$KESM / 9334 (KESM INDUSTRIES BERHAD) (KESM INDUSTRIES BERHAD): 9334
Introduction:
Much like crude oil prices and dry bulk charter rates, semiconductors are in an inflection point where the divergence between increasing demand and decreasing supply are causing a shortage and thus rising prices. KESM being the victim of the US-China Trade War in 2019 and is now going through a "difficult time" with the shortage of auto chips globally. In this article, I will explain why I think this stock could potentially become a multi-bagger in the long term with its exposure to the EV/Automobile tech sector despite recent headwinds.
Business Overview:
KESM is Malaysia's largest burn-in & tester service provider, and could also be one of the largest in the world (according to their annual reports). They offer burn-in process for automotive semiconductor manufacturers, which make up approx. 80% of their revenue. Rigorous testing for auto integrated circuits is to weed out any defects and faults in its design. They have three factories in Malaysia and one in Tianjin Province, China.
Investment Thesis:
1. Growing Semiconductor Content in Automobiles (i.e. Growing Total Addressable Market)
According to Infineon, the semicon content for Hybrid and Battery EV cars range between $500-800. While this is significant compared to $300 worth in internal combustion cars (ICE), KESM claims that in the future, Hybrid and EV cars could possess semicon content worth between $1000-3000. Not to mention that Infineon forecasts that by 2030, the world will see 32mil EV vehicles and 30mil Hybrid cars.
2. Global Semiconductor Billings & Growth
Among different products of the semicon industries which are auto, communications, industrial, data processing and consumer electronics, the growth in auto chips according to PwC, will have the highest CAGR rate between 2019-22F.
3. Developed Countries Pledge to Ban ICE cars by 2030
According to Thomson Reuters, over 10 countries such as Norway, UK, Netherlands, Israel, Ireland and Germany are banning the sale of ICE cars by 2030-2040, further propagating the demand for higher semicon in automobiles.
4. Higher Barriers to Entry (i.e. Economic Moat)
Among all the different types of semicons, automotive has the most stringent requirements with a target rate of 0% failure as they are required to last up to 15 years. With such high requirements, it implies that it can tough for new players to come into the market considering that auto chipmakers require a highly reliable partner to undertake this process. Which brings me on to the next point:
5. Longstanding Partnership with 5 Largest Global Auto Chip Makers:
KESM has had long-term partnerships with 5 of the 10 world's largest auto chip makers. Some of these players include Renesas, Infineon, NXP Semiconductors, and Texas Instruments. Although their clients have not been disclosed, we can have a good idea who these clients are as some of their plants are located with a 100m radius of KESM's plants in Malaysia.
6. KESM's New Capacity in Melaka for Future Growth
KESM's recent establishment of a new factory in Melaka containing 100,00 sq ft of capacity that was reported in January 2021, is also testament that the Management is anticipating strong and robust future growth in the near future.
7. Solid Balance Sheet & Strong Operating Cash Flows
As of 3QFY21 KESM’s net cash position is of RM50mil, which translates to RM1.16 per share. Not to mention the stock is current trading relatively close to its net tangible assets of RM8.46 or P/BV ratio of 1.42 at the time of writing.
Their Debt/Equity ratio stands at 0.04. Total loans and borrowings have been pared down to RM16mil in 3Q21 from RM26mil in 4Q20.
Now this is where things get interesting…
Table 1:
FY20 FY19 FY18 FY17
Revenue 241mil 307mil 350mil 338mil
PAT 96k 6.3mil 39mil 44mil
OCF 87mil 88mil 78mil 101mil
ICF (28mil) (42mil) (99mil) (153mil)
FCFE 8mil 1.6mil (6mil) (31mi)
ROIC 31.6% 29.5% 23.7% 35%
The revenue and PAT (Profit After Tax) simply reflects the effects of the US-China Trade War that started in FY18 and the shortage in auto chips from FY20.
However, if you look at the third line: OCF (Net Operating Cash Flow) i.e. Net Operating Income After Tax, the company has recorded resilient operating cash flow suggesting that the business has been healthier than the income statement initially suggests.
ICF (Investing Cash Flow) used has also been decreasing year by year.
FCFE or Free Cash Flow to Equity refers to how much cash is available to the equity shareholders of a company after all expenses, reinvestment, and debt are paid has been steadily increasing since FY17.
And finally, ROIC or Return on Invested Capital, calculated based on OCF/(Debt+Equity-Cash) refers to the amount of money a company makes that is above the average cost it pays for its debt and equity capital. Again, the company’s ROIC further indicates the company has been efficient in allocating capital to generate cash flow.
