KCE Electronics Pub Co. Ltd. (OTC:KCEEY) [KCE:TB] is among the world's top five automotive PCB players whose share price has suffered a severe share price decline in the past year from short-term commodity and currency headwinds. As these near-term pressures are likely to be eased this year, the stock's valuations should re-rate positively, as investors focus on the long-term merits of KCE Electronics with respect to its market leadership, industry-leading margins and attractive growth prospects as a proxy for secular automotive trends. I arrive at a target price of Bt103.20 for KCE Electronics by applying a 16 times forward P/E to my estimated FY2019 EPS of Bt6.45, which implies a 33% upside to KCE Electronics' share price of Bt77.25 as of February 9, 2018.
KCE Electronics is a Thailand-listed manufacturer of printed circuit boards, or PCBs, that also trades on an OTC basis in the U.S. It ranks among the world's leading automotive PCB suppliers, and its clients include European and North American Tier-1 automotive suppliers such as Bosch (OTC:BSWQY), Delphi (DLPH), Continental (OTCPK:CTTAF).
Why It Got Cheap And Things Look Better This Year
Based on its share price of Bt77.25 as of February 9, 2018, KCE Electronics is currently trading 40% off its 5-year share price peak of Bt127.50 in December 2016. In the same period, KCE Electronics' profitability has substantially weakened, which saw its gross margin decline from 36.0% in 3Q16 (YE Dec) to 30.1% in 3Q17 (net margin down from 22.4% to 17.0% over this period) as the price of a key raw material, copper foil, accounting for roughly 10% of sales, surged and the Thai baht appreciated strongly against the U.S. dollar.
At the end of 2017, copper prices reached a new four-year high exceeding $7,300 per tonne (versus $4,500 per tonne at the start of 2016), driven by strong demand from China (the world's largest consumer of copper), and supply shortages due to labor strikes at copper mines. Looking ahead, weaker China demand (particularly the property market, Reuters' poll of analysts sees Chinese property prices flat YoY in 2018 as measures to tighten credit are potentially extended to Tier 3- and Tier 4- cities in China) should moderate the upward trend in copper prices. This is validated by the median of analysts' copper price forecast at $6,884 per tonne for 2018, based on Reuters data.
Another key factor contributing to KCE Electronics' weak gross margins last year was the strengthening of the local Thai currency. The USD:THB exchange rate hit a new 3-year high of 32.22 in early 2018, compared with an exchange rate of 36.00 at the start of 2017. This is largely attributable to strong investment inflows into Thailand (Bt47 billion baht net investment in Thai bonds in 2018 year-to-date) and U.S. dollar weakness. In response, Thailand's central bank governor issued a statement saying that it will "ensure local currency strength does not adversely impact certain businesses," suggesting that the central bank is ready to intervene if the Thai baht appreciates in a big way. This is hardly a surprise, since Thailand's central bank is motivated to act when needed as a strong Thai baht hurts Thailand's economy whose exports account for 70% of GDP. Furthermore, a significant portion of investment inflows into Thailand might reverse over time following the U.S. tax rate cut and the Fed interest rate hike, which should see the Thai baht weaken relative to the USD. Note that KCE Electronics does adopt a natural hedging strategy, where it pays for certain raw materials that are priced in USD with its foreign currency revenues (80% of sales denominated in USD), but there is still a mismatch since a lower proportion of KCE Electronics' costs are in USD.
I expect the pressures from copper price spike and the appreciation of Thai baht to ease in 2018 based on the factors mentioned above, which would be favorable for KCE Electronics. Nevertheless, I acknowledge it is difficult to predict commodity price and currency movements with 100% accuracy, so it is much more important to focus on KCE's strengths and the long-term structural tailwinds that it benefits from.
Competitive Advantages Validated By Superior Profitability
KCE Electronics' recent gross margin downtrend is not indicative of the quality of the company's business. On the contrary, KCE Electronics is one of the world's five largest automotive PCB manufacturers and its profitability is the highest among listed peers. As per the peer comparison table below, KCE Electronics boasts the highest gross margin, net profit margin and ROE among its peers both on a trailing twelve months (even taking into account the recent currency and commodity headwinds) and five-year average basis. In absolute terms, a net margin in the high-teens and ROEs in the 20-30% range will easily qualify KCE Electronics as a high-quality business.
|Symbol||Stock||Gross Margin-trailing 12 month||Gross Margin-5 year average||Net Profit Margin-trailing 12 month||Net Profit Margin-5 year average||Return on average equity-trailing 12 month||Return on average equity-5 year average|
|BAK:KCE||KCE Electronics Public Company Limited||31.4%||30.0%||19.0%||17.4%||26.5%||33.0%|
|BAK:SVI||SVI Public Company Limited||8.1%||10.3%||4.8%||14.4%||8.2%||30.4%|
|BAK:DELTA||Delta Electronics Thailand PCL (OTC:DLEGF)||25.8%||25.3%||10.4%||12.7%||16.7%||21.3%|
|NASD:FLEX||Flex Ltd (FLEX)||6.7%||6.1%||2.1%||1.6%||19.2%||17.2%|
|BAK:HANA||Hana Microelectronics Public Co. Ltd. (OTC:HMICF)||15.5%||12.6%||13.2%||11.8%||14.2%||13.3%|
|BAK:SMT||Stars Microelectronics (Thailand) PCL||10.1%||-0.2%||-13.2%||2.2%||-16.8%||8.4%|
|BAK:CCET||Cal-Comp Electronics Thailand PCL||4.9%||4.5%||1.1%||0.8%||6.9%||6.2%|
There are three key reasons why KCE Electronics is able to rank among the largest automotive PCB players globally and achieve superior profitability relative to listed peers.
