focus on functions and features greater china...

Important disclosures, including any required research certifications, are provided on the last two pages of this report.

Electronics / Regional

10 October 2012

Focus on functions and features

• We expect vendors to slow CPU and memory improvements and focus on upgrading cameras, displays and sound quality

• Google may settle its Android patent issue with Apple/Microsoft, which would have a mixed impact on the ecosystem

• Buy Apple supply chain players; we like Hon Hai, TXC, Largan, AAC and FIH; in metal casing, we prefer Catcher over Foxconn Tech

Greater China Smartphone Sector

How do we justify our view?How do we justify our view?


Birdy Lu (886) 2 8758 6248 [email protected]

What's new We assess in depth the Greater China Smartphone Sector, including the industry outlook, component specifications, and the patent war, along with our investment strategy for the smartphone supply chain for our expanded stock universe following a transfer of coverage.

What's the impact Overly smart? After years of rapid evolution in mobile computing (CPU, memory), today’s smartphones are as powerful as notebook PCs were in 2009. Dual-core CPUs, 512MB+ memory, Wi-Fi, Bluetooth and light/motion sensors have become the norm even in mid-range smartphones. A Swiss army knife – does many things, excels at none. Smartphones can replace a wide range of personal devices, such as PDAs, digital cameras, MP3 players, and camcorders. However, their photo, video, and audio quality is not yet as good as that of standalone devices. Functional components > semiconductors. To take the user experience to the next level, we believe smartphone vendors will focus more on upgrading displays and video,

audio enhancing components, rather than on CPUs and memory. Apple/Samsung Electronics (SEC), Huawei/ZTE should be winners. In a maturing market, vendors with premium devices and those with cost advantages should gain market share. Competition in the middle is likely to be very fierce. Cross-licensing. We believe SEC’s recent lawsuit loss to Apple is likely to compel Google to speed up cross-licensing negotiations with Apple/Microsoft. Given its patent portfolio, Google is likely to obtain a better licensing deal than each Android licensee negotiating on its own. If this happens, the Android OS would no longer be free. We expect this to be slightly negative for tier-one legal Android licensees, more negative for tier-two legal Android licensees, but positive for some China white-box vendors that make Android phones without licences.

What we recommend We have a Positive sector rating. We favour high-quality Apple supply chain players. Hon Hai Precision Industry (Hon Hai), reaffirming our Buy (1) rating, and TXC, initiated with Buy (1), are our top picks here, as they supply almost all i-devices. Foxconn International Holdings (FIH) may make iPhones for Apple soon and we initiate with a Buy (1) rating. We reaffirm our Buy (1) ratings on Largan Precision (Largan), and AAC Technologies (AAC); both stand to benefit from Apple continuing to upgrade i-devices with

better cameras and acoustics. In the metal-casing space, we maintain our Outperform (2) rating on Catcher Technology (Catcher), which we prefer to Foxconn Technology (Foxconn Tech) on valuation, clientele, and technology diversity grounds, and retain our Sell (5) rating on Foxconn Tech. We reaffirm our Sell (5) rating on HTC, whose R&D and product design capability we think are on a par with SEC but which lacks SEC’s much stronger brand name and distribution channels.

How we differ Our view on cross-licensing differs from the market’s belief that the patent war will last a long time, and cost more. Our preference for Catcher over Foxconn Tech runs counter to the consensus view.

Key stock calls New Prev. HTC Corp (2498 TT) Rating Target price Up/downside

Sell NT$240.00

(16.4)%

Sell NT$320.00

Largan Precision (3008 TT) Rating Target price Up/downside

Buy NT$730.00

19.3%

Buy NT$640.00

TXC Corp (3042 TT) Rating Target price Up/downside

Buy NT$63.00

27.5%

Hon Hai Precision Industry (2317 TT) Rating Target price Up/downside

Buy NT$120.00

35.3%

Buy NT$105.00

Foxconn International Holdings (2038 HK) Rating Target price Up/downside

Buy HK$3.80

41.3%

Source: Daiwa forecasts Note: Please refer to page 3 for details.

Electronics / Regional

10 October 2012

Focus on functions and features

• We expect vendors to slow CPU and memory improvements and focus on upgrading cameras, displays and sound quality

• Google may settle its Android patent issue with Apple/Microsoft, which would have a mixed impact on the ecosystem

• Buy Apple supply chain players; we like Hon Hai, TXC, Largan, AAC and FIH; in metal casing, we prefer Catcher over Foxconn Tech

Greater China Smartphone Sector


Growth outlook Smartphone demand should remain brisk for several more

years

Gartner projects the global smartphone penetration rate to rise from 34% in 2012 to 56% in 2016, with shipments reaching 1.3bn units in 2016 (a CAGR of 19%). We forecast a CAGR of 20%+ over 2012-16 and penetration of 60%+ in 2016. We view the rise of smartphones as just an extension of Internet usage moving from PCs to handier devices. If the time of ‘everyone using the Internet’ has come, the timeof ‘smartphones for everyone’ should not be far off. However, we note that China is now a larger market for smartphones than the US, indicating that smartphones are becoming a mature product in China. We expect greater ASP and margin pressure ahead due to price competition from newcomers.

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Smartphone shipment (LHS) YoY growth (RHS)

(m units)

Source: Gartner (‘Market Share: Mobile Devices by Region and Country, 2Q12’ by Anshul Gupta, David Glenn, Roberta Cozza, Tuong Huy Nguyen, Carolina Milanesi, Sandy Shen, Hugues J. De La Vergne, Annette Zimmermann, Atsuro Sato and CK Lu, published on 13 August 2012), compiled by Daiwa

Valuation Greater China Smartphone Sector: valuations

Hon Hai, TXC, Largan and AAC trade at 2013E PERs of 10-13x based on our EPS forecasts, below their past-3-year ranges of 12-16x. We think they are undervalued, as we believe they have clear earnings-growth drivers (Apple i-devices) with stable margin outlooks (product upgrades). We see FIH as a turnaround play, with a cash-rich and clean balance sheet, which could trade at a 1x PBR when sales momentum accelerates, which we expect in late 4Q12 or early 1Q13. We suggest investors go long Catcher and short Foxconn Tech as a pair trade and expect their current valuation gap to narrow in the months ahead. HTC does not look out of the woods yet; as we see weak 4Q12 momentum and an unclear 2013 outlook, we do not think its 2013E PER of 14.2x (on our EPS) looks sustainable.

Bloomberg PER (x) PBR (x) Company code 2012E 2013E 2014E 2012E 2013E 2014E Hon Hai 2317 TT 12.8 9.6 8.4 1.6 1.4 1.2 HTC 2498 TT 12.1 14.2 14.1 2.8 2.7 2.5 FIH 2038 HK n.a. 145 27 0.7 0.7 0.7 AAC 2018 HK 16.1 12.5 11.0 4.5 3.7 3.1 Largan 3008 TT 18.9 13.4 11.5 3.8 3.2 2.7 Catcher 2474 TT 11.0 9.8 8.9 1.7 1.5 1.4 Foxconn Tech 2354 TT 17.7 13.8 13.1 2.2 2.0 1.8 TXC 3042 TT 13.6 11.0 9.1 2.0 1.8 1.6 Source: Bloomberg (tickers), Daiwa forecasts

Note: multiples are based on share prices of 8 October 2012

Earnings revisions Greater China Smartphone Sector: consensus 2013E EPS

revisions

The Bloomberg-consensus 2013E EPS for the smartphone hardware companies in Greater China have been on a downward trend since mid-2011 due to the lacklustre performances of the companies’ non-Apple clients (such as Nokia, Research in Motion [RIM], HTC, and Motorola). We believe most negatives are priced in, as the consensus EPS revisions appear to have bottomed out over the past two months. Most of the smartphone hardware firms we cover have become ‘Apple plays’ (higher sales exposure to Apple than to other clients). For 4Q12 and 2013 we expect EPS revisions to trend up, driven by strong iPhone 5 sales and potentially a new iPad.

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Index

Source: Bloomberg, Daiwa

Note: the index is compiled by Daiwa by using the weighted-average EPS revision trend of Hon Hai, HTC, FIH, Largan, AAC, Catcher, Foxconn Tech and TXC

How do we justify our view?

Growth outlook Valuation Earnings revisions

Greater China Smartphone Sector 10 October 2012

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Key stock calls

EPS (local curr.) Share Rating Target price (local curr.) FY1 FY2

Company Name Stock code Price New Prev. New Prev. % chg New Prev. % chg New Prev. % chg

HTC Corp 2498 TT 287.00 Sell Sell 240.00 320.00 (25) 23.659 35.922 (34.1) 20.151 27.095 (25.6)

Largan Precision 3008 TT 612.00 Buy Buy 730.00 640.00 14.1 32.395 32.142 0.8 45.634 44.576 2.4 TXC Corp 3042 TT 49.40 Buy 63.00 n.a. 3.637 n.a. 4.508 n.a. Foxconn Technology 2354 TT 110.50 Sell Sell 95.00 95.00 0.0 6.252 7.958 (21.4) 7.982 8.953 (10.8) Catcher Technology 2474 TT 136.00 Outperform Outperform 150.00 192.00 (21.9) 12.401 15.972 (22.4) 13.821 20.369 (32.1) Hon Hai Precision Industry 2317 TT 88.70 Buy Buy 120.00 105.00 14.3 6.903 8.078 (14.5) 9.210 10.898 (15.5) Foxconn International Holdings 2038 HK 2.69 Buy 3.80 n.a. (0.026) n.a. 0.002 n.a. AAC Technologies 2018 HK 27.15 Buy Buy 32.50 26.00 25 1.371 1.246 10 1.761 1.505 17 Source: Daiwa forecasts


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Overly smart? ................................................................................................................................... 6

Global market, winners and losers ................................................................................................. 10

OS competition and our view on Apple/SEC lawsuit .................................................................... 15

How to invest in the Greater China smartphone sector? .............................................................. 19

Appendix I – Spec comparison ...................................................................................................... 24

Appendix II – Component breakdown .......................................................................................... 32

Appendix III – Greater China handset supply ............................................................................... 35

Company Section

HTC Corp .................................................................................................................................... 37

Largan Precision ......................................................................................................................... 46

TXC Corp .................................................................................................................................... 54

Foxconn Technology ................................................................................................................... 67

Catcher Technology .................................................................................................................... 75

Hon Hai Precision Industry........................................................................................................ 83

Foxconn International Holdings ................................................................................................ 91

AAC Technologies ..................................................................................................................... 100

Table of contents


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Overly smart?

We believe smartphones today are smart enough. We expect semiconductor content (CPU/memory) upgrades to slow in the coming years. Instead, we believe vendors will make their phones look, sound, and handle touch better.

An in-depth top-down analysis to form our stock calls

We expect the following trends to prevail in the smartphone industry in 2013 and 2014:

• To enhance the user experience, smartphone vendors are likely to shift their focus from central processing unit (CPU)/memory upgrades to providing better displays, cameras, acoustics, and exterior looks.

• Apple and SEC should continue to gain smartphone market shares globally in the coming two years, as both have unusual business models within the industry that are difficult for others to replicate.

• SEC’s recent loss of an intellectual property (IP lawsuit) to Apple is unlikely to change the industry’s dynamics, or to slow down shipment growth of Android phones much. However, it is very likely to increase the costs of Android phone vendors.

• Apple’s contribution to the smartphone supply chain in Greater China should continue to increase, compared to SEC’s. Apple’s approach is to try and innovate new types of components and materials and source all its components externally. SEC makes most of its components in-house or via subsidiaries.

We relate these industry trends to the individual companies to set our recommendations. We summarise our stock recommendations here and provide individual company analyses with our revised (new in the case of TXC and FIH) valuations further on in this report. We set our six-month target prices for seven of the eight companies in our sector coverage using their past PER ranges as a benchmark, and for FIH based on PBR (detailed in the company analyses).

• We reiterate our Buy (1) ratings on Largan and AAC, both suppliers of high-quality lens modules, and acoustic components to Apple.

• We reaffirm our Buy (1) rating on Hon Hai, which makes almost all Apple i-devices. In addition, we expect Hon Hai’s operating-profit margin to trend up over 2013-14.

• We initiate coverage on TXC with a Buy (1) rating. TXC’s slim form factor crystal components are widely adopted by Apple’s and SEC’s high-end smartphones.

• We initiate coverage of FIH with a Buy (1) rating. Our industry research indicates that FIH is likely to make iPhones for Apple soon, which we believe could boost FIH’s top line considerably and become a major share-price catalyst. We expect FIH to return to profit in 2013.

• In the metal-casing space, we maintain our Outperform (2) rating on Catcher and reaffirm our Sell (5) rating on Foxconn Tech. We prefer Catcher from the perspective of its valuation, clientele, and technology diversity. Also, we believe the Bloomberg consensus gross-margin assumptions for Foxconn Tech for 4Q12 and 2013 could be too high.

• We believe HTC is not out of the woods yet and we reiterate our Sell (5) rating. HTC lacks the strong brand name, distribution channels and substantial marketing budgets of SEC.

Smartphones: a type of Swiss army knife

Smartphones can do so many things ... Today people can use smartphones to browse the Internet, take pictures, listen to music, navigate through traffic, and access multiple contacts on various social-network websites in a single window. In some situations (say, getting lost in a dark forest), smartphones can double up as flashlights and compasses to increase the chances of surviving in the wild, although they are not edible. We name just a few of their applications; the list could easily go on and on.


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Smartphone = phone + digital camera, DSC + camcorder + PDA + MP3 player + GPS + ...

Source: Daiwa

... but are arguably not particularly good at any of them

Smartphones might seem good enough for many users. However, sophisticated consumers still have a lot of complaints, such as the following:

• The quality with photos/videos taken by smartphones with a 8MP lens is worse than that of a 5MP digital camera (especially for moving objects or in dim light).

• The display size is small; smartphones do not provide the ‘PC-like’ Internet browsing experience that vendors claim.

• Voice/audio quality is moderate at best (there is a high level of background noise).

• Smartphones are not able to guide people as well as Garmin or TomTom GPS navigators.

• Smartphones are becoming bulkier; people generally want them to be as slim as possible.

From semiconductor to non-semiconductor

Specs look too high in semiconductors and too low in optical/acoustic/mechanical aspects Simply put, our analysis reveals that the issue with smartphones is not functionality. Actually, today’s smartphones are too complicated for many consumers to master all the functions. In fact, we believe the issue is that, for some frequently used functions (photos, music, browsing), smartphones are much less able to perform these functions than standalone devices (digital cameras, MP3 players, etc.). In developing future phones, we believe vendors will spend more money on upgrading displays, optical, acoustic and mechanical components, instead of on CPU and memory. CPU and memory levels now look sufficient In terms of semiconductor power, we believe most smartphones now are powerful and versatile enough to handle a wide range of computing, connection and multimedia applications simultaneously. As such, we see little room for further upgrades here. For example, mid-range smartphones typically come with a dual-core 1GHz (or 800MHz) CPU, 512/768MB of DRAM, Wi-Fi (11b/g/n), Bluetooth, and all types of sensor ICs (such as ambient-light sensor, digital compass/gyroscope, 3D accelerometers, proximity sensor, etc). We believe such hardware specifications will become the norm for tier-one vendors’ low-end smartphones in late 2013 or early 2014.


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Hardware spec comparison: popular mid-range smartphones in 2012 Vendor Apple SEC HTC Motorola Model iPhone 4 Galaxy Ace 2 Desire X Droid X2

CPU Single-core 800MHz, Apple A4

Dual-core 800MHz, STE U8400

Dual-core 1GHZ,

Qualcomm S4 (MSM 8225)

Dual-core 1GHz, Nvidia

Tegra2

Nand flash 16GB/32GB 4GB 4GB 8GB DRAM 512MB 768MB 768MB 512MB Display 3.5”, 640 x 960 3.8”, 480x800 4’’, 480x800 4.3”, 540x960 Wi-Fi 802.11b/g/n 802.11b/g/n 802.11b/g/n 802.11a/b/g/n Bluetooth Yes Yes Yes Yes GPS Yes Yes Yes Yes Ambient-light sensor Yes Yes Yes Yes

Proximity sensor Yes Yes Yes Yes 3D accelerometer Yes Yes Yes Yes Gyroscope Yes Yes Yes Yes Main camera 4.9MP 5MP 5MP 8MP Front camera 0.3MP 0.3MP n.a. n.a. Battery 1420mAh 1500mAh 1650 mAh 1540 mAh Dimension (mm) 58.66 x 115.2 x 9.3 62.2 x 118.3 x 10.5 62.3 x 118 x 9.3 66x128x10 Weight 137g 122g 114g 155g Source: Companies, Daiwa

Displays, cameras, acoustics and mechanicals are not yet sufficient

To take users’ video/audio/browsing experience to the next level, we believe smartphone vendors will need to upgrade those components that can make their devices look, sound, and handle touch better, such as displays, cameras, acoustic, and mechanical components.

• Display size – we expect the display size to continue to increase. For mid-range smartphones, it may increase from 3.5-4.0” in 2012 to 4.0-4.3” in 2013. The display sizes of high-end smartphones may increase even more.

• Display type – we believe this is likely to change from the current a-Si TFT LCD versions to LTPS TFT, metal oxide (IGZO), TFT-LCD, or active-matrix organic light-emitting diode (AMOLED) displays. These emerging display technologies not only consume less power but also provide higher resolutions and faster response times.

• Camera – the pixel migration (from 8MP to 10MP or above) should continue, but speeds might slow. However, if smartphones want to have digital camera-like capabilities, vendors will need to upgrade the phone camera’s optical features, such as provide a large aperture, wide-angle lens, shorter shutter time, and faster auto-focus (AF).

• Acoustics – we see several areas that can be upgraded, such as the increasing the use of high-definition (HD) receivers (better sound quality over LTE/3G networks), dual-speaker designs (for a surround-sound effect), and the dual MEMS microphone design (for noise-cancellation purposes).

• Miniature size – to keep a very slim form factor, mechanical component vendors (those making connectors, cables, and casings) need to make their products compact. In addition, the use of lithium-ion polymer batteries might increase, compared with the conventional prismatic types. Polymer-type batteries can be made very thin (3mm) to fit into limited spaces.

Comparison of TFT LCD displays, using LTPS, metal oxide,

and a-Si backplanes LTPS TFT a-Si TFT Metal-oxide TFT

Power consumption Low High Low Resolution (PPI) Best Good Better Brightness Highest Medium High Dimension (height) Thin Thick Thin Electron mobility Highest Medium High

VT* shift reliability Highest Medium High

VT* shift uniformity Medium Highest High

Maximum display size (in theory)

< 40" > 100" > 100"

Maximum display size (in practice)

< 10" > 60" < 12"

Yield rate Moderate Very high Low

Cost Highest Low High

Manufacturing process Mature Very mature Immature; still room for improvement

Leading vendors JDI, LGD, Sharp AUO, CMI, SEC, LGD Sharp Source: Daiwa

Note: * VT refers to voltage & temperature

Comparison of different display technologies: OLED, TFT LCD,

and colour STN LCD AM OLED TFT LCD Colour STN LCD Backlight unit No Yes Yes Power consumption Good Moderate Best Brightness Best Good Moderate Viewing angle Best Good Moderate Contrast ratio Best Best Moderate Colour richness Best Good Moderate Response time Best Good Moderate Durability Moderate Good Best Product size Thinner Thicker Thinner Production cost Higher Low Lowest Source: Daiwa


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History seems to be repeating itself

Before smartphones (ie, with feature phones), there was a similar trend, with vendors shifting their focus from semiconductor components to non-semiconductor components once technologies became relatively mature. In the early stages, what was inside the phone was important In the early days of feature phone development (1990s and early-2000s), handsets were mainly for mobile communication purposes. Semiconductors played a critical role in maximising voice quality and minimising the chances of dropped calls, especially baseband (BB) processors, radio frequency (RF) transceivers, power amplifiers (PA), power-management ICs, and mobile memory. These components easily accounted for more than 70% of a feature phone’s build of materials cost then (compared with 30-50% currently). There were only a handful of quality BB chip vendors worldwide, such as Texas Instruments, Ericsson (now ST Ericsson), Infineon, Motorola (now Freescale), and Qualcomm. The same oligopolistic situation applied to other semiconductor components, such as RF transceivers, Pas, and mobile memory. At the mature stage, what is outside matters In the mid-2000s two trends emerged. First, the rapid rise of MediaTek (2454 TT, NT$327, Buy [1]) a low-cost vendor, reflects the fact that the handset BB had become a commodity product. At this stage, the voice quality of white-box phones (using MediaTek chips) was as crystal clear as Nokia phones (using Texas Instruments’ chips). Second, the leading handset vendors tried to differentiate their products in terms of how they looked and sounded rather than what powered them. For example, Nokia’s N8x and N9x series featured Carl Zeiss lenses on their cameras. Sony Ericsson launched its Walkman series, which emphasised a superior music experience, and Motorola’s Razr surprised the world with its ultra-slim body. All were very popular products, despite carrying high price tags.

Mirroring the trend – feature phone vendors tried to differentiate their products by how they looked and sounded

Carl Zeiss lens on Nokia N82

Better audio quality from Sony Ericsson Walkman Series

Slim metal casings with polished look on Motorola Razr

Source: Company websites

Power-efficient > powerful

We believe the end of competition in CPU processing power for smartphones is not far off. This should be bad news for technology leaders such as Qualcomm, NVidia, and Texas Instruments, but good news for cost leaders such as MediaTek. We do not mean that semiconductor vendors should stop innovating. For heavy users, smartphones barely last a single day without needing to be recharged once or twice. We think semiconductor vendors will work on products with lower power consumption by streamlining circuit designs and migrating to advanced foundry geometry.


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Global market, winners and losers

The smartphone industry still has high growth potential but is becoming mature, in our view. In a mature market, we expect high-end vendors and cost leaders to be the winners.

We disagree that the smartphone industry is now ex-growth…

Smartphones are a trend, not a fad Some may believe that smartphones are just a fad like the once-popular clamshell phones, etc. The key argument is that not everyone needs a smartphone – it is a niche product for the earlier adopters, business users, the younger generation, etc. Some in the market are arguing that smartphone demand is likely to hit the ceiling soon, as the global penetration rate is set to exceed one-third by the end of the year. We think otherwise, and believe global smartphone penetration could reach 70% five years from now (it could even hit 90%+ in developed countries). If we compare smartphones to the Internet, 15 or 20 years ago people generally thought the Internet was only for computer geeks. Now, however, Internet usage is almost a given across all age groups worldwide. From a broad view, the rise in smartphone penetration is merely an extension of Internet usage from PCs to handier devices – if the day when ‘everyone is using the Internet’ has come, we see no reason why the day of ‘smartphones for everyone’ will not come. Gartner projects a 19% smartphone shipment CAGR globally over 2012-16 Gartner forecasts global smartphone shipments to rise from 649m for 2012 to 1,281m for 2016, at a four-year CAGR of 19%, and for the global smartphone penetration rate to reach 56% by then, up from 34% in 2012.

Global handset demand likely to go nowhere for years to come ...

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... but smartphone demand is still surging

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... but we agree that the best part of the party is over

Looking out over the next 3-5 years, demand (ie, smartphone growth) should not be an issue, in our view. However, we think ASP and profit margin pressures will loom large in the coming years. Industry ASP likely to trend lower ... We believe the future growth of smartphones will be driven mainly by emerging countries, for three reasons. First, telecoms infrastructure is well established in emerging countries. A 3G service is also up and running in major emerging countries (notably China, India and Brazil). Second, mobile operators are increasing their handset subsidy budgets to stimulate 3G service subscriptions. Third, the penetration rate of smartphones has hit 60%+ in developed countries, but it is still at the sub-30% level in emerging countries. As such, we see plenty of room for future growth in smartphone demand from emerging countries. On the flip side, we believe the industry’s ASP is likely to fall over the next 3-5 years, considering that consumers in emerging countries tend to buy mid-to-low-end devices (the iPhone is an exception). Also, operators’ handset subsidies are lower in emerging countries (on the basis of subsidy per device) than in developed countries.

