Is KESM an investment opportunity?

Value Investing Case Study 76-1: A fundamental analysis of KESM to see whether it is a value trap or an investment opportunity.

KESM is the world's largest independent provider of burn-in and test services for integrated circuits, a critical component in the semiconductor industry.

Despite its strong market position, KESM has faced significant challenges in recent years. This followed the onset of the COVID-19 pandemic and ongoing geopolitical tensions, which have disrupted supply chains.

To be transparent I invested in KESM years ago when it was trading around RM 2.50 per share. I then sold it off when the market price increased to RM 5.00 per share. I thought that I was being clever having doubled my investment.

Imagine my regret when the price went up after my sale to almost RM 20 per share. Yes, I was an idiot. Today the market price had declined to below RM 5 per share and I wanted to see whether there was another round to make money.

This article delves into KESM's operational performance, financial health, and market positioning. By analyzing the company's strategic focus on the automotive semiconductor segment and its response to industry challenges, I aim to provide a comprehensive assessment of KESM's current standing and prospects.

My analysis showed that to regain its profit performance, it needs to rebuild its revenue. Would KESM be able to do this? Read the article to find out.

Should you go and buy it? Well, read my Disclaimer.

Company background

Operating performance

Financial position

Valuation

Conclusion

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Company background

According to KESM, the Group is principally involved in assuring the reliability and functionality of integrated circuits by providing burn-in and test services. It is the world’s largest independent provider of these critical services.

Founded in 1983 as an integrated circuit burn-in services provider, the Group diversified into electronics manufacturing services “EMS” in 1997. In 2007, KESM established a factory in the province of Tianjin, China, to provide semiconductor burn-in and test services.

The Group did not provide any breakdown of its services but it began to scale down its EMS operations in 2022.

The bulk of the operations in terms of revenue from customers and non-current assets are from Malaysia. Refer to Chart 1. In 2024, China (PRC) only accounted for about 17 % of the revenue and 9 % of the non-current assets of the Group.

Chart 1: Revenue and Non-Current Assets

Operating performance

Over the past 12 years, revenue initially grew from 2013 to a peak in 2018. Thereafter there was a drastic decline such that 2024 revenue was even lower than that in 2013. Refer to the left part of Chart 2.

Profit was even more volatile. From 2013 to 2017/18, there was a fourfold increase in PAT. But profit began to deteriorate such that the Group incurred losses in 2023.

KESM described the decline as follows in its 2022 Annual Report.

“The events that led to the current chip shortage crisis could be traced back to when US-China trade tension escalated into a tech war (2019). Then, the pandemic began (2020/21). Following the slowdown in the car market, orders for automotive chips have scaled down. In 2022, demand for cars rebounded faster than expected but car makers were unable to secure chip supplies as foundries had reallocated capacity for consumer electronics which experienced a surge in demand during the COVID lockdown.” 2022 Annual Report

The challenging market situation continued till 2024.

“The global semiconductor industry faced considerable uncertainties due to ongoing geopolitical tensions and economic headwinds. These factors, combined with fluctuating demand and supply chain disruptions, impacted our operations.” 2024 Annual Report

Given the profit performance, we see similar peak and decline patterns for the returns. As such over the past 12 years, KESM delivered an average of 6% ROIC and 5% ROE. These returns were much lower than the current 9 % WACC and 10 % cost of equity, implying that no shareholders’ value was created.

It is interesting to note that KESM revenue has been “stable” since COVID-19. I think part of the reason for this was its decision to focus on the automotive segment:

“…by keeping focus on new and growing opportunities in the automotive market segment of the semiconductor industry…We are committed to the semiconductor automotive market.” 2016 Annual Report

“…Our volumes for test and burn-in are growing. We envision a future of many new cars with embedded chips that would be tested in our manufacturing process. Automotive electronics are expanding…” 2018 Annual Report.

“…Despite the broader industry challenges, the demand for automotive semiconductors remained relatively robust.” 2024 Annual Report.

Chart 2: Performance Index and Returns

The other feature to note is the declining gross profitability. As can be seen from the left part of Chart 2, this decline started in 2015 and seemed to reach the trough in 2023.

Despite the decline in revenue from 2018, KESM’s gross profit margin seems to be relatively stable as shown in the left part of Chart 3. I would posit that the declining gross profitability was attributable to a faster increase in total assets.

While there was some stability in the gross profit margin, the Selling, General, and Administration (SGA) margin trended up over the past 12 years. The result was a decreasing operating profit margin that was less than 1 % over the past few years compared to an average of 7 % in 2013/14.

Unlike many of the other manufacturing companies that I have covered, KESM has a very high “fixed cost” component. Refer to the right part of Chart 3. This meant that KESM had a very high breakeven sale. I estimated that based on the 2024 cost, it required RM 250 million in revenue to break even.

