Venture Corporation (VMS SP) - UOB Kay Hian 2018-04-23: Going Up In Smoke Over A Largely Unchanged Outlook

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VENTURE CORPORATION LIMITED V03.SI

Venture Corporation (VMS SP) - Going Up In Smoke Over A Largely Unchanged Outlook

• Venture’s share price largely overreacted to Philip Morris International (PMI)’s slower 1Q18 I Quit Ordinary Smoking (IQOS) growth. While IQOS makes up a significant chunk of revenue, it is important to note that growth is driven by a host of other products. For IQOS alone, unit sales in 1Q18 require production levels comparable to 2H17’s. 
• Production might be slow in 1H18 but could pick up in 2H18. We lower our 2018-20 earnings forecasts by 0-3% to adjust for the 1H18 seasonal slowdown. 
• Maintain BUY with a lower target price of S$30.60.

WHAT’S NEW

Slower IQOS demand growth in Japan. 

• In Philip Morris International’s (PMI) 1Q18 results last Thursday, it was reported that I Quit Ordinary Smoking (IQOS) demand in its key market, Japan, had slowed. This was attributed to sales reaching an older segment of users in their 50s at a faster-than-expected rate, resulting in a slowdown in growth due to slower adoption. Despite this, PMI’s management reiterated that they remain on track to achieve their year-end target for IQOS.

Europe and South Korea pick up the slack; US FDA approval remains on the horizon. 

• While growth in Japan had slowed down, PMI’s 1Q18 results showed IQOS’ share of market (SoM) saw a significant pick-up in other markets. European cities in Slovakia, Czech Republic and Ukraine showed a near doubling in SoM on a q-o-q basis.
• Meanwhile, South Korea continued to show strong growth momentum for IQOS, reaching a 7.3% SoM (4Q17: 5.5%). No remarks with regard to the US FDA approval were made, but it is still expected to be secured within 2Q18.

Xiamen Intretech guiding for lower IQOS production in 2Q18. 

• At the same time, Venture’s supplier for IQOS plastic components, Xiamen Intretech (XIA, 002925 CH), reported its 1Q18 results. Revenue in 1Q18 rose 11% y-o-y, but fell 30% q-o-q owing to production orders being seasonally higher in 4Q17. 
• In its management guidance, they remarked that 2Q18 orders for IQOS plastic components would be lower, which will result in 1H18 revenue falling by 0-15% y-o-y. This translates to 2Q18 revenue coming in 2-32% lower q-o-q, by our estimates.

STOCK IMPACT

It’s not just all about IQOS. 

• Before diving into the specifics about the impact of these developments to Venture, it is important to point out that IQOS is not everything. 
• While the product’s revenue contribution stands out among the Test & Measurement/Medical/Others segments, there are several other products that have driven Venture’s growth in 2017 and this is expected to continue into 2018.

Production orders are dynamic. 

• According to an investor meeting in early-April, XIA had remarked that production orders for the IQOS are seasonally stronger in 2H. Orders are typically received a few months beforehand, but only firmed up some 20-30 days before production starts. This suggests that PMI can scale production on-the-fly according to its demand outlook.

Demand should pick up in 2H18. 

• Blending the above-mentioned factors, XIA’s weaker 2Q18 production outlook and the slower IQOS demand outlook in Japan suggests that PMI could be tapping the brakes as it revises its demand estimates. This could be reversed in 2H18, as FDA approval to market the IQOS in the US provides a boost to order outlook. Furthermore, as demand in Europe/South Korea rises, this could more than offset the slower growth in Japan. 
• All in all, the production outlook for Venture and IQOS remains largely intact, though 1H18 could represent a soft patch.

IQOS units sold in 1Q18 declined slightly vs 4Q17. 

• The implied IQOS units (device / kits) sold in 1Q18 is estimated to be at 4.1m units, comparable to the 4.8m units sold in 4Q18. Demand still remains high and there is no outright collapse. Additionally, it was remarked that replacement demand had also kicked in, given the device lifespan of ~2 years. 
• IQOS has been sold over the last 2.5 years in Japan. It is expected that both suppliers (VMS/Flex) will have to continue to produce at elevated rates as seen in 2H17 to supply PMI with the required units.

Current share price suggests total decimation of IQOS production. 

• Venture's share price has largely overreacted to PMI’s results, declining by 12.3%. At this price, it reflects a complete loss of IQOS earnings, although the outlook remains largely intact. 
• In the worst case, we only expect the ASP for IQOS to face a sharper than 5% y-o-y decline, but this could be offset by revenues from design services, which Venture continues to do so wholly for PMI.

Recent share price collapse could see lower forward multiples.

• Post the share price collapse, we caveat that market might start pricing in lower multiples if:
  1. y-o-y growth outlook comes in less than expected, resulting in PEG rising above 1.0x, and
  2. market begins building in a discount for the limited visibility and trading liquidity. 
• This could affect valuation despite earnings coming in on-track against consensus. A sensitivity table is provided on the right.

EARNINGS REVISION/RISK

Lowering 2018-20 earnings forecasts by 0-3%. 

• Taking into account the potential seasonal weakness in 1H18, we trim our earnings by 3% for 2018. We also adjust our earnings forecasts for 2019-20 to account for increased IQOS production share going to other international suppliers.
• Our revised earnings forecasts are at S$458m (-3%), S$489m (-1%) and S$531m (-0%).

VALUATION/RECOMMENDATION

Maintain BUY, target price lowered to S$30.60. 

• Our lower earnings forecasts have our target price (pegged to 19x 2018F PE) declining to S$30.60, representing 21% upside.
• Venture continues to see strong growth potential into 2018, driven by IQOS production and a multitude of products across its business segments. Clients such as Illumina, Agilent, Keysight, and Medtronics continue to report strong revenue growth and we expect them to be key drivers of the Test & Measure/Medical/Others segments’ growth into 2018. 
• Venture's share price has largely overreacted to PMI’s results, which represents a short-term setback, likely to be offset by growth from other markets and the key US FDA approval. 
• Maintain BUY.

Foo Zhi Wei UOB Kay Hian | http://research.uobkayhian.com/ 2018-04-23

SGX Stock Analyst Report BUY Maintain BUY 30.60 Down 31.880