Valuetronics hk: Start of the share price turn around?
Since the beginning of the year, we guided that 1H22 will be "weak and whippy" and that we should focus on "defensive value stocks." Althouth 1H22 was weaker than we thought, yet, our advise turned out to still be much better than average.
Our top picks have massively outperformed the markets. ET and VST are up more than 20% while the SPX is down 20%, and growth stocks down 50%. That's a whopping relative outperformance of +40% vs market.
Even Valuetronics outperformed! It started at 60 cents at the beginning of the year and dropped to 53 cents... "only" a 14% drop.
But we also guided that the Valuetronics story was for "later"... but has that "later" come?
We told the Valuetronics story a couple months ago and advised to wait and see because we knew the market couldn't get excited when management guidance sounded pessimistic, especially in the short term. We think it is a good time to recap the story now. "Later" seems to be quite close.
One defensive value stock that we believe has lagged but have great potential at this time is Valuetronics. While most stocks have exceeded their pre-pandemic sighs (even after the 20% drop in the S&P500), Valuetronics has not because of it's unique own story. We believe it to be good reward-to-risk to take profit on some ET and VST and shift it to a stock like Valuetronics.
This is a deep value stock with good cash flow but is not a highly covered stock. Except predictable dividend yield while waiting for it's story to change, however, we think the story will begin to change this week as their report their earnings on 26th May 2022, Singapore premarket.
Valuetronics is a highly regarded EMS headquartered in HK with manufacturing capabilities in both China and Vietnam (recently operational!), but listed on the Singapore exchange.
Here are a snap shot of their capabilities and key milestones.
Notice the trend of the earnings per share?
Though somewhat cyclical, they trend up over time. No doubt based on the management's conservative style of growth, where they believe in finding high quality clients to build for, coupled with great financial discipline.
In terms of longer-term value investing, it's hard to find a better candidate. Valuetronics has never turned in a negative EPS year, even during the 2009 financial crisis and 2020 COVID crisis. By and large, their NAV and net cash has trended up over time. This is what you want to see as a Value-Investor... a cash flow company that grows it's NAV over time while still giving dividends.
We believe this will continue as long as present management remains.
Why then is Valuetronics share price been consolidating for almost a year and a half?
In fact, this downtrend line BEGS the question, at some point, there could be a breakout into a new trend, or at least the start of the formation of a bottom.
Will it breakout? Or, will price capitulate further, giving investors an even better price for a fundamentally sound stock?
We believe that either case will be catalyzed THIS WEEK: Valuetronics reports 2H21 earnings on 26th May 2022 Singapore premarket.
Understanding Valuetronics's story is critically important to being able to optimize your investment going forward, and have conviction to make moves as the price moves.
Important Story Points lost in the numbers:
After recovering from the initial COVID crash starting March 2022 that affected global markets, the downtrend started.
REASONS for the DOWNTREND
This downtrend was primarily due to firstly:
1) Because of the US-Sino trade war, some US clients had to move their business out of China. This caused a permanent loss of business (with those particular clients).
2) More recently, even after taking those losses of business, 1H22's earnings (end Sep 2021) were affected by the disrupted supply chain. This decreased margins and also increased working capital. You can see this effect by the net profit drop from 96M hkd to 57M hkd between 2H21 and 1H22, a 40% drop.
In addition, management also guided that the global components shortage will "continue to erode the Group's profit margin in the NEAR TERM." Management left this approximation vague. Does this mean that margins will be a little or significantly worse than 1H22 or does it mean the impact will be the same? 1H22 already had a drop in margin. Perhaps "continue to erode" means margins will be equally impacted, and in that case we can actually model a BOTTOM in earnings per share? But it could also mean margins could get worse too... hard to get excited about that. Even more difficult for analysts to give buying recommendations in case margins are way worse than they could expect.
We did a deep dive in the financials of Valuetronics and built our own model so we could see the impacts over the years of the US clients leaving.
Here we show a small part of our model, indicating in red where earnings dropped because of the permanent leaving of some clients, and in yellow where earnings dropped because of temporary margin pressures due to supply chain issues.
REASONS to be BULLISH:
The FUNDAMENTALS are BUILDING for VALUETRONICS.
1) The bottom, or at least close to bottom annual runrate valuation is too cheap. assuming the price of Valuetronics to be $0.53 sgd, and using the net profit annual run-rate of 1H22's already weakened half gives us an a fw PE of 12x. Even more significant that could be missed by casual investors, Valuetronics has already amassed a great deal of net cash. At a market cap of about 231M SGD, Valuetronics holds about 160M GSD of net cash, or about 70% of marketcap.
Pause for a second.
This means that even though fw PE is 12x, the PE ex cash on that 1H22 weakened EPS is 3.5x-4.0x!
Valuetronics is very cheap and has one of highest margin of safety's around, especially in today's market where stocks (not growth stocks of course) had already climbed way past ore-pandemic highs, even with the recent 20% drop in the S&P500. Yet, the analysts were hesitant to recommend Valuetronics because they didn't have an obvious growth angle that is reflected in the earnings. I believe management's somewhat pessimistic statement of having margins "continue to be eroded" played a big part in it. If you want to be extremely conservative, PE ex cash will be 4x if you include current tax liabilities.
Also, cash might be increase over time as working capital becomes more efficient over time.
A PE ex cash of 4x means that the company could use it's own profits and cash and totally buy itself
out in 4 years.
It's hard to lose money on the long term with such profitability and valuation.
2) The systematic problems are mostly over.