Smartphone penetration in emerging countries is way below that of developed countries Smartphone penetration (%) 2008 2009 2010 2011 2012E 2013E 2014E 2015E 2016E Asia-Pacific 6 8 10 18 26 30 34 39 45 Japan 49 52 53 68 84 95 98 99 99 Western Europe 18 24 44 54 64 71 79 84 89 North America 20 25 38 55 67 79 84 88 90 Latin America 3 6 11 18 22 27 36 43 50 Middle East & Africa 9 10 12 17 20 27 34 40 46 Eastern Europe 8 9 13 18 29 43 55 61 67 Total 11 14 19 27 35 40 46 50 56 Source: Gartner (‘Market Share: Mobile Devices by Region and Country, 2Q12’ by Anshul Gupta, David Glenn, Roberta Cozza, Tuong Huy Nguyen, Carolina Milanesi, Sandy Shen, Hugues J. De La Vergne, Annette Zimmermann, Atsuro Sato and CK Lu, published on 13 August 2012), compiled by Daiwa

Smartphone shipments by region: emerging countries should be the future growth driver (m units) 2008 2009 2010 2011 2012E 2013E 2014E 2015E 2016E Asia Pacific 28 38 73 159 244 310 381 463 559 Japan 20 17 18 25 33 36 36 37 36 Western Europe

32 46 86 97 120 141 154 165 171

North America 36 46 72 107 135 167 180 187 194 Latin America 4 7 18 34 43 55 75 90 111 Middle East, Africa

12 12 19 30 41 59 80 101 122

Eastern Europe 7 7 13 20 34 51 68 79 88 Total 139 172 299 472 649 818 973 1,121 1,281 Source: Gartner (‘Market Share: Mobile Devices by Region and Country, 2Q12’ by Anshul Gupta, David Glenn, Roberta Cozza, Tuong Huy Nguyen, Carolina Milanesi, Sandy Shen, Hugues J. De La Vergne, Annette Zimmermann, Atsuro Sato and CK Lu, published on 13 August 2012), compiled by Daiwa

Smartphone-shipment breakdown – Asia-Pacific on the rise

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... and higher cost pressure likely With smartphones becoming a consumer device, competition is likely to intensify year by year. In developed countries, major vendors are not only engaged in a spec war (upgrading product specs, while maintaining the same or lower price), but also in a patent and marketing-budget war. Increasing number of lawsuits might lead to higher licensing

costs for smartphone vendors Major lawsuits in mobile world

Source: Daiwa

There is a fierce price war in emerging countries at present. For example, local smartphone vendors are offering dual-core smartphones in China priced at below Rmb2,000, which is 30-40% cheaper than comparable devices from tier-one vendors. Lack of a new killer app: we cannot see what’s next In the smartphone’s short history (about 10 years), once in a while we have seen new killer applications (apps) emerging, such as:


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• Mobile e-mail in the early-2000s: the rise of Blackberry and Windows Mobile phones replacing PDAs,

• Mobile Internet and app downloads in 2007, enabled by iPhone, and

• Mobile social networking in 2010: the rise of Android phones, featuring Facebook, Tweeter, Flickr, etc.

The arrival of new killer apps has always initiated a new round of hardware upgrades, such as capacitive touch panels in 2007 (to provide intuitive user interfaces and easy browsing), and multi-core CPUs in 2010 (to perform multiple tasks smoothly and simultaneously). We are still in search of the next killer application The rise of new killer applications…

… result in new winners and hardware upgrades?

Source: Daiwa

However, we do not see new killer apps arriving in the next two years that could drive similar hardware upgrades. Some analysts might suggest near-field communication (NFC) or 3D viewing as the new killer apps. We take a different view, and give our rationale in the following two paragraphs. NFC? Too many conflicts of interest are preventing its take-off NFC (turning the smartphone into an e-wallet) is a conceptually good idea. In reality, however, the lack of a standard is slowing its take-off. The lack of a standard is not just a ‘global’ issue. We do not have a standard at the ‘country’ level (or even at ‘city’ level) either, because of major conflicts of interest between phone makers, credit-card handlers, mobile-service providers and other related parties. Every party wants to take the lead, handle transactions, keep client data, and collect fees. The other limitation is that equipping smartphones with an NFC chip is not enough –two-way communication is needed to make NFC happen. On the retail side, all shops and outlets are required to install

scanners. Then, here comes the next question: Who will subsidise the hardware costs for these retail stores (many of them could be mom-and-pop shops, instead of chain stores)? 3D display? Have you tried it for more than 30 minutes (on a small display)? Watching a 3D video is an amazing experience in an iMAX theatre or with a 60”+ home-theatre system. In our view, however, a 3D display is not a good idea for a small-size app. Our experience with 3D video on a mobile display is not pleasant – we see only two sets of images overlapping (due to the size limitation of the display). We do not feel that these small displays create the depth necessary to constitute a 3D image. It does not take long for us to feel dizzy when watching 3D videos or playing a 3D game on a small-size display device.

In a market soon likely to be mature, high- and low-end vendors should prevail

High-end and low-end products likely to squeeze out mid-range goods The smartphone market is likely to mature soon, in our view. As such, we believe the winners will be vendors with a strong presence in high-end devices (which still enjoy high ASPs and margins) and/or low-end devices (which enjoy economies of scale). The competition for mid-range phones is likely to be very intense. Also, it is hard to differentiate mid-end devices. Apple and SEC dominate the high-end segment Our house view holds that Apple (APPL US, US$638.17 Outperform [2]) and SEC (005930 KS, W1,373,000, Buy [1]) stand to be the high-end winners of the smartphone war. They have not only good products (Apple – iPhone 5, SEC – Galaxy S3), but also a business model that is hard for others to replicate. Apple is the great innovator with strong capabilities in software and hardware design, plus a very profitable and tightly-controlled iTunes/App Store ecosystem. Among all the hardware makers, SEC has the best vertical-integration capability, which results in the best cost structure in this industry, in Daiwa’s view. It can produce almost all the key components in-house, including CPU, flash memory, DRAM, AMOLED display, PCB, and battery. In addition, it has deep


- 13 -

pockets (for marketing campaigns and waging patent wars), tight relationships with mobile operators, and widespread global distribution networks. Global smartphone market shares, 2Q12 – Apple and SEC combined now have nearly a 50% market share

Apple19%

Samsung30%

RIM5%

Nokia8%

HTC6%

ZTE4%

Hwawei3%

Others25%


Today’s premium smartphones – detailed specs iPhone 5 iPhone 4S Galaxy S3

Price (on contract) US$199/US$299/US$399

US$199/US$299/US$399

US$199/US$299

OS iOS6 iOS5 Android 4.0 (ICS) Processor Apple A6 Dual-core 800MHz,

Apple A5 Quad-core, 1.4GHz,

Exynos Memory 1GB 1GB 1GHz Display 4-inch IPS 1,136 x

640 3.5-inch IPS 960 x 640 4.8" AMOLED,

720x1080 Pixel density 326 ppi 326 ppi Storage 16GB / 32GB /

64GB 16GB / 32GB / 64GB 16GB / 32GB

Primary camera 8 MP, AF, f/2.4 aperture

8 MP, AF, f/2.4 aperture 8 MP, AF, f/2.4 aperture

Secondary camera 1.2 MP at 30fps (1080p)

VGA at 30fps (1080p) 1.9 MP at 30fps (1080p)

Cellular LTE, WCDMA or LTE/CDMA EV-

DO

Hybrid WCDMA/CDMA-EV DO

LTE/3G or 3G only

WiFi Dual-band 802.11 a/b/g/n

802.11 b/g/n Dual-band 802.11 a/b/g/n

Bluetooth Version 4 Version 4 Version 4 Orientation Accelerometer,

digital compass, gyroscope

Accelerometer, digital compass, gyroscope

Accelerometer, digital compass, gyroscope

Navigation A-GPS A-GPS A-GPS Face time WiFi and Cellular WiFi-only (iOS 5) n.a. SIM standard nanoSIM microSIM SIM Weight 112 grams / 3.9 oz 140 grams / 4.9 oz 133 grams / 4.7 oz Dimensions 123.8 x 58.6 x

7.6mm 115.2 x 58.6 x 9.3mm 70.6 x 136.6 x 8.6 mm

Source: Companies, Daiwa

Why do we believe high-end smartphones can maintain high ASPs and margins? In our view, robust sales of high-end smartphones (especially in developed countries) since the iPhone launched in 2007 have been driven mainly by high subsidies from the mobile operators. As long as the mobile operators do not cut subsidies on these high-end phones, we believe demand for them will remain strong. We have been watching the US operators’ subsidy plans for a long time. Over the past two years, we have not seen a big change in their smartphone subsidy policies. As the next two tables show, AT&T and Verizon still subsidise high-end phones by about US$400/ device. We do not expect this to change in the next 1-2 years. (Note: our definition of subsidy refers to the gap between the device’s retail price and contract price). Another important reason is because the market leader, Apple, does not tend to compete by cutting price. As such, we expect the ASP of high-end smartphones to remain relatively stable for the foreseeable future.

Smartphone subsidies in the US (September 2012Operator Verizon Verizon Verizon Verizon Verizon Phone iPhone 4S

(16GB) HTC Droid

Incredible 4G Samsung Galaxy S3

Blackberry Curve 9370

LG Lucid 4G

Estimated retail price

US$600-650 US$500-550 US$600-650 US$500-550 US$3450-500

Price (2-yr contract)

US$199 US$149 US$199 US$149 US$49

Voice plan (month)

US$40+ US$40+ US$40+ US$40+ US$40+

Data plan (month)

US$40+ US$40+ US$40+ US$40+ US$40+

Operator AT&T AT&T AT&T AT&T AT&T Phone iPhone 4S

(16GB) Blackberry Bold

9900 Samsung Galaxy S3

Samsung Galaxy S2

HTC One X


US$650-700 US$600-650 US$600-650 US$400-450 US$550-600


US$199 US$199 US$199 US$99 US$99

Voice plan (month)

US$40+ US$40+ US$40+ US$40+ US$40+

Data plan (month)

US$20+ (300 MB)

US$20+ (300 MB)

US$20+ (300 MB)

US$20+ (300 MB)

US$20+ (300 MB)

Source: AT&T, Verizon websites


- 14 -

Smartphone subsidies in the US (3Q11) Operator Verizon Verizon Verizon Verizon Verizon Phone Motorola

Droid X HTC Droid Incredible

Samsung Fascinate

Blackberry 8650

LG Ally


US$600-650 US$500-550 US$600-650 US$550-600 US$350-400


US$199 US$99 US$199 US$149 US$49

Voice plan (month)

US$40+ US$40+ US$40+ US$40+ US$40+

Data plan (month)

US$30+ US$30+ US$30+ US$30+ US$30+

Operator AT&T AT&T AT&T AT&T AT&T Phone iPhone 4

(16GB) Blackberry

Torch Samsung Captivate

Sony Ericsson X10

HTC Aria


US$650-700 US$650-700 US$650-700 US$550-600 US$450-500


US$199 US$199 US$199 US$149 US$129

Voice plan (month)

US$40+ US$40+ US$40+ US$40+ US$40+

Data plan (month)

US$15+ (200 MB)

US$15+ (200 MB)

US$15+ (200 MB)

US$15+ (200 MB)

US$15+ (200 MB)

Source: AT&T, Verizon websites

ZTE and Huawei are the rising stars in the low-end space In the low-end space, we believe ZTE (Not rated) and Huawei (Not listed) will take the lion’s share of the China market within a year. Both based in China, they enjoy low-cost labour, well-established supply chains (in their neighbourhoods), the biggest domestic market globally, and strong government support. Also, both companies have high market shares in the telecoms infrastructure business. They sell a lot of routers, switches, base stations, and core network equipment to telecoms/mobile operators, and can bundle the terminal devices (such as smartphones or broadband modems) into a single package. They can therefore price the total solution at discounts to their clients.

Global smartphone market shares – Huawei and ZTE came from zero in 2009 to 3-4% in recent quarters

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2009 2010 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12

Others

Sony Ericsson

LG

Motorola

Hwawei

ZTE

HTC

Nokia

RIM

Samsung

Apple



- 15 -

OS competition and our view on Apple/SEC lawsuit

From the smartphone operating system (OS) perspective, we expect the current duopolistic situation to last for a long while. SEC losing the lawsuit to Apple is likely to increase the cost of making Android phones but not slow shipment growth.

A duopolistic market

The Android OS and iOS (iPhone’s operating system) are late-comers to the market for operating systems, compared with Blackberry, Symbian and Windows Mobile OS (now the WP 8 OS). However, this duo has been growing quickly since their inception, and accounted for 83% of the global smartphone OS share for 2Q12. Smartphone OS shares globally (2Q12) – Android has the

lion’s share

Android64.1%

iOS18.8%

Microsoft2.7%

BB5.2%

Symbian5.9%

Linux0.5%

WebOS0.0%

Other OS2.8%


Smartphone OS shares globally (2011)

Android46.7%

iOS18.9%

Microsoft1.9%

BB10.9%

Symbian18.7%

Linux0.8%

WebOS0.1%

Other OS2.1%


iPhone growth has been very strong Introduced in 2Q07, the iOS device (ie, the iPhone) is far superior to other devices in terms of user experience (multi-touch, finger swiping, zooming user interface, etc.) and mobile Internet content. iPhone sales rose from 4.1m in 2007 to 221m in 2011. Apple introduced the AppStore in mid-2008, which further solidified its foothold in this business. The sheer number of available apps (more than 600,000 as at June 2012) and the ‘big bang’ within the app developer community raised the bar even higher. We believe iPhone sales look on track to exceed 140m for 2012. iPhone growth is very strong, but Android growth is far better

050

100150200250300350400450

2007 2008 2009 2010 2011 2012E

Android OS iOS

(m units)


Android phone growth is even stronger Android made its debut in late 2008. It incorporated the iOS’s key features. It also added a multi-tasking capability and provided tight integration with social networking websites (such as real-time message alerts and short clips of messages. iOS did not include either at that time.


- 16 -

Many people thought the iPhone would be the fastest-growing consumer device in human history. However, the growth of the Android phone eclipsed it. Gartner forecasts Android-phone shipments to rise from 0.6m for 2008 to 420m for 2012 and account for about a 60% share of the global market this year. Other OSs are struggling to catch up Seeing the major success of the iOS and Android, other OS owners have reinvented themselves aggressively and launched new OS versions, such as the Windows Phone 8 (WP 8) and Blackberry OS 10 (BB 10).

Smartphone OS comparison – Android leads the way Android OS iOS BlackBerry

OS Windows Phone 8

Symbian S60

Founders/major shareholders

OHA (led by Google)

Apple RIM Microsoft Nokia

Licensing fees to handset maker

No Proprietary Proprietary Yes No

Application store Google Play (Android market)

App Store Blackberry App World

Windows Phone

Marketplace

Nokia Ovi

Available apps 600,000+ 650,000+ 80,000+ 80,000+. 30,000+ Total number of app downloads

20bn+ 30bn+

Profit-sharing scheme

App developers (70%), network owners (mobile

operators) (30%)

Application developers

(70%), Apple (30%)

Application developers (80%), RIM

(20%)

Application developers

(70%), Microsoft

(30%)

In negotiations

Censor mechanism Loose censorship: developers have

the highest degree of freedom

Apple has tight control over content of the App

More freedom to developers

MSFT has tight control

More freedom to developers

SDK availability/ support to developer community

Yes Yes Yes Yes Yes

Media content download/sync mechanism

Handset vendor/mobile

operator can build their own, or use 3rd party solution (such as Amazon)

iTunes Blackberry Media

Sync; 7 digit

Zune, XBOX 360

Live

Ovi Music Store, etc.

Is App Store the only channel to sell apps?

No Yes No No No

Source: Daiwa

As a result of these catch-up efforts, all mobile OSs are almost the same in terms of functionality and feature sets now. Only the user interfaces are slightly different. Despite this, we do not think the revamped WP 8 and BB 10 will be able to gain back too much market share from the Android and iOS. First, it is too late, in our view. Mobile OS competition is all about the ecosystem (app availability, the size of the developer community, and support from the mobile service operators and handset makers). The number of available apps for Android and iOS is almost 7x greater than that for WP 8 and BB 10.

Second, Android is still winning more support from the handset makers and mobile operators. Android is free for the handset makers now, while WP 8 is still charging them a licensing fee (BB10 is proprietary). Android is the only mobile OS that shares profit (from over-the-air app downloads) with the mobile operators.

New Windows phones come with decent hardware... HTC 8X Samsung ATIV S Nokia Lumia 920

OS Windows Phone 8 Windows Phone 8 Windows Phone 8

CPU Qualcomm S4, 1.5GHz,

dual core Qualcomm S4,

1.6GHz, dual core Qualcomm S4, 1.7GHz,

dual core

RAM 1GB 1GB 1GB

Storage 16GB 32GB 32GB

Screen 4.3 inch super LCD 2 4.8 inch HD Super

AMOLED 4.5 inch IPS LCD

Resolution 1280 x 720 (341 PPI) 1280 x 720 (306 PPI) 1280 x 768 (332 PPI) LTE Yes Yes Yes

Back cam 8MP, F/2.0 8MP 8.7M, with optical image

stabilisation

Front cam 2.1 MP, wide angle lens 1.9MP 1.3MP

Size 132.35 x 66.2 x 10.12mm

137.2 x 70.5 x 8.7 mm, 130.3 x 70.8 x 10.7 mm

Weight (g) 130 135 185

Battery 1800 mAh 2300 mAh 2000 mAh

Colour Black, blue, red, yellow Metallic White, black, yellow, red,

grey

Noise cancellation N.A. N.A. Yes

Audio Beats Normal Dolby NFC Yes Yes Yes

Super-sensitive touch

No No Yes

Wireless charging No No Yes

Expandable memory card slot No Micro SD No

Source: Daiwa

... but when it comes to smartphone purchases, availability of

apps and user-friendliness come first

0%

2%

4%

6%

8%

10%

12%

14%

16%

Applications Ease of use Internet access

Integration capabilities

Email Others

Source: ChangeWave

Note: This is a survey conducted in the US that asks consumers what they consider first when deciding which smartphone to purchase next


- 17 -

Apple has the upper hand in the patent war against Android

US court ruled in Apple’s favour On 24 August 2012, in the Northern District Court of California (San Jose), a jury ruled that SEC had violated Apple’s patents, awarding Apple about US$1.05bn in damages. The jury rejected SEC’s counterclaim that Apple had violated its patents. The decision in this case had the effect of boosting significantly public awareness of the ongoing patent cases between the leaders in the smartphone market. The jury determined that SEC had violated six of Apple’s patents: three regarding device utility and the other three concerning design patents. Apple’s claims against SEC in the US case

Jury found infringement?

Utility patents

#163 Tap-to-zoom Yes #381 ‘Bounce-back’ (screen animation when user has

scrolled to bottom of page) Yes

#915 Multi-touch function of using one finger to scroll, two to zoom

Yes

Design patents

#087 Design of Apple’s white iPhone models (ornamental design)

Yes

#305 Rounded-corner square design of icons Yes #677 Design of black iPhone models (ornamental

design) Yes

#889 Industrial design of iPad No Source: SEC, Apple, compiled by Daiwa Note: Based on information as at 30 August 2012

The jury found that 28 Samsung smartphones and tablets violated Apple’s patents, although this did not include SEC’s latest model, the Galaxy S III. On 27 August 2012, Apple sought a preliminary injunction against SEC to stop the sale of eight Samsung smartphone models in the US. The hearing on this matter had been set for 20 September, but has been rescheduled to 6 December given the broad scope of Apple’s request. The new hearing will discuss a permanent injunction. On 20 September, a hearing was held to discuss SEC’s request to lift a court-imposed ban on sales of the Galaxy Tab 10.1. For a detailed analysis of the smartphone patent wars, please see our report of 11 September 2012, Smartphone patent wars: who stands to win?

Apple vs. SEC patent litigation worldwide Country Winner Germany Sep 2011 Apple SEC tablet sales banned due to design patent

violations (firm to change design to avoid ban) Australia Dec 2011 SEC SEC tablet sales permitted after finding that firm did

not violate Apple’s touch-screen patent UK Jul 2012 SEC Court found SEC did not violate Apple’s design patent;

SEC tablets permitted to be sold South Korea Aug 2012 Tie Found violations of patents on communications

technology and utility. Both firms ordered to pay damages, sales of some devices banned in South Korea

US Aug 2012 Apple SEC ordered to pay damages for violating Apple’s user interface and design patents

Japan Aug 2012 SEC Found SEC did not violate data-syncing patent Source: SEC, Apple, compiled by Daiwa

Possibility of cross-licensing agreements

We expect Google to talk to Apple and Microsoft directly In our view, Google (the founder of Android) is likely to negotiate directly cross-licensing agreements with Apple and Microsoft to make Android phones, and we believe doing so would in the best interests of all Android licensees. We believe Google would get a better deal (ie, a lower licensing fee) from Apple and Microsoft than SEC, HTC or other Android phone makers would by negotiating individually with Apple and Microsoft. A cross-licensing deal could be in favour of Apple and Microsoft... Google has more patents than Apple and Microsoft covering the communications field following its acquisition in 2011 of Motorola Mobility, while we believe Apple and Microsoft have a wider range of patents covering user interfaces and multimedia computing. As it stands, we think user interface/multimedia/computing patents are more valuable than communication patents for smartphone apps, such that Apple and Microsoft might hold the upper hand in any negotiations on cross-licensing. ... and the Android OS might be not free As a result, Google might end up having to pay royalties to Apple and Microsoft. In this case, we believe Google would pass this extra cost on to the Android device makers by charging them a licensing fee. This means the Android OS might no longer be free.

http://asiaresearch.daiwacm.com/eg/cgi-bin/files/SmartphoneDispute120911.pdf#page=1


- 18 -

What impact on Android makers if a licensing fee is applied?

Increased costs likely for the Android phone makers It is hard to predict the result of the cross-licensing negotiations. There are too many moving parts that could affect the outcome. We are not legal or IP rights experts, but our best-effort analysis suggests a possible licensing fee in the range of US$12-15 per smartphone. Our rationale is as follows: HTC, SEC, LG Electronics (LG), Huawei and a few other OEMs have made deals with Microsoft to pay a licensing fee of US$8-10 per smartphone, according to our industry research. Google might be able to pay less than this to seal a deal with Microsoft; we assume the fee would be US$6-8 per device. Assuming Apple’s patent portfolio is as good as Microsoft’s, we believe Google might have to pay the same US$6-8 to Apple. Android vendors are on an evening playing field – a positive for the leading brands As mentioned above, several leading Android device makers have started paying licensing fees to Microsoft, but many smaller brands do not. This situation is putting the leading vendors at a disadvantage to those vendors that do not pay. Especially for low-end devices, the licensing fee could account for as much as 10% of the total bill of material (BOM) cost, based on our estimates. We believe Google will set clear guidelines regarding the licensing fee, and will charge the same amount for all licensees, regardless of size. This means all the vendors would be competing on even ground. China white-box vendors: unlikely to pay licensing fees, might capitalise on a Google cross-licensing agreement However, there is a flip side to this scenario. Many of the China white-box smartphone makers use the Android platform without any agreement with Google, and we believe they will continue to do so in the future. As such, they are unlikely to pay licensing fees, and there is likely to be little that Google will be able to do to stop them (considering the PRC Government’s hostile attitude towards Google).

Smartphone shipment market shares worldwide (2Q12)

Samsung29.7%

Apple18.8%Nokia

7.6%HTC6.1%

RIM5.2%

Motorola3.0%

LG3.8%

Huawei3.5%

ZTE4.1%

Sony3.5%

Others14.7%

Wor ldwide (2Q12)

Source: Gartner (‘Market Share: Mobile Devices by Region and Country, 2Q12’, by Anshul Gupta, David Glenn, Roberta Cozza, Tuong Huy Nguyen, Carolina Milanesi, Sandy Shen, Hugues J. De La Vergne, Annette Zimmermann, Atsuro Sato, CK Lu, published 13 August 2012), compiled by Daiwa

Android growth is unlikely to affected We believe most smartphone makers would continue to focus on Android (even if they increase their R&D on the Windows Phone OS), for three reasons if licensing fees are introduced. 1) Even if licence fees are introduced, the Android OS should still be cheaper than the Windows Phone OS. (Google would transfer its costs to licensees and would not try to make a profit from the OS itself, whereas Microsoft would still need to make a profit from licensing the OS). 2) Android still gives licensees considerable freedom to customise their own user interface, product design, and hardware/component contents. 3) The Android ecosystem (taking into account the number of apps, developer community, etc.) is currently much larger than that of the Windows Phone OS. We believe it is likely to take 2-3 years (or longer) for the Windows Phone OS to catch up.


- 19 -

How to invest in the Greater China smartphone sector?

