Company background
Venture Corporation Limited (VMS) was founded in 1984 as a global electronics manufacturing services (EMS) provider. VMS capabilities expanded from assembly and manufacturing into research, design and development, product and process engineering, design for manufacturability, supply chain management, as well as product refurbishment and technical support across a widely diversified range of high-mix, high-value and complex products. Headquartered in Singapore, the Group comprises more than 30 companies with global clusters in Southeast Asia, Northeast Asia, America and Europe and employs over 12,000 people worldwide.
Investment thesis
Initiate coverage on VMS with a BUY rating TP of S$17.68
Our valuation is based on a 14x PE multiple. Our valuation is conservative given VMS’s superior return on equity, profit margin and balance sheet. We expect VMS dividend yield to be stable at 4.6%.
Revenue
VMS generates revenue by providing technology services, products and solutions. We can essentially split VMS’ revenue streams into two main segments.
Figure 1: FY18 Geographical breakdown of revenue
Source: Company, PSR
Figure 2: Group revenue by technology domain
Design revenue accounts for more than 50% of total revenue. This is a rare feat in the contract manufacturing space. We believe VMS’ ability to maintain a profit margin of 10.6% is due to its extensive capability in R&D which results in value creation and customer stickiness. VMS generally prices its services by internal benchmarks. VMS is also selective with its customers as it aims for quality growth. Among its peers, VMS is ranked 6 out of 7 in terms of revenue while it ranks first in terms of net profit. We believe portfolio 1 will provide growth for VMS as it shifts away from its legacy businesses (portfolio 2).
Key Customers – Positive outlook
VMS serves more than 100 customers globally. Figure 3 shows the potential customers of VMS. We think Philip Moris, Illumina and Keysight are likely to be VMS’s key customers.
Figure 3: List of potential customers
Source: PSR
Philip Morris
Philip Morris (PM) is an international tobacco company engaged in the manufacture and sale of cigarettes, smoke-free products and associated electronic devices and accessories.
VMS is one of the few manufacturers producing PM’s I-Quit-Original-Smoking (IQOS) product. IQOS is a smoke-free product which heats tobacco units up to a temperature of 350 degrees without combustion. PM claims IQOS produces less harmful chemicals as compared to normal cigarettes.
Korea and Japan: Despite slight weakness in PM’s sale of Reduced Risk Products (RRP) in Korea and Japan, we believe VMS’ on-going introduction of IQOS products in new markets should offset some of the softness in Korea and Japan.
The United States: On 30 April 2019, the Food and Drug Administration (FDA) approved the sales of IQOS 2.4 in the United States. In recent news, lawmakers in the United States urged the FDA to immediately pull pod-based and cartridge-based e-cigarettes off the market due to an outbreak of lung disease. IQOS faces less regulatory scrutiny than e-cigarettes. This may have a net positive impact to PM’s IQOS heat not-burn-product as consumers have fewer alternatives available.
Figure 4: PM’s heated tobbaco product (IQOS)
Source: Company
Figure 5: Total iQOS users rising rapidly
Source: Company, PSR
Illumina
Illumina provides sequencing and array-based solutions for genetic analysis. Its products are designed to accelerate and simplify genetic analysis. Illumina’s products include integrated sequencing and microarray systems, consumables, and analytical tools. Over the last 5 years, Illumina enjoyed revenue CAGR of 12.4%. The outlook for Illumina is positive as it continues to gain market share in genomic sequencing. Illumina is also enjoying healthy growth in its NovaSeq portfolio of products.
Figure 6: Illumina’s revenue trend
Source: Bloomberg, PSR
Keysight
Keysight offers electronic measurement services using wireless, modular and software solutions.
In FY18, Keysight achieved revenue growth of 21.6% YoY. As of 3Q19 results, Keysight raised its outlook for FY19 with expected revenue growth of 9% to 10% citing strong enterprise demand and 5G.
Figure 7: Keysight’s revenue trend
Expenses
Majority of VMS’ expense is made up of changes in finished goods, work in progress and raw materials used, making up 81% of FY18’s total expenses (Figure 8).
Staff costs: VMS currently employs more than 12,000 workers globally, with staff costs accounting for 10% of FY18’s total expenses. VMS margin expansion is in part the ability to keep employee expenses hovering at a steady rate of 10% of total annual expenses since FY15 despite expanding its operations.
Research and Development (R&D) costs: VMS is spending 1.72x more on R&D as compared to peers over the last 10 years (Figure 9). We believe this has allowed it to provide more value add to the customer, entrench the relationship and penetrate earlier into new projects. In FY18, VMS’ R&D expenditure surged 66% to S$83mn while peers were relatively muted at an average of S$23mn. We believe VMS’ consistent R&D efforts will lead to more value creation to support its impressive profit margin.
