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Wednesday, June 14, 2006

Aztech @ 20 cts ( Electronics / Singapore ) 0 comments

Final Poll Results: 4:2

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Main issues

1.Lacks competitive advantage for OEM/ODM segment

2. Unattractive valuation vs tech peers

3. Negative net cashflow

In a clear bull market one adopts a top-down stock-picking strategy where he singles out the sectors that will ignite market interest the most and then picking stocks within the sector that show the most promise. In a clear market downturn he adopts a similar approach to do "reverse stock-picking" (ie. hotstocksnot) --- a sector scan of which industries are likely to be hit the most, whether justifiably or otherwise.

The clear sectors to avoid now can be summarised in two words: "export" and "electronics". In any worry over US consumption, the export sectors of Asian countries suffer the most damage. This is exacerbated by currency concerns where the exporters' currencies appreciate against the consuming countries' (US) and hence eroding their competitive advantage. In downturning markets, electronics traditionally perform badly, due to their high market betas and volatility in earnings (susceptible to margin squeeze).

Aztech has corrected substantially from its peak at above 30 cents in sync with the declining market tide but I cannot see a substantial recovery from there when market sentiment recovers. The fact is that for the intensely competitive electronics industry where products can become obsolete before they even exit the production line, I see no clear competitive advantage for the company that can sustain or stabilise margins in an industry downturn, even though it has been growing profits in the last three years.

Aztech's business can be divided into three segments: OEM/ODM segment (~50% revenue in FY05) which designs, develops, manufactures and markets of data communication, voice communication and multimedia products on ODM and OEM basis; Contract Manufacturing segment (~35%) which provides manufacturing services such as tooling and assembly; and Retail Distribution segment (~15%) which markets proprietary Aztech and Shiro products. Where is the competitive advantage for the first two segments? There is no scale (S$100M revenue for ODM/OEM, S$60M for Manufacturing: hardly substantial), no obvious strategic customer relationships (none of its customer accounts for more than 10% of its sales) which can often anchor sales and repeat orders, nor clear technological edges or key products (eg. Trek with their Thumbdrives). Apparently the company's order book has grown to >S$100M as compared to S$84M last year (according to DBS Vickers' latest report), but it is not clear whether profit will keep pace accordingly.

I say this because out of the two, the Manufacturing segment (surprisingly) appears to be the growth driver in FY05, in both revenue (30% growth) and profit (>60%) year-on-year over FY04, while ODM/OEM has actually exhibited drop in profit and marginal (~5%) revenue growth. For manufacturing, Aztech's sole production facility is in Dongguan where minimum wages have reportedly doubled (or more) due to limited labour supply and rising standards of living (companies like Surface Mount have been a victim of this trend), making things progressively difficult combined with a rising renminbi; comparative valuation with Surface Mount (at 5X trailing) is unflattering for the manufacturing segment. As for ODM/OEM, I have seen so many design houses on the SGX touting their design value-add flop over the years (eg. Giant Wireless, Eastern Asia, KXD) that I remain highly sceptical of any professed comparative advantages, and it is in this case corroborated by the abovementioned declining margins for the segment, of course. Aztech operates in the IT and telecommunications space, one of the most competitive segments in electronics.

The third segment, Retail Distribution, forms such a small proportion of the revenue pie and such marginal profits that one can only see it as a hedging strategy and infant division.

Of course, all this might not come to the fore if the economic outlook had continued to be sanguine. Now, however, the huge correction in the world markets suggest a rising possibility of global economic downturn, and one must not ignore the underlying signals sent by such a massive correction, nor can he ignore the many other relative bargain buys now offered in the tech space compared to Aztech, all of which have greater competitive advantages or more attractive valuations: Jurong Tech (key Motorola account, corrected by 50%), MMI (Seagate strategic supplier), Venture (scale, and quite cheap now, 13X trailing PE), Surface Mount (as mentioned above), plus most of the plastics suppliers. Aztech is now trading at 8X FY05 PE, and I would advise against using forward PE like the always-bullish DBS Vickers which projects a great set of FY06 results that will bring forward PE = 5X. Considering the inherent volatility of the electronics industry, it is not advisable to over-project, and bear in mind that FY06 results announcement is ~9 months away.

Instead, it will be prudent to consider the alternative views offered by NRA (Netresearch Asia), the other main research house besides DBS Vickers covering Aztech under the SGX Research Scheme. NRA is concerned about the cash flows rather than profits, and indeed they have reason to: for investment cashflows, the capital expenditure has approximately equalled operating profits in both FY04 and FY05. Add that to the consistent requirements for additional working capital (receivables, inventory) and in fact the company has been experiencing negative net cashflow, which has been financed by loans to the tune of a combined ~S$20M over the last two years. The balance sheet is sufficiently geared to suggest that there is little additional room for juicing future growth through acquisitions or new ventures. The company also lacks a solid performance record (it sustained consecutive losses through 1998-2002) which suggests possible danger should buoyant conditions commencing 2003 turn sour. Combine all these together and it forms a strong basis for my hotstocksnot call on this stock at 20 cents.

(1) DBS Vickers analyst report on Aztech 5 June
(2) NRA analyst report on Aztech 17 May




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