Hi-P International (HIP SP) - Maybank Kim Eng 2017-12-20: A Clean Slate

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HI-P INTERNATIONAL LIMITED H17.SI

Hi-P International (HIP SP) - A Clean Slate

Initiate at BUY with SGD2.11 TP 

• We see Hi-P entering a phase of record revenues and improved earnings quality. 
• FY18E-19E EPS CAGR of 19% is driven by its key wireless customer, as well as the ramp-up of business with IOT customers and P&G. ROE profile should also markedly improve now that Hi-P has selectively moved way from unprofitable assembly projects to focus on stable ones from blue-chip customers, such as Apple, Keurig, and Colgate. 
• Our TP is based on FY17E P/B of 3.4x.

INVESTMENT THESIS

Strong earnings momentum 

• We forecast EPS growth of 95%/19%/20% in FY17E-19E for Hi-P, on the back of FY16-19E revenue CAGR of 13.7%, driven by the ramp up of products and allocation gains from key customers, such as Apple.
• More importantly, Hi-P is entering a phase of record revenues and markedly improved earnings quality. This comes at a time when Hi-P has shifted away from customers with diminishing market shares to prioritise blue-chips with stable market shares.

FY17E – a transition and a record year 

• Hi-P has consciously shifted its business mix towards higher component manufacturing (low revenue, high margin) and away from selected assembly projects that contribute high revenues but are not profitable. This has translated into a 9M17 net profit spike of 138% YoY to SGD61.9m despite a 1.4% fall in revenue. 
• Hi-P has guided a strong finish in 4Q17 on the back of ramp ups from its key wireless customer, as well as IOT projects (more below).

CORPORATE INFORMATION

• Hi-P is an EMS and ODM provider serving a roster of blue-chip customers, such as Apple, P&G, Keurig, and Colgate. It is fully-integrated, with in-house design, tooling, plastics, metals, PCB and assembly capabilities. Its strengths in plastic injection moulding trace back to its founding days as a tool maker in the 1980s. 
• Hi-P’s exposure is heavily skewed towards the consumer electronics space. Hence, Hi-P faces heavy seasonality effects, with utilisation hovering around 30-40% in 1H, then gradually ramping up to 60-70% in 2H, in most years. Top 7 customers make up about 70% of sales. Apple is the top customer and is estimated to contribute around 40-50% of sales.
• Hi-P has 13 manufacturing sites across four countries (Singapore, Thailand, Poland and China). In China, the sites are in Shanghai, Nantong, Suzhou, Chengdu, Xiamen and Tianjin.

GROWTH DRIVERS

• Hi-P’s revenue growth is two-pronged, via wallet share gains with existing key customers (e.g. Apple), and new product ramp ups. Aside from ramp-ups from Customer A and Customer O, Hi-P is also seeing growth from new launches in the consumer segment, as well as outsourcing trends.
• It is important to note that declines in the wireless and computer peripherals segments were due to Hi-P’s strategic direction to shift away from low-return assembly projects. Currently, Hi-P is optimising capacity and ramping up projects with improved profitability.

Wireless 

• Hi-P’s key customer in this sector is one of the largest smartphone makers globally. Due to strong execution, Hi-P has won expanded allocation from this customer in recent years, including in FY17E. Hi-P intends to maintain this momentum in coming years.
• Hi-P manufactures small components (e.g. sim tray, buttons, and other plastic and metal parts) for all three models of smartphones launched in 2017. 
• Management guides that current orders for the ultra-flagship device have so far met Hi-P’s own internal forecasts, and are expected to contribute well to its 4Q17 and 1Q18 performance.

Smart speakers 

• Hi-P is ramping up production of 1-2 smart speaker projects for Customer A in FY17E. We understand that the scope of work includes plastic injection moulding and spray painting. Hi-P has guided that the number of projects with this customer is expected to increase to four in FY18E.
• Hi-P’s guidance is for Customer A to contribute c6-7% of revenues in FY17E, accelerating to a c10% contribution in FY18E, which would make it the second largest customer after Apple. To cater to demand from this internet retail customer, Hi-P is currently building a new plant with estimated completion in 1H18.
• As Customer A’s smart speakers play the role of smart home hubs, we expect it to have a similar growth trajectory as smart homes. Statista estimates that in the combined markets of US, China and Europe, smart homes are expected to grow at a 36.4% 2016-2021 CAGR to 71.3m units.

