Is The Downgrade From RHB On Notion Vtec Fair?

Yesterday I blogged on Notion Vtec because the stock price had been falling rather dramatically in the posting Some Comments On Notion Vtec and apparently RHB had downgraded Notion Vtec.

And the Edge Financial Daily even highlighted this issue yesterday: Notion VTec top loser on downgrade

Here's the link to RHB's report: Notion Vtec Berhad : Not As Good As Hoped - 03/08/2010

• ♦ Warning for 3Q results. The market yesterday beat us to the punch, de-rating Notion’s share price by 10.3%. We believe 3QFY9/10 results (to be announced on 5 Aug) are likely to be worse than expected due to higher costs incurred from the RM80m expansion of the 2.5” Hard-Disk Drive (HDD) baseplate capacity and lower revenue after adjusting for the weaker US$ vs. RM. Conditions are not expected to improve in 4QFY9/10.
  
  ♦ Outlook dimmed due to competition and weak demand. The outlook for 4QFY9/10 and beyond now appears more negative compared to the more bullish view after our visit to the company in May. We note that major HDD manufacturers including Western Digital and Seagate recently guided that lower-than-expected HDD demand caused by EU debt problems and slow US recovery has been compounded by capacity oversupply in the industry. Aggressive competition has thus resulted in falling prices and diminishing margins. The upside from Samsung’s aggressive expansion plans in the 2.5” HDD segment also appears to have evaporated
  
  ♦ Forecasts cut. We have cut our FY9/10-12 EPS forecasts by 21.1%, 36.2% and 47.4% respectively, after factoring in 25-35% lower sales and lower margins. We had originally expected baseplate capacity to rise from 350-400/month currently to 1m/month by end-FY10, 5m/month in FY11 and 7m/month in FY12, but the likelihood now is that the company will stop at 2m/month in FY11 while further capacity expansions will be on hold for now. We note that 80% of the capex has already been spent. For FY10, revenue has also been affected by the -7.7% YTD decline in the US against the ringgit. However, we note that we are still looking at the RM/US$ exchange rate coming back to around RM3.20-3.30 by year end.
  
  ♦ Risks to our view. 1) Recovery in demand if US economic growth strengthens earlier than expected; and 2) Fluctuations in RM/US$ exchange rate.
  
  ♦ Downgrade. Although the camera segment remains resilient and will provide some support to revenue growth, the focus will likely remain on the negative outlook for PC sales growth and the oversupply of HDDs. Our fair value has been cut to RM2.07 based on our new forecasts and a more conservative target FY9/11 PER of 8x (vs. 10x previously). Although yesterday’s share price fall suggests that the market has already factored in this negative view, we believe there is still downside risk given the uncertain earnings outlook. We thus downgrade our call on the stock to Underperform from Outperform.

Here's Notion Vtec numbers..

As it is Notion Vtec's most recent 4 quarters or trailing twelve months earnings is already some 50.553 million.

RHB's earnings forecast for Notion fy 2010 has been cut from 53.6 mil to just 41.25 mil.
RHB's earnings forecast for Notion fy 2011 has been cut from 72.4 mil to just 44.8 mil.

Of course the cuts are drastic.

RHB mentioned Western Digital itseself had been guiding lower earnings forecasts.

From yesterday posting: Some Comments On Notion Vtec

• So Western Digital says it expects the coming quarter, Q1 eps to be around 80 to 90 sen.
  Wastern Digital Q4 EPS was 1.23. (Street was expecting 1.35)
  From an eps of 1.23 to an eps of just 80-90 sen is rather a huge decline, yes?

RHB also mentioned the following factors.

1. higher costs incurred from the RM80m expansion of the 2.5” Hard-Disk Drive (HDD)
2. revenue has also been affected by the -7.7% YTD decline in the US against the ringgit.
3. Aggressive competition has thus resulted in falling prices and diminishing margins

Are the reasoning valid?

Yes, some would point out that they DID NOT like the TIMING of the downgrade!

On 16th July, which was not long ago, Notion Vtec was trading at 2.99. Why didn't RHB Research warn the investing public then? Why ONLY release the report when Notion Vtec had fallen to a low of 2.35? Notion closed yesterday at 2.11.

Isn't the timing of the downgrade way too late?

And the previous RHB Research report was made on 20th May 2010:hNotion Vtec Berhad : Set To Deliver - 20/5/2010

Yeah.. anothe massive complaint then because Notion price in May was 2.73 and RHB gave Notion an Outperform with a target price of 4.68!

Yes the grouse and utter frustration is understandable because the investing public were told by RHB Research that Notion Vtec is deemed to have a GREAT FUTURE on 20th May 2010. It's now only the beginning of August!

How can a company value diminish from 4.68 to 2.07 in just 2 months?

How can?

Here's the first two paragraphs of the RHB's report in May 2010.

