Description

THINKING ELECTRONIC INDUSTRIAL CO LTD (2428.TW)

IDEA

Thinking Electronic (TE) is a global market leader for thermistors and varistors, listed in Taiwan. TE’s products are used in power supply and most electrical devices to help regulate temperature, voltage and current. A large market share of 40% has allowed the company to develop cost advantages. The products are tailor-made and represent a low cost - yet crucial - item for their customers. Customers sign long term contracts with trusted suppliers whom they believe can meet their requirements in terms of R&D, timing, quality, cost etc. and can guarantee the supply, typically for a period of 10 years. These attractive characteristics resulted in a strong historical financial performance with revenue growth of 5% p.a., EPS CAGR of 12% and high operating margins & ROE over the past 5 years of respectively 21% and 18%.  

The share price has declined 17% from its peak early this year because of concerns over COVID. Although there will be a short-term impact on TE’s financial performance we believe the longer-term outlook remains positive. At a trailing P/E of 9.5x (7.6x net of excess cash), we believe our downside is protected and the probability of generating an attractive return is high.

BUSINESS

TE is a manufacturer of a broad range of circuit protection solutions that guarantee user safety for electrical devices. The slide below provides an overview of product categories and applications.

When we met with the company in October 2018 TE estimated its global market share at 40% for NTC (negative temperature coefficient) thermistors and 42% for varistors with its 3 main competitors, TDK, Murata and Shibaura, dividing the rest of the market. [1]  The company indicated its market share had been stable for the last 10 years. 

Over-Temperature/Over-current Protection NTC Thermistors account for 53% of sales, Ceramic PTC (positive temperature coefficient) Thermistors 9%, Over-voltage Protection Varistors 33% and others 5%. [2]

The company generates 10% of its sales through distributors. For its direct sales the breakdown by application is as follows: power supply 34%, home appliances 15%, PC 10%, industrial system 8%, others 7%, automobile 6%, lighting 4%, consumer electronics 4%, telecom 2%. [1]

TE has a diversified customer base consisting mainly of MNC’s such as Panasonic, Samsung, Sony, Midea, and Philips.

70% of sales are generated in Asia with 20% in Europe and 10% in the US. The factories are located in Taiwan and in China.

To be able to compete effectively in this industry you need to be able to provide high-quality, reliable components at competitive prices. Most of the products sold by TE are highly customised. Before thermistors or sensors are integrated in the product of one of their customers there are long discussions about the specifications of the thermistors and sensors. Products are therefore different for each client. BMW and Tesla for example would have very different designs for their battery set-up and motherboards, therefore thermistors and sensors will be different.

Customers work with several suppliers. TE is the main supplier for their main products with allocations from 70% to 90% and 3% to 10% allocations for each back-up supplier. As evidenced by the consolidated nature of the industry, barriers to entry are high. Thinking Electronics’ decades-long focus on R&D has allowed it to develop proprietary production techniques and designs giving it an advantage over its competitors. The company has internally developed automated production processes and equipment that enable it to efficiently produce at scale. 

Price is important but so are quality and support. Customers search for providers that help them meet safety regulations across a variety of geographies. This industry uses a certification process and once certified as a supplier the price determines the allocations. The key is to get certified and then develop advantages in terms of quality or cost to increase allocations.

For a new product, the client will release the specs and then it’s up to TE and its competitors to develop a product that meets these specifications. Sometimes the specs are determined in consultation with potential suppliers.

TE is the largest player in this industry and that makes it easier for potential customers to have them certified. Their size also helps TE to develop cost advantages.

Certification is a 2-way partnership, TE’s facility will be inspected but potential customers also help their suppliers to meet their requirements.

For the last 10 years, when TE was the main supplier, they always remained the main supplier.

TE believes its sales have grown in line with their customers and therefore its market share with those customers must be stable. 

Certified suppliers sign long term contracts with their customers. Contracts for Electric Vehicles are for a period of at least 3 years. Contracts for home appliances are for a period of 10 years, renewable every 3 years because the customers want to make sure they’re guaranteed of a stable supply.

Technology has evolved over time. Over the past 10 years TE’s products have gradually become smaller and performance has improved. The company spends 2 to 3% of sales on R&D.

Demand is driven by old products being replaced with new ones and also by new applications for their products. Short term, sales are cyclical although the largest yoy decline since 2003 was -4.2% (in 2012). With regards to the impact of Covid-19, the monthly disclosure of sales shows a decline of -22% in Q1 2020 versus Q1 2019.

GROWTH

Over the last ten years, sales have increased with 6% p.a. and TE believes this growth rate can be maintained in the future. Global electricity consumption is expected to grow, and the functionality of electric devices will increase making the products more complex. This trend should support the demand for protection components.

TE is also expanding its business lines. Components for the car industry account for ∽7.5% of revenue in 2019 [3]. This business grew âˆ½14% since 2015 and the company expects the components for Electric Vehicles to be a large market. It has built a production line especially for the car industry and has achieved some early success, for example by becoming a supplier to Tesla.

In addition, the company sees growth related to 5G, both in power supplies and applications for 5G base stations, as well as 5G-connected cars.

TE is also looking at India because they see a lot of potential for power meters and telecom as a result of large infrastructure and construction needs in that country. Electric motorcycles are another growth opportunity in India, similar to China. India is also being considered as a possible location for a new factory.

When we met with the company the focus was on organic growth and there were no plans for acquisitions. TE wants to focus on their core expertise.

PROFIT MARGINS

Operating margin is currently at a historical high of 24.9% with a range of 11.0%-24.9% over the past 10 years. Volatility in profit margins is largely driven by changes in the gross profit margin. Cost of goods sold consists of precious metals accounting for 50%, followed by labour costs for 20% and other manufacturing costs for the remaining 30%. The increase in gross margins is partly due to the advances the company made over the last few years in automating its production processes. TE does not disclose profit margins per segment. 

VALUATION

The shares are now valued at 9.5x last year’s after-tax earnings and 7.6x, net of excess cash. This is very cheap for a company with the characteristics we described above. A net-cash balance sheet should allow TE to survive the current downturn and benefit from the long-term growth drivers for their industry.  

MANAGEMENT

TE shares some of the characteristics that we have seen in many other companies in Taiwan: high insider ownership, modest compensation and a high dividend pay-out ratio.

The management team, the BoD and their family members hold 42.40% of total shares. 

The CEO and Vice-CEO are paid in total USD 712k, of which approx. half in performance-related compensation. 

The dividend payout ratio is 40% to 50%.

A buy-back plan was announced on March 27th 2020 to repurchase 0.94% of outstanding shares in April & May with a price limit at 80 NTD.

RISKS

- COVID-19

- Increase in the price of precious metals

- Increase in labour cost 

[1] Source: Thinking Electronic Industrial – Legal Person Briefing 2018

[2] Source: Thinking Electronic Industrial – Legal Person Briefing 2019 Q1

[3] Source: Thinking Electronic Industrial – Legal Person Briefing 2019 Q1 - estimate for FY19

Catalyst

- Economic recovery from Covid-19

- Continued sales growth