Dufu Technology Corp turned in a poor set of results for the third quarter of the financial year ending Dec 31 (3QFY12). The company unexpectedly slipped back into the red due to a weakening of the global hard disk drive (HDD) sector.

The company recorded a pre-tax loss of RM1.77 million for 3Q, compared with a pre-tax profit of RM830,000 last year. Net losses totalled RM1.56 million against a net profit of RM710,000 a year ago.

This came on the back of a steep 16.2% year-on-year (y-o-y) decline in revenue from RM34.45 million to RM28.86 million, as HDD component orders decreased due to a downturn in the industry. Compared with 2Q, when the industry was still holding up well, revenue declined 15.4% quarter-on-quarter (q-o-q) from RM34.11 million while 2Q saw a pre-tax profit of RM1.35 million.

With the sharply lower sales volume and thin margins, the company slipped into the red.

Apart from the decline in sales, Dufu also attributed the poorer performance to foreign exchange losses as the US dollar weakened against the ringgit and higher staffing costs.
The poorer outlook for the global HDD sector is now starting to negate the recovery gains from the Thai flooding in late 2011 of earlier this year.

The floods caused Dufu to slip into the red in 4QFY11 and for the full FY11, with a net loss of RM6.1 million in4QFY11. Dufu then returned to profitability in 1QFY12 which was sustained in 2Q.

Year-to-date, the company remains marginally profitable, with nine-month (9M) pre-tax profitof RM740,000 and net profit of RM680,000. This was down from RM1.64 million and RM1.25 million in 9MFY11. Cumulative revenue stood at RM91.48 million, down 6.2% from RM97.56 million in 9MFY11.

Dufu’s weak performance in 3QFY12 is representative of the HDD component industry, which is suffering from the effects of lower sales, lower margins and an industry consolidation that has reduced the number of global players and put more pricing power in the hands of the principal players.

Other local players such as JCY International Bhd and Notion VTec Bhd also recently reported lower than expected results, and expect a cautious outlook ahead. The shares of these companies are trading near their year lows.

We have reduced our net profit forecast for FY12 from RM3.7 million to RM2.1 million, and from RM5 million to RM3.5 million for FY13, with earnings per share of 1.8 sen and 2.9 sen for the two years. This places the stock’s price-earnings ratio at 14.7 times for FY12 and nine times for FY13.

Positively, we expect Dufu’s earnings to receive a boost from its expansion into new non-HDD business — the healthcare components sector which is expected to yield better margins.

With the stock also at a steep 64% discount to its net assets of 73 sen per share, we believe further downside risks are low, despite the unexciting earnings outlook.

Uncertain outlook for global HDD industry
While the global HDD shortage has recovered from the Thai flooding with supply fully back to normal around April, the supply recovery has also caused abnormal margins for the major players — Western Digital and Seagate Technology — to ease from their earlier highs this year.

A shortage of HDDs after the Thai floods prompted HDD prices to surge by over 50%, which boosted margins for the principal players. However, the performance of the local listed HDD component suppliers, although better than during the floods, has not moved fully in step with the principals.

The notable exception was JCY International, which produces parts such as actuators and base plates. Competitors for these parts in Thailand were affected by the floods and this resulted in bumper prices. However, players like Dufu, which produces more common components such as clamps, spacers and pins, have not enjoyed much of a windfall.

Now, with HDD prices starting to ease again and demand concerns emerging, the sector is starting to feel a squeeze in margins and these abnormal margins are starting to disappear. With most of the industry now controlled by two players, the oligopolistic structure will likely see component players further down the food chain being squeezed.

A slowdown in HDD demand has been happening since the middle of the year. Apart from the sluggish economic outlook in the US and Europe, the other key reason is a structural shift from HDD and solid state drives (SSD) given the strong demand for tablets and smartphones.

Consumers are also delaying purchases of laptops ahead of the introduction of next generation ultrabooks with embedded HDDs, as well as the introduction of Windows 8.
International Data Corp (IDC), the provider of market intelligence and advisory services for the ICT industry, recently announced that global PC shipments contracted 8.6% in the third quarter. This was worse than IDC’s August outlook of a 3.8% y-o-y fall.

Western Digital and Seagate have guided investors towards a sluggish December quarter — traditionally the strongest for the sector.

Seagate recently released results showing revenue of US$3.73 billion (RM11.38 billion) for its September quarter, below analysts’ expectations of US$3.75 billion and earlier guidance of US$4 billion. The company has guided lower revenues of US$3.5 billion for the December quarter.

Western Digital provided an outlook for the December quarter that was also below analysts’ expectations. The company guided revenues of US$3.55 billion to US$3.7 billion, below analysts’ predictions of US$4.08 billion.

Diversification expected to yield better margins
With uncertainties permeating the HDD sector, Dufu is pressing on with its diversification to reduce its reliance on the sector and expects to show results in 2013 and 2014.
The company is embarking on manufacturing medical components for orthopaedic medical devices, a fast growing market with relatively high margins. Orthopaedic fixation devices and instruments assist in attaching fractured or broken bones and torn ligaments and tendons.

The non-HDD segment, which accounts for about 20% of revenue, has largely focused on components for the telecom, industrial safety and sensor sectors and metal stamping, which provide relatively low margins.


Note: This report is brought to you by Asia Analytica Sdn Bhd, a licensed investment adviser. Please exercise your own judgment or seek professional advice for your specific investment needs. We are not responsible for your investment decisions. Our shareholders, directors and employees may have positions in any of the stocks mentioned.

This article first appeared in The Edge Financial Daily, on Dec 7, 2012.