■ 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 to about 12% but gross profit contribution is significant at ~40%. Our assumptions result in a surprisingly good fit with the underlying business’ (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’s lower cost of production, has seen IQOS production share shift away from VMS faster than we had expected. 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’ momentum might be slowing going into 2019. Revenue growth might revert to historical averages.
■ 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% yoy, which is at the low end. Even if growth was to exceed 20% yoy 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’ diminishing contributions as production shifts away to FLEX, and slowing growth in the exIQOS, 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.
■ Earnings forecasts cut by 16-34% for 2018-20 as IQOS’ 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. We cannot further recommend a BUY, and thus downgrade to HOLD. Our target price is pegged to 14x (long-term mean) 2018F PE.
Source : UOB KayHian Research