Venture - Many Faces of Growth

Research report dated January 10, 2018

BUY

Share Price SGD 21.45
12m Price Target SGD 27.50 (+28%)

Company Description
Venture is an EMS and ODM provider with manufacturing facilities in Singapore, Malaysia, and China.

Statistics

Price Performance

Source: FactSet

FY17E not a blip; breadth of new growth

We initiate coverage of VMS with a BUY and TP of SGD27.50. We believe VMS' estimated 39% revenue surge in FY17E is no fluke and the Street may be underestimating forward revenue and margins. Our analysis suggests further increases for both, sustained by multiple sources of growth: 1) we believe VMS benefitted from outsized orders from certain customers' bigger COGS wallets. As VMS' allocations are still a tiny part of their COGS, we believe they may not have peaked; 2) VMS' ramp-up of new products with high R&D content is still in the early stages and should get stronger; and 3) new customers and projects provide a medium-term pipeline. Our FY18-19E EPS is 17/20% higher than consensus. We value VMS at 18.8x FY18E P/E, a 10% premium over its global high-mix, lowvolume peers, given our estimated 21% EPS CAGR for FY17-19E vs 12%.

Expanded allocations sustainable

We expect VMS' FY17E revenue to grow 39% YoY. Importantly, our analysis of its revenue and customers suggests it likely won significant allocations from a few existing customers. Our shortlist of probable customers includes Broadcom, Thermo Fisher and Honeywell. All have hefty margins and either large sales or materially higher sales since 2015. For example, consensus FY17E COGS for an enlarged Broadcom-Avago is USD9.1b, 3x Avago's pre-merger USD3.3b in FY15. Broadcom was not a customer prior to the merger. Broadcom opened a global warehouse in Batu Kawan, Penang, in 2017 to facilitate the export of export USD16b of products, nearly 80% of FY18E revenue. It plans to invest USD1b over 10 years on its local supply chain. VMS' manufacturing facilities are largely based in Malaysia and bought 30.6 acres of land in Batu Kawan in 2016.

Higher R&D content, with higher margins

We believe VMS has also ramped up products with high R&D content. There was a pick-up in its R&D expenses in FY15 that preceded its FY17E revenue growth. Recently, VMS has been beefing up its capabilities in radio frequency (RF), optics, biology etc. Its recent upgrade of netmargin guidance to 6-10% from 6-8% signals that its business mix is tilting towards higher-margin products with more design / R&D content.

Possible contributions from new customers

Channel checks suggest VMS may have won contracts for smokeless cigarette devices from a tobacco giant, and smart toothbrushes from a prominent high-end consumer-appliance company. If true, we estimate each to contribute 2-3ppt of FY18E revenue growth each.

Value Proposition

  • An EMS that has been consistently creating value for its customers. Able to design complex industrial products and reduce time-to-market.
  • As such, it is able to price products for industry-leading profitability and productivity, despite cutthroat competition.
  • Good diversification with 180 active customers, many of them blue chips.
  • Good exposure to test & measurement & life-science customers, still largely underpenetrated due to regulatory requirements and high specs
  • FY17E ROIC of 14.6% to exceed WACC of 6.1%

Industry-leading profitability and productivity

Source: Bloomberg, companies

Financial Metrics

  • Revenue driven by allocations from existing customers & new projects. Could include smokeless cigarette devices & smart toothbrushes in near term.
  • Operating margins should continue to expand from more products with higher R&D content & operating leverage.
  • Net cash since 2008. Rising FCF in FY17-19E could provide upside for dividends.

Rising profitability & cash flow as revenue ramps up

Source: Company

Price Drivers

Historical share price trend

Source: Company, Maybank Kim Eng, Factset

1. US economic weakness and disruption from customers' M&As.

2. Street rasied TPs for the first time in two years following strong 3Q/4Q16 earnings.

3. Strong 2Q17. Increasing market familiarity with VMS' potential from Illumina and cloud & 5G network spending.

4. CEO Wong Ngit Liong bought 400,000 shares at SGD15.26

5. Strong 3Q17; management raised net-margin guidance

Swing Factors

Upside

  • Better-than-expected reception for high-growth products
  • Strength of US / global economy.
  • Moderate USD strength as VMS' revenue is entirely in USD.

