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Wednesday, 24 January 2018

ANALYSIS : HAIR DRYER TURNS SKP RESOURCES INTO A SEXY STOCK


Can a plastic parts manufacturer and components assembler ever be thought of as cool? Sure - provided that they make cool stuff. This Johor company certainly does.

 
Sin Kwang Plastic is a no-nonsense company with a proven track record. Its annual revenue grew from RM100mil to RM2bil in 10 years. It's a tightly owned family business with little desire for media exposure or stock-related shenanigans.


It struck gold a couple years ago after the Dyson Group contracted them to manufacture sophisticated vacuum cleaners. It also won a RM2bil contract to manufacture Dyson's new hair dryer. Think of Apple's current relationship with FoxConn - that's how bright SKP's prospects are.


The hair dryer is arguably the real driving force behind SKP's aggressive expansion plans. It is Dyson's freshest and most appealing product, it's being sold as a high margin luxury item, and it's selling like crazy. As I'll explain later, SKP is putting itself in a position to leverage on this - simply put, the company is currently on standby to take on billions of ringgit in new Dyson contracts. This can lead to an extra RM500 million in annual revenues for the group, based on its current contractual agreement with Dyson.


I've been fascinated with the hair dryer for a while. It's gained considerable buzz and remains a highly desirable item. Relative to its famous vacuum cleaners, it's a new product for Dyson ; I'm not hesitant to compare it to the time Apple unlocked a new revenue source and created a globally desirable product with the iPhone (I will stop the Apple-Dyson parallels here as it is admittedly a tired cliché).

So let's do a bit of research on this product.


Part I : Peter Lynch Told Me To Do It


People who aspire to be like Warren Buffett or Peter Lynch end up trying to be like Peter Lynch (it's hard to start reinsurance companies, it turns out). There was a lot of allure in his most famous advice - that you can dissect a company's prospects just by visiting their stores and talking to their customers - or even by asking your friends and family about the company's product.


By using this seemingly dubious logic, I set out to validate my pre-existing assumptions about a product which I already like (the technical term is confirmation bias - I'm sure you understand the futility of walking into a Starbucks and asking customers if they like Starbucks). Using anecdotal evidence is a lightning rod for criticism when you're trying to make investment decisions, yet large corporations do it all the time - they just call it market research.


Sometimes a product can be so appealing that it can be a game changer - so much so that it's a high-margin product, even the most expensive product in its class, and it can still outsell everyone else.


The iPhone no longer does that. You know what does? The Dyson V9 Supersonic hair dryer.


Without further ado, here's my extensive list of Peter Lynch-isms that I gathered during the Christmas break. Note that I'm currently based in Hong Kong, where conspicuous consumption and tech fetish go hand-in-hand ; the most stylish, advanced products will sell quickly.


1) Prominent ad placements in many parts of the city since September. This includes the gigantic electronic billboard in Causeway Bay as well as station exits at Central. They seem to have been put up since September as Dyson wanted to position its hair dryer as the hottest Christmas gift.


2) Prominent product placements at Fortress and Broadway stores since October (they're the equivalent of Harvey Norman in Malaysia). In some places the hair dryer wasn't grouped with others in a tired-looking beauty products aisle, it was right at the store's entrance, as if it was the latest iPhone. This includes repeated sightings of people who were only interested in testing the Dyson hair dryer and left quickly afterwards.


3) I helped organize an event where the lucky draw's main prize was an iPhone 8; the hair dryer was one of the other prizes. Multiple people remarked to me : 'I wouldn't mind winning that hair dryer instead' (Out of  sample size of 4, 3 were using older iPhones). I know that the iPhone 8 was rendered obsolete by the X since launch day, but still.


4) During the same event one person said "I don't want to win that hair dryer. I've already bought two (he has a wife and kids)". Another said that if she wins the hair dryer she will sell it because she already owns one. Two other people are in the same predicament.


5) Increased daily sightings of people carrying big cardboard boxes of the hair dryer, obviously just after a purchase. This was early December.


6) Online assessments of the product revolved around one question : 'Is it worth the ridiculous price'? Shockingly, the goodwill was such that a lot of reviewers said yes, in no uncertain terms. Just like the iPhone used to be, of course.


7) This is the second Christmas cycle for the product itself since its 2016 release; it seems that demand has stayed strong for the second year, possibly even more so thanks to new international launches (it is now available in more than 70 countries). People are calling it the 'Tesla of hair dryers' or 'the iPhone of hair dryers' and other nonsense.


