TMT INDUSTLANDY UPDATE:Hua Hong and SMIC,Key takeaways from
SMIC [0981.HK]. SMIC’s Q3 2017 turnover was US$769.7m, up by 2.5% QoQ (close to high end of the previously guided range), from US$751.2m in Q22017, and down 0.7% YoY, from US$774.8m in Q3 2016. The QoQ turnover growth in Q3 2017 was mainly due to increased wafer shipments and demandrecovery on the smartphone side. In terms of applications, power management ICs, NOR flash and fingerprint contributed sequen tial growth. SMIC’s Q32017 gross margin was 23.0%, (lower than previous guidance of 23 to 25%), down 2.8ppt QoQ, partly due to a lower utilization rate. SMIC’s utilization ratedropped from 85.7% in Q2 017 to 83.9% in Q3 2017. SMIC’s R&D expenses decreased US$4.3m QoQ to $107m in Q3 2017. Funding of R&D from thegovernment was US$24.2m in Q3 2017, up from US$16.1m in 2Q 2017. SMIC’s net profit of US$25.9m in Q3 17 was higher than our expectation ofUS$23.2m. In our view, the higher-than-expected Q3 2017 results were due to lower operating expenses. The ramping-up of sales of 28nm is the positivepoint in the Q3 2017 results, as 28nm sales as a percentage of total sales increased from 6.6% in Q2 2017 to 8.8% in Q3 2017.SMIC management guidedthat a) turnover in Q4 2017 would be from 1% to 3% QoQ; b) the gross margin would range from 18% to 20%; and c) operating expenses would beUS$204m to US$210m (not including employee bonuses, government funding and disposal gains). The 4Q guidance is below our and market expectations,especially the gross margin, which is due to a shift in the product mix, higher depreciation and price erosion. Non-controlling interest, according to management,was US$$48-50m due to an R&D sharing charge for 28nm in Q4 2017. Depreciation charges were guided at US$255m and full-year deprecation willbe US$975m. SMIC management didn’t provide any quantified guidance for Q1 2018, but it will be a low season, given seasonal adjustments in the mobilecommunication industry. However, SMIC management still looks for a top-line CAGR of 20% in the next 3-4 years, and the margin is likely to rebound in2018. During the conference call, SMIC management highlighted that the Company’s strategic targets include maintaining profitability, top-line growth andthe ratio of its leading technology in revenue. Regarding 28nm platforms, PolySiON is in mass production and HKC+ started risk production in Q3 2017.
As the 3Q17miss was mainly due to the rising selling expense and lower nonopincome, we lower our 2017earnings by 7% but leave our 2018forecastunchanged. We remain positive on Dahua and our TP is unchanged atCNY27.5, based on 22x FY2018E PE, supported by accelerated profit growth of38%/43% in 2017/2018and ROE expansions. Risks: market share loss andweak orders from solution projects.
3Q17E and 4Q17E margin outlook. For 3Q17E with few large-scale promotion events,we expect 29% revenue growth (vs management guidance of 26%-30%), 5.3% non-GAAP operating margin, and 4.4% net margin. For the promotional-heavy 4Q17E, weproject 4.5% operating margin (down 1.6-ppt YoY) and 3.8% net margin (down 1.3-ppt) with 29% revenue growth. Meanwhile, growing ticket size building on categoryexpansion, better personalization, and enhanced fulfillment service may help restoreinvestor confidence in Vipshop, in our view.
Overall, given strong demand, Hua Hong management expects the Company’s ASP to continue to improve in Q4 2017 and 1H 2018. Hua Hong is trying toexpand capacity by de-bottlenecking and the Company is also looking for M&A activity (the parent owns a 12” fab). Hua Hong is trying maximize profitability,given strong downstream demand. Hua Hong will add 2-3k wafer capacity by the end of 2017. Management will focus more on profitability than salesgrowth.
