Venture Corp (VMS SP) - Maybank Kim Eng 2018-01-10: Many Faces Of Growth

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VENTURE CORPORATION LIMITED V03.SI

Venture Corp (VMS SP) - Many Faces Of Growth

FY17E not a blip; breadth of new growth 

• We initiate coverage of Venture Corp (VMS) with a BUY and Target Price of SGD27.50. We believe VMS’ estimated 39% revenue surge in FY17E is no fluke and the Street may be underestimating forward revenue and margins. 
• Our analysis suggests further increases for both, sustained by multiple sources of growth:
  • we believe VMS benefitted from outsized orders from certain customers’ bigger COGS wallets. As VMS’ allocations are still a tiny part of their COGS, we believe they may not have peaked;
  • VMS’ ramp-up of new products with high R&D content is still in the early stages and should get stronger; and
  • new customers and projects provide a medium-term pipeline. 
• Our FY18-19E EPS is 17/20% higher than consensus. We value VMS at 18.8x FY18E P/E, a 10% premium over its global high-mix, low volume peers, given our estimated 21% EPS CAGR for FY17-19E vs 12%.

INVESTMENT SUMMARY

Breadth of new growth: higher revenue + margins 

• We believe Venture Corp (VMS) is on track to finish 2017E with 39% YoY revenue growth to SGD4b. VMS has not provided much clarity but we estimate that:
  • 13ppts likely from the organic growth of other customers in its TMO (Test & Measurement/ Medical & Life Sciences/ Others) and N&C (Network & Communication) businesses;
  • 25ppts from higher allocations by existing customers; and
  • 1ppt from its remaining Retail Store Solutions / Industrial Products (RSSIP), Computer Peripherals & Data Storage (CPDS), Printing & Imaging (P&I) segments.
• If we are right about this split, then 2017 should not be a fluke. None of these drivers appears to have peaked and the Street could be underestimating growth from its existing and new customers. 
• Our FY18- 19E EPS is 17/20% higher than consensus, premised on:
  1. higher allocations from customers’ bigger COGS wallets;
  2. a ramp-up of products with greater R&D content; and
  3. new customers and projects.
• Importantly, management has raised its net-margin guidance, signalling a possible shift towards higher-margin products with greater design / R&D content.
• For the avoidance of doubt, our conclusions in this report are based on our analysis and investigations. The thesis has neither been confirmed nor denied by management.

Expanded allocations from bigger customer wallets 

• We think the largest portion of its revenue growth in FY17E should have accrued from customers with bigger COGS since 2015/16. Our shortlist of probable customers includes Broadcom, Thermo Fisher and Honeywell. All have hefty margins and either large sales bases or have increased their sales materially since 2015.
• Of its customers in TMO and N&C that have materially bumped up their COGS, Broadcom’s spike has been the sharpest. Consensus COGS forecast for Broadcom is USD9.1b, up 3x from USD3.3b in FY15. This follows its 2017 merger with Avago, which was already an existing VMS customer. We understood from VMS that Broadcom was not a customer prior to the merger. (All global peers’ and global customers’ stocks mentioned in this report are Not Rated by MKE).
• We single out Broadcom because: 
  1. VMS has a track record of bagging increased orders from customers after their M&As have settled. This is on account of its strong execution.
  2. VMS’ manufacturing facilities are largely based in Malaysia. This complements Broadcom’s plans to improve its supply chain in Malaysia. Broadcom’s supply chain, which includes VMS, is expected to benefit from the opening of its global distribution warehouse in Batu Kawan, Penang in Sep 2017. This was set up to help export MYR65b (USD16.2b) of Broadcom products from Malaysia in 2018E, making up about 77% of its consensus FY18E sales.
  3. VMS bought a 30.6 acre plot of land in Batu Kawan, Penang in 2016 to cater to future growth. This is close to Broadcom’s warehouse.

Higher R&D content with higher margins 

• We also think FY17E revenue growth could have been from a ramp-up of higher-value projects. VMS spent more on R&D in FY15. Historically, increases in R&D precede its sales growth by 1-2 years. 
• More recently, VMS has been beefing up its capabilities in biology, RF, optics and software. It also upgraded its net-margin guidance to 6-10% in its 3Q17 analysts’ briefing from its historical run rate of 6-8%. This signals that its business mix could be tilting towards higher-margin products with greater R&D content. Such products should include Illumina’s NovaSeq, which we think may be further ramped up in FY18E.

Scoping the possibilities of new customers and contracts 

• Several industry sources suggest that VMS may have been selected by a tobacco major and a premium consumer appliances maker to work on smokeless cigarette devices and a smart toothbrush respectively. 
• If market speculations are true, working off exchange filings by the tobacco major, we estimate that this customer may have contributed SGD50-70m in revenue to VMS in FY17E, and full year contributions in FY18E could be up to 3x as large. The second customer’s contributions are likely to stream in only in FY18E, at the earliest, as it has several products for launch in 2018. We factor in 2ppt contributions to VMS’ revenue growth in FY18E from smart toothbrushes. 
• We clarify that VMS has not confirmed its participation the value chain of these two customers.

