A Bullish Call on China Techfaith Wireless (CNTF)

Mobile handset designer China Techfaith Wireless' (ticker: CNTF) stock price continues to fall (see chart below). But the future may be bright according to a reader of The China Stock Blog:

It is almost becoming a destiny that CNTF will head to the same valuation as its Chinese peers Sim and LongCheer.

So, first let us look at why Sim and LongCheer have such a low P/E. It is primarily because their clients, Chinese mobile terminal brand owners have a very bad year so far. Many of them incur loss while some of them went bankrupt. For an example, Soutec who used to the one of the top five Chinese brand owners had a cash-flow problem which led to the courts froze its operating assets. BTW, Soutec owed money to CNTF too and CNTF wrote off the A/R competely in 2Q. So, considering Sim and LongCheer's clients are all Chinese brand owners, I think it is rational for the investors to value the two at low P/E. Tomorrow they may disappear with their clients on the market together. But, look back at CNTF, 70% of its revenue in 2005 comes from international clients as disclosed by the CFO in the 2Q conference call. I expect the percentage will go even higher in the future as CNTF is doing its best at getting away from Chinese clients (disclosed in the Prospectus and other filings). So, it is rational to value CNTF as comparable international players in the mobile terminal sector of the telecom industry. That will price CNTF as 15x 2006 EPS (a sector average), which gives u hint on why analysts have all pointed to a price target of 15 or something. Here I think I found the answer for why Sim and LongCheer have such a low P/E and why CNTF has followed it so far. But, the real picture shows CNTF is designing for the winners which makes CNTF deserve a valuation like its clients and competitors (like HTC) while Sim and LongCheer are designing for the losers. The market will recognize the difference and give CNTF a proper valuation in the future.

A little more on mobile terminal R&D: let us get realistic about it. The R&D units of the mobile terminal sector are functioming as system integrators who combine third-party hardware and software to offer a final solution. Do they add value in the process? Yes, but it is not that big as most think. What they need to do is to offer a trendy outlook, pratical and easy-to-use functions and assure product stability in manufacturing and usage. The designers of enabling components and software applications plus new network capabilities and attractive content provide more value to the customer's experience with a mobile terminal. So, the innovation here boils down to a little bit creativity (mainly enabled by third-paty innovations) and quality. Why quality plays such an important role here? Get back to Chinese brand owners: they have the cheapest price on the market and have the worst product quality also. The latter kills them, not their products' mimic outlook and generic funtions. So, the whole thing let me questiion what R&D units at international brand owners are doing. It has been referred by many sources that designing a new model cost them at least 10M dollars, while CNTF can get it done by 1.5M with a 45% net margin and Flextronics (ticker: FLEX) can do it with 3M. So, outsourcing a highly-inefficient internal function which adds moderate value makes perfect sense. The future is bright for CNTF and its competitors who will help the sector achieve a better economic structure. Brand owners will focus on sales and marketing and supply chain management like what Dell does. Under this backdrop, do the prominent design houses deserve a P/E like its clients?

At the same time, I expect we will see more players enter the mobile terminal segtor in the future. A strong force is network operators. Their networks put them most close to the end users. Almost all the cool functions and rich content have to be delivered through the networks, which make them most interested with integrating the terminals into their product portfolios. They tend to offer the machines that are best catering to the network capabilities and content offerings. This makes perfect sense. Why use Nokia (ticker: NOK) and Moto since it is so easy to get a customized terminal by just calling a design house like CNTF and a EMS like FLEX? On the other side, Dell (ticker: DELL) and Hewlett-Packard (ticker: HPQ) will join the force since they will see the small terminal performs more fuctions of a PC and they know it is the future form of PC or whatever you call it. The No. 3 PC sellers in the world, Lenovo, already joined the race and it fares pretty good as one of only two Chinese mobile terminal brand owners who make profit so far this year. Its supply chain for PC must have functioned well for the cellphone also. So, it makes sense for PC vendors to join the race to proect their turf. This is certainly a good news for CNTF and its competiors. Get back to CNTF's edge: now I adjust it to design quality/ cost considering mobile terminal's R&D process is heaviy dependent on third-party innovations (design quality should assure product's stability in manufatcuring and usage after meeting client's feature requirement). So, the segment reminds me of an industry that has fuled China's growth in the past 20 years: manufacturing outsourcing service. Since it is just a low-end R&D process which emphasizes cost after assuring quality, will Chinese be the king of it? You tell. I think they will. CNTF already told you: they offer the cheapest price available (from public sources) and still enjoy a 45% net margin. Should investors benefit from this new trend of outsouring to China? We will see.

CNTF chart.

Related

• Investor Assesses China Techfaith Wireless’ Weak Stock Performance.
• Stocks covered by The China Stock Blog.

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