Meet Malaysia’s most profitable listed company

Making sure the lights work is big business. Malaysia’s most profitable company, Elsoft Research Bhd, has a track record of constantly reinventing itself not only to adapt — but also to capture valuable market opportunities

Testing: more important than you think

In a world filled with billions of goods, the only way to stand out is with high quality, value-added products. This is what differentiates a popular brand like Apple or Samsung from lower-end competitors.

Testing is a very important part of the production process. By building test equipment and conducting important quality checks, companies like Elsoft make sure only the best products make it to the shelf. Ever experienced an unreliable product? That’s probably due to a bad tester!

Bursa Malaysia’s most profitable company..checks if your lights work

Test solutions provider Elsoft Research Bhd is Malaysia’s most profitable listed company, generating a 51% profit-after-tax margin in FY2018. Elsoft has successfully transformed over the years to adapt to the ever-changing technology industry. Despite Elsoft having to shift product offerings and business positioning multiple times, the group’s net profits are up 28x since 1997.

Elsoft combines its expertise in electronics and software to deliver a complete tester solution to some of the world’s biggest LED makers. Elsoft focuses on tough segments like smartphone flash LED and automotive LED.

Due to the highly demanding requirements for these tests, few rivals can do what Elsoft does. Quality and reliablity are extremely important in these segments: if your car lights fail, it could affect your safety.

In this report, we take a deep dive into:

  • How Elsoft achieves its superb margins
  • The test industry and the growing market for LEDs
  • Elsoft’s transformational growth story, and what could lie ahead

Standing tall in a crowded space

As one of the world’s largest electronics manufacturing hubs, Malaysia has many players in the tester sector. But only a few of them can meet the demands of the LED industry, which is dominated by multinational corporations like Philips, Lumileds, Osram, General Electric and Toshiba.

LED testing is difficult. LED testers go far beyond just checking every single LED to see if it can be turned “on.” Testers must also inspect the quality of an LED’s color spectrum, the brightness of the light, and even the uniformity of lights(i.e., whether the lights light up an area without any gaps).

FROM LEFT: Inside Elsoft’s factory(Photo taken from The Star), LED burn-in testing system developed by Elsoft, automated LED test equipment developed by Elsoft

Within the LED industry, Elsoft has opted to focus on sub-segments where testing requirements are tougher — and there is less competition. Elsoft is less involved in the “general lighting” segment. It focuses on the smartphone camera flash and automotive sub-segments, where testing requirements are difficult. Due to the advanced technology demands of this segment, Elsoft’s testers are able to earn impressive profit margins.

In 9M 2019, tester equipment for the smart devices and automotive segments contributed to 66% and 21% of Elsoft’s revenue. Elsoft earned just 7% of its revenue from the general lighting (8%) and other (6%) segments.

Winning in the smartphone battleground

Elsoft supplies testers to a manufacturer making Flash LEDs for one of the world’s biggest smartphone brands. The boom in smartphone photography has been a major driver for Elsoft’s business, ever since it entered the segment in 2012.

Over 1 trillion photos were taken by smartphones in 2017. Research shows camera quality is the third-biggest consideration for smartphone buyers — more important than battery life, speed, and screen resolution. This links up with a Deloitte survey that found photography is the most popular use for a smartphone.

Between 2018 to 2022, more than 1 billion smartphones will be sold, as consumers from emerging economies upgrade from lower-end “feature-phones” to smartphones. There are over 610 smartphone brands fighting for a slice of this valuable market opportunity.

To win over consumers, smartphone makers are racing to introduce new, exciting camera features. This has resulted in the development of front-flash, multi-flash, and multicolor LEDs. Technavio expects the global market for smartphone flash LEDs to grow at a CAGR of more than 21% from 2017 to 2021.

LED-enabled notifications are the next big thing. Samsung’s Galaxy S10 camera is considered to have one of the best front-flash LEDs.

