Valuetronic: Too Much RISKS To Ignore

Rosesyrup Research

Call: Sell       

Target Price: $0.34

Valuetronic: Too Much RISKS To Ignore

Instead of analyzing the macroeconomic forces in action, AmFraser spent large amount of its report describing what the analyst saw inside the production plant. The followings are 2 majors risks which AmFraser failed to consider in deriving at its 69cents "CONSERVATIVE" valuation

1.    Major Oversupply in the LED market

Over the past years, heavy investments have been pouring into China LED industry which ultimately lead to a serious oversupply. This explains the thin profit margin of 1-3% as mentioned in AmFraser report. Nevertheless most suppliers produce low quality LED, thus ValueTronic's higher margin of 5% is most probably due to its ability to manufacture higher quality LED (which enable it to seal a deal with international brand like Phillips). AmFraser went further to assure the readers that such competitive advantage can be maintained in the coming years.

"Valuetronics has consistently shown superior net margins (5‐ 6%) vis‐ à ‐ vis its other EMS peers (1‐ 3%) and we expect this key competitive advantage to be maintained in the coming years.  "

With quick advancement in technology, huge investment in R&D (for LED industry), and weak patent law in China, it is highly doubtful to claim that Valuetronic's superior technology could be maintained for long (>2years). AmFraser conveniently describe the advantage "to be maintained in the coming years" without quantifying it. The fact that China LED industry is reaching maturity means that the once unique and superior technology will now be a common technology adopted by all players in the industry and the competition will now rest on incremental innovation instead.

Should Valuetronic loses it competitive advantage (which is what we believe), it will be exposed to very intense competition with the other industry peers in an oversupply market. Thus the assumption of CAGR (compounded average growth rate) of 10% for the next 3 years dreamt up by AmFraser would not be achievable and overstated.

Perhaps this explains why the management "currently maintains that there is still no need to build on the empty plots of land at Daya Bay for THE NEXT couple of years as there is still idle shop floor space at the existing plant". Management decision to uphold a generous dividend payout of 30-50% also signalled that expectation for any significant growth isn't realistic. After all high growth is possible only if the company plough back large portion of its earning, which naturally means low dividend policy.  

2.    Anti-Dumping Policy From Western Countries

When Chinese's solar panel industry grew so huge that it started to threaten its US and Europeans' peers, the western governments imposed tariff on China manufactured solar panels. This resulted in billions of losses to the industry and aggravate the already oversupply condition in China.

Similarly, China LED industry has grown quickly and is starting to takes market from western players. Although most Chinese suppliers produce lower standard LED (different market from premium LED produced by western counter parts), experts have estimated that Chinese suppliers will start to threaten the premium market within 1-2 years. Thus there is a risk that western governments will once again impose costly trade barrier on the oversupplied LED industry. Trade barrier is a very significant risk, afterall it even killed an once largest Solar panel manufacturer in China. However this risk is not even mentioned in Amfraser analysis.

Valuation

As the above mentioned 2 risks have high possibility and high impact, we revalue the company's shares using FCFF model and made the following adjustments:

High Discount rate:  20.256% (Similar to that of an Chinese Solar Panel firm)

Growth rate = 3% (for next 2 years)

Growth rate = 0% (for perpetuity)

Target Price Per Share = SGD $0.34

Conclusion

Apparently this was AmFraser analyst first visit to an automated plant. He was so overwhelmed by big machines and modern production lines that he forgotten about companies do not operate in vacuum. In fact for most companies and businesses, macroeconomic (external) forces accounted for nearly 80% of their performance. Few companies are able to buck macro trend and even fewer firms are able to persistently buck that trend in longer run (> 5 years).

With such serious risks to valuetronic's prospect, it is even doubtful that valuetronic is able to upkeep a stable dividend (in absolute term) payout for long. Thus AmFraser might want to re-think whether DDM is an appropriate model for valuing Valuetronic at all.