We came away from a management meeting unexcited about D&O’s 2019 outlook. While 2Q19 could see profit improvement as D&O reaps higher market share and impact from WLTP regulation subsides, management heeds uncertainty in 2H19 amid trade war. Its new plant should be ready by 2Q-3Q19, but machineries/equipment would only be in place next year as existing capacity is sufficient. Trim FY19-20E NP by 8-12% to RM41.5-50.2m. Maintain MP with lower TP of RM0.600.

Possible recovery in 2Q19... We believe the adverse effect of the Worldwide Harmonised Light Vehicle Test Procedure (WLTP) regulation on the European passenger vehicle sales has mostly subsided, as evidenced by the slowing pace of decline in April 2019 (-0.4% YoY vs. average of -8.1% YoY in the prior 7 months). In addition, we believe the group has been gaining market share in the automotive LED space lately, thanks in part to new interior applications – backlight unit (BLU) display used for infotainment systems. As such, we are sanguine that the group will post a commendable improvement in 2Q19 earnings YoY and QoQ.

...but 2H19 remains cloudy. Management has toned down its revenue growth guidance for FY19 from 10-15% to flat (in the worst-case scenario), as 2H19 outlook remains ambiguous amid intensifying US-China trade war, which could affect consumer sentiment and affordability of passenger vehicles. Nevertheless, we still expect to see an uptick in FY19 profit on a slight improvement in net profit margin, underpinned by better operational efficiency through lower headcount (reduced from c.2,400 to c.2,200 while maintaining output) and fully automating the visual inspection process (currently c.25% labour dependent).

New plant almost ready, but production won’t start so soon. The group targets to shift its office to its new plant by November 2019 post completion in 2Q-3Q19, and subsequently convert the existing office to a manufacturing facility (likely next year). Coupled with plans to increase manufacturing density (dense placement of machineries/equipment), the facility conversion should free up enough floor space to double production capacity. However, management did not provide any timeline as to when the group would expand production capacity in the existing plant, and any expansion will be on an as-needed basis. Meanwhile, the remaining floor space in the new plant will be reserved for capacity expansion in 1-2 years’ time. Fortunately, the incremental depreciation for the new plant is expected to be minimal at

Trim FY19-20E NP by 8-12% to RM41.5-50.2m as we tone down our earlier bullish automotive LED growth assumptions from 7-16% to 4-11% to account for cloudier global economic outlook amid heightened trade war tension. Additionally, we have lowered our FY19-20E GPM assumptions from 29.0-30.0% to 28.5-29.5% (still higher than 28.3% in FY18) to reflect heftier manufacturing overheads after a c.30% capacity expansion in late-FY18.

Maintain MARKET PERFORM with a lower Target Price of RM0.600 (from RM0.650) based on FY19E PER of 18.0x, in line with the valuation of its German competitor – OSRAM. While D&O offers exciting long-term growth prospects, we believe the trade war could affect consumer sentiment and spending on cars, at least in the short-to-medium term. Valuation also appears unattractive at current price levels.

Risks to our call include: (i) disruption of components supply, (ii) replacement/obsolescence of LED technology, (iii) sharp currency fluctuations, and (iv) adverse foreign labour policy.

Source: Kenanga Research - 12 Jun 2019