3Q17EPS of RMB0.16
We believe Vipshop is de-rating due to the rising uncertainty on its margin profile amidcompetition. In light of the company’s increasing readiness to reward consumers, werevise down our 2017-19E operating margin assumptions to 4.2%-4.5% (from previously6.0%-6.3%) and lower our net profit forecasts by 11%-14%. However, we think that a morepersonalized product portfolio and the full launch of membership program, together withstronger bargaining power with suppliers, should help Vipshop increase user stickinessand recoup margins especially in the long run. Meanwhile, we still think it would besensible for Vipshop to team up with traffic partners like JD.com (JD US, BUY, TPUS$51.00). It is industry trend to form strategic alliance and leverage the advantages ofpartners for win-win results. Rolling over to 2018E EPS on 16.5x P/E (-1SD below itsaverage, vs previously on par), we set new TP at US$15.50 (from US$17.00), still offering52% upside. Remain BUY. Downside risks: slower user gain and larger margin squeeze.
SMIC management expects 28nm products to account for 10% of the top line in Q4 2017. SMIC has started R&D on 22nm, and 14nm FinFET productionwill start in 2019.The 14nm node will enter risk production, with the schedule unchanged in 2019. Management highlighted that SMIC will remain a beneficiaryof the development of local IC supply chain and sees the China fabless industry growing at a 20% CAGR in the coming years. Management highlightedthat in Sep 2017 SMIC announced the first NB-IoT chip designed by ZTE. This chip is based on SMIC’s 55nm ULP+RF+eFlash technology, which can beused in smart meters, shared bikes, smart devices, smart cities, etc. SMIC and Chengdu Analog Circuit Tech (ACTT), a leading analog IP provider, announcedthe availability of ACTT’s analog IP on SMIC’s 55nm eFlash technology. SMIC’s 2017 foundry CAPEX guidance remained at US$2.3bn. The Company’sCAPEX is based on customer commitments, and part of the burden can be shared with its JV partners. SMIC’s 2018 CPAEX will not increase significantlyfrom the level in 2017.SMIC has no difficult in securing raw wafer supply, and the recent tight supply of wafers has h ad no impact on SMIC.
Valuation and risks
Trading idea. BUY on dips. We project Vipshop to deliver a non-GAAP net profit CAGRof 20% on a 25% revenue CAGR across 2016-19E. Downside risks: weaker traffic gainand deeper margin decline amid competition with larger online players.
Hua Hong management expects approximately 3% revenue growth and the gross margin to be in the range of 33% to 34% in Q4 2017. According to HuaHong management, the sequential drop in gross margin in Q4 2017 is due to market year-end activities, such as bonus and changes in the product mix.
Dahua’s 3Q17revenue and gross profits were in line with the DB forecast, but3Q17operating profits were 9% below, at RMB359m, -49% QoQ/+72% YoY,mainly due to a higher selling expense ratio, at 15%. Moreover, the non-opprofits were below our forecast, as the recurring income from the VAT taxreturn was offset by a surge in finance expense from forex losses. While 3Q17pre-tax income was 24% below the DB forecast, on rising expenses and lowernon-op, Dahua incurred a tax credit of RMB28m, as with the RMB32m taxcredit in 3Q16. 3Q17net income was 12% below the DB forecast at CNY461m,-34% QoQ/+28% YoY, for EPS of CNY0.16. For 1-3Q17, net profit registeredCNY1.4bn, within management guidance of CNY1.3-1.5bn
2Q17 missed on slimmer gross margin. Overall, non-GAAP net profit grew by 7% YoYto RMB728m, as 30% revenue growth and 0.3-ppt improvement in operating leveragewere dragged by 2.2-ppt contraction in gross margin. Total revenue increased by 30%YoY to RMB17.5bn (at the higher end of management guidance), driven by ordergrowth (+23%) and growing ticket size (+6%). However, gross margin narrowed to a5-year low of 22.0%, attributable to heavier-than-expected promotions for marketshare gain especially in June. Fulfillment cost (non-GAAP) trended up by 0.8-ppt YoYand 0.4-ppt QoQ to 9.3% of revenue, due to the expansion of last-mile delivery forexternal parties. Meanwhile, marketing expense was under good control at 4.2% ofrevenue (vs 4.9%/4.5% in 2Q16/1Q17). Non-GAAP operating margin and net marginwere 4.2% and 5.1% in 2Q17, vs around 5% and 6% since 2014, respectively. JunendedTTM operating cash and capex stood at RMB1.9bn and RMB2.8bn, respectively.
