Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Skyworth Digital Holdings Ltd (751:HK)/(SWDH: US) -Recovery Of Core Business, Management Actively Looking To Enhance Value Via Disposals And Spin-Offs, Stub Trading At A Premium To Parent

|Includes: Skyworth Digital Holdings Ltd. ADR (SWDHY)

Summary

Number one TV manufacturer in China with excellent growth track record and attractive returns trading at 7 times historical PE

Non-TV businesses include leading set top box business in China as well as high growth white goods and LCD modules businesses

Non-TV businesses and surplus property assets cover the current share price

Share price depressed due to tough prior year comparative sales due to termination of subsidies in China last May and a strong buy China sentiment following the diplomatic challenges with Japan last year. Market also concerned about predatory pricing of new internet TV players

Spin-off of the set top box business in China A-share market is approved and already spun off. Market cap of the spin-off currently exceeds the market cap of the HK parent.

Overview of Skyworth

Skyworth holds the number one market share of flat screen televisions in China. It also has the number one market share in China for set top boxes and is the fourth largest producer of set top boxes globally.

Skyworth also owns growing businesses in LCD modules and white goods. It also owns three commercial properties in Shenzhen.

Television business

Skyworth is the leading television manufacturer in China with approximately 20% market share. The Chinese television market is increasingly becoming consolidated amongst the top 4 domestic players who account for more than 60% of sales. International players now only account for less than 10% of the market. The table below outlines the market shares of the major participants.

Domestic producers dominate the flat screen television market in China as they produce at significantly lower prices than international players and have superior distribution into lower tier cities and rural areas.

In recent years, the Chinese Government has provided subsidies to consumers to upgrade their televisions to lower energy consumption models. This has resulted in volatile sales trends driven by the timing of subsidies. The last subsidy ended in May last year and this has resulted in flat industry sales over the past 9-12 months. During 2012, sales of domestic made TVs were also boosted by a 'buy China' sentiment as a result of diplomatic issues with Japan, magnifying the flat sales effect in 2013.

The market is also currently concerned about the effect of internet television on the traditional television players such as Skyworth. The internet television players are content focused and supply hardware including screens and set top boxes to secure new subscribers. The screens are priced at substantial discounts; however customers are required to sign subscription contracts for content. The major internet players are LeTV and Xiaomi TV.

Skyworth is competing with the internet players by offering on-line only products at the same prices. The on-line channel provides substantial cost savings versus traditional channels and this saving is being used to provide lower pricing. For Skyworth, the gross margins on line are lower than off line but the operating margins are similar.

There is also a perception in the market that the television market has matured. This is not the case. The industry and Skyworth have enjoyed revenue growth of almost 20% per annum over the past three years. Demand is currently driven largely by upgrading existing sets and is complimented by household formations.

Technology change has been the key driver of industry growth historically - CRT TVs to flat screens and now upgrades to ultra high definition TV and also Smart TV. Smart TV is essentially just an in-built set top box that enables the TV to connect to the internet. We expect Smart TV to drive replacement sales due to the availability of an extensive amount of free content on the internet. Smart TV also provides the potential for ancillary revenues for Skyworth through advertising, e-commerce and paid for content. For instance, Skyworth has just released an affordable second brand Smart TV in association with Alibaba including the incorporation of Alipay into the TV's operating system. Skyworth currently collects viewing data from 3 million customers and this will increase to 10 million by year end. Skyworth plans to monetise this data with advertisers.

Set top box business

Skyworth's set top box business has superior margins and returns to its TV business. The set top box market in China has matured, however growth is expected over the next few years from the introduction of digital cable TV. During the recent period of flat to declining sales in China, Skyworth has aggressively expanded its OEM business internationally. International sales now account for 51% of its set top box revenues.

Skyworth is planning to spin out its STB business via a back door listing on the A-share market. The market capitalisation of the spin-off is expected to exceed the market capitalisation of Skyworth itself. The spin-off is expected to complete this calendar year.

In the past 18 months, Skyworth has very successfully entered the white goods business leveraging its extensive distribution network. Sales for the last reported half to September 2013 were RMB1.2bn and the business is already profitable with an operating margin of 8.6%.

Skyworth's ability to successfully launch the white goods business in a very competitive market is an indication of the strength and value of its distribution network.

LCD Components Business

Skyworth is a major player in the manufacture of LCD components for smart phones and is a major supplier to Samsung. Skyworth announced that it intended to spin-off this business in HK almost 12 months ago. The spin-off was delayed but the company still intends to do this.

Skyworth's corporate strategy is to build the various business segments independently and to provide key management with equity involvement. The rationale for spinning out is to provide liquidity and access to further capital to grow the businesses.