Downside

  • M&As among customers. Acqusitions of VMS' customers by others could disrupt or discontinue orders.
  • Excessive USD strength may erode competitiveness of VMS' customers. Excessive USD weakness may weaken its SGD earnings.
  • Customer demand for VMS to hold more inventories at its major hubs. This will tie up working capital.

1. Investment Summary

1.1 Breadth of new growth: higher revenue + margin

We believe VMS is on track to finish 2017E with 39% YoY revenue growth to SGD4b. VMS has not provided much clarity but we estimate that: 1) 13ppts likely from the organic growth of other customers in its TMO (Test & Measurement/ Medical & Life Sciences/ Others) and N&C (Network & Communication) businesses; 2) 25ppts from higher allocations by existing customers; and 3) 1ppt from its remaining P&I, RSSIP, CPDS segments (discussed further in Section 4).

If we are right about this split, then 2017 should not be a fluke. None of these drivers appears to have peaked and the Street could be underestimating growth from its existing and new customers. Our FY18-19E EPS is 17/20% higher than consensus, premised on: 1) higher allocations from customers' bigger COGS wallets; 2) a ramp-up of products with greater R&D content; and 3) new customers and projects. Importantly, management has raised its net-margin guidance, signalling a possible shift towards higher-margin products with greater design / R&D content.

For the avoidance of doubt, our conclusions in this report are based on our analysis and investigations. The thesis has neither been confirmed nor denied by management.

1.2 Expanded allocations from bigger customers wallets

We think the largest portion of its revenue growth in FY17E should have accrued from customers with bigger COGS since 2015/16. Our shortlist of probable customers includes Broadcom, Thermo Fisher and Honeywell. All have hefty margins and either large sales bases or have increased their sales materially since 2015.

Of its customers in TMO and N&C that have materially bumped up their COGS, Broadcom's spike has been the sharpest. Consensus COGS forecast for Broadcom is USD9.1b, up 3x from USD3.3b in FY15. This follows its 2017 merger with Avago, which was already an existing VMS customer. We understood from VMS that Broadcom was not a customer prior to the merger. (All global peers' and global customers' stocks mentioned in this report are Not Rated by MKE).

We single out Broadcom because:

  1. VMS has a track record of bagging increased orders from customers after their M&As have settled. This is on account of its strong execution.
  2. VMS' manufacturing facilities are largely based in Malaysia. This complements Broadcom's plans to improve its supply chain in Malaysia. Broadcom's supply chain, which includes VMS, is expected to benefit from the opening of its global distribution warehouse in Batu Kawan, Penang in Sep 2017. This was set up to help export MYR65b (USD16.2b) of Broadcom products from Malaysia in 2018E, making up about 77% of its consensus FY18E sales.
  3. VMS bought a 30.6 acre plot of land in Batu Kawan, Penang in 2016 to cater to future growth. This is close to Broadcom's warehouse.

1.3 Higher R&D with higher margins

We also think FY17E revenue growth could have been from a ramp-up of higher-value projects. VMS spent more on R&D in FY15. Historically, increases in R&D precede its sales growth by 1-2 years. More recently, VMS has been beefing up its capabilities in biology, RF, optics and software. It also upgraded its net-margin guidance to 6-10% in its 3Q17 analysts' briefing from its historical run rate of 6-8%. This signals that its business mix could be tilting towards higher-margin products with greater R&D content. Such products should include Illumina's NovaSeq, which we think may be further ramped up in FY18E.

1.4 Scoping the possibilities of new customers and contracts

Several industry sources suggest that VMS may have been selected by a tobacco major and a premium consumer appliances maker to work on smokeless cigarette devices and a smart toothbrush respectively. If market speculations are true, working off exchange filings by the tobacco major, we estimate that this customer may have contributed SGD50-70m in revenue to VMS in FY17E, and full year contributions in FY18E could be up to 3x as large. The second customer's contributions are likely to stream in only in FY18E, at the earliest, as it has several products for launch in 2018. We factor in 2ppt contributions to VMS' revenue growth in FY18E from smart toothbrushes. We clarify that VMS has not confirmed its participation the value chain of these two customers.

