Success Transformer 10/21

I am not a professional investor, and this writing practice does not provide advice or education. Information, including financials and ratios, may be inaccurate. Nothing in this report should be relied upon for investing decisions. At the time of writing, I own shares in Success Transformer.

Company Description

Success Transformer (STC) manufacture electrical components and LED lighting. Their components are generic, with a wide range of uses including manufacturing equipment and building electrics. Their LEDs are technologically capable, with features like pollution monitoring and surveillance, and are used in large indoor and outdoor spaces.

STC also provide maintenance and managed services alongside their products to optimize the customer experience. They conduct marketing and distribution. About half of their products are sold in Malaysia, 20% in China, and 30% in other countries around the world.

STC have traded electrical components since 1978 and since entered new lines of business with varying levels of success. Their lighting business became a major focus around 2010.

Industry Overview

Transformers and other electrical apparatus sold by STC are broadly essential. Demand is growing with global infrastructure development, and there is an ongoing need for replacement of older products due to the power-saving benefits of upgraded technology.

While electrical products are widely available, producers gain a competitive advantage by providing components with high reliability and reasonable prices. Efficient, cost-effective manufacturing is a priority, while a relatively low failure rate is a significant advantage. Components that save more power are also advantageous.

LED lighting provides similar cost benefits. With energy and lifespan advantages over older forms of lighting, LEDs are the preferred option. Promising applications include industrial environments and outdoor urban areas. The global LED market is expected to experience a CAGR of 12.9% (GLOBE NEWSWIRE).

Cost and reliability are important in lighting solutions, but as customers interact with products more regularly, improving the user experience is a potential competitive advantage. This is achieved with innovative designs, enhanced useability (ie. remote control), and optimization services provided by the seller. Strong marketing is also important. 

External forces are beneficial. Social demographic trends lead to more manufacturing, building, and urbanization, each increasing the demand for both LED lighting and electrical components. Political aspirations generally align with this trend. Supporting manufacturers is seen as an important part of strengthening the overall economy.

Management

Mr. Tan Ah Bah founded STC. He is the most senior manager and directs most subsidiaries. He has managed previous iterations of the business since 1978. His spouse and three daughters have served the company and are substantial shareholders.

STC began as an electronics trader. They strengthened their electronic and lighting brands, QPS and Nikkon, over the years with reliability and innovative designs. They have added marketing, distribution, and electrical service subsidiaries. A recent brand addition is iLCS, an intelligent outdoor lighting solution. They aim to form ongoing relationships with customers, integrating, maintaining, and upgrading equipment.

The long-term strategy is to achieve further growth internationally. There is also a strong focus on creating smart and futuristic products.

Their short-term strategy is to build online sales through social media with aggressive marketing techniques (contests, vouchers). For the duration of COVID, lowering costs remains a priority.

The company focus on the value created by their products- public safety and increased productivity in lighting, and reduced power consumption and lower environmental impact for electrical components.

Sentiments in STC’s mission include passion, dreams, preparation for tomorrow, and successful, long-term relationships with customers. They aim to become a globally recognized brand.

Quality of Earnings

STC received 50.1% of revenue from Malaysia, 17.8% from China, and 31.2% from “other countries”. They report that sales have been made in over 40 countries, and have active international subsidiaries in Singapore, Kenya, Indonesia, and Thailand.

Revenue has been decreasing since 2017, as STC discontinued an unprofitable “process equipment” business. Costs have been well controlled, and the company have managed to remain largely profitable, with net margins of 4.5-8%. While total earnings have been choppy, the earnings from their current operations grew from 11mRM in 2017 to 21mRM in 2019. FY 20 results were weaker, attributed to COVID, but future growth and margin expansion appears likely.

It is unclear how much revenue comes from lighting versus electrical components. Subsidiary reports from research firm EMIS indicate that electrical component revenues and earnings are declining, while lighting revenue is stable with growing profit margins. While these trends may not be indicative of actual results (subsidiary revenue may be from within the group, rather than external customers), it appears that STC are focused on expanding their lighting segment as it has the most promising future.

Lighting products are suited to businesses, or perhaps local governments, who are charged with developing large areas, to improve the experience for those who use that area. Shopping malls, apartment blocks, leisure areas, streets and paths are a few examples. Lighting is an essential part of improving the quality of life in developing nations.

STC can employ a “land and expand” strategy with their customers. They offer services to optimize the customer experience, creating potentially strong relationships that result in future transactions. As lighting can also demand high margins due to the aesthetic and technological advancements made by STC, it represents a significant opportunity for high growth.

Electrical components remain a trusted and reliable source of revenue for STC, though due to their generic nature, margins are likely to be low. Nonetheless, demand for components is ever-increasing, and diversity of revenue somewhat protects company earnings.

STC purchase raw materials from third parties. They have control over manufacturing, occurring in Malaysia and China.

They aim to sell directly to customers as much as possible, with recent efforts to improve this, but remain reliant on wholesale to retailers for many products (no customer represents over 10%).

Distribution relies largely on external freight, though they have South Asian distribution capabilities.

