ECS Holdings Ltd - Higher risk profile; but focusing on addressing key issues (OCBC)

Maintain BUY

Current Price: S$0.55

Fair Value: S$1.04

Focusing on working capital improvement. We believe that ECS Holdings' (ECS) key focus would be to manage its working capital over the next two quarters, which could mean softer top-line growth. Recall that its net gearing ratio had jumped up to 86.5% in 2Q11, beyond management's target of maintaining it below the 70% mark. This is further exacerbated by an increase in the group's cost of debt due largely to higher borrowing rates in China. Nevertheless, management recently updated us that the working capital situation of the group has since improved.

Impact of HP's decision to possibly spinoff or sell its PSG business… Regarding HP's decision to spin-off or sell its Personal Systems Group (PSG) business, ECS opines that the impact of a spin-off (most likely outcome) is likely to be mitigated as it is expected to continue to act as a regional distributor for PSG. This business contributed ~18% of ECS's total purchases (contribution has been declining) and ~8% of its total net profit.

…likely to be limited. Assuming ECS loses the entire 8% contribution in its FY12F net profit in a worst case scenario, which we believe is unlikely, we estimate that our fair value would only decline by 4.4% (would not change our recommendation). Moreover, even prior to HP's announcement, we had expected contribution of HP's PSG business to form a smaller proportion of ECS's top-line and bottom-line moving forward. This is due to continual efforts by management to broaden its vendor and product base as a means of diversifying its business. We understand that ECS is seeking to negotiate for more regional distributorship agreements with leading vendors such as Asustek, on top of existing regional partnerships with leading vendors such as Apple and Dell. We believe that these negotiations would be aided by ECS's extensive network coverage in its addressable markets.

Higher risk profile; but still warrants a BUY. While the risk profile of the group has increased over the past couple of months, in our opinion, we expect management to focus on addressing these key issues. For now we maintain our estimates and BUY rating with an unchanged fair value estimate of S$1.04 (based on 7x blended FY11/FY12F core EPS). ECS is trading at 3.3x FY12F PER, below its average forward PER of 3.5x during the 2008-2009 global recession. As such, we believe that the market has already priced in the uncertainties concerning both the group and macro economy. Risks to our target price include a sharper-than-expected slowdown in consumer spending on electronics products and corporate spending on IT upgrading.

Jump in net gearing ratio. ECS's net gearing ratio increased from 65.8% in 1Q11 to 86.5% in 2Q11, beyond management's target to maintain it below the 70% mark. This was due to higher working capital requirements and increased bank borrowings to fund its aggressive expansion plans. Looking ahead, we opine that there is increasing financial risk on the group given that its cost of borrowing has also spiked up due largely to higher interest rates in China. Moreover, we believe it is unlikely for ECS to use equity financing at this stage given the recent sell-down in its share price (ECS had just announced its intention to withdraw its TDR application in Aug 2011). Hence we are positive on management's priority to focus on its working capital management in the immediate term to ease its financial strain, although this could mean softer sales growth.

Futrure expansion plans. China remains a key geographical market for ECS. The group is seeking further penetration into lower-tier cities in China. Four offices have been set up in 1H11, with another three slated to be opened in 2H11. There are also plans for 13 new offices in FY12, but this is subjected to review depending on how well it manages to control its working capital in the next couple of quarters. India and Vietnam also remain as viable new target markets although this is unlikely to happen in the near future despite the potential of these geographies, in our opinion. Although the group has carried out extensive research on these areas, we believe it will manage its expansion plans less aggressively moving forward to focus on improving its working capital before embarking on penetration into new territories.