September 21, 2016 China: Technology Equity Research VR trip takeaways: Exploring and awaiting breakthroughs We visited 7 VR companies in China across the value chain We hosted a Virtual Reality (VR) trip on September 12-14 in China and visited RELATED RESEARCH companies to explore and get an update on current trends. Companies Global: Technology: Augmented reality starts to liven up the VR/AR market, July 18, 2016 visited include: original design manufacturer, GoerTek; hardware companies, Baofeng and Pico; content providers, Ourpalm and Letin; and platform Profile in Innovation: Virtual & Augmented Reality – Understanding the race for the next computing platform, companies, HTC Vive and LekeVR. Our trip takeaways are listed below. January 13, 2016 Taiwan: Technology: Initiate HTC at CL-Buy: From hardware Upstream is awaiting breakthroughs in technology maker to platform owner: Vive to revive HTC, May 24, 2016 Upstream content makers are still waiting for breakthroughs in VR GoerTek Inc. (002241.SZ): Sony PS VR to launch in Oct & technology to enable high-quality VR hardware to penetrate mass users. iPhone 7 supporting strong 3Q; Buy , July 28, 2016 Specifically, upstream players are awaiting a standardized industry infrastructure such as: operating system, motion tracking system, etc. as this could enable the same content to reach more people. B2B has higher commercial visibility for startups in near term Currently, most startups opt for a B2B model, which has higher commercial visibility than B2C as consumers are typically not well versed in the capabilities of high-quality VR and their willingness to pay is still very low. Major B2B areas include: offline VR experience stores, real estate, shopping, tourism, education, etc. Moreover, platform companies generally have more stable revenue streams than content companies because content is aggregated, permitting stable revenue share and advertising revenue. VR game still the major opportunity in content development According to management teams we met with, VR game is still viewed as the biggest opportunity in content development (and the fastest development at present), while VR video and live streaming still have a long way to go as CDN and data transmission constitute the biggest hurdle. GoerTek: VR/AR an important pillar to driving revenue growth Chairman Jiang Bin (Bryan) reiterated GoerTek’s focus on system solutions and views on VR/AR, which with wearable devices are key the growth driver through 2020E alongside smart audio and sensor. Management believes GoerTek is leading global peers by at least one year in VR ODM and expects higher precision processing requirements for next gen VR, which could be thinner and brighter, an area where GoerTek believes it can sustain its leadership. Xufa Liao, CFA +86(21)2401-8902 [email protected] Beijing Gao Hua Securities Company Limited Goldman Sachs does and seeks to do business with Wei Chen companies covered in its research reports. As a result, +886(2)2730-4185 [email protected] Goldman Sachs (Asia) L.L.C., Taipei Branch investors should be aware that the firm may have a conflict of Lingling Hu interest that could affect the objectivity of this report. Investors +86(10)6627-3520 [email protected] Beijing Gao Hua Securities Company Limited should consider this report as only a single factor in making Brian Dai +86(21)2401-8944 [email protected] Beijing Gao Hua Securities Company Limited their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non- US affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc. Global Investment Research September 21, 2016 China: Technology Takeaways from Virtual Reality trip and company visits in China We hosted a Virtual Reality (VR) trip on September 12-14 in China and visited a few companies to explore and get an update on current trends. Companies visited include: original design manufacturer, GoerTek; hardware companies, Baofeng and Pico; content providers, Ourpalm and Letin; and platform companies, HTC Vive and LekeVR. We highlight our trip takeaways below. Local hardware companies in China actively exploring technology After developing for more than a year, VR hardware has grown materially in China. Apart from international VR HMD (head-mounted device) manufacturers like Oculus, HTC Vive and Sony PSVR whose devices sell at US$600-800, many domestic companies are now offering VR devices at a more affordable price points (from Rmb100-2000 or c.US$20-300). Companies we visited noted: Pico (Not Covered) Pico launched their mobile integrated VR HMD at the price of c.Rmb2,000. According to Pico, the company is confident about the future of integrated VR HMD and believes it is one of the few companies to have successfully developed such a product. Baofeng Mojing (Not Covered) The company has sold out more than 1.5mn slide-on VR HMDs, at a price range of