We expect R&D expenses to decline from its peak in FY18 (Figure 10). Although R&D expense is commonly used to gauge future turnovers of EMS companies, we think for VMS, it may not hold true. The fluctuations in VMS’ R&D expense may be due to timing differences as it is purely customer-driven. R&D expenses are recognised after reaching certain milestones this is done in different phases. The recognition of milestones is decided by customers and could range from 25% of a new product launch (NPI) to 100% of an NPI. Upon completing an NPI, customers may add or modify its products thereby delaying milestones and hence delaying the recognition of VMS’ R&D expenses.
Figure 8: FY18 expense breakdown
Source: Company, PSR
Figure 9: VMS spends 1.72x more on R&D VS peers
Source: Company, PSR
Figure 10: Research and development expense trend (S$mn)
Tax expenses: VMS recently initiated a tax optimisation programme which centralised all of its taxes. As of 2Q19, the effective tax rate was brought down to 13.7% from 15% a year ago. We expect the steady-state of the effective tax rate to be in a range of 14% to 14.5% going forward. The initiative could potentially save VMS approximately S$2mn in tax expenditure annually.
Gaining industry profit pool
We combined the GAAP earnings of US-listed EMS peers to visualise the gain in profit share VMS accumulated throughout the years. VMS’ profit pool grew from 4% of the industry to 39% in less than five years (Figure 11). We believe VMS’s ability to gain profit share is attributable to its (i) Extensive R&D capabilities; (ii) Adoption of lean cost structure; (iii) Selective customer acquisition; and (iv) Focus on low volume, high mix projects.
Figure 11: VMS is consistent in gaining profit pool amongst peers
Source: Bloomberg, PSR
Peer average net profit margins are approximately 2% (inclusive of foreign & local peers) while VMS enjoys 10% (Figure 12).
Figure 12: Net income and profit margin trend
Source: Company, PSR
We forecast an EPS growth of -1.6%/3.4% YoY for FY19e/FY20e respectively. We expect net profit margin to remain stable at 10.5% for both years. NPI should offset any weakness from a slowdown in existing production.
Robust balance sheet – Dividend support
Dividend visibility for VMS is backed by its strong balance sheet. As of 2H19, VMS has a net cash position of S$760mn which is approximately 17% of its market cap. Net cash to equity is at 32%. With a strong cash generation and a robust balance sheet we can expect consistency in dividend payments and potential share buybacks. We forecast VMS to pay S$202mn in dividends in FY19e, this equates to a pay-out ratio of 55% and a yield of 4.6% at current share price.
Figure 13: VMS has expanded dividends 40% over the past 3 years
Source: Company, PSR
Outlook
VMS near term outlook is shrouded by escalating geopolitical tensions and the prolonged trade war. Its focus will be on selected domains that have growth and value creation opportunities. Strong initiatives are in place for building new differentiating capabilities to enhance the Group’s competitiveness. With its strong balance sheet, VMS is well placed to capture growth opportunities as and when they arise.
Strong South East Asia presence
VMS will be a long-term beneficiary from the supply chain disruption in China due to the ongoing trade dispute with the United States. VMS’ exposure in China only accounts for 5% of its total properties (Figure 16). Note that there is less than 2% of turnover directly impacted by the trade dispute.
Among its peers, VMS has the largest (86%) proportion of its production facility in SEA (Figure 16), namely in Malaysia (Figure 19). From our discussion with manufacturers and analysis of various announcements, there is an ongoing shift of the electronics supply chain from China into SEA (Figure 15). In addition, we have observed a surge in electrical and electronic investment approvals in Malaysia (Figure 17). VMS is poised to benefit due to its existing production capacity in SEA.
Figure 15: Relocation of electronics manufacturing from China to Malaysia is underway
Source: Nikkei Asian Review, The Edge, NST, Bloomberg, WSJ
Figure 16: VMS has the largest facilities in SEA and is least exposed to China
Source: Company, PSR
Figure 17: Spike in investment approved in electrical & electronics products (MYR mn)
Risk factors
Increased competition. Competitors could ramp up their R&D efforts to mimic VMS’ success and possibly win over VMS’ clientele. This will erode the premium margins that VMS commands. This scenario is rather unlikely because the cost for VMS’ customers to switch may outweigh the benefits, switching entails a long design and development process.
Escalation in the trade war. Increased trade tension could weaken customer sentiment and hence, delay new product launches and tapering down of inventory. Escalation could also further weaken global economies therefore negatively affecting end-user demand.
Stringent regulation. Increased regulation on PM’s IQOS product is likely to hurt turnover.
Investment thesis
Valuation
We initiate VMS with a target price of S$17.68. Our valuation is based on a 14x PE multiple this is in line with peer valuations. Our valuation is conservative given VMS’s superior return on equity, profit margin and balance sheet. VMS also boasts a dividend yield of 4.6% which we expect to be stable (Figure 13).
Figure 18: US-listed peer valuations
Source: Bloomberg, PSR
Figure 19: VMS trading at -1SD
Source: Bloomberg, PSR
Figure 20: List of properties
Source: Company, PSR
Alvin covers telecommunication and technology sector.
He graduated with a bachelor of commerce, majoring in Accounting and Finance from Monash University.