Distribution Network - Key Competitive Advantage

Skyworth's key competitive advantage is its extensive distribution into lower tier cities and rural markets. The company has 20,000+ points of sale, 41 branches and 209 service centres. The company also has about 5,000 company branded retail stores. The retail stores are small size shops located in suburban areas, much like convenience stores.

The pie chart below shows the segmentation of the company's sales by channel. Importantly, the company only has 20% of its sales through national chain stores, as the margins obtained from this channel are much lower than other channels. The international players are reliant upon the national chain stores.

SWOT Analysis

Strengths: Economies of scale - 4m TV sales pa are required to break even in China Distribution network

Technical product development

Cost control

Ability to develop valuable ancillary business such as modules and white goods

Weakness: Brand is China only and not global Product design still lags international players though picture quality is comparable
Opportunities: Smart TV entrenches the TV as a key device Smart TV provides additional revenue streams Threat: Internet TV players Unforeseen new technologies

Comparable companies

The major competitors to Skyworth are Hisense and TCL. TCL is a HK listed state owned enterprise. Its parent company manufacturers LCD panels and TCL suffers from high transfer prices of panels so is barely profitable. Hisense is a similar business to Skyworth and is a privately controlled, A-share listed company. Its returns and margins and growth profile are similar to Skyworth as is its valuation.

Other competitors are the international players, Samsung, Sony and LG plus smaller domestic manufacturers such as Konka and Changhong. All of these players lack critical mass and are not profitable.

Skyworth has enjoyed around 25% annual growth in revenue and 33% in EPS for the period from 2009 to 2013. However, this includes a rebound from the financial crisis low point of 2009 and growth has slowed for the 2014 primarily due to the removal of Government subsidies as discussed above. We expect low double-digit growth for the medium term as a base case. Return on equity throughout this period has declined from a peak of 20% in 2010 to mid teens today.

Income Statement

HK$ (m) 2009 2010 2011 2012 2013
Revenue 15,329 22,769 24,339 28,137 37,824
Gross profit 3,093 4,873 4,663 5,956 7,406
Operating Income* 752 1,674 1,633 1,753 2,059
Net profit after tax 503 1,326 1,281 1,268 1,594
EPS 0.18 0.47 0.45 0.45 0.56
           
GPM 20.2% 21.4% 19.2% 21.2% 19.6%
NPM 3.3% 5.8% 5.3% 4.5% 4.2%
EPS (c) 0.18 0.47 0.45 0.45 0.56

Source: Company Financials Skyworth's balance sheet is conservatively financed with net debt of RMB 2.9bn versus equity of RMB 10.2bn. Working capital is the largest component of invested capital at RMB 9.8bn, followed by plant and equipment of RMB 3.1bn. The balance sheet is further strengthened by surplus property assets with book value of HK$385m and estimated market value of HK$3.0bn.

Balance Sheet

HK$ (m) 2009 2010 2011 2012 2013
Property, plant and equipment 1,433 1,399 1,709 2,328 3,068
Prepayment 20 12 4 0 124
Investment property   125 77 11 11
Interests in jointly controlled entity 113 156 195 218 219
Other receivables 84 90 96 102 108
Others 378 398 647 727 1,008
Noncurrent assets 1,944 2,090 2,632 3,284 4,430
           
Trade receivables 1,759 2,276 2,954 3,512 6,213
Bills receivables 4,539 6,938 7,251 9,118 9,773
Stock of Properties   0 4 40 539
Inventories 1,267 3,298 2,657 3,151 5,109
Structured bank deposits   0 36 224 25
Pledged bank deposits 154 2,394 558 630 623
Cash and bank deposit 1,385 2,191 2,524 2,164 2,301
Others 15 35 59 101 50
Current assets 9,119 17,132 16,043 18,940 24,633
           
Bank borrowing 0 0 778 715 225
Others 451 504 617 720 924
Noncurrent liabilities 451 504 1,395 1,435 1,149
           
Trade payables 4,322 5,189 5,162 7,107 9,586
Bills payables 191 586 917 941 1,699
Bank borrowing 1,429 6,721 3,577 3,568 5,581
Othes 266 368 375 505 812
Current liablities 6,208 12,864 10,031 12,121 17,678
           
Total equity 4,404 5,854 7,249 8,668 10,236

Skyworth's free cash flow has been approximately break even over the past 4 years due to investment in working capital of RMB 7.9bn and fixed assets of RMB 2.5bn. The incremental return on these investments has been attractive with ROE remaining in the mid teens. The company has been paying a regular dividend at a payout ratio of around 30%, which on the current stock price equates to a 4-5% dividend yield. However, the company has in a place a share dividend option, which is typically taken up by the vast majority of shareholders. This explains the lower growth in EPS versus NPAT over the past 4 years. Other than the stock dividends and employee equity based compensation plans, the company has not issued material amounts of equity.