1.5 Valuation

Our TP of SGD27.50 is based on 18.8x FY18E P/E, a 10% premium over its global high-mix, low-volume peers' 17.1x. We think our premium is reasonable, given VMS' potentially stronger FY17-19E EPS CAGR of 21% vs 12% for the latter. Our valuation is supported by ROE-g/COE-g valuation. Using an average FY17-20E ROE of 18%, COE of 6.5% and FY18E BVPS of SGD8.25, we arrive at a fair value of SGD29.30.

2. Focus Charts

Fig 1: VMS’ revenue grew faster than that of its well-known customers for the first time in over a decade

Source: Company, Maybank Kim Eng

Fig 2: Some SGD467m of its FY17E sales growth remains largely unaccounted for

Source: Company, Maybank Kim Eng

Fig 3: We think it likely sprang from a ramp-up of products with higher R&D content…

Source: Company

Fig 4: ...and operating leverage, likely from allocation gains

Source: Company

Fig 5: This led to a spike in its profitability…

Source: Company

Fig 6: … which, in any case, has been industry-leading/strong>

Source: Bloomberg, companies

3. Corporate Information

VMS is an EMS provider with operations in Malaysia, Singapore, China (Shanghai), Europe and the US. About 90% or 382,024 sqm of its owned properties is in Malaysia. Of this, at least 123,706 sqm is vacant, to cater to future growth.

VMS traditionally excels at providing turnkey solutions for complex industrial products. These include R&D, design and assembly. Its mission is to create value for its OEM customers by reducing their total costs of delivery, not necessarily via lower dollar costs but reduced manufacturing efforts and time. As VMS is a pure assembler and not vertically integrated, it purchases the bulk of its raw materials. These make up some 80% of its product costs.

VMS serves mostly industrial clients, in contrast to most Singapore-listed contract manufacturers which serve end-markets. As such, revenue seasonality is minimal. Its 1H:2H sales mix is typically 45:55.

VMS disclosed in its 3Q17 earnings briefing that 65% of its revenue had some element of design content. We believe it will increasingly focus on jobs with higher engineering, design and R&D content.

Fig 7: 2016 revenue split and typical customers

Source: Company, Maybank Kim Eng

Fig 8: Milestones

Source: Company, Maybank Kim Eng

4. FY17E Not a Fluke; Multi-Faceted Growth Prospects

We believe VMS likely finished 2017E with 39% YoY revenue growth or +SGD1.1b to SGD4b, after posting 9M17 revenue of SGD2.9b. This would be a phenomenal increase. As VMS does not break out its revenue, the origins of much of its growth are unclear. However, we believe that understanding where it comes from could give crucial insights into its revenue sustainability and growth prospects.

This is what VMS has articulated about its revenue increase so far:

  • Growth was broad-based in 3Q17, from more than 60% of its customers.
  • There has been ramp-up of several high-growth S-curve products. Illumina's NovaSeq is only one of them. VMS has remained mum on its remaining high-growth products.
  • More than 65% of its 3Q17 revenue was from products with design content. VMS said this was a large improvement from two years ago, although it did not disclose its prior base.

Through our investigation and analysis, we believe that 2017 benefitted not only from a ramp-up of a few S-curve products but more importantly, increased allocations from existing customers. The latter likely played the most important part. Both sources should sustain VMS' profit momentum.

4.1 Behind 2017's revenue increase

Segmentally, we think that TMO and N&C spearheaded VMS' 2017 revenue growth. We estimate that their combined revenue grew 62% (Fig 9). Of VMS' 39% YoY revenue growth, we estimate that:

  • 13ppts came from 105 customers, including five added in FY16, in its TMO and N&C businesses. This is based on our assumption that existing customers' revenue grew 15%, slightly higher than the FY12-16 CAGR of 11%, in view of a cyclical recovery in 2017 (Fig 11).
  • 25ppts from higher allocations by existing customers. The bulk could have been from their increased COGS wallets and / or a ramp-up of high-value products with higher R&D content. We think this forms a solid basis for growth in FY18-19E. Of the 25ppts, we think 5ppts or SGD144m were related to Illumina's NovaSeq (Fig 21).
  • 1ppt or SGD33m from its remaining RSSIP, CPDS, P&I segments.

Fig 9: TMO and N&C likely ramped up

Source: Company, Maybank Kim Eng
  • Of all its businesses, we think that TMO and N&C will continue to lead growth.
  • This is because P&I, RSSIP and CPDS are already mature businesses. Their sales declined by a compounded 6% in 2012-16. Management guides for stable sales in FY17E.
  • VMS' TMO products have the strongest secular-growth prospects in its stable. N&C is also benefitting from data-centre and infrastructure spending to boost network capabilities.

