Short-sellers bring Venture Corp back down to earth on 10th May 2018 (Old News)

• Venture Corporation (VMS)&rsquo stellar 2017 was driven by IQOS.  Our deep dive into the supply chain has revealed reasonable evidence to suggest a revenue contribution of 25% and gross profit contribution of 40% from the device. 
• With IQOS production slowing down and shifting away to its competitor, Venture Corporation&rsquo s earnings are at risk of declining in 2018 and beyond.  Growth and margins are expected to normalize and we cut earnings by 16- 34%.
• Downgrade to HOLD, with a lower target price of S$18.20.  Entry price: S$14.00.

Deep Dive Into Supply Chain Affirms IQOS Significance

Our analysis affirms our initial belief that  the I Quit Ordinary Smoking (IQOS) smokeless cigarette device that Venture Corporation (VMS) manufactures for Phillip Morris International (PMI) made up close to 25% of 2017 revenue on an accounting basis.  On a pure value-add basis, this shrinks by half but gross profit contribution is significant at ~40%. 

Our assumptions result in a surprisingly good fit with the underlying business&rsquo (ex-IQOS) historical gross margins.

Production Share of IQOS Shifting Away Faster Than Expected

The combination of an unexpected slowdown of sales in Japan, the price war with Japan Tobacco, and competitor FLEX&rsquo s lower cost of production has seen IQOS production share shift away from VMS faster than we had anticipated. Actual orders are coming in lower than the original production outlook had suggested.

Underlying Core Business Also Showing Signs of Slowing

Apart from IQOS, 2017 also saw the test & measurement/medical (T& M/Med) segment (ex-IQOS and Illumina) exhibit strong growth. 

While its key clients continue to report a positive growth outlook, VMS&rsquo momentum might be slowing going into 2019. Revenue growth might revert to historical averages.

Earnings Cut by 16-34% as IQOS&rsquo Significance Diminishes

VMS used to derive above-average margins from producing IQOS. With production declining, margins are expected to start compressing going into 2H18. With this and slowing growth momentum from the T& M/Med segment, earnings growth in 2018 will moderate or even decline.

Downgrade to HOLD, Target Price Reduced to S$18.20

VMS is expected to deliver a 16% 2018F ROE and thus deserves a PE valuation of 16x. However, the slower growth outlook, weak market sentiment, and decidedly crowded trade will result in further multiples de-rating. io.

We cannot further recommend a BUY, and thus downgrade to HOLD. Our target price is pegged to 14x (long-term mean) 2018F PE.

GETTING AROUND THE ELEPHANT IN THE ROOM

PMI sells IQOS at a loss.  Our channel checks indicate that PMI is indeed making a loss on IQOS, owing in part to the high price that VMS is charging. It only profits from sales of HEETstick consumables, which command a substantial margin. Referencing the discounted price of ¥ 7,980 (~US$75) for an IQOS starter kit, we assume that to be the base-case ASP that VMS charges.

TechInsights under-estimates ASP at US$19/unit.  Our analysis of the supply chain suggests the material cost of US$40, excluding final assembly costs. Participants were noted to also be enjoying above-average margins. Furthermore, the report stated that the estimated final assembly cost excludes other cost components such as SG& A, R& D, and non-recurring fees. Other cost components common in any contract manufacturer&rsquo s quote include inventory/scrap reserves, profit margins, and overheads. Hence, directly using the US$19/unit figure would be inappropriate.

Bill of lading shipment data, channel checks suggest a US$40 cost.  Based on shipment data of IQOS units from VMS&rsquo factory Technocom Systems to PMI, the unit value of IQOS kits is about US$45. This comes close to our estimate above. Channel checks with manufacturers return a similar estimate, and we understand that this is lower than the price that VMS likely charges.

At least 10m units produced in 2017 alone.  Channel checks suggest that VMS made up the bulk of the US$900m in device sales that PMI recognized in 2017. Using PMI&rsquo s rule of thumb of 0.33m-0.36m devices sold for every 1b additional HEETsticks sold, it translates to 9.5m-10.0m IQOS holders/kits sold. However, we can only strongly verify 75% of that figure. Bear in mind that this figure does not account for any inventory build- upon PMI&rsquo s end which we imagine to be substantial.

IQOS revenue contribution at ~S$1b on an accounting basis.  In Xiamen Intretech&rsquo s prospectus (pg.1-1-245), it was stated that they resell components to Technocom Systems, who does final assembly and resells to PMI&rsquo s designated party. This practice likely applies to the rest of the component suppliers. Therefore, VMS has to recognise the full material cost and their value-add in their revenue. This comes up to about S$1b (25% of 2017 revenue), based on our estimates.

Isolating VMS&rsquo value-add, IQOS revenue contribution closer to 12%.  Revenue has been inflated due to the inclusion of the material cost, which is reversed out at the COGS level. If we only account for VMS&rsquo value-add on IQOS, the attributable revenue shrinks to S$500m, or 12% of 2017 revenue. Framed from that perspective, it validates the annual report statement that only one client made up > 10% of its revenue.

IQOS made up 40% of 2017 gross profit.  Channel checks suggest that a gross margin of 30-35% was recognized on the total ASP charged to PMI. Based on this, 2017 gross profit contribution is estimated at S$250m or about 40% of the full-year figure.

Analysis of our assumptions using ex-IQOS figures shows good fit.  VMS&rsquo stellar performance was mostly attributed to IQOS. Pre-IQOS, the rest of the business saw fairly stable gross margins of 10-11%. Assuming no change in the underlying business, gross margins of the business ex-IQOS hypothetically should remain in the 10-11% range. Our assumptions result in a surprisingly good fit with the underlying business&rsquo (ex-IQOS) historical gross margins.

