Asia Automation: Replacement demand and margins to drive growth

Disclosures & Disclaimer This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it. Issuer of report: HSBC Securities (Taiwan) Corporation Limited View HSBC Global Research at: https://www.research.hsbc.com ✔VoteinAsiamoneyBrokersPoll20164July-12AugustIf youvalueourserviceandinsight,voteforHSBCClickheretovote  Replacement demand driving automation orders; expect accelerated share gains after yen appreciation  Margin expansion a catalyst for near-term earnings upgrades; acquisition and product expansion to drive long-term growth  Buy Airtac, Delta, Ennoconn and Advantech for potential market share gains and margin upside China’s pneumatic sector sales growth is on track to improve from 2015’s low-single-digit level to a mid-single-digit level in 2016. Airtac’s management believes a marginal acceleration to mid- to high-single-digit growth in 2017 is likely in light of replacement demand, which is in turn being spurred by the trend towards automation. Indeed, the major capacity expansion during 2H09-1H10 means many machines in China’s manufacturing sector are now eight or more years old; replacing such outdated equipment could help improve manufacturing efficiency and save on labour costs. Currency movements in the aftermath of the Brexit vote could benefit Taiwan’s automation sector, especially those companies with more limited sales exposure to Europe. The profitability of the major automation suppliers in Taiwan, Airtac and Hiwin, has been under significant pressure since mid-2014, when the JPY depreciated more than 20% against the USD from peak to trough. Airtac’s gross margin was only 50% in 1Q16, versus 55-60% in mid-2013, when USDJPY was at 95. We expect Taiwan’s automation players to enjoy gradual gross margin expansion. Key automation players in Taiwan are expanding their product offerings via in-house development and acquisitions. Delta and Airtac are pursuing more integrated solutions and trying to expand their modularization offerings. New applications and sector exposure are also part of Delta and Hiwin’s growth strategies. Lastly, communications/ networking capabilities are becoming increasingly important in industrial applications, driving recent acquisitions by Advantech and Delta. The main risk for the sector is a potential capex slowdown if the global economy weakens further. We like stocks that offer potential market share gains and margin expansion (Advantech, Airtac, Delta, Ennoconn, all rated Buy). Delta is our preferred play as we expect its structural business shift to drive a longer-term re-rating. We raise our 2016 EPS estimates by 0-9%. Our EPS estimates are above consensus for Airtac (+7%), Delta (+7%), Ennoconn (+2%) and Hiwin (+10%). 12 July 2016 Jenny Lai*, CFA Analyst HSBC Securities (Taiwan) Corporation Limited jennylai@hsbc.com.tw +8862 6631 2860 *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations Asia Automation EQUITIES MACHINERY Taiwan Key changes to ratings and estimates Market cap ADTV Current ______ TP _______ __ Rating ___ Upside/ 2016e EPS (TWD) Company Ticker Currency (USDbn) (USDm) price Old New Old New downside (%) Old New Cons. 2016e PE (x) 2016e PB (x) Advantech 2395 TT TWD 4.9 6.2 251.0 265 265 Buy Buy 5.6 9.00 9.02 9.15 27.8 6.4 Airtac 1590 TT TWD 1.4 6.9 245.0 247 295 Buy Buy 20.4 11.42 11.76 10.97 20.8 3.9 Delta 2308 TT TWD 13.1 23.5 162.0 178 178 Buy Buy 9.9 8.02 8.19 7.66 19.8 3.1 Ennoconn 6414 TT TWD 1.0 8.1 445.5 494 494 Buy Buy 10.9 17.19 17.29 16.99 25.8 6.4 Hiwin 2049 TT TWD 1.2 9.6 146.5 121 134 Hold Hold -8.5 5.73 6.23 5.65 23.5 2.7 Source: Company data, HSBC, Bloomberg. Priced as of close at 11 July 2016. Replacement demand and margins to drive growth  EQUITIES  MACHINERY 12 July 2016 2 We hosted a week of investor meetings with Airtac’s management and came away with positive take-aways about the company and the automation sector. In this note, we evaluate the comments that were made at the meetings with management and assess the current state of the overall automation sector. Replacement demand According to Airtac’s management, automation sales growth is stabilizing with a small improvement seen in replacement demand. China’s pneumatic sector sales grew at a low-single-digit rate in 2015 but growth is now on track to improve to a mid-single-digit rate in 2016, according to Airtac management. Management believes marginal acceleration in sales growth in the overall pneumatic sector to a mid- to high-single-digit rate is likely in 2017, driven by replacement demand. The major capacity expansion in China’s manufacturing sector during 2H09-1H10 indicates that many machines will be eight or more years old; this equipment may lack the much needed automation features to help improve manufacturing efficiency and save on labour costs. While overa