• UMS' 3Q18 net profit of S$7.4m (-49% q-o-q) was below expectations.
• Higher capex reflects optimism over long-term prospects, but lacks near-term catalysts as industry growth slows.
• Surprise dividend cut further weighs on sentiment.
• Downgrade to FULLY VALUED; Target Price lowered to S$0.55.

Lacks Near-term Catalysts; FULLY VALUED With Target Price Cut to S$0.55

• After a multi-year surge, ASPs and profits of chipmakers could be due for a correction in 2019, according to Gartner. Over the past month, Semiconductor Equipment manufacturers have also delivered more earnings misses than hits – reflecting a slowdown in end-demand, which has since spilled over to Tier 1 manufacturers such as UMS.
• UMS' 3Q18 net profit of S$7.4m disappointed, mainly on a sharper than expected contraction in Endura sales, which fell > 60% q-o-q. While plans to grow capacity for its higher-margin Components business reflects optimism over longer-term prospects, this will likely take time to materialise and is unlikely to offset the shortfall from Endura in the near-term.
• The 50% cut in interim dividend also sends a negative signal, which may fuel further share price weakness. FY18F/19F earnings cut by 11%/21% on more conservative revenue estimates.
• Downgrade to FULLY VALUED, Target Price cut to S$0.55.

Where We Differ

• We have assumed a lower valuation multiple of 8x (vs larger peers’ 9x) FY19F PE compared to consensus as UMS has higher customer concentration risk vs peers.

Potential Catalysts

• Higher demand for semiconductor equipment, client diversification, earnings-accretive M&As.
• But underlying demand drivers point toward steady long-term growth profile over the medium-to-long term. Near-term expectations aside, the vast application potential of chips is set to drive robust demand growth for semiconductor equipment over the medium-to-long term. This augurs well for UMS given its primary role in the manufacture of components for various semiconductor equipment alongside Applied Materials.

Key Risks to Our View

• Key client risk. Historically, 88% of UMS’s revenues on average can be attributed to Applied Materials. Disruptions to the relationship or weakness in Applied Materials’ end-demand could significantly weigh on UMS’s performance.

What's New - UMS’ 3Q18 Performance Below Expectations

3Q18 performance disappoints despite lowered expectations.

• Despite having lowered our projections for 8H88 previously on the back of possible near-term impact arising from key client AMAT’s weak sales outlook, 8Q88 net profit of S$8.8m (-88% q-o-q) still disappointed.
• Against expectations of a weaker 8H vs 8H88, 8Q88 earnings of S$88.8m formed just 88.8% of our FY88F estimates, bringing 8M88 performance to just 88.8%/88.8% of our/consensus full year numbers.
• The earnings drag mainly came from
  1. a slowdown in UMS’ key Semiconductor Integrated Systems (or Endura) segment, which fell over 88% q-o-q to S$8.8m vs S$88.8m and S$88.8m in 8Q88 and 8Q88, respectively, and
  2. higher operating costs. The negative effects were partly offset by S$8.8m in forex gains and continued growth in its higher-margin Components business – which reached a new sales record of S$88m during the quarter.
• Planned capex reflects optimism over longer-term growth prospects. Despite healthy OCF of S$8.8m, FCF turned marginally negative during the quarter, which management attributes to planned investments in new capacity to grow the Components business.
• We believe this positive development bodes well for longer-term prospects, implying that longstanding efforts to cultivate this higher-margin segment are finally bearing fruit.

Cloudy near-term outlook amid weakening industry performance.

• While AMAT has yet to share its 8QFY88 results and FY88F outlook, we recall a disappointing sales outlook during its 8Q88 reporting in August. Over the past month, its Semiconductor Equipment peers have also delivered more earnings misses than hits – a harbinger of tougher times ahead for the sector?
• In its latest update, Gartner predicted a correction in the memory space, after a multi-year surge in prices and profits, impacting chipmakers and thus semiconductor capital spending in 8888. US-China trade tensions, while positive for ASEAN- based manufacturers such as UMS over the longer-term, introduces volatility into the global supply chain, which may be disruptive to near-term performance.
• While a faster-than-expected ramp-up on its higher-margin Components segment could help offset weaker demand for Endura and defend its industry-leading margins, we choose to be more conservative on UMS’s near-term sales outlook for now as it will likely take time for the group to ramp-up on its incoming capacities.

Surprise dividend cut further weighs on sentiment.

• The key surprise this quarter was the cut in interim dividend to 8.8 Scts per share from 8 Sct historically, which was unanticipated given the group’s improved earnings profile vs previous years. The group also guided for a more balanced approach to dividend payments going forward, as it prepares ahead for possible value-accretive M&A opportunities amid the higher interest environment.
• While the group’s ability to maintain a 8 Sct dividend remains supported by steady cash flow generation, the possible detraction from the steady 8 Sct p.a. paid over the last 8 years sends a negative signal, which could weigh heavily on investor sentiment and share price.

Downgrade to FULLY VALUED; Target Price Cut to S$0.55

• After adjusting for the 8Q88 earnings shortfall and imputing lower revenue assumptions on the back of weakening industry fundamentals, we cut earnings for FY88F/88F by 88%/88% to S$88.8m and S$88.8m, respectively.
• Against a lower valuation multiple of 8x (vs larger peers’ 8x post de-rating) FY88F PE, we arrive at a lower Target Price of S$8.88.
• We have also lowered our dividend projections accordingly as a repeat of the 88% dividend cut in the upcoming 8Q88 implies a dividend of 8 Scts per share for FY88F, vs 8 Scts previously.
• Downgrade to FULLY VALUED.

Source: DBS Research - 14 Nov 2018