Apple and SEC should continue to dominate the market. We believe Apple is a better client to the supply chain than SEC; thus, we recommend that investors buy high-quality Apple suppliers.

Smartphone supply chain

Apple supply chain is our preferred theme We like the Apple supply chain for three reasons:

• Innovative and high-quality components: Apple has a strong track record of innovating on new types of components that can improve performance and/or reduce the form factor, such as the capacitive touch panel in 2007 (for the iPhone), unibody casing in 2008 (for the MacBook Air), the retina display in 2010 (iPhone 4), and the in-cell touch panel in 2012 (iPhone 5). In addition, Apple places greater emphasis on quality than costs.

• Strong business growth with multiple drivers: We believe Apple will continue to outgrow other competitors in the years ahead. It has a diversified portfolio of products (iPhone, iPad, iPad mini, MacBook, iTV, iPod, etc.), which can communicate seamlessly with each other. When consumers start to buy one i-device, they tend to buy more of them thereafter.

• High reliance on Asia-Pacific suppliers: Apple does not make any of its components, nor does it assemble any i-device in-house. As such, Apple needs to source all its components externally, and relies on electronic manufacturing services (EMS) companies for box assembly, quality control and logistics services. In addition, Apple purchases a high percentage of components from component vendors based in Greater China.

iPhone 4 supply chain – most semiconductor components are made by Greater China vendors Part BBG code Manufacturer Order allocations from Apple Semiconductor Processor 005930 KS SEC (foundry) over 80% 4G modem QCOM US Qualcomm 100%

Wifi module 6981 JP Murata 70% 6762 JP TDK 20%

WIFI, Bluetooth, GPS BRCM US Broadcom Nand Flash

6502 JP Toshiba 60% 000660 KS SK Hynix 40%

Mobile DRAM

005930 KS SEC 30% 000660 KS SK Hynix 30% Not listed Elpida 40%

IC substrate 009150 KS SEMCO 4062 JP Ibiden PWM IC DLG GR Dialog Semiconductor 100%

Display

Incell TFT

6753 JP Sharp 35% Not listed Japan Display 40% 034220 KS LGD 25%

Polariser 6988 JP Nitto Denko 4005 JP Sumitomo Chemical In-cell touch sensor AAPL US Apple 100% Component Camera module

011070 KS Innotech 50% 6753 JP Sharp 50%

8MP camera lens 3008 TT Largan 50% 3406 TT Genius 50%

1.3MP camera lens

3406 TT Genius 50% 3008 TT Largan 30% Private Sang-ying 20%

VCM for lens 6770 JP ALPS 50% 6767 JP Mitsumi 50%

Imaging CMOS sensor OVT US Omni vision 50% 6758 JP Sony 50%

MLCC

6981 JP Murata 40-45% 009150 KS SEMCO 6976 JP Taiyo Yuden 10-20% 6762 JP TDK 0-5% AVGO US Avago 15-20%

Antenna switch module 6981 JP Murata 100%

Connector

6807 JP Japan Aviation 50% 6981 JP Murata MOLX US Molex 6752 JP Panasonic Cable and charger 2392 TT Cheng Uei 70%

Crystal 3042 TT TXC 40% 6779 JP NDK 40% Not listed River 20%

Vibration 6594 JP Nidec 100%

HDI 4062 JP Ibiden 40% 2313 TT Compeq 30% 3037 TT Unimicron 30%

Flexible PCB

6269 TT Flexium 40% 051370 KS Interflex 7240 JP NOK 30% 3390 JP MFLX 30%

Acoustic 2018 HK AAC 70% Private Knowles 30%

PA

TQNT US Triquint 25-50% SWKS US Skyworks 25% AVGO US Avago 25-50%

Metal casing

2317 TT Hon Hai 40% 2354 TT Foxconn Tech 50% JBL US Jabil 10%

Light sensor Not listed TAOS (US) 100% G/Gyro sensor INVN US Invensense 100%

Battery 6762 JP TDK Not listed ATL

Source: Companies, compiled by Daiwa


- 20 -

SEC is a tough client (to component vendors in Greater China) Our SEC analyst, Jae Lee, has a positive investment view on the company. In the context of our analysis on the Greater China Smartphone Sector, however, we would recommend that investors buy SEC shares directly, rather than shares of players in the SEC supply chain. We do not prefer the SEC supply chain over the Apple supply chain from an investment standpoint for three reasons:

• SEC has a vertical integration business model: SEC generally procures most of its key components in-house, and commodity components from external vendors.

• SEC generally prefers Korean vendors when outsourcing: component vendors in other countries tend to serve a back-up role.

Taiwan/China smartphone players: revenue contributions

from Apple and SEC

Company Bloomberg code Apple-related SEC-related

Taiwan Semiconductor Manufacturing 2330 TT △ △ MediaTek 2454 TT n.a. n.a. Radiant Opto-Electronics* 6176 TT ○ (40-57%) ○ (20-30%) Largan Precision 3008 TT ○ n.a. Genius 3406 TT ○ n.a. AAC Technologies 2018 HK ○ ○ Cheng Uei 2392 TT ○ △ Hon Hai Precision Industry 2317 TT ○ n.a. Pegatron 4938 TT ○ n.a. Compal Electronics # 2324 TT n.a. △ Quanta Computer # 2382 TT ○ n.a. Source: Companies, compiled by Daiwa Note: Triangles indicate that sales to Apple and SEC each comprises 0-10% of total sales,

circles indicate 10% or more *Radiant supplies backlight units to Apple through SEC’s manufacturing of LCD panels

# Compal and Quanta are PC ODMs for Apple and SEC

Hon Hai and TXC: our top picks in large-cap and small-cap Apple supply space Hon Hai, the world’s largest EMS company in terms of revenue, manufactures iPhones, iPads (potentially including the expected iPad Mini), iPods, Apple TVs (set-top boxes) and iMacs (DT PC) for Apple. Hon Hai is a direct beneficiary of the strong demand for all Apple i-devices and we reaffirm our Buy (1) rating on the stock. TXC is the world’s fourth-largest vendor of crystal components. We forecast Apple to account for about 20-25% of TXC’s revenue for 2012. We believe a potential near-term stock catalyst for TXC is that Apple has just upgraded the spec of its crystal components from 2016 type to 1612 type (with a smaller form factor

and a higher ASP) in the iPhone 5. TXC also supplies crystal components to China white-box smartphone makers (accounting for 7-10% of TXC’s revenue) and SEC (5-7% of TXC’s revenue). We initiate coverage of TXC with a Buy (1) rating. We also like Largan and AAC Largan is the primary supplier of the 8MP lens module used in the main camera of the iPhone 4S and iPhone 5; the camera is placed at the back of the device. Largan also supplies the lens module for the iPhone 5, front-facing camera (recently upgraded from VGA to 1.3MP). As both are slim-form-factor products, we believe they can raise Largan’s product ASP and gross margin over 2012-13. We reiterate our Buy (1) rating on Largan. AAC supplies a wide range of acoustic components to Apple, including receivers, speaker boxes and MEMS microphones. To ensure good voice quality, we believe the iPhone will continue to use the dual-microphone design to enable the noise-cancellation feature. Moreover, we believe other smartphones will adopt the same design concept. We reaffirm our Buy (1) rating on AAC. In the metal-casing space – we like Catcher and would avoid Foxconn Tech Both Catcher and Foxconn Tech are key metal-casing suppliers to Apple. We expect Foxconn Tech to see stronger QoQ shipment-growth momentum in 4Q12 than Catcher, as it currently has a better product mix vs. Catcher. Foxconn Tech is the primary casing supplier for the iPhone and iPad, while Catcher mainly supplies iPod and MacBook casings. Foxconn Tech’s likely business strength in 4Q12 has been well discussed, but we are concerned that the Bloomberg consensus gross-margin assumptions for 4Q12 and 2013 could be too high. By contrast, Catcher trades currently at a deep discount to Foxconn Tech in terms of PERs for 2013 based on our EPS forecasts (at 10x compared with 14x), and we believe it has a solid earnings-growth outlook. For long-term investors, Catcher has a more diversified clientele and technology base, whereas Foxconn Tech’s metal-casing sales are highly concentrated on Apple. If Apple switches the materials of its next iPhone to plastics or glass, Foxconn Tech will have a lot of idle capacity. We reiterate our Sell (5) rating on Foxconn Tech and recommend switching into Catcher, on which we maintain our Outperform (2) rating.


- 21 -

HTC – not out of the woods yet

Being number four is not good enough According to Gartner, HTC shipped 9.3m smartphones in 2Q12, making it the world’s fourth-largest smartphone vendor with a 6.1% market share that quarter. However, in a consumer electronic market (especially the duopolistic smartphone one), being the number four is not good enough, in our view. We think only the top two vendors (ie, SEC and Apple) can generate decent margins and profits, and that all the others can only make thin margins (sub-5% operating-profit margins) in the long run. HTC still generates a 6-7% operating-profit margin now. If it cannot improve its brand equity, marketing and distribution, we believe its operating-profit margin could fall below 5% within two years. It is not a product issue ... We think HTC’s R&D and product design capability is on a par with SEC’s. From our comparison of the HTC One X/S and the Samsung Galaxy S3,we have found that the scores and feedback from professional review websites (CNET, Tech Radar, Engadget Mobile, etc.) are quite similar (rated either 4.5 stars or 5 stars). … but rather a brand equity, marketing and distribution issue Smartphones are no longer niche products for early adaptors or tech-savvy people, who spend a lot of time browsing review websites for advice. Smartphones have become a real consumer product. On this front, SEC has much stronger brand power, distribution networks and mobile operator relationships (especially in Latin America) than HTC, not to mention a substantial marketing budget. We believe HTC needs to do the following to turn round ... Building brand equity and a global distribution network is a long-term investment, and there are no short cuts. HTC’s marketing budget is not even the equivalent of 20% of SEC’s at present. To regain earnings-growth momentum, we believe HTC needs to see either a quantum leap with a next-generation product (making a very outstanding phone among the ‘me-too’ Android crowd), or formulate a very clever and effective marketing campaign (without overspending). Both are very challenging tasks, in our view. We therefore reaffirm our Sell (5) rating on HTC.

FIH is our top pick in the EMS/ ODM space

The rise of the iPhone, SEC and China white-box vendors are putting pressure on ODM companies Apple dictates every detail of product design and component selection. Therefore, it only needs an EMS service. By contrast, SEC hardly outsources handset production because it can make its handsets in-house at very low cost, thanks to its vertically-integrated business model. China white-box vendors are too nimble for ODM companies to serve them, in our view. The white-box business model can be characterised as ‘multiple models, very small volume for each model, and a short product life cycle’. We prefer EMS to ODM companies It is becoming hard to draw a fine line between EMS companies, such as FIH, and ODM companies, such as Compal Communications (Not rated). On a relative basis, however, our analysis shows that EMS companies have better vertical integration capabilities (as they make mechanical and function components in-house), while ODMs have better product design capabilities. The rise of the smartphone is relatively in favour of EMS companies while against ODMs. Global original equipment manufacturers (OEM) tend to keep the smartphone design function in-house and outsource part productions to EMS firms. Unlike feature phones, global OEMs tend to outsource both the design and production of low-end smartphones to ODMs. FIH is our top pick in the EMS/ODM space FIH is the world’s largest handset EMS firm in terms of revenue (if we exclude its parent company, Hon Hai). It has a diversified client base, including almost all global OEMs (excluding Apple, as Apple is Hon Hai’s captive account). According to our industry research, FIH might start to make iPhones in late 2012 or early 2013. We believe this could be a strong share-price catalyst for FIH in the short term. From a financial standpoint, FIH has the strongest balance sheet among its handset EMS peers globally, with positive free cash flows. It is sitting on net cash of US$1.5bn, which represents 60% of its current market cap.


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Daiwa universe of Greater China Smartphone companies: ratings and valuation data Target Daiwa Mkt cap EPS (local currency) PER (x) EPS growth (%) ROE (%) PBR (x) Company Ticker price (lc) Rating (US$ bn) 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E Hon Hai 2317 TT 120 1 35.9 6.9 9.2 10.5 12.8 9.6 8.4 -0.9 33.4 14.3 13.2 15.6 15.7 1.6 1.4 1.2 HTC 2498 TT 240 5 8.3 23.7 20.2 20.4 12.1 14.2 14.1 -67.6 -14.8 1.3 21.3 19.2 18.4 2.8 2.7 2.5 FIH 2038 HK 3.8 1 2.5 0.0 0.0 0.0 n.a. 145 27 n.a. n.a. 430.2 n.a. 0.5 2.6 0.7 0.7 0.7 AAC 2018 HK 32.5 1 4.3 1.4 1.8 2.0 16.1 12.5 11.0 62.4 28.5 13.7 31.6 32.6 30.6 4.5 3.7 3.1 Largan 3008 TT 730 1 2.8 32.4 45.6 53.2 18.9 13.4 11.5 -16.4 40.9 16.6 20.8 25.7 25.6 3.8 3.2 2.7 Catcher 2474 TT 150 2 3.5 12.4 13.8 15.4 11.0 9.8 8.9 -17.2 11.4 11.1 15.9 16.0 16.1 1.7 1.5 1.4 Foxconn Tech 2354 TT 95 5 4.7 6.3 7.9 8.4 17.7 13.8 13.1 -4.1 27.7 5.5 13.3 15.1 14.2 2.2 2.0 1.8 TXC 3042 TT 63 1 0.5 3.6 4.5 5.4 13.6 11.0 9.1 4.7 24.0 19.8 14.9 17.2 18.8 2.0 1.8 1.6 Source: Bloomberg (tickers and share prices), Daiwa (target prices, ratings and forecasts)

Note: data is based on share prices as at 8 October 2012

China white-box food chain

Apple and Android camp lawsuit should benefit white-brand vendors As a result of the patent lawsuit between Apple and SEC the US, we believe that Google may eventually have to start charging licensing fees to all Android OS licensees to cover its cross-licensing costs (analysed earlier in this report). Almost all the China smartphone makers use the Android platform without any cross-licensing agreements with Google at present. Should the global smartphone brand-name makers (such as Samsung and HTC) have to pay to use the Android OS, we believe this would increase the China smartphone makers’ cost advantage (as we think it is unlikely that some of them would pay the licence fee). MediaTek is Daiwa’s top pick for the white-box smartphone theme MediaTek should benefit from high demand for smartphone ICs in China over the next three years. Daiwa analyst Eric Chen forecasts the company to ship 105m units for 2012 and 200m units for 2013, up from just 10m units for 2011. Eric believes MediaTek will be the major beneficiary of the rapid growth that Daiwa projects in China smartphone shipments over the next three years. Eric reaffirms his Buy (1) rating on MediaTek. For further details, please see Daiwa’s recent notes on MediaTek (Smartphone ICs driving value, of 20 August 2012) the China Tech Food Chain (Supply chain should benefit from China smartphone growth, of 13 August 2012).

MediaTek: smartphone vs. feature phone shipment pattern

2011 2012E 2013E 2014E 2015E 2016E

-

100

200

300

400

500

600

0

100

200

300

400

500

600

2004 2005 2006 2007 2008 2009 2010 2011

(m units)(m units)

Feature phone IC (LHS) Smartphone IC (RHS)

2012-2014CAGR 63%

2005-2009CAGR 78%

Source: Company, Daiwa forecasts

Who else could benefit from the rise of China white-box handsets? MediaTek is currently Daiwa’s only investible idea for long-term investors in the China white-box handset space. We have identified other beneficiaries in this supply chain that we list below. However, we believe these companies do not stand to benefit from the rise of China white-box handsets as much as MediaTek does. From the product design and manufacturing perspective, the white-box handset business has low entry barriers. The key know-how of this business lies in strong market acumen, time-to-market and tight cost control. White-box phone vendors are not particularly concerned about product quality and tend to purchase low-quality components.

http://asiaresearch.daiwacm.com/eg/cgi-bin/files/20120820tw_MediaTek.pdf#page=1

http://asiaresearch.daiwacm.com/eg/cgi-bin/files/20120813cn_ChinaTechFoodChain.pdf#page=1


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In this business, MediaTek’s SoC chip is the only component that is virtually irreplaceable. All other components can be sourced from various suppliers. As such, these component vendors might face stronger competition and pricing pressure in the future:

• Display/touch panels: Truly (Not rated), Giantplus (Not rated)

• Display controller and driver ICs: Ilitek (Not rated), Novatek Microelectronics (3034 TT, NT$106, Hold [3]), Sitronix (Not rated)

• Touch panel ICs: Elan Microelectronics (Not rated)

• Environmental sensing ICs (ambient light sensors, proximity sensors, etc): Capella Micro (Not rated), Sitronix (Not rated)

• Crystal components: TXC (3042 TT, NT$49.4, Buy [1])

• Camera modules: Sunny Optical (Not rated)

• Acoustics: Goertek (Not rated)

Cost gap between selected global brand names and China players (US$) iPhone 4 RIM - BlackBerry torch China white-box smart phone Xiaomi HTC WildFile 1. Application processor 15.46 (A4) 12 (QCOM) 0 (was embedded into

Baseband) 10 (QCOM) 0 (was embedded into Baseband)

2. Display (module + touch) 37.8 (3.5") 34.85 (3.2") 15 (3.2")/12(2.8") 35 25 3. Memory 40.4 (Flash: NAND, 16GB,

SDRAM: 4GB MCP: to be verified

34.25 (Flash-eMMC NAND, 4Gb, MCP-8Gb OneNAND Flash+4Gb Mobile DDR)

1Gb Mobile DDR (additional cost)

22 15(512Mb Mobile DDR)

4. Mechanical/E-Mechanical (glass & metals, PCB, etc.)

20 23 8 20 17

5. Battery (3.7V) 6 3 3 5 5 6. Bluetooth/ WLAN 8.27 (Broadcom BCM4329) 10.6 (TI's W1271A) 8 8 4 7. Camera 13.7 (5MP/VGA) 10.8 (5MP) 5 12 5 8. Baseband / RF / PA 16.41 (QCOM MDM6600 /

SWKS CDMA 800/1900) 13.9 12 (7225A/7227A or MT 6573) 20 12

9. User interface (sensors) 8 12 3 4 3 10. Power management IC 7 5 4 2 4 11. Box content 6 11 6 8 8 Total materials 177 170 64 151 83 Estimated manufacturing cost 7 12 7 9 7 BOM cost 184 182 71 160 90 Shipment price for operator 500 380 80 180 150 Source: Daiwa


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Appendix I – Spec comparison

Apple

Model iPhone 5 iPhone 4S iPhone 4 Photo

OS iOS6 iOS5 iOS4 CPU Dual-core, A6, 1200MHz Dual-core, A5, 800MHz Single-core, A4, 800MHz LTE version available Yes No No DRAM 1GB 512MB 512MB Nand flash 16/32/64 GB 16/32/64 GB 16GB/32GB Display size, type 5", IPS TFT (Retina) 3.5", IPS TFT 3.5", IPS TFT Display resolution 640 x 1136 640 x 960 640 x 960 Front camera 8MP, f/2.4 8MP 4.9MP Back camera 1.2MP 0.3MP 0.3MP Camcorder 1920x1080, 30f/s Yes Yes Wi-Fi 802.11a/b/g/n 802.11b/g/n 802.11b/g/n Bluetooth v4 v4 Yes Battery capacity n.a. n.a. n.a. Weight (g) 112 140 137 Dimension (mm) 123.8x58.6x7.6 58.6 x 115.2 x 9.3 58.6 x 115.2 x 9.3 Source: Daiwa

Note: Picture sizes of smartphones shown above are not in proportion to their actual sizes


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SEC

Model Galaxy Note 2 Galaxy S3 Galaxy S2 Galaxy R Galaxy Ace 2 Galaxy Rush Omnia M

Photo

OS Google Android 4.1.1 Google Android 4.0.4 Google Android 2.3.3 Google Android 2.3.4 Google Android 2.3.6 Google Android 4.0.4

Microsoft Windows Phone 7.5

CPU Quad-core, Samsung Exynos 4412, 1600MHz

Quad-core, Samsung Exynos 4412, 1600MHz

Dual-core, Samsung S5PC210 Exynos 4210,

1400MHz Dual-core , Nvidia Tegra2, 1000MHz

Dual-core, STE U8400, 800MHz

Single-core, Qualcomm S1, 1000MHz


LTE version available Yes Yes Yes No Yes No No

DRAM 2GB 1GB 1GB 1GB 768MB 768MB 384MB Nand flash 32GB 32GB 16GB 8GB 4GB 2GB 4GB Display size, type 5.5", AMOLED 4.8", AMOLED 4.3", AMOLED 402", TFT 3.8", n.a. 3.5", n.a. 4",AMOLED

Display resolution 720 x 1280 720 x 1280 480 x 800 480 x 800 480x800 320 x 480 480 x 800

Front camera 8MP 8MP 8MP 4.9MP 5MP 3.1MP 5MP

Back camera 1.9MP 1.9MP 1.9MP 1.2MP 0.3MP 1.3MP 0.3MP Camcorder Yes Yes Yes Yes Yes Yes Yes Wi-Fi 802.11a/b/g/n 802.11a/b/g/n 802.11a/b/g/n 802.11a/b/g/n 802.11b/g/n 802.11b/g/n 802.11b/g/n Bluetooth v4 v4 v3 v3 v3 v4 v2.1 Battery capacity 3100 mAh n.a. 1650 mAh 1650 mAh 1500 mAh 1750m Ah 1500 mAh

Weight (g) n.a. 133 116 131 122 n.a. 119 Dimension (mm) 80.5 x 151.1 x 9.4 70.6 x 136.6 x 8.6 66.1 x 125.3 x 8.49 66.7 x 125.7 x 9.55 62.2 x 118.3 x 10.5 n.a. 64.1 x 121.6 x 10.5

Source: Daiwa



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HTC

Model HTC One X+ HTC One X HTC One S HTC OneV HTC Desire V HTC Desire C HTC 8X Photo

OS Google Android 4.0.4 Google Android 4.0.3 Google Android 4.0.3 Google Android 4.0.3 Google Android 4.0.3 Google Android 4.0.3 Microsoft Windows Phone 8

CPU Quad-core, Nvidia Tegra3, 1700MHz

Quad-core, Nvidai Tegra3, 1500MHz

Dual-core, Qualcomm S4, 1700MHz





LTE version available No Yes Yes No No No No

DRAM 1GB 1GB 1GB 512MB 512MB 512MB 1GB Nand flash 64GB 32GB 16GB 4GB 4GB 4GB 16GB Display size, type 4.7", TFT 4.7", TFT 4.3", AMOLED 3.7", TFT 4", TFT 3.5", n.a. 4.3", TFT

Display resolution 720 x 1280 720 x 1280 540 x 960 480 x 800 480 x 800 320 x 480 720 x 1280

Front camera 8MP 8MP 8MP 5MP 5MP 5MP 8MP Back camera 1.3MP 0.3MP 1.3MP n.a. n.a. n.a. 2.1MP Camcorder Yes Yes Yes Yes Yes Yes Yes Wi-Fi 802.11a/b/g/n 802.11a/b/g/n 802.11b/g/n 802.11b/g/n 802.11b/g/n 802.11b/g/n 802.11b/g/n Bluetooth v4 v4 v4 v4 v3 v4 v2.1 Battery capacity 1800 mAh 1800 mAh 1650 mAh 1500 mAh 1650 mAh 1230 mAh n.a.

Weight (g) 129 130 119.5 115 114 98 n.a. Dimension (mm) 69.9 x 134.36 x 9.3 69.9 x 134.8 x 9.3 65 x 130.9 x 7.95 59.7 x 120.3 x 9.24 62.3 x 118.5 x 9.3 60.6 x 107.2 x 11.95 n.a.

Source: Daiwa



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Nokia

Model Lumia 920 Lumia 820 Lumia 900 Lumia 800 Lumia 710 Lumia 610 Photo

OS Microsoft Windows Phone 8 Microsoft Windows Phone 8 Microsoft Windows Phone 7.5



Microsoft Windows Phone 7.5 Refresh

CPU Dual-core, Qualcomm S4, 1700MHz






LTE version available Yes Yes Yes No No No

DRAM 1GB 1GB 512MB 512MB 512MB 256MB Nand flash 32GB 8GB 16GB 16GB 512MB 8GB Display size, type 4.5", TFT 4.3", AMOLED 4.3", AMOLED 3.7", AMOLED 3.7", TFT 3.7", n.a.

