SHARES of precision component producer Notion VTec (RM2.96) had rallied strongly in recent months — rising from a low of 80 sen in early April 2009 to a high of RM3.52 in mid-January 2010 before easing to about RM3 due to profit-taking activities and the current market downturn.

The rally vindicates our positive view on the company, which we have long liked it for its strong earnings growth, excellent track record, high margins and return on equity — and very attractive valuations.

Nonetheless, it was a series of recent events that have raised investor interest further in the stock and the broader hard-disk drive (HDD) sector. The first major catalyst was Notion's private placement exercise, which raised expectations of a strategic foreign investor. This was confirmed by the entry of camera giant Nikon Corp Ltd of Japan in January 2010.

The second was the imminent listing of its larger competitor JCY International, expected in 1Q10. This has raised awareness for the HDD component sector as JCY's planned IPO will be the local bourse's second largest IPO in six years, after the relisting of Maxis. JCY reportedly plans to raise up to US$350 million (or about RM1.2 billion), with pricing to be finalised in February 2010.  

The indicative pricing for JCY's IPO was reportedly around 10-14 times forward earnings, as compared to our current estimated P/E for Notion (post stock price rally) of 8.6 and 6.6 times for FY September 2010-2011. Note that its valuations were far lower before the rally began. At current prices, Notion's shares remain undervalued and could see another rerating when JCY lists.  

JCY is one of the world's largest HDD components manufacturers, with operations in Malaysia, Thailand and China. It reportedly had revenue of RM1.76 billion and net profit of RM207 million for the financial year ended 30 Sept 2009.

Nikon's entry
In October 2009, Notion had proposed a private placement exercise of up to 10% of its share capital, with proceeds to be utilised to fund its Thailand expansion.

Nikon Corp Ltd emerged as a substantial shareholder in mid-January 2010 when it took up all the 13.84 million shares issued under the exercise, giving it a 9.1% stake in Notion. The shares were placed out for RM2.44 per share, raising a total of RM33.8 million.

Nikon's entry will likely see Nikon steering more of its component orders to Notion. One item we understand that is being considered is the mount, which is presently manufactured in Japan at relatively higher costs.

We understand Nikon currently contributes about RM8 million-RM10 million in monthly sales for Notion. With these new orders, the company hopes to increase these sales by about 30%-50% in FY11. In 4QFY09, 44% of Notion's sales were derived from camera components, and solely from Nikon.

Proceeds of the private placement exercise will fund Notion's Thailand expansion, which will cater primarily for Nikon. The company had earlier acquired a five-acre plot of land with a 23,000-sq ft factory in Ayutthaya, just outside Bangkok for RM5.05 million. The new plant is expected to be operational in 1Q2010 and the company will increase capacity by 200,000 sq ft.

The Thai operations will enjoy an eight-year tax exemption, which augurs well for Notion's overall effective tax rate. Over time, we would not discount the possibility of the camera operations being moved entirely to Thailand, freeing up the Klang plants for HDD orders, as Notion is receiving strong orders from Samsung for 2.5-inch HDD components.  

Key growth catalysts for Notion
Notion will see strong growth over the next few years driven by its aggressive expansion programme, especially in Thailand, and a widening of its product range, customers and markets. The key catalysts are:

1) Thailand expansion. Notion will be able to cater more for its biggest client, Nikon Thailand and later, to other multinationals as the country also hosts a large concentration of HDD and auto companies. The plant will enjoy tax exemption, lowering effective group tax rates.

2) Increased HDD orders and new products. Notion has secured orders from a new customer, Samsung, for production of the 2.5-inch form factor HDD. This opens up a new market base, as Notion presently focuses on the 3.5-inch form factor. The smaller form factor is used for smaller, mobile consumer electronic devices, such as laptops, where demand is growing rapidly.

We understand trial runs started in December 2009, with monthly production being ramped up from sales of RM600,000 to a targeted RM6 million by June 2010. HDD demand has also been resilient, even during the worst period in Notion's 2QFY09. Demand is being driven by the need for increased storage for the increasing use of web-based applications.

3) Over the longer term, Notion is also going into production of more complete components to offer HDD multinationals a more integrated and value-added service and improve on margins.

In total, Notion will spend about RM100 million on capex in the next two-three years, in Malaysia and Thailand. This will be easily funded by the private placement and strong operating cashflows. Its two plants in Klang are currently operating at full capacity, and the company is planning to acquire further space nearby to cope with rising demand, especially Samsung.

Forecasts raised, valuations attractive
We are raising our FY2010-2011 net profit forecast by 6% and 15%, respectively. We expect Notion's net profit to grow a robust 48% to RM53.2 million in FY10 and a further 30% to RM68.9 million in FY11, with earnings per share of 34.4 sen and 44.6 sen, respectively.

Despite the stock's rally, Notion's valuations remain very attractive, especially relative to its strong growth prospects. At RM2.96, its shares are priced at just 8.6 and 6.6 times for FY2010-2011 earnings. With the impending listing of JCY, there will also be a new industry pricing benchmark, while more opportunities are likely to emerge from the Nikon strategic tie-up.

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.