Frencken Group - Maybank Kim Eng 2020-07-12: Upping In Quality; Initiate Coverage With BUY


Frencken Group - Upping In Quality; Initiate Coverage With BUY

Quality growth, diversity and margins; initiate BUY

  • Frencken Group (SGX:E28) manufactures components and modules for market leaders leveraged to growth trends in 5G/ AI, health and wellness and population aging.
  • Our FY21-22E PATMI are 14% higher vs. Bloomberg consensus, as we believe margin uplift potential from a breadth of new products with higher design content is underappreciated. Geographic and product diversity, as well as net cash-to-equity position of 23% should offer resilience amid Covid-19.
  • Initiate coverage on Frencken Group with BUY with ROE-g/COE-g Target Price of SGD1.20 (1.6x FY20E P/B).

Frencken Group's Business Overview

  • Frencken is a contract manufacturer that provides end-to-end solutions from product conceptualisation and design to volume manufacturing and logistics services. Its key segments are mechatronics and integrated manufacturing services (IMS).
  • In the mechatronics segment, Frencken manufactures high-precision and complex systems for customers that are global leaders in healthcare, analytical & life sciences, semiconductor and industrial automation markets.
  • Meanwhile, the IMS segment designs and manufactures products for automotive and consumer & industrial electronics end-markets.
  • Frencken operates across 17 factories globally, and has 3,400 employees.

Frencken Group's Investment thesis

  • Our BUY on Frencken is premised upon:
    1. exposure to structurally growing markets through blue-chip customers;
    2. earnings resilience despite a challenging business environment due to Covid-19 and US-China trade tensions; and
    3. track record of margin improvement with room for more.

Covid-19 response and impact to Frencken Group

  • Currently, Frencken's factories in Singapore, Malaysia and China have resumed normal manufacturing operations following the easing of government restrictions. In Thailand, the Netherlands, the US and Switzerland, operations are continuing as usual.
  • While management adopts a cautiously optimistic tone, visibility is presently limited, due to the fluid and uncertain nature on the extent of the impact on supply chains and end-market demand. At this juncture, management has not observed significant order cancellations, although there are order delays, such as in the medical and analytical segments.

Leveraged to structurally growing end-markets

Diverse end-markets with structural growth

  • We estimate 46% of Frencken’s revenue are leveraged to secular technology trends such as cloud, 5G and AI (through the semiconductor and industrial automation subdivisions) while 33% of revenue are linked to trends relating to health and wellness, and population aging (through the medical and healthcare segments).

Riding the data boom

  • We see Frencken as a beneficiary of the current semiconductor capex recovery that is led by sustained spending in logic and foundry, with the recovery in NAND and DRAM to follow. In the latest 2Q20 update, SEMI now sees global fab spending to grow 24% y-o-y to a record USD67.7b in 2021 (1Q20 forecast: USD65.7b).
  • 5G is widely expected to usher in the “Data Era”, enabling data-intensive applications like AI, IOT, AR/VR, high-resolution video streaming and autonomous driving. With such intensive machine-to-machine communications, data generated is expected to reach 35ZB (zettabyte) by 2023, from 2.5ZB in 2018, based on Applied Materials’ estimate.
  • We expect this trend to drive both chip volumes and complexity. Volumes are driven by growing end-markets, while complexity rises due to increasingly demanding cloud and edge workloads to support these applications.
  • We believe Frencken is leveraged to this data boom as its customers address key challenges in bringing a 5G world to fruition:
    • The continued need to shrink transistor sizes – ASML believes that in the coming decade, its Extreme Ultraviolet (EUV) lithography technology will be a key driver in shrinking transistor sizes. According to ASML, process technology (including lithography) accounts for 30% of performance improvement opportunities. While Frencken currently has nascent exposure to EUV, we note that this technology can bring exciting growth opportunities to Frencken. Smaller transistor sizes should also translate to more advanced inspection and metrology equipment, which should also benefit Frencken through customer KLA.
    • Need for innovative materials and scaling approaches. However, there are limitations to traditional Moore’s law scaling in driving performance improvements. This is overcome through the use of innovative materials and scaling approaches such as 3D stacking and heterogeneous packaging integration. In turn, this should benefit Applied Materials, of which Frencken is a supplier to.
    • Beneficiary of the data explosion – As the data economy takes off storage requirements are also expected to increase. Seagate believes that its Heat Assisted Magnetic Recording (HAMR) technology is the key to enable larger amounts of data to be stored on a hard drive. Volume production of 20 TB HAMR drives are expected to begin later in the year. We expect Frencken to be a beneficiary of this through its industrial automation subdivision, as Seagate is expected to require the installation of new production lines for the volume manufacturing of this product.
  • Whilst still cyclical, fluctuations in semiconductor spending have been less pronounced in recent years, due to:
    • structural growth of semiconductor chips in an increasingly data-centric world; and
    • rising capital intensity from increased semiconductor manufacturing complexity.
  • However, we expect the industrial automation segment to be lumpier, depending on the capacity and product needs of Seagate.

