Valuetronics - DBS Research 2020-06-19: Holding On To Its Value; Initiate Coverage With HOLD

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VALUETRONICS HOLDINGS LIMITED (SGX:BN2)

Valuetronics - Holding On To Its Value; Initiate Coverage With HOLD

• Potential loss of customers due to shift in supply chains.
• Weak economic outlook to weigh on both businesses.
• Zero debt, cash of c.HK$1bn – 52.3% of total assets, 76.4% of market capitalisation.
• Initiate coverage on Valuetronics with HOLD and Target Price of S$0.53.

VALUETRONICS - Company Background

• Valuetronics Holdings Limited (SGX:BN2) is headquartered in Hong Kong and is an integrated Electronics Manufacturing Service (EMS) provider that offers design, engineering, manufacturing, and supply chain support services for high quality electronic and electro-mechanical products.
• Valuetronics was established in 1992 and listed on the SGX Mainboard in 2007. The Group’s financial year end reporting period is in March.

Valuetronics' Business Operations

• Valuetronics offers one-stop manufacturing solutions. These include plastic tool fabrication and injection moulding, metal stamping and machining, to surface mount technology and full turnkey finished product assembly.
• It has two reporting business segments:
  1. Consumer Electronics – Consumer lifestyle products (electric shavers, electric toothbrush, etcetera) and smart lighting, etcetera.
  2. Industrial and Commercial Electronics – Printers, Point-of- Sale (POS) machines, sensing devices, communication products, electronic products for automotive, medical equipment, etc.
• Its CE business fluctuates with the prevailing consumer sentiment while its ICE business has been on a steady uptrend. As of FY20A, its CE:ICE revenue mix was 41%:59%.

US and China accounted for 67% of FY20A revenue.

• Valuetronics has the largest revenue exposure to the US (39% in FY20), followed by China (28%) and Poland (7%). Revenue from other countries accounted for 26% of its total revenue in FY20A.

Supply Chain

• Four major customers collectively account for 69% of FY19A revenue. These four major customers individually account for more than 10% of the Group’s revenue.
• Two manufacturing facilities in China and Vietnam. Its main manufacturing facility, which spans 600,000sqft, is located in the Guangdong Province in China. Valuetronics has a secondary manufacturing facility in Vietnam that began production in June 2019 in Phase One of its facility. Its expansion is scheduled to be operational by the end of FY22F and the total factory size will be expanded to 550,000 sqft.

VALUETRONICS - Business Strategy

Expanding its secondary manufacturing facility in Vietnam.

• The escalation of trade tensions between the US and China has created a high level of uncertainty in the macro-environment that the Group operates in. Its customers are also beginning to diversify their supply chain to mitigate the impact of the US tariffs as well as other possible future events that might affect Valuetronics’ production. As a result, the Group has identified Vietnam as a second low-cost manufacturing base. It has leased the land until October 2065 and is in the midst of developing Phase Two.

Focus on securing customers in the US.

• Valuetronics has expanded its business development team in the US and is currently sourcing for additional customers for its Vietnam facility when it is completed by the end of FY22F.

Cash conservation for difficulties and M&A purposes.

• Valuetronics has built up its cash reserve of c.HK$1bn as at end- FY20A and aims to continue doing so. The cash reserve is for trying times and M&A that would add value to the company.

VALUETRONICS - Investment Thesis

1) Potential loss of customers Due to US-China trade tensions

Valuetronics had lost revenue from some customers in FY19 due to US-China trade tensions.

• The protraction of the US-China trade war, which began in early 2018, had started to weigh on its Consumer Electronics (CE) business in FY19. Due to the on-going uncertainties, its smart lighting customer had begun to diversify its supply chain out of China, which resulted in Valuetronics losing some of its business.
• As a result, revenue from its CE business declined 16.9% y-o-y in FY19.
• Even with the Phase One Trade Deal, majority of Valuetronics’ goods that are shipped to the US are subjected to tariffs ranging from 7.5-25.0%. While the conflict between the two nations had initially improved with the signing of the Phase One Trade Deal in January 2020, most of the tariffs imposed by the US on China remained. Almost the entirety of Valuetronics’ products is made in China and a large majority of its shipments to the US are subject to the tariffs that range from 7.5-25.0%.

Resurfacing of US-China trade tensions could reignite risks.