Cash flows

HK$ (m) 2010 2011 2012 2013
Operating cash flow 1,873 1,850 2,161 2,488
Change in NWC (3,731) 253 (1,828) (2,603)
Net operating cash flow (1,858) 2,103 333 (115)
Capex (316) (587) (823) (819)
Net free cash flow (2,174) 1,516 (490) (934)
Dividends (112) (163) (199) (177)
Change in net debt 2,143 (1,250) 814 1,481
Share issuance / (repurchase) 254 17 23 13
Others (112) (119) (148) (383)

Segment financials and analysis

The set top box business whilst now relatively mature enjoys very attractive returns on equity (30+%) and superior margins to the TV business (10% EBIT margin).

The overseas TV business is a break-even business and this is not expected to change. It provides buying power for LCD panels.

The white goods and modules businesses were founded recently and are enjoying high rates of growth and generating attractive returns

Valuation

We believe that Skyworth should trade on a PE of at least 10-12 times earnings given its historical track record of growth and attractive returns.

We forecast FY14 EPS to be $0.50 and $0.57 for FY15. Hence, using 10 times 2015 earnings we derive a target price of HK$5.70/share.

The current share price equates to a 2014 PE of 7.2x and 2015 PE of 6.3x and a small discount to current book value per share. Note that the book value does not include any intangible assets.

This valuation does not include any value for the surplus property assets other than the capitalization of rental income at the 10 PE multiple. It also does not explicitly include any upside from Smart TV revenues such as advertising or e-commerce.

Based on current market prices, this results in a potential gain of 60% over an investment time frame of 1-2 years.

Why is Skyworth trading so cheaply?

The threat of internet TV has been widely reported in the media and the key players have undertaken extensive marketing and promotional expenditures recently.

Stock prices have historically responded to short term trends in monthly TV sales data, which has been negative for the past 12 months for the reasons outlined above. This trend is expected to reverse from June this year.

Key events

Spin-out of the STB business, completed this calendar year with a special dividend post disposal announced.

Return to positive sales trend once the tough prior period comparisons driven by the terminated subsidies and the anti-Japan sentiment are over. This is expected from June this year

Benefits of the Smart TV adoption to Skyworth become clearer. Smart TVs are expected to be 80% of sales in FY15. The company currently has 3m TV users from whom it collects viewing data and this is expected to increase to 10m by end FY15.

Fears of the negative effect of internet TV on traditional players prove to be overblown

Key risks

Internet TV does disrupt the business model and leads to lower margins

Increasing competition in the Chinese TV market. There is no reason to believe that this is likely to happen. The barriers from economies of scale are significant as outlined above.

Downside protection

Skyworth is trading at a small discount to book value. The book value does not include any intangibles assets and includes HK$385m of property assets located in Shenzhen. The estimated market value of these properties is HK$3.0bn

Skyworth's non-TV businesses contribute 25% of the companies EBIT and provide down side protection in the event of a decline in earnings in the TV business.

We estimate that the value of the property assets plus the value of the non-TV businesses to comfortably exceed the current market cap.

Appendix 1 - Segment analysis

Skyworth segment breakdown:

HK$ (m) 2009 2010 2011 2012 2013
Revenue:          
TV products (PRC) 13,819 19,277 19,284 22,290 27,433
TV products (overseas)   1,358 1,143 1,731 3,108
Digital set top box 1,309 1,895 3,696 3,270 3,906
LCD modules   527 818 905 1,489
White appliances   142 399 726 1,691
Property Holding 103 124 75 82 83
Others 360     453 1,468
Elimination (204) (554) (1,076) (1,320) (1,354)
Total 15,387 22,769 24,339 28,137 37,824
           
Growth:          
TV products (PRC)   39.5 % 0.0 % 15.6 % 23.1 %
TV products (overseas)     (15.8)% 51.4 % 79.5 %
Digital set top box   44.8 % 95.0 % (11.5)% 19.4 %
LCD modules     55.2 % 10.6 % 64.5 %
White appliances     181.0 % 82.0 % 132.9 %
Property Holding   20.4 % (39.5)% 9.3 % 1.2 %
Others   (100.0)%     224.1 %
Elimination   171.6 % 94.2 % 22.7 % 2.6 %
Total   48.0 % 6.9 % 15.6 % 34.4 %
           
EBIT:          
TV products (PRC) 514 1,229 1,291 1,510 1,733
TV products (overseas)   0 23 (11) (15)
Digital set top box 192 272 371 385 396
LCD modules   61 7 123 148
White appliances   10 (13) (11) 83
Property Holding 24 36 45 57 52
Others 29     (30) (109)
Total 759 1,608 1,724 2,023 2,288
           