Display resolution 1280 x 768 480 x 800 480 x 800 480 x 800 480 x 800 480 x 800

Front camera 8.7MP 8MP 8MP 8.8MP 5MP 5MP Back camera 1.2MP 0.3MP 0.9MP n.a. n.a. n.a. Camcorder Yes Yes Yes Yes Yes Yes Wi-Fi 802.11a/b/g/n/l 802.11a/b/g/n/l 802.11b/g/n 802.11b/g/n 802.11a/b/g/n 802.11a/b/g/n Bluetooth v3.1 v3.1 v2.1 v2.1 v2.1 v2.1 Battery capacity 2000 mAh 1650 mAh 1830 mAh 1450 mAh 1300 mAh 1300 mAh Weight (g) 185 160 160 142 125.5 131.5 Dimension (mm) 70.8 x 130.3 x 10.7 68.5 x 123.8 x 9.9 68.5 x 127.8 x 11.5 61.2 x 116.5 x 12.1 62.4 x 119 x 12.48 62 x 119 x 12 Source: Daiwa Note: Picture sizes of smartphones shown above are not in proportion to their actual sizes


- 28 -

Research in Motion

Model BB Bold Touch 9900 BB Bold 9790 BB Torch 9860 BB Curve 9320 BB Curve Touch 9380 Photo

OS RIM BlackBerry 7 OS RIM BlackBerry 7 OS RIM BlackBerry 7 OS RIM BlackBerry 7.1 OS RIM BlackBerry 7 OS

CPU Single-core, Qualcomm S2, 1500MHz

Single-core, Marvell PXA930, 1000MHz

Single-core, Qualcomm S2, 1500MHz 806MHz Single-core, Marvell PXA930,

1000MHz LTE version available Yes No No No No

DRAM 768MB 768MB 768MB 512MB 512MB Nand flash 8GB 8GB 4GB 512MB 512MB Display size, type 2.8", TFT 2.4", TFT 3.7", TFT 2.4",TFT 3.2", TFT Display resolution 640 x 480 480 x 320 480 x 800 320 x 240 320 x 480 Front camera 4.9MP 4.9MP 4.9MP 3.1MP 4.9MP Back camera n.a. n.a. n.a. n.a. n.a. Camcorder Yes Yes Yes Yes Yes Wi-Fi 802.11a/b/g/n 802.11a/b/g/n 802.11a/b/g/n 802.11b/g/n 802.11b/g/n Bluetooth v2.1 v2.1 v2.1 v2.1 v2.1 Battery capacity 1230 mAh 1230 mAh 1230 mAh 1450 mAh 1230 mAh Weight (g) 130 107 135 103 98 Dimension (mm) 66 x 115 x 10.5 60 x 110 x 11.4 62 x 120 x 11.5 60 x 109 x 12.7 60 x 109 x 11.2 Source: Daiwa


Sony Ericsson

Model Xperia Ion Xperia V Xperia J Xperia T Xperia Neo Xperia U Photo

OS Google Android 2.3 Google Android 4.4 Google Android 4.4 Google Android 4.4 Google Android 2.3.4 Google Android 2.3

CPU Dual-core, Qualcomm S3, 1500MHz

Dual-core, Qualcomm S4, 1500 MHz




Dual-core, Cortex-A9, 1000 MHz

LTE version available Yes Yes No No No No

DRAM 1GB 1GB 512MB 1GB 512MB 512MB Nand flash 16GB 8GB 2GB/4GB 16GB 1GB 4GB/8GB Display size, type 4.55", n.a. 4.3", TFT 4", TFT 4.55", TFT 3.7", TFT 3.5", n.a.


Front camera 12MP 13MP 5MP 13MP 4.9MP 5MP Back camera 1.3MP n.a. n.a. 1.3MP 0.3MP n.a. Camcorder 1080, 30f/s 1080, 30f/s Yes 1080, 30f/s Yes 720, 30f/s Wi-Fi 802.11b/g/n 802.11a/b/g/n 802.11b/g/n 802.11a/b/g/n 802.11b/g/n 802.11b/g/n Bluetooth v2.1 v4 v2.1 v3.1 v2.1 v201 Battery capacity 1900 mAh 1750 mAh 1750 mAh 1850 mAh 1500 mAh 1320 mAh Weight (g) 144 120 124 139 126 110 Dimension (mm) 133 x 68 x 10.8 129 x 65 x 10.7 124.3 x 61.2 x 9.2 129.4 x 67.3 x 9.4 57 x 116 x 13 112 x 54 x 12 Source: Daiwa



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LG Electronics

Model Optimus Vu (Intuition) Optimus G Optimus Escape 4G Optimus LTE2 LG P940H Prada Optimus L7

Photo

OS Google Android 4.0.4 Google Android 4.0.4 Korean Google Android 4.0.4 Google Android 4.0.3 Korean Google Android 2.3.7 Google Android 4.0.3

CPU Quad-core, NVIDIA Tegra 3 AP30H, 1600MHz

Quad-core, Qualcomm S4, 1700MHz



Dual-core, Texas Instruments OMAP 4430,

1000MHz Single-core, Qualcomm S1,

1000MHz

LTE version available Yes Yes Yes Yes No No

DRAM 1GB 2GB 1GB 2GB 1GB 1GB Nand flash 24 GB 16GB 4GB 16GB 512MB 4GB Display size, type 5", TFT 4.7", IPS+TFT 4.3", IPS 4.7", IPS+TFT 4.3", IPS+TFT 4.3", IPS+TFT


Front camera 8MP 13.2MP 5MP 8MP 8MP 4.9MP Back camera 1.3MP 1.3MP 1.3MP 1.3MP 1.3MP 1.3MP Camcorder 1920x1080 1920x1080 1080, 30f/s Yes Yes Yes Wi-Fi 802.11a/b/g/n 802.11b/g/n 802.11b/g/n 802.11a/b/g/n 802.11a/b/g/n 802.11b/g/n Bluetooth v3 v4 v4 v4 v3 v3 Battery capacity 2080 mAh 2100 mAh 2150 mAh 2150 mAh 1540 mAh 1700 mAh

Weight (g) 168 142 n.a. 145 138 121 Dimension (mm) 90.4 x 139.6 x 8.5 68.9 x 131.9 x 8.45 n.a. 69.5 x 134.7 x 8.9 69 x 127.5 x 8.5 69 x 127.5 x 8.7

Source: Daiwa



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Huawei

Model Ascend D1 Quad Ascend D LTE Ascend G600 Ascend G330 Vision (U8850) Fusion (U8652)

Photo

OS Google Android 4.0.3 Google Android 4.0.4 Google Android 4.0.4 Google Android 4.0.4 Android 2.3 Google Android 2.3.3

CPU Quad-core, Huawei K3V2 HiSilicon Hi3620, 1500MHz





Single-core, Qualcomm MSM7227, 600 MHz

LTE version available No Yes No No No No

DRAM 1GB 1GB 768MB 512MB 512MB 256MB Nand flash 8GB 4GB 4GB 4GB 2GB 512MB Display size, type 4.6", IPS+TFT 4.5", IPS+TFT 4.5", IPS+TFT 4", n.a. TFT, 3.7" 3.5", n.a.


Front camera 8MP 8MP 8MP 5MP 5MP 3.1MP Back camera 1.3MP 1.3MP 0.3MP 0.3MP VGA n.a. Camcorder Yes Yes Yes Yes Yes Yes Wi-Fi 802.11b/g/n 802.11b/g/n 802.11b/g/n 802.11b/g/n 802.11b/g/n 802.11b/g/n Bluetooth v3 v3 v3 v2.1 v2.1 v2.1 Battery capacity 2600 mAh 1750 mAh 1930 mAh 1500 mAh 1400 mAh 1400 mAh

Weight (g) n.a. 135 150 140 121 120 Dimension (mm) 64.9 x 129.9 x 11.5 65.5 x 131 x 10.5 67.2 x 133.8 x 10.5 62.6 x 122.5 x 11.2 59.5 x 118.5 x 9.9 60.5 x 116.3 x 11.9

Source: Daiwa



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ZTE

Model PF112 Lord (V882) Grand X LTE Blade III Blade II Nova V6500 Photo

OS Google Android 4.0.1 Google Android 2.3.5 Chinese Android 4.0.3 Android 4.0 Google Android 2.3.5 Google Android 2.3.6

CPU Dual-core, ARM Cortex-A9 MPCore




Single-core, Qualcomm S1, 1000 MHz

Single-core, Qualcomm S1, 1000 MHz

LTE version available No No Yes No No No

DRAM 1GB 512MB 1GB 512MB 512MB 256MB Nand flash 7.5GB 4GB n.a. n.a. 1GB 512MB Display size, type 4.5", n.a. 3.8", n.a. TFT, 4.3" TFT, 3.5" 3.5", n.a. 3.5", n.a.


Front camera 8MP 4.9MP 8MP 5MP 4.9MP 3.1MP Back camera 1.3MP n.a. 0.9MP n.a. 0.3MP n.a. Camcorder Yes Yes Yes Yes Yes Yes Wi-Fi 802.11b/g/n 802.11b/g/n 802.10b/g/n 802.11b/g/n 802.11b/g/n 802.11b/g/n Bluetooth v3 v2.1 v2.0 v2.1 v2.1 v2.1 Battery capacity n.a. 1500 mAh 1900 mAh 1600 mAh n.a. 1400 mAh Weight (g) n.a. 152 n.a. n.a. 117.4 124 Dimension (mm) n.a. 63 x 124 x 12 65 x 131 x 11.2 n.a. 57.9 x 115.1 x 10.9 60 x 112 x 11 Source: Daiwa



- 32 -

Appendix II – Component breakdown

A close look at smartphone components

We categorise the handset components into the following six subsystems: baseband (BB), radio frequency (RF), display module, mechanical parts, functional parts, and mechanical and passive components. In general, the BB subsystem and the display module are the most expensive items. Above all, the cost of display modules has risen in recent years, because of the increasing adoption of high-resolution display and touch-panel modules.

Radio frequency (RF) subsystem

The most critical components within the handset system are the BB and RF subsystems. The design of the BB/RF subsystems will determine the quality of the phone calls. The RF subsystem performs the front-end function of handset modem, where it transforms the radio waves (ie, analogue signals) into electrical pulses (ie, digital signals), when the handset receives a call. It also works the other way around, when a call is made from the handset. The RF subsystem consists of various small components. Some of them have been integrated into a single chip, but we describe them in a discrete way to make the concept clearer for readers:

• Antenna: An electronic component designed to transmit or receive radio signals. It is an arrangement of conductors designed to radiate (transmit) or receive an electromagnetic field in response to an applied alternating voltage and the associated alternating electric current.

• Transmit/receive (T/R) switch: The T/R switch allocates the antenna's time between transmitting and receiving radio signals. Sometimes performed

by a specialised IC, this function can also be carried out by discrete devices or a passive pole filter array.

• Power amplifier: A discrete device or IC that boosts a radio signal to the necessary power for transmission.

• Synthesiser: The synthesiser uses an oscillator's signal to create a phase-lock loop (PLL), which the mixers use to alter a signal to a higher or lower frequency.

• RF ICs (RF transmitters (TX) receivers (RX), and transceiver [TXR]): A RF transmit modulator/mixer is an integrated ASIC (application-specific IC) that modulates and up-mixes a signal for RF transmission, while a RF receiver performs the other way round by demodulating RF transmissions into digital signals.

Baseband (BB) subsystem

The BB subsystem performs the back-end function of the handset modem. Its main tasks include: 1) signal, voice, channel coding and decoding; 2) power and system control, and; 3) multimedia, memory, and user interface management. The handset system design has become complicated as handsets migrate from being feature phones to smartphones. The smartphone can be perceived as a combination of a phone and a mini-PC. As a result, the smartphone requires additional parts, such as a CPU (which is sometimes incorporated into the BB processor), or different types of memories (NAND Flash, mobile DRAM) and sensor ICs. Similarly, some of the parts have been incorporated into a single chip, yet we describe them in a discrete way to clear the concept:

• Baseband processor: The primary digital engine in the BB system. In general, it comprises a processor (DSP), a microprocessor core, and an application-specific logic.

• Sensor IC: Sensor ICs are becoming increasingly popular in smartphone design. Here we refer to ASICs, such as 2-axis or 3-axis accelerometer, ambient light sensor, gyroscope, proximity sensor, digital compass, etc. These are designed to sense the movement of the handset or the change in the environment, to allow the phone to adjust the power supply for backlight, etc.

• Connectivity ICs: Usually, the feature phone has Bluetooth but not Wi-Fi or GPS; the majority of


- 33 -

smartphones have Wi-Fi, GPS connectivity, and Bluetooth.

• Application ICs: These are designed to run certain applications. For instance, a Skype handset may need a VoIP ASIC in addition to the BB processor, while a MP3 or mobile TV handset can use a multimedia co-processor.

• Memories: For different purposes, a variety of memories are adopted in a handset. For example, NOR Flash is mainly used for drive and code storage and execution; ROM or embedded Nand Flash is generally used for data storage; and mobile SDRAM is used for tentative data storage and buffer.

Display module

The display module includes the display panel, driver IC, and backlight unit (BLU). Mid-to-high end handsets usually adopt TFT-LCDs or LTPS-LCDs, while low-end phones commonly use STN-LCDs. BLUs are essential for LCD family displays, with LED being the favoured technology for providing the BLU’s light source. Another display alternative is the organic light emitting diode (OLED), which can be categorised into two types: AM (active matrix) OLED and PM (passive matrix) OLED. From almost all perspectives (such as colour richness or responding time), AM OLED performs better than PM OLED. However, PM OLED was hitherto used mainly in the sub-panels of clamshell handsets due to cost constraints. As costs have dropped quickly over the past three years, some vendors like SEC, HTC, and Nokia are starting to adopt AM OLED displays in their high-end models. OLED technology contains a light-emitting layer of organic compounds, so it does not require a backlight. Consequently, OLED’s power consumption performance is better than that of LCD family displays. In addition, OLED has a better performance on response time and colour richness. The major drawback is its short life span and higher production costs compared with other displays.

Mechanical parts

Mechanical components include casings/frames, keypads, connectors, cables, hinges, and more. These parts provide the external cover, inner support, and connections for the various functional and electronic components within handsets. Mechanical parts are primarily made of metal (steel, aluminium alloy,

magnesium alloy and copper, etc.), plastic (ABS, PS, etc.), or carbon fibre. Therefore, the cost structures of mechanical component manufacturers are very sensitive to raw-material prices. While mechanical components are often considered to be low-technology and to have low entry barriers, we note that it is not necessarily the case. These components mainly determine the appearance of a handset in consumers’ eyes. The trend of handset design is towards slimmer, smaller, lighter, and more polished, which requires the selection of proper materials, the choice of technique to put together the materials (including precision die-casting, metal intrusion, double injection, insert-moulding, multiple-axis precision, slide forming, and more), and the surface-coating technologies (vacuum sputtering, EMI coating, diamond-cut, hair-line streak, etc.). Meeting all these details may not be as simple as people initially thought.

Functional parts

Acoustic components (speakers, receivers, microphones), compact camera modules (CCM), vibrators, hands-free earpieces, and batteries are major functional components in handsets. In the coming years, we expect demand for higher-quality functional components like 8MP/12MP camera, surround sound/stereo sound acoustics to expand, as people expect handsets with better and more multimedia features. Functional components

Source: Daiwa


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Passive components

The most commonly used passive components include capacitors (MLCC), resistors (Chip-R), inductors, discrete devices (bipolar transistors, rectifier diodes, etc.) and quartz crystals (SAW filters and crystal units). The functionality or the type of passive components used in handsets is similar to those used in computers and other IT products. Nevertheless, passive components for handsets are manufactured in a smaller size to fit into a limited space in a handset, which increases their production costs.


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Appendix III – Greater China handset supply

Ramping up for smartphones

China has become the global handset-manufacturing hub. We hold a positive opinion on the Greater China handset supply chain. Taiwanese and Chinese component vendors have proximity advantages, close relationships and solid track records with tier-1 clients.

Proximity to the world’s largest production site: China

More than 60% of the world’s handsets are made in China. Handsets are a consumer product with a short lifecycle. It is not rare for clients to slightly modify the designs and specs of non-semiconductor components two or three weeks before their product launches. Therefore, local component vendors enjoy the proximity advantage, particularly for components that require high customisation, like mechanical

components, functional components, and touch panels. Before component vendors can finally secure orders from clients, the process from receiving requests through to sampling-out design-in and design-win takes much communication effort between the vendor and the client.

Vendors have good relationships with tier-one clients

Western vendors like Apple, Motorola, Nokia and RIM have been implementing an asset-light strategy for several years. Although Nokia and Motorola have in-house handset factories, neither participates in component manufacturing. They have outsourced a high percentage of functional and mechanical components and display modules to Taiwanese and Chinese vendors since the early 1990s. SEC and LG have lower component-outsourcing ratios than the abovementioned Western vendors, because they are big conglomerates with subsidiaries involved in manufacturing various components. Yet, with their growing scale, over recent years they have attempted to diversify the sourcing risk and have increased procurements of some mechanical components and touch panels from Taiwanese and Chinese vendors.

Handset supply chain in Greater China

Category Component vendors in Taiwan & China Global market share (2011) (shipments)

Growth potential

Baseband Baseband MediaTek/MStar (2454 TT), Spreadtrum Communications (SPRD US) 35-40% ★★

Memory Micronix (2337 TT), Etron (5351 TT), < 5% ★

Display Small-size panel Wintek (2384 TT), AU Optronics (2409 TT), Chimei Innolux (3481 TT), GiantPlus (8105 TT), RitDisplay (unlisted)

30-35% ★★★

Touch panel Wintek (2384 TT), TPK (3673), Young Fast (3622 TT), J-Touch (3584 TT) 60-70% ★★★

LED backlight Epistar (2448 TT), Opto Tech (2340 TT), Lite-On (2301 TT), Everlight (2393 TT), BrightLED (3031 TT), Harvatek (6168 TT)

60-65% ★★

Mechanics PCB Compeq (2313 TT), Unimicron (3037 TT), Unitech (2367 TT), WUS (2316 TT) 50-55% ★

FPC Career (6153 TT), Ichia (2402 TT), Taiflex (8039 TT) 25-30% ★★

Casing FIH (2038 HK), BYD (0285 HK), TGP (unlisted), Chi Cheng (3095 TT), Catcher (2474 TT), Foxconn Tech (2354 TT), DragonJet (unlisted), Coxon (3607 TT), UniPower (unlisted)

50-60% ★★

Keypad Silitech (3311 TT), Ichia (2402 TT), FIH (2038 HK), BYD (0285 HK), Teehwa (unlisted), Coxon (3607 TT)

50-60% ★

Connector Cheng Uei (2392 TT), Hon Hai (2317 TT), Jess-Link (6197 TT), Sinbon (3023 TT) 40-45% ★★

Functional Battery BYD (0285 HK), Cheng Uei (2392 TT), Dynapak (3211 TT), Simplo Technology 20-25% ★★★

Acoustic & hands-free

AAC Technologies (2018 HK), Goertek (002241.SZ), Merry (2439 TT), Fujikon (0927 HK), Fortune Grand (unlisted), Cheng Uei (2392 TT), Primax (unlisted), Pan Int'l (2328 TT)

55-60% ★★★

CCM & lens Lite-On (2301 TT), Altus (unlisted), Premier (unlisted)), Largan (3008 TT), Genius Optical (3406 TT), Asia Optical (3019 TT), Sunny Optical (2382 HK), San-Ying (unlisted)

30-35% ★★★

RF Saw filter, crystal oscillator

TXC (3042 TT), Taisaw (3221 TT), Siward (2484 TT) 15-20% ★★★

Power amplifier AWSC (unlisted), WIN Semicon (unlisted) (note: they are PA foundries for Skyworks and RFMD

40-50% ★★

Antenna Auden (Unlisted), Whayu (3419 TT), Wistron Neweb (6285 TT) , Smart Antenna (Unlisted) 30-40% ★★

Source: Daiwa


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Not just a cost advantage—technology level is improving too

Chinese and Taiwanese handset vendors are renowned for their superior cost structures because of their lower labour costs and unparalleled operational flexibility compared with Western vendors. We note that their technology levels have also improved over recent years. Chinese and Taiwanese vendors no longer just supply mid-to-low end products. For the highest-end products, such as the iPhone or the HTC One series, for instance, the autofocus 8MP camera, unibody metal casing and frame, any-layer HDI PCBs, miniature crystal oscillator and passive components, stereo-sound speaker, noise cancellation microphone, and high-sensitivity touch panel are all designed and manufactured by Chinese or Taiwanese vendors.

A high percentage of iPhone components is supplied by Taiwanese and Chinese vendors

Metal casing/frame: Foxconn Tech

Camera lens: Largan, Genius Optical, Asia Optical

Any-layer PCB: Unimicron. Compeq, Tripod Crystal oscillator: TXC Passives: Yageo, Cyntac

Acoustics: AAC Acoustics

Connector/cable/charger: Cheng Uei Touch panel: TPK, Wintek, CMICover glass: G-Tech Optical

Source: SlashGear, Daiwa

Sales exposure of Taiwan/China-based component vendors to global OEMs (2012E) Company Compal Comm Arima Comm FIH Largan Merry AAC Technologies Ticker 8078 TT 8101 TT 2038 HK 3008 TT 2439 TT 2018 HK Products ODM ODM EMS & components Lens Acoustics Acoustics Motorola 10% 40% 17% 8% 12% 5% Nokia 80% 35% 20% 32% 26% Sony Ericsson 0% 20% 12% 4% 30% 2% LG Electronics 5% 35% 5% 2% Apple 40% 37% SEC 3% 8% RIM 8% 4% 3% HTC 10% 5% 3% China vendors 18% 3% 3% 7% Silitech Ichia Cheng Uei Youngfast Wintek TPK Ticker 3311 TT 2402 TT 2392 3622 TT 2384 TT 3673 TT

Products Keypad Keypad Connector, cable Touch panel Small display, touch panel

Touch panel

Motorola 10% 20% 8% 2% 4% Nokia 30% 30% 9% 10% 12% Sony Ericsson 6% 5% 5% 1% LG Electronics 15% Apple 0.25 60% 50% SEC 0.2% 0.15% 3% 0.3% 4% RIM 17% 22% 2% 2% 3% HTC 1% 3% 20% 5% 8% China vendors 2% 6% 5% 0% Catcher Foxconn Tech TXC Unimicron Compeq Unitech Ticker 2474 TT 2354 TT 3042 TT 3037 TT 2313 TT 2367 TT Products Casing Casing Crystal oscillator PCB PCB PCB Motorola 5% 3% 2% 3% 15% 10% Nokia 1% 10% 20% Sony Ericsson 4% 5% 20% LG Electronics 2% 2% Apple 0.3% 0.27% 0.2% 14% 30% SEC 7% 0.02% 1% RIM 3% 7% HTC 15% 3% 3% 15% China vendors 9% 7% 10% 3% Source: Companies, Daiwa

Disclaimer All statements in this report attributable to Gartner represent [Bank’s/Issuer’s/Client’s] interpretation of data, research opinion or viewpoints published as part of a syndicated subscription service by Gartner, Inc., and have not been reviewed by Gartner. Each Gartner publication speaks as of its original publication date (and not as of the date of this [presentation/report]). The opinions expressed in Gartner publications are not representations of fact, and are subject to change without notice.



What's new In our view, HTC still has good products, but it needs something else to compete with Apple and Samsung (SEC). This report marks the transfer of analyst coverage.

What's the impact Being No.4 is not good enough: HTC was the world’s 4th largest smartphone vendor with a 6% share in 2Q12. But in the consumer electronics market, we believe only the top-2 global vendors can make a decent margin and profits. HTC is enjoying a 7-10% operating margin now. If it cannot move forward in terms of increasing its brand equity and marketing, and establishing a distribution channel, we estimate its operating margin could fall below 5% within two years. It is not a product issue ... We think HTC’s R&D and product design capability are on a par with that of SEC. Comparing HTC’s One X/S with SEC’s Galaxy S3, the scores and feedback from professional

review websites are similar (either 4.5 stars or 5 stars). … but rather a brand, marketing and distribution issue: The smartphone is no longer a niche product for early adaptors or tech-savvy individuals, who spend time browsing websites for professional reviews. It has become a consumer product. On this ground, SEC has much stronger brand power, as well as a better distribution network and mobile operator relationships (especially in Latin America), not to mention a huge marketing budget. To regain growth momentum, HTC needs to see either a quantum jump in its next-generation product (making an outstanding phone among the me-too Android crowd), or formulate a very clever and effective marketing campaign (without overspending). Both are challenging tasks. We therefore maintain our negative view on the company.

