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Wednesday, July 05, 2006

Eucon @ 24 cts ( Electronics mfg / Taiwan ) 0 comments

Final Poll Results: 0:4

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Main issues

1.Looming overhang from Europtronic distribution

2.Tepid medium-term outlook for electronics industry

3.Volatile business given high operating leverage

Those familiar with this stock will know exactly the reason why I am timing the hot-stock-not call now. There is a long thread on Eucon on the Channelnewsasia forum which gained considerable popularity due to Eucon's stellar stock performance since the start of the year (a 3-bagger for those who bought early), and those reading this thread will know that Europtronics, a key shareholder of Eucon and an SGX-listed company itself, is planning a distribution of its 25% holding in Eucon to its shareholders.

Eucon shareholders or those planning to buy should be left in no doubt of the effect of this move by Europtronics on Eucon's medium-term share price. It leaves an overhang of shares due to the massive supply of previously-locked up shares (under Europtronics) now ready to be sold by Europtronics shareholders (and sell they will, since it's effectively like a scrip dividend). A case in point is Sinwa, whose share price was depressed for nearly a year after KS Tech released its shareholding of Sinwa to the company's shareholders. Another more general example would be the Shanghai Stock Exchange which was depressed for several years prior to 2006 (despite the raging Chinese economy) due to a massive overhang of "non-tradeable" shares.

By itself, I am not convinced that the correction from 35 cents to below 25 cents recently suggests a rebound is imminent. The initial price rise was due to a recovery of the company's profits in 2H05 and 1Q06 which saw pre-tax profit margins recover to >20-25% on increased utilisation of its drilling machines. It was then propelled further by a series of analyst reports, none more optimistic than DMG Securities' price target of 76 cents based on projected S$34M net profit (based on 1Q06 net profit of S$6M and stronger demand for services in 2H06). There were even some insider buys around the 33-34 cent level.

Why am I not optimistic? The operations of Eucon can be divided into drilling and routing services segment, and PCB manufacturing segment. Although both segments contribute roughly equal revenue, the former segment's gross profit margins are much better than the latter's, at about 50% compared to ~25% for the latter. This means the drilling & routing services segment is more influential towards the bottomline: according to the segmental analysis in the FY05 results, it constitutes >60% of total gross profit. Yet this segment is a high operating leverage, high capital expenditure business, where the business will suffer if utilisation rate of the drilling/routing machines is low.

The fact is that Eucon is essentially an outsourcing operation to PCB manufacturers ie. they provide specialised services and possibly service swing demand. When electronics demand is high and manufacturing capacity is tight on the PCB manufacturers' side, demand for Eucon's services will be high. However, if the industry enters a slump, the manufacturers will simply rely on in-house capabilities to service the reduced demand. The PCB manufacturing segment, which is meant to complement the drilling & routing services to provide a vertically integrated capability, are also likely to be affected as it is not the company's core capability. What it means, in effect, is that Eucon's is a volatile business with volatile earnings.

This can be seen in its earnings trend. It demonstrated strong growth in FY02-03, then stagnated and experienced a downturn in late FY04 which lasted through 1H05 where depressed demand led to low utilisation of its drilling machines, then saw the electronics industry recovery, particularly in handsets, propel its profit recovery in 2H05 and 1Q06. What this teaches us is not to be over-optimistic on its profit projections. DMG's FY06 profit projections of S$34M are actually way above market expectations of S$21M, and its price target implies forward PE of 13X. If we adopt the market expectation of S$21M and use a conservative forward PE of 8X in view of the inherent earnings volatility (1Q06 might be near the peak, in view of less sanguine recent views on US consumption demand --- see my views on Aztech as well), we would be talking about a more realistic target of ~30 cents.

The intention here is not to provide a price target for the stock, but rather to illustrate how different earnings and valuation assumptions can affect the "target price" significantly. One needs to adopt an independent perspective, and recognise the inherent risks in a business and ascertain the sustainability of margins and earnings growth. In this case, not only is the outlook on the general electronics industry bleaker than before (one may compare recent muted price performances of peers Multichem, Jadason, Advance SCT), the share overhang is going to cast a further pall over any sustained price move ---- profit-taking is likely to provide strong resistance along each step of the way.

(1) DMG Analyst Report on Eucon 28 Apr 2006




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