Valuetronics (VALUE SP) - Maybank Kim Eng 2018-03-22: New Tech Illuminating The Way

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VALUETRONICS HOLDINGS LIMITED BN2.SI

Valuetronics (VALUE SP) - New Tech Illuminating The Way

On the cusp of secular lift-off; initiate with BUY 

• Valuetronics is a beneficiary of emerging demand for home IOT and car connectivity through its smart-lighting customer and Aptiv. Both customers are domain leaders and should enjoy outsized growth in their markets, which are on the cusp of a takeoff. 
• Relationships with these customers are also sticky, thanks to strong execution. These underpin our above-consensus EPS forecasts for FY18-20E. 
• Strong cash flow should pave the way for 4.7-6.1% dividend yields. Our ROE-g/COE-g-based Target Price is SGD1.25 (2.8x FY19E P/BV, average adjusted ROE of 24.6%, LTG 2%).

Products in early life cycles: home IOT & auto connectivity 

• IOT bulbs and in-car connectivity modules account for the lion’s share of our 13-32% revenue-growth estimates for FY18-20E. The IOT lighting market should grow by a 21.5% CAGR in 2018-23 to USD21b, according to research firm MarketsandMarkets. 
• As an early mover, we expect Valuetronics’ lighting customer to benefit from rapid market growth in IOT bulbs until their commoditisation. In fact, this customer recently observed accelerating smart-lighting sales, stoked by strong take-up of smart speakers. Elsewhere, Valuetronics’ growth from Aptiv could spring from:
  1. wider acceptance of in-car smartphone integration by the Detroit automaker customer; and
  2. a ramp-up of similar modules for a Nasdaq listed non-traditional automaker in FY19E. 
• We estimate that 45 car models now carry Valuetronics’ connectivity modules, up from 30 in 2016.

Focus on returns drive ROE 

• Valuetronics boasts robust customer relationships, strong and agile execution and efficient working-capital management. This is reflected in its consistent double-digit ROEs and strong cash flows since IPO in 2007. This is a rare feat, as EMS companies’ earnings are often volatile. 
• Its cash flows helped it build up a strong cash position of HKD672m or 28% of its market cap as of 3QFY18 and pay attractive dividends.

EPS upside & catalysts 

• We see room for positive earnings surprises from:
  1. stronger-than-expected IOT-bulb sales;
  2. possible new customer(s) and/or new project(s) from Aptiv; and
  3. potential synergistic M&As.

INVESTMENT SUMMARY

Beneficiary of emerging demand for IOT lighting & auto connectivity 

• Emerging technologies, particularly in IOT lighting and in-car smartphone connectivity, are expected to power EPS growth of 34%/15%/13% for Valuetronics in FY18-20E. 
• Valuetronics’ customers are domain leaders of products which are still in their infancy. These should underpin its growth prospects in the medium term. We expect these products to account for the lion’s share of our 32% revenue-growth estimate for FY18E and 40% of group revenue. They account for 11ppts of our 13-15% revenue-growth expectations for FY19-20E.
• Valuetronics makes IOT bulbs for a leading Dutch lighting MNC. This customer’s IOT bulbs are widely regarded as the having the best value proposition, with top-of-the-mind brand awareness in its category. This is crucial, as in the early stages of a product lifecycle, features tend to be products’ biggest differentiators, not price. This customer should continue to dominate the IOT lighting market, until such time when IOT bulbs become commoditised. Market research firm, MarketsandMarkets, estimates that the global smart lighting market will grow by a 21.5% CAGR in 2018-23 to USD21b. Given the increasing popularity of smart speakers such as Amazon Echo, we see strong growth Valuetronics’ IOT bulbs. Corroborating this, its customer’s IOT lighting sales have been accelerating since 3QCY17. We would turn cautious only when pricing becomes their main differentiator.
• Judging from Valuetronics’ previous mass-market LED project, this could happen when IOT lighting hits a global penetration rate of 25%. Currently, smart-home penetration is 5-13.5% in the UK, Japan, Canada, Australia and the US. Penetration is inconsequential in emerging countries.
• Valuetronics also makes in-car connectivity modules for Aptiv (APTV US, Not Rated), recently spun off from Delphi (DLPH US, Not Rated). Aptiv’s in-car connectivity modules enable in-vehicle smartphone integration via Apple CarPlay and Android Auto. In 2016, only 30 car models of Valuetronics’ existing end-customer, one of Detroit’s Big Three, were CarPlay-enabled. The latest list furnished by Apple1 touches 45. Facilitated by its strong relationship with Aptiv, Valuetronics was recently qualified by a Nasdaq-listed non-traditional automaker to work on similar solutions for the latter’s cars. Contributions could stream in in FY19E. Backed by Valuetronics’ track record with Aptiv, we see the possibility of Valuetronics winning over more endautomotive customers.