Leveraged to globally aging population, rising awareness for health and wellness

  • Through the medical and analytical segments, we see Frencken as a beneficiary of the needs of a globally aging population, as well as the rising awareness for health and wellness through two key customers, Philips (medical) and Thermo Fisher (analytics and life sciences).
  • One of the key products in the medical segment is cardiovascular patient tables, which we believe should see steady growth from rising instances of cardiovascular diseases (CVDs) globally. According to the WHO, CVDs are the No.1 cause of death globally, claiming the lives of 17.9m people annually, or 31% of deaths. The WHO expects this number to rise to 23.6m by 2030, representing a 2019-30 CAGR of 2.1%. Prevalence of CVDs tends to rise with age, as seen from data from the American Heart Association. One of the key customers in the medical segment is Philips, which has a sales growth target of 4-6% p.a. for 2017-20 with scope for further improvement beyond 2020. However, due to disruptions caused by Covid-19, Philips is now expecting only modest sales growth in 2020.
  • If the post-Covid-19 world sees an acceleration in academic, biotech and pharmaceutical R&D, we believe Thermo Fisher is a beneficiary. Thermo Fisher is a leading analytical and life science company that serves a USD160b addressable market that grows at a rate of 3-5% annually. Through a portfolio of strong products and services as well as exposure in high-growth markets (e.g. China), Thermo Fisher expects to deliver 5-7% organic revenue growth over a longer horizon, or 1-2ppt above the market.

Resilience to Covid-19

Demand outlook broadly constructive

  • Despite limited visibility, Frencken’s assessment of the demand outlook is cautiously optimistic. From a recent call with analysts, we noted that Frencken has not suffered material order cancellations, with the exception of the automotive business.
  • As at 1Q20, Frencken noted that much of the disruptions were related to:
    1. supply chain disruption;
    2. order push-outs; and/ or
    3. customers that were experiencing temporary shut downs and as such were not able to receive orders.
  • We believe the commentary from Frencken broadly corroborates observations from its customers. For instance, Philips and Thermo Fisher remain constructive on demand side view, and believe that the resumption of elective surgeries and lab work following the easing of shut-down measures globally would reignite demand for their products. Despite the Covid-19 situation, Thermo Fisher continues to showcase new equipment – such as the Orbitrap Exploris 240 mass spectrometer, in early Jun-20.
  • Meanwhile, with the lifting of many lockdown measures globally, Applied Materials views that risks of material disruptions in the supply chain is expected to be reduced going forward, as semiconductor and semiconductor equipment industries are seen as critical in many countries. Frencken expects its semiconductor subdivision to enjoy q-o-q growth in 2Q20 – which also broadly corroborates the resilience in semiconductor equipment spending amid the current up-cycle.
  • An area of caution is the automotive segment, due to weak car sales globally. However, this segment now accounts for only 14% of revenue from 27% in 2015.

Resilience from diversity in product range and geographical spread

  • Amid lingering uncertainties from Covid-19 and rising US-China tensions, we seek comfort in Frencken’s geographical and product diversity.
  • Thus far, we observe limited impact from the US-China trade war to Frencken’s operations. In our view, this is because:
    1. China accounts for only 14% of revenue; and
    2. across markets, Frencken largely adopts a “local-for-local” approach (i.e. largely catering to the local supply chain of the customer).
  • Meanwhile, we favour Frencken for its product diversity where strength from certain product categories can offset weaker ones during various parts of the business cycle or economic developments. For instance, while Frencken is currently experiencing push-outs for its high-end CVD patient tables, it has been enjoying brisk sales for digital pathology units in light Covid-19.

