Frencken Group - RHB Invest 2019-05-09: Riding The Industrial Automation Boom


Frencken Group - Riding The Industrial Automation Boom

  • Initiate coverage with BUY and DCF-derived Target Price of SGD0.82, 33% upside plus 4.5% FY19F yield (implied FY19F P/E of 9x).
  • FRENCKEN GROUP LIMITED (SGX:E28) provides global integrated technology solutions to world-class MNCs across five different business segments.
  • For FY19F, we expect industrial automation to be the main growth driver, with orders from a key customer setting up a new factory. We project a 27% boost in FY19F PATMI.
  • At 6.8x FY19F P/E vs peers’ 9.9x, we believe this gem is undervalued.

Industrial automation to lead growth in FY19.

  • Sales at the industrial automation segment, which are typically lumpy in nature, increased significantly by 548.4% y-o-y in 4Q18 and 153.5% in FY18, boosted by increased orders for storage drive production equipment from a key customer that is setting up a new factory.
  • Management expects to post robust y-o-y growth in 1Q19 due to the same reason – we expect these growth factors to continue to drive sales in 2Q19 and 3Q19, which should be very positive for the company.
  • Management is also bullish on the outlook of its analytical and medical units, and expects y-o-y growth at these segments in 1Q19. We are projecting y-o-y growth in FY19F at these two units as well, driven by new customers and new projects.

About Frencken Group

Frencken is a global integrated technology solutions company.

  • FRENCKEN GROUP LIMITED (SGX:E28) provides original design, original equipment and integrated manufacturing solutions to MNCs in the automotive, healthcare, industrials, life sciences and semiconductor industries. Frencken’s customer base includes a large number of blue chip names like Continental AG, BMW AG, Intel, Seagate, Panasonic, Philips and Siemens.
  • Frencken’s presence spans Asia, Europe and the US with 16 operating sites and a strong team of 3,500 employees. It was formerly known as ElectroTech Investments when it went public in May 2005. It is listed on the Main Board of Singapore Exchange.
  • Frencken made a series of acquisitions since its listing, such as ETLA Ltd in 2009, All Mepp in 2013 and US Motion Inc in 2012. It also acquired Juken Technology in the same year, after which Juken was delisted from the Singapore Stock Exchange. In 2013 and 2014, the company acquired Supertool Industries and NTZ International respectively.
  • Frencken’s business comprises two core segments:
    • Mechatronics division – designs and manufactures high-precision and complex systems for OEM players in the industrial automation, semiconductor, healthcare and life-science sectors. The division’s core capabilities lie in providing a “one-stop” solution for the design, development and manufacturing of precision-engineered systems with complete machines, complex electromechanical assemblies and high precision parts and components. The mechatronics division contributed 79.4% (or SGD496.8m) of total revenue (SGD625.8m) in FY18;
    • IMS division – provides integrated contract design and manufacturing services to the automotive, office automation, consumer and industrial electronics segments. Formerly known as the EMS division, this division provides product design, tooling design and manufacture, product industrialisation, plastic injection moulded parts and components, PCBAs and final test and assembly of modules and box build products. The IMS division contributed 20.6% (or SGD128.7m) of total revenue (SGD625.8m) in FY18.

Frencken Group's Business Analysis

  • Frencken Group recorded SGD625.8m in sales for FY18, up 21.5% y-o-y, mainly lifted by an increase in revenue from the mechatronics division. 79.4% (or SGD496.8m) of total revenue was generated by the mechatronics division, with the analytical sector (22% of total revenue) being the biggest contributor, followed closely by industrial automation (21%) and semiconductor (20%).
  • On a y-o-y basis, the mechatronics division grew 33.1% to SGD496.8m in FY18 primarily due to increasing orders for storage drive production equipment from a key customer in the industrial automation segment. Revenue from industrial automation grew 153.5% to SGD129m in FY18.
  • Frencken divested Precico Electronics on 31 Mar 2017. As a result, revenue from the IMS division decreased by 13.9% and 9.1% in FY17 and FY18.
  • Gross profit grew 54.2% to SGD101.7m in FY18 from SGD66m in FY14 in tandem with higher sales achieved y-o-y. GPM for Frencken improved and remained stable at 16.3% during FY17-18 as compared to 14% in FY14 mainly due to higher capacity utilisation.
  • Excluding one-off items, PATMI grew by 44.5% and 47.7% during FY17-18 to SGD23m and SGD33.9m respectively. This was mainly driven by higher profit contributions by the mechatronics segment.
  • The exceptional loss in FY18 of SGD3.9m was due to impairment losses for goodwill relating to NTZ Nederland B.V and in FY17, Frencken recognised an exceptional gain of SGD10.5m in relation to the disposal of its subsidiaries.
  • Frencken has been consistent in its dividend payout ratio, which has been at 30-40% over the past five financial years. See Frencken's dividend history.
  • Due to the strong set of results in FY17, the board declared a special dividend of SGD0.0073. Together with the ordinary dividend, DPS was up 99% to SGD0.0239, representing a payout ratio of 29.8%. Maintaining the dividend payout ratio of 30%, the DPS declared for FY18 was SGD0.0214, a 10.5% drop as compared to the previous year.
  • Frencken incurred capex of SGD25.2m and SGD24.3m in FY17 and FY18. It expanded its facility in Malaysia as well as purchased new robotic machines and more advanced machining equipment. To increase productivity and achieve operational efficiency for its manufacturing processes, Frencken continues to invest in equipment to increase the level of automation.
  • Due to the receipt of proceeds from the disposal of subsidiaries, cash and cash equivalents as at 31 Dec 17 increased to SGD68.2m from SGD18.5m as at 31 Dec 2016.
  • At the end of FY17, Frencken was in a net cash position of SGD4.5m as compared to net debt of SGD40.3 in the previous FY. Frencken had a minimal net debt of SGD1.6m at the end of FY18.

