SECTOR: TECHNOLOGY - TECHNOLOGY HARDWARE & EQUIPMENT

ELSOFT RESEARCH BHD (0090.KL)

Big business: Making sure the
Latest price Market cap CU P/E FQA
RM0.935 RM621.68m 15.58 95% lights work
Malaysia’s most profitable listed company,
Elsoft, has a track record of constantly
KEY THEMES reinventing itself not only to adapt - but also
Track record of transformation-driven growth to capture valuable market opportunities
Winning supply chain position with superb margins
Testing: more important than you think
Exciting product pipeline in valuable markets 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
LED burn-in testing system developed listed company, generating a 51% profit-after-tax margin in FY2018.
by Elsoft 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

em Tester system complete tester solution to some of the world's biggest LED makers. Elsoft
focuses on tough segments like smartphone flash LED and automotive LED.
by developed by
Elsoft 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.

Automated LED In this report, we take a deep dive into:

How Elsoft achieves its superb margins
test equipment
’s developed by Inside Elsoft’s The test industry and the growing market for LEDs

Elsoft factory Elsoft’s transformational growth story, and what could lie ahead

See page 9 of this document for important disclaimer information.

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ELSOFT RESEARCH BHD

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).

Within the LED industry, Elsoft has

opted to focus on sub-segments
where testing requirements are
t o u g h e r - a n d t h e re i s l e s s
competition.
Elsoft is less involved in the "general
lighting" segment. It focuses on the
s m a rt p h o n e c a m e ra fl a s h a n d
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.
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ELSOFT RESEARCH BHD

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.
phone flash LED Samsung’s smartphone flash LED
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.

Cameras are the most important smartphone component

ABOVE: LED-enabled notifications are the next big thing. RIGHT: Samsung's
Galaxy S10 camera is considered to have one of the best front-flash LEDs.
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ELSOFT RESEARCH BHD

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.

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 car makers 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.

se between
By 2020, one64 interior
in five cars will be using LED lights, according to the Boston You can choose between 64 interior
Consulting Group. That is a far cry from 2015, when just 3% of all cars used
Mercedes-Benz E-class colors in the Mercedes-Benz E-class
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.

LEDs last the longest, and are the most energy-efficient lights available
ghts Daytime running Matrix LED lights Daytime running
lights lights
Halogen Xenon LED

1,000 - 1,500 3,000 2,000 Lumens

Brightness Lumens Lumens upwards

200-1000 2,000 - 5,000 5,000 hours TOP: Ever had to close your eyes while driving because of another car's
Lifespan hours hours upwards lights? When approaching another car on the road, some of Audi's Matrix
LED lights turn off.. to avoid blinding the other driver. BOTTOM: With
LED-enabled dynamic corner illumination, headlamps light up the
Less Very Most corner.. even before the driver turns the wheel!
Energy Efficiency efficient efficient efficient

Dynamic corner illumination Dynamic corner illumination

High High Low
Heat emission
 ELSOFT RESEARCH BHD 5

INDUSTRY INSIGHT
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.
HOW EYE-TRACKING WORKS
Lighting takes up 19% of the world’s electricity consumption. When you wear an eye-tracking headset, tiny LEDs shine infrared (invisible)
Governments around the world - such as the EU, the U.S. and China have light into your eyes. When this happens, the light will bounce off your eyes,
banned inefficient lighting as part of policies to combat global warming. This creating a reflection.
has driven up usage of LEDs, which are 4-5x more energy-efficient than
conventional lighting. 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
No more changing light bulbs: while LEDs appear more expensive than of gaze, and your focus.
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 Because the headset now knows what you're looking at, it knows what you
years) and 10x the lifespan of incandescent, halogen lights(1-2 years). want to "select," or zoom in on.

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
hismake
suitheavy
using
use of infrared LEDs - LEDs that create invisible light - to work. Iron Man controls his suit using
eye-tracking
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.
Tiny LEDs are Tiny LEDs are
installed in VR/AR installed in VR/AR
Eye-tracking in VR/AR headsets
headsets headsets
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. Microsoft’s
HoloLens
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 APPLE’S FACEID USES LEDS TO UNLOCK YOUR PHONE
useful in a VR/AR system because VR/AR is three-dimensional, requiring us to In 2017, Apple introduced FaceID, an iPhone feature allowing you to unlock
move our heads(and eyes) up and down. 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
In fact, Avi Bar-Zeev, the co-inventor of Microsoft's AR/VR headset, predicts used to create a 3D “map” of your face.
eye-tracking will one day replace the computer mouse as the main
interface used to interact with computers. 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.
Facial recognition technology
Facial recognition technology is transforming 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.
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INDUSTRY INSIGHT
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
forming
4, which “test”
was launched in October 2019. Medical students are performing “test”
ality headsets surgeries using virtual reality headsets