Note that because of the nature of its business, depreciation & amortization accounted for an average of 27 % of the fixed cost. This suggests that cost control especially for the SGA and other operating expenses is critical for its profitability.

Chart 3: Margins and Operating Profit

Note to Op Profit Profile. I broke down the operating profits into fixed costs and variable costs.

Fixed cost = SGA, Depreciation & Amortization and Others.
Variable cost = Cost of Sales that excluded Depreciation & Amortization.
Contribution = Revenue – Variable Cost.
Contribution margin = Contribution/Revenue.

Efficiencies

Given the high break even and the importance of cost control, the Group needs to focus on improving efficiencies. To be fair, the Group has been addressing this.

“In the next 4 years, we are driving towards Industry 4.0 by investing in Artificial Intelligence.

“AI” and data to change and excel in process quality.” 2018 Annual Report

“The Group has set its goal to accelerate automated processes” 2022 Annual Report

Notwithstanding the Group’s goals, there is not enough evidence that the Group has achieved better operating and capital efficiencies.

Operating efficiencies. Refer to the left part of Chart 4. While there was improving inventory turnover, there were no improving trends for the other 3 metrics.

Capital efficiencies. Refer to the right part of Chart 4. While there was an improving Reinvestment margin, there were no clear improving trends for the other 3 capital efficiency metrics.

Chart 4: Operating and Capital Efficiency Trends

Peer comparison

I compared KESM's performance with 4 other Bursa electronic companies as shown in Table 1. You can see that KESM was the biggest among the peer groups in terms of the 2023 revenue. The 2 other peers with revenue data from 2013 also showed declining revenue. You can say that KESM had the lowest revenue decline.

Table 1: Peer Revenue

Note: Edelteq and Oppstar were not listed in 2013.

I looked at the trends of 4 metrics to get a sense of how well KESM performed compared to its peers. Refer to Charts 5 and 6.

KESM appears to be facing significant challenges, particularly in cash flow generation and profitability, despite having stable capital returns relative to peers. The declining EPS and worsened cash flow margins suggest a need for strategic re-evaluation to enhance financial health and improve competitive positioning in the market.

I would rate KESM's return on capital and EBIT margin as average. Compared to its peers, it had a more stable return on capital.

KESM's levered free cash flow margin seemed to have deteriorated over the past few years to be the worst in 2023.

While it had the best EPS initially, it began to decline in 2019 to be the worst in 2023.

Chart 5: Bursa Peer Return on Capital and EBIT Margin

Chart 6: Bursa Peer Levered Free Cash Flow Margin and EPS

Financial position

I would rate KESM as financially sound.

As of Jun 2024, it had RM 247 million cash. This is equal to 53 % of its total assets.

It had a Debt Equity ratio of 0.17 as of Jun 2024. This has come down from its 2018 high of 0.21.

Over the past 12 years, it generated positive cash flow from operations every year. During this period, it generated RM 743 million cash flow from operations compared to the total PAT of RM 164 million. This is a very good cash flow conversion ratio.

From 2013 to 2024, it had a negative Reinvestment. I defined Reinvestment = CAPEX + Acquisition – Depreciation & Amortization + increase in Net Working Capital. The negative value implies that the amount spent on CAPEX and/or the increase in Net Working Capital was smaller than the Depreciation & Amortization. This is a good position as it meant that the company did not have to allocate funds to support its growth.

KESM's main weakness is its capital allocation track record. Refer to Table 2. A big part of the cash flow from operations was used to fund its CAPEX. There was not much excess that could be returned to shareholders.

Table 2: Sources and Uses of Funds 2013 to 2024

Valuation

In valuing KESM, I adopted the following picture:

I assumed that there would not be high revenue growth. Rather I assumed that growth would follow the long-term GDP growth rate of 4%.

There would not be any improvement in the operating and capital efficiency. Given the scaling down of the EMS operations in 2022, I assumed that the 2023/24 operating and capital efficiencies as the long-term ones.

Given the high breakeven picture, I looked at 2 scenarios.

Scenario 1. This is based on the current revenue.

Scenario 2. This assumes that the Group would be able to rebuild the revenue to the past 12 years' average level.

Table 3 summarizes the intrinsic values compared to the market price of RM 4.45 per share. You can see that there is not enough margin of safety under Scenario 1. But there is a 171 % margin of safety under Scenario 2.

Table 3. Valuation summary

Notes

a) 2024 revenue. Others are average 2023/24 post-EMS.

b) Average 2013/24 revenue. Others are average 2023/24 post-EMS.

As a sanity check, I considered other valuation metrics as illustrated in Table 2. You can see that

KESM is trading below its Asset Value. Note that this Asset Valuation only makes sense if KESM does not incur further losses.