Fig 10 : Revenue growing faster than the average of its well-known customers in FY17E

Source: Bloomberg, Maybank Kim Eng
  • 2017E was the first time VMS' growth far outpaced the average of its well-known customers in at least a decade
  • Its well- known customers' revenue grew by an 8% average in 2017E, based on consensus forecasts.

Fig 11 : The bulk of its FY17E sales spike likely came from higher allocations rather than new customers. This implies greater stability and sustainability

Source: Company, Maybank Kim Eng
  • Our analysis below suggests that about SGD733m of its revenue increase of SGD1.1b in 2017E stemmed from outsized order allocations by a handful of customers.
  • In FY16, VMS' sales per customer in TMO and N&C were SGD18m, up from SGD14m in FY15 and SGD12m back in FY12.
  • Assuming each customer's sales grew by a generous 15% YoY (FY12-16 CAGR: 11%) given the cyclical recovery in 2017, sales per customer should have reached SGD20m in FY17E for total sales of SGD2.1b for VMS.
  • But at 3Q17's run rates, these two divisions could have generated SGD2.9b in 2017E. The difference of SGD733m - SGD2.9b minus SGD1.8b - would be over and above its customers' 15% organic growth.
  • What if we assume it came from new customers? At a normalised SGD20m sales contribution per customer, it would mean VMS added 36 new customers in 2017: (2,879-2,146)/20.
  • Such customer additions are extraordinary in any year and are highly unlikely, in our view. We believe VMS more likely won very large allocations from a few key customers.

Fig 12 : Arriving at "unaccounted" sales growth

Source: Maybank Kim Eng
  • Who could these be?
  • As suggested by management, Illumina, which makes NovaSeq, could have been one of them. We estimate Illumina's NovaSeq FY17E revenue at SGD140-150m.
  • Industry sources also point to the possibility of smokeless cigarette devices (Device I). If so, we think their potential revenue contribution was SGD50-70m.
  • After deducting NovaSeq and Device I, SGD526m of VMS' higher sales in 2017E remains unexplained.

... & margin increase

Over the years, VMS has gradually improved its profitability, from a 2012 net margin of 5.8% to 9M17's 7.9%. It accomplished this through: 1) projects with improved pricing: 2012's gross margins of 20.3% to 9M17's 22.6%; and 2) operating leverage (Fig 14). By 3Q17, more than 65% of its revenue had design content, a marked improvement from previous years, according to VMS.

Management is confident that an improved product mix with greater design and R&D content could further lift its profitability. Reflecting this, it upgraded its net-margin guidance from 6-8% to 6-10% during its 3Q17 results briefing. In the past, VMS has roughly suggested that EMS/ODM/total solutions projects typically fetch gross margins of 15-18%/25%/40% respectively. A long-term shift in business mix towards higher-margin products should bode well for VMS.

We think its production of high-value projects may not have hit a steady state yet. This is because while its revenue started climbing in 4Q16, its margins only spiked in 3Q17 (Fig 13). Two possible reasons were:

  • VMS started producing more products with higher R&D content in 3Q17.
  • VMS could have factored in higher COGS in the initial phase of its ramp to compensate for possibly lower yields from higher wastage at the start of its projects.

Fig 13: As rising revenue has been accompanied by rising margins, we think VMS is producing and selling more high-value products

Source: Company

Fig 14: VMS, in the past, demonstrated operating leverage

Source: Company

5. Expanded Allocations Sustainable

We plumbed VMS' known customer base to shortlist potential customers for its 2017E revenue increase and gauge their potential future allocations. Our shortlist includes Broadcom, Thermo Fisher, Honeywell and ABB. If any were responsible for its revenue surge, their forward revenue outlook could then signal allocations coming along VMS' way.

5.1 Revenue surge most likely from customer reallocations

We believe that higher allocations from existing customers explain a large part of VMS' revenue surge. Our reasons are:

  • Discounting organic growth of the customer base, the potential surge in FY17E was in the ballpark of SGD500m. This would have been well above VMS' own average sales per TMO and N&C customer of SGD20m.
  • The spike is sharp, implying it is less likely to come from new relationships.
  • There are company-specific reasons that caused one or two of VMS' customers to change outsourcing allocations in 2017.