• ♦ On track to deliver 2.5’’ baseplate target. According to management, construction work on its new 150k sq ft plant is near completion. The new plant which is expected to house most of the base plate production capacity is set to commence production by Sep-10. Note that management expects capex of around RM80m to ramp up the base plate capacity to 1m/month, 5m/month, and 7m/month by FY10-12 respectively from 350-400k/month (currently) vs. 100k/month in Jan-10, pending the arrival of additional equipment and machinery i.e. die casting and computer numerical control (CNC) machines. Additionally, management is planning to increase the total workforce to 3,000 by 2011 (vs. 1,900 currently).
  
  ♦ Riding on volum e loading for Western Digital (WD). The company expects stronger volume loading in 2H2010 from WD on the back of strong demand for HDD components i.e. antidisks, disc clamps, and spacers as well as WD’s market share gain. Recall that WD overtook Seagate as the number one HDD vendor in 1Q10. WD now expects to increase its total HDD shipments by more than 20%. While Notion’s current capacity for these components is 800-900k/month, management is expecting to increase capacity to 1.5-2.0m/month by end-2010....

Ah... apparently RHB Research was guided by Notion's management notes in May.

And the warrants issue. Sorry but let me repeat this again.

• Did you see OSK's report on Notion Vtec dated 16th July 2010. Notion then was 2.99 and since the conversion price for the warrants was priced at 2.55, OSK shouted out very loud that one was getting free warrants that was 'in the money'! It's now 3rd August 2010, and the warrants are no longer in the money! :P), perhaps one should use 169 million shares as the potential share base for Notion Vtec. This is to prevent the investor from being shocked by the dilution in earnings.

Putting the quality issue of OSK aside ( LOL! Yeah, what's new mate? :P) these warrants went ex yesterday, 3 Aug 2010. Entitlement is based on a 1 for 5. And some 34,003,503 were issued. With the conversion price at 2.55, some might want to account for the possible dilution in eps caused by conversion of the warrants.

Ok, let's take Western Digital's guidance numbers as a guide. Western Digital says it expects its earnings per share to drop from 1.23 to around 80-90 sen. Now the worse case 80 sen eps would represent a decline of 34.9%!!

And we do have to factor in the current strength in the Ringgit versus USD (is the Ringgit really strong or the USD really weak? :P ). What would be your guesstimate of the impact on Notion since Notion's products are priced in the USD? Would you say maybe a 5% impact caused by the exchange rate? Fair assumption? Or perhaps the impact is minimal? ( Why? Because if you look at the latest report pdf file from Notion, Notion currently has an existing USD50 million hedged to its USD receivables. )

But then ... some might argue that perhaps RHB is being far too negative. Why? Notion Vtec does NOT cater to HDD segment only!

From Notion's last earnings report.

• In Q2FY2010, HDD parts revenue recorded RM26.9 million (Q1FY2010: RM19.1 million), camera parts recorded RM20.4 million (Q1FY2010: RM26.7 million) whilst the industrial/automotive revenue was at RM9.2 million (Q1FY2010: RM10.5 million). The product mix for the Q2FY2010 was HDD:Camera:Industrial/Automotive of 48%:36%:16% compared to previous quarter's mix of 34%:47%:19%. The HDD revenue increased by 40% whilst the camera sector was lower by 24% compared to Q1FY2010.

Hmmm.... HDD revenue increased by 40% in Q2Fy2010!

And what about me?

If I have to throw in a dart, I would say perhaps an earnings of 32 million for Notion for its fiscal year 2011. LOL! Yes, that low. :P

LOL! Stop starring la. I am NOT a Sotong and that's my darts figure and surely I could be dead wrong. :P

Now RHB's earnings per share is based on just 154 million. The last approved placement share of 15.4 million shares, which has not been placed out yet, has been currently discounted by RHB.

Let's see two scenarios. One with 154 million share base and the other with 169 million shares.

1. With 154 million share base, an earnings of 32 million equates to an eps of 20.7 sen.
2. With 169 million share base, an earnings of 32 million equates to an eps of 18.9 sen.

And what would be the fair PEx multiple you would use?

And so far, apparently RHB is the ONLY research house to downgrade Notion's Vtec earnings.

Now in the posting Update On Notion VTec. on 4th May 2010, I noted some of the other earnings forecast made on Notion Vtec.

• RHB's 2011 net earnings forecast for Notion is 56 million. (LOL! Downgraded since then)
• Kenanga's 2011 net earnings forecast for Notion is 62 million.
• CIMB's 2011 net earnings forecast for Notion is 80.8 million.
• And here comes the champion... OSK... OSK's 2011 net earnings forecast for Notion is 95.0 million.

How?

You want to BUY Notion now because you think Notion has dropped a lot?

Or you want to do a wait and see. Yeah, wait for Notion's quarterly earnings notes, which should be announced this month, first.

How?