Bike-sharing smart locks 

• Hi-P also assembles the smart-locks for Customer O, a bike-sharing provider in China. Customer O is among two of the most dominant providers, with a collective market share presently of 95%.
• Customer O’s growth ambitions do not just stop at home. It has raised USD700m in a series E funding led by Alibaba in Jul 2017, and has explicitly stated plans to deploy 20m bikes to 20 countries from the present base of more than 10m across 13 countries. Online sources suggest that the upgrading of Customer O’s present fleet only began in early 3Q17.
• This smart lock (co-developed by Huawei) helps Customer O overcome several problems: 
  1. First smart lock to feature an NFC payment feature, which is much more user-friendly than current QR code-based payment; 
  2. Has a GPS feature, which helps users locate bikes via an app. More importantly, the GPS helps mitigate errant parking and bike vandalism; 
  3. Works on NB-IOT (NarrowBand IOT) technology. This is important to reduce average payment processing time (5 seconds from 25s), which improves the lock’s battery time (2-3 years from 1-2 months), and provides stronger coverage in poor signal areas by a factor of 100x compared to standard terminals. 
• All-in-all, this lock does not just improve user-friendliness, it also gathers terminal data for Customer O to make intelligent business decisions based on its customers’ usage habits.
• That said, Hi-P is limiting its exposure to Customer O, and has opted to take a smaller than initially offered allocation. This strategy takes into account that Customer O is a start-up that presently faces challenges generating cash flows, and operates in an uncertain business environment, including regulatory.
• Management is guiding for Customer O to form c5% of revenue in FY17E, increasing to 6-7% in FY18E. We understand that Hi-P is one of three suppliers for this lock.

Consumer electronics 

• Growth in this segment (c35% of FY17E revenue) is driven by a broad-based launch of new products in FY17E to both new and more than 10 of its existing customers. 
• In FY18E, growth in this segment is expected to be propelled by the rampup of P&G’s products as part of the outsourcing trends of its customers.
• Prospects for Keurig are also bright, with business expected to grow in the low-teens.

Growth optionality from M&A 

• M&A is also now part of Hi-P’s growth strategy. Management is seeking to acquire two companies, each with around a SGD100m price tag in FY18E/19E. Companies that Hi-P is interested in include those in the automotive and medical industries to circumvent certification lead times.
• Alternatively, management may also consider expanding its manufacturing footprint outside of China in light of rising costs and risks of production shut downs in light of new environmental regulations M&A is expected to be funded by a mix of internally generated cash, treasury shares (79m), and some debt, if necessary.

STABLE RETURNS FROM BLUE-CHIP CUSTOMERS

A stronger base of customers mitigates ROE fluctuations 

• With a stronger customer profile and a more profitable business mix, we forecast average ROEs of 21.9% from FY17E-19E. This is an improvement from the 13% average from FY04-16, a period when ROEs fluctuated quite strongly with market share declines of its wireless customers.

Hi-P’s strategies to build a stronger customer base 

• To strengthen its profit-base, Hi-P has spent the past two years rightsizing contributions from each segment. Today, we estimate that c80% of its revenue comes from customers who are market leaders in their respective fields with a stable market share outlook.
• In the wireless segment (c25% of FY17E revenue), Hi-P has reduced the assembly of smartphones to less than 5% of revenue from > 50% at its peak a few years back. Hi-P’s key customer in this segment is now a smartphone leader with customers that have demonstrated a strong degree of loyalty and repeat sales.
• In the consumer electronics segment (c35% of revenue), Hi-P mostly does ODM work for market leading brands, such as Keurig, P&G and Colgate, etc. As these products (e.g. coffeemaker, electric toothbrush, electric shavers, cleaning robots, etc.) tend to have longer lifecycles, cash-flows tend to be relatively stable with minimal capex requirements.
• In addition, Hi-P’s participation at the design stage also implies a stronger degree of customer stickiness. This is because it is less cost efficient for the customer to transfer projects after the design stage. Hi-P’s ODM capabilities also help it obtain a better glimpse into the technology and product roadmap of its customers.
• In the computer and peripherals segment (c20% of revenue), FY17E revenue contributions are expected to fall by 27%. However, this is because after a year of negotiations, Hi-P plans to shift its allocation to components manufacturing (high margin, low revenue). This was because the keyboard module assembly project was not profitable due to the amount of third-party components required. 
• Looking ahead, contributions from this segment are expected to remain stable from both of its key customers. This is notwithstanding that the PC and tablet markets have matured.
• Looking ahead, a maturation of the smart-speakers market could also mean that Customer A could one day become a customer that contributes steady cash-flows.

