Introducing Cheung Woh
Cheung Woh Technologies Ltd manufactures and supplies precision hard disk drive (HDD) components. The company operates through two segments, HDD Components and Precision Metal Stamping Components with HDD Components being the core segment at 84.5% and 73.7% of FY16 group revenue and profit before tax respectively. The company has factories in Zhuhai, China and Johor and Penang, Malaysia. After Armstrong was delisted in 2012, Cheung Woh, to my knowledge, remains as the only listed supplier of HDD components in the Singapore stock market.
It’s Perception as an Undervalued Gem
As of 10th June, Cheung Woh trades at a market capitalisation of SGD62.0mn. Based on its FY16 results, this corresponds to a 0.55x P/B, 6.9x P/E and 3.2x EV/EBITDA. The company also gave out SGD4.5mn of dividends in FY16 which is a 7.3% dividend yield at current share price. Numerically, it is easy to see why Cheung Woh should be regarded as a cheap stock. The more speculative might even conjure privatisation or buyout scenarios as possible catalysts.
However, for reasons to be covered below, we have our misgivings about Cheung Woh’s supposed undervaluation.
Unfavourable Industry Dynamics
There are only two main players for HDDs – Western Digital and Seagate. As a duopoly, Cheung Woh is totally dependent on them for its survivability. And as a duopoly, Western Digital and Seagate will inevitably be the price setters, and Cheung Woh the price takers. It will do no good to them if Cheung Woh goes out of business, but neither will they pay significant premiums – unless they are able to pass the premium onto consumers.
That would be tall affair given the availability of a technologically superior substitute – solid state drives (SSDs) – which have less moving parts (lower chance of breakdown), generate less heat (lower power consumption) and have faster speeds. Prices between HDDs and SDDs have narrowed steadily in the last few years.
We will not go so far as to predict total obsolescence for HDDs, but it is indubitable that the threat of SDDs will hang like a knife. This does not bode well for the long term prosperity of a HDD supplier like Cheung Woh.
Highly Capital Intensive Business
As with most technologies, the HDD industry is built on innovation and development. Unfortunately, it also means that a supplier like Cheung Woh’s has to constantly replace and upgrade its production lines just to stay in the game.
We will use figures from 2013 (after the disposal of their automotive operations) to illustrate the point.
Depreciation as a percentage of property, plant and equipment has been north of 13%, though it has been trending down. There is a possibility that it has been overstated – perhaps the management is being conservative.
Unfortunately, the company has also only generated a cumulative SGD6.0mn in free cash flow from 2013 to 2016. Admittedly, 4 years may not be the best of judge, but the numbers from 2010 to 2012 paint a similar picture with a cumulative negative SGD15.6mn in free cash flow. Cheung Woh is far from a cash cow.
Due to its capital intensive nature and unfavourable industry dynamics, I would think that Cheung Woh is more likely to be a value trap than a value gem. Securities can remain under-priced for long periods of time. Ideally, like tension building up in a spring, the discrepancy between price and value should widen over time. As the discount persists, tension builds and threatens to snap it ever more. Unfortunately, I don’t believe the same can be said for Cheung Woh due to low free cash flow and the threat of SSDs. There may be short term upsides, perhaps from industry consolidation or so. But in the long term, it is highly unlikely to be a tightening spring.