Returns-focused management driving ROEs 

• Valuetronics’ robust customer relationships, attractive projects and efficient working-capital & capex management have helped it consistently deliver double-digit ROEs and strong cash flows since IPO in 2007. This is a rare feat among EMS companies, whose earnings often fluctuate with customer-specific risks and/or business cycles. 
• Its strong cash flows have helped Valuetronics build a sizeable cash and short-term-investment position of HKD672m - 28% of market cap - and pay attractive dividends. We forecast yields of 4.7-6.1% for FY18-21E.

Valuation 

• Our ROE-g/COE-g Target Price of SGD1.25 is based on 2.8x FY19E P/BV, adjusted ROE of 24.6%, cost of equity of 10.2% and LTG of 2%. Our adjusted ROE is 2.8ppts higher than our average ROE forecast of 21.8%, as we assume:
  1. Valuetronics will plough HKD400m into investments, including M&As, in FY19E; and
  2. its new investments will earn 10% pa ROEs. 
• Management is exploring synergistic M&As, although it will carefully evaluate opportunities.

CORPORATION INFORMATION 

• Valuetronics is an EMS and ODM manufacturer which offers various volumes, product mixes and complexity. It also has design and development capabilities, in plastic injection, metal stamping and machining. It is able to provide a whole gamut of services, from design to PCB and box-build assembly. Plants are in Danshui and Daya Bay, Guangdong, China.
• Valuetronics’ revenue is almost evenly split between its CE and ICE segments. In CE, Valuetronics box-builds IOT bulbs and manufactures PCBs for two Dutch MNCs. ICE products are wide-ranging. They span in-vehicle connectivity modules for Aptiv, industrial GPS / thermostats and commercial wireless printers for North American companies. Its top four customers account for 70% of its sales. Of this 70%, its lighting customer alone is responsible for 20-25%.
• Valuetronics believes it enjoys some degree of dependency from customers which have security concerns about product firmware and/or IP protection. It believes that one reason for its strong relationship with its Dutch lighting customer is its robust internal processes which offer IP protection and firmware security. Management thinks this dependency could be more pronounced with IOT products, as security breaches in firmware could result in large product recalls and brand liabilities for end customers.
• The global EMS industry is fragmented and highly competitive. Pricing pressure is common. Valuetronics mitigates this by choosing projects which it can add value to with its strong design-for-manufacturing capabilities. Its ICE segment faces less pricing pressure than its CE segment as Valuetronics has wider scope to add value in ICE’s product introduction.

Emerging Technologies To Underpin MediumTerm Growth 

• We forecast revenue growth of 13-32% for FY18-20E, as we are optimistic that emerging adoption of home IOT and car connectivity could continue to spur demand for Valuetronics’ IOT bulbs and in-car connectivity modules. As Valuetronics’ customers for these two products are market leaders, we believe they will continue to cater to the products’ rapid growth during their early life cycles.
• These two products account for 13/12 ppts of our revenue-growth forecasts for FY19-20E. Growth is partially tempered by slower momentum expected for industrial temperature, GPS and communications product clusters.
• Potential developments that could present upside to our revenue forecasts include: 
  1. Stronger-than-expected growth of demand for IOT bulbs.
  2. Announcement of new automotive customers. Management is optimistic that it can further penetrate Aptiv’s broad portfolio. We have not factored in any growth beyond two of Aptiv’s current endcustomers.
  3. Accretive investments / M&As. 
• Management is exploring synergistic M&As but is not under any time pressure.

IOT bulb market still nascent; growing popularity of smart speakers 

• Valuetronics assembles latest-generation IOT LED bulbs for a leading Dutch lighting MNC. The project began contributing in 2QFY17. We estimate it could contribute 20-25% to FY18E revenue. 
• Valuetronics has a strong relationship with this customer, having been its preferred supplier since 2008. It is also preparing for upcoming refreshes of this customer’s IOT bulbs.