CORPORATE INFORMATION

• Venture Corp (VMS) is an EMS provider with operations in Malaysia, Singapore, China (Shanghai), Europe and the US. About 90% or 382,024 sqm of its owned properties is in Malaysia. Of this, at least 123,706 sqm is vacant, to cater to future growth.
• VMS traditionally excels at providing turnkey solutions for complex industrial products. These include R&D, design and assembly. Its mission is to create value for its OEM customers by reducing their total costs of delivery, not necessarily via lower dollar costs but reduced manufacturing efforts and time. As VMS is a pure assembler and not vertically integrated, it purchases the bulk of its raw materials. These make up some 80% of its product costs.
• VMS serves mostly industrial clients, in contrast to most Singapore-listed contract manufacturers which serve end-markets. As such, revenue seasonality is minimal. Its 1H:2H sales mix is typically 45:55.
• VMS disclosed in its 3Q17 earnings briefing that 65% of its revenue had some element of design content. We believe it will increasingly focus on jobs with higher engineering, design and R&D content.

FY17E Not A Fluke; Multi-Faceted Growth Prospects 

• We believe VMS likely finished 2017E with 39% YoY revenue growth or +SGD1.1b to SGD4b, after posting 9M17 revenue of SGD2.9b. This would be a phenomenal increase. As VMS does not break out its revenue, the origins of much of its growth are unclear. However, we believe that understanding where it comes from could give crucial insights into its revenue sustainability and growth prospects.
• This is what VMS has articulated about its revenue increase so far: 
  1. Growth was broad-based in 3Q17, from more than 60% of its customers. 
  2. There has been ramp-up of several high-growth S-curve products. Illumina’s NovaSeq is only one of them. VMS has remained mum on its remaining high-growth products.
  3. More than 65% of its 3Q17 revenue was from products with design content. VMS said this was a large improvement from two years ago, although it did not disclose its prior base. 
• Through our investigation and analysis, we believe that 2017 benefitted not only from a ramp-up of a few S-curve products but more importantly, increased allocations from existing customers. The latter likely played the most important part. Both sources should sustain VMS’ profit momentum.

Behind 2017’s revenue increase… 

• Segmentally, we think that Test & Measurement/Medical & Life Science/Others (TMO) and Networking & Communications (N&C) spearheaded VMS’ 2017 revenue growth. We estimate that their combined revenue grew 62%. 
• Of VMS’ 39% YoY revenue growth, we estimate that: 
  • 13ppts came from 105 customers, including five added in FY16, in its TMO and N&C businesses. This is based on our assumption that existing customers’ revenue grew 15%, slightly higher than the FY12- 16 CAGR of 11%, in view of a cyclical recovery in 2017.
  • 25ppts from higher allocations by existing customers. The bulk could have been from their increased COGS (Cost Of Goods Sold) wallets and / or a ramp-up of high-value products with higher R&D content. We think this forms a solid basis for growth in FY18-19E. Of the 25ppts, we think 5ppts or SGD144m were related to Illumina’s NovaSeq.
  • 1ppt or SGD33m from its remaining Retail Store Solutions / Industrial Products (RSSIP), Computer Peripherals & Data Storage (CPDS), Printing & Imaging (P&I) segments.

… & margin increase 

• Over the years, VMS has gradually improved its profitability, from a 2012 net margin of 5.8% to 9M17’s 7.9%. It accomplished this through:
  1. projects with improved pricing: 2012’s gross margins of 20.3% to 9M17’s 22.6%; and
  2. operating leverage. 
• By 3Q17, more than 65% of its revenue had design content, a marked improvement from previous years, according to VMS.
• Management is confident that an improved product mix with greater design and R&D content could further lift its profitability. Reflecting this, it upgraded its net-margin guidance from 6-8% to 6-10% during its 3Q17 results briefing. 
• In the past, VMS has roughly suggested that EMS/ODM/total solutions projects typically fetch gross margins of 15- 18%/25%/40% respectively. A long-term shift in business mix towards higher-margin products should bode well for VMS.
• We think its production of high-value projects may not have hit a steady state yet. This is because while its revenue started climbing in 4Q16, its margins only spiked in 3Q17. Two possible reasons were:
  1. VMS started producing more products with higher R&D content in 3Q17.
  2. VMS could have factored in higher COGS in the initial phase of its ramp to compensate for possibly lower yields from higher wastage at the start of its projects.