Gaining from the car industry’s shift to LED

Elsoft entered the automotive industry in 2006. This gave it a foothold in an industry that’s difficult to penetrate, as there are just a handful of lighting firms supplying tier-one manufacturers. Today, Elsoft generates about 20% of its revenue from the automotive LED segment.

Ever had to close your eyes while driving because of another car’s lights? When approaching another car on the road, some of Audi’s Matrix LED lights turn off.. to avoid blinding the other driver.
With LED-enabled dynamic corner illumination, headlamps light up the corner.. even before the driver turns the wheel!

The cost of LED technology has dropped a lot over the years, making it cheap enough to be used in cars of all price levels. Previously, LEDs were only used in high-end cars. Lower-end cars used halogen and xenon lamps, which are generally cheaper to produce.

Today’s carmakers use LEDs to add value to their cars, through functionality and design. Daytime running lights were among the earliest applications of LEDs. Today, a Mercedes-Benz E-class uses LEDs to create 64 different interior colors, which can be easily changed by the driver. The E-class’ LED headlights, meanwhile, has 84 LEDs that can be controlled individually, enabling safety functions such as dynamic corner illumination, or high beam assist.

By 2020, one in five cars will be using LED lights, according to the Boston Consulting Group. That is a far cry from 2015, when just 3% of all cars used LED lights.

As the cost of LED technology falls, carmakers are finding more and more ways to use LED. This is causing the volume of LED content in cars to increase. Driven by rising usage of LEDs, the car lighting industry is expected to grow at a CAGR of 5.3% to $37.3 billion in 2023, according to analyst group Yole Développement.

The end of the light bulb

The global lighting market is shifting to LED because of its low energy consumption, long lifespan and ability to provide different colors and brightness levels, as well as technology functions.

Lighting takes up 19% of the world’s electricity consumption. Governments around the world — such as the EU, the U.S. and China have banned inefficient lighting as part of policies to combat global warming. This has driven up usage of LEDs, which are 4–5x more energy-efficient than conventional lighting.

No more changing light bulbs: while LEDs appear more expensive than older lighting tech, the total cost of LED ownership is actually lower. LED lamps last about 15 years, 4x the lifespan of compact-fluorescent lamps(4–5 years) and 10x the lifespan of incandescent, halogen lights(1–2 years).

LEDs: brightening up our future

The magic of LED is that it can be combined with other electronics to create new technology.

LEDs are now helping bring futuristic technologies such as eye-tracking, gesture recognition, and facial recognition to life. These three technologies make heavy use of infrared LEDs — LEDs that create invisible light — to work.

Between 2018 to 2023, the infrared light source market is expected to grow 3.6x to US$6.5 billion, according to analysts at Yole Développement.

Eye-tracking in VR/AR headsets

LEFT: Microsoft’s HoloLens RIGHT: Iron Man controls his suit using eye-tracking.

In the Iron Man films, Tony Stark interacts with his armor through its eye-tracking function. This very technology is well on its way to our world, in Virtual Reality/Augmented Reality(VR/AR) headsets made by Apple, Facebook, Google, and Microsoft.

Eye-tracking uses your eyes to control your device. Our eyes immediately focus on whatever we are paying attention to, which makes eye-tracking a natural way to move around a user interface. Eye-tracking will be particularly useful in a VR/AR system because VR/AR is three-dimensional, requiring us to move our heads(and eyes) up and down.

In fact, Avi Bar-Zeev, the co-inventor of Microsoft’s AR/VR headset, predicts eye-tracking will one day replace the computer mouse as the main interface used to interact with computers.

HOW EYE-TRACKING WORKSWhen you wear an eye-tracking headset, tiny LEDs shine infrared (invisible) light into your eyes.  When this happens, the light will bounce off your eyes, creating a reflection.This reflection is "captured" by cameras installed on the headset itself, allowing it to track the movement of your eyes - your pupil size, your direction of gaze, and your focus.Because the headset now knows what you're looking at, it knows what you want to "select," or zoom in on.