Market leader 

• This customer’s IOT bulbs are market-leading. They are widely considered to be the best in the market, reflecting the customer’s heavy investments in product development, innovation and marketing. Presently, the bulbs offer the widest array of features - alarm, notification, geo fencing etc - and support the widest array of platforms, including Amazon Alexa, Apple Homekit, Samsung SmartThings, Baidu DuerOS and JD.com’s DingDong. 
• In a 2017 Statista survey of 1,177 respondents on intelligent consumer electronics brand awareness in North America, 21% of the respondents indicated their awareness of Valuetronics’ customer. Valuetronics’ customer was the only smart-bulb brand shortlisted in the survey findings.
• As with its previous mass-market LED project, we expect Valuetronics to be a beneficiary of IOT bulbs’ growth in their early phases, until product commoditisation. In the case of its mass-market LED project, it took 3-5 years for non-branded OEMs to come up with cheaper offerings with similar features. Valuetronics is only in the fifth quarter of this project and price disruptions have not begun. Based on LEDinside’s data, global LED penetration was around 26% when the commoditisation of LEDs began to eat into Valuetronics’ revenue and margins.
• Three positive factors underpinning Valuetronics’ IOT-lighting outlook are: 
  1. A nascent global smart-home market: In developed markets like the US, UK, Australia, Canada and Japan, smart homes are only in their “early adopter” stage. Penetration during this stage tends to be below 16%. This stage precedes a high-growth “early majority” stage in a theoretical product-adoption curve. In its previous mass-market LED project, Valuetronics’ revenue tracked global LED growth. MarketsandMarkets estimates a 21.5% revenue CAGR for the global smart-lighting market for 2018-23, to USD21b, with APAC having the largest growth potential.
  2. Features, not price, the main differentiator:  While expensive, Valuetronics’ customer’s bulbs are not out of the range of competing IOT bulbs. Its multi-coloured IOT bulbs are priced at USD48 on Amazon.com, which is within the USD40-60 range among the popular brands. While bulbs for under USD30 have emerged, there are often stark trade-offs in product & ecosystem user-friendliness, bulb variety and ergonomics. As investments are still required for further innovation, it is unlikely that pricing competition will emerge in the next 3-5 years. Valuetronics’ customer continues to invest in product and ecosystem improvements to up its ante.
  3. Margins should be stable, until commoditisation: Price reductions for Valuetronics’ IOT bulbs are currently benign. They are also offset by stronger volumes and efficiency gains. We foresee decent profitability for another 3-5 years, until cheaper products with competing quality disrupt the market.  Gross margins for its previous mass-market LED project were stable at 14% in FY09-12, despite cost-downs by its customer. Only when the LED products were commoditised did gross margins plunge. Related gross margins fell to 9.6% in FY13, when price became the differentiator in this market.

Adoption of voice-enabled IOT devices 

• Valuetronics’ customer attributed the strong growth of its “home” segment in 3Q / 4Q17 to the fruition of partnerships with makers of voice-enabled IOT devices, or smart speakers. Although voice-activated speakers have existed since 2015, their popularity only surged in 2017, after intense marketing efforts by tech giants like Amazon (Echo), Google (Home) and Apple (HomePod). For example, Amazon Echo shipments grew 2-3x to 20-30m units in 2017, from 8-10m in 2016, according to various sources. 
• Echo devices are currently considered the leading smart speakers, with surveys estimating a 70-80% market share for them in the US. We believe tech companies like Amazon, Apple, and Google will continue to push for smart-speaker adoption, as smart speakers are precious terminals for collecting consumer data and / or promoting e-commerce transactions.

Multiple growth levers from Aptiv 

• Valuetronics assembles in-car connectivity modules for Aptiv, formerly Delphi. These support smartphone integration such as Apple CarPlay, introduced in 2014, and Android Auto. Aptiv is expected to contribute 15% to Valuetronics’ revenue in FY18E.
• Valuetronics first penetrated the Delphi value chain following the latter’s acquisition of one of Valuetronics’ customers. Aptiv’s current end-customer is one of Detroit’s Big Three carmakers. Valuetronics’ in-car connectivity modules were initially offered in this end-customer’s mid-to-higher-end cars in 2015. The modules that Valuetronics manufactures have special USB compatibility for CarPlay/ Android Auto enablement. As such, the growth prospects of its in-car connectivity modules should track the popularity of CarPlay and Android Auto in the end-customer’s portfolio, in our view.
• We estimate that only 30 of this auto customer’s car makes in 2016 were CarPlay-enabled. The number has since grown to 45. This comes at a time of increasing smartphone-car integration among newer car models. Market intelligence firm, IHS Automotive, in 2015 forecast that 37m vehicles would be equipped with CarPlay by 2020, from under 1m in 2015.
• Valuetronics should remain the sole supplier to Aptiv for this end-customer even if volume picks up, in our view. This is because adding a second supplier could be too onerous. Both Aptiv and its end-customer would need to qualify their new supplier, which could take up to a year. The dollar value of this module is also miniscule compared with the total solutions that Aptiv offers to its end-customer as a tier-1 provider.
• Aptiv’s 5-year average gross margin of 26.4% is healthy, often outperforming peers’. This could reduce the urgency for Aptiv to pressurise Valuetronics on prices. Instead, it is likely to focus on growth opportunities in vehicles connectivity. Valuetronics’ own margins from this project should also benefit from further automation. It successfully consolidated three manual assembly lines into one automated line recently.
• Given an extremely competitive automotive market, we think it is in the interest of automakers to adopt CarPlay sooner than later. A Strategy Analytics report in Oct 2017 found that 23%/56% of 1,503 US survey respondents considered Apple CarPlay a “must have” / “interested in” feature for cars. It further added that “all our research suggests that consumers will soon be ready to adopt CarPlay and Android Auto for their infotainment needs”.