5.2 Our Shortlist customers

Customers responsible for the spike likely possess a few of the following traits:

  • Large COGS

  • Rapid growth prospects from new products in networking / life sciences, following technological developments

  • High gross margins

  • Company-specific reasons for reallocations

Among its known and large TMO and N&C customers, COGS for Broadcom and Thermo Fisher jumped the most in the past two years. We think this makes them highly likely customers from whom VMS may have won bigger allocations. Although consensus expects Broadcom's COGS to drop by USD0.8b in FY19E from FY17E levels, we think there remains room for VMS to win greater allocations from Broadcom. This is due to Broadcom's supply-chain development in Malaysia. Fig 15 also suggests that ABB, Honeywell and Thermo Fisher, with their expected revenue expansion, may increase their allocations to VMS heading into 2019E.

Fig 15: Based on their rising COGS, Broadcom and Thermo Fisher appear the most likely customers to have awarded more jobs to VMS in the past two years.

Source: Bloomberg

5.3 VMS' footprint matches Broadcom's strategic developments

In the past two years, Broadcom has been giving more and more priority to its Malaysian operations. We think this benefited and could continue to benefit VMS. Some 90% of VMS' owned 382,024 sqm of industrial space is located in Malaysia, about evenly split between Penang and Johor. Broadcom's Malaysian developments included:

  • In Jun 2016, its announcement of a USD250m investment in its Penang plant over 12 months. The money would be spent on R&D, new products, product testing & development and its global supply chain.
  • In Sep 2017, the opening of its new Global Distribution Warehouse1,2 in Batu Kawan. Malaysian Trade Minister Datuk Seri Mustapa Mohamed told the press that this warehouse is poised to help Broadcom export MYR65b (USD16.2b) out of Malaysia. This would account for 77% of Broadcom's FY18E consensus revenue. The minister also thought that local enterprises in supply chain and logistics could benefit. VMS makes most of its products in Malaysia. It bought a 30.6 acre plot of land in Batu Kawan in 2016 to cater to future growth.
  • In Sep 2017, an announcement of a MYR4.1b (USD1b) investment plan over 10 years to expand its supply-chain operations in Malaysia. These include global production planning, quality management strategic procurement and logistics management.

Footnote:
1. Broadcom chooses Malaysia for New Global Distribution Warehouse - http://www.mida.gov.my/home/4465/news/broadcom-chooses-malaysia-for-new-global-distribution-warehouse-/
2. Penang CM's opening speech of Broadcom's new warehouse - https://www.penang.gov.my/en/dmedia/359962-the-opening-ceremony-of-broadcom-global-distribution-warehouse-batu-kawan-industrial-park-penang

Fig 16: Announced M&As by well-known customers

Source: Various sources

6. S-Curve & Higher-Margin Products

We think another source of its revenue increase could have been a ramp-up of higher-value products after significant R&D work done since FY15. VMS refers to some of these products as having "S-curve" growth potential. This means when the technology is new, initial adoption is low. However, the growth of such products can turn exponential, from catalysts such as lower costs of use, improved user-friendliness in successive product generations and / or just from their gradual introduction into new markets. Their growth flattens only when they hit maximum penetration.

Aside from Illumina's NovaSeq, VMS has been tight-lipped on is high-value products.

That said, we observe that its R&D spending rose in 3Q14-3Q15, preceding its revenue spike in 9M17. While a risk is that a dip in R&D between 3Q15 and 3Q16 could limit the launch of high-value products in FY18E, we flag that its R&D spending remains the highest in a decade (Fig 18). In fact, a recent recovery in such spending could portend interesting product launches in 2019.

More importantly, VMS has been beefing up its R&D capabilities in RF, optics, biology etc and capabilities in software, development alliance and marketing. It believes these will strengthen its ability to create value in the design and / or R&D processes of its customers, thereby enhancing customer stickiness.

Fig 17: Rising R&D two years ago

Source: Company

Fig 18: Higher R&D spending historically precedes a revenue uptick

Source: Company, Maybank Kim Eng

6.1 Sizing Illumina's potential

Illumina is widely believed to be the leader in genome sequencing. VMS is the sole supplier of its game-changing NovaSeq 5000 and 6000 genome-sequencing platforms, launched in early 2017. We estimate that NovaSeq could contribute SGD144-193m to VMS' FY17-19E revenue, based on Illumina's public disclosures.