Facial recognition technology

Facial recognition technology is changing the world. In China, millions of cameras are used by the government’s surveillance network. Many of these cameras are fitted with facial recognition technology.

MasterCard’s Identity Check app allows customers to confirm a payment using their smartphone camera. With facial recognition technology, healthcare providers may one day be able to diagnose a patient online, simply by “looking” at a patient’s features.

APPLE’S FACEID USES LEDS TO UNLOCK YOUR PHONEIn 2017, Apple introduced FaceID, an iPhone feature allowing you to unlock your phone using your face. When setting up FaceID, the iPhone uses infrared LED to project thousands of invisible dots onto your face. These dots are then used to create a 3D “map” of your face.When you want to unlock your phone with FaceID, infrared LED is used again to create a map of your face. To check your identity, your iPhone compares this map with what was saved earlier.

Gesture recognition

No more fiddling with buttons or switches. Using gesture recognition, car drivers can “turn up or turn down the volume, accept or reject a phone call, and change the angle of the multi-camera view” — with just a quick flick of their hands or fingers.

The number of in-car gesture recognition systems is expected to jump to 38 million units in 2023, from 700,000 units in 2013. Audi, BMW, Cadillac, Ford, GM, Hyundai, Kia, Lexus, Mercedes-Benz, Nissan, Toyota and Volkswagen are all installing gesture technology into their cars. Gesture recognition has also made its way into smartphones such as Google’s Pixel 4, which was launched in October 2019.

HOW LEDS ARE USED TO “SENSE” YOUR GESTURESInfrared LEDs are used to find out the distance and direction of a user’s hand from a gesture-sensing device, such as a car dashboard system.1 LEDs installed on the device shine invisible light into the air2 As a hand passes over the device, light is reflected from the user’s hand and detected by the device3 This tells the device where the hand is — and the direction of the hand movement, which is then used to control the device

Health technology: as revolutionary as the smartphone?

The MobiUS Sp1 and the KardiaMobile

Elsoft is venturing into the fast-growing health technology industry by making embedded controllers for a medical device manufacturer.

According to Health iQ, an insurance company, healthcare is now is at a similar point to when smartphones first launched. Today, parents can use a phone to snap a photo of their child — even before they’ve been born. The MobiUS Sp1 combines a smartphone and an accessory to deliver ultrasound imaging, analysis and measurement. It costs $7,495 — traditional ultrasound machines cost upwards of $300,000.

The KardiaMobile, meanwhile, obtains a clinical-grade electrocardiogram in just 30 seconds. These are just a few examples of the revolutionary products offered by the health technology industry — which promises to improve access to affordable, high-quality medical treatment.

Growth through constant transformation

Elsoft has constantly adapted to changes in the technology industry. To achieve this, Elsoft shifts its product offering to meet market opportunities. To stay ahead of the curve, Elsoft invests about 10% of annual revenue to research and develop new products.

Elsoft began as a manufacturer of keyboard emulators in 1997. In the year 2001, it entered the tester industry, supplying testing solutions for optical mice and camera module manufacturers. The decline of the optical mouse(which was replaced by laser mice) in the mid-2000s resulted in a gradual drop in Elsoft’s revenue.

By 2010, Elsoft had reversed its fortunes and shifted to the growing automotive and smartphone LED segments. It also broadened its capabilities — now, instead of only providing of testing solutions, Elsoft also supplies automation equipment. Elsoft’s transformation into a “total test solution” provider has paid off, with net profits rising over 495% since 2008.

Winning supply chain position delivers fat margins

While rival tester equipment providers need to purchase some key technologies from third-party suppliers, Elsoft owns all the technology used in its testers.

Elsoft has a very lean administrative cost structure, and benefits from tax incentives for Malaysian firms with tech capabilities. Coupled with the strong gross margins generated by the tester business, Elsoft has achieved an impressive net profit margin of over 40%, since 2012.

