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Broker's Calls
Ng Qi Siang Published on Mon, Jul 13, 2020 / 4:51 PM GMT+8 / Updated 18 hours ago

SINGAPORE (July 13): Despite the Covid-19 pandemic and US-China rivalry rattling markets in recent months, Maybank Kim Eng (MKE) analyst Gene Lih Lai has initiated a “buy” call on the technology hardware manufacturer, Frencken. Quality growth and its relative insulation against geoeconomic conflicts, he says, are likely to make it a good prospect for investors.

“Our “buy” on Frencken is premised upon exposure to structurally growing markets through blue-chip customers; earnings resilience despite a challenging business environment due to Covid-19 and US-China trade tensions; and track record of margin improvement with room for more,” Lai comments in a MKE broker’s report dated July 12. He has given the counter a $1.20 12-month price target with a 34% upside.

Frencken manufactures components and modules for a wide range of growth industries including 5G and artificial intelligence (AI), as well as wellness and population ageing. In mechatronics, which consists of 82% of its revenues, Frencken serves established market leaders like ASML, Seagate, Thermo Fisher and Phillips, with its products critical to their operations. Frencken is also often the sole supplier of these components -- which are subject to demanding requirements -- and has a reputation for reliable service among its customers.

Particularly in the mechatronics segment, Frencken’s products tend to be critical but are not core competencies of its customers, says Lai. Using Frencken’s services allows the customers to free up resources to maintain their market leadership. Frequently, Frencken is chosen as a supplier not just because of its engineering and manufacturing expertise, but also because of its experience in managing the supply chain for complex products.

“Frencken boasts deep relationships with customers that span decades, for products that require strong expertise, stringent qualification processes, and at instances very demanding turnaround times. These products are often integral to the success of the customers’ final product in the market place. Overall, we believe this boosts Frencken’s stickiness with customers,” remarks Lai. He expects Frencken to tap into these relationships to introduce products with greater value-add, consequently further driving its margins.

The firm is not, however, resting on its laurels -- it has been selectively upgrading its equipment and facilities. Besides investing in capacity expansion for high-precision machinery and establishing a new facility in Chuzhou for its IMS segment, it has also rolled out the Frencken Operations eXcellence (FOX) and Frencken Production System programmes to improve operating efficiency. Lai believes that it was partially these initiatives that helped drive EBIT margins to 9% in 2019 from 5% in 2015, with SG&A as a percentage of sales falling from 11.4% to 8.4% over the same period.

“Such effects are even more pronounced in the automotive subdivision in our view, due to a large fixed cost base. With incrementally better volumes and/ or pricing, coupled with judicious cost management, the scope for operating leverage is attractive. For example, although IMS fell 6% in 2019, segment results jumped 7.6x to SGD6.1m on the confluence of improved product mix, and strong cost control,” comments Lai.

Moreover, Lai does not believe that Francken will be unduly affected by Covid-19 despite present uncertainty. Much of demand-side disruptions has tended to arise from order or receipt delays rather than cancellations; key customers remain bullish about the future, believing that the resumption of elective surgeries and reopening of labs will lead to demand recovery. Frencken’s geographical and product diversity also shelters it from US-China trade tensions -- its supply chains are relatively ring-fenced and China only accounts for 15% of its revenue.

“Currently, factories in Singapore, Malaysia and China have resumed normal manufacturing operations following the easing of government restrictions. In Thailand, the Netherlands, the US and Switzerland, operations are continuing as usual,” the Lai observes.

The firm’s strong balance sheet should help it tide over the cashflow pressure plaguing businesses in the virus economy, with the MKE analyst forecasting Frencken’s net cash to equity to rise from 23% in FY19 to 35% in FY22E due to robust cash generation. He assumes a 30% dividend pay-out ratio as the firm’s free cash flow should be sufficient to cover its distribution per share.

Looking towards the future, Frencken has become increasingly involved in new products across promising growth areas like semiconductors, analytical and medical products. In light of its strong execution track record, Lai expects Frencken to gain wallet share with its customers going forward, probably by providing new products with stronger value-add and enhanced margins. He estimates a FY21-22 PATMI of 14% or higher against the Bloomberg consensus for the counter, arguing that the firm’s strong potential has often been overlooked by the market.

Though the firm’s net profit looks set to decline 11% y-o-y in FY20 due to supply chain and order delays, Lai sees profits recovering by 18% and 10% y-o-y in FY21 and FY22 respectively on the back of revenue growth and margin expansion. Nevertheless, net margin estimates for FY22 is estimated to come in at a disappointing 7.7%, with the firm already achieving a core net margin of 7.1% in FY19 and maintaining significant room to further improve customer value-add.

Upside factors for Frencken include stronger than expected performance in semiconductor and industrial automation in FY20-21 as well as robust margin accretion from new products and efficiency gains. The stock could also potentially find itself re-rating towards peer valuations as a result of institutional interest. Downside risks, however, include reduced revenue resilience due to present economic weakness, more widespread supply chain disruptions and lower-than-expected dividend payouts.

As at 4pm today, Frencken is trading 0.035 points up at $0.95 with a 3.16% dividend yield. Price-to-earnings ratio stands at 9.53.
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