Resilience from strong relationship with customers

  • Frencken boasts deep relationships with customers that span decades, for products that require strong expertise, stringent qualification processes, and at instances very demanding turnaround times. These products are often integral to the success of the customers’ final product in the market place. Overall, we believe this boosts Frencken’s stickiness with customers.
  • For instance, in the semiconductor subdivision, Frencken is the sole source of reticle masking units, a critical component for ASML’s lithography equipment. ASML is the market leader in electron-beam wafer steppers, and development of future technologies requires considerable financial and human resources. As such, ASML looks to specialized suppliers like Frencken to turn their leading-edge technologies into machines for series production. Frencken has been a partner supplier for ASML since the latter’s early days.
  • In the medical segment, one example would be built-to-order CVD patient tables for Philips, a leader in cardiovascular and diagnostic systems. These tables are integral in accurately positioning the patient within the scanner. Turnaround requirements for these products are very fast – three days from receipt of order to the delivery of a plug-and-play product. In turn, this enables Philips to maintain its competitive positioning with customers by providing very short lead times with high level of flexibility and customisation.

Room to expand margins

Mechatronics – driving margins through increasing value-add

  • Particularly in the mechatronics segment, Frencken’s products tend to be critical but are not core competencies of its customers. This allows the customers to free up resources to maintain their market leadership. Frequently, Frencken is chosen as a supplier not just because of its engineering and manufacturing expertise, but also because of its experience in managing the supply chain for complex products.
  • Given Frencken’s solid executional track record, we see scope for Frencken to gain wallet share with its customers going forward, likely by providing new products with stronger value-add and enhanced margins. One key approach is to shift away from build-to-print plus projects (i.e. largely manufacturing with very little scope for engineering value-add) towards more engineering-to-spec (greater scope to provide engineering design solutions per required specifications from customers). We understand many of the higher value-add engineering work takes place in the Netherlands, where Frencken is close in proximity to customers with deep expertise like ASML, FEI and Philips.
  • Frencken is currently involved in new products across many of its sub-divisions, including semiconductor, analytical, medical and industrial automation.

IMS – driving proprietary technology

  • The key revenue contributor in the IMS segment (18% of revenue) is from the automotive subdivision (14%). In this segment, legacy projects tended to yield weak returns due to high working capital requirements, and razor-thin margins. In turn, razor-thin margins were caused by insufficient scale and pricing competition due to commoditisation.
  • Management’s strategy is to move away from commoditised “dumb” plastics towards “smart” plastics, implying projects with value-add. If new projects are able to generate sufficient returns, we believe management would be more willing to commit further investment in this area.
  • To illustrate – with improving product mix, IMS segment margins jumped from 1% in both 2017-2018, to 5% in 2019. We view FY20E IMS margins of 3% to be a realistic expectation, due to weak automotive sales globally. However, we anticipate stronger margins as automotive sales recover, as well as from a more optimised mix over time.
  • Frencken believes one area of promise is its proprietary eco-PVD technology for coating processes. This process is cost-effective and it’s expected to allow Frencken to ride the trend of environmentally-friendly processes in the automotive industry.
  • While our long-term view of Frencken’s automotive prospects is favourable due to the strategy transition, we are cautious towards short-term prospects, owing to the discretionary and cyclical nature of global motive demand.

Improving efficiency and returns

  • To grow in its competencies and efficiency, Frencken has been selectively upgrading its equipment and facilities. In mechatronics, such investments include capacity expansion for high-precision machinery, while in the IMS segment a new facility in Chuzhou has been completed and received accreditations as a qualified supplier to the automotive industry.
  • Frencken is also constantly improving operating efficiency through its Frencken Operations eXcellence (FOX) and Frencken Production System. In short, these programmes continually identify processes that can be improved to extract efficiency. We believe these partially drove EBIT margins to 9% in 2019 from 5% in 2015. Over the same period, SG&A as a percentage of sales fell from 11.4% to 8.4%.
  • Such effects are even more pronounced in the automotive subdivision in our view, due to a large fixed cost base. With incrementally better volumes and/ or pricing, coupled with judicious cost management, the scope for operating leverage is attractive. For example, although IMS fell 6% in 2019, segment results jumped 7.6x to SGD6.1m on the confluence of improved product mix, and strong cost control.

