Excerpts from analyst's report
DBS Vickers analyst: Paul Yong, CFA
|Cheung Woh is a HDD (Hard Disk Drive) component manufacturer. The Group is a main supplier to leading global HDD manufacturers - Seagate Technology and Western Digital Corp. At 5x FY Feb 2015 earnings and dividend yield of 7%, valuations are attractive if the group can sustain its earnings.
» Cheung Woh is an established manufacturer, backed by more than 40 years of expertise in the demanding HDD space. Through its manufacturing facilities in Johor and Penang, Malaysia and Zhuhai, China, the Group operates two main business segments: (1) HDD Components business accounts for 80% of Group revenue, while (2) Precision Metal Stamping Components business accounts for about 20%.
» Despite the challenging operating environment, Cheung Woh was able to turnaround from a loss of S$1.5m in FY13, to a small profit of S$1.1m in FY14, before registering core net profit of S$12.6m in FY15 - driven by strong demand from a new key HDD customer. This was supported by a 40% increase in capacity between FY13-15, and production lines operating at full capacity.
» To maximize output and efficiency, the Group aims to keep utilization rates between 90-95%. However, Cheung Woh will invest S$6m across FY16 and FY17 to fund the construction of a new building, which would allow for future expansion. Given that it has good visibility on its orders through its proprietary 16-month rolling forecast, it can scale up its operations quickly to mop up excess demand - aided by its ability to add on new capacity in as little as 3 months, after construction works on the new building are complete.
» Lower-capacity HDDs (2½” drives) that are used in the consumer segment (i.e. laptops, tablets, etc) are increasingly substituted by SSDs as the latter is not only lighter (on average, HDDs weigh 9-10x that of flash-based SSDs), but also quieter and faster.
However, the role of HDDs in the technology storage industry are not likely to be eliminated as high-capacity HDDs – as opposed to high-capacity SSDs, are the mainstay in the enterprise segment. Only costing approximately 5% that of high-capacity SSDs, these high capacity HDDs are considered the most cost effective on a dollar/gigabyte basis to end-users (i.e. banks, data centres, etc) and are in high demand in the enterprise segment (i.e. data centres).
» Although the demand for high-capacity HDDs (in terms of volume) is likely to remain flat between 200-300m units p.a. over the next decade, the technology roadmap for HDDs suggest that HDD manufacturers will focus on growing per unit capacity (memory size/HDD unit) rather than output capacity, which should drive ASPs upward. Given its technical prowess, Cheong Woh is well-positioned to capitalize on the long-term earnings potential of the HDD industry, as it continues to innovate alongside HDD customers.
» At present, Cheong Woh has at least one new HDD component pending introduction to the market in CY16 - when its key HDD client officially launches its new HDD product.
» Cheung Woh did well in anticipating the growing preference for alternative forms of storage media among retail consumers, as it began to downplay the production of VCM (Voice Coil Motor) plates and Air Combs used in 2½” HDDs from about 4-5 years ago, in favour of the higher-performing 3½“ and ESG (Enterprise Strategy Group) variety.
» Today, most of the Air Combs produced by Cheung Woh are for use at data centres, with only 20% of total Air Comb revenues contributed from the 2½“ HDD division. Going forward, in terms of volume, both the Air Comb and VCM businesses are likely to be sustained at current levels – consistent with the outlook for HDDs. The price ratio of VCM: Air Comb is also expected to remain unchanged at 1:5 as price declines are highly unlikely, given the high barriers to entry.
» Unlike the HDD components business, the precision stamping components business is not a niche segment for Cheung Woh and is challenged in terms of growth. The company’s pricing power is also weaker for this segment due to the broader customer base. In order for this segment to grow meaningfully, Cheong Woh has to identify alternative avenues of expansion within this space (e.g. develop frame and bracket components for LED light source customers). Meanwhile, Cheung Woh’s advanced technical know-how in the precision stamping business allows it to pass on cost advantages to its customers. Resultantly, this segmental profit should continue to serve as a relatively stable and consistent source of dollar earnings for the Group.
|"Valuations are undemanding at 5x FY15 EPS and 0.6x FY15 book, against an attractive dividend yield of 7%. If Cheung Woh is able to maintain its earnings and dividends similar to FYE Feb ’15 levels, valuations does seem attractive." -- Paul Yong (photo)|
» Cheung Woh strengthened its net profit margins at both the HDD business level (from -12.9% in FY13 to 13.2% in FY15) and Group level (from -0.3% in FY13 to 13.7% in FY15). Net profit margins for the precision metal stamping business however, fell y-o-y to 15.3% in FY15 due to the weakening of the RM against USD, in which majority of the segment’s intercompany payables are recorded.
» Key risks: (1) Sustainability and growth potential of Cheung Woh’s earnings is largely pegged to its ability to innovate its HDD component products successfully, in accordance to the HDD industry’s technological roadmap. (2) Upside to the precision metal stamping components business, if any, is uncertain in the near-term and will be dependent on the Group’s ability to secure clients from other sectors. (3) As the majority of Cheung Woh’s earnings are exposed to the HDD sector, it will be impacted by demand weakness in the segment.