What we recommend Following our transfer of coverage, we are lowering our EPS forecasts. We maintain our Sell (5) rating, and reduce our six-month target price to NT$240, based on a 12x 2013E PER, which in line with its past-3-year trading average.

How we differ We believe the recent share-price rally is due to high expectations for 4Q12 (10-15% QoQ sales growth), but we think 4Q could be flattish. Forecast revisions (%) Year to 31 Dec 12E 13E 14E Revenue change (20.3) (17.3) (10.9) Net-profit change (34.1) (25.6) (11.8) EPS change (34.1) (25.6) (11.8) Source: Daiwa forecasts

Share price performance

30

50

70

90

110

210

360

510

660

810

Oct-11 Jan-12 Apr-12 Jul-12 Oct-12HTC Corp (LHS) Relative to TWSE (RHS)

(NT$) (%)

12-month range 236.00-755.00 Market cap (US$bn) 8.34 Average daily turnover (US$m) 147.33 Shares outstanding (m) 852 Major shareholder Wei-Chih Investment (5.1%) Financial summary (NT$) Year to 31 Dec 12E 13E 14E Revenue (m) 301,072 314,728 338,728 Operating profit (m) 22,790 18,758 18,922 Net profit (m) 20,159 17,169 17,399 Core EPS 23.659 20.151 20.420 EPS change (%) (67.6) (14.8) 1.3 Daiwa vs Cons. EPS (%) -8% -12% -4% PER (x) 12.1 14.2 14.1 Dividend yield (%) 5.4 4.6 4.6 DPS 15.379 13.098 13.273 PBR (x) 2.8 2.7 2.5 EV/EBITDA (x) 7.3 8.2 7.5 ROE (%) 21.3 19.2 18.4 Source: Bloomberg, Daiwa forecasts

Electronics / Taiwan

10 October 2012

HTC Corp 2498 TT

Target price: NT$320.00 → NT$240.00 Up/downside: -16.4% Share price (8 Oct): NT$287.00

In need of something else

• HTC still designs and makes decent smartphones that are competitive with the iPhone or Samsung Galaxy S series

• But product isn’t the issue; HTC’s brand equity, marketing and distribution channel are not yet up to its archrivals’ level

• Time is of the essence, and HTC needs to make some changes immediately; maintain Sell rating



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Growth outlook HTC: muted growth momentum with stagnant ROE in 2013E

and 2014E

After a disappointing year (we forecast 30%+/60%+ sales/EPS declines in 2012), we project another lacklustre year in 2013 (with 1% YoY sales growth but an 18% YoY decline in EPS due to margin and ASP erosion). In the high-end smartphone space, HTC is competing with two giants (Apple and SEC). This uphill battle will be tougher than any it has faced before. In our earnings forecasts, we assume HTC fails to gain back market share in the high-end, and continues to face fierce price competition (from Huawei, ZTE and other Chinese vendors) in the mid/low-end space.

(100% )

(50% )

0%

50%

100%

150%

2006 2007 2008 2009 2010 2011 2012E 2013E 2014EROE Sales growth EPS growth


Valuation HTC: forward PER band

We set our new target price at NT$240, which is based on a 12x 2013E PER (versus our previous target price of NT$320, based on the same 12x 2013E PER). The 12x forward PER is in line with the average of the stock’s past-3-year trading range. We believe PER methodology is a more appropriate way to evaluate downstream tech companies such as HTC. We recognise flaws with PER methodology, such as a lack of insight into the long-term business outlook, a mismatch between earnings/cash flow, etc. But we think it is a more straightforward, intuitive and arguably accurate way to predict a tech company’s earnings power, at least in the near term.

0

200

400

600

800

1,000

1,200

Mar-0

2Se

p-02

Mar-0

3Se

p-03

Mar-0

4Se

p-04

Mar-0

5Se

p-05

Mar-0

6Se

p-06

Mar-0

7Se

p-07

Mar-0

8Se

p-08

Mar-0

9Se

p-09

Mar-1

0Se

p-10

Mar-1

1Se

p-11

Mar-1

2Se

p-12

(NT$)

Share price 6x 10x 14x 18x Source: TEJ, Daiwa

Earnings revisions HTC: consensus earnings revisions

Following the transfer of coverage, we are lowering our EPS forecasts to NT$23.7 for 2012, NT$20.2 for 2013 and NT$20.4 for 2014. Our new forecasts are respectively 34%/26%/12% lower than our previous forecasts. HTC’s market share decline in 2H12 was sharper than we had assumed. According to Bloomberg, analysts have been cutting HTC’s EPS forecasts since early 3Q11. However, the current consensus 2013 EPS forecast of NT$23.9 is still 18% higher than our forecast.

020406080

100120

Apr-0

9Ju

n-09

Aug-0

9Oc

t-09

Dec-0

9Fe

b-10

Apr-1

0Ju

n-10

Aug-1

0Oc

t-10

Dec-1

0Fe

b-11

Apr-1

1Ju

n-11

Aug-1

1Oc

t-11

Dec-1

1Fe

b-12

Apr-1

2Ju

n-12

Aug-1

2

Consensus: 2013 EPS

2498 TT

Source: Bloomberg




- 39 -

Key assumptionsYear to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Handset shipment (m) 10.4 12.0 11.7 24.6 45.0 30.6 34.7 40.9 Average selling price (LC) 348 328 323 307 326 323 304 307

Profit and loss (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Smartphone 116,790 145,005 136,571 270,451 454,584 288,729 299,233 320,990 Tablet PC 39 539 393 289 6,357 5,549 7,312 9,145 Others 1,751 6,809 7,528 8,021 4,854 6,794 8,183 8,593 Total revenue 118,580 152,353 144,493 278,761 465,795 301,072 314,728 338,728 Other income 0 0 0 0 0 0 0 0 COGS (72,880) (101,363) (98,330) (194,893) (333,997) (224,089) (238,690) (260,528) SG&A (10,799) (11,294) (13,168) (26,796) (47,049) (35,225) (37,232) (38,530) Other op. expenses (3,877) (9,351) (8,373) (12,940) (15,961) (18,968) (20,048) (20,747) Operating profit 31,023 30,345 24,623 44,133 68,788 22,790 18,758 18,922 Net-interest inc./(exp.) 816 1,391 360 310 671 879 613 691 Assoc/forex/extraord./others 312 0 414 521 1,965 (228) 365 385 Pre-tax profit 32,151 31,736 25,396 44,964 71,424 23,441 19,735 19,999 Tax (3,212) (3,183) (2,782) (5,450) (9,125) (3,282) (2,566) (2,600) Min. int./pref. div./others 0 83 (6) 19 (323) 0 0 0 Net profit (reported) 28,939 28,635 22,609 39,534 61,976 20,159 17,169 17,399 Net profit (adjusted) 28,939 28,635 22,609 39,534 61,976 20,159 17,169 17,399 EPS (reported) (NT$) 35.992 34.844 27.105 46.790 72.926 23.659 20.151 20.420 EPS (adjusted) (NT$) 35.992 34.844 27.105 46.790 72.926 23.659 20.151 20.420 EPS (adjusted fully-diluted) (NT$) 35.992 34.844 27.105 46.790 72.926 23.659 20.151 20.420 DPS (NT$) 24.236 24.489 24.124 35.806 40.104 15.379 13.098 13.273 EBIT 31,023 30,345 24,623 44,133 68,788 22,790 18,758 18,922 EBITDA 31,579 31,154 25,597 45,135 71,189 25,080 21,287 21,740

Cash flow (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 32,151 31,819 25,391 44,983 71,100 23,441 19,735 19,999 Depreciation and amortisation 556 808 974 1,002 2,401 2,290 2,530 2,818 Tax paid (3,212) (3,183) (2,782) (5,450) (9,125) (3,282) (2,566) (2,600) Change in working capital 10,257 8,612 1,011 6,458 24,852 (15,029) 2,150 3,183 Other operational CF items (104) 6 4 0 4 1,216 85 (35) Cash flow from operations 39,648 38,061 24,598 46,994 89,233 8,636 21,934 23,365 Capex (1,331) (5,947) (1,885) (5,030) (9,052) (2,000) (2,400) (2,400) Net (acquisitions)/disposals (1,971) 2,352 (273) (422) (2,457) (1,790) (840) (890) Other investing CF items (238) (1,433) (1,863) (2,765) (30,318) 2,518 2,341 2,178 Cash flow from investing (3,540) (5,028) (4,021) (8,216) (41,827) (1,272) (899) (1,112) Change in debt 0 185 (31) (116) 997 122 12 11 Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid (11,685) (19,487) (20,126) (20,122) (30,253) (34,082) (13,103) (11,160) Other financing CF items (3,772) (4,563) 2,496 (10,337) (5,011) 0 0 0 Cash flow from financing (15,457) (23,865) (17,661) (30,576) (34,266) (33,960) (13,091) (11,149) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 20,650 9,168 2,916 8,201 13,139 (26,596) 7,944 11,103 Free cash flow 38,316 32,114 22,713 41,964 80,180 6,636 19,534 20,965 Source: Company, Daiwa forecasts

Financial summary


- 40 -

Balance sheet (NT$m) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 55,069 64,238 67,154 75,355 88,494 61,898 69,842 80,946 Inventory 6,119 8,250 5,558 26,414 28,431 20,372 21,699 23,684 Accounts receivable 19,484 29,455 27,126 61,614 64,720 45,367 47,425 51,041 Other current assets 2,500 2,314 4,585 5,256 11,783 7,527 7,868 8,468 Total current assets 83,173 104,257 104,422 168,640 193,428 135,164 146,835 164,140 Fixed assets 3,716 8,916 9,900 14,024 21,512 21,223 21,093 20,675 Goodwill & intangibles 0 0 0 0 0 0 0 0 Other non-current assets 3,556 2,569 4,628 7,718 39,652 37,708 36,122 34,869 Total assets 90,445 115,742 118,951 190,382 254,592 194,095 204,049 219,684 Short-term debt 0 104 95 12 0 122 134 145 Accounts payable 22,020 28,570 25,153 63,917 77,268 55,255 58,855 64,240 Other current liabilities 12,348 26,325 28,003 51,712 74,862 50,179 52,455 56,455 Total current liabilities 34,368 54,999 53,250 115,641 152,130 105,556 111,444 120,839 Long-term debt 0 47 24 12 0 0 0 0 Other non-current liabilities 1 35 35 14 1,036 1,036 1,036 1,036 Total liabilities 34,369 55,081 53,310 115,667 153,166 106,591 112,479 121,875 Share capital 5,731 7,554 7,889 8,177 8,521 8,521 8,521 8,521 Reserves/R.E./others 50,344 53,108 57,751 66,538 92,906 78,983 83,049 89,288 Shareholders' equity 56,076 60,661 65,640 74,714 101,427 87,504 91,570 97,809 Minority interests 0 0 0 0 0 0 0 0 Total equity & liabilities 90,445 115,742 118,951 190,382 254,592 194,095 204,049 219,684

EV 178,335 173,519 174,773 168,016 156,045 182,763 174,831 163,738 Net debt/(cash) (55,069) (64,087) (67,035) (75,331) (88,494) (61,776) (69,708) (80,801) BVPS (NT$) 68.952 73.272 77.908 88.117 119 103 107 115

Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 13.1 28.5 (5.2) 92.9 67.1 (35.4) 4.5 7.6 EBITDA (YoY) 16.2 (1.3) (17.8) 76.3 57.7 (64.8) (15.1) 2.1 Operating profit (YoY) 16.8 (2.2) (18.9) 79.2 55.9 (66.9) (17.7) 0.9 Net profit (YoY) 14.6 (1.0) (21.0) 74.9 56.8 (67.5) (14.8) 1.3 EPS (YoY) 12.0 (3.2) (22.2) 72.6 55.9 (67.6) (14.8) 1.3 Gross-profit margin 38.5 33.5 31.9 30.1 28.3 25.6 24.2 23.1 EBITDA margin 26.6 20.4 17.7 16.2 15.3 8.3 6.8 6.4 Operating-profit margin 26.2 19.9 17.0 15.8 14.8 7.6 6.0 5.6 ROAE 58.7 49.1 35.8 56.3 70.4 21.3 19.2 18.4 ROAA 37.0 27.8 19.3 25.6 27.9 9.0 8.6 8.2 ROCE 62.9 51.9 38.9 62.8 78.1 24.1 20.9 20.0 ROIC 608.3 n.a. n.a. n.a. 974.3 101.4 68.6 84.7 Net debt to equity net cash net cash net cash net cash net cash net cash net cash net cash Effective tax rate 10.0 10.0 11.0 12.1 12.8 14.0 13.0 13.0 Accounts receivable (days) 60.3 58.6 71.5 58.1 49.5 66.7 53.8 53.1 Payables (days) 59.8 60.6 67.9 58.3 55.3 80.3 66.2 66.3 Net interest cover (x) n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Net dividend payout 67.3 70.3 89.0 76.5 55.0 65.0 65.0 65.0 Source: Company, Daiwa forecasts

Company profile Founded in 1986, HTC designs, makes and sells PDAs and smartphones. HTC was initially engaged in the ODM business, making PDAs/smartphones for Palm, HP, Orange, O2 and T-Mobile. It decided to launch its own brand business in 2006, and had enjoyed strong growth after the business model transition. HTC was the world's first company to launch a Windows Mobile smartphone (in 2Q02) and an Android phone (in 4Q08).

Financial summary continued …


- 41 -

In need of something else

From a rising star to fallen angel, HTC needs to modify its product, branding and distribution strategies, in our view

No.4 is not good enough

According to Gartner (‘Market Share: Mobile Devices by Region and Country, 2Q12’ by Anshul Gupta, David Glenn, Roberta Cozza, Tuong Huy Nguyen, Carolina Milanesi, Sandy Shen, Hugues J. De La Vergne, Annette Zimmermann, Atsuro Sato, CK Lu (13 August 2012), HTC shipped 9m smartphones in 2Q12, which put it in the fourth largest vendor position with a 6.1% market share. However, in the consumer electronics market, being No.4 isn’t good enough. Particularly in this duopolistic market, the top-2 vendors (Apple and SEC) have nearly a 50% market share. In the long run, we believe only the top-2 vendors can maintain a decent margin (10%+ operating margin) and record a good profit. The No.3 to No.5 players could make only a thin margin (sub-5% operating margin). Smaller vendors can make losses, except some local brands that focus on niche segments. HTC is still currently recording a 7-10% operating margin. If it cannot move forward, we are concerned that its operating margin could fall below 5% within two years.

Global smartphone market share – HTC ranked 4th with a 6% share

Samsung29.7%

Apple18.8%Nokia

7.6%HTC6.1%

RIM5.2%

Motorola3.0%

LG3.8%

Huawei3.5%

ZTE4.1%

Sony3.5%

Others14.7%

Wor ldwide (2Q12)


It’s all about brand, marketing and distribution

It’s not a product issue ... We think HTC’s innovation and product design capability is on a par with that of SEC, although it is not yet up to Apple’s level. Taking HTC’s One X/S and SEC’s Galaxy S3 as a comparison, we note that the scores and feedback from professional review websites (CNET, Tech Radar, Engadget Mobile, etc) are similar. Both are well recognised as the best Android phones on the street. In terms of its key product launch schedule, HTC pumps out new products faster than SEC. When officially launched in April 2012, the HTC One X won the laurel of first quad-core smartphone in the world, while the Samsung Galaxy S 3 was launched two months later. … but rather a brand equity and marketing, distribution issue Always being the first to launch superior products, HTC had enjoyed strong growth in the early 2000s, when the smartphone was a niche product. In the early stage, most smartphone buyers were tech-savvy individuals (sophisticated enough to know which smartphone had better hardware and software), or early adaptors (who spent time browsing professional reviews for advice). However, the smartphone has become a consumer product today. On this ground, SEC has much stronger brand power, as well as a better distribution network and mobile operator relationships (especially in Latin America) with which to beat the competition. Moreover, there is a huge gap between the two companies’ marketing budgets.

HTC needs some changes

Building brand equity and a global distribution network is a long-term investment. It isn’t easy to take a shortcut. In terms of marketing budget, HTC’s isn’t even 20% of SEC’s. To regain sales growth momentum, we believe HTC needs to see either a quantum jump in its next-generation product (make an outstanding flagship device to differentiate it from the me-too Android crowd), or formulate a very clever and effective marketing campaign (without going over the marketing


- 42 -

budget by much). Both are challenging tasks, in our view. We therefore maintain our negative view on the company.

3Q12 review and 4Q12 outlook

Review on 3Q12 preliminary results HTC announced preliminary 3Q12 results on 8 October. The results came in at the low end of the company’s guidance, with revenue and operating profit trailing the Bloomberg consensus forecasts by about 7%. The shortfall was mainly caused by weak demand for old products (One X/S/V and Desire V/C), while contributions from new phones have yet to kick in. Management expects most of the new phones to enter mass production in early 4Q12. Details of the results are as follows:

• 3Q12 revenue of NT$70.2bn (vs guidance of NT$70-80bn), -48% QoQ and -23% YoY.

• 3Q12 operating profit of NT$4.9bn (-76% YoY; -40% QoQ), with operating margin at 7% (in line with guidance of 7%).

• 3Q12 pretax profit of NT$4.0bn (-82% YoY; -55% QoQ), largely due to investment loss (write-down of

US$40m investment in OnLive, a US-based online gaming provider)

• 3Q12 net profit of NT$3.9bn (-78% YoY; -47% QoQ) 4Q12, no peak season this year; could disappoint on the downside HTC’s share price has rebounded by 20%+ since the recent low on 8 August, which we believe was mainly driven by rising expectations for 4Q12 momentum (10-15% QoQ growth in sales and shipments). However, we forecast 4Q12 sales to only remain flat QoQ with a stable gross margin of 24.9% (versus 25% for 3Q12). However, we forecast the operating margin to decline by 0.8pp QoQ to 6.3%. We expect marketing expenses to increase as a result of several new product launches, including new Window phones (HTC 8X and 8S), three mid-end phones for China operators (the HTC One SU/SC/ST), and One X plus (a flagship Android phone with a 5” display). We do not expect these new product launches to drive HTC’s sales growth, but rather believe they will only offset the sales decline from old devices. In our view, the iPhone 5 will be the big winner in 4Q12. Our supply chain research indicates iPhone 5 production might go up 60%+ QoQ in 4Q12.

HTC: quarterly P&L highlights P&L (NT$m) 2011 1Q12 2Q12 3Q12E 4Q12E 2012E 1Q13E 2Q13E 3Q13E 4Q13E 2013E Sales 465,795 67,790 91,040 74,613 77,629 311,072 67,559 74,748 79,855 92,566 314,728 Gross profits 131,798 16,970 24,590 18,647 19,333 79,540 16,055 18,490 19,361 22,132 76,038 Op. profits 68,788 5,105 8,200 5,047 5,195 23,547 4,030 1,896 5,387 7,446 18,758 Non-op 2,636 452 670 78 -438 761 248 248 248 248 992 Pre-tax income 71,424 5,556 8,870 5,125 4,757 24,308 4,278 2,144 5,635 7,694 19,750 Net profit 61,976 4,805 7,400 4,510 4,190 20,905 3,765 1,886 4,959 6,573 17,182 EPS (NT$) 72.93 5.64 8.68 5.29 4.92 24.53 4.42 2.21 5.82 7.71 20.17 No. of shares 850 852 852 852 852 852 852 852 852 852 852 Margin Analysis (%) Gross profits 28.3% 25.0% 27.0% 25.0% 24.9% 25.6% 23.8% 24.7% 24.2% 23.9% 24.2% Op. profits 14.8% 7.5% 9.0% 6.8% 6.7% 7.6% 6.0% 2.5% 6.7% 8.0% 6.0% Pre-tax income 15.3% 8.2% 9.7% 6.9% 6.1% 7.8% 6.3% 2.9% 7.1% 8.3% 6.3% Tax rate 13.2% 13.5% 16.6% 12.0% 11.9% 14.0% 12.0% 12.0% 12.0% 14.6% 13.0% YoY%

Sales 67.1% -34.9% -26.8% -45.1% -23.5% -33.2% -0.3% -17.9% 7.0% 19.2% 1.2% Gross profits 57.1% -44.3% -31.3% -51.0% -29.7% -39.6% -5.4% -24.8% 3.8% 14.5% -4.4% Op. profits 55.9% -69.0% -57.4% -75.0% -59.7% -65.8% -21.1% -76.9% 6.7% 43.3% -20.3% Pre-tax income 58.8% -67.4% -55.6% -75.9% -63.8% -66.0% -23.0% -75.8% 9.9% 61.7% -18.8% Net profit 56.8% -67.6% -57.8% -74.3% -76.1% -66.3% -21.7% -74.5% 9.9% 56.9% -17.8% QoQ%

Sales -33.2% 34.3% -18.0% 4.0% -13.0% 10.6% 6.8% 15.9% Gross profits -38.3% 44.9% -24.2% 3.7% -17.0% 15.2% 4.7% 14.3% Op. profits -60.4% 60.6% -38.5% 2.9% -22.4% -53.0% 184.2% 38.2% Pre-tax income -57.7% 59.6% -42.2% -7.2% -10.1% -49.9% 162.9% 36.5% Net profit -72.6% 54.0% -39.1% -7.1% -10.2% -49.9% 162.9% 32.6% Source: Company, Daiwa forecasts


- 43 -

Recommendation and valuation

Reiterate Sell with target price of NT$240 Following the transfer of coverage to Birdy Lu, we are lowering our EPS forecasts to NT$23.7 for 2012, NT$20.2 for 2013 and NT$20.4 for 2014. We reiterate our Sell (5) rating on the stock. HTC is competing with Apple and SEC at the same time, and we expect this uphill battle to be tough. After a disappointing year in 2012 (with a 30%+ YoY decline in sales and 60%+ YoY decline in EPS, on our forecasts), we expect another lacklustre year in 2013 (we forecast 1% YoY sales growth with an 18% YoY EPS decline due to margin and ASP erosion). In our earnings forecasts, we assume HTC cannot gain back market share in the high-end space, and believe it will face fierce price competition in the mid/low-end space.

HTC: growth and ROE profiles do not look good for 2013 and 2014

(100% )

(50% )

0%

50%

100%

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Margins have been going one way down since 2007

05

1015202530354045

2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

Gross margin Op. margin Net margin


We set our new six-month target price at NT$240, which is based on a 12x 2013E PER. The 12x forward PER is in line with the average of its past-3-year trading range.

HTC: forward PER band

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(NT$)


HTC: forward PBR

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(NT$)



- 44 -

Valuation table – handset OEMs Price (lc)

8 Oct 2012 Daiwa Rating

Mkt cap (US$ m)

PER (x) EPS growth (%) ROE (%) PBR (x) Company Ticker 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E Local peers HTC* 2498 TT 287.0 Sell 8,348 12.1 14.2 14.1 -67.6 -14.8 1.3 21.3 19.2 18.4 2.8 2.7 2.5 Acer* 2353 TT 27.8 Buy 2,690 40.3 11.9 8.5 0.0 239.6 39.9 2.5 8.2 10.6 1.0 0.9 0.9 Asustek* 2357 TT 307.0 Underperform 7,889 11.3 10.8 10.5 23.5 4.2 3.1 16.9 16.3 15.8 1.8 1.7 1.6 Global peers Apple AAPL US 653 Outperform 611,742 14.7 12.2 10.4 59.3 20.7 16.7 40.4 36.8 31.3 5.35 3.93 2.98 SEC 005930 KS 1,373,000 Buy 181,872 9.5 8.0 7.4 64.7 17.9 8.9 20.6 19.8 18.0 1.82 1.51 1.28 Nokia NOK US 2.6 Not rated 10,036 n.a. n.a. 11.0 n.a. n.a. n.a. -18.7 -0.2 5.7 0.86 0.97 1.25 Motorola MSI US 51.3 Not rated 14,544 16.9 14.4 12.5 18.3 17.6 15.6 19.0 23.9 32.9 3.5 3.6 3.7 LG Elec. 066570 KS 69,800 Hold 10,051 14.7 9.5 8.2 n.a. 54.4 15.3 6.0 8.7 9.5 0.90 0.83 0.76 RIM* RIM CN 8.1 Not rated 4,318 n.a. n.a. n.a. n.a. n.a. n.a. -8.0 -3.5 0.0 0.49 0.48 0.43 Source: Bloomberg, *Daiwa forecasts

Balance sheet and cash flow remain solid Despite its core business being on a downtrend, HTC remains a robust cash-flow-generating machine. It has generated free cash flow every year since its IPO. First, HTC runs an asset-light business model (assembly only, no components), so capital expenditure is low. Second, its working capital requirements are also very low, owing to HTC’s long AP days with short AR days, and quick inventory turnover.