New-end customer(s)  

• Valuetronics’ strong execution and flexibility have helped Aptiv surpass the expectations of their current end-customer. Valuetronics was among nine in a long list of suppliers to receive Aptiv’s highest supplier recognition award in FY17.
• Based on its achievements, Valuetronics was qualified in 2H17 by another end-customer, a Nasdaq-listed non-traditional automaker which pioneered electric vehicles. We understand Valuetronics will assemble modules to enable smartphone integration for this new end-customer. Contributions could stream in in FY19E.
• We believe qualification by this new end-customer is a strong endorsement of Valuetronics’ ability to adapt to and execute stringent demands, as this customer is known to be very fussy with requirements. Its technology applications are also cutting-edge.
• We also understand that Valuetronics is exploring new automotive applications with another new end-customer of Aptiv. 

Returns-focused Management Driving ROEs 

• Since its listing in 2007, Valuetronics has consistently generated double-digit ROEs and positive FCF. We think it achieved this with:
  1. its ability to secure customers / products with decent medium-term growth potential; 
  2. strengths in high-mix manufacturing and electronics design-for-manufacturability; and
  3. efficient use of working capital.
• This has helped Valuetronics consistently deliver stronger-than-peers’ ROEs.
• Valuetronics’ P/E in the last 12 months fluctuated in a narrower range than its global EMS peers’. We believe this was in large part due to its lower earnings volatility. 
• Valuetronics’ consistent double-digit returns are rare among EMS companies, whose earnings typically fluctuate with customer-specific risks and/or business cycles. We believe the above underscores Valuetronics’ astute management.

Choosing projects with better returns 

• Valuetronics is typically selective with projects. It tends to opt for profitability and growth prospects over large volumes that tend to face steep pricing pressures. This is reflected in its gross margins, which have been stronger than peers’ for most of the past decade.
• Backed by its design and development capabilities, it is also able to charge lump sums for certain ICE projects.  
• Lump-sum pricing is not the norm unless a manufacturer is able to provide strong end-to-end solutions. This is because lump-sum projects tend to be priced higher than conventional cost-plus.

Strong balance sheet & cash flow 

• Since IPO in 2007, Valuetronics’ FCF has been positive every year, except in 2010-11 when it needed more working capital to accommodate increased volumes. We forecast FCF of HKD70m for FY18E, lower than the past five years. This is because working-capital requirements are expected to be higher during a revenue ramp. 
• Capex has also been incurred in the earlier part of the year for future projects. We expect FCF to return to historical strength from FY19E onwards.
• ROEs have been double digits since listing, although Valuetronics maintained net-cash positions throughout. It was debt-free except in FY11-12.
• Valuetronics’ latest cash-position of HKD672m formed an estimated 28% of its market cap.

5-6% yields 

• Payouts have averaged 44% since listing. Valuetronics declared a 30-50% policy in 2013. We forecast SGD4.6-5.9cts or HKD27-35cts for FY18-20E, based on 55% payouts. This translates to dividend yields of 4.7-6.1%.
• Our 55% payouts are premised on:
  1. the midpoint of its 49-63% payouts in FY14-17; and
  2. expected strong FCF in FY19E, which could potentially lift its cash and short-term investments above HKD800m. 
• Such strong payouts are rare for EMS companies, as most prefer to conserve cash for working capital when business cycles turn down. As such, Valuetronics’ dividend yields often outperformed peers’.