FINANCIAL ANALYSIS

P&L: FY17-19E EPS CAGR of 21% 

• We forecast revenue CAGR of 14% for FY17-19E. In FY17E, we think its revenue could increase 39% YoY, led by allocation gains, a ramp-up of high-value projects such as Illumina’s NovaSeq and initial contributions from smokeless cigarette devices.
• In FY18-19E, we expect 16 / 12% growth, likely driven by momentum of reallocation gains. We also pencilled in possible contributions from Device I & smart toothbrushes and other new customers / projects.
• The growth should mostly stem from TMO and N&C. CPDS, RSSIP and P&I share of revenue have been dwindling. VMS has guided for stable contributions in FY17E. Owing to product maturity, we think they could resume their sales declines from FY19E.
• We expect EPS to grow 77% / 28% / 15% in FY17-19E, faster than revenue. This would reflect operating leverage and expectations of bigger contributions from higher-value products with better margins.
• Through persistent efforts to improve its revenue mix, VMS has gradually improved its gross margins, from 18.5% in 2008 to 22.6% in 9M17. We see upside as high-value products have yet to hit a steady state.

BALANCE SHEET & CASH FLOW

Net cash as dry powder 

• VMS had net cash of SGD407m in FY16. It has had net cash since 2008. Management wants to maintain this as it would have the firepower to expand working capital for further ramp-ups or buy distress inventories when these opportunities arise.

Working-capital management 

• We believe VMS’ cash conversion cycle has peaked. From 118-120 days in FY14-16, we expect the cycle to fall below 90 in the next two years, as:
  • its customers increasingly opt for air-freight delivery amid a cyclical recovery. This should improve VMS’ inventory turnover;
  • VMS has gotten favourable factoring terms from banks for its smaller suppliers to shorten its receivable days; and
  • it has been more selective in holding finished goods for customers.

Capex 

• We are pencilling in maintenance capex of SGD28-37m for FY17-19E, which are in line with its depreciation charges in FY12-16 as well as guidance.

Dividend upside 

• With improving cash flows and SGD32m proceeds from the sale of its 18.8% stake in Fischer Tech at the end of 2017, we see room for VMS to increase dividends from its current SGD0.50 pa. 
• We forecast SGD0.60-0.70 for FY17-19E. This implies 52-42% payouts, still less than its 85% average in FY06-16, as there is a chance VMS may build a factory on its Batu Kawan land.

VALUATION

Premium for higher growth & returns 

• Our SGD27.50 target price implies 18.8x FY18E P/E. This is a 10% premium over its global high-mix, low-volume peers like Plexus Corp and Benchmark Electronics. We think our premium is reasonable, given VMS’ potential EPS CAGR of 21% for FY17-19E vs a consensus 12% for the latter. 
• VMS has industry-leading profitability and productivity, a testament to its high-mix, low-volume execution, in our opinion. Our target price can be supported by ROE-g/COE-g valuation. A P/BV of 3.56x on FY18E BVPS of SGD8.25 implies a fair value of SGD29.30. This is based on an average FY17-20E ROE of 18% and COE of 6.5%, using a market return of 6.5% and beta of 1x. 
• For the bulk of the past five years, VMS has traded close to its justified P/BV, except between 2016-1H17 when an average discount of 13% emerged. We think this was due to an under-appreciation of its return potential. 
• We believe any discounts could narrow if and when management provides more clarity on its growth ecosystems, and strategic trajectory.

RISKS

US / global economies 

• VMS’ financials closely track the health of the US and global economies. Its earnings may be hit by reduced orders from declines in end-user demand as a result of economic downturns.

Customer cancellations & delays 

• VMS faces risks from order cancellations and revisions, production delays, or even changes in sourcing strategies by customers. 
• Large fluctuations in customers’ product demand may also stress its resources. The marketplace success or failure of its customers eventually decides the fate of its business.

M&As 

• VMS historically faced poorer sales during waves of customer M&As, such as in 2011-13. During such times, orders from affected customers dry up as they rationalise their product portfolios and suppliers. 
• Among VMS’ global customers, Broadcom recently made an unsolicited bid for Qualcomm while Cavium announced a merger with Marvell. While VMS’ sales may be affected by these M&As in the short term, it has never lost a customer. Typically, once its customers’ supply-chain rationalisation is over, VMS wins higher allocations from the enlarged entities.

Forex 

• VMS earns all its revenue and pays for inputs in USD. Labour and utilities are paid in local currencies. Financials are reported in SGD. Since 2010, a 5% increase in USD against its functional currencies has had a SGD2m favourable effect on its annual net profits, ceteris paribus. 
• VMS may book material FX losses when there are sudden and steep USD declines during its contract re-pricing intervals.

Inputs 

• Industry supply shortages of some components have been known to curtail product assembly for EMS providers. This may delay shipments and affect profitability. 
• VMS may also have to bear price spikes for components in between contracts, which will eat into its profitability.

Competition 

• The EMS industry is highly competitive, characterised by a few large global players and a long tail of small players. VMS does not just compete with EMS players but also the OEMs themselves as they weigh their insourcing / outsourcing options. 
• VMS must constantly improve its capabilities not only in manufacturing but also design, technology and / or supply-chain solutions. It must also try to accommodate various customer requirements to retain relationships.

Lai Gene Lih Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2018-01-10

Maybank Kim Eng SGX Stock Analyst Report BUY Maintain BUY 27.50 Up 13.350