About

Per the annual report: “Uchi Technologies Berhad (UCHI) is primarily an Orignal Design Manufacturer specializing in the design, research and development, and manufacturing of electronic control systems. These include software development, hardware design and system construction.” We deduced that UCHI business is B2B focused on end-to-end solutions and product provider to appliances, laboratory and instrumentations manufacturers.

We decided to value Uchi as the counter demonstrated attractive earning multiple, high return on capital, net cash balance sheet and zero debt. In addition to that we found that UCHI’s revenue are derived internationally which present more economic resilience compared to a domestic business.

Core Operations

According to Uchi’s annual report majority of the revenue are generated from the manufacturing segment. Namely the manufacturing of touch screen advance display, high precision light measurement, mixed signal control system for centrifuge / laboratory equipment, mixed signal microprocessor based application, system integration products and electronic modules.

We tabulated 7 years of annual results and observed that the operating profit margin of the business remain in the range of 40% to a high of 47%. We assume an annualized rate of 41.6% operating profit margin for the business at a constant rate.

Upon arriving to 41.6% operating profit we noticed that over the years Uchi’s R&D expensed are in the range from RM 3 – 4 million every year. We at Valunomics decided to capitalize all R&D expensed and amortize R&D assets over a period of 3 years. According to Professor Damodaran of the University of New York Stern School of Business R&D expenditure are essentially capital investment that shall generate economic benefit to the company over the long run and should hence be shown in the balance sheet. As per current accounting practices R&D are expensed and there is no showing of it in the balance sheet.

As we look closer we noted that Uchi has two customers that contributed a combined 82% of the revenue which is probably a lot less diversified than we actually preferred. This is indeed an economic risk of Uchi.

Return on Capital

On the topic of return on capital side Uchi have demonstrated very favorable results. In fact it is rare to find counters above 30% however Uchi showed return of a low of 50% and of a high of 94%. This astronomically high return is as a result of astronomically high operating profit margin and astronomically low tax rate as mentioned.

Growth

Uchi’s net profit attributed to shareholders for the period of 3 years have been fluctuating and it would be challenging to arrive to a CAGR that is measureable. We therefore decided to normalize the results to a period of 3 years and take a downside risk adjusted growth rate. We therefore arrived at a Downside Risk Adjusted Growth Rate (DRACAGR) of 1.0%. Reader will think this is low and to those who are growth investors you may stop reading this valuation here and look elsewhere.

For this valuation we will employ the historical 3 years reinvestment rate witness by the company of 7% and at the return on capital of 81% to arrive at the core growth rate of 5.3%. We shall assume this to be the base case for our discounted cash flow. Definitely more optimistic the reader would say comparing to the backward looking growth rate above. We attempted to reconcile this differences base of records in the annual results but to no avail.

Tax

During the valuation we noted that Uchi’s tax rate is extraordinarily low. Uchi’s annual report assisted us to shed some light on this situation. Per the annual report: “Because of its pioneer status, UOM is currently not being taxed for income generated from the research & development and manufacture of pioneer products. However, this pioneer status will be expiring on December 31, 2017. With the Group being at the forefront of new and innovative technology, UOM will endeavour to obtain approval from the relevant authorities to extend its pioneer status and consequently further facilitate our efforts in applying new technologies in our designs, processes and products. Nevertheless, this extension is subject to the approval of the relevant authorities.”

We assume that the pioneer status taxes are to be adjusted at the end of the 2017 to normal levels of 14% and incrementally increased to 26% at terminal growth period. We caution the reader to not pay for something like a perpetual subsidy assuming the government is going to extend the subsidy assistance forever.

Valuation

We employ a 2 step discounted cash flow of the future free cash flow to firm of Uchi with the following assumptions:

1.       Growth rate of 5.3% CAGR and at terminal growth period of 2.7%;

2.       Operating profit margin of 41.6% at a constant rate;

3.       Tax rate of 14% at year 1 and increased to 26% at terminal growth period (We remove the pioneer tax subsidy as mentioned);

4.       Return of Capital of 51%;

5.       Weighted average cost of capital of 11%;

6.       We added all cash and non-operating assets;

7.       We deducted all deferred tax and also liability provisions;

We arrived at a valuation of RM 1.51 per share. At the day of the valuation the current price of Uchi is RM1.88 which is a 20% premium to the value.

We attribute the 20% premium the market is paying is not attributed to the growth of Uchi but of the tax subsidy which is schedule to be revoked at the expiry of the pioneer status at end of 31 December 2017. We expect adjustment of the price towards the value next year.

We cannot recommend a buy on the stock.