FINANCIAL ANALYSIS

P&L 

• We forecast revenue growth of 13-32% for FY18-20E. FY18E’s higher growth would reflect its ongoing ramp-up of IOT bulbs and a low FY17 comparison base. We expect Valuetronics’ lighting/auto/printing businesses – at 60% of revenue - to account for 13 / 12ppts of our revenue-growth forecasts for FY19-20E. Growth in its remaining product clusters in CE and ICE should either be single digits or negative.
• Our gross margins drop from 14.5% in FY18E to 14.1% in FY20E. This is from a shift in its business mix towards lower-margin CE with gross margins of 11% vs ICE’s 17%. We also factor in some cost-downs by Valuetronics’ lighting customers. Our expectations are at the lower end of the 14-16% range flagged by Valuetronics.
• We also factor in marginal improvements in SG&A to sales from operating leverage. As a result, we forecast net margins of 6.9% for FY18-20E. This is within management’s implied range of 6-7%. Our EPS growth forecasts are 13-34%.
• Utilisation rate is 80-90%, with a few automated machines running round the clock. Manufacturing capacity can be quickly installed in 2-3 months by buying new SMT/plastic injection moulding machines. There remains 20-30% of idle floor space in Valuetronics’ premises, to cater to further ramps in production. 
• Valuetronics’ ongoing automation and consolidation of manual assembly lines into single automated lines should also free up manufacturing floor space.

Balance sheet & cash flow 

• We assume capex of HKD65m for FY18E and HKD55m each in FY19-20E. The spike in our FY18E capex incorporates:
  1. its acquisition of surfacemount technology machines to meet higher volumes and improve yields; and
  2. system upgrades to improve efficiency. 
• When its existing building at Daya Bay runs out of space, Valuetronics has enough land to build another to double its manufacturing capacity. Building costs, ex-machines, should be HKD100-150m, currently not in our forecasts.
• As of 3QFY18, Valuetronics sat on HKD672m of cash and short-term investments, with zero debt. These formed an estimated 28% of its market cap. We forecast more than HKD800m by FY19E. 
• Management is keen to acquire, if it can find value-accretive targets.

VALUATION & RISKS

Initiate with BUY & SGD1.25 Target Price

• Our ROE-g/COE-g-derived Target Price is SGD1.25 (2.8x FY19E P/BV, average adjusted ROE of 24.6%, LTG 2%). Our adjusted ROE is 2.8ppts higher than our average ROE forecast of 21.8%, as we assume:
  1. Valuetronics will invest HKD400m in FY19E; and
  2. its investments will earn 10% ROEs pa. 
• In our view, HKD400m is a reasonable amount for strategic investments, including M&As, as it would leave ample room for working capital. Similarly, we think 10% ROEs pa are reasonably conservative and should factor in timing uncertainties of any new investments. 
• We understand that Valuetronics is interested in companies with nascent technologies that could benefit from its own manufacturing capabilities. It may not acquire companies within China solely for manufacturing capacity as it thinks such ventures are not likely to yield satisfactory returns.
• Our Target Price implies 15x FY19E P/E for a FY18-21E EPS CAGR of 12%. In our view, this is not onerous against Singapore-listed peers’ 16.8x FY18E P/E for an EPS CAGR of 17%, given:
  1. Valuetronics’ FY19E ROE of 21.8% beats its Singapore peer average of 20.3% for FY18E; and
  2. its potential for earnings upside. 
• Valuetronics has a March year-end while its Singapore peers all have December year-ends. Increased market understanding of Valuetronics’ growth potential led to a P/BV re-rating in the last 15 months. Given the prospects of its new products, we think its re-rating could continue.

RISKS

Global economy

• Valuetronics’ financial results are tied to end-demand for consumer electronics, which can be affected by global economic cycles and discretionary consumer spending.

Customer concentration

• Its top four customers are behind 70% of its revenue. In its CE segment, it has concentration risks for its IOT lighting project. This customer accounts for 25% of its FY18E revenue.

Competition 

• The EMS industry, especially consumer electronics, is highly competitive and cutthroat. This affects pricing power. To maintain pricing, Valuetronics must constantly improve its capabilities not only in manufacturing but also design.

Forex 

• Around 90% of its sales is in USD. COGS is mostly USD-linked. Labour and fixed overheads are CNY-denominated. While Valuetronics does not hedge formally, it may enter into forward contracts. 
• Had the CNY weakened by 1% against USD in FY17, its reported net profit of HKD154m would have been lower by an insignificant HKD17,000.

Inputs 

• Supply shortages have been known to affect EMS providers’ product assembly. This may delay shipments which could affect profitability.
• Valuetronics may also have to bear components’ price spikes in-between contracts, which will eat into profitability.

Strategic and execution missteps 

• Any shift in business direction carries risks. For instance, Valuetronics went into the licensing business in 2010, where it used established brands to market its own portable air purifiers in North America. Valuetronics exited this business in FY13 after losses. It will be carefully evaluating M&As to avoid such a risk.

Lai Gene Lih Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2018-03-22

Maybank Kim Eng SGX Stock Analyst Report BUY Initiate BUY 1.25 Same 1.25