HTC: cash conversion cycle is very low (or even negative) 2007 2008 2009 2010 2011 2012E 2013E Inventory days 27.8 25.9 25.6 29.9 30.0 39.0 32.7 AR days 60.3 58.6 71.5 58.1 49.5 65.5 54.7 AP days 97.3 91.1 99.7 83.4 77.1 105.9 88.7 CCC (days) -9.2 -6.6 -2.6 4.6 2.3 -1.4 -1.3 Source: Company, Daiwa forecasts HTC: net cash position

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2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

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Source: Company, Daiwa forecasts HTC: EPS vs. free cash flow per share – earnings quality is good, despite the fundamental outlook turning sour

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HTC: cash dividend and payout ratio

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EPS sensitivity analysis Assumptions of ASP changes and gross margin are two key variables that would affect our earnings forecasts for HTC. We therefore conducted a sensitivity analysis on how such changes would impact 2013E EPS (see following table).

EPS sensitivity – ASP and gross margin change on EPS EPS 2013E % change of ASP Assumption -12.0% -9.0% -6.0% -3.0% 0.0% 3.0% 6.0% 9.0% 12.0%

Gros

s mar

gin

22.2% 7.3 8.9 10.5 12.1 13.7 15.3 17.0 18.6 20.2 22.7% 8.7 10.4 12.0 13.7 15.3 17.0 18.7 20.3 22.0 23.2% 10.1 11.8 13.5 15.2 17.0 18.7 20.4 22.1 23.8 23.7% 11.5 13.3 15.0 16.8 18.6 20.3 22.1 23.8 25.6 24.2% 13.0 14.8 16.6 18.4 20.2 22.0 23.8 25.6 27.4 24.7% 14.4 16.2 18.1 19.9 21.8 23.6 25.5 27.3 29.2 25.2% 15.8 17.7 19.6 21.5 23.4 25.3 27.2 29.1 31.0 25.7% 17.2 19.1 21.1 23.0 25.0 26.9 28.9 30.8 32.8 26.2% 18.6 20.6 22.6 24.6 26.6 28.6 30.6 32.6 34.6

Source: Daiwa

Note: The column and row in blue represent the base-case scenario in our earnings model. Note 2: Other assumptions: (1) 70% of opex is fixed and 30% is variable (in proportion to sales growth or decline); (2) non-op gain/loss (interest income/expense, forex gain/loss, etc) and tax rate are held unchanged in the sensitivity analysis.

Investment risks Key upside risks to our negative opinions include: 1) new flagship devices regaining traction with key clients, 2) faster-than-expected market-share gains in China, and 3) less intense price competition from tier-two smartphone vendors.


- 45 -

When to revisit?

Despite having a negative investment opinion now, we would not suggest investors write off HTC. Bear in mind that HTC is a company that has turned itself around several times before. We would recommend investors revisit this name should HTC stop losing market share in the cash cow markets and start riding on the strong growth of the China market. A cat with nine lives? In its short history (founded in 1996), HTC has been on the edge of becoming an irrelevant company three times, but has been able to survive and thrive again within 1-2 years. These periods included: 1) shifting its business focus from the notebook PC ODM market to PDA ODM in the late 1990s (and further to smartphone ODM in the early 2000s), 2) the bold decision to phase out its profitable ODM business and build its own brand in mid-2006, and 3) the disruption in product transition from Windows Mobile phones to Android phones in 2H09 (demand for Windows Mobile phones fell off a cliff, but Android phones only picked up mildly in the beginning). Prior examples of successful turnaround in a short time showcase that HTC is a nimble and visionary company with strong execution. First, the US and Europe (cash cow markets) need to stop bleeding HTC recently downsized its operations in Korea, Latin America, and the Middle-East/Africa. We think this was the correct decision. In our view, profitability is more important than market share. It is hard for HTC to make decent profits from these countries/regions. However, we believe HTC must halt the market-share decline in its cash cow markets, particularly North America and Europe (where product ASPs and margins are higher than in other regions). We note that HTC is still perceived as a premium brand and maintains relatively high market shares in the US and Western Europe. According to Gartner (‘Market Share: Mobile Devices by Region and Country, 2Q12’ by Anshul Gupta, David Glenn, Roberta Cozza, Tuong Huy Nguyen, Carolina Milanesi, Sandy Shen, Hugues J. De La Vergne, Annette Zimmermann, Atsuro Sato, CK Lu on 13 August 2012), HTC’s global, North American and Western European market shares are 6.1%, 9.3% and 7.9%, respectively. If HTC were to launch exciting new products, covered with clever marketing campaigns, it is likely that it could revive sales momentum.

HTC: market share by region: HTC still has higher market shares in N. America and E. Europe than in emerging countries

0%2%4%6%8%

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W. Europe E. Europe Asia Pac MEA Japan Latin America

Global

2Q12 mar ket shar e


Second, China business needs to break out further After years of slow momentum, HTC saw its China sales breaking out in 2Q12, thanks to the success of the Desire V series (low-end smartphones for China’s big-3 mobile operators). HTC shipped about 1.8m smartphones to China in 2Q12 (+149% QoQ and +384% YoY). Based on our industry research, 3Q12 momentum remains buoyant in China. HTC is about to launch the One S series (mid-to-high end phones) for the big-3 again in 4Q12. Due to the higher price tag, we do not see as strong demand for these new phones as that for the Desire V series. If the One S series turns out to be a hit, we would see upside to our earnings forecasts. HTC: quarterly smartphone shipments and market share in

China

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Smartphone shipments, mn units(LHS) Market share (RHS)




What's new We believe the smartphone vendors will continue to upgrade the optical features of their cameras, and that this trend will benefit Largan, as the leading global lens module vendor. This report marks the transfer of analyst coverage.

What's the impact People are rarely satisfied with photo quality: there is always room to upgrade a camera’s optical features, such as the lens aperture, auto-focus (AF) speed, shutter time, depth of field, wide-angle view, etc. Optical improvements are more related to the design of the lens module than semiconductor chips. Front-camera lenses to boost revenue: Largan has just won its first front-camera lens order from Apple (iPhone 5). Driven by this, we forecast the sales contribution from front-camera lenses to surge from sub-5% in 2011 to 8-10% in 2012, and to 20-25% in 2013 and 2014.

Due to the success of Apple’s FaceTime app, we believe other smartphone vendors will need to offer similar features, which in turn will spur demand for front cameras. Leader of the slim-form lens: We estimate that Largan supplies 60%+ of the lens modules for the iPhone 5, whose 8MP camera is the slimmest in the world. We estimate that the ASP of slim-lens modules is 10-15% higher than that for its bulkier peers. Pixel war kicks off again: the phone camera’s pixel count has remained at 8MP for nearly two years (high-end phones). However, our market research indicates that all smartphone vendors are working on 10-14MP cameras for 2013.

What we recommend Following the transfer of analyst coverage, we are raising our 2012-14 EPS forecasts. We reiterate our Buy (1) rating and raise our six-month target price to NT$730 (from NT$640), based on 2013E 16x PER, which is in line with the stock’s past-3-year trading average.

How we differ Our 2012-14 EPS forecasts are higher than those of the Bloomberg consensus, as we believe Largan’s EPS growth is not just driven by the

iPhone, but because people will always want better cameras. Forecast revisions (%) Year to 31 Dec 12E 13E 14E Revenue change 6.1 3.9 18.5 Net-profit change 0.8 2.4 9.7 EPS change 0.8 2.4 9.6 Source: Daiwa forecasts


60

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Oct-11 Jan-12 Apr-12 Jul-12 Oct-12Largan Precision (LHS)Relative to TWSE (RHS)

(NT$) (%)

12-month range 464.00-738.00 Market cap (US$bn) 2.80 Average daily turnover (US$m) 32.30 Shares outstanding (m) 134 Major shareholder Cathay Life Insurance Co., Ltd.

(5.2%)

Financial summary (NT$) Year to 31 Dec 12E 13E 14E Revenue (m) 16,622 21,382 26,435 Operating profit (m) 4,990 6,784 7,911 Net profit (m) 4,345 6,121 7,137 Core EPS 32.395 45.634 53.209 EPS change (%) (16.4) 40.9 16.6 Daiwa vs Cons. EPS (%) 0.6% 8.6% 9.4% PER (x) 18.9 13.4 11.5 Dividend yield (%) 2.6 3.7 4.3 DPS 16.197 22.817 26.604 PBR (x) 3.8 3.2 2.7 EV/EBITDA (x) 11.2 8.1 6.6 ROE (%) 20.8 25.7 25.6 Source: Bloomberg, Daiwa forecasts


10 October 2012

Largan Precision 3008 TT

Target price: NT$640.00 → NT$730.00 Up/downside: +19.3% Share price (8 Oct): NT$612.00

What a pretty picture

• The iPhone 5 camera upgrade should benefit Largan, as it is the market leader

• But still lots of room to improve its smartphone cameras, such as lens aperture, AF speed, shutter time, wide-angle view, etc

• Near-term share-price driver would be a rise in shipments of lens modules for the iPhone 5 front/back cameras; reiterate Buy



- 47 -

Growth outlook Largan: top line and bottom line both back on a growth track

This year has been a tough one for Largan. We forecast the company to post a 16% YoY decline in EPS, as order flow from non-Apple clients (Nokia, HTC and RIM) has been weaker than we previously expected. However, we feel upbeat about its order-flow outlook for 2013 and beyond. We believe winning front-camera orders for the new iPhone will drive Largan’s revenue and EPS growth over the same period. In addition, we believe Largan’s product ASP will remain stable or even rise slightly in the next two years, due to product upgrades.

-30%

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(60% )(40% )(20% )

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2006 2007 2008 2009 2010 2011 2012E 2013E 2014E 2015E

ROE (RHS) Sales growth (LHS) EPS growth (LHS)


Valuation Largan: 12-month forward PER bands (x)

Following the transfer of analyst coverage, we are raising our six-month target price to NT$730, which is based on 16x 2013E PER (vs. the previous target price of NT$640, or 20x 2012E PER). A 16x 12-month forward PER is in line with the average of its past-3-year trading range. We believe PER methodology is the most appropriate way to evaluate downstream tech companies such as Largan. We recognise flaws with PER methodology, such as a lack of insight into the long-term business outlook, a mismatch between earnings/cash flow, etc. But we think it is a more straightforward, intuitive and arguably accurate way to predict a tech company’s earnings power, at least in the near term.

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(NT$)

Share price 8x 12x 16x 20x

Source: TEJ, Daiwa forecasts

Earnings revisions Largan: Bloomberg consensus EPS forecast changes (NT$)

We are also introducing our new 2012/2013/2014 EPS forecasts of NT$32.4/NT$45.6/NT53.2, which are 1%/2%/10%, respectively, higher than our previous forecasts. We are raising our 2014 EPS forecast by more than for the earlier years in our forecast period, because we believe the upgrade in smartphone cameras is not just a short-term story.

0102030405060708090

Consensus: 2013 EPS

3008 TT (NT$)

Source: Bloomberg




- 48 -

Key assumptionsYear to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Mobile phone lens shipment (K units) 152,836 200,491 173,300 215,100 285,554 281,380 392,739 477,685 Blended ASP of mobile phone lens (US$) 0.98 1.01 1.12 1.21 1.34 1.40 1.35 1.28

Gross margin of VCM assembly (%) 0.0% 0.0% 5.0% 7.3% 6.8% 4.8% 4.5% 4.5%

Profit and loss (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Mobile Phone Lens 4,825 6,412 7,421 11,433 15,263 15,682 20,549 23,845 DSC lens 487 507 377 555 391 422 413 409 Others 571 559 357 363 330 518 419 2,181 Total revenue 5,882 7,478 8,154 12,351 15,984 16,622 21,382 26,435 Other income 0 0 0 0 0 0 0 0 COGS (2,604) (3,491) (4,580) (6,546) (9,043) (10,103) (12,893) (16,479) SG&A (159) (412) (345) (374) (506) (994) (1,108) (1,329) Other op. expenses (203) (456) (507) (770) (963) (535) (597) (716) Operating profit 2,917 3,119 2,722 4,661 5,472 4,990 6,784 7,911 Net-interest inc./(exp.) 54 56 30 28 50 99 112 145 Assoc/forex/extraord./others 31 163 (109) (356) 314 (93) 60 55 Pre-tax profit 3,002 3,338 2,643 4,334 5,837 4,995 6,956 8,111 Tax (432) (96) (157) (289) (638) (649) (835) (973) Min. int./pref. div./others 0 0 0 0 0 0 0 0 Net profit (reported) 2,570 3,242 2,486 4,044 5,199 4,345 6,121 7,137 Net profit (adjusted) 2,570 3,242 2,486 4,044 5,199 4,345 6,121 7,137 EPS (reported) (NT$) 19.846 24.653 18.651 30.150 38.755 32.395 45.634 53.209 EPS (adjusted) (NT$) 19.846 24.653 18.651 30.150 38.755 32.395 45.634 53.209 EPS (adjusted fully-diluted) (NT$) 19.846 24.653 18.651 30.150 38.755 32.395 45.634 53.209 DPS (NT$) 9.515 9.895 10.064 13.500 17.000 16.197 22.817 26.604 EBIT 2,917 3,119 2,722 4,661 5,472 4,990 6,784 7,911 EBITDA 3,468 3,684 3,344 5,398 6,372 6,266 8,319 9,673

Cash flow (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 3,002 3,338 2,643 4,334 5,837 4,995 6,956 8,111 Depreciation and amortisation 552 565 622 737 900 1,276 1,534 1,762 Tax paid (432) (96) (157) (289) (638) (649) (835) (973) Change in working capital 510 711 (466) (539) 1,202 (352) (270) (310) Other operational CF items (10) (17) 14 21 18 (5) (5) (5) Cash flow from operations 3,621 4,502 2,656 4,263 7,318 5,265 7,381 8,584 Capex (733) (1,420) (1,057) (1,066) (3,149) (2,150) (1,900) (2,115) Net (acquisitions)/disposals 12 (39) (20) (1) (2) (10) (10) (10) Other investing CF items 4 (16) (26) (21) (23) 72 0 0 Cash flow from investing (716) (1,475) (1,103) (1,088) (3,173) (2,088) (1,910) (2,125) Change in debt (230) 94 (120) 142 319 (335) 23 (41) Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid (1,383) (1,232) (1,301) (1,341) (1,811) (2,280) (2,173) (3,061) Other financing CF items (220) (200) 591 (23) 37 0 0 0 Cash flow from financing (1,834) (1,338) (831) (1,223) (1,456) (2,615) (2,150) (3,102) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 1,071 1,688 723 1,952 2,690 563 3,321 3,358 Free cash flow 2,889 3,081 1,599 3,197 4,169 3,115 5,481 6,469 Source: Company, Daiwa forecasts

Financial summary


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Balance sheet (NT$m) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 4,216 5,904 6,627 8,579 11,268 11,831 15,152 18,510 Inventory 620 625 622 902 1,461 1,632 2,082 2,661 Accounts receivable 1,782 1,494 2,377 3,182 3,510 3,650 4,696 5,805 Other current assets 97 234 199 153 234 243 313 387 Total current assets 6,715 8,257 9,825 12,815 16,473 17,356 22,243 27,364 Fixed assets 4,163 5,018 5,453 5,795 8,057 8,931 9,296 9,649 Goodwill & intangibles 0 0 0 0 0 0 0 0 Other non-current assets 294 365 397 386 379 322 337 352 Total assets 11,172 13,640 15,675 18,996 24,909 26,608 31,876 37,365 Short-term debt 24 111 16 112 444 122 134 145 Accounts payable 248 273 410 560 1,358 1,246 1,590 2,032 Other current liabilities 740 1,278 1,521 1,871 3,243 3,324 4,276 5,287 Total current liabilities 1,012 1,662 1,948 2,543 5,045 4,692 6,000 7,464 Long-term debt 0 0 0 0 0 0 0 0 Other non-current liabilities 40 47 21 67 54 41 52 0 Total liabilities 1,051 1,709 1,969 2,610 5,099 4,733 6,052 7,464 Share capital 1,257 1,301 1,341 1,341 1,341 1,341 1,341 1,341 Reserves/R.E./others 8,863 10,629 12,365 15,045 18,469 20,534 24,483 28,559 Shareholders' equity 10,121 11,931 13,706 16,386 19,810 21,875 25,824 29,901 Minority interests 0 0 0 0 0 0 0 0 Total equity & liabilities 11,172 13,640 15,675 18,996 24,909 26,608 31,876 37,365

EV 75,816 75,424 75,484 73,627 71,270 70,385 67,076 63,729 Net debt/(cash) (4,192) (5,793) (6,610) (8,467) (10,824) (11,709) (15,018) (18,365) BVPS (NT$) 77.415 89.902 102 122 148 163 193 223

Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) (19.9) 27.1 9.0 51.5 29.4 4.0 28.6 23.6 EBITDA (YoY) (25.0) 6.2 (9.2) 61.4 18.0 (1.7) 32.8 16.3 Operating profit (YoY) (29.1) 6.9 (12.7) 71.3 17.4 (8.8) 36.0 16.6 Net profit (YoY) (33.9) 26.2 (23.3) 62.7 28.5 (16.4) 40.9 16.6 EPS (YoY) (34.7) 24.2 (24.3) 61.7 28.5 (16.4) 40.9 16.6 Gross-profit margin 55.7 53.3 43.8 47.0 43.4 39.2 39.7 37.7 EBITDA margin 59.0 49.3 41.0 43.7 39.9 37.7 38.9 36.6 Operating-profit margin 49.6 41.7 33.4 37.7 34.2 30.0 31.7 29.9 ROAE 26.7 29.4 19.4 26.9 28.7 20.8 25.7 25.6 ROAA 23.9 26.1 17.0 23.3 23.7 16.9 20.9 20.6 ROCE 29.8 28.1 21.1 30.8 29.8 23.6 28.3 28.3 ROIC 40.9 50.2 38.7 57.9 57.7 45.3 56.9 62.3 Net debt to equity net cash net cash net cash net cash net cash net cash net cash net cash Effective tax rate 14.4 2.9 6.0 6.7 10.9 13.0 12.0 12.0 Accounts receivable (days) 119.7 79.9 86.6 82.1 76.4 78.6 71.2 72.5 Payables (days) 15.5 12.7 15.3 14.3 21.9 28.6 24.2 25.0 Net interest cover (x) n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Net dividend payout 47.9 40.1 54.0 44.8 43.9 50.0 50.0 50.0 Source: Company, Daiwa forecasts

Company profile In Asia ex-Japan, Largan Precision (Largan) is the leading lens manufacturer for mobile handsets. Nokia, Motorola, Sony Ericsson, Apple, HTC and RIM are the company’s major customers. It currently has around a 28% share of the global handset lens market.



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What a pretty picture

We like Largan because we see it as the right company (technology leader with superior clientele) in the right business

Photo quality can always improve

We need better optical features on our phone cameras We believe the design and fabrication of lenses is a business with a bright long-term outlook, because people are never satisfied with the quality of their photos. In particular, many people are often frustrated when taking photos with their smartphones of moving objects or those set in a low-light environment. As such, there is always room to upgrade a camera’s optical features, such as the lens aperture, auto-focus speed, shutter time, depth of field, wide-angle view, etc. Improvements in these optical features are highly related to the design of the lens module, and not the type of semiconductor chip (CMOS sensor) that the smartphone makers choose to install in the phone. The leader in the slim lens business We believe Largan is the industry leader in providing slim lens modules (less than 5mm in depth) with a high pixel count (8MP+). The evidence is that Largan supplies 60%+ of the lens modules for the iPhone 5, which is equipped with the slimmest 8MP camera in the world at this moment. We estimate that the ASP of slim form factor lens modules is at least 10-15% higher than that of its bulkier peers. The majority of the mid-to-high-end smartphones are 7-11mm deep. The room (depth) left for the lens module is often less than 5mm. In particular, the high-end phones are equipped with cameras of 8-12MP, with lens modules that typically consist of 5 pieces in different shapes and sizes. It is very difficult to squeeze 5 tiny lens pieces into such a limited space, not to mention placing them in the correct position.

Lens modules for the front camera, a new earnings-growth driver We expect Largan’s sales of front-camera lenses to increase substantially in 4Q12, thanks to its iPhone 5 orders. Largan has been supplying the iPhone’s back-camera lens module since the first iPhone in 2007. But this is the first time that Largan has won orders for the front camera (the iPhone 4 in 2010 was the first iPhone with a front camera). As such, we believe the sales contribution from the front-camera lens is likely to increase significantly, from sub-5% in 2011 to 8-10% in 2012E. We project it will further rise to 20-25% in 2013E and 2014E. Owing to the success of the iPhone’s FaceTime app, a dual-camera design is becoming a standard for high-end smartphones and becoming more popular for the mid-range phones as well. The dual-camera design refers to having a main camera (5MP/8MP in resolution) on the back to take pictures of still images plus a secondary camera (VGA/1MP) on the front to conduct video calls. Largan: lens sales breakdown – surging demand for front

cameras lifts VGA and 1MP lens revenue

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VGA 1MP 2MP 3MP 5MP 8MP+


Note: the breakdown only includes revenue from lenses and excludes revenue from VCM assembly

Pixel war heats up again in 2013 The pixel count for phone cameras has remained at 8MP for nearly two years (for high-end phones), but we expect the upgrades to resume in 2013. According to our market research, the tier-one smartphone vendors are working on 10-14MP cameras for the next generation of their flagship devices. We believe this will trigger another round of pixel competition. Initially, the ASP of next generation products is typically 10-15% higher than the current generation products.


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This is a highly customised product with high entry barriers Mastering this business requires deep knowledge of optical system design, and expertise in ultra-precision tooling, moulding and plastics injection. In the later stage (module assembly), the lens maker needs to ramp up the yield rate in all workshops (bonding, lamination, lens alignment, and focus calibration, etc) within a short period. Any slight tilt during the assembly process will result in poor image quality. Furthermore, the product lifecycle of a handset is as short as three to four quarters; hence time-to-market is extremely important. Largan: high entry barriers for compact lens modules

Source: Company, Daiwa

Widely (and wrongly) regarded as a volume-production product, the lens module is in fact a highly customised one. The lens-module makers need to fine-tune their products to work perfectly with CMOS image sensors from various vendors, and to fit into the given space inside handsets, as defined by the handset makers. In addition, client requests for image resolution, lens aperture, field of view, field number, and chief ray angle could be very different from each other.