IQOS PRODUCTION SLOWING FASTER THAN EXPECTED

The slowdown in Japan impacting orders in 2018.  Production in 2018 is being cut due to a slowdown in IQOS sales in Japan, a key market for PMI. With this and our belief of a sizeable inventory build-up in 2017, less production will be required for 2018. Actual orders are coming in below previous expectations.

Shift in production towards FLEX accelerating faster than expected.  It was envisioned that VMS would lose some production share to FLEX, which has lower prices and better production yield. However, this shift appears to be accelerating faster than expected, after PMI slashed prices for the starter kit to US$75 (usual: US$110) in a price war with Japan Tobacco in May. At that price, PMI is selling at a loss so that raises the impetus for them to allocate more production to the lowest-cost producer. As such, VMS is producing even fewer devices than expected.

Supply chains suggest a pickup in 4Q18, but production may not go to VMS.  As far as we can tell, IQOS production levels in 2Q18 seem comparable on a q-o-q basis. Despite investor meeting minutes from Xiamen Intretech suggesting a pickup in the later part of 2H18, suggestions are that the pickup may not necessarily be reflected at VMS&rsquo level owing to the production shift. Production in 2H18 may come in lower hoh.

Still continues to receive R& D revenue despite lower production.  VMS is working on IQOS 3.0 and is expected to receive R& D revenue for it in spite of the lower production for 2018.

US FDA approval a wild card.  PMI has two applications with the US:

1. a modified risk tobacco product (MRTP) application to market IQOS as a lower-risk product, and
2. a pre-marketing tobacco application (PMTA) to commercialize IQOS in the US with/without the MRTP labeling.

Approval of the latter is more important as it will result in a production ramp-up. 

 

Post PMI&rsquo s setback in Japan, incremental production for the US was largely anticipated to go to FLEX. However, the recent trade spat between the US and China has seen suggestions that production could shift from FLEX back to VMS. At the point of writing, we have not been able to verify this, and the base-case assumption should be that FLEX still gets the bulk of production.

Ex-IQOS and Illumina, the T& M/Med segment grew 28% y-o-y in 2017.  The remainder of the T& M/Med segment grew about 28% y-o-y. Central to this growth was likely higher production from clients in the T& M space, namely Fortive (Fluke, Tectronix), Keysight, Trimble Navigation and Waters. These clients have experienced strong revenue growth from 3Q17 onwards.

Revenue recognition likely one-quarter prior due to lead times.  Factoring in manufacturing lead time, this would have likely been recognized by VMS at least a quarter before. This is corroborated against VMS&rsquo historical shipments, which saw a sharp uptick in 2Q17.

Shipment data shows a slowdown in exports in 4M18.  At the same time, shipments for 4M18 saw a y-o-y decline. As the shipment data captures only external imports to one country, the main takeaway here should be that VMS&rsquo shipments are potentially slowing down, but still remain at above-average levels.

Continued growth in 2018, albeit slowing from 2017 levels.  Result transcripts of clients in the networking/communications and T& M/Med segments continue to report a mostly positive outlook for 2018. The growth appears strongest from T& M clients, as they either report accelerating order growth, or are raising their guidance for 2018. Headwinds are seen for Waters, while Illumina sees the rate of growth moderating. For networking/communication clients, growth is moderating (Broadcomm). 

Strong T& M growth insufficient to arrest decline from IQOS.  Growth for the T& M/Med segment (ex-IQOS) is currently estimated at 8% y-o-y, which is on the low end. Even if growth were to exceed 20% y-o-y in 2018, earnings are still likely to come in below S$400m due to the outsized contributions from IQOS.

Growth slowing, be cautious going into 2H18.  The sharp growth momentum seen in 2017 is slowing, with risk of production slowing below 2017 levels. This stems from IQOS&rsquo diminishing contributions as production shifts away to FLEX, and slowing growth in the ex-IQOS, ex-Illumina T& M/Med segments. We would turn extremely cautious going into 2H18 if production does not ramp up further, resulting in an earnings decline.

THIS CANNOT REMAIN A BUY

Cut earnings by 16-34% for 2018-20.

We have factored in a decline in production share for VMS over 2018-20, from an increase previously. Growth assumptions for the five core segments (ex-IQOS and Illumina) have also been revised. 

Factoring in lower contributions and ASP from the high-margin IQOS business, our gross margin assumptions have been lowered.  Overall, revised net profit estimates for 2018-20 are S$370m (-16%), S$345m (-27%) and S$341m (-34%) respectively.

Strengthening of US$/S$ to have limited impact.

The US dollar has strengthened against the Singapore dollar by 4-5% since 1Q18, lending positive headwinds. However, the impact to earnings seems muted and based on the sensitivity analysis provided in the annual report, is likely to move earnings by S$2m-3m (~1%) for every 5% increase.

Multiples to de-rate, despite above-average 2018 ROE.

Despite the softer outlook, we do not expect an outright collapse in VMS&rsquo share price. 

For 2018, the above-average ROE of 16% will continue to support an implied 16x 2018F PE on a P/B-ROE relationship. However, given the possible earnings decline going forward, multiples will de-rate and we expect forward multiples to trade below its long-term mean of 14x until consensus earnings similarly de-rate.

Downgrade to HOLD, lower target price to S$18.20 based on 14x 2018F PE.

The potential for

1. earnings to come in below consensus,
2. a return to normalised growth and,
3. crowded trade

means that a premium valuation can no longer hold.

Despite valuations supporting a higher PE multiple, we can no longer recommend a strong case to buy under such circumstances. We thus  lower our PE multiple to the long-term mean of 14x, translating to a target price of S$18.20.

Downgrade to  HOLD. Entry price: S$14.00.

Source: UOB Kay Hian Research - 05 Jul 2018