4. RISK FACTORS 4. RISK FACTORS INVESTORS SHOULD RELY ON THEIR OWN EVALUATION AND CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS (WHICH MAY NOT BE EXHAUSTIVE) THAT MAY HAVE A SIGNIFICANT IMPACT ON THE FUTURE PERFORMANCE OF THE GROUP, IN ADDITION TO THE OTHER INFORMATION CONTAINED ELSEWHERE IN THIS PROSPECTUS, BEFORE APPLYING FOR ANY OF THE IPO SHARES. DEPENDENCE ON THE HDD INDUSTRY As a precision engineering specialist, the Duru Group specialises in the making of precision metal components for the HOD industry. These components. namely disk spal.:crs, disk clamps. latch pins, ground pins and hexagon nuts, are essential for the assembly of a complete HDD. The sale of these components, which form the largest contributor in terms of revenue, contributed approximately 86% to the Group’s turnover for the seven (7)-month period ended 31 July 2006 (FYE 31 December 2005 : 81 %). In view of the above, there is a degree of dependence on this industry and the continued future prospects and profitability of the Group will be, to a certain extent, dependent on the continued demand for the aforementioned components. Any unexpected industry downturn of and adverse change in the demand for the HOD components may result in an adverse development in the future results of the Group. In addition to the above, there is also a possibility that technological advancement would lead to a shift in consumers’ preference from the traditional HDD to nash memory products. Flash memory is shock resistant (no moving parts) and consumes less power compared to HOD. However. the Management is of the view thallhc above risk is mitigated by the following factors: );0-According to the D&B Malaysia Report, the desktop and mobile computers segment will continue to make up the biggest segment of the global HOD market. The expected growth in demand for HDD~ based products from various application markets will indirectly create demand for components and parts from the precision machining industry. The demand for HDD will continue to be strongly driven by the increasing proliferation of pes in the household and commercial segments as a result of anticipated demand for the storage of. amongst others, digital photos. videos and on~demand television shows. The Management anticipates a further increase in orders in 2007 based on the latest production commitments requested by its customers. > In an attempt to further reduce the Group’s dependence on the HDD industry, the Group is working towards expanding its customer base in non-HOD segment (i.e. industrial safety and sensor, telecommunications. computer peripherals and consumer electronics) and penetrating new application markets. );0-In respect of the risk of the HDO being substituted with flash memory products, the Management does not foresee flash memory products posing a significant threat for the time being because in temls of total capacity and pricing per gigabyte. a HDD is still superior to flash memory products. In general, the capacity requircments and end-applications differcntiate a I-IDO from flash memory products. As such. even though nash memory products are dominating portable consumer electronic products such as MP3 players, cell phones, and digital cameras, it is not deemed a suitable substitute for HOD as it is not able to match the latter in terms of cost, performance and storage capacity. 4. RISK FACTORS (Collt’d) DEPENDENCE ON KEY CUSTOMERS A majority of the world’s HDD is manufactured by a handful of MNCs, namely Seagatc, Western Digital, HGST, Toshiba, Samsung and Fujitsu Ltd. Seagate and Western Digital are independent HDD manufacturers (core business is focused on HDD) while for HGST, Toshiba. Samsung and Fujitsu Ltd. the manufacture of HDD is only a segment of their business interests. In 2005. the top four (4) HDD manufacturers, namely, Seagale, HGST, Western Digital and Maxtor, generated about USD20 billion in sales which accounted for approximately 70% of the global HOD industry revenue. Seagate’s acquisition of Maxtor fUI1her reduce the number of HDD manufacturers in the world. (Source: D&B Malaysia Report) In view of the nature of the industry whereby it is dominated by a handful of MNCs and the fact that HDD components accounted for a significant portion of the Group’s turnover in FYE 31 December 2005 and seven (7)-month period ended 31 July 2006, the Group is, to a degree, dependent on its key customers. Funhermore, there is no contractual obligation on the pan of any of the Group’s customers to purchase a minimum number of products from the Duru Group as the demand for the Group’s products is based on a project-to-project basis. Therefore. any change in the business conditions of the Group’s major customers, loss of major customers or a reduction in the production allocation by the Group’s major customers, may affect the Group’s financial position. For the seven (7)-month perioo ended 31 July 2006, the Group’s major customers (details of which are set out in Section 5.7 of this Prospectus) accounted for approximately 60% of its revenue (FYE 31 Decemher 2005 : 54%). For the HDD segment, the Dufu Group is currently supplying its HDD components to the top two (2) HOD manufacturers namely Seagate and Western Digital. The Management believes that the risk of losing key customers is mitigated by the following factors: ~ The HOD manufacturers source HOD components from only a handful of suppliers. As quality. reliability and delivery time are crucial in this competitive market, the HOD manufacturers are very stringent in their selection of component and pans suppliers. Hence. orders are usually placed with suppliers who are able to continuously comply with their strict requirements. Furthermore. the longterm business relationships and rapport fostered with its customers largely mitigate the risk of dependency as it is a testimonial to the reliability and quality of the Group’s products. This is evidenced by business relationships which averaged seven (7) years amongst its top ten customers for FYE 31 December 2005. The long-standing relationships have resulted in repeat and, in some cases, incremental new orders for the Group’s products and services. ~ The Group works closely with its customers to dt;velop components and parts with the view of meeting the customer’s short to medium-term production demand. This husiness model has served the Group well. enabling the Group to secure and retain MNCs such as Seagate, Western Digital, MMI. First Technology Pic. and Inventec Electronics (M) Sdn Bhd as customers. ~ The Group also seeks to expand and diversify its customer base to include both HOD and non-HDD customers in order to further reduce its dependence on existing key customers. Allhough the Group seeks to limit the dependence on key customers through the efforts mentioned above, no assurance can he given that existing and new customers will continue to use the Group’s products and services or will maintain their relationship with the Group. 4. RISK FACTORS (Conl’d) 4.3 COMPETITION AND NEW MARKET ENTRANTS According to the D&B Malaysia Report. in 2005, there arc approximately 170 companies in Malaysia that provide specialised precision machining services and general supporting machine services to meet the demand of the loc.:al manufacturing industry. However, global HDD manufacturers source HOD components from a handful of suppliers only. The closest competitors to the Dufu Group for the supply of HOD disk spacers and clamps to Seagate and Western Digital are estimated to be Disk Precision Industries Pte Ltd of Singapore (“DP”) and Global Primax of China (for Seagatc) and Notion VTec Berhad of Malaysia and DP (for Western Digital). (Source: D&B Malaysia Report). Overall. the HDD industry is a highly competitive industry. The glohal HDD market is dominated by a handful of MNCs such as Seagate, HGST and Western Digital. Competition amongst the HDD components suppliers are intensified as they have to compete for contracts from just a handful of HDD manufacturers. The HDD components suppliers face stiff competition in terms of product quality, pricing and timely delivery. Nevertheless, the Management believes that the competition from the Group’s existing competitors is, to a certain degree. mitigated as the Group has a competitive advantage based on the following factors: ) Proven track record and long-term relationships with its key MNCs customers such as Seagate Technology International. Singapore (18 years), Seagate Technology (Thailand) Ltd. (7 years), Western Digital (M) Sdn Bhd (13 years). Western Digital (Thailand) Pte. Ltd (7 years), and MMI (8 years); )-With respect to its major customers, the Group is involved in a wide range of products in their manufacturing programme; );> Ability to produce HDD components for all HDD sizes, namely the 3.S-inch, 2.5-inch, 1.8-inch, I.Dinch and O.8-inch disk dri Yes; )-Competitive operational COSI achieved through process engineering and process development innovations as wcll as continuous improvement programmes: )-Strong operational team that is able to deliver consistently, reliably and rapidly in terms of time-tomarket (introduction of new range of HDD) and volume-ta-market (mass production to meet demand) without compromising quality; )-Dedicated team of skilled personnel. As at the Latest Practicable Date, the Group’s technical engineers and QA/QC staff numbers eighty two (82) personnel; and };;> Stringent international-level quality standards. DISB and IPG obtain~d their ISO 900t:2000 certifications in 2002 and 2003 respectively from 8M Trada Certification Ltd. The ISO 9001 :2000 certification is a testament to the quality and consistency of the Group’s products as well as its commitment to meeting its customers’ and regulatory requirements. In addition to existing competitors. there is also a potential threat from new market entrants. However. the