KUALA LUMPUR: Affin Investment Bank Research says the recent sell-down of the market including the technology sector (KLCI -5% and Technology -18% from its year-to-date peak) may present an excellent opportunity to increase weighting in the sector.

This is not only premised on the improved data points (although lagging) as reported by the Semiconductor Equipment Manufacturers Industry (SEMI) and Semiconductor Industry Association (SIA) but also the encouraging evidence that we are seeing — ranging from improved visibility, strong capex expansion in key growth areas and steady demand from major markets, particularly that of China.

China — key demand driver
The low salaries and high property prices has however not crimped the spending of the population. The younger generation in particular, direct their monthly income towards consumer electronic items, cellular phones, electric scooters/bicycles and even locally produced cars (note that bulk of semiconductor sales goes to industries such as PCs, cellular phones and consumer electronics).

Also interesting to note is the growth of the "backyard" manufacturer, which at times produces knock-offs of major branded electronic items (including that of Apple's iPhone which can be easily obtained at a fraction of the price of an original unit). This, and including the legitimate brands are key demand drivers for the technology companies there.

Remain overweight — Unisem is top China exposure
Coupled with the government's stimulus programme and an improving social safety net in China, consumer spending and sentiments in China appears robust and likely to be a major driver for their domestic economy.

On-going capex expansion plans by our technology companies in China therefore appears to be well timed and ready to capitalise on the growth the China economy will experience in the years ahead.

A timely expansion would also improve the revenue contribution from the region which roughly contributes to 10%-20% of our technology company's revenue at present, while at the same time aiding margin expansion due to better efficiencies from its newer and better designed facilities.

In our view, risk-reward ratio is in favour to the sector, given its rather low PE multiples and strong earnings growth (albeit the low base in 2009).

Moreover valuations are trading at an unjustified discount to their historical mean levels. This mismatch is further amplified after taking into consideration the record revenue these technology stocks are expected to report this year.

We are thus maintaining our overweight rating on the sector. Of the lot, Unisem (M) Bhd appears to be the most aggressive in terms of its Chengdu expansion and projects nearly half of revenue to be derived from its China unit by FY11.

Chinese youth fuelling demand
Our emphasis for this report is however tilted towards China, prompted by our recent visit to several Malaysian technology companies with operations there. Our primary objective was not only to better understand operations but also to better gauge demand drivers for the sector as a whole.

First of all, we gather that industry dynamics are in favour of manufacturers in the technology sector. This is partially attributed to lofty property prices that are beyond the means of the population thus spurring demand for relatively more affordable items including that of cellular phones, PCs and consumer electronic products. This applies particularly to the younger generation, which apparently have a different mindset vis-à-vis the older generation.

Array of affordable electronic items available
Proliferation of local Chinese chip design houses, which produces an array of cheaply available consumer electronic gadgets (including imitations of branded electronic items) is also fuelling demand down the semiconductor chain. Nearly half of Unisem's customers in Chengdu comprise of local and Taiwanese design companies.

Longer-term growth factors in place
Longer term, the Chinese government's stimulus package and an improving social safety net should ensure that consumer demand remains rife.

We note that infrastructure development — highways and metro (at least in the cities we visited — Shenzhen and Chengdu) will spur demand for transportation including that of automobiles and scooters. Locally made cars are widely available at affordable prices, thus spurring growth of the semiconductor sector.

Loans growth guidance of 25%-30% given by Bank of Chengdu (Sichuan province) echoes this ongoing rapid development, and also suggesting that it would take some time before such growth tapers down to more normalised levels, as recorded in developed nations.

This also provides some comfort to us in terms of capex spending by the technology players here (Unisem US$40 million (RM135.6 million) in FY10 Chengdu alone, RM160 million-RM180 million group wide); MPI Bhd's capex to more than double to RM300 million on a group basis although we believe most will likely go to Suzhou), although we believe that management's foresight would also limit any excessive building of capacity.

Contribution from China still small, has room for growth
We estimate that contribution from China operations to the semiconductor assembly and test players are still small, accounting for approximately 15% of both MPI's and Unisem's revenue.

Revenue contribution from China for hard disk component manufacturer ENG Tek is slightly higher at 25% while that of Uchi Technologies Bhd is irrelevant as all its China sales are primarily to its Malaysian operations while its end market is in Europe. Bulk of capex expansion plans for both MPI and Unisem is headed towards this region, primarily to meet growing demand and given ample room for expansion in this area.

As a guide, Unisem has targeted 50% revenue contribution from Chengdu by FY11. We understand that MPI has also similar aggressive expansion plans in Suzhou.

Valuations
Year-to-date valuations for the KLCI technology sector has come off by a sharper 19% vs the market's 5%, thus providing a good entry point into the sector. Sector PER multiples at 9.8 times are also attractive and potentially likely to benefit from a sector valuation re-rating, in light of the improving fundamentals.

On a regional basis, smaller cap pure play assembly and test players (Amkor Technology and King Yuan Electronics) trade at 11.2 times in line with their larger peers (Powertech, ASE and Siliconware). We continue to value our technology stocks based on a P/B basis and most, excluding Unisem, continue to trade below its historical mean valuation. We believe that Unisem's loftier valuations could partially be attributed to its larger exposure to China and also better liquidity.

Favourable risk-reward ratio, maintain overweight
In our view, risk-reward ratio is in favour to the sector, given its rather low PE multiples and strong earnings growth (albeit the low base in 2009). Stocks under our coverage are expected to register growth of 46% in 2010 relative to a sector wide PE of 10 times (both excluding BCT).

Moreover valuations are trading at an unjustified discount to their historical mean levels. This mismatch is further amplified after taking into consideration the record revenue these technology stocks are expected to report this year. We are thus maintaining our overweight rating on the sector.

Watch out for small-cap tech space
While we like the big caps in the technology space, we think that small caps including that of ENG Teknologi and Uchi should not be overlooked. Indicative offer price PE multiple at nine times for soon-to-be-listed JCY, ENG's larger peer, is nearly 80% above that of ENG Teknologi's valuation.

This in our view is too steep, after taking into consideration ENG's track record, management commitment and beneficiary from outsourcing trends.

Coffee module manufacturer, Uchi, is also set to benefit from increased orders following the introduction of green coffee machines in Europe. New products at higher pricing are likely to also aid margin expansion ahead. At 11 times FY10 EPS, stock is cheap while providing superior yields of 6%-8%.