Did I mention the price?



This is not fake news.


Bear in mind that the innovation here is not just from the technology. It's the ability to compel people to pay premium prices for something that was never seen as a luxury must have item before. Most people wouldn't think of buying a professional grade hair dryer previously; now they do. A new market unlocked.


​If you only do one Peter Lynch thing a day, read some possibly partly fake customer reviews.

Analysing 'hype' and 'cool' is predominantly based on anecdotal evidence and imperfect market surveys, just like the one I attempted. Yet I assure you, multi-billion dollar market research firms adopt pretty much the same approach. My point is that all these anecdotal findings should lead somewhere; in this case it's a good investment opportunity.


Part II : The 'S' in SKP Resources is 'Sexy'


SKP is a bread-and-butter manufacturer, so its fundamental prospects are not difficult to analyse - just read all the research reports out there. At risk of oversimplification, the company focuses on manufacturing plastic parts and product assembly. More than three quarters of its revenue now come from Dyson contracts, as will be the case for the next few years. The total lifetime value of the current Dyson jobs are close to RM3bil.


SKP's margins and industry variables are predictable, making its future earnings projections slightly more reliable than, say, an oil and gas tender rig provider with a similar name. As with other manufacturers, its major cost components aside from raw materials (plastic) is labour and electricity costs.


SKP had a couple quarters' worth of earnings hiccups as it experienced a shortage of workers to meet higher production needs, and the stock stagnated for a while. This has since been sorted out. Recent strong earnings coincided with a rally since August last year. In 2017 the stock rose 83%.


This is a somewhat low margin business where the best companies would record margins in the high single digits (5-9%; SKP's inching towards 6% this year). But don't mistake it for low expectations; consistently high strong revenue growth over the next few years means that it can be 6% of whatever and you'll still benefit.


In fact, might even be a sign of consistency and ability to manage costs. If there's a growth in margins, it can also be down to better economies of scale - the holy grail of mass-scale manufacturing.


VS Industry is its sexier, larger, and more profitable cousin. Among others, that company produces the printed circuit assembly boards (PCAB) - the electronic guts of the product - and holds the vaunted vertical integration status - they're an integrated manufacturer with the capability to produce internal and external parts in-house, thus greater efficiency from being able to manage the the supply chain.


SKP wants to be everything that VS is and more, hence its expansion plans to catch up. But there's a twist : according to analysts, SKP is said to have better manufacturing capabilities. And VS's margins worsened year on year (4.7% in FY17 from 5.3% in FY16) despite growing its annual revenue by a billion ringgit last year.


Think of the following as a trading thesis as opposed to an investment thesis (you can find those by reading all the analysts' reports ; rest assured that their financial modeling skills are far better than yours or mine).


So I'm going to lay down the groundwork for a trade. By looking at several thematic play for this stock over the next 6-18 months, there are reasons for the stock to gain positive buying sentiment at different points in the immediate future.


Sentiment is the extra boost to a fundamentally solid company's shares; it also speeds up the momentum of the stock price. You can buy the stock now or when any of these catalysts play out.


You can also get the call warrants ; right now I prefer SKPRES-CG for its price, tenure (expires in June 2018), and volume. The liquidity's a bit lousy at times though, so that's an added risk.


1) Higher-than-expected demand could mean new contracts on the way. SKP is the sole manufacturer of the Supersonic hairdryer. In the next 12 months, watch out for new Dyson V9 contracts being given to them.


These guys take up a lot of Dyson jobs; the hair dryer and the cordless vacuum cleaners are the two best-selling items for the Dyson group globally. As far back as a year ago, SKP's management has insinuated that current production orders for both items have exceeded the initial volume agreed in the contract agreement .


Let's focus on the hairdryer - I'm going to take a big leap of faith here and assume that in terms of complexity, the number of components, and mass market potential, the V9 commands higher profit margins and will presumably achieve higher sales growth than the vacuum for Dyson. So they (Dyson) are likely to focus on growing brand exposure and new markets for the hair dryer and the increase in customer demand that comes with those.


Note: another reason not to focus on the vacuum is that SKP's peer, VS Industry Bhd, has a similar long term contractual agreement to produce them.


SKP's RM2bil V9 contract in early 2016 by Dyson was based on initial four-year demand projections. This was prior to the US and international launches. The high priced vacuums beat the pants off initial sales expectations - why not the hair dryers? The dubious market research in Part I certainly supports this thought.


