TP raised to S$2.30.

Earnings momentum to remain strong. 

• After a few consecutive quarters of strong results, we expect earnings momentum to remain strong in 4Q17, on the back of the new products in the Wireless and IoT segments. Our FY17F and FY18F earnings were raised by 16% and 18% respectively, after factoring in further ramp-up in production. We have also added FY19F forecasts. We are now expecting EPS CAGR of 34% for FY16-FY19F. 
• Hi-P is in a sweet spot now as more than half of its earnings are derived from the Wireless (smartphone) and Computer Peripherals (IoT segment, e.g. smart home) segments, which are expected to continue to do well in the next one to two years.

Optimising capacity utilisation. 

• Capacity utilisation has improved from < 40% in 1Q17 to about 70% now. With the continued ramp-up in production, we expect utilisation rate to remain high at about 70% (based on 24/7 basis) in 4Q17.

Where we differ: We are the only broker covering Hi-P. 

• We believe the market under-appreciates the potential of the capacity ramp-up, the strong cash-generating capabilities and strong earnings momentum. 
• Hi-P has also guided for a stronger 4Q17, as compared to 3Q17 and 4Q16.

Potential catalyst: 

• Stronger-than-expected production ramp-up and demand would help to boost sales while better operational efficiency would help to improve margins.

Valuation

• Reiterate BUY; TP raised to S$2.30. 
• We apply a 10% premium to peers' PE of 14x on FY18F earnings, on the back of the strong earnings momentum, to arrive at our revised target price of S$2.30, up from S$1.67 previously.

Key Risks to Our View

• Volatile industry with shorter product life cycle. This presents risks on margins and inventories.
• Forex exposure. Bulk of revenue in USD but overheads are mainly in RMB and the reporting currency is in SGD.

WHAT’S NEW - Strong earnings momentum; addressing succession planning 

Expecting stronger 4Q17. 

• Hi-P is guiding for higher revenue and profit for 4Q17, as compared to 4Q16 and 3Q17, after delivering strong quarterly earnings since 2H16. Revenue and profit for 2H17 and FY17 are also expected to be stronger as compared to 1H17 and FY16 respectively.
• Going forward, we expect Hi-P to deliver earnings CAGR of 34% for FY16 to FY19F, on the back of new products in the Wireless and IoT segments. The group will also continue its strategy of diversifying its customer base while margin improvement can be achieved by enhancing operational efficiency, effective cost controls and boosting productivity.

Addressing succession planning. 

• Hi-P has addressed one of the key concerns in the market – succession planning, by appointing Mr Yong Inn Nam as Chief Operating Officer. Mr Yong has been working in Hi-P for a few years and has demonstrated a deep appreciation of Hi-P’s culture and practices. 
• In addition to Mr Yong, the team that will form the next-generation leadership is also being identified to ensure long-term sustainability.

NDR key takeaways. 

• We have also highlighted here key takeaways from the recent Non-Deal Roadshow (NDR) in USA and Hong Kong.

NDR in USA and Hong Kong well received 

• We recently brought Hi-P to a NDR in the US – New York, Boston, California, Chicago and San Francisco, followed by Hong Kong.
• We met about 30 clients. Generally, feedback was positive as this is the first time the company has done a roadshow of this scale post listing on SGX in 2003. Key questions revolved around the product mix, key customers, especially in the Wireless segment, competitive strength and growth strategy.
• Concerns were mainly related to the short product life cycle especially in the Wireless segment, volatile earnings in the past, low liquidity and also the recent steep run-up in share price.

Key takeaways:- 

What are your key segments and the products for each segment? 

• Hi-P’s business can be broadly classified into six key segments. The table below shows the breakdown for each segment.

What is your involvement with your key customer in the Wireless segment? 

• Hi-P is still a relatively small player among all the suppliers for this key customer. Hi-P started working with this customer a few years back. Over the years, the number of projects awarded by this customer has been growing. Hi-P is now involved in more and more projects. For the Smartphone segment, revenue from this customer accounts for < 20% of the group’s total revenue. Including other products from the Computing & Peripherals and the Accessories segments, total revenue from this customer accounts for about 40% of the group’s total revenue.

What are your key growth areas? 

1. More projects from existing key customer in the wireless segment. Hi-P has been servicing this customer in the past few years. Over the years, the number of projects awarded by this customer has been increasing and Hi-P expects this trend to continue.
2. More projects from existing key customer in the IOT segment. Hi-P has been servicing this customer for a few years already. Going forward, Hi-P is expected to secure more projects from this customer.
3. New customer in the IOT segment. Hi-P has secured a new customer in the IOT segment and has been ramping up production since 2Q17. Hi-P expects increasing orders from this customer.
4. M&A in the automotive segment. Hi-P has identified the Automotive segment as one of the key growth areas. Thus, it is looking for acquisition target in this segment.
5. Medical segment. The medical segment is also another area that Hi-P intends to explore. 

What is your competitive strength? 

1. Expert in both plastics and metals. Hi-P is one of the few companies of this size (staff strength ~13,000 to 15,000) that is capable of handling both plastic and metal. Being well versed in both areas enables the group to cut down on outsourcing requirement and to improve efficiency and productivity. 
2. Niche player, able to service smaller customers well. Though Hi-P is much smaller in size as compared to its global peers, it is still able to provide some of the services offered by the bigger players. Some smaller customers would prefer to go to Hi-P instead as their project size may be too small for the bigger players. 
3. Able to provide total solution. Hi-P provides total solution for some of its customers in the Consumer Electronics segment, including design, manufacturing and assembly. This would help to forge long-term relationship as it creates stickiness with its customers as it is not cost effective to switch suppliers. 
4. Servicing the top customer in the Wireless segment. Hi-P has been servicing this top customer in the Wireless segment in the last few years, and is also able to secure more projects. With its good track record, other customers are willing to pay a premium for Hi-P’s services. 
5. Good corporate governance. Being incorporated and listed in Singapore, which has a relatively strict corporate governance, customers are more willing to trust Hi-P with their technology know-how and intellectual property rights. 

