AAC Technologies: Profit Warning Sets Alarm Bells Ringing
- AAC Technologies issued a profit warning expecting 1Q2020 earnings to fall by 85%-90%, and there seems to be room for further cuts to consensus earnings estimates for FY2020.
- AAC Technologies' 4Q2019 gross margin was below expectations, representing YoY and QoQ declines of -9.1 percentage points and -1.0 percentage points respectively, as lower-margin legacy products were still a drag.
- The optics business is a key growth driver for AAC Technologies with revenue expectations of RMB10 billion in the medium term, having just crossed the RMB1 billion mark inFY2019.
- AAC Technologies trades at 19.7 times consensus forward next twelve months P/E, and it offers a consensus forward FY2020 dividend yield of 2.0%.
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I maintain a "Neutral" rating on Hong Kong-listed smartphone micro component solutions supplier AAC Technologies Holdings' (OTCPK:AACAY) (OTCPK:AACAF) [2018:HK].
AAC Technologies issued a profit warning expecting 1Q2020 earnings to fall by 85%-90%, and there seems to be room for further cuts to consensus earnings estimates for FY2020 given expectations of weak smartphone demand going forward. In addition, AAC Technologies' gross profit margin of 29.0% for 4Q2019 was below expectations, representing YoY and QoQ declines of -9.1 percentage points and -1.0 percentage points respectively, as lower-margin legacy products were still a drag.
On the flip side, there is room to expand the profitability of the company in the medium term, if AAC Technologies can continue to grow the revenue contribution from higher-margin new products vis-a-vis lower-margin legacy products. The optics business is also a key growth driver for AAC Technologies with revenue expectations of RMB10 billion in the medium term. The optics business was a bright spot for the company in FY2019, having just crossed the RMB1 billion mark last year. As such, I retain my "Neutral" rating on the stock.
This is an update of my prior article on AAC Technologies published on December 9, 2019. AAC Technologies' share price's has fallen by-39% from HK$61.95 as of December 6, 2019 to HK$37.55 as of May 7, 2020 since my last update. AAC Technologies trades at 19.7 times consensus forward next twelve months P/E, versus its historical five-year and 10-year mean consensus forward next twelve months P/E multiples of 17.4 times and 16.0 times respectively. The stock also offers a consensus forward FY2020 dividend yield of 2.0%.
Readers are advised to trade in AAC Technologies shares listed on the Hong Kong Stock Exchange with the ticker 2018:HK where average daily trading value for the past three months exceeds $60 million and market capitalization is above $9 billion. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage such as Interactive Brokers, Fidelity, Charles Schwab or local brokers operating in their respective domestic markets.
1Q2020 Profit Warning
Year-to-date, AAC Technologies' share price has been steadily declining from its one-year share price peak of HK$70.00 on January 2, 2020 to HK$35.95 on March 23, 2020, before rebounding to as high as HK$43.10 on April 7, 2020. The market has been worried about production disruptions and weak smartphone demand as a result of the coronavirus pandemic, and AAC Technologies' share price weakness is not surprising given its status as a smartphone micro component solutions supplier.
AAC Technologies issued a profit warning for 1Q2020 on April 8, 2020, and that turned out to be the straw that broke the camel's back. The company's share price fell to a new year-to-date low of HK$35.85 on May 4, 2020, before recovering slightly to close at HK$37.55 as of May 7, 2020.
In the company's profit warning, AAC Technologies guided that its profit attributable to shareholders is expected to drop by 85%-90% YoY to between RMB43 million and RMB63 million for 1Q2020. The company's poor 1Q2020 performance was a combination of "work suspension" as a result of measures to contain the coronavirus pandemic and "reduction of revenue from dampened consumer sentiment for smartphones" as per its announcement.
On the positive side of things, AAC Technologies' production activities have started to recover to normalized levels in mid-March 2020, which suggests that disruption of manufacturing operations or supply constraints will be less of an concern for the rest of the year.
On the negative side of things, AAC Technologies emphasized in its profit warning announcement that "it remains uncertain whether the disruption and negative impact to global economy and end-user demand will continue to be affected in the rest of the year." In other words, the company's profit warning sends alarm bells ringing about overly-optimistic expectations of a quick recovery in smartphone demand.
More importantly, the company also noted that it "upheld the on-going research expenditures and development of new products to ensure future growth of all its technology business segments" in 1Q2020. While it is reassuring to know that AAC Technologies takes a long view and does not cut back on research & development during difficult periods like these, it also implies that research & development costs will remain "sticky" in FY2020 and hurt the company's earnings in the form of negative operating leverage.
International Data Corporation estimated that global smartphone shipments decreased -11.7% YoY in 1Q2020, while Canalys' numbers suggest that China's smartphone shipments fell by an even larger -18% YoY over the same period. Another research firm Strategy Analytics expects a -21% YoY decline in smartphone revenues this year, and noted that "we expect the rebound in smartphone market will start from 2021 onwards, but it will take three or four years to (GO) back to pre-COVID-19 level."
