A-share research Tuesday, 11 December, 2018 Bringing China to the World BUY Hangzhou Hikvision Digital Technology (002415:CH) Unchanged Hangzhou Hikvision Digital Technology Co Ltd Sector: Information Technology Changing focus Industry: Electronic Equipment, Instrume Sub-Industry: Electronic Equipment & Instrum The US agreed to hold off on raising the tariff on US$200bn worth of Chinese goods from Key data 10% to 25% on 1 January 2019. We believe a sustainable truce between China and the US Price (Rmb) 26.87 52wk High (Rmb) 44.29 may benefit Hangzhou Hikvision Digital Technology. We maintain our EPS forecasts of 52wk Low (Rmb) 23.60 Rmb1.25 in 18E (+21.4% YoY), Rmb1.58 in 19E (+26.4% YoY) and Rmb1.86 in 20E (+17.7% Market Cap (Rmbm) 247,937 YoY). Our target price is unchanged at Rmb68.48 (43.3x 19E PE). With 155% upside, we Market Cap (US$m) 35,935 Shares outstanding (m) 9,227 maintain our BUY recommendation. Free float (%) 23.9 1M relative return (%) 0.8 Minimal revenue exposure to US. The US restricted exports of 14 types of emerging 6M relative return (%) -11.2 technologies in November, and added 44 Chinese companies to its export control list in YTD relative return (%) -2.6 Dividend yield (2017, %) 1.86 August, which we expect to have a limited impact on Hikvision at present. In order to cope CSI 300 3,160 with a potential escalation of the Sino-US trade war, Hikvision has aimed to promote high- value-added solutions in developing countries and increased sales of low-end products in Inst Ownership (Top 5) North America. It derived c.29% of 17A revenue from overseas markets, with less than 6% CETHIK GROUP CO LTD 39.6% Gong Hongjia 13.6% from the US. Hong Kong Securities 10.4% WEI Xun Investment M 4.9% Shifting supply chain. According to Hikvision’s IPO prospectus, its upstream suppliers HK Pukang Internatio 2.0% include integrated circuit (IC), printed circuit board (PCB), power supply, case, and audio & Source: Bloomberg video algorithm firms. We see its IC imports as a potential weak link, which may impede Sector head its growth if Sino-US trade tensions intensify. We note domestic firms started the development of application specific integrated circuit (ASIC) for artificial intelligence (AI) Liu Yang products in 2016-17, which may satisfy robust demand from surveillance, internet and [email protected] automation companies in the future. An industry fund, set up by Hikvision’s parent CET Hik Group, invested Rmb200m in the series A funding of chip developer NextVPU in Analyst October. We believe domestically produced AI chips are already capable of replacing Liu Yang imported visual processing units (VPU) for Hikvision, and may become good alternatives for graphic processing units (GPU) going forward. [email protected] Growing market. We estimate sales from distributors, government clients and corporate clients account for 30%, 30-35% and 35-40% of Hikvision’s domestic sales, respectively. Hikvision initiated a campaign to help its distributors reduce inventories this year, which we expect to affect sales from distributors by Rmb2bn. We note the firm’s incremental accounts receivable-to-quarterly revenue ratio declined to 8.5% in 2Q18 and 9.5% in 3Q18, from 13.5% in 1Q18, and therefore anticipate improving performance from the distributor channel in 4Q18. Meanwhile, public tenders for security and surveillance projects recovered significantly in October-November, with the number of tenders up 52% YoY and a combined tender value jumping 82% YoY, beating both figures in 4Q17. Maintain BUY. We maintain our EPS forecasts of Rmb1.25 in 18E (+21.4% YoY), Rmb1.58 in 19E (+26.4% YoY) and Rmb1.86 in 20E (+17.7% YoY). Our target price is unchanged at Rmb68.48 (43.3x 19E PE). The stock is currently trading at 21.5x 18E PE and 17.0x 19E PE. With 155% upside, we maintain our BUY recommendation. 50 (Rmb) Volume Price (m) 180k 45 160k Financial Table 40 140k 35 120k (Rmbm) 2017 2018E 2019E 2020E 30 100k 25 80k Revenue 41,905 50,421 62,896 76,667 20 15 60k Growth YoY (%) 31.2 20.3 24.7 21.9 10 40k Net profit 9,410.9 11,544.1 14,563.6 17,162.0 5 20k 0 0k Growth YoY (%) 26.8 22.7 26.2 17.8 EPS (Rmb) 1.03 1.25 1.58 1.86 Growth YoY (%) -16.3 21.4 26.4 17.7 12/2015 02/2016 04/2016 06/2016 08/2016 10/2016 12/2016 02/2017 04/2017 06/2017 08/2017 10/2017 12/2017 02/2018 04/2018 06/2018 08/2018 10/2018 12/2018 Gross margin (%) 43.5 42.5 43.3 43.2 ROE (%) 34.2 34.2 35.4 34.5 Source: Bloomberg PE (x) 26.1 21.5 17.0 14.4 Source: Bloomberg, SWS Research swsresearch.com.hk Please visit us at www.swsresearch.com.hk, or find SWS Research on your Bloomberg terminal at SWSE <GO>, on Thomson Reuters, FactSet and S&P Capital IQ. A-share research Tuesday, 11 December, 2018 Bringing China to the World Changing focus