FINANCIAL ANALYSIS

FY17E-19E earnings CAGR of 19% 

• We forecast FY16-19E revenue CAGR of 13.7%. In FY17E, we forecast revenue growth of 11% as Hi-P shifts its business mix focus to higher margin components and manufacturing, and reduces contributions from specific lower-profitability assembly projects in wireless and computer segments.
• In FY18E/19E, we forecast 15%/16% revenue growth, primarily driven by momentum from Customer A and Customer O, as well as allocation share gains from its key wireless customer.
• With the change in business mix, gross margin is expected to improve 3.8ppt YoY to 15.7% in FY17E. Our margin forecasts for FY18E/19E are 15.8% and 16.1%, stable but marginally higher, largely as
  1. projects undergoing ramp-up have slightly better margins and
  2. to factor some degree of operating leverage.
• The change in business mix is expected to be the key driver for Hi-P to achieve record net profit of SGD105m (+93% YoY) in FY17E. 
• We forecast FY17E-19E EPS CAGR of 19.3%, largely driven by operating leverage from increased volume and improved utilisation.

Strategies to control cost 

• To counter rising costs in China, Hi-P is increasingly automating its processes, as well as rationalising capacity. For automation, we understand that Hi-P has set up a team that focuses exclusively on facilitating knowledge transfer and the application of automation technologies across all the factories in the group. This is one of the approaches to help the company reduce headcount from 18,000 at the peak a few years ago to 15,000 currently.
• In terms of optimising capacity, Hi-P will gradually shift lower value work from Shanghai to other manufacturing areas with lower wages, and will prioritize Shanghai for higher value work. The smart speaker projects will be shifted to Suzhou from Shanghai when the new plant is completed.
• Further on the horizon, work will also gradually shift to Nantong, where Hi-P has vacant land to build new capacity.

Balance sheet and cash flow analysis 

• If Hi-P does not increase debt, we expect the group to finish FY17E with a marginal net cash position of SGD12m. An acquisition of a debt-free company of SGD100m would only bring it to a net debt position of up to 9% in FY18E, depending on the portion of consideration paid by cash/borrowing vs. treasury shares.
• The new factory that Hi-P is building to cater to Customer A is expected to cost SGD13m, excluding machinery. Our capex expectations of SGD60m/90m/80m for FY17-19E reflect Hi-P’s balance between optimising capacity built in previous years, as well as new machines required for the new factory / new products and processes.
• We forecast DPS of SGD0.04/0.05 in FY18/19E, equal to payout ratios of 26% and 27%. We think this leaves some funding room for Hi-P’s M&A plans. The average pay-out over 13 years through FY16 was 34%.
• For FY17E, we expect total DPS of SGD0.23, of which SGD0.21 has been already announced in 9M17. This was announced on the back of strong operating cash flow generation, and disciplined capex spending.

VALUATION 

Initiate BUY with SGD2.11 TP 

• Our TP of SGD2.11 is based on FY17E P/B ratio of 3.4x. This is based on FY17-19E average ROE of 21.9%, long term growth of 2%, cost of equity of 7.8%, and FY17E BVPS of SGD0.62.
• This valuation also implies FY18E P/E of 13.6x, and PEG of 0.7x, based on FY17E-19E EPS CAGR of 19%. We think this is reasonable as Singapore-listed peers are trading at 14.5x with FY17E-19E EPS CAGR of 10.3% (1.4x PEG).
• At 13.6x FY18E P/E, our valuation includes a premium for earnings momentum and larger market cap compared to smaller EMS peers. 
• At the same time, it is also a discount to larger peer Venture, which has a stronger profile of clients in the industrial space.