Rmb100-200. Meanwhile, Baofeng is also developing its own mobile integrated VR HMD. GoerTek (002241.SZ, Buy, September 20 close, Rmb29.26) We met with Chairman Jiang Bin (Bryan), design manufacturer of Facebook Oculus and Sony PSVR. Chairman Jiang reiterated GoerTek’s long-term focus on system solution and views on VR/AR (augmented reality), which together with wearable devices are key growth drivers through 2020E alongside smart audio and sensor. Management believes GoerTek is leading global peers by at least one year in VR ODM and expects higher precision processing requirements for next gen VR, which is expected to be thinner with higher resolution and have a more optical upgrade feature, an area where GoerTek believes it can sustain its leadership in vertical integration and precision manufacturing. We think GoerTek is well positioned to benefit from the development of the VR market and maintain our Buy rating. Our 12m target price of Rmb33.50 is derived by applying global peers’ average 2017E P/E of 21.5X to 2021E earnings and discounting back to 2017E with 8.4% COE. Key risks: Slower-than-expected ramp up of VR. Upstream players awaiting breakthroughs in technology At the current stage, it seems quality and price are difficult to reconcile, as leading discreet VR HMDs are still too expensive and lower-priced slide-on VR HMDs have not provided the best experience. As such the consensus is that mass audience is still under-exposed to high quality VR capabilities. Ourpalm (300315.SZ, Neutral, Rmb9.61) In our visit with Ourpalm, Vice President, Haosheng Li, noted that upstream content makers are still waiting for breakthroughs in VR technology, which include higher resolution, higher refresh rate, lower latency, more precise motion tracking, and above all, making all of these at more affordable prices. Mr. Li further noted that such breakthroughs would make it much easier for the company as a content provider to benefit from scale effect. We Goldman Sachs Global Investment Research 2 September 21, 2016 China: Technology think VR currently still makes a limited contribution to earnings and maintain our Neutral rating. Our 12m target price of Rmb11.45 is based on 18X P/E target multiple applied to our 2020E EPS of Rmb0.87 discounted back to 2016E using the sector COE of 8%. Key risks: Higher-/lower-than-expected game revenue. Another obstacle facing upstream companies is that different VR hardware has different standards, and it’s very costly to adapt to different versions of hardware, actually more costly than migrating an APP from android to iOS. As a result, a standard industry infrastructure like an operating system could be extremely helpful for content makers in our view as it would help enable the same content to reach a larger audience. Given it is compatible with multiple smartphones like Huawei and ZTE, Google’s Daydream platform could address this need. B2B model offers higher commercial visibility than B2C for startups in short term In our visit with Letin Digital, COO Jishun Zhuang said that most startups typically opt for the B2B model, which currently offers higher commercial visibility than B2C, mainly because consumers are generally not well versed on high quality VR capabilities and their willingness to pay is still very low. Low penetration rate of hardware also leads to a small user base and lower scalability for content markers. Even in VR game, an area which is commonly viewed as the fastest developing segment and the largest opportunity of monetization in the future, it’s also very hard to monetize in the current stage given China gamers are not used to paying for games directly. Instead, users still prefer to pay in- games. We think in-game paying requires a larger user base to monetize content, which could take some time. Major B2B areas include offline VR experience stores, real estate, shopping, tourism, education, etc. As pointed out by Mr. Zhuang, many players are already engaged in these areas, making the market more and more competitive. There are also other vertical areas like VR dating which are under explored. Platform companies might enjoy more stable revenue than content companies Because consumer willingness to pay is still low and business model is still not clear, revenue of content companies tends to fluctuate. A Content company could have one or two solid hit titles, but blockbusters can hardly be predicted. According the management teams we met with, platform companies may be to achieve more stable revenue share by aggregating content, and receive advertising revenue. LekeVR (Not Covered) LekeVR provides technological and operating solutions to offline VR experience store operators and supplies content to them by aggregating VR video and games on its VRLe platform. LekeVR then takes a small percentage of revenue from experience store operators.