Short-term trade war overhang pushed back The market concerned about the negative impact on Hikvision’s export business from the escalating trade frictions between China and the US. Hikvision derived c.29% of 17A revenue from overseas markets, and less than 6% from the US. Based on our estimates, c.25% of Hikvision’s products exported to the US (by value) are subjected to 10% tariff, which are shared by the firm and its customers. The Trump administration approved the National Defense Authorization Act (NDAA) in June, restricting government institutions using technologies from ZTE (000063:CH - BUY) and prohibiting the National Defence Department from renewing contracts with suppliers that have Chinese partners. The bill has a limited impact on Hikvision, given its small exposure to business with the US government. In August, the US added 44 Chinese companies to its export control list. Hikvision was not included in the list, and it does not sell products or services to the US military. In November, the Bureau of Industry and Security (BIS) of the US Ministry of Commerce called for public comments on an export control policy that restricts exports of 14 types of emerging technologies. During the Group of 20 summit in Argentina, President Xi Jinping and US President Donald Trump agreed to hold off on imposing new tariffs, and pledged to step up negotiations toward the removal of all additional tariffs and reach a concrete deal that is mutually beneficial. Trump will postpone a plan to raise tariffs on US$200bn worth of Chinese goods from 10% to 25%, on 1 January. Meanwhile, President Xi agreed to increase purchases of American agricultural, energy and industrial products in a bid to narrow the trade surplus with the US. Although the trade war overhang is mitigated in the short-term, the US will continue to raise the tariff to 25% if no deal on technology transfer, intellectual property, non-tariff barriers and agriculture is reached within 90 days. Hikvision generated c.50% of export sales from Southeast Asia and other developing countries, 30% from west Europe and Australia, and only 20% from the US. In order to minimise the impact from the trade frictions, it aims to promote high-value-added solutions in developing countries. In the North America market, it aims to increase sales of low-end products, which we believe can offset shrinking sales of higher-end products in the US as certain large customers may shift to non-Chinese suppliers for compliance reasons. Addressing the chip supply shortage According to Hikvision’s prospectus and previous annual reports, the company’s upstream suppliers mainly consist of IC, PCB, energy supply, chassis and basic audio & video algorithms vendors. The company can purchase energy supply and chassis products from domestic suppliers, develop software for audio & video algorithms, and secure PCB products domestically. However, IC becomes the major constraint to its development, with central processing unit (CPU) and GPU as the core setbacks. Intel (INTC:US) and NVIDIA (NVDA:US) were the major processor vendors for Hikvision before the trade frictions, and now investors worry about a chip supply shortage facing the company after the trade restrictions. A-share research Tuesday, 11 December, 2018 Bringing China to the World Fig 1: Overview of Hikvision’s upstream suppliers Name Major upstream products Upstream suppliers Proportion Producing area Original source Source Year The main raw materials for Sony (6758:JP), Sharp (6753:JP), Micron production include IC, PCB, Hikvision IC Technology (MU:US), Philips, Texas Japan, US Prospectus 2010 power supply and chassis Instruments (TXN:US), Analog Devices (ADI:US) accessories, etc. Basic audio & video algorithms ITU-T, ISO/IEC Prospectus 2010 Top five suppliers Seed International 22.47% Prospectus 2009 Shanghai Hong Ri International Electronics 4.99% IC Prospectus 2009 Ningbo Guanshuo Electronics 4.20% PCB Prospectus 2009 Hangzhou Yucheng Electronics 4.09% Power supply and chassis Prospectus 2009 Join Young Corporation 3.09% Prospectus 2009 Key suppliers NVIDIA US Since 2014 Source: ifind, Company prospectus, Company filings, SWS Research Following the rise of artificial intelligence (AI) in the Chinese market, a number of start-ups led by veterans or former executives at leading IC firms started to invest in AI application- specific integrated circuits (ASIC) from 2015 onwards. After several years of development, some of them have raised more than Rmb100m of funds and launched products available for mass production. As per Sohu Tech news on 24 October, chip and system solutions start-up NextVPU raised Rmb200m from series A fundraising, led by Hangzhou CETC HiK Equity Investment Fund Management Partnership (L.P.).