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Sunday, March 19, 2006

MFS Tech @ 1.11 (Electronics mfg / Singapore) 0 comments

Final Poll Results: 2:2

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Main issues

1.Approaching merger from a position of weakness

Strictly speaking, MFS is not an electronics manufacturing firm; rather, it is in the upstream portion of the electronics manufacturing sector, specialising in the wireless sector for which it manufactures FPCs (flexible printed circuits) that are used in the killer application of the millenium: mobile phones.

Any sector, no matter how hot, has its price. The tendency for people is to focus on the demand growth (for it is the human tendency to be optimistic) and forget about supply growth. The former brings revenue growth, the latter brings margin decline, and often qualitative judgment, a very difficult pseudo-science, needs to be exercised by the investor//trader. So it is with mobile phones, or oil and gas, or property, or China stocks --- all the hot sectors the past two years.

I know its share price surge in recent times has been fuelled by M&A (merger & acquisition) talk but let's look at the fundamentals first --- I think it's still relevant. MFS Tech had a rather insipid FY05, with revenue and net profit dropping by about 15-20%, reflecting the volatility of the electronics industry. Its 1Q06 results showed it had apparently got out of the woods, with net profit growing 25% quarter-on-quarter. But 1Q05 was precisely the quarter which disappointed investors in 2005, as it showed marginal growth over 1Q04.... so was the 1Q06 results really that great? Note also that there was virtually no revenue growth --- it remained around S$120M.

Often when earnings disappoint, an institutional stock can be sold down heavily by the fund managers. This has happened to many technology stocks, which are seen to be volatile and therefore not typical long-term-hold prospects. Recent examples would be Seksun, Meiban, Fu Yu, Huan Hsin. That was how MFS was sold down to ~55 cents in late 2005 before doubling back to its current price of $1.11 within the last 6 months on the back of projections of a better FY06 and then the recent acquisition talks. One might note that some institional holders are now selling into strength, such as UBS AG; that is how they manage their risks.

Now returning to the M&A angle, my reading of the apparently impending move to merge with Nasdaq-listed sister company Multi-Fineline(MFLX) is that it is approaching this from a position of weakness. Given stagnating revenue and difficulty in growing margins (my view is that FPC production capacity ie. competition, in China, where MFS has most of its plants, had grown rapidly over 2004 --> see Reference below, hence leading to MFS's problematic FY05), presumably the parent company WBL has decided a merger of both sister companies would help improve bargaining power. Comparing MFLX's valuation of forward PE 27X to MFS's expected forward PE of 17X and saying that the latter's valuation must re-rate towards the former's is like the Singapore engineer comparing his pay with that of the US engineer and saying that it should re-rate towards the latter's. The circumstances are different; you just negotiate a fair deal for yourself and the argument that valuations must be comparable can only hold reason up to a certain point. For a (limited) reality check, fellow PCB manufacturer Elec & Eltek is trading at 11-12X, although the latter is not a pure-play FPC manufacturer. Those expecting acquisition valuation to rate MFS up to MFLX's PE level will be sorely disappointed. Why was MFS a target for merger talks in the first place? A highly-valued share price will sow the seeds of the breakup of merger/general offer talks.

Note that MFS had recently moved quickly to refute analyst projections that earnings growth for FY06 could experience >40% yoy growth to $50mln, saying that their internal target was only 20%. They then highlighted key challenges: raw material shortages (the key one being copper, I believe), volatile consumer demand for cellphones, foreign exchange risk and increasing competition. They also declared that dividend payout ratio will be around 30% this year, not the 80% that they had paid out last year, translating to a yield of about 2%.

This seems to be a case where the company is not too eager for its share price to soar.

(1) Research and Markets-China's Flexible Printed Circuit (FPC) Market Study 2005-2006
(2) Lim & Tan's research note 17 Mar 06 on MFS Tech




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