• Even though the Phase One Trade Deal had improved the tariff situation, the remaining US tariffs on China would only be removed in a second phase. However, tensions between the two countries resurfaced after a recent series of events strained the relationship:
  • Spreading of the COVID-19 pandemic – The US has blamed China for the spread of the pandemic and has demanded for an investigation into the origins of the virus.
  • China tightens its grip on Hong Kong – The US is considering revoking Hong Kong’s special trading status while Hong Kong’s government has warned the US against interfering in its internal affairs.
• This reignites risks that more customers would diversify their supply chains out of China for fear of a protraction or worsening of the tariff situation.

c.40% of Valuetronics’ revenue, which is from the US, is at risk.

• The US contributed 39.4% to Valuetronics’ revenue in FY20 and has ranged between 40% and 50% in the past five years. With the on-going uncertainties for the tariff situation, several of Valuetronics’ customers have indicated that they will start diversifying production outside of China – either to other suppliers or to the Group’s plant in Vietnam. Its US customers in the automotive industry and CE segment have plans to switch over to alternative suppliers in the US in FY21F. We view this as one of the main pressures onValuetronics' share price in the coming year.
• We believe the revenue loss from customers switching suppliers could be c.28/10% of FY21F/22F of Valuetronics’ revenue. While there is no clarity and certainty on the plan that Valuetronics’ customers have on adjusting their supply chains, we have assumed a complete supplier switch for its automotive customer and a moderate switch of its CE customer and other ICE customers in the US over a two-year period. Our assumptions in this scenario reflect a gradual but slow improvement in trade relations between the US and China.

Scenario analysis indicates loss could be 16%-36% in FY21F and 7-13% in FY22F.

• Our bear case encompasses a sharp turn for the worse in US-China relations in which most of its customers would switch suppliers. Our bull case reflects a faster-paced improvement of the situation which could translate to fewer customers switching suppliers.

2) Weak and uncertain economic outlook

Job losses and weakened economic outlook are likely to weigh on demand for consumer electronics.

• The COVID-19 pandemic has weakened global economic activity and its outlook. To combat the spread of the virus, governments have implemented social distancing and lockdown measures which substantially reduced consumer spending and demand for business activity. As a result, businesses retrenched workers and unemployment rose, feeding into the cycle and further reducing consumer spending.
• Even as economies re-open, we believe the recovery process towards low unemployment will be slow and gradual as a vaccine is not yet available. This is likely to weigh on consumer demand and Valuetronics’ CE business in FY21F and possibly FY22F.

While China’s manufacturing PMI bounced back, the US and EU are still struggling.

• While the manufacturing gauge in China has recovered and has been in the expansion region (above 50) since March 2020, the US and Europe remain well in contraction territory at 43.1 and 39.5, respectively, in May. In our view, unemployment and a weakened economic outlook are likely to continue to dampen manufacturing activity as consumers and businesses cut back on spending, thus reducing demand for both Valuetronics’ CE and ICE business.

US-China trade tensions have gradually reduced manufacturing activity in the US, EU, and China.

• Since the onset of the trade war between the US and China, manufacturing PMIs in the US, EU, and China have gradually declined, as global growth prospects were limited. As we do not envision a quick resolution to the dispute, manufacturing activity could continue to remain under pressure in the near term.

Weak global economic outlook – global GDP is projected to contract by 3% in 2020.

• The IMF is projecting a 3% contraction in global GDP in 2020 due to the pandemic. This is a drastic change from the previous forecast of a 3.3% growth earlier in January 2020, and a contraction that is worse than the 2008-09 global financial crisis where world GDP shrank by 0.1% in 2009.

Potential further downside risks – IMF’s base case of a 3% global contraction assumes the pandemic fades in 2H20.

• The IMF’s base case assumes that the pandemic fades in 2H20 and containments efforts can be gradually unwound, aiding a 5.8% rebound in 2021. However, the new daily reported COVID-19 cases in the US seemed to have recently hit a plateau at c.20,000 cases each day.
• As the world’s largest economy, this is puts into question a bleaker 2020 and poses as a potential risk to the recovery in 2021.

3) Strong fundamentals to tide through difficulties

• While the Group currently faces many headwinds, we are confident it is able tide through the difficulties with its strong financial position and longer-term strategic plans.

HK$1bn in cash with zero debt is sufficient to fund an estimated annual cash burn rate of HK$200m and Vietnam expansion (HK$200m).

• While many companies have gone under due to cash flow problems, Valuetronics is not one of them. The Group has always remained disciplined with its cash use and has been accumulating a reserve for M&A purposes and turbulent times such as this.
• As of 31 March 2020, Valuetronics had HK$1,053m of cash, representing 52.3% of its total assets and 76.4% of its market capitalisation. With our estimated annual cash burn rate of c.HK$200m (capex: HK$50m, other costs: HK$150m) and an additional HK$200m set aside for its Vietnam expansion, we believe the group has sufficient cash to tide through the difficulties.