Financial Strength and Capital Allocation

STC have a strong balance sheet that has improved in a reliable trend since 2015.

Notable features are tabled below.

Their return on equity for FY20 was 3.21%. While the year was COVID affected, the company have earned only modest returns since 2017. They have been in the process of divesting their unprofitable “process equipment” segment, and it appears probable that future returns on equity, earned from their lighting business, will be higher.   

Capital is consistently allocated into research and development- the amount spent in FY20 was 6.27mRM, compared to 12.9mRM net profit.  They also increase the core capacity of their business via acquisition of property, plant, and equipment, spending 15% of net profit in FY20 and 30% FY19.

STC have entered new lines of business with varying results. Despite their failure in process equipment and their unimpressive ROE, they have managed to perform well enough to keep the business secure. The decision to divest their process equipment, and the original move to pursue LED lighting, are examples of strong capital allocation decisions by STC.

Dividends have yielded between 1.05% and 3.98% in the past 5 years. The company made a significant buyback in Q1 ‘20, with excellent results.

Risks and Threats

Competition: Many of STC’s products are generic and easily replicated. Many other businesses could serve their customers. Should the company fail to deliver worthwhile value to their customers, there is little to prevent them from shopping elsewhere.

This is somewhat mitigated in cases where products are integrated into customer’s infrastructure, causing higher switching costs. STC aim to avoid allowing their products to become generic by remaining innovative.

Demand: STC heavily rely on sales in Malaysia and China. The broad trends that benefit demand in these regions could cease due to unforeseen events. The more that STC can diversify geographically, the lower the demand risk. 

Manufacture: Adverse events in manufacturing include accidents, faulty products, and manmade or natural disasters. Adequate safety procedures reduce the risk of physical destruction or injury, but it can be more difficult to ensure consistency of products. A manufacturing error that results in products failing, especially in the case of electrical components, could severely damage the company’s brand.

Brand: STC’s brands can be damaged in other ways. Products may be poorly received or fail to deliver sufficient value to customers. Aggressive marketing efforts can backfire, projecting an undesired brand image. And adverse events like worker complaints or litigation can be spread in the media and negatively impact STC’s brand. If their brand is damaged, they may lose pricing power resulting in a contraction of margins and an inability to compete.

Substitute services: Electronic technology is constantly evolving. While LED’s remain the best lighting solution available, this may change. STC must remain engaged, adapting with technological evolution. Their history indicates that they can achieve this.

Management: It is unlikely that the four senior management positions held by the founder’s family members were awarded to the most skilled potential candidates. While a family connection can provide superior motivation and cohesion, it may indicate that the company does not always employ the best person for the job.  

Valuation

Over the last 5 years, STC have traded at a PE multiple of about 10. They are priced as a manufacturer of generic components with an unremarkable ROE. Their process equipment and electrical component segments are well matched to such a valuation.

However, their lighting business is increasingly technological. It provides greater intangible value to the consumer, with innovative aspects and potential brand power. While not reported, it appears likely that lighting produces higher margins and a greater ROE. Should this segment dominate company revenue, the value placed on their future earnings should become higher.

Additionally, STC may benefit from broader economic recovery. Socioeconomic growth demands further infrastructure, including STC’s products. While this could generate company growth, it may also expand valuation multiples in the Malaysian market overall. There is a potential for a simultaneous growth in company income, and a greater future value to be placed upon those earnings.

On the other hand, poor economic conditions would negatively affect the company in the same way. Earnings would decline, margins may contract, and the price multiple could lower. The tangible value of the company, by my estimation, is 117mMR. With a current market cap of 238mMR, the value of company shares could be cut in half.

Conclusion

STC are an experienced group. Their business has adapted over the decades and maintained a fair level of success throughout. The current state of the business is focused on creating innovative, intelligent lighting products for a global market, while maintaining their manufacture of other electronic components.

Demand for lighting is growing rapidly as emerging markets develop- quality lighting provides significant value to consumers. By differentiating their products with advanced technology, they may earn significant returns, although ambiguous reporting means that results are unclear.

The divestment of a previous business has contributed to falling revenue for the last 5 years. With the added disruption of COVID, predicting the future of STC’s earnings is difficult. There is a case to be made that their lighting business is primed to deliver positive results- they have spent 10 years refining LED products and have a foothold in many countries.

STC cut costs during COVID and are experimenting with new marketing strategies. They made an excellent buyback when the share price was lowest. They have a strong balance sheet and proven capital allocation strategies, with ongoing investment in their core capacity and research and development.

Catastrophic disasters are unlikely to befall STC. The biggest threats are their competitors and the demand conditions in Malaysia and China. If demand does not continue to grow at a sufficient rate, the already intense competition between products will increase further. Pressure on margins could yield more unremarkable results for the company.

They are valued appropriately for a company in the electronics manufacturing industry with their current earnings. Their downside is protected by a history of resilience, and reliably valued assets worth half their current valuation. Should STC succeed in expanding margins and growing revenue, their future earnings should be given a higher valuation. They could also benefit significantly from improved economic condition.