Despite its share price more than doubling over the past year, we believe that this under-researched gem has further upside potential amid rising car production by global automakers and increased chip content in vehicles. Among the initiatives taken to capitalize on these trends include i) Massive RM75m-80m/p.a. CAPEX plans over the next two years ii) Developing technologies to take on more complex/higher margin products iii) Increase operational efficiencies and greater economies of scale. We are estimating FY17/FY18E net profits of RM38.8m/RM44.3m (+26.5%/14.1%) and are initiating coverage on KESM with an OUTPERFORM rating and a Target Price of RM15.20 based on 15x FY18E PER.

Betting big on the automotive segment. KESM’s foray into the Testing Services business over the years has begun to bear fruit and KESM now enjoys a market-leading position as the largest independent “Burn-in & Test” services company in Malaysia. Through its acquisition of the remaining 34.6% equity interest in KESM Test for RM35.0m (May-2015), KESM now has a stronger foothold in the high growth automotive semiconductor market – an area of high growth at a 2014-2019E CAGR of 4.9%, far outpacing the computer and consumer segments which are only expected to grow at a pace of 1.5%-2.8%.

In a sweet spot. We believe that KESM is uniquely positioned to benefit from two salient trends: i) Rising car production by global automakers (Global light vehicles sales are expected to reach 93.8m units in 2017 (+2.7%) and accelerate at a 2016-2020E CAGR of 2.8%) and ii) Increased chip content within vehicles where the value of electronics is expected to grow from US$315 in 2012 to US$385 by 2017. Currently, the automotive semiconductor business already accounts for sizeable 70- 80% if KESM’s revenue base (UNISEM:17% and MPI:24% as at the latest quarter).

CAPEX plans are expected to more than double to RM75-80m for FY17E/FY18E (FY16: RM30m), the bulk of which is in testing equipment for automotive semiconductors. We believe this will provide a c.10% increase in overall capacity p.a. Given the longer product life cycles of 3-7 years for automotive semiconductors (compared to 1-7 years for the commercial segment) and recurring nature of the business, we also envisage that KESM will also benefit from better long-term earnings visibility and smoothened quarterly delivery.

We expect FY17-FY18E net profit to grow by 26.5%/14.1% to RM38.8m/RM44.3m on the back of 10.3%/11.7% revenue growth (RM315.1m/RM351.8m). Our revenue assumptions are based on i) Organic growth via capacity expansion of its testing services, which will increase overall capacities by 10% ii) Assume overall utilisation rate to maintain at 80% iii) Higher ASPs given the increasing complexities of chips being tested. We also expect EBIT margins to expand by 1.3ppt- 0.2ppt for FY17E/FY18E to 14.1%/14.3%, taking into account and increase in operational efficiency and as a result of automation and economies of scale.

We initiate coverage on KESM with an OUTPERFORM call and a target price of RM15.20 based on the ascribed 15x PER over FY18E EPS of RM1.01. Our valuation is in-line with local OSAT players MPI and UNISEM, both of which we recently assigned up-cycle valuations in view of the industry’s recovery and favorable macro-economic factors.

Source: Kenanga Research - 25 May 2017