Slight hiccup in 4Q07 but LT outlook remains positive

SYNOPSIS: 4Q07 was affected by sudden decline in OA orders and slow keypad sales but Mechatronics division performed better than expected. FV lowered to S$0.62. Maintain our long term BUY recommendation.

4Q07 RESULTS HIGHLIGHT
While revenue for 4Q07 was in line with our expectation, gross profit fell marginally short of our forecasts due to the underperformance of ELC’s keypad business and higher costs incurred during the industrialization phase of its Office Automation (OA) projects. Despite continuing weakness in the EMS division,revenue managed to increase by 7.6% to S$63.7m with growth in Mechatronics division offsetting the decline in EMS revenue. Gross profit declined by 17.1% to S$10.7m due to softer profit margin in the EMS division.

In the Mechatronics division, 4Q07 revenue grew 19.7% to S$45.5m. The medical segment was the star performer in 4Q07 with revenue surging 51.4%, contributed by the mass production launch of a major project in 3Q07. On the other hand, revenue from the semiconductor segment declined by 9.1% due to the slowing down in the chip industry. In addition, the appreciation of Euro against SGD added another 5.4% to topline growth (in SGD).

In the EMS division, 4Q07 revenue declined by 14.2% to S$18.2m. Weakness in the keypad segment continued in 4Q07 with revenue plunging 40.5% as key customer Shin-Etsu faces intense pricing pressure from its low cost competitors in China. The OA segment was also affected by a sudden and sharp drop in orders from its key customers, Xerox and Neopost. While the Automotive segment continued its exponential growth, contribution from this segment was still relatively small.Operating expenses surged by 20.6% in 4Q07 due to increase in commission paid for the period and higher freight costs. Tax expense was lower as ELC’s Mechatronics division paid lower taxes due to the reduction in tax rates in Netherlands from 29.6% to 25.5%. For 4Q07, ELC’s net profit fell 26.3% to S$5.6m, falling short of our forecast of S$6.1m.

Balance sheet remains strong with abundance of cash. ELC is in a net cash position with low debt/equity ratio of 0.4%. Operating cashflow recovered in 4Q07, generating S$8.2m of operating cash.

EMS: OUTLOOK DENTED BY 4Q07 SLOWDOWN AND THE DELAY IN PRODUCTION SCHEDULE IN OA SEGMENT
Our positive outlook has been slightly dented due to 2 issues: 1) the sudden slowdown in OA segments in 4Q07 and the pushback in the production schedule of the 4 OA projects on hand. The sharp slowdown in orders from 2 key OA customers – Xerox and Neopost was one of the reasons for ELC’s 4Q07 slowdown. This has highlighted 2 issues – ELC’s heavy reliance on these 2 customers and the challenging outlook ahead arising from the slowdown in US economy (these 2 customers of ELC have exposure in the US market). Latest guidance from management indicates that order flow remains slow for 1Q08 despite some of the orders coming back.

Another negative came from the delay in production schedule of its OA projects. 2 of the larger SYNOPSIS: 4Q07 was affected by sudden decline in OA orders and slow keypad sales but Mechatronics division performed better than expected. FV lowered to S$0.62. Maintain our long term BUY recommendation. 4Q07 RESULTS HIGHLIGHT While revenue for 4Q07 was in line with our expectation, gross profit fell marginally short of our forecasts due to the underperformance of ELC’s keypad business and higher costs incurred during the industrialization phase of its Office Automation (OA) projects. Despite continuing weakness in the EMS division, revenue managed to increase by 7.6% to S$63.7m with growth in Mechatronics division offsetting the decline in EMS revenue. Gross profit declined by 17.1% to S$10.7m due to softer profit margin in the EMS division. In the Mechatronics division, 4Q07 revenue grew 19.7% to S$45.5m. The medical segment was the star performer in 4Q07 with revenue surging 51.4%, contributed by the mass production launch of a major project in 3Q07. On the other hand, revenue from the semiconducscale OA projects originally scheduled for production in 4Q09 have now been pushed back to 2Q and 3Q FY10. While we understand that such delays are acceptable given that ELC and its customers have to consistently work on design improvements and issues relating to production during the industrialization phase, financially, this would mean a delay in revenue recognition and also the delay in the much needed stability from the OA projects to help cushion the volatile conditions in the keypad segment.

KEYPAD LIKELY TO REMAIN WEAK; POTENTIAL TO SURPRISE ON THE UPSIDE IN 2H08
Outlook for the keypad business remains challenging for FY08 as we believe key customer Shin-Etsu will continue to face tough competition from Chinese competitors in the production of lower-end keypads and the uncertain outlook of global economy would lead to greater uncertainty in the volatile keypad business.

While business in the lowerend keypads remain challenging, ELC is moving towards high-end keypad production and is in talk with Shin-Etsu for such projects in 2H08. ELC has also boosted its manufacturing capabilities after adding 2 sputtering machines, which will commence production in March 2008.

MECHATRONICS: POSITIVE OUTLOOK AMIDST THREAT FROM WEAKENING USD
On the whole, outlook for Mechatronics division remains positive. Although its semiconductor segment is expected to weaken in FY08 due to slower industry conditions, growth in the medical segment is expected to continue in FY08 after the mass production of a major project begins in 3Q07 and more than offset the decline in semiconductor segment. For
the analytical segment, revenue is expected to remain stable in FY08.

On the downside, the Mechatronics division could face pricing pressure from its customer as a result of depreciating USD. ELC sells to its customer in Euro while its customer sells the product in USD. With the expectation of continue weakening of USD against Euro, ELC could be pressured to lower its Euro selling price by its customer to take some pressure off the depreciating USD.

‘DEFENSIVE’ AMIDST VOLATILE MARKET CONDITION
We did a study of ELC’s price movement against STI and against some of SGX-listed electronic contract manufacturers with similar market cap which includes Aztech Systems, Valuetronics and Beyonics Technology. The study period tracks back to the time when market had peaked (ie STI at its highest level of 3831 in October 2007). In both cases, ELC outperformed the index
and other electronic CMs. ELC appears to be a defensive play among the contract manufacturer and with its attractive dividend yield and large cash holding, we believe that ELC is a safe addition to investment portfolios under current volatile market conditions.

VALUATION & RECOMMENDATION
While our long term positive view on ELC remains intact, we believe that over the short term, ELC could face increasing downside risk from the slowdown in US, pricing pressure from customers and weakening USD. As such, we are lowering our FY08 revenue and profit forecasts to S$256.0m (previously S$276.9m) and S$24.4m (S$25.8m). There is an improvement in our margin forecast for the Mechatronics division as the division had defended its margins well in FY07 and we believe that our previous forecast was over-pessimistic. However, we still expect some decline in margins going forward, arising from subcontracting costs and potential pricing pressure. We have also taken into consideration the push back in the production schedule for the OA projects in our valuation.

Our DCF fair value of ELC has been lowered to S$0.62 (previously S$0.64) after taking into account of the revision in our earnings forecast and a higher discount rate. Key assumptions include WACC of 11.9% and terminal growth rate of 1.0%, which we deem conservative. Taking away its cash holding, ELC is currently trading at a very attractive EV/EBITDA of just 2.6x. Dividend yield is also attractive at 5.8% for FY07. Thus, we are maintaining our short-term HOLD and long-term BUY recommendation for ELC.

[This article is contributed by NRA Capital Pte. Ltd., a licensed Financial Adviser by the MAS. Readers of this content are bound by the same terms & conditions of our website www.netresearch-asia.com .]