Growth:          
TV products (PRC)   139.1 % 5.0 % 17.0 % 14.8 %
TV products (overseas)       (147.8)% 36.4 %
           
Digital set top box   41.7 % 36.4 % 3.8 % 2.9 %
LCD modules     (88.5)% 1,657.1 % 20.3 %
White appliances     (230.0)% (15.4)% (854.5)%
Property Holding   50.0 % 25.0 % 26.7 % (8.8)%
Total   111.9 % 7.2 % 17.3 % 13.1 %

Skyworth margin and segment ROE:

HK$ (m) 2009 2010 2011 2012 2013
Margins:          
TV products (PRC) 3.7 % 6.4 % 6.7 % 6.8 % 6.3 %
TV products (overseas)     2.0 % (0.6)% (0.5)%
Digital set top box 14.7 % 14.4 % 10.0 % 11.8 % 10.1 %
LCD modules   11.6 % 0.9 % 13.6 % 9.9 %
White appliances   7.0 % (3.3)% (1.5)% 4.9 %
Property Holding 23.3 % 29.0 % 60.0 % 69.5 % 62.7 %
Others 8.1 %     (6.6)% (7.4)%
           
ROE:          
TV products (PRC) 12.8 % 15.8 % 16.0 % 15.6 %  
TV products (overseas)   0.0 % (197.2)% (5.9)%  
Digital set top box 30.8 % 46.5 % 42.4 % 31.2 %  
LCD modules   (1,302.9)% 31.6 % 110.0 %  
White appliances   11.1 % (5.6)% 11.6 %  
Property Holding 3.2 % 27.2 % 94.1 % 46.8 %  
Others 27.7 %     (6.0)%  
 

Comparable company statistics

TCL Multimedia (1070 HK)

HK$ (m) 2009 2010 2011 2012 2013
Revenue 30,343 26,949 32,932 36,025 39,495
Gross Profit 4,924 3,765 5,289 6,145 5,414
Operating income 685 (725) 463 846 (253)
Net Income 397 (983) 453 911 (48)
           
Net gearing 19.8 % 132.5 % 143.9 % 95.3 % 99.9 %
           
ROA 2.88 % (5.88)% 2.12 % 3.49 % (0.19)%
ROE 11.48 % (29.07)% 13.55 % 21.95 % (1.05)%
           
EV/Sales 0.31 x 0.29 x 0.24 x 0.30 x 0.24 x
EV/EBIT 13.75 x NM 17.36 x 12.64 x NM
P/E 21.69 x NM 5.93 x 6.93 x NM
P/B 2.37 x 1.07 x 0.75 x 1.20 x 1.10 x
           
Growth:          
Revenue   (11.2)% 22.2 % 9.4 % 9.6 %
Gross Profit   (23.5)% 40.5 % 16.2 % (11.9)%
Operating income   (205.8)% (163.9)% 82.8 % (129.9)%
Net Income   (348.0)% (146.0)% 101.3 % (105.3)%
           
Margins:          
Gross Profit 16.2 % 14.0 % 16.1 % 17.1 % 13.7 %
Operating income 2.3 % (2.7)% 1.4 % 2.3 % (0.6)%
Net Income 1.3 % (3.6)% 1.4 % 2.5 % (0.1)%

Hisense (600060 CH)

HK$ (m) 2009 2010 2011 2012
Revenue 20,827 24,334 28,209 30,963
Gross Profit 3,849 4,135 5,770 5,442
Operating income 582 1,098 2,192 2,125
Net Income 565 958 2,035 1,971
         
Net gearing (34.2)% (33.5)% (27.5)% (7.8)%
         
ROA 6.13 % 7.31 % 11.80 % 9.32 %
ROE 12.67 % 15.78 % 26.31 % 20.10 %
         
EV/Sales 0.72 x 0.39 x 0.36 x 0.50 x
EV/EBIT 25.96 x 8.57 x 4.65 x 7.35 x
P/E 25.53 x 11.99 x 6.10 x 8.23 x
P/B 3.04 x 1.76 x 1.44 x 1.50 x
         
Growth:        
Revenue   16.8 % 15.9 % 9.8 %
Gross Profit   7.4 % 39.5 % (5.7)%
Operating income   88.8 % 99.6 % (3.0)%
Net Income   69.5 % 112.3 % (3.1)%
         
Margins:        
Gross Profit 18.5 % 17.0 % 20.5 % 17.6 %
Operating income 2.8 % 4.5 % 7.8 % 6.9 %
Net Income 2.7 % 3.9 % 7.2 % 6.4 %