Firstly, KCE Electronics owns a laminate production factory in Thailand via its subsidiary, Thai Laminate Manufacturer, to manufacture laminate and fiberglass, which are key raw materials for the production of PCBs. From a cost perspective, KCE Electronics is not vulnerable (as compared to its competitors) to price increases from third-party suppliers of laminate and fiberglass, which help to secure its high gross margins. With respect to customer satisfaction and retention, KCE Electronics is able to leverage on its own production facility for laminate and fiberglass to reduce production lead times with its own vertically integrated supply chain for laminate and fiberglass.
Secondly, the barriers to entry for the automotive PCB space are high. KCE Electronics' PCB products are used in the end-products of automotive brands like BMW, Mercedes, Chrysler, and Toyota, so the quality standards are high and Tier-1 automotive suppliers typically take a few years to qualify new suppliers and new production plants. An indication of the exacting demands imposed by automotive suppliers is that defect rates have to be below 6 pieces per million.
Thirdly, it is very difficult for new entrants to replace incumbents in the automotive PCB space, even assuming that they have acquired the technical know-how and invested the time and money to be qualified by Tier-1 automotive suppliers successfully. KCE Electronics was started in 1983 and the company has established long-term relationships with customers such as Bosch and Continental in the automotive PCB space. A Tier-1 automotive supplier typically only engages between two to four PCB suppliers, so it is challenging for a new entrant to grab market share from existing market leaders like KCE Electronics.
Capitalizing On Structural Tailwinds In Automotive
Arizton Advisory and Intelligence, a market research company, forecasts the global automotive PCB industry to grow at an 8.2% CAGR between 2017 and 2023 to achieve a market of size of $13.3 billion. The Arizton research report points out that "PCB has a wide range of applications in the automotive industry that include management of the engine, radar, entertainment systems, GPS, digital displays, mirror controls, and power relays timing systems." For example, advanced driving assistance systems (ADAS) to improve vehicle safety require more sensors powered by PCBs and the global automotive ADAS is forecasted to grow at a 2017-2022 CAGR of 21% driven by tighter government regulations and the increased proportion of premium vehicles installed with ADAS systems. Another automotive trend is the increased demand for connectivity and infotainment within cars need more complex PCBs to support centralized control management systems, and research firm Global Industry Analysts, Inc, expects the market for automotive infotainment systems to double from $27.2 billion in 2015 to $58 billion by 2024 as car owners get wealthier and are more willingly to pay for a premium in-vehicle experience. All of the above imply that demand for KCE's automotive PCBs should grow, as the number of electronic components in vehicles increases. To quantify this, Statista predicts that automotive electronics cost as a percentage of total car cost to increase from 30-35% now to 50% by 2030. As highlighted above, KCE Electronics is among the top five players globally and clients typically only rely on two to four suppliers, so this makes KCE Electronics a good proxy for automotive PCB growth.
In terms of product mix within the automotive PCB space, multi-layer PCB is expected to be the fastest growing segment due to "rising demand for advanced electronics such as windshield Head-Up Displays, camera modules, drive mode selector, and advanced telematics," according to a January 2018 report published on Research And Markets. KCE Electronics understands industry dynamics well and has been progressively shifting its product mix from lower margin double-sided PCBs to higher margin high layer count PCBs over the past few years. The revenue contribution of double-sided PCBs decreased from 29.7% in 2012 to 25.7% in 2016 (4-layer PCBs saw a smaller revenue contribution decline from 55.1% to 52.1%), while KCE Electronics increased its proportion of sales generated by PCBs with more than 6 layers from 15.2% to 22.2% over the same period.
I arrive at a target price of Bt103.20 for KCE Electronics by applying a 16 times forward P/E to my estimated FY2019 EPS of Bt6.45.
I expect KCE Electronics to expand its top line by a three-year CAGR of 11% from Bt13.8 billion in FY2016 to Bt18.9 billion in FY2019. The revenue growth assumption rate is reasonable, taking into account the company's 5-year revenue CAGR of 13.3% and Arizton's 8.2% 2017-2023 CAGR for the global automotive PCB space (KCE Electronics should grow faster than the industry as it shifts its sales mix to higher-value PCBs and takes market share from weaker competitors suffering from raw material cost pressures). I forecast that KCE Electronics will improve its net profit margin from 18.9% in the trailing twelve months period ended September 30, 2017 to 20.0% for FY2019 (assuming more favorable FY2019 copper price of $6,500 per tonne and USD:THB exchange rate of 34). This results in a FY2019 EPS of Bt6.45.
I have assumed a 16 times forward P/E valuation multiple, based on the median forward P/E peer valuation of KCE Electronics' peers listed below (excluding KCE Electronics and Star Microelectronics which is loss-making). As per my analysis above, KCE Electronics boasts the highest profitability among its peers, so a median forward P/E is relatively conservative.
|Symbol||Stock||Forward PE Ratio|
|BAK:SMT||Stars Microelectronics (Thailand) PCL||(12.5)|
|BAK:CCET||Cal-Comp Electronics Thailand PCL||10.1|
|BAK:HANA||Hana Microelectronics Public Co. Ltd.||13.3|
|BAK:DELTA||Delta Electronics Thailand PCL||17.0|
|BAK:KCE||KCE Electronics Public Company Limited||18.0|
|BAK:SVI||SVI Public Company Limited||19.9|
My target price implies a 33% upside to KCE Electronics' share price of Bt77.25 as of February 9, 2018.
The key risk factors for KCE Electronics are the cyclicality of the automotive end-market (structural tailwinds highlighted above, notwithstanding year-to-year volatility) and volatility in commodity prices and foreign currency exchange rates (difficult to predict but current negative outlook has been priced in).
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