ROE of 15.0%, ex-cash ROE of 87.9% in FY20A.

• We believe Valuetronics’ ROE of 15-20% is being masked by its higher levels of cash (30-50% of total assets). While we are not implying a value on its underlying ROE, its ex-cash ROE is 87.9% in FY20A is an interesting area to consider.

Expansion of its Vietnam facility will diversify its risk as an EMS producer solely operating in China.

• With the launching of its trial production at its second facility in Vietnam, the Group is expanding its Vietnam campus to offer its existing as well as new customers an alternative to its production site in China.
• Its Vietnam campus has about the same floor space as its facility in China and is expected to complete by the end of FY22F. While this will take some time, we believe the alternative site will begin to benefit Valuetronics gradually from FY21F-22F.

Valuetronics is currently pursuing business opportunities in the US.

• While the Group has deviated from its original plan of establishing a manufacturing presence in the US, it has expanded its business development team in the US to source for customers.

Don’t rush – Now is the time to be patient.

• While its valuation is attractive compared to its peers and it has a high cash as a percentage of its market capitalisation, we believe the uncertainties will continue to put pressure on Valuetronics' share price in the near-term.
• Key developments that we are looking out for that would warrant a change in our recommendation include more clarity on the impact of the loss in customers and stabilisation and improvement of the economic outlook.

VALUETRONICS - Valuation, Recommendation & Peers Comparison

• HOLD recommendation on Valuetronics with a target price of S$0.53 (-7% upside from its last traded price S$0.57).
• We derived our target price of S$0.53 based on a 12-month rolling forward PE of 9.4x, which is its 4-year average. We used the average as we believe Valuetronics’ strong fundamentals will allow it to tide through its current headwinds. It is currently trading at 10.2x (+0.3SD) of its 12-month rolling forward PE.

Deserving of a HOLD – cheap valuation multiples relative to peers.

• Valuetronics is currently trading at 10.3x FY21F and 9.6x FY22F forward PE, which is below its peer average of 17.7x and 14.2x respectively. Its FY21F and FY22F EV/EBITDA of 2.5x and 2.0x are also below its peer average of 9.9x and 8.2x respectively. While the cheaper valuation could be attributed to its risk premium as a smaller firm, this is still at a significant discount when compared against its peers.

VALUETRONICS - Key Assumptions

Revenue growth: -23%/7%/6% in FY21F/22F/23F.

• We have incorporated the impact of the supply chain diversification by its customers as well as the headwinds from a weakened economy.
  • Supply chain diversification – In general, we have assumed a 30% loss in revenue from its customers in the US over a span of two years. We have taken a considerable portion as we believe there is a fair chance that its customers would reconsider their supply chains due to the trade tariffs as well as to hedge against future unforeseeable supply chain disruptions.
  • Weakened economy – We have pencilled in lower growth rates for its different business segments in FY21F due to the weakened economy and are expecting a recovery from FY22F.

Gross profit margins: 15.0%/15.2%/15.1% in FY21F/22F/23F.

• Valuetronics’ ICE business has higher gross profit margins than its CE business, and we are expecting a shift in segment contribution mix mainly due to the loss of its automotive customer. As such, we are projecting gross profit margins to decline from 15.4% in FY20A to 15.1% in FY23F, as the product mix shifts towards its CE business.

SG&A as a % of revenue: 8.0%/8.0%8.0% in FY21F/22F/23F.

• Despite its smaller economies of scale (due to lower revenue), we believe Valuetronics will be able to maintain its SG&A as a % of revenue due to
  1. its continual improvement in factory automation,
  2. ability to adjust its employee count, and
  3. lower staff costs at its Vietnam facility.

VALUETRONICS - Scenario analysis

• See Valuetronics Share Price; Valuetronics Target Price; Valuetronics Analyst Reports; Valuetronics Dividend History; Valuetronics Announcements; Valuetronics Latest News.
• Our scenario analysis indicates Valuetronics' target price range of S$0.51- 0.60.
  • Bear case (S$0.51) – Steep deterioration in US-China trade relations and a rapid diversification of supply chains from customers.
  • Base case (S$0.53) – Gradual but slow improvement in trade relations but moderate diversification from customers.
  • Bull case (S$0.60) – Improvement in trade relations but some diversification of supply chains from its customers.

Lee Keng LING DBS Group Research | Singapore Research Team DBS Research | https://www.dbsvickers.com/ 2020-06-19

SGX Stock Analyst Report HOLD INITIATE HOLD 0.53 SAME 0.53