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Tuesday, July 18, 2006

China Precision @ 38 cts ( Precision engineering / China ) 0 comments

Final Poll Results: 4:4

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Main issues

1.Unattractive valuation vs peers

2.Exposure to rising raw material costs (esp. plastics)

3.Tepid medium-term outlook for electronics industry

What's the story about China Precision? That has to be the main question on the mind of investors who want to buy in on the back of a limited track record, since it only recently went IPO in early May.

Very little to go on, in my view. It may be another case similar to Jiutian, where good IPO timing (ie. bull market) generated high price levels that have since served as psychological anchor levels.

Optimists about the stock point to two things: its niche in electronic tuner components (80% of total group sales), and its association with Jurong Technologies which holds a 20% stake. Electronic tuner components are omnipresent in consumer electronics: in TV sets, set-top boxes, DVD players, PCs, satellite receivers, automobile audio systems. The volume of demand can only go up in the future for such items.

A truism if there ever was one. So it is for handphones and look where it has landed MFS Tech recently. And so it is for hard disk drives and look where Magnecomp is now. And those two were among the global leaders in their respective fields. The keys to the issue are twofold: (1)competitive strength: what differentiates China Precision from its competition? It has integrated manufacturing capability in precision engineering down to contract manufacturing, with the capacity for injection moulding for plastic parts, metal stamping for metal parts (note that tuners comprise both metal and plastic parts), down to surface treatment and product assembly... but so do a lot of bigger competitors (eg. Amtek) which, through their association with identical customers albeit in other product segments, could easily cross-sell their services, given no obvious crucial technological impediments; (2)the state of the industry: if the sector (contract manufacturing and electronics) undergoes certain transitions or cyclical downturns, margins and revenues are sure to crimp, providing a double whammy (check out China Precision's pre-tax profit margins from FY04-1Q06, where it appears to have compressed margins to secure orders).

Things are not exactly looking up for the electronics industry, as market observers would note. That was part of the reason why I covered Aztech and Eucon in this blog recently: the confluence of "export" and "electronics" themes do not exactly inspire investor optimism in a period of rising oil prices and toppish US consumption. Let's look at some relative valuations for manufacturing peers.

Amtek(diversified precision engineering): 8X trailing PE (expected 5-6X forward)
Surface Mount(electronics assembly in similar locations in China for similar Korean and Japanese clientele): 5X trailing PE
Hi-P(plastics moulding and assembly): in trouble, PE irrelevant
Beyonics(metal components and assembly): 6X trailing PE

China Precision, at 38 cents, is trading at 11X trailing PE.

In particular, one should watch out for the plastic components segment of China Precision, given the strong material cost sensitivity of precision engineering firms. The recent problems encountered by plastic moulders across the board, from tier-one firms like Hi-P to tier-two firms like Fu Yu down to smaller firms like Fischer, is indicative of their inability to pass material costs to customers. Metals working firms have had their problems in 2004-05, but there is still cost pressure (see Amtek).

China Precision might yet prevail, but surely given its recent IPO status it may be wise to watch for an established post-listing track record (in particular, an ability to sustain margins)? The low peer valuations, material cost pressures and lacklustre near-term industry outlook would provide strong headwind; the investor must not be too headstrong.

A last note: although Jurong Tech has a 20% stake in this firm, in the wake of its probably losing a big chunk of business from the disappearing Maxtor, surely it would be looking to reconfigure some of this released capacity for new customers? Why would it forward orders to a 20% associate, if it could do the job itself (for box-build, assembly)? Until there is evidence in the form of tangible business flow from Jurong Tech's incumbent customers (particularly Motorola, I would guess) for China Precision's tuner component fabrication services, it may not be a good time yet to go into this stock.




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