VMS' relationship with Illumina started in 2012, when they co-developed Illumina's NextSeq benchtop genome sequencer. This was launched in 2014. In 2015, VMS was once again selected to co-develop Illumina's NovaSeq platforms. NovaSeq was developed not just to reduce form factors but also optimise platform designs for manufacturability.

At latest (8 Jan 2018), Illumina had also announced a new desktop sequencer - the iSeq - which is aimed at sequencing germs. This sequencer is particularly useful for studying viruses, bacteria and other microbes. Given that VMS has had two successful projects with Illumina, we do not preclude that VMS may be a beneficiary of this new launch.

Why is NovaSeq exciting?

Genomics has come a long way in the past decade. Rapidly falling sequencing costs, to USD1,000 from USD10m, has enabled the proliferation of genome sequencing. That said, genome sequencing is still a nascent market limited to well-funded academic institutions, government bodies and a few commercial enterprises.

Illumina has a goal to bring costs down to USD100 eventually, which it hopes to achieve through its NovaSeq architecture. This is expected to trigger price-elastic adoption that could expand its market by leaps and bounds. Even within Illumina's current user base, NovaSeq's refresh cycle is expected to stretch over a few years.

Fig 19: Falling human genome sequencing costs is a democratising factor in personal medicine

Source: National Human Genome Research Institute

Fig 20: Selected technological advances in genome sequencing

Source: National Human Genome Research Institute, various sources

Sizing NovaSeq contributions

We make the following assumptions to estimate the size of NovaSeq's market, based on 2Q-3Q17 earnings calls:

  • Of about 350 NovaSeq units ordered in 9M17, 200 have been shipped since product launch early this year.
  • We assume Illumina is capable of shipping 80-100 units per quarter. Illumina will gradually work down its order backlog of more than 100 units, as it adds new capacity. This should limit its supply bottleneck as demand grows.
  • Two-thirds of NovaSeq's 9M17 sales were for the replacement of predecessor models Hi-Seq and Hi-Seq X. A third was from new users.
  • The launch of an S4 flow cell in Oct 2017 is expected to expedite migration from HiSeq X - with an installed base of 400 units as at end-2016 - to NovaSeq. This is due to improved economics per sequence on the NovaSeq platform.
  • Interest from new commercial customers is growing, from bigger capex budgets. Interest from academic labs is building up as grants get approved. These customers are expected to flow in from 2H17.
  • VMS is currently the sole supplier of NovaSeq, although we do not preclude Illumina finding a second source of supply as demand rises.
    • Fig 21: Sizing NovaSeq market and value accretion to VMS

      Source: Illumina, Maybank Kim Eng

      Fig 22: Illumina’s genome-sequencing devices

      Source: Illumina

      7. Scoping the possibilities of new customers

      Our channel checks also suggest that VMS might have been contracted to make smokeless cigarette devices for a tobacco major (Device I) and smart toothbrushes for a maker of premium consumer products.

      VMS did NOT confirm with us its participation in the value-chain of these customers. As such, the exercise in this segment is to scope out possible contributions from these customers, if market rumblings are true.

      7.1 Sizing the potential of Device I

      We estimate Device I's market size and potential accretion to VMS based on the following:

      • VMS may only be a second source for the tobacco major. We factor in contributions only from 3Q17, with a 35% wallet share, assuming this is reasonable enough for VMS to devote resources to its manufacture. VMS' customer expects Device I supply constraints to ease from adding VMS as its supplier. It expects to meet market demand fully by early 2018.
      • Starter kits are priced at SGD130-160 on Amazon Japan or a median of SGD145m. Its customer's profit margins are reportedly low, akin to those for razors and razor blades. We assume VMS can capture 40% of this value or SGD58. Our conservatism moderates the effects of any overestimation in other areas.
      • Device I's quarterly growth accelerated from a low base in 4Q16 to 43% in 1Q17-3Q17. Again, to be conservative, we model a decline, from 35% in 4Q17E to 20% by 4Q18E.
      • The global smoking population is 1.2b. According to Statista, this tobacco customer had a 44% market share in 2016. This would translate to half a billion potential users in the long run. We estimate 12.7m Device I users by end-2018, assuming QoQ growth rates of 20-30% (1Q17-3Q17 CQGR: 43%). This implies a 2.4% penetration rate for Device I.
      • Initial reception was strong in Japan, a big smoking market. Penetration of the heated cigarette exclusively used with Device I, in Tokyo hit 16% in Oct 2017, from just 10% in Jan 2017. Initial adoption in new markets such as South Korea and several European countries is also promising.
      • We believe Device I can generate repeat sales. The current generation of its heating device has a battery size that only holds one charge. Users must recharge it inside a larger device that contains a battery that holds 20 charges. Japanese users are known to be forced to buy two devices, to avoid waiting time for charging. Alternatively, as Device I's technology improves, replacement demand is expected.

