Venture Corporation - UOB Kay Hian 2018-08-06: 2Q18 A Series Of Unprecedented Events

Venture Corporation - UOB Kay Hian Research 2018-08-06: 2q18 a Series Of Unprecedented Events VENTURE CORPORATION LIMITED SGX:V03

Venture Corporation - 2Q18 A Series Of Unprecedented Events

  • VMS’ 2Q18 net profit of S$97.9m was above our expectations.
  • Results saw lower revenue, with the beat coming on the back of higher net margins, aided by a boost from R&D. It remains to be seen whether this margin can be sustained.
  • The period also included unprecedented corporate actions that are share price defensive. Visibility remains unclear, and our earnings estimates are unchanged.
  • Maintain HOLD with unchanged target price of S$18.20. Entry: S$16.00.



RESULTS


Core net profit of S$95.4m, above expectations.

  • Venture Corporation (VMS) reported a headline net profit of S$97.9m. Excluding forex gain of S$2.5m, core net profit was S$95.4m. Results formed 26%/24% of our/consensus estimates, and was above our expectations.
  • The beat stemmed largely from a jump in net margin to 10.3%, and was understood to have been helped by R&D profits that boosted margins.


~ SGinvestors.io ~ Where SG investors share

Lower revenue for 2Q18, even on a constant currency basis.

  • Revenue for 2Q18 was S$952m (-6% y-o-y). VMS noted that on a constant currency basis 1H18 revenue was up 3.4% y-o-y.
  • Taking into account that 1Q18 revenue was up 9.1% y-o-y on a constant currency basis, this implies that 2Q18 revenue, on constant currency, was ~S$999m, down 1.3% y-o-y.

R&D expense at all-time high at S$34m, boosting margins.

  • VMS admitted to R&D improving margins in 2Q18, though they stopped at quantifying its impact. There is a sizeable revenue impact from R&D here, given that it correlates with R&D expense to an extent. The implication here is that 2Q18 revenue would have declined much more than 1.3% y-o-y on a constant currency basis had R&D revenue been excluded.

First ever interim dividend of 20 S cents declared.

  • This is the first time VMS has declared an interim dividend in its long history. Management remarked that they wanted to split the dividend payment so that it would not be lumpy. 
  • Asked as to whether this will be the practice going forward, the response was that VMS tries to “be consistent... and to pay the same, or better.”


STOCK IMPACT


High R&D expense implies substantial revenue impact.

  • At the heart of it, VMS’ earnings beat was predicated on lower revenue, but higher net margins were boosted by R&D. R&D expense was the highest in VMS’ history, and is an indication of the R&D revenue/profit size. This has historically been known to lift gross margins, as shown on the right.
  • R&D revenue can either be recognised during the quarter or recovered over a period. However, since it did make an impact on margins during the quarter, it would have to be at least over S$35m in order to return a profit. This is an outsized figure, by any measure.
  • Our estimates suggest a larger quantum.

Net margin boost from R&D begs questions to its sustainability.

  • While it is acceptable to believe that R&D revenue will grow over time as VMS takes more orders with design content, it seems unlikely to manifest itself to such a degree within three consecutive quarters. The issue begs the questions:
    1. which clients are collectively signing off such a huge quantum of R&D revenue in a quarter and,
    2. can such a quantum be repeated in future?
  • Unless this can be proven to be recurring, it is hard to accept that the high net margin of 10% can be sustained.

VMS benefitting from heightened trade tensions.

  • Management remarked that they were already seeing clients shifting some production from China to their Singapore/Malaysia facilities as a result of the trade tensions between China and the US. This is a positive for VMS, and we think translation is likely immediate for existing product lines. 
  • New product lines will probably take a longer time to show up in the financials given qualification and production lead times.

Limited order outlook for 2H18; customer transcripts suggest slowdown.

  • Management could not comment on its 2H18 order outlook, citing visibility of only 1-2 months. Key client Illumina in its 2Q18 results maintained its FY18 NovaSeq delivery target of 330-350. It is important to note that the momentum in instrument sales is slowing, and that a large part of Illumina’s current revenue growth is being driven by consumables, which we believe VMS has little to no exposure to.
  • Philip Morris’ (PMI) latest earnings guidance is negative, as it cuts production for IQOS to reduce inventory and transition to the next generation device. For the next gen IQOS, the benefits from a production ramp in 2019 are unclear as the production split between VMS and FLEX is not certain.

Unprecedented moves to defend share price.

  • These include the interim dividend (acting on feedback from its AGM meeting apparently), sharing of their transformation strategy, and an offer to tour their plants. The moves are unprecedented in VMS’ long history and appear defensive. 
  • Management quipped that this was to encourage long term investors in their shares, though we remain sceptical about the real motivations.


EARNINGS REVISION/RISK


No change to earnings estimates.

  • Our estimates for 2018-20F remain unchanged. We have however made adjustments to reflect a higher operating margin as a result of elevated R&D expenses.


VALUATION/RECOMMENDATION


Maintain HOLD, with unchanged target price of S$18.20.

  • Despite the unexpected good results, VMS has not addressed key issues, which are flagging IQOS production, a slowdown in the production outlook and a clear explanation as to whether net margins of 10% are sustainable. Current set of results appears to have an element of window dressing.
  • While we appreciate that VMS is evolving for the better, transformations do not happen overnight, and rarely without some short-term setbacks. With limited clarity on the sustainability of their results, we maintain our HOLD rating.
  • Target price is unchanged pegged to 14x 2018F PE. Entry price: S$16.00.





Foo Zhi Wei UOB Kay Hian Research | https://research.uobkayhian.com/ 2018-08-06
SGX Stock Analyst Report HOLD Maintain HOLD 18.200 Same 18.200



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