Management believes that competition from new entrants will not have a major impact on the Group’s business due to the following considerations: )-POlemial entrants will have to invest substantial amounts to equip themselves with advanced machinery and must be able to constantly upgrade their machinery; )i;o Potential entrants arc required to meet the operational requirements uf the HDO manufacturers (HDD manufacturers require their suppliers to set the same operational standards as they do). In this respect, potential entrants are required to go through stringent component testing and trial periods ranging from six months to one year; 4. RISK FACTORS (COIu’d) }iI-Potential entrants must be able to provide similar volume-to-market and timc-lO·markcl. In this respect, potential entrants may not have the manufacturing capacity or capability to meet the HDD manufacturer’s production aJlocation requirements; and }o> Potential entrants must be able to meet stringent quality and cleanliness requirements of the HOD manufacturers in order to provide similar reliability in terms of quality (stable and zero failure). Although the Management seeks to continue to adopt appropriate strategies to remain competitive. there can be no assurance that competition from existing competitors andlor new entrants will not have a material adverse effect on the Group’s fUlure performance. 4.4 DEPENDENCE ON KEY SUPPLIERS The major suppliers of the Dufu Group, namely Top Expertise Enterprise Ltd and EbeJ Industries ?Le Ltd, account for approximatcly 46% of the Group’s total purchases during the seven (7)-month period ended 31 July 2006 (FYE 31 December 2005: 52%). Funhennorc. about half of the Group’s supplies are sourced from international companies which are involved in the manufacturing and trading of tooling, maehinc parts, machinery, metaJ bars, rods and coil sheets, and measuring equipment. It is pan of the Group’s procurement policy to diligently strengthen its relationships with reliable suppliers to ensure consistent supplies of high quality goods and services. The Management believes in fostering long tenn business relationships and extending its supply chain management system with its suppliers. Having preferred suppliers as part of the supply chain management are practice norms in the HDD industry. This is to ensure reliable and quality supplies. This is evidenced by business relationships between six (6) to twelve (12) years among its major suppliers. In addition, the Group has taken the initiative to source for alternative suppliers should a disruption in raw materials exist. The Management believes that the Group is in position to source for new suppliers as most of its raw materials can be readily sourced worldwide. The raw materials purchase orders normally allow volume and value arrangement for the duration of three (3) to six (6) months depending on the application market and the needs of the project. The normal credit term is between thirty (30) and sixty (60) days, depending on the production volume and the customers’ credit standing and whether purchases are made by letters of credit or cash basis. THE RESTOFTHIS PAGE HAS BEEN INTENTIONALLY LEFT BLANK 4. RISK FACTORS (Conl’d)
4.5 DEPENDENCE ON KEY PERSONNEl, The Group believes that its continued success will depend, 10 a significant extent, upon the abilities and continued efforts of its existing directors and key management and technical personnel. The Joss of any director and key management. in particular the Chief Executive Officer and the Chief Operation Officer. and any of the key technical personnel. could adversely affect the Group’s continued ability to compete in itc; industry. The Board of Directors recognises the importance of lhe Group’s ability to attract and retain its key management and technical personnel, an’d has in place a remuneration package which is on par with the industry standards for employees, as well as providing a good working environment which promotes productivity and loyalty. Furthennore, in conjunction with the listing of and quotation for Dufu Shares on the Second Board of the Securities Exchange. Dufu has allocated a portion of the Orrer Shart:s to iLS eligible employees. including members of key management and technical personneL Should its employees subscribe for such Dufu Shares, they will also become shareholders in the Company and be motivated to work even harder for the success of the Group as well as maintain their loyalty with the Group. In addition. efforts are consmntly made to continuously develop a new generation of management to gradually take over the operations of the Group in the future. Allhough the Group seeks to limit the dependence of key management and technical personnel through the efforts mentioned above. no assurance can be given that any change in the key management and technical personnel structure will not have a material adverse effect on the Group’s future performance.