      We underscore that VMS has not confirmed its participation in the Device I value chain, our estimates on market users, devices per user, value accretion to VMS and VMS' share of wallet may prove wrong.

      Fig 23: Device I has attractive growth prospects

      * 2Q17 device estimates are based on a 1Q17-3Q17 CQGR of 43%, compiled from Device I’s manufacturer’s disclosures.
      Source: Device I manufacturer, Maybank Kim Eng

      Fig 24: Device I is gaining traction in several markets

      Source: Device I manufacturer, Maybank Kim Eng

      7.2 Sizing smart-toothbrush potential

      We also attempt to size smart toothbrushes' potential value accretion to VMS, using the following assumptions:

      • VMS gets 2m unit orders in 2018E, as its customer is known to award orders in sizes of 2m units. For instance, an order of 6m units will be divided out evenly to three suppliers.
      • A SGD300 retail price per toothbrush. This customer's premium hairdryers cost SGD600 while its premium vacuum cleaners cost SGD500-900. High-end toothbrushes from other brands typically cost SGD200-300.
      • VMS can capture 15% of the selling price of this toothbrush, translating to SGD90m of potential revenue pa. This is close to the value captured by other EMS for other products from this customer.
      • Patented diagrams of the toothbrush indicate it has a small but powerful water jet to blast away debris. The toothbrush could also be equipped with sensors or a camera to detect where its handle is in relation to teeth. This is to alert users if they are brushing too hard.

      But as our sources suggest that this customer could have a busy 2018 with the launch of several new products, the launch of this toothbrush might be pushed out. As yet, it has not been announced by the customer. We also reemphasise that VMS has not confirmed its participation in this customer's value chain.

      Fig 25: The toothbrush’s patented diagram…

      Source: Daily Mail

      Fig 26: … features an inlet to store water

      Source: Mirror.co.uk

      8. Financial Analysis

      8.1 P&L: FY17-19E EPS CAGR of 21%

      We forecast revenue CAGR of 14% for FY17-19E. In FY17E, we think its revenue could increase 39% YoY, led by allocation gains, a ramp-up of high-value projects such as Illumina's NovaSeq and initial contributions from smokeless cigarette devices.

      In FY18-19E, we expect 16 / 12% growth, likely driven by momentum of reallocation gains. We also pencilled in possible contributions from Device I & smart toothbrushes and other new customers / projects.

      The growth should mostly stem from TMO and N&C. CPDS, RSSIP and P&I share of revenue have been dwindling. VMS has guided for stable contributions in FY17E. Owing to product maturity, we think they could resume their sales declines from FY19E.

      We expect EPS to grow 77% / 28% / 15% in FY17-19E, faster than revenue. This would reflect operating leverage and expectations of bigger contributions from higher-value products with better margins.

      Through persistent efforts to improve its revenue mix, VMS has gradually improved its gross margins, from 18.5% in 2008 to 22.6% in 9M17. We see upside as high-value products have yet to hit a steady state.

      Fig 27: P&L

      Source: Company, Maybank Kim Eng

      8.2 Balance sheet & cash flow

      Net cash as dry powder
      VMS had net cash of SGD407m in FY16. It has had net cash since 2008. Management wants to maintain this as it would have the firepower to expand working capital for further ramp-ups or buy distress inventories when these opportunities arise.

      Working-capital management
      We believe VMS' cash conversion cycle has peaked. From 118-120 days in FY14-16, we expect the cycle to fall below 90 in the next two years, as: 1) its customers increasingly opt for air-freight delivery amid a cyclical recovery. This should improve VMS' inventory turnover; 2) VMS has gotten favourable factoring terms from banks for its smaller suppliers to shorten its receivable days; and 3) it has been more selective in holding finished goods for customers.