Hua Hong [1347.HK]. Hua Hong’s Q3 2017 turnover was US$209.9m, reaching an all-time high, up by 6.0% QoQ from US$198.1m in Q2 2017 (strongerthan guidance released in Aug 2017) and up by 13.3% YoY from US$185.3m in Q3 2017. The Company’s Q3 2017 gross margin was 35.2%, (higher thanprevious guidance of 33%), up 2.0ppt QoQ, primarily due to improved product mix, high utilization and higher average selling price (ASP). Operating expenseswere US$29.3m in Q3 2017, up 7.2% QoQ, primarily due to a) higher labour costs and b) RMB appreciation. Hua Hong reported a net profit ofUS$35.3m in Q3 2017, up 2.3% QoQ, and 18.5% YoY. However, we would like to point out that the QoQ and YoY net profit growth in Q3 2017 was distortedby increased accruals dividend withholding tax. Hua Hong management mentioned that every business segment continues to show strong growth in Q42017 and that regarding applications, smart cards, smart card ICs, MCUs, super-junction IGBTs and power management ICs are all seeing strong demand.
Higher selling expense and non-op loss impact on 3Q17profit
Different direction of guidance but seeing the same type of treatment. The three leading HK-listed semi-conductor foundries — ASMC [3355.HK], HuaHong [1347.HK] and SMIC [0981.HK] — reported their Q3 2017 results and highlighted the outlook for Q4 2017. The divergence in their operating performancecontinued in Q3 2017, and guidance on the outlook released by management of the foundries is also different. Hua Hong management reiterated itspositive guidance for Q4 2017 and early 2018, and ASMC management remains cautiously optimistic about the Q4 2017 outlook, but SMIC managementhighlighted that the near-term outlook, especially Q4 2017 and Q1 2018, is somewhat uncertain. Based on our understanding, the divergence is somewhatdue to different technology nodes, product mix, capacity expansion schedules and client mix. At this stage, 8” capacity is st ill tight, given more attractive coststructure along the supply chain (IC design + foundries + packaging and testing). It seems that 12” capacity is facing more competition in the near term, butthis situation is likely to change going forward, with lower costs in the packaging and testing segment. We believe that the lower technology node (HuaHong) is also facing less competition from global players, and this situation is likely to continue in 2018. We think that the foundries using lower technologynodes, especially Hua Hong, should continue to outperform SMIC in terms of operating results in the coming quarters, given their better market positioningand more stable profitability. Therefore, in the foundry segment, Hua Hong’s price is expected to outperform SMIC’s in the near term. We would not be surprisedto see SMIC’s weaker-than-expected outlook to be a drag on sentiment on the HK-listed IC related names for a while. But we maintain the view thatthe Chinese government will continue to promote the localization of high-end upstream electronic components and that the whole IC supply chain will be oneof the beneficiaries of this trend. We continue to suggest investors broaden their radar screens from foundries to IC design names (CE Huada [0085.HK],Solomon Systech [2878.HK] and Shanghai Fudan [1385.HK]), materials (AVIC Int’l [0161.HK]’s Shannan Circuits), and equipment (ASMPT [0522.HK]) tocapture the growth potential. Regarding foundries, after their re-rerating, we suggest investors wait for a better re-entry opportunity.
Dahua reported 3Q17EPS of RMB0.16, which was 12% below the DB forecastof RMB0.18on rising selling expenses and higher finance costs. We maintainour Buy rating and TP of CNY27.5.
2017full-year guidance on profit growth at 20-40%
Positive 2018outlook with accelerated profit growth
We expect the strong revenue growth momentum to sustain into 2018as thecompany continues to expand market share with rising total solution projects.In addition, the AI applications and future PPP projects are catalysts to driveDahua’s growth outlook. In particular, Dahua has indicated participation inAlibaba’s “City Brain” project in providing infrastructures such as front-endsensors, back-end storage and access platforms. We expect OPM to sustain atthe 2017level of 12%, with a rising solution contribution and increasing scale.
Management gave 2017full-year guidance of annual profit to grow 20-40%YoY, with the range of net profit at CNY2.2bn-2.6bn. We note that the newguidance is lower than the raised 25-45% guidance for 1-3Q17profit growthgiven out in August 2017. The lower guidance could potentially be a reflectionof the lower non-op income. As we enter the peak season in 4Q17, we expectrevenue to grow 26% QoQ/59% YoY, while operating margin recovers fromscale. Our 2017full-year profit forecast of RMB2.5bn, for EPS of RMB0.87, isat the high-end of management’s guidance.