Rating, valuation and EPS sensitivity

Reiterate Buy; raise target price to NT$730 We reiterate our Buy (1) rating, but following the transfer of analyst coverage, we are introducing our new 2012/2013/2014 EPS forecasts of respective NT$32.4/NT$45.6/NT53.2. We see plenty of long-term earnings-growth drivers for Largan, including optical feature upgrades, increasing demand for front cameras and the resumption of pixel migration upgrades for smartphone cameras. The near-term share-price catalyst would be an increase in orders for lens modules for the iPhone 5. We set our new six-month target price at NT$730, which is based on 16x 2013E PER (versus the previous target price of NT$640, 20x 2012E PER). A 16x 12-month forward PER is in line with the average of its past-3-year trading range. Largan: 12-month forward PER bands (x)

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Largan: 12-month forward PBR bands (x)

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Valuation table: handset component companies Price (lc) Daiwa Mkt cap EPS (local currency) PER (x) EPS growth (%) ROE (%) PBR (x) Company Ticker 10/8/2012 Rating (US$ m) 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E Largan* 3008 TT 612.0 Buy 2,802 32.4 45.6 53.2 18.9 13.4 11.5 -16.4 40.9 16.6 20.8 25.7 25.6 3.8 3.2 2.7 Genius Optical 3406 TT 251.0 Not rated 740 9.9 12.8 14.0 25.4 19.6 18.0 -24.5 30.0 8.8 10.4 13.5 14.6 3.17 3.13 n.a. Merry 2439 TT 47.5 Not rated 250 3.7 3.8 4.1 12.9 12.5 11.7 122.6 3.1 7.0 11.1 13.3 13.3 1.71 1.60 1.51 Silitech 3311 TT 56.3 Not rated 341 5.3 5.4 5.6 10.7 10.4 10.0 -30.5 3.3 3.9 15.7 15.3 14.3 1.61 1.58 1.49 Ichia 2402 TT 15.5 Not rated 174 0.3 0.5 n.a. 48.7 30.9 n.a. 37.8 57.7 n.a. 2.3 3.3 n.a. 0.76 0.74 n.a. TXC* 3042 TT 49.4 Buy 509 3.6 4.5 5.4 13.6 11.0 9.2 4.7 24.0 19.8 14.9 17.2 18.8 2.0 1.8 1.6 ChengUei 2392 TT 70.6 Not rated 1,153 3.3 4.9 5.7 21.5 14.4 12.5 34.8 49.8 15.0 5.5 10.8 12.2 1.57 1.46 1.37 Catcher* 2474 TT 136.0 Outperform 3,485 12.4 13.8 15.4 11.0 9.8 8.9 -17.2 11.4 11.1 15.9 16.0 16.1 1.7 1.5 1.4 Foxconn Tech* 2354 TT 110.5 Sell 4,666 6.3 8.0 8.4 17.7 13.8 13.1 -4.1 27.7 5.5 13.3 15.1 14.2 2.2 2.0 1.8 AAC Tech* 2018 HK 27.2 Buy 4,300 1.37 1.76 2.00 16.1 12.5 11.0 62.4 28.5 13.7 31.6 32.6 30.6 4.5 3.7 3.1 Hirose 6806 JP 8740.0 Not rated 4,549 386.5 422.6 452.2 22.6 20.7 19.3 7.8 9.3 7.0 5.7 6.0 6.3 1.27 1.23 1.19 Goertek 002241 SZ 37.3 Not rated 4,936 1.1 1.7 2.4 34.3 22.5 15.6 61.4 52.1 44.0 25.2 27.6 28.1 6.50 5.12 3.95 Sunny Optical 2382 HK 4.3 Not rated 588 0.4 0.5 0.6 10.5 8.3 6.8 65.4 27.3 22.6 17.9 19.8 20.9 1.74 1.52 1.30 Hosiden 6804 JP 435.0 Not rated 437 2.7 19.6 19.5 160.3 22.2 22.3 -105.7 n.m. -0.3 0.2 1.6 1.7 0.32 0.32 0.32 SEMCO 009150 KS 96,300.0 Not rated 6,334 5,628.5 6,375.4 6,941.1 17.1 15.1 13.9 63.2 13.3 8.9 11.3 11.5 11.5 1.89 1.70 1.53 BYD Elec. 0285 HK 1.7 Not rated 485 0.3 0.3 0.3 5.1 5.0 4.9 -24.7 1.2 3.6 6.5 6.1 6.2 0.36 0.34 0.32 NDK 6779 JP 839.0 Not rated 239 100.1 120.1 113.8 8.4 7.0 7.4 n.a. 19.9 -5.2 7.2 9.0 7.8 0.59 0.54 0.51 KDS 6962 JP 217.0 Not rated 130 12.0 18.2 21.7 18.0 11.9 10.0 -186.5 51.2 19.3 1.2 2.3 n.a. 0.32 0.31 n.a. Rakon RAK NZ 0.5 Not rated 72 0.0 0.0 0.1 41.8 11.2 7.0 57.1 n.m. 61.1 1.3 4.1 5.7 0.46 0.45 0.42 Average 27.1 14.3 11.7 10.2 11.6 12.6 1.7 1.4 1.3 Source: Bloomberg, *Daiwa forecasts

Premium firm merits to trade at a premium In terms of valuation, Largan has been consistently trading at a premium to its peers over the past decade (12-24x PER), averaging at 16x. Its local peers tend to trade in a range of 8-18x, averaging at 12-14x. We believe Largan’s valuation premium is justifiable. Aside from its solid fundamental outlook, its concentrated shareholder structure also helps keep its valuation buoyant. Its key founders and the management team of the company still own over 50% of total shares. Their shareholdings have barely changed since the company’s IPO in March 2002, exhibiting a strong commitment to the company. Strong cash flow and earnings quality Largan is a robust cash-flow-generating machine. Its net cash position has been rising consistently since its IPO. Its cash dividend paid-out ratio has been stable at 40-50% over the past 8 years, and we expect it to remain at this level. Largan: net cash position is going only one way – up

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Largan: EPS vs. free cash flow per share: earnings quality is good

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EPS sensitivity analysis Changes in ASPs and gross margins are two key variables that would affect our earnings forecasts for Largan. We therefore conducted a sensitivity analysis (see the following table) on how such changes would impact our 2013 EPS forecast.

EPS sensitivity: effect of ASP and gross-margin changes on EPS EPS 2013e % change of ASP Assumption -12.00% -9.00% -6.00% -3.00% 0.00% 3.00% 6.00% 9.00% 12.00%

Gros

s mar

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37.7% 36.9 38.4 39.9 41.3 42.8 44.3 45.8 47.3 48.8 38.2% 37.5 39.0 40.5 42.0 43.5 45.0 46.5 48.1 49.6 38.7% 38.1 39.6 41.2 42.7 44.2 45.8 47.3 48.8 50.3 39.2% 38.7 40.3 41.8 43.4 44.9 46.5 48.0 49.6 51.1 39.7% 39.4 40.9 42.5 44.1 45.6 47.2 48.8 50.3 51.9 40.2% 40.0 41.6 43.2 44.7 46.3 47.9 49.5 51.1 52.7 40.7% 40.6 42.2 43.8 45.4 47.0 48.6 50.3 51.9 53.5 41.2% 41.2 42.8 44.5 46.1 47.7 49.4 51.0 52.6 54.3 41.7% 41.8 43.5 45.1 46.8 48.4 50.1 51.7 53.4 55.1

Source: Daiwa estimates

Note: The column and row in blue represent the base-case scenario in our earnings model. Note 2: Other assumptions: (1) 70% of opex is fixed and 30% is variable (in proportion to sales growth or decline), (2) non-op gain/loss (interest income/expense, forex gain/loss, etc) and tax rate are held unchanged in the sensitivity analysis.

Investment risks In our view, the key downside risks to our target price and rating would include: 1) slow upgrades to smartphone cameras due to cost concerns, 2) increased price competition from low-cost competitors, and 3) NT Dollar appreciation against the US Dollar in the long term.



What's new TXC has a long track record of delivering strong sales growth while maintaining superior profitability. Looking ahead, we believe it will keep outperforming the industry, as it has the right product (mini-size crystals) and right clientele (Apple, Samsung [SEC], China handset vendors).

What's the impact Not the biggest but the fastest growing and most profitable: TXC ranks fourth in the global crystal component industry with a 9.2% market share for 2011. Since 2004, TXC has posted the highest sales growth and highest operating margin among the tier-one competitors in all but one year. Increasing demand for miniature crystals: In our view, smartphones and tablets replacing feature phones and notebook PCs is positive for the industry, as they consume smaller-sized crystals

(which have a higher ASP and better gross margin). New wireless technologies to increase the usage of crystals: On average, a smartphone with LTE and NFC features consumes 4-5 pieces of crystals, versus 2-4 pieces for general smartphones (with 2G/3G, Wi-Fi, Bluetooth and GPS). As for legacy feature phones (2G or 3G with Bluetooth), they tend to consume 1-2 pieces only. High exposure to winners: We believe Apple, SEC and China handset vendors (Huawei, ZTE and white-box vendors) will keep gaining smartphone market share. They are also TXC’s top-3 clients, accounting for around 35% of its total revenue.

What we recommend We initiate coverage of TXC with a Buy (1) rating and six-month target price of NT$63.0, based on a 14x 2013E PER, the mid-point of the stock’s trading average during prior upward cycles. In our view, TXC is heading into another up-cycle, driven by market-share gains in smartphones and tablet PC crystals, and margin expansion due to a better product mix.

How we differ Our 2013-14 EPS forecasts are 6-7% higher than those of the consensus, as we believe TXC will see gross margin expansion along with top-line growth. Share price performance

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Oct-11 Jan-12 Apr-12 Jul-12 Oct-12TXC CORP (LHS) Relative to TWSE (RHS

(NT$) (%)

12-month range 33.60-50.00 Market cap (US$m) 509.34 Average daily turnover (US$m) 4.47 Shares outstanding (m) 302 Major shareholder Matthews Int'l (0.1%) Financial summary (NT$) Year to 31 Dec 12E 13E 14E Revenue (m) 10,941 13,112 15,963 Operating profit (m) 1,276 1,566 1,873 Net profit (m) 1,099 1,363 1,632 Core EPS 3.637 4.508 5.400 EPS change (%) 4.7 24.0 19.8 Daiwa vs Cons. EPS (%) 2 6 7 PER (x) 13.6 11.0 9.1 Dividend yield (%) 4.4 5.5 6.6 DPS 2.182 2.705 3.240 PBR (x) 2.0 1.8 1.6 EV/EBITDA (x) 6.9 5.7 4.8 ROE (%) 14.9 17.2 18.8 Source: Bloomberg, Daiwa forecasts


10 October 2012

TXC Corp 3042 TT

Target price: NT$63.00 Up/downside: +27.5% Share price (8 Oct): NT$49.40

Initiation: crystal clear

• The fourth-largest crystal component vendor globally, but has grown the fastest over the past decade

• Rise of smartphones/tablets has increased demand for crystal components, as will forthcoming new wireless technologies

• Compared to peers, TXC has cost advantage, production flexibility and a better clientele; coverage initiated with a Buy rating



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Growth outlook TXC: sales growth, EPS growth and ROE are trending up

We expect TXC’s sales growth, EPS growth and ROE to trend up in the next two years. Top-line growth will likely be driven by: 1) TXC gaining higher order allocations from key clients Apple, SEC and MediaTek, and 2) its key clients gaining more share in the smartphone market. We also expect product upgrades tohelp TXC maintain its ASP and gross margin stable, if not result in them going higher. This year, Apple upgraded the crystal unit used in its iPhone 5 and new iPods, from 2016 type to 2612 type (smaller size). The next-generation iPad might follow suit. MediaTek has adopted the high-ASP temperature compensated crystal oscillator (TCXO) in its reference design for the 3G smartphone.

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Valuation TXC: 12-month forward PER bands

We set our six-month target price at NT$63, which is based on a 14x 2013E PER, the mid-point of its trading average during its previous upward cycles (in early 2007 to late 2008 and mid-2009 to early 2011). We believe PER methodology is a more appropriate way to evaluate downstream tech companies such as TXC. We recognise flaws with PER methodology, such as a lack of insight into the long-term business outlook, a mismatch between earnings/cash flows, etc. But we think it is a more straightforward, intuitive and arguably accurate way to predict a tech company’s earnings power, at least in the near term.

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Earnings revisions TXC: consensus earnings-forecast revision trend

TXC has experienced a downward earnings revision trend since early 2011, but this trend seems to have bottomed out in early 3Q12. We have seen slight upward EPS revisions from the street over the past two months, along with the company’s recovering sales momentum. We believe the strong top-line momentum will last into 2013, and that the operating margin will trend up slightly. We see more room for further EPS upgrades by the street.

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3042 TT (NT$)





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Key assumptionsYear to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Handset related sales growth (% YoY) (10) 136 26 44 16 27 41 30 Consumer related sales growth (YoY%) 31.5 (43.7) (8.0) 8.2 (1.4) 19.7 2.4 1.9

PC and networking related sales growth (YoY%) 17.7 1.0 2.7 22.2 23.6 0.4 10.7 21.0

Profit and loss (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Networking components 1,625 1,914 2,051 2,481 2,350 2,769 3,293 4,188 Mobile device components 563 1,325 1,671 2,413 2,797 3,542 5,010 6,518 Others 4,063 4,123 4,005 4,757 4,750 4,630 4,810 5,256 Total revenue 6,250 7,362 7,728 9,651 9,897 10,941 13,112 15,963 Other income 0 0 0 0 0 0 0 0 COGS (4,357) (5,321) (5,823) (7,115) (7,497) (8,352) (10,051) (12,334) SG&A (451) (596) (584) (781) (786) (853) (972) (1,141) Other op. expenses (199) (317) (316) (409) (463) (460) (523) (615) Operating profit 1,244 1,127 1,004 1,347 1,152 1,276 1,566 1,873 Net-interest inc./(exp.) (24) (25) (25) (22) (17) (20) (19) (16) Assoc/forex/extraord./others (14) (47) (10) 0 78 8 18 19 Pre-tax profit 1,206 1,056 968 1,325 1,213 1,263 1,566 1,876 Tax (67) (104) (186) (135) (163) (164) (204) (244) Min. int./pref. div./others 0 0 0 0 0 0 0 0 Net profit (reported) 1,140 952 782 1,190 1,050 1,099 1,363 1,632 Net profit (adjusted) 1,140 952 782 1,190 1,050 1,099 1,363 1,632 EPS (reported) (NT$) 4.172 3.289 2.668 3.966 3.475 3.637 4.508 5.400 EPS (adjusted) (NT$) 4.172 3.289 2.668 3.966 3.475 3.637 4.508 5.400 EPS (adjusted fully-diluted) (NT$) 4.172 3.289 2.668 3.966 3.475 3.637 4.508 5.400 DPS (NT$) 1.755 1.877 1.981 2.469 2.200 2.182 2.705 3.240 EBIT 1,244 1,127 1,004 1,347 1,152 1,276 1,566 1,873 EBITDA 1,772 1,866 1,849 2,199 2,074 2,346 2,769 3,202

Cash flow (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 1,206 1,056 968 1,325 1,213 1,263 1,566 1,876 Depreciation and amortisation 528 739 845 852 922 1,071 1,203 1,329 Tax paid (67) (104) (186) (135) (163) (164) (204) (244) Change in working capital (39) (419) 232 (125) (471) (196) (525) (689) Other operational CF items 0 0 0 (4) (16) (6) (6) (7) Cash flow from operations 1,629 1,271 1,859 1,914 1,486 1,968 2,034 2,265 Capex (1,102) (1,910) (499) (1,780) (1,519) (1,100) (1,050) (1,050) Net (acquisitions)/disposals 0 0 0 (131) (140) (10) (10) (10) Other investing CF items (88) (9) (104) (26) (86) (5) (5) (5) Cash flow from investing (1,190) (1,919) (603) (1,937) (1,745) (1,115) (1,065) (1,065) Change in debt (413) 839 (193) 673 333 83 86 88 Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid (400) (480) (543) (581) (741) (665) (660) (818) Other financing CF items 567 36 57 (2) 322 0 0 0 Cash flow from financing (245) 395 (680) 90 (86) (582) (574) (729) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 193 (253) 577 67 (345) 272 396 471 Free cash flow 527 (639) 1,360 133 (33) 868 984 1,215 Source: Company, Daiwa forecasts

Financial summary


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Balance sheet (NT$m) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 1,244 992 1,568 1,635 1,290 1,562 1,958 2,429 Inventory 747 902 837 1,128 1,160 1,392 1,675 2,056 Accounts receivable 2,214 2,262 2,468 2,788 3,134 3,297 3,952 4,811 Other current assets 138 113 302 140 143 168 202 246 Total current assets 4,342 4,270 5,175 5,691 5,727 6,420 7,786 9,541 Fixed assets 3,221 4,439 4,110 5,062 5,690 5,719 5,566 5,288 Goodwill & intangibles 0 0 0 0 0 0 0 0 Other non-current assets 130 93 180 316 527 547 568 589 Total assets 7,694 8,801 9,465 11,069 11,943 12,686 13,921 15,418 Short-term debt 692 832 810 729 634 673 693 714 Accounts payable 1,049 747 1,264 1,310 1,272 1,373 1,652 2,027 Other current liabilities 386 448 492 769 718 842 1,009 1,228 Total current liabilities 2,126 2,027 2,566 2,809 2,623 2,887 3,354 3,969 Long-term debt 407 1,136 893 1,718 2,088 2,131 2,194 2,260 Other non-current liabilities 48 19 91 19 77 79 80 82 Total liabilities 2,582 3,181 3,549 4,545 4,788 5,097 5,629 6,311 Share capital 2,402 2,717 2,873 2,972 3,022 3,022 3,022 3,022 Reserves/R.E./others 2,709 2,903 3,042 3,552 4,133 4,567 5,270 6,085 Shareholders' equity 5,112 5,620 5,915 6,523 7,155 7,589 8,292 9,107 Minority interests 0 0 0 0 0 0 0 0 Total equity & liabilities 7,694 8,801 9,465 11,069 11,943 12,686 13,921 15,418

EV 13,906 15,472 14,751 15,636 16,362 16,172 15,860 15,476 Net debt/(cash) (145) 976 135 812 1,431 1,241 930 545 BVPS (NT$) 17.971 19.152 19.993 21.738 23.673 25.110 27.436 30.131

Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 20.1 17.8 5.0 24.9 2.6 10.5 19.8 21.7 EBITDA (YoY) 26.9 5.3 (0.9) 18.9 (5.7) 13.1 18.0 15.6 Operating profit (YoY) 24.9 (9.4) (10.9) 34.2 (14.5) 10.8 22.8 19.6 Net profit (YoY) 35.3 (16.5) (17.8) 52.2 (11.8) 4.7 24.0 19.8 EPS (YoY) 30.4 (21.2) (18.9) 48.6 (12.4) 4.7 24.0 19.8 Gross-profit margin 30.3 27.7 24.6 26.3 24.3 23.7 23.3 22.7 EBITDA margin 28.3 25.3 23.9 22.8 21.0 21.4 21.1 20.1 Operating-profit margin 19.9 15.3 13.0 14.0 11.6 11.7 11.9 11.7 ROAE 25.6 17.7 13.6 19.1 15.4 14.9 17.2 18.8 ROAA 16.1 11.5 8.6 11.6 9.1 8.9 10.2 11.1 ROCE 21.7 16.3 13.2 16.2 12.2 12.6 14.5 16.1 ROIC 25.6 17.6 12.8 18.1 12.5 12.7 15.1 17.3 Net debt to equity net cash 17.4 2.3 12.4 20.0 16.4 11.2 6.0 Effective tax rate 5.5 9.9 19.2 10.2 13.4 13.0 13.0 13.0 Accounts receivable (days) 118.5 111.0 111.7 99.4 109.2 107.3 100.9 100.2 Payables (days) 54.3 44.5 47.5 48.7 47.6 44.1 42.1 42.1 Net interest cover (x) 52.8 45.9 40.0 60.3 69.6 63.0 84.6 120.1 Net dividend payout 42.1 57.1 74.2 62.2 63.3 60.0 60.0 60.0 Source: Company, Daiwa forecasts

Company profile TXC Corporation (TXC) was founded in 1983. The company designs, manufactures, and sells frequency-control crystal components.TXC has two major production sites, one in North Taiwan (Ping-Cheng) and the other in East China (NingBo). Each accounts for roughly 50% of the firm’s total output value, but the Taiwan company is mainly engaged in small crystal production and advanced optical modules.s.



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Like the Energizer Bunny

… it keeps going on and on and on

Not the biggest but the fastest

We like TXC for its long and solid track record of delivering high top-line growth while maintaining superior profitability (gross margin/operating margin) vis-à-vis its competitors.

Consistently gaining market share TXC was the world’s fourth-largest crystal component vendor in 2009, and we expect the company to enter the top-3 by 2013 or 2014. TXC has a good track record of top-line growth. According to Consulting Services & Associates LLC (CS&A), TXC has registered the highest revenue growth among the tier-1 vendors in every single year since 2004, except for 2010 when some vendors rebounded sharply, as they were hard hit in 2009 due to the financial crisis. Noticeably, TXC is the only vendor which posted 8% YoY revenue growth in 2009, while all other tier-1 vendors saw revenue dip by 4-26% YoY. During this period (2004 to 2011), TXC’s market share grew from 3.0% to 9.2%, and its global ranking rose from No 8 to No 3.

TXC: revenue and growth of global tier-one crystal component vendors

Rank (2011) Company 2005 2006 2007 2008 2009 2010 2011 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

revenue revenue revenue revenue revenue revenue revenue ( % ch) ( % ch) ( % ch) ( % ch) ( % ch) ( % ch) 1 Epson Toyocom 589 645 656 675 641 793 592 10% 1.7% 2.9% -5.0% 23.7% -25.3% 2 NDK 515 626 649 571 459 547 557 22% 3.7% -12.0% -19.6% 19.1% 1.8% 3 KDS 253 290 293 327 271 391 389 15% 1.0% 11.6% -17.0% 44.1% -0.5% 4 TXC 117 161 192 222 241 301 327 38% 19.3% 15.6% 8.3% 25.2% 8.6% 5 Kyocera Kinseki 338 372 380 304 292 297 265 10% 2.2% -20.0% -3.8% 1.6% -10.8% 6 Vectron (Corning) 188 211 206 200 148 205 196 12% -2.4% -2.9% -26.1% 38.6% -4.4% 7 Rakon (C-MAC) 53 59 109* 96 82 106 111 11% 84.7%* 11.9% -15.1% 30.1% 4.7% Source: CS&A

Note*: New Zealand-based Rakon saw sales double in 2007 because of its acquisition of the crystal component division of C-MAC (with sales contribution of around US$40m pa). Excluding this, Rakon’s organic growth would be slower than TXC

Consistently more profitable as well Not just top-line growth, TXC also beat its competitors on profitability. TXC has been delivering the highest operating margin among tier-one vendors each year since 2004. Its gross margin is also higher than that of its peers – during the financial crisis period, TXC still posted a positive operating margin of 15.3%, while most of its archrivals were in negative territory. We attribute TXC’s strong margin performance to:

• Improving product portfolio: Dating back to the early 2000s, TXC has been a technology follower. The company set a clear goal to catch up in small-size products (such as 2016/2012 type crystals) first and then focus on high reliability products (such as TCXO, VCXO, etc). As of today, TXC’s capability in miniature components is on a par with industry leaders. For example, TXC is sharing iPhone 5’s 1612-type crystals (the smallest crystals today) with NDK. And, its high reliability products are catching up currently – TCXO has been seeing 100%+ sales growth over the past two years.

• Cost advantage: Compared with its major competitors (who make most of their products in Japan), TXC has a bigger production site in China, responsible for commodity type products, to save costs. However, it still keeps R&D and high-end products in Taiwan to keep key know-how in-house.

• An asset-light strategy: TXC only focuses on product design and mid-to-back-end manufacturing processes, such as slicing, cleaning, plating, packaging, and testing. It is not involved in any front-end processes, such as QC material production, which is capital-intensive. Most of its competitors have adopted a vertical integration model, and make the raw materials in-house. In our view, raw materials are commodity type products and are widely available from the market.


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Gross margin comparison – TXC has been in the lead since 2005

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5

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25

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35

2004 2005 2006 2007 2008 2009 2010 2011TXC Epson Toyocom KDS NDK


Note: Epson Toyocom acquired by its parent company Seiko Epson in 2009. Financial data unavailable after 2009

Operating margin comparison – TXC has been in the lead

since 2004

(15)

(10)

(5)

0

5

10

15

20

25

2004 2005 2006 2007 2008 2009 2010 2011

TXC Epson Toyocom KDS NDK


Note: Epson Toyocom acquired by its parent company Seiko Epson in 2009. Financial data unavailable after 2009

Increasing demand for high-end crystal components

Smartphones and tablets to drive product upgrades Smartphones replacing feature phones is positive for the industry, as smartphones consume more high-end and small-size crystals. The system design of smartphones is complicated, as a smartphone is essentially a feature phone plus a mini notebook PC. In addition, today’s smartphones are only marginally larger than feature phones; thus, without sacrificing performance, crystal components must be smaller (20x25mm, 20x16mm, or smaller) in order to squeeze into limited space. Miniature QC components cost more to produce and carry higher ASPs.

The rise of the tablet PC is positive for the industry too. Compared with notebook PCs, the iPad and tablet PCs are much slimmer and tend to use small size crystals too.