      Capex
      We are pencilling in maintenance capex of SGD28-37m for FY17-19E, which are in line with its depreciation charges in FY12-16 as well as guidance.

      Fig 28: Balance sheet

      Source: Company, Maybank Kim Eng

      8.1 Dividen upside

      With improving cash flows and SGD32m proceeds from the sale of its 18.8% stake in Fischer Tech at the end of 2017, we see room for VMS to increase dividends from its current SGD0.50 pa. We forecast SGD0.60-0.70 for FY17-19E. This implies 52-42% payouts, still less than its 85% average in FY06-16, as there is a chance VMS may build a factory on its Batu Kawan land.

      Fig 29: Room for dividend upside

      Source: Company, Maybank Kim Eng

      Fig 30: Cash flow statement

      Source: Company, Maybank Kim Eng

      9. Valuation

      9.1 Premium for higher growth & returns

      Our SGD27.50 TP implies 18.8x FY18E P/E. This is a 10% premium over its global high-mix, low-volume peers like Plexus Corp and Benchmark Electronics. We think our premium is reasonable, given VMS' potential EPS CAGR of 21% for FY17-19E vs a consensus 12% for the latter. VMS has industry-leading profitability and productivity (Fig 34), a testament to its high-mix, low-volume execution, in our opinion.

      Our TP can be supported by ROE-g/COE-g valuation. A P/BV of 3.56x on FY18E BVPS of SGD8.25 implies a fair value of SGD29.30. This is based on an average FY17-20E ROE of 18% and COE of 6.5%, using a market return of 6.5% and beta of 1x. For the bulk of the past five years, VMS has traded close to its justified P/BV, except between 2016-1H17 when an average discount of 13% emerged. We think this was due to an under-appreciation of its return potential. We believe any discounts could narrow if and when management provides more clarity on its growth ecosystems, and strategic trajectory.

      Fig 31: Peer comparisons

      *Calculated as FY2 P/E over FY1-3 EPS CAGR
      Source: Factset, Bloomberg, Maybank Kim Eng

      Fig 32: 5-year P/BV band

      Source: Bloomberg

      Fig 33: Forward P/E in FY04-06 when EPS CAGR was 16.6%

      Source: Factset

      Fig 34: Industry-leading profitability and productivity warrant P/E premiums, in our opinion

      Source: Bloomberg

      9.2 Risks

      US / global economies
      VMS' financials closely track the health of the US and global economies. Its earnings may be hit by reduced orders from declines in end-user demand as a result of economic downturns.

      Customer cancellations
      & delays VMS faces risks from order cancellations and revisions, production delays, or even changes in sourcing strategies by customers. Large fluctuations in customers' product demand may also stress its resources. The marketplace success or failure of its customers eventually decides the fate of its business.

      M&As
      VMS historically faced poorer sales during waves of customer M&As, such as in 2011-13. During such times, orders from affected customers dry up as they rationalise their product portfolios and suppliers. Among VMS' global customers, Broadcom recently made an unsolicited bid for Qualcomm while Cavium announced a merger with Marvell. While VMS' sales may be affected by these M&As in the short term, it has never lost a customer. Typically, once its customers' supply-chain rationalisation is over, VMS wins higher allocations from the enlarged entities.

      Forex
      VMS earns all its revenue and pays for inputs in USD. Labour and utilities are paid in local currencies. Financials are reported in SGD. Since 2010, a 5% increase in USD against its functional currencies has had a SGD2m favourable effect on its annual net profits, ceteris paribus. VMS may book material FX losses when there are sudden and steep USD declines during its contract re-pricing intervals.

      Inputs
      Industry supply shortages of some components have been known to curtail product assembly for EMS providers. This may delay shipments and affect profitability. VMS may also have to bear price spikes for components in-between contracts, which will eat into its profitability.

      Competition
      The EMS industry is highly competitive, characterised by a few large global players and a long tail of small players. VMS does not just compete with EMS players but also the OEMs themselves as they weigh their insourcing / outsourcing options. VMS must constantly improve its capabilities not only in manufacturing but also design, technology and / or supply-chain solutions. It must also try to accommodate various customer requirements to retain relationships.

      Source: Company; Maybank