All the US clients that were supposed to pull out because of the US-China trade war issues have already left. This means that the only primary "risk" is how big and how long margins will "continue to be eroded" due to global component shortage and labor costs.
3) Their Vietnam expansion is already operational.
This means two things: 1) the majority of CAPEX spent for the Vietnam expansion is done. 2) Valuetronics is now free to court US clients agressively.
4) They already managed to court 3 new ICE clients!
Management guided that they expect to be gaining revenue from these new clients in FY23. FY23 has just started. For context, at present, Valuetronics has only 8 ICE clients. Also, CE segment profit is 26M hkd and ICE segment is 108 hkd in 1H22. A simply linear extropolation of 3 more ICE clients to 11 implies an eventual increase of 30% total segment profit assuming those 3 clients are of average size, and they get to maximum utilization of manufacturing for those clients.
One uncertainty. Two growth elements going forward.
The short term continued "margin erosion" due to global component shortage. Will margins be even worse this half? Will margins stay eroded for another year? If so, it's possible for share price to dip further.
TWO growth elements:
Valuetronics can more agressively court US clients now that Vietnam is operational.
Eventually, the global component shortage will abate. Margins will get closer to historical, revenues should increase.
To get a sense of valuation, we make the following assumptions for us to get a benchmark.
We model 0% revenue growth for CE and ICE for 2H2022, and we drop segment margins for CE and ICE to 8% and 15%. We also increase staff costs by 8% for next year. (We are trying to be conservative.)
By 2H23 (1 year later), we increase CE margins from 8% to 10% (11% in 1H21) and ICE margins from 15% to 17% (18% in 1H21) as the global component shortage should improve. This is not demanding.
We model an undemanding 14% revenue increase for CE and a 12% revenue increase for ICE.
This would imply a fw 2023 PE of 8.4x, and a PE ex cash of 2.9x.
Analysts that cover this stock have been hesitant to get excited about the stock, but I find that if one takes a three-year view, Valuetronics is undoubtably very cheap and has a much higher reward-to-risk story than many other stocks.
However, once those analysts do get excited, it will be very easy for Valuetronics to rerate to 12x PE or a PE ex cash of at least 5.5x. This implies a 40% upside by end 2023.
We model a slight decrease in margin and earnings in 2H22 followed by an improvement closer to normal, while estimating the impact of 3 new ICE clients.
Margin of Safety:
We acknowledge the bearish nature of the global markets now. Although the macro environment isn't that bad, it seems that the market has decided that the economy is "guilty" until proven "innocent." That is, although macro isn't bad now, the market is assuming recession is coming.
Although we think a bear market rally could be coming, at the same time, we acknowledge that there could be a continued "buyer's strike" in the markets.
In such a regime, Valuetronics at this time looks good compared to many others. It is cash flow rich. It pays a good dividend. Assuming they pay out half their earnings based on their temporarily depressed 1H22 numbers, that's roughly a dividend yield of 4% while you wait for capital appreciation.
We think Valuetronics is cheap based on intrinsic value.
We liken Valuetronics like a "high fixed deposit with upside catalysts" once the market can digest the temporary weakness.
If Valuetronics show that margins are the same this half, we think the share price will increase based on their growth potential in ICE earnings.
If Valuetronics show that margins are even worse than last half, it's possible for there to be a sell-off. However, I would take that opportunity to accumulate more, assuming there is no new exceptional news outside of the global supply shortage impacting margins.
We aren't the only ones that think Valuetronics is cheap at this level.
Valuetronics has also been buying back its own shares.
Note that under their share repurchase program, they have a maximum of 43M shares to purchase out of 430M shares outstanding... this is about 10% of all stocks left. This number isn't big, but it's not small either. They have been accumulating aroung $0.53 to $0.54 cents. Since this program started, they have purchased 1% of their stocks so far.
We think Valuetronics might be going to find a bottom soon, especially after this week's earnings report. Price could drop more after the report. Revenues and margins might shrink but remember this is temporary, an eventual recovery to normalized business implies 40% upside from today's prices. Of course, how long it takes to recovery is the question. Could be 1 year, could be 2 years. Either way, today's price seems to be of great value.
We think the margin of safety on a 2-year horizon is high enough.
HENCE, when you read Valuetronic's earnings report this week. If the headlines are bad because there is even more deterioration of revenue and margin, PAY special attention to growth prospects going forward... especially if they think they can add more customers next year on top of 3 new ICE clients. Pay attention to when they think margins can stablize and then normalize. That's when a potential 40%+ gain can be realized, on top of healthy dividends.
For those people that are looking for "safe" stocks that won't go bankrupt, has no debt problems at all, that historically can churn out a profit even in the worst of times, Valuetronics is a candidate.
Thought analysts are not excited about it (yet) and has margin uncertainty, a recovery to regular margins and business could imply more than 40% upside.
While you wait, enjoy a very safe dividend.
Also, don't forget that became Valuetronics accumulated such a large warchest of cash, in higher interest rate environments, it will give them alot of intangible and tangible benefits.
Tangible benefits: as rates increase and bear market looms, Valuetronics could acquire assets for cheap should they choose to. Further, there will be a slight boost in earnings because of bank interest of their cash.
Intangible benfits: They become an EVEN better candidate to be a manufacturing partner. Their clients will appreciate a manufacturing partner with great financial flexibility when their own cash flows become and working capital becomes tighter.
Extra risk: if the global economy morphs into a recession, or a bad recession. I suspect revenues might drop high single digits as client demand could be impacted. This will be offset some by Valuetronics acquiring new clients.
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