4.6 SUPPLY AND PRICE OF RAW MATERIALS Aluminium rods and sheets and various grades of stainless steel coils. rods and sheets accounted for approximately 22.0% of the Group’s total purchases in the seven (7)-month period ended 31 July 2006 (FYE 31 December 2005: 19.1%). The Group sources these raw materials locally and from overseas when certain material grades are not available in the local markel. Although the Group imports most of its raw materials, the volatile international metal prices has not adversely affected the Group’s financial performance. In the event of a substantial rise in raw material price. the Group may pass on the price increase to its customers periodically. In addition. the Group purchases its raw materials directly from the manufacturers, not from stockists, fun her buffering it from the volatile price fluctuations.
4.7 DEPENDENCE ON SKILLED LABOUR A main factor for the Group’s success is the consistent high quality of its components in meeting the requirements of its customers as weB as maintaining iLS position as one of the leading manufacturers of HDD components. As such, [he Group depends on specialised skilled workers and has therefore invested in a team of trained and skilled personnel to continuously ensure the quality of ils manufactured components, meeting the constant demands of its customers and maintaining proper control over its manufacturing processes. In line with the nature of the business. skilled and semi·skilled workers represent approximately 80% of the Group’s total workforce as at the Latest Practicable Date. 1be Management recognises the importance of human resource training 10 ensure that lhe high quality of its products is constantly mel and that its manufacturing processes are properly controlled at all times. In this respect, the Group aJiocat’cs approximately 0.5% of the 100aI monthly gross salary to the Human Resource Development Fund which iL then utilises for training purposes. 4. RISK FACTORS (Conl’d) Furthermore, the Group also recognises that there should nO( be any over-reliance on any single personnel in the production process of the Group. In view of the above. the Group employs on-the~job and external training for its employees so as to ensure that the technical know-how of its production processes is spread out. Although the Group seeks to limit the above risk. no assurance can be given that it will not have adverse effects on the Group’s business. 4.8 FOREIGN CURRENCY EXCHANGE FLUCTUATIONS For the FYE 31 December 2005 and the seven (7)-month period ended 31 July 2006. a significant ponion of the Group’s revenue was derived from exports and is mainly denominated in USD. Furthermore, the Group also sources a significant portion of its raw material from overseas markets such as Taiwan. Japan, Switzerland and Thailand and is denominated in foreign currencies such as usn, Japanese Yen (¥) and Swiss Fmnc (CHF). As such, the Group is exposed to foreign currency exchange losses or gains arising from timing differences. Any appreciation or depreciation of these foreign currencies against the RM will result in th~ Group incurring foreign currency exchange losses or gains due to revaluation of these foreign currencies. Foreign currency exchange fluctuations may also result in translation gains or losses on consolidation as the financial statements of the Group’s overseas subsidiary company is denominated in the foreign currency and RM is the Group’s reporting currency. Any such translation gains or losses will be recorded as translation reserves or deficits as part of the Group’s shareholders’ funds. It is the intention of the Group to use hedging techniques such as foreign exchange contracts, when the need arises to mitigate the risk of foreign currency exchange fluctuations. The risk of foreign currency exchange fluctuations is, to a certain extent. mitigated by the managed float mechanism adopted by Bank Negara Malaysia on the RM vs. USD conversion rate since the de-pegging of the RM. This may prevent extreme fluctuation of the RM vis-a.-vis USD. Nevertheless, there can be no assurance thal any significant foreign currency exchange fluctuation will not impact the revenue and earnings of the Group. THE REST OF TI-nS PAGE HAS BEEN INTENTIONALLY LEFT BLANK