Frencken Group's Investment Merits

Undervalued at 6.8x FY19F P/E, a steep discount to peers’ average of 9.9x P/E.

  • We believe Frencken’s technology, which has been making rapid advancements in recent years, will provide more solutions to its customers and support future projects in terms of margins and profitability.
  • The stock is trading at just 6.8x FY19 P/E, well below its peer average of’ 9.9x for FY19F, plus a 4.5% FY19F dividend yield. As such, we believe Frencken is undervalued at current levels and will likely continue to rerate upwards, as earnings growth continues to pick up in subsequent quarters.

Industrial automation to lead growth in FY19.

  • Sales at the industrial automation segment, which are typically lumpy in nature, surged by 548.4% y-o-y in 4Q18 and 153.5% in FY18, boosted by increased orders for storage drive production equipment from a key customer that is setting up a new factory. Management expects to post robust y-o-y growth in 1Q19 due to the same reason. We expect these strong growth factors to carry on in 2Q19 and 3Q19.
  • The surge in revenue will likely help to bump up Frencken’s overall net margins and, with operating leverage, this should lead to increased profitability. We are projecting a 35% y-o-y growth in revenue for this segment.

Two other pillars of growth – analytical and medical segments.

  • Management is also bullish on the outlook for its analytical and medical segment, and expects y-o-y growth for both in 1Q19. We are projecting 12% y-o-y growth for FY19 for both businesses, which have been growing steadily over the last few years.

Well-diversified revenue streams.

  • Frencken operates in a wide variety of different industries and business segments, with world-class MNCs globally as its customers. Their manufacturing sites are located close to customers – it has 16 locations across three regions – the US, Europe and Asia.

Exceptional positive operating cash flow.

  • Frencken’s business model enabled it to generate healthy cash flow of SGD18-35m from operating activities over the past couple of years, especially in a stable business environment. With the further surge in profitability, the company will likely generate more positive cash flow in FY19F, in our view.

30% payout ratio will likely result in higher dividends

  • Frencken has typically paid about 30% of its profits as dividends to shareholders. With increased profitability, we think dividends will likely grow along with the same payout ratio.
  • We expect an FY19F dividend yield of 4.5%. If there is no surge in capex, there is also a possibility that more dividends can be dished out due to the strong operating cash flow derived from operations.

Frencken Group's Valuation

Initiating coverage with BUY and Target Price of SGD0.82

  • We initiate coverage on Frencken with a DCF-derived Target Price of SGD0.82, and a Conviction BUY on the stock.
  • Our assumptions are listed below:
    • Bloomberg WACC of 7%;
    • Terminal growth rate of 0%.

Peer Comparison

  • Frencken is currently trading at 6.8x FY19F P/E, ie at a discount against the peer average of 9.9x FY19F P/E. Other valuation metrics also indicate that the market is undervaluing Frencken vs its peers. Its P/BV and EV/EBITDA are at 1x and 2.9x, below the peer averages of 1.4x and 5.3x.
  • Our DCF-backed Target Price of SGD0.82 implies FY19F P/E of 9x.
  • At the current Frencken share price level, Frencken offers a decent dividend yield of 4.5% - we think the dividend per share is likely to increase proportionately as earnings increase over time, even if the dividend payout ratio remains consistent at c. 30%. See Frencken's dividend history.

Key Risks

Exposed to customer’s capex cycle.

  • Frencken serves customers from various industries such as medical, electronics, analytical, semiconductor and general production equipment. These industries are cyclical in nature and subjected to industry upturns and downturns.
  • During the cyclical downturn, customers may delay investment decisions for new capital equipment or cut their capex budgets. The financial performance of the company may be adversely affected, as a result.

Reliant on major customers.

  • Frencken is dependent on a number of major customers. In FY17’s revenue, approximately SGD64.9m was derived from a single customer in the mechatronics division. In the event Frencken loses its business with these customers, its financial performance will be adversely affected.

Foreign exchange fluctuation risk.

  • Frencken has operations in four principal geographical regions excluding Singapore, namely, China, Malaysia, the Netherlands and the Czech Republic. Extreme volatility in the movement of foreign currencies, particularly in RMB, EUR, USD and MYR may impact the company’s bottomline.
  • Frencken also transacts in JPY, RMB, THB and CHF. The largest revenue component comes from a customer based in the Netherlands, which accounted for 23.6% of its total revenue in FY17 and 23.4% in FY18. It manages its forex exposures primarily with natural hedges. If needed, it will enter into forward currency contracts to hedge uncovered positions.

Highly competitive market

  • Frencken operates in a highly competitive market. Its competitors include much bigger players which have greater resources to keep up with technological changes and meet customers’ demands. As such, competitors may offer better products and services at a lower cost.
  • In the event Frencken is not able to successfully compete with its rivals, it may end up losing market share and hurting its profitability.

Jarick Seet RHB Securities Research | Lee Cai Ling RHB Invest | https://www.rhbinvest.com.sg/ 2019-05-09
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