There seems to be room for further reduction in consensus earnings estimates for FY2020. Market consensus expects AAC Technologies' normalized and headline earnings per share to decline by only -5.3% YoY and -8.3% YoY to RMB1.74 and RMB1.69 respectively for FY2020. Taking into account the expected 85%-90% YoY drop in 1Q2020 earnings, AAC Technologies will have to see a significant turnaround for the remainder of the year to meet consensus expectations.
Margin Pressure Was Already A Concern In 4Q2019
A combination of declining revenue and high fixed costs (such as research & development expenses) will result in negative operating leverage and possibly a significant drop in earnings for AAC Technologies this year.
Even prior to the coronavirus pandemic and the 1Q2020 profit warning, margin pressure was already a concern for AAC Technologies as evidenced by the company's 4Q2019 financial results.
AAC Technologies' gross profit margin of 29.0% for 4Q2019 was below expectations, representing YoY and QoQ declines of -9.1 percentage points and -1.0 percentage points respectively. Specifically, the company's core acoustics business segment saw gross margin in 4Q2019 contract by -4.4 percentage points YoY and -3.1 percentage points QoQ to 30.3% in 4Q2019.
The company attributed the gross margin decline for the acoustics business in 4Q2019 to the fact that "ASP (Average Selling Price is still on a declining year-on-year trend" at its FY2019 earnings call on March 25, 2020. But AAC Technologies also noted that the "magnitude (of the ASP decline in 4Q2019) has narrowed from the rest of the year."
AAC Technologies had earlier guided for a 40% gross margin for the acoustics business segment in the long run at the 3Q2019 earnings call on November 8, 2019. This was to be driven by an increase in SLS or Super Linear Structure (new stereo module with two speakers in a single device) Android penetration rate (in terms of total acoustics business' Android acoustics module shipments). Looking ahead, AAC Technologies is targeting to grow SLS Android penetration rate from 65% as of end-2019 to 80% by end-2020.
Going forward, AAC Technologies' mix of lower-margin legacy products and higher-margin new products will be a key factor in determining the company's future gross profit margins.
Optics Business Remains Key Long-Term Growth Driver
At the company's 2Q2019 earnings call on August 23, 2019, AAC Technologies referred to the optics business as one of four product lines which should "achieve more than sales revenue of RMB10 billion" in the medium term alongside the other core businesses, acoustics, haptics and precision mechanics.
The optics business moved closer towards its medium revenue target, by crossing the RMB1 billion mark in FY2019, as the segment delivered a revenue of RMB1.07 billion for FY2019 representing a +94% YoY growth. Despite being a late-comer in the optics market having entered the business only in 2009-2010, AAC Technologies is now already a "Top 3 global supplier of plastic lens" as per the company's 1H2019 results presentation. The top two players in the optics market are Sunny Optical (OTCPK:SNPTF) (OTCPK:SOTGY) [2382:HK] and Largan Precision (OTC:LGANF) [3008:TT].
More importantly, there has been a gradual improvement in the optic business' profitability with economies of scale and more favorable product mix. AAC Technologies noted at the FY2019 earnings call on March 25, 2020 that the optics business achieved "a much better gross margin for the fourth quarter 2019", as "both ASP and yield have been improved further" on a QoQ basis.
AAC Technologies does not disclose the gross margin for the optics business separately, but expects the optics business margin to be 40% or higher when average monthly shipments exceed 100 million and ASP increases to RMB4.0 with a growing mix of higher specification plastic lens (6P/7P plastic lens or six or seven plastic lens pieces).
The company earlier guided for average monthly shipments for the optics business to increase beyond 100 million by July 2020, but weaker smartphone demand as a result of the coronavirus pandemic could mean that AAC Technologies needs more time to achieve this target.
Valuation And Dividends
AAC Technologies trades at 18.4 times trailing twelve months' P/E and 19.7 times consensus forward next twelve months P/E based on its share price of HK$37.55 as of May 7, 2020. In comparison, the stock's historical five-year and 10-year mean consensus forward next twelve months P/E multiples were 17.4 times and 16.0 times respectively.
AAC Technologies offers a historical FY2019 dividend yield of 1.1% and a consensus forward FY2020 dividend yield of 2.0%. The company paid an interim dividend of HK$0.40 per share for 1H2019, but it chose to omit the final dividend for 2H2019.
At the company's FY2019 earnings call on March 25, 2020, AAC Technologies explained that the company's decision on the dividend omission was made to "further preserve our cash at this very unusual moment" and highlighted that "our net gearing is at 10.5%, which we consider as healthy." Market consensus expects AAC Technologies to resume dividend payments for FY2020 with an estimated payout of HK$0.76 per share this year.
The key risk factors for AAC Technologies are weaker-than-expected smartphone demand as a result of the coronavirus pandemic, a lower-than-expected penetration rate of its products among clients, and an extended suspension of dividend payment.
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