Who cares about whether they make vacuums or hair dryers, you ask? I'd look at it like this : SKP has the technical consistency to produce these hair dryers. As far as anyone knows, it reliably manufactures them - any production bottlenecks would have to be due to late delivery of internal components or other parts for the assembly phase. The company has a lot of excess capacity to tap into with higher orders - why won't they be able monopolize the hair dryer production contract?


Oh, and a minor detail : VS Industry is operating near full capacity right now. It has a far larger customer base and more products to make ; good for income diversification, not so good if you want to bag a multibillion Dyson job in the near future.


The possibility of more contracts for SKP is always there. Given the hair dryer's positive reception, it's more likely than a scale down in existing orders. It's most likely the recipient will be SKP; they tick all the right boxes.


2) Dyson's record profits in 2017 suggests that the direct revenue boost were from sales of vacuum cleaners and the new hair dryer product line. Perhaps the business model and subsequent success with the vacuum cleaner can be replicated with the hair dryer. Look out for Dyson's 2017 profit numbers* in March - the hair dryer's business success will be a reflection of this. It is a catalyst that directly impacts SKP, and only SKP.

This is the main reason behind my fixation with the V9. The main reason behind my simple market survey was due to this:


From the Financial Times.

The emerging APAC middle class will keep buying status items and appealing gadgets. Dyson products are both of these, and their day-to-day utility makes them appealing purchases. And if China can drive up demand for BMWs and designer handbags to multi year highs, they can definitely do the same for less expensive status items.


3) SKP's own profit numbers and expansion plans - see if they can deliver on these over the next 6 months. Its second half of the financial year (2HFY18; its Q3 results is out in March) is significant. Its product mix will continue to shift with higher deliveries of hair dryers during this period. SKP is starting to make its own PCABs to finally get that vertical integration status; it would put them on a level playing field with VS. In terms of PE, SKP's stock has historically lagged VS.


The following passage from an analyst report sums up what to look for:



4) The normalized PE is your minimum upside. Any recurring positive sentiment or new contracts will propel it much further.

SKP's stock went through a typical hype cycle - the Dyson contracts (and the expected cash flows from it) propelled the PE to the mid-20s range in 2016. The limited upside and production troubles meant that the stock had nowhere to go for a while, until the Dyson numbers began rolling in last quarter.


Its actual PE in FY17 (year ended March 31) was 14 times, largely within consensus expectations and lower VS's FY17 PE at around 16.5 times. SKP had better margins but worse better year-on-year EPS growth (20%) than VS (30%). Again this seems to have been due to the staff shortage in FY17. SKP had to discontinue a huge contract due to this. The lack in earnings growth meant that from a share price perspective, SKP has been lagging behind VS.


Simply put, the stock is being punished for past problems. Its future earnings potential are not being priced in properly. Hence it is a buying opportunity.


So let's look at possible scenarios by using VS as a benchmark. I'll use a 30% EPS yearly growth assumption (taken from VS) and apply it to SKP to determine a potential price range for the stock over the next 12 months. We use the trailing twelve months EPS for a more accurate analysis. The scenario here is the possibility that SKP can catch up with VS in terms of EPS growth or in terms of sentiment (higher PEs).



Obviously high PEs don't last forever; they will decrease once the EPS component (E) outpaces the share price (P). But with Dyson as a key catalyst, and with more information on the hair dryer business coming in over the next few months, the sentiment alone could boost SKP's valuation significantly.





​Current share price as at January 19, 2018
Some context:

1) 14 times is close to the historical average PE for SKP.
2) 16 times is closer to recent analyst estimates. Some even use FY19 figures to determine a target price at 18 times earnings.
3) 21 times is the premium valuation assigned to VS right now. If SKP gets anywhere close, RM2.98 would be the maximum upside if the market prices in a 30% EPS growth.


To me, 30% is a modest growth assumption but a feasible one. SKP's yearly EPS growth was 20% in FY17 (production issues) and 58% in FY16 (coming off a low earnings base; don't expect this to recur). Its improving profit margins in FY18 also suggests better overall net income figure alongside the expected strong revenue growth.



Most importantly : this growth does not include new Dyson contracts being awarded. If that happens, imagine how high the stock can go?





*Dyson's a private company so they don't disclose quarterly numbers.