Table 2:
3Q21 2Q21 1Q21
Revenue 61mil 68mil 61mil
PAT 764k 6.3mil 894k
OCF 19mil 5.6mil (2.1mil)
ICF (27mil) (16mil) (9.9mil)
FCFE (21mil) (17mil) (20mil)
ROIC 6.2% 1.86% -0.7%
According to the PAT trend of the last three quarters of FY21, it is rather lumpy although it has already surpassed the PAT of 2019 suggesting that the company may be making a pivoting point for a turnaround.
Although OCF, FCFE and ROIC has been decreasing so far in FY21, this is expected because of the auto chip shortage, ramping up of investing activities and the paring down of their loans and borrowings to strengthen their balance sheet.
Risks:
1. Global Automotive Chip Shortage
In an article by Ian King and Debby Wu (Bloomberg) from the Edge’s August 9 issue (pg. 30), Infineon Technologies & NXP Semiconductors stated that supply and demand for auto chips would not come into balance until mid-2022. Further prolonging the auto chip shortage. This is because the industry’s pivot to EV cars is further making the demand an even faster “moving target” to catch up to.
At the moment, famous chipmaker TSMC plans to boost output of automotive microcontrollers by 60% from 2020 levels. However, as chipmakers set aside CAPEX to boost output, it would, “take about 12 to 18 months for those fabs to come online”, says Syed Alam, head of Accenture plc’s semiconductor department.
NXP’s CEO stated in an interview, “It’s really important to stress how much we’re increasing supply. Demand is still outstripping supply, and the tightness will last into 2022”.
Mirroring NXP’s CEO, Infineon CEO Reinhard Ploss said, “Inventories are extremely tight and end demand is being postponed. All in all, it will take time to get back to a supply-demand equilibrium. In our view, this will take until well into 2022.”
2. Downturn in China and US Vehicle Sales
As KESM has a factory in Tianjin Province, the Management guided in its 2019 Annual Report, that “the drop in China’s car sales following the dispute in the U.S. and China trade war had weakened our revenues.” Overall, global car sales have been dropping since 2018.
Meanwhile in 2021, the China Association of Automobile Manufacturers stated, “Auto sales in China dropped by 11.9 percent year-on-year to 1.86 million units in July 2021, a third consecutive month of decline, as a global shortage of semiconductors continued to hurt the auto sector. Sales of passenger cars fell 7.0 percent from a year earlier to 1.55 million.
Regarding EV, the CAAM added, “Meanwhile, sales of new energy vehicles (NEVs), including battery-powered electric vehicles, plug-in petrol-electric hybrids, and hydrogen fuel-cell vehicles, surged 164.4 percent to 271,000 units.”
3. US-China Trade War
It is likely that the US-China Trade War affected KESM and their client’s supply chain has been further exacerbated by the semiconductor shortage. However, as of the time of writing of this article, the trade war has escalated to the point where the two countries are effectively “de-coupling” from each other’s supply chain; some companies like Aemulus are already taking advantage of this vis-à-vis ‘Made in China 2025’. At this point, it is unclear if this is a positive or a negative for KESM.
Valuation:
Assuming that the company eventually returns to its profit in FY18. The long-term intrinsic value for the stock could be calculated as follows using a conservative P/E of 40:
PAT of 39mil x P/E of 40 = RM1560mil market cap
Divided over 43mil shares = RM36.28 per share (200% upside)
At this moment, the company does not disclose new contracts as well as factory utilisation rates making any form of near-term earnings estimation difficult.
Concluding Remarks:
Considering the urgent measures currently being taken for foundries to create new capacity for auto chips and the fact that semiconductor content in cars are growing as we speak as well as the other factors mentioned above, it all leads to the conclusion that pent-up demand for KESM’s services will eventually be reflected in the company’s profits, assuming when supply and demand reach equilibrium.
In other words, the longer-term trend of increasing semiconductor content per vehicle outweighs the short-term negative impact from the automotive semiconductor chip shortage.
But at this point, it remains a long-term play. Of course, “smart money” has also recently caught on to the stock’s potential turnaround story… With Aberdeen Asset Management mopping up some shares recently.
Either way, if you’re looking for a “cheap” tech stock with exposure to the EV sector, that has the potential for turning into a multi-bagger (did I mention that its market cap is only about 500 million?), with minimal downside and a long-term play, then I would say KESM’s prospects seem “burn-in hot!”. :fire:
Thanks for reading. -Leon Jake Lim