Strong cash flow, blockbuster dividends

With a highly profitable business, Elsoft has generated positive operating cash flow since its IPO in 2005. Over the last ten years, Elsoft has paid over 45% of its profits as dividends every year. Both factors help Elsoft achieve a high 95% on EquitiesTracker’s FQA scoring system.

Even with dividend payouts as high as 87.3% of profit(2016), low capex spending enabled Elsoft to build up a “war chest” of RM63 million. Elsoft outsources the manufacturing of tester components to third-party vendors. This reduces its own capital expenditure requirement.

Share price history 2008–2019

Share price history 2008–2019

Demand for Elsoft’s testers depends on whether its customers develop new products…or not

In 9M2019, Elsoft’s revenue more-than-halved to RM27.3 million, compared to RM65.10 million a year ago.

The main reason for this was a sharp slowdown in demand for new testers from the automotive and smartphone segments.

As we mentioned earlier, Elsoft provides testers to LED makers, that in turn, supply LEDs to their own customers, such as smartphone makers.

Usually, a new product feature — for example, a more advanced camera flash LED — boosts demand for Elsoft’s testers. This especially applies when existing equipment is not able to test this new feature.

However, in 9M2019, Elsoft’s customers did not need to upgrade their testers. As a result, 9M sales of testers for smartphone segment fell 55% to RM17.9 million, from RM40 million a year ago. During the same period, sales to the automotive segment dropped 67% to RM5.8 million ringgit from RM17.4 million ringgit.

Slowing car sales could hit auto LED tester demand

Source: WSJ

Global car sales are falling year-on-year, hurt by the trade war, and alternatives to car ownership, such as ridesharing. Analysts expect global auto sales to fall 4% to 6% this year. Last year, global new-car sales fell about 0.5%, the first drop since the 2008 financial crisis. China, the world’s biggest car market, also experienced its first drop in car sales since the 1990s.

Elsoft earns about 20% of its revenue from the automotive segment. A drawn-out industry downturn could hurt demand for automotive LEDs tested with Elsoft’s equipment. The development of new automotive LEDs could also be affected, due to lower investment by car manufacturers.

Kickstarting Elsoft’s next phase of growth

Embedded systems — a sort of mini-computer — are found in almost every single electrical device. Healthcare is one of the fastest-growing markets for embedded systems, due to the increasing use of portable medical devices and health-monitoring gadgets. As life expectancy and demand for better health care increases, the market for health technology is expected to grow at 15.9% CAGR to US$280.25 billion between 2016–2021, according to analysts at MarketsandMarkets.

Elsoft has entered the health technology industry, supplying embedded controllers for peritoneal dialysis machines — devices that allow dialysis patients to undergo treatment at home. According to management, market response to the client’s products has been positive.

The health sector is not cyclical in nature, unlike the tester industry, or the automotive and consumer electronics sectors. Tester demand is far beyond Elsoft’s control. As we pointed out earlier, only the development of new products or new product features — such as a new automotive LED, for example, may cause Elsoft’s customers to buy new testers.

While its client’s dialysis machines have just launched in the market, we think success in this venture could kickstart Elsoft’s next phase of growth.

Elsoft’s revenue jumped 13x between 2009 and 2018 after the company transformed into a total test solution provider serving high-value segments of the LED industry. So far, 2019 has been rough for Elsoft as its clients have not upgraded their products.

But in technology, change is the only constant. Could 2020 be a year of major product upgrades, reviving revenue growth for Elsoft?

Meet the CEO of Elsoft at our upcoming event

On Nov. 26, 2019, meet Tan Cheik Eaik, Elsoft’s Chief Executive Officer, at the EquitiesTracker Theatrette. Cheik Eaik will share in-depth insights into the tester industry and Elsoft’s transformation strategy.

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