HOW LEDS ARE USED TO “SENSE” YOUR GESTURES

Infrared 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 air
2 As a hand passes over the device, light is reflected from the user's hand and
detected by the device
3 This tells the device where the hand is - and the direction of the hand movement,
which is then used to control the device

MobiUS Sp1 KardiaMobile

MobiUS Sp1 KardiaMobile

reasingly being Smartwatches are increasingly being

toring used for health monitoring

Health technology: as revolutionary as the

Gestures recognition systems are increasingly smartphone?
finding their way into today’s cars 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
With a wave of a hand, Pixel 4 users can of the revolutionary products offered by the health technology
control their music, timers and phone calls industry - which promises to improve access to affordable, high-
quality medical treatment.
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FINANCIAL INSIGHT
Growth through constant transformation
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 constantly adapted to changes in the technology industry. To Elsoft has paid over 45% of its profits as dividends every year. Both
achieve this, Elsoft shifts its product offering to meet market opportunities. To factors help Elsoft achieve a high 95% on EquitiesTracker’s FQA
stay ahead of the curve, Elsoft invests about 10% of annual revenue to research scoring system.
and develop new products.
Even with dividend payouts as high as 87.3% of profit(2016),
Elsoft began as a manufacturer of keyboard emulators in 1997. In the year low capex spending enabled Elsoft to build up a "war chest' of
2001, it entered the tester industry, supplying testing solutions for optical mice RM63 million. Elsoft outsources manufacturing of tester
and camera module manufacturers. The decline of the optical mouse(which components to third-party vendors. This reduces its own capital
was replaced by laser mice) in the mid-2000s resulted in a gradual drop in expenditure requirement.
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.

SHARE PRICE HISTORY 2008-2019

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0.80

0.60

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2008 2010 2012 2014 2016
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KEY RISKS
Demand for Elsoft's testers depends on whether its OUTLOOK
customers develop new products…or not
Kickstarting Elsoft’s next phase of growth
In 9M2019, Elsoft’s revenue more-than-halved to RM27.3 million, compared to
RM65.10 million a year ago. Embedded systems - a sort of mini-computer - are found in almost
every single electrical device. Healthcare is one of the fastest-
The main reason for this was a sharp slowdown in demand for new testers growing markets for embedded systems, due to the increasing
from the automotive and smartphone segments. use of portable medical devices and health-monitoring
gadgets. As life expectancy and demand for better health care
As we mentioned earlier, Elsoft provides testers to LED makers, that in turn, increases, the market for health technology is expected to grow at
supply LEDs to their own customers, such as smartphone makers. 15.9% CAGR to US$280.25 billion between 2016-2021, according
to analysts at MarketsandMarkets.
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.

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.
Slowing car sales could hit auto LED tester demand
Global car sales are falling year-on-
year, hurt by the trade war, and In a rough patch - or on verge of a revival?
alternatives to car ownership, such Elsoft’s revenue jumped 13x between 2009 and 2018 after the
as ridesharing. Analysts expect global company transformed into a total test solution provider serving
auto sales to fall 4% to 6% this year. high-value segments of the LED industry. So far, 2019 has been
Last year, global new-car sales fell rough for Elsoft as its clients have not upgraded their products.
about 0.5%, the first drop since the
2008 financial crisis. China, the world’s But in technology, change is the only constant. Could 2020 be a
biggest car market, also experienced year of major product upgrades, reviving revenue growth for
its first drop in car sales since the Elsoft?
1990s.

Elsoft earns about 20% of its revenue

from the automotive segment. A
drawn-out industry downturn could MEMBER EXCLUSIVE: MEET THE CEO OF ELSOFT
hurt demand for automotive LEDs On Nov. 26, 2019, meet Tan Cheik Eaik, Elsoft’s Chief
tested with Elsoft’s equipment. The Executive Officer, at the EquitiesTracker Theatrette. Cheik
development of new automotive LEDs Eaik will share in-depth insights into theEric
tester
On Oct. 30, 2019, meet Dato' Leeindustry
Kong Sim, andLSK’s M
could also be affected, due to lower Elsoft’s transformation strategy.
SOURCE: Wall Street Journal Director, at the EquitiesTracker Theatrette. Dato’ Eric will sh
investment by car manufacturers.
insights into the mattress industry and the transformation o
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