Why does Hi-P have so many plants, especially in China? 

• Hi-P has six plants in China:- 
  1. Tianjin plant, which was started off with a key customer in the Wireless segment, but this customer has since scaled down production 
  2. Chengdu plant, which started off as a tooling house 
  3. Nantong plant. This plant is catered for future expansion, as the government may take back the land in Shanghai for other developments 
  4. Shanghai plant, which started off as a tooling house, and is also for its key customer in the Wireless segment 
  5. Suzhou plant, mainly for its key customers in the Wireless and IoT segments 
  6. Xiamen plant, mainly for the Consumer Electronics segment. 
• Some of the company's key customers require dedicated plants. Moreover, they also do not want the plant that is manufacturing their products to be close to their competitors. Thus, Hi-P needs to have different plants in different locations to cater to them. Next year, Hi-P will build a new plant in Suzhou for its key customer in the IOT segment. 
• Singapore is the headquarters with one manufacturing plant, mainly for a key customer in the Computer Peripherals segment. It also has one plant in Thailand (Rayong), mainly to support the Singapore operations. The plant in Poland (Wroclaw) is mainly for the Consumer Electronics segment as a handful of its customers from this segment are in Europe. 
• Among the 13 manufacturing plants, Hi-P only owns three plants – in Nantong, Suzhou and Singapore. 
• Other than manufacturing plants, Hi-P has three sales offices, one in Taipei and the other two in the US – Chicago and San Francisco. The US is one of the gateways to high-tech research and innovation. Thus, it is essential for Hi-P to have offices there in order to keep itself in the frontline of technology, and also to be closer to its customers in the US. 

How Hi-P has evolved over the years? 

• Hi-P has evolved from a tooling house in the 90s into a component manufacturer in year 2000 and subsequently into a contract manufacturer ten years ago. Hi-P is now an original design manufacturer (ODM) and electronic manufacturing services (EMS) solution provider, servicing mainly the top-tier customers in each segment it services. 
• In recent years, Hi-P has reduced the number of turnkey projects in the Wireless segment to focus on manufacturing smaller parts. Though the contract value for turnkey projects is higher, parts offer better margins. 

Exploring new segment to seek growth 

• Hi-P is exploring the possibility of entering the automotive segment via M&A, likely next year. In the past few years, Hi-P has been trying in vain to enter this segment as it requires certain certification in order to qualify as a supplier for the key customers in this segment. But Hi-P lacks a track record in this area. Thus, the fastest way is to look for M&A targets. 
• Hi-P also reckons that automotive, especially the sensory segment, is a growth area and it needs to constantly look for new growth areas for the group. 

Moving towards automation 

• Hi-P is moving towards automation to improve operational efficiencies. In terms of staff strength, it was reduced from a peak of 20,000 a few years back to between 12,000 and 15,000 now, depending on the season. It has also set up a company, solely in charge of automation. 

Areas of concern:- 

Liquidity issue, free float too small 

• Hi-P is aware that the free float in the market is small as Mr Yao now owns an 83% stake, after acquiring the 22% stake from the second largest shareholder, Molex in mid-June at S$0.98 per share, a 10% premium to its last closing price. 
• Hi-P has been actively buying back shares in the past one year, and has accumulated about 80m treasury shares, which could be used to improve the liquidity of the shares in the market. The small free float could make Hi-P a takeover target.  
• With its entrenched relationship with key customers, which include some of the world’s biggest names in mobile phones, tablets, household & personal care appliances, Hi-P could be an attractive target for global companies looking to build a base in Asia. 

Volatility in earnings, as seen in the past few years 

• In the past, key customers from the Wireless segment like Motorola, Nokia and Blackberry account for > 50% of the group’s total revenue. Thus, the diminishing market share for these key players affected Hi-P’s performance. 
• In 2015/2016, Hi-P was also badly affected by another key customer in the Wireless segment, Yota Device, a Russian company. Yota failed to take delivery of the mobile handset manufactured by Hi-P and this has led to a net loss of about S$100m for Hi-P. 
• In the past ten years, its share price was mainly affected by the diminishing market share of its key customers in the Wireless segment. Hi-P has since learnt from its experience from the Wireless segment, and has been diversifying its customer base, especially in the Consumer Electronics segment. The Consumer Electronics segment now accounts for about 38% of total revenue, as compared to about 20% a few years ago. 
• Other than customer diversification, Hi-P has also strengthened its internal risk control. It has set up a total exposure limit framework, whereby all business units are involved in controlling the levels of exposure and risk to the group through
  1. Customer & project business outlook;
  2. Credit risk; and
  3. Inventory & open purchase order management. 
  This framework would enable the group to better manage cashflow and also to optimise capacity utilisation. 
• For some of its new customers, Hi-P now requires them to make an upfront payment before starting production. This would help to prevent the Yota Device saga from reoccurring.

Lee Keng LING DBS Vickers | http://www.dbsvickers.com/ 2017-11-08

DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 2.30 Up 1.670