This article first appeared in Capital, The Edge Malaysia Weekly on July 29, 2024 - August 4, 2024

SINCE the second quarter of the year, most counters in the electronics manufacturing services (EMS) sector have been enjoying a good run as orders had started to stack up again after a difficult 18 months.

But last week, as the first of the Magnificent Seven tech stocks announced second-quarter earnings, the Nasdaq fell by more than 3% in a single trading day — the worst it has seen in over a year — as Tesla’s earnings came in below expectations while that of Google parent Alphabet was only slightly above expectations.

Some are of the view that the Nasdaq’s recent dip points to investors turning more realistic — perhaps even sceptical now — about the unbridled optimism over artificial intelligence (AI) that had propelled technology stocks this year.

Closer to home, local technology and EMS stocks have not been immune from the US selldown, and have shed some of the gains made in recent months. Nonetheless, the share prices of most EMS stocks remain higher than they were at the beginning of the year.

Share price performance aside, many agree that the worst for the EMS sector is over as tepid orders from the past have come to an end from subsiding destocking initiatives and order books have started to show signs of improvement. Furthermore, the AI and data centre themes have helped to push the sector higher.

“The technology sector is one that needs to be backed up by earnings [for share prices to move higher]. I believe the uptick in earnings will come in 3Q or 4Q,” says Rakuten Trade head of equity sales Vincent Lau.

Lau is of the view that stocks in the EMS sector still have room to move higher when compared to others like construction or property, which have also gained this year.

The EMS space is largely divided into consumer-centric EMS and those that serve the industrial market.

Analysts appear to prefer players with higher exposure in the industrial segment because of the AI and data centre boom that has fuelled the Malaysian stock market thus far this year.

Companies with diversified portfolios and substantial exposure to industrial products have proven to outperform peers that are heavily reliant on consumer electronics as their primary revenue driver.

This is true for both PIE Industrial Bhd (KL:PIE) and NationGate Holdings Bhd (KL:NATGATE) as their share prices have rallied by more than 100% and 30% year to date respectively, as they have secured new customers related to AI data centres, Kenanga Research said in a July 3 sector report.

In April, PIE announced that it is expecting a new Chinese customer that specialises in servers and switches to come on board and occupy its new plant 6 measuring 280,000 sq ft. The new customer is expected to contribute RM1 billion in revenue to PIE for 2025 and RM1.5 billion in 2026.

Kenanga said in its report that NationGate’s venture into own-brand AI servers continues to remain in the spotlight, riding the data centre boom in Malaysia. Moreover, NationGate has also been appointed as the approved original equipment manufacturer for the world’s leader in AI computing.

“While the earnings contribution from this segment is still meagre thus far, the door-opening opportunity provides a new platform for the group to ride the booming AI demand and trade diversion opportunities,” UOB Kay Hian Research observed in a July 5 report.

Nevertheless, Kenanga Research is of the view that the current share prices of NationGate and PIE already reflect their respective outlooks and that further upside will likely depend on a valuation re-rating rather than earnings upgrade.

Kenanga has an “outperform” call on PIE with a target price of RM6.75 and also an “outperform” call on NationGate, whose current share price of RM2.25 already exceeds its target price of RM2.06.

UOB Kay Hian Research is of the view that the consumer-centric EMS should see better days ahead as its key customers replenish orders following sharp inventory adjustments. UOB Kay Hian highlighted that VS Industry Bhd’s (KL:VS) management said its new subsidiary in the Philippines has a favourable risk-reward ratio, considering its experience in supporting key customers’ sub-operations, favourable export tariffs from the Philippines to the US on wider product offerings and higher utilisation, hence the margin enhancement that can be reaped via the cross-selling of its four new capabilities, and more job tender wins on multi-site offerings.

UOB Kay Hian has a “buy” call on VS Industry with a target price of RM1.56.

As for SKP Resources Bhd (KL:SKPRES), UOB Kay Hian said that its major customer’s inventory replenishment has been holding steady and what is more encouraging is that its key customer has been in ramp-up mode.

Kenanga said that it has also turned positive on SKP as it sees value emerging with improved recovery visibility from its existing customers related to household products.

“The group is in the process of securing two new potential customers, aiming to begin production towards end-2024,” said Kenanga, which has an “outperform” call on SKP with a target price of RM1.35, similar to UOB Kay Hian’s “buy” call and target price of RM1.36.

However, some analysts think that a recovery in the consumer-centric EMS companies will be slow, given that the sector is closely tied to consumption. In Malaysia, many local EMS companies focus on household appliances and the recovery of this segment worldwide has been lacklustre.

Others are neutral on the sector, irrespective of whether the companies are highly exposed to the industrial segment or otherwise.

Fortress Capital Group CEO Thomas Yong is one of them. He says that the consumer-centric EMS appears more attractive at the moment in terms of valuation, given its lower earning multiples relative to its industrial counterparts.

Nevertheless, the key issue for this subsegment is the short maturity period of the product portfolio of EMS companies for their primary clients.

“These products are approaching the end of their life cycle, and more critically, we are observing a trend where the manufacturing of new-generation products is increasingly being allocated to contract manufacturers in neighbouring countries. This shift could pose longer-term earnings risk if they fail to secure new products from their existing clients or onboard new clients [and grow them] quickly enough to compensate for the potential decline from the phasing out of mature products,” he shares.

On the other hand, industrial-centric EMS companies usually deal with products that have longer life cycles compared to the consumer-centric ones.

Yong says that the valuations of these companies are elevated and driven by investor expectations of substantial earnings growth, particularly for those with exposure to the AI sector.

“However, this optimism brings its own set of risks. Should these companies fail to meet the high earnings expectations, significant drawdowns in share prices could ensue,” he cautions.

Yong believes that current valuations are no longer “a clear bargain” for the EMS sector, having rebounded from its trough, and any further upside potential will rest upon the companies’ ability to deliver robust earnings.

“There are few nuances that could impact future earnings. Being export-oriented enterprises, local EMS companies are particularly vulnerable to global economic uncertainties. Although the China + 1 strategy is benefiting local EMS firms, it does not preclude end clients from establishing operations in neighbouring countries such as Thailand and the Philippines.

“There has been a noticeable trend of MNCs (multinational corporations) directing new [generation] product manufacturing to contract manufacturers in these countries. This shift could potentially dampen future growth, especially so for consumer electronics EMS, given that their current product portfolios are relatively mature,” Yong observes.

He believes that to sustain growth, local EMS companies need to secure contracts from manufacturing new-generation products or diversify their client base. He adds that another issue to take into account is the impact of a depreciating US dollar against the ringgit, as the US Federal Reserve is anticipated to start cutting rates later this year. 

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