RISKS

Poor growth track record in recent past 

• Hi-P has posted weakened profitability and/or swung into a loss in four out of the past six years. Over the past decade, Hi-P’s profitability and share price have been volatile (FY07: SGD60m net profit, FY16: SGD54.5m net profit). This has been due to declining market shares of Motorola, Nokia and Blackberry, as well as the non-payment episode of Yota.
• Looking ahead, investors will likely pay close attention to Hi-P’s ability to manage revenue and customer concentration risks, as well as to latch on to emerging consumer technology trends.

Lack of visibility on longer-term growth drivers 

• While consciously shifting away from assembly work and aggressively building up its components business have been key drivers of profitability in the past 12-18 months, we are concerned that this may not be a good long-term strategy for Hi-P to carve out durable competitive advantages.
• Due to the cutthroat competition in the EMS space, industry players have exhibited the following trends to build their competitive advantages: 
  1. Larger players tend to use their balance sheet to build economies of scale, which in turn allows them to be price leaders; 
  2. Smaller players tend to build up technological capabilities to design and assemble increasingly complex products to win better margin products, and/or to forge a more strategic working relationship with OEMs; 
  3. Integrated providers (i.e. one-stop turnkey, design, in-house components manufacturing) are often preferred due to better execution (shorter lead time, improved yield).
• Given Hi-P’s departure from the above trends and its limited sustainable competitive advantages, we are concerned that its longer-term fortunes may depend solely on its ability to win new contracts and ramp up new products year after year.

Relatively narrow management bench 

• Chairman and Chief Executive Mr Yao Hsiao Tung has been the visionary and driving force behind Hi-P's growth since inception. But the company is no longer a small cap and we believe that, relative to peers its size or even smaller, its corporate structure has lagged the infusion of professional managers and key decision making still largely concentrated in the hands of a small team at the top. 
• Hi-P's controlling shareholder concurrently holds the roles of Chairman and CEO and hence the head of the Board of Directors is not independent. We believe that a segregation of Chairman and CEO roles and a deeper bench of professional managers would enhance the management team and go towards mitigating operating risks of the business. To this end, we understand that Mr. Yao is currently in the midst of identifying the next generation of leadership to eventually succeed Mr. Yao.

Cyclicality risks 

• Hi-P’s customer profile indicates it is exposed to end demand risk affected by economic cycles and levels of discretionary consumer spending.

Customer concentration 

• Hi-P’s top 7 customers account for around 70% of sales (Apple contributes c40-50%), indicating there remains a degree of customer concentration risk. The delinquency from Yota is a prime illustration of such risk.

Competition risk 

• The global EMS industry is highly competitive, especially in the higher volume consumer electronics segment. This translates into poorer pricing power for Hi-P, which means it is reliant on scale and operating leverage to deliver profit growth.

Small free float 

• Free float is currently small at 17%, with the largest shareholder being Chairman Yao Hsiao Tung (83% ownership, after purchasing the 22% stake from Molex).
• We understand that Mr Yao might consider selling part of his ownership stake in order to boost liquidity, if needed.

Shorter product life cycle 

• The wireless and IOT sectors that Hi-P participates in (c45% of revenue) are characterised by short product lifecycles (2-3 years). This creates risks in terms of continuous product redesign, market shifts away from existing customers, as well as working capital (mainly inventory).

FX risks 

• Hi-P operates on a cost pass through mechanism with its major customers. However, it faces FX risks when there are sudden and steep declines in the USD against the CNY (operating exposure) and SGD (reported currency) between contract re-pricing intervals.
• Over the past five years, a 1% strengthening of the USD against the SGD/CNY would have improved net profit by an average of SGD1m/SGD0.2m respectively.

Lai Gene Lih Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2017-12-20

Maybank Kim Eng SGX Stock Analyst Report BUY Initiate BUY 2.11 Same 2.11