Based on the Acquirer’s Multiple KESM is considered cheap. A big part of this was contributed by the large depreciation & amortization.

Based on the past 12 years' Free Cash Flow yield, it is a good investment opportunity. This of course assumed that KESM could rebuild its performance.

Table 4: Valuation metrics

Notes

a) EV / (average 3 years Op profit + Depreciation).

b) 2013 to 2024 average Free cash flow/market price.

Valuation model

In valuing KESM, I based it on the operating profit model shown in the right part of Chart 3. I valued it based on the single-stage Free Cash Flow to the Firm model.

FCFF = EBIT(1 – t) - Reinvestment.

EBIT = Revenue X Contribution margin – Fixed cost.

Reinvestment was based on the Reinvestment margin. I assumed this to be zero due to the negative historical rate.

Value to the firm = FCFF X (1 + g) / (WACC – g).

Table 5 illustrates the calculation under Scenario 2. The WACC was based on the first-page result of a Google search for “KESM WACC” as shown in Table 6.

Table 5: Sample calculation – Scenario 2

Table 6: Estimating the cost of funds

Case Notes

When valuing companies using Free Cash Flow to the Firm (FCFF), cash is often considered a non-operating asset for several reasons:

Core business focus: FCFF aims to assess the cash generated by a company's core operations. This separation helps in understanding how much value the core business generates without the influence of financial assets.

Investment opportunities. Excess cash can indicate that a company is not fully utilizing its resources to invest in growth opportunities. By excluding non-operating cash, analysts can better evaluate the efficiency and effectiveness of the company’s operations and capital investments.

Risk assessment. Cash can be a low-risk asset, while the firm's operating assets carry different risk profiles. By isolating cash, analysts can better assess the risk and return associated with the firm's operational activities.

Capital structure. When calculating FCFF, it is important to understand how much cash is necessary to maintain operations versus how much is available for distribution to investors.

Considering cash as a non-operating asset in FCFF valuations provides a clearer picture of a company's operational performance, investment efficiency, and overall value derived from its core business activities, which is crucial for accurate financial analysis and decision-making.

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Risks and limitations

There are 2 issues to consider when looking at my valuation.

How much of the cash should be considered as non-operating assets?

How long it would take for KESM to rebuild its revenue?

I wish to point out that KESM had cash amounting to RM 247 million. The value of the firm from the Free Cash Flow under Scenario 2 amounted to RM 389 million (refer to item o, Table 5). Assuming a proportionate contribution, cash accounted for about 39% of the intrinsic value.

Along the same line, the value of the firm under Scenario 1 came to RM 65 million. You can see that a big part of the intrinsic value came from the cash holdings rather than the business operations.

The challenge for KESM is that because of its high CAPEX, the cash should not be considered as part of the non-operating assets.

To be transparent, when I was a shareholder of KESM years ago I did write to the company asking for the cash to be returned to shareholders. The company replied stating that because of the nature of its operations, it wants to retain the cash so that it can be used for its Reinvestments. This supports my contention that the cash should not be counted as part of the non-operating assets.

If you assumed all the cash as operating assets, the intrinsic value of KESM under Scenario 2 reduces to RM 6.34 per share. It would be negative under Scenario 1.

But the more important point from the two Scenarios is that KESM needs to rebuild its revenue to provide a sufficient margin of safety. Given its history and focus on the automotive sector, there is a fighting chance. The challenge is how long it would take to rebuild this.

The intrinsic value derived under Scenario 2 assumes that this would be immediate. Any delay would mean a lower intrinsic value. You can get a sense of this by discounting each year by the WACC.

The challenge for an investor then is figuring out how long it would take for KESM to rebuild its revenue. At the same time, you also have to figure out the portion of cash to be counted as non-operating. Both impact the intrinsic value.

Conclusion

KESM operates as the world’s largest independent provider of burn-in and test services for integrated circuits. However, the company has faced significant challenges in recent years.

Revenue declined since 2018, exacerbated by global supply chain disruptions and geopolitical tensions. This resulted in a drop in profit margins and earnings per share.

Despite these difficulties, KESM is financially sound.

It has cash reserves and a low debt-to-equity ratio.

The company has consistently generated positive cash flow from operations.

However, its capital allocation decisions raise concerns, as a significant portion of cash flow has been directed toward capital expenditures, limiting returns to shareholders.

Looking ahead, KESM must focus on improving operational and capital efficiencies. The strategic pivot towards the automotive semiconductor market shows promise. However, achieving significant growth will require a commitment to cost control.

My valuation scenarios suggest that the current revenue levels do not provide a favourable margin of safety. But there is potential for substantial upside should KESM manage to restore revenue to historical averages.

Look for turnaround signs before you invest.

END

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I am not an investment adviser, security analyst, or stockbroker. The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies. Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them.

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such.

I may have equity interests in some of the companies featured.

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