Frencken Group Financial analysis


  • We forecast Frencken's FY20 core net profit to decline 11% y-o-y due to supply chain and order delays caused by Covid-19. However, we expect Frencken's earnings to increase by 18%/10% y-o-y in FY21-22E on the back of revenue growth and margin expansion, as Frencken optimises its product mix.
  • Our FY22E net margin estimate is 7.7%. This does not appear optimistic as:
    1. Frencken has already achieved core net margin of 7.1% in FY19; and
    2. there is still plenty of room to improve on value-add with customers. Frencken is currently working on a range of new products across segments.
  • Our FY21-22 net profit forecasts are 14% higher than consensus despite revenue being 2-5% lower than consensus, as we believe the street may not fully appreciate the potential for margin upside during our forecast horizon. In our view, further evidence of margin accretion could catalyse a rerating for the stock.
  • In our view, upside swing factors are our potential underestimation of:
    1. industrial automation sales in FY20E;
    2. semiconductor revenue strength in FY21E;
    3. margin accretion from favourable product mix and cost control.
  • In this bull-case scenario, we estimate fair value of SGD1.45.
  • On the other hand, we see a bear-case fair value of SGD0.95, which is higher than the current Frencken Group Share Price. This suggests long-term investors may find current valuations attractive. We believe this scenario can play out if:
    1. industrial automation and semiconductor revenue are weaker than expected in FY20-21E;
    2. other divisions are more vulnerable than expected to a protracted slump in the global economy;
    3. supply chain disruptions resurface persistently; and
    4. our thesis of improving product mix and operating efficiencies does not play out.

Balance sheet and cash flow

  • On the back of earnings resilience, we expect Frencken's FCF to sufficiently cover DPS over our forecast horizon. We used a 30% dividend pay-out ratio assumption, referencing Frencken’s historical pay-outs. See Frencken Group Dividend History.
  • We forecast capex to be slightly higher than depreciation during our forecast period, reflecting our view that Frencken will selectively build capabilities in promising growth areas.
  • Overall, its balance-sheet health is strong. We forecast net cash to equity to rise from 23% in FY19 to 35% in FY22E due to robust cash generation.

Frencken Group - Valuation & Risks

  • Initiate coverage on Frencken with BUY and Target Price of SGD1.20
  • Our ROE-g/COE-g Target Price of SGD1.20 is based on 1.6x FY20E P/B, in turn based on average FY20-22E ROE of 14%, COE of 9.7% and long-term growth of 2%. Our Target Price implies 12.2x FY20E P/E, a 20% discount to Singapore-listed EMS and precision engineering peers, which are trading at 15.4x.
  • While our Target Price implies valuation multiples at the higher-end of its historical trading range, we believe it is realistic. Frencken was under-researched for the most part of the past decade, and could rerate higher towards what is justified by its ROEs, as institutional investors gain interest, in our view.
    1. We see key risks to our view as:
    2. slower-than-expected economic recovery, leading to lacklustre earnings growth; and
    3. margin-accretion profile being shallower than we expect, e.g. due to increasing difficulty in driving marginal gains.
  • See Frencken Group Share Price; Frencken Group Target Price; Frencken Group Analyst Reports; Frencken Group Dividend History; Frencken Group Announcements; Frencken Group Latest News.
  • Frencken is trading at the higher end of its long-term forward P/E and P/B bands. Still, we see good potential for the stock to rerate further if our investment thesis plays out. This is even more so because the stock appears undervalued relative to peers and to its own intrinsic returns-generating ability.
  • See attached 29-page PDF report for complete analysis on Frencken Group (SGX:E28).

Gene Lih Lai CFA Maybank Kim Eng Research | https://www.maybank-ke.com.sg/ 2020-07-12
SGX Stock Analyst Report BUY INITIATE BUY 1.20 SAME 1.20