ASP of MHx crystals (US$) – crystals in smaller sizes carry higher ASPs Product Type Dimension 2008 2009 2010 2011 2012 2016 20x16mm 0.4 0.38 0.37 0.35 2520 25x20mm 0.35 0.33 0.32 0.31 0.3 3225 32x25mm 0.3 0.29 0.27 0.27 0.26 5032 50x32mm 0.24 0.24 0.23 0.23 0.22 6035 60x35mm 0.24 0.23 0.22 0.22 0.21 7050 70x50mm 0.2 0.2 0.2 0.19 0.19 Source: CS&A

New wireless technologies (LTE, NFC) to increase crystal usage The usage of crystal components increases in proportion to the complexity of the circuit design on the device’s printed circuit board (PCB); and the complexity of the circuit design is highly related to how many wireless technologies go into that device. On average, a smartphone with LTE and NFC features consumes 4-5 pieces, versus 2-4 pieces for general smartphones (with 3G, Wi-Fi, Bluetooth and GPS). As for legacy feature phones (2G or 3G with Bluetooth), they tend to consume 1-2 pieces only.

High exposure to winners

Our house view holds that Apple, SEC and the China handset vendors (Huawei, ZTE and white-box vendors) will be the smartphone market-share winners. They happen to be TXC’s top-3 clients, accounting for around 35% of its sales in 2012. Apple business firing on all cylinders Apple accounted for about 20% of TXC’s sales in 2H12, and we believe the ratio is set to soar over the next few years. TXC supplies crystal components for the iPhone, iPad, iPod, iMac, MacBook and others to Apple via ODM/EMS companies (Hon Hai, Quanta, etc). A new sales-growth catalyst for TXC has come in the form of Apple just upgrading the spec of crystals from 2016 type to 1612 type (smaller size) in its iPhone 5 and new iPods. Apple had been using 2016 crystals for three generations (iPhone 3GS, 4 and 4S), resulting in a sharp ASP decline for TXC. However, we estimate that this upgrade could lift the ASP (for TXC’s iPhone/iPod projects) by around 15%. The gross margin for the 1612-type crystal is close to 30%, versus 23-25% for the 2016 type.


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Smartphone market share – Apple, SEC and China vendors are gaining market share

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2009 2010 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12

Others

Sony Ericsson

LG

Motorola

Hwawei

ZTE

HTC

Nokia

RIM

Samsung

Apple Source: Gartner (‘Market Share: Mobile Devices by Region and Country, 2Q12’, by Anshul Gupta, David Glenn, Roberta Cozza, Tuong Huy Nguyen, Carolina Milanesi, Sandy Shen, Hugues J. De La Vergne, Annette Zimmermann, Atsuro Sato, CK Lu, published 13 August 2012), compiled by Daiwa

Smartphone market share, 2Q12 – Apple and SEC take up

nearly 50% of the market

Apple18.8%

Samsung29.7%

RIM5.2%

Nokia7.6%

HTC6.1%

ZTE4.1%

Hwawei3.5%

Others25.0%


We see lots of upside from SEC in the future SEC is the fastest-growing client of TXC over the past year. TXC won the first crystal component order for a Samsung smartphone in 2H11 (for the Galaxy S2, the flagship device), and won the second big order this year (for the Galaxy S3). SEC has emerged as TXC’s third-largest client, accounting for 5-6% of its sales in 2012 (versus 1% in 2011). TXC is confident that it can win more orders from SEC for mid-to-low end smartphones. Potentially, we estimate that SEC could account for 8-10% of sales 2-3 years from now. China handset vendors are rising again On our forecasts, TXC’s sales from China handset vendors could nearly double in 2012, with the sales contribution growing from 5-6% in 2011 to 9-10% in 2012.

MediaTek just raised its 2012 smartphone chipset target again from 85m to 95m (9m in 2011). Eric Chen, our MediaTek analyst, believes it could hit 105m. Some 95%+ of MediaTek’s chipsets go to China handset makers. Apparently, based on our market research, the sales momentum for smartphones in China is very strong. MediaTek has been using TXC’s MHz crystals in its reference design since mid-2000. As such, a big portion of China handset vendors have bought crystals from TXC (they tend to just follow MediaTek’s reference design and change nothing). A new catalyst for TXC has come in the form of MediaTek upgrading (in 2Q12) the crystal component used in its 3G smartphone reference design from an MHz crystal to a TCXO. The price of the TCXO is 2-3x higher than that for MHz crystals.

Initiating with a Buy rating

Target price of NT$63

We initiate coverage of TXC with at Buy (1) rating. In our view, the industry outlook is turning brighter, and we expect TXC to continue gaining market share.

Our six-month target price of NT$63 is based on a 14x 2013E PER, the mid-point of the stock’s trading average during prior upward cycles. In our view, TXC is heading into a new up-cycle, driven by market-share gains in smartphone and tablet PC crystals, and margin expansion due to a better revenue mix and product upgrades.

TXC is heading into another upcycle, with ROE trending up

(40% )

(20% )

0%

20%

40%

60%

80%




- 61 -

Valuation table – handset component companies Price (lc) Daiwa Mkt cap EPS (local currency) PER (x) EPS growth (%) ROE (%) PBR (x) Company Ticker 10/8/2012 Rating (US$ m) 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E Largan* 3008 TT 612.0 Buy 2,802 32.4 45.6 53.2 18.9 13.4 11.5 -16.4 40.9 16.6 20.8 25.7 25.6 3.8 3.2 2.7 Genius Optical 3406 TT 251.0 Not rated 740 9.9 12.8 14.0 25.4 19.6 18.0 -24.5 30.0 8.8 10.4 13.5 14.6 3.17 3.13 n.a. Merry 2439 TT 47.5 Not rated 250 3.7 3.8 4.1 12.9 12.5 11.7 122.6 3.1 7.0 11.1 13.3 13.3 1.71 1.60 1.51 Silitech 3311 TT 56.3 Not rated 341 5.3 5.4 5.6 10.7 10.4 10.0 -30.5 3.3 3.9 15.7 15.3 14.3 1.61 1.58 1.49 Ichia 2402 TT 15.5 Not rated 174 0.3 0.5 n.a. 48.7 30.9 n.a. 37.8 57.7 n.a. 2.3 3.3 n.a. 0.76 0.74 n.a. TXC* 3042 TT 49.4 Buy 509 3.6 4.5 5.4 13.6 11.0 9.2 4.7 24.0 19.8 14.9 17.2 18.8 2.0 1.8 1.6 ChengUei 2392 TT 70.6 Not rated 1,153 3.3 4.9 5.7 21.5 14.4 12.5 34.8 49.8 15.0 5.5 10.8 12.2 1.57 1.46 1.37 Catcher* 2474 TT 136.0 Outperform 3,485 12.4 13.8 15.4 11.0 9.8 8.9 -17.2 11.4 11.1 15.9 16.0 16.1 1.7 1.5 1.4 Foxconn Tech* 2354 TT 110.5 Sell 4,666 6.3 8.0 8.4 17.7 13.8 13.1 -4.1 27.7 5.5 13.3 15.1 14.2 2.2 2.0 1.8 AAC Acoustic* 2018 HK 27.2 Buy 4,300 1.37 1.76 2.00 16.1 12.5 11.0 62.4 28.5 13.7 31.6 32.6 30.6 4.5 3.7 3.1 Hirose 6806 JP 8740.0 Not rated 4,549 386.5 422.6 452.2 22.6 20.7 19.3 7.8 9.3 7.0 5.7 6.0 6.3 1.27 1.23 1.19 Goertek 002241 SZ 37.3 Not rated 4,936 1.1 1.7 2.4 34.3 22.5 15.6 61.4 52.1 44.0 25.2 27.6 28.1 6.50 5.12 3.95 Sunny Optical 2382 HK 4.3 Not rated 588 0.4 0.5 0.6 10.5 8.3 6.8 65.4 27.3 22.6 17.9 19.8 20.9 1.74 1.52 1.30 Hosiden 6804 JP 435.0 Not rated 437 2.7 19.6 19.5 160.3 22.2 22.3 -105.7 n.m. -0.3 0.2 1.6 1.7 0.32 0.32 0.32 SEMCO 009150 KS 96,300.0 Not rated 6,334 5,628.5 6,375.4 6,941.1 17.1 15.1 13.9 63.2 13.3 8.9 11.3 11.5 11.5 1.89 1.70 1.53 BYD Elec. 0285 HK 1.7 Not rated 485 0.3 0.3 0.3 5.1 5.0 4.9 -24.7 1.2 3.6 6.5 6.1 6.2 0.36 0.34 0.32 NDK 6779 JP 839.0 Not rated 239 100.1 120.1 113.8 8.4 7.0 7.4 n.a. 19.9 -5.2 7.2 9.0 7.8 0.59 0.54 0.51 KDS 6962 JP 217.0 Not rated 130 12.0 18.2 21.7 18.0 11.9 10.0 -186.5 51.2 19.3 1.2 2.3 n.a. 0.32 0.31 n.a. Rakon RAK NZ 0.5 Not rated 72 0.0 0.0 0.1 41.8 11.2 7.0 57.1 n.m. 61.1 1.3 4.1 5.7 0.46 0.45 0.42 Average 27.1 14.3 11.7 10.2 11.6 12.6 1.7 1.4 1.3 Source: Bloomberg, *Daiwa forecasts;

TXC: forward PER band

010203040506070

Jan-0

3Ju

l-03

Jan-0

4Ju

l-04

Jan-0

5Ju

l-05

Jan-0

6Ju

l-06

Jan-0

7Ju

l-07

Jan-0

8Ju

l-08

Jan-0

9Ju

l-09

Jan-1

0Ju

l-10

Jan-1

1Ju

l-11

Jan-1

2Ju

l-12

(NT$)


Source: TEJ, Daiwa

TXC: PBR bands

010203040506070

Jan-0

3Ju

l-03

Jan-0

4Ju

l-04

Jan-0

5Ju

l-05

Jan-0

6Ju

l-06

Jan-0

7Ju

l-07

Jan-0

8Ju

l-08

Jan-0

9Ju

l-09

Jan-1

0Ju

l-10

Jan-1

1Ju

l-11

Jan-1

2Ju

l-12

(NT$)


Source: TEJ, Daiwa

Cash flow and earnings quality improving Due to the business nature calling for high capex requirements, TXC’s cash flow and earnings quality have not been good in most of the past few years. However, after completion of the big capacity expansion in 2010 and 2011 (which incurred capex of

NT$1.8bn and NT$1.5bn, respectively), TXC now guides for 2012 capex to decline to NT$1.2bn, and expects the same or a slightly lower amount for 2013. With capex on the decline while earnings are on the rise, we believe TXC will generate more free cash flow and improve its balance sheet.

Earnings quality has not been good, but is improving

(3)(2)(1)

0123456

2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

EPS (NT$) FCF per share (NT$)


Dividend policy – TXC maintains its cash dividend payout ratio at 60%

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2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

DPS (NT$), LHS Cash div payout ratio, RHS



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EPS sensitivity analysis ASP changes and gross margins are two key variables that can affect our earnings forecasts for TXC. We therefore conducted a sensitivity analysis on how such changes would impact 2013E EPS, as presented in the following table.

EPS sensitivity – ASP and gross margin changes on EPS EPS 2013e % change of ASP Assumption -12.0% -9.0% -6.0% -3.0% 0.0% 3.0% 6.0% 9.0% 12.0%

Gros

s mar

gin

21.3% 2.9 3.1 3.3 3.6 3.8 4.0 4.2 4.4 4.6 21.8% 3.1 3.3 3.5 3.7 3.9 4.2 4.4 4.6 4.8 22.3% 3.3 3.5 3.7 3.9 4.1 4.3 4.6 4.8 5.0 22.8% 3.4 3.7 3.9 4.1 4.3 4.5 4.8 5.0 5.2 23.3% 3.6 3.8 4.1 4.3 4.5 4.7 5.0 5.2 5.4 23.8% 3.8 4.0 4.2 4.5 4.7 4.9 5.2 5.4 5.6 24.3% 3.9 4.2 4.4 4.6 4.9 5.1 5.4 5.6 5.8 24.8% 4.1 4.3 4.6 4.8 5.1 5.3 5.6 5.8 6.0 25.3% 4.3 4.5 4.8 5.0 5.3 5.5 5.8 6.0 6.3

Source: Daiwa

Note: The column and row in blue represent the base-case scenario in our earnings model. Note 2: Other assumptions: (1) 70% of opex is fixed and 30% is variable (in proportion to sales growth or decline); (2) non-op gain/loss (interest income/expense, forex gain/loss, etc) and tax rate are held unchanged in the sensitivity analysis

Investment risks In our view, the key downside risks would include: 1) mobile operators slowing down LTE deployment, 2) severe price competition from tier-two clients, and 3) NT Dollar appreciation against the US Dollar in the long term.


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Company background

Company profile

From low-end to high-end TXC was founded in 1983. The company designs, manufactures, and sells frequency-control crystal components. Similar to most of the Taiwanese component vendors, TXC was initially engaged in lower-end products, such as large DIP-type QC units. Major consumers are Taiwanese DT PC motherboard vendors, such as Asustek, Microstar, and Gigabyte. Starting from the late 1990s, TXC increased its R&D commitment and made aggressive inroads into SMD type crystals (which require greater packaging skills), as well as small form factor products (2520, 2016 type), and high reliability products (such as TCXO, OCXO, etc). From PC to networking, and handsets TXC’s products started to gain traction with wireless networking companies in the early 2000s. In 2003, Intel aggressively promoted Centrino platform-based notebook PCs, which successfully pushed Wi-Fi technology into every notebook PC. Thanks to its strong relationships with ODM/EMS firms and improved product quality, TXC soon took the lion’s share in crystals for Wi-Fi modules. Networking applications became the key sales growth driver for TXC during 2003-07. Meanwhile, TXC tried to penetrate the handset crystal market by working closely with MediaTek (for China white-box handset vendors) and smartphone clients (HTC and Apple). Having the right product and right clients, TXC has seen its handset crystal sales grow quickly since the late 2000s.

TXC: sales breakdown by application

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Networking Mobile Auto CE PC Others


TXC: sales breakdown and key clients

Industry / application % of sales (2012E) Customers Networking 25% Intel (Asus, USI, Gemtek), ANI, Zyxel,

Huawei, ZTE, Motorola Mobile phone 32% Apple, SEC, HTC, ZTE, Huaweia, Compal

Comm, Arima, Mediatek PC 19% Hon Hai, Asus, Compal, Inventec, Flextronics Consumer electronics 9% Sony, Apple, Seagate, Canon, Premier Auto & others 15% Jabil, Continental Source: Company, Daiwa

Production sites and global networks TXC has two major production sites, one in North Taiwan (Ping-Cheng) and the other in East China (NingBo). Each accounts for roughly 50% of the firm’s total output value, but the Taiwan company is mainly engaged in small crystal production and the advanced optical module (AOM, for automotive applications) product lines. It also has sales offices and sales reps around the world to provide a better customer service (California in the US, Milan in Europe, Osaka and Yokohama in Japan, and Beijing/Shanghai/Suzhou/Shenzhen/Wuhan in China). Manufacturing process and product roadmap As we discussed in a prior section, TXC has adopted an asset-light strategy – it only focuses on product design and the mid-to-back-end manufacturing processes such as slicing/cutting, cleaning, plating, packaging, and testing. It is not involved in any front-end processes, such as QC material production, which is capital-intensive.


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TXC mainly focuses on the mid-to-back end of crystal component manufacturing – cutting, lapping, cleaning, plating and packaging

Synthetic Quartz Lapping DimensioningLambert process

Frequency adjustment & sealing

Etching & washing

Electrode formation

Wafer-cutting

Assembling Final inspection

Source: Company

In terms of product development, for legacy products (KHz crystals and MHz crystals), TXC will continue to shrink the device size to win smartphone, tablet PC projects. For more advanced products, TXC is working on reducing phase noise and improving performance stability. TXC product roadmap

Source: Company


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Industry overview

What is a crystal component?

A quick look at crystal components Crystal components are widely used in various IT and consumer electronics products, as they are the most reliable timing and frequency-control devices – ie, defining the clock speed of data transition on a system’s PCB or motherboard. Crystal unit vs. crystal oscillators (such as TCXO, VCXO) The key difference between crystal units and crystal oscillators is that crystal units are simple frequency control devices, but crystal oscillators are equal to a crystal unit plus a controller IC. The performance of crystal oscillators is more stable and reliable. Crystal units are considered passive components, but oscillators are active ones. There are various types of crystal oscillators, such as TCXOs, voltage-controlled crystal oscillators (VXCO), oven-controlled crystal oscillators (OCXO), etc.

Comparison of different crystal oscillators Type Full name ASP range (per

piece) Applications

CXO Clock Crystal Oscillator US$0.65 to US$3 A wide range of IT, CE and communication devices

VCXO Voltage Controlled Crystal Oscillator

US$2.15 to US$16 Router, Wireless base station, Fibre optic communication

TCXO Temperature-Compensated Crystal Oscillator

US$0.8 to US$ 15 Handset, GPS navigator, router, switch

OCXO Oven-Controlled Crystal Oscillator

US$60 to US$70 Router, Satellite/Wireless base station, Military,

Source: Daiwa

How a crystal component works? The key characteristic of a quartz crystal is that it applies the ‘piezoelectric effect’ – electricity is generated on its surface when under mechanical pressure. Conversely, when electricity is applied to the surface, mechanical strain/stress is generated. This effect is a basis of a number of electronics devices and instruments. Piezoelectricity is the ability of materials (such as quartz crystals and certain types of ceramics) to generate an electric field in response to applied

mechanical stress, or vice versa. In the case of a crystal oscillator, it will vibrate at various frequencies, when electric current passes through it. The thickness of the crystal blank determines the resonance frequency of the device.

Piezoelectricity effect: voltage applied to cause the change of shape of the material

Source: Company data

Crystal components are irreplaceable Although other materials such as ceramics also apply this effect, quartz crystal has the most accuracy, stable frequency, and biggest cost advantage. Consequently, a quartz crystal has become an essential component in various electronics devices ranging from information products such as notebooks and PCs, communication products such as mobile phones, to automotive electronics, etc. According to the Industrial Technology Research Institute of Taiwan (ITRI), 45% are in communication products, followed by 30% in information products and 25% in consumer electronics and others. In terms of product types, crystal components can be generally categorised into quartz crystal units, crystal oscillators, crystal filters, SAW devices, and optical devices. Smaller size, higher frequency, and higher reliability are the trend What differentiates QC components from high-end to low-end is their size, frequency, and reliability (accuracy). Generally speaking, the ASPs of smaller size, higher frequency and better reliability crystals are higher than those for bigger size, low frequency and low reliability products. Small in size: Apple’s iPhone 4 and iPhone 4S apply the 2016 type (2.0mm*1.6mm) QC, which is 40% smaller than the 2520 type (2.5mm*2.0mm) used in the original iPhone. The 1612 (1.6mm*1.2mm) type QC has been adopted in the iPhone 5. TXC is now working on the mass production of a next-generation QC component – the 1210 type.


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High frequency: Wireless devices have penetrated into people’s daily life in different forms (cellular, Wi-Fi, Bluetooth, Satellite radio, digital TV broadcasting, GPS, etc). All of them require higher frequency QC components to enable data communication. High reliability: Reliability has also become more important in order to reduce the noise intervention issue faced by low-frequency but high accuracy requirement applications (such as automotive). High-reliability crystal components (such as OCXO) are widely used in aerospace and military equipment, as they have zero tolerance for errors and miscommunication.

The trend is smaller and thinner

Source: Company data



What's new We expect Foxconn Tech to post the strongest 2013 sales growth among its regional metal-casing peers because of the iPhone 5. But we believe such a scenario is largely priced in. We are concerned that the street’s margin and EPS assumptions could be too high. This report marks the transfer of analyst coverage.

What's the impact Slim but solid: we expect the adoption of light-metal casing in smartphones, tablet PCs and notebook PCs to increase. The trend among today’s consumers is for mobile devices to look slim and stylish, and feel solid when held. Industry leader with close ties to Apple: Foxconn Tech is the world’s largest vendor (excluding Hon Hai) of mobile device metal casings. As a Hon Hai affiliate, Foxconn Tech has been consistently gaining orders for Apple i-devices. Foxconn Tech and Hon Hai are the

primary metal-casing suppliers for the iPhone, iPad and iPod Nano. Foxconn Tech also shares MacBook metal-casing orders with Catcher. We believe high exposure to the iPhone/iPad puts Foxconn Tech in a good position to outgrow its peers. Game-console sales ramping up: we expect game-console assembly sales (40-45% of total sales with a sub-4% gross margin) to more than double in 2H12, thanks to the launches of the new Nintendo 3DS XL/LL in 3Q and Wii U in 4Q. Margins are always a swing factor, although the top line is predictable, in our view. We find it difficult to get a good grasp of the gross-margin trend, due to the huge volatility of the very-low-margin business (ie, game consoles) from quarter to quarter, and the unpredictable order allocation between Hon Hai and Foxconn Tech (many treat them as a single entity).

What we recommend Following our transfer of coverage, we are lowering our EPS forecasts. We reiterate our Sell (5) rating, and maintain our six-month target price of NT$95, based on a 12x 2013E PER, about 15% lower than its past-3-year trading average of 14x, but the same as the PER we assign to derive Catcher’s target price.

How we differ Unlike the street, we prefer Catcher to Foxconn Tech in the metal-casing space, as we believe Catcher has a more diversified clientele and broader technology base. Forecast revisions (%) Year to 31 Dec 12E 13E 14E Revenue change (29.6) (29.2) n.a. Net-profit change (13.0) (0.9) n.a. EPS change (21.4) (10.9) n.a. Source: Daiwa forecasts


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12-month range 81.71-132.86 Market cap (US$bn) 4.66 Average daily turnover (US$m) 47.53 Shares outstanding (m) 1,237 Major shareholder Hon Hai (10.1%) Financial summary (NT$) Year to 31 Dec 12E 13E 14E Revenue (m) 129,359 147,935 149,175 Operating profit (m) 8,465 11,799 12,376 Net profit (m) 7,709 9,872 10,418 Core EPS 6.252 7.982 8.424 EPS change (%) (4.1) 27.7 5.5 Daiwa vs Cons. EPS (%) -0.07 -11.5 -15.1 PER (x) 17.7 13.8 13.1 Dividend yield (%) 1.4 1.8 1.9 DPS 1.568 1.996 2.106 PBR (x) 2.2 2.0 1.8 EV/EBITDA (x) 7.7 5.6 4.7 ROE (%) 13.3 15.1 14.2 Source: Bloomberg, Daiwa forecasts


10 October 2012

Foxconn Technology 2354 TT

Target price: NT$95.00 → NT$95.00 Up/downside: -14.0% Share price (8 Oct): NT$110.50

Expectations too high

• We see clear top-line growth drivers ahead, including the new iPhone, iPad, Nintendo 3DS XL/LL and Wii U …

• … but margins are a swing factor due to high volatility of low-margin business and unpredictable order allocation

• We prefer Catcher to Foxconn Tech in the metal-casing space; Sell



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Growth outlook Foxconn Tech: growth momentum looks set to pick up in 2013

but could slide again in 2014

After two stagant years, we expect Foxconn Tech to resume strong sales growth in 2013, driven by multiple new product launches (iPhone, likely iPad mini, Wii U, 3DS XL, etc). However, we see the key driver as Apple switching the glass casing used in its iPhone 4/4s back to metal casing in the iPhone 5. After this effect plays out throughout 2013, we believe Foxconn Tech will see growth momentum decelerating in 2014.

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Valuation Foxconn Tech: 12-month forward PER

Following our transfer of coverage, we are lowering our 2012/2013/2014 EPS forecasts to NT$6.3/NT$8.0/ NT$8.4, respectively. We maintain our target price at NT$95, based on a 12x 2013E PER, which is about 15% lower than its past-three-year trading average of 14x, but the same as the PER we assign to derive Catcher’s target price. Foxconn Tech might have stronger short-term sales, but we think Catcher has sounder fundamentals in the long term, as it has a more diversified clientele and broader technology base in the light-metal casings space. We think the valuation gap between the two companies will narrow over time.

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Earnings revisions Foxconn Tech: consensus earnings revision trend

The street has been gradually revising down the 2013 EPS forecast for Foxconn Tech over the past year. The disappointing 2Q results (due mainly to the margin decline) triggered another round of EPS cuts in recent months. However, we think the current consensus EPS (surveyed by Bloomberg) of NT$9.0 for 2013 remains too high (versus our forecast of NT$8.0). We expect to see another around of EPS cuts in the next few months.

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2354 TT (NT$)





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Key assumptionsYear to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E ASP change - PC casing (% YoY) (1) (1) (1) (2) (2) (5) (8) (8) Shipment growth - PC casing (% YoY) 60 1 (33) (14) 29 (20) 4 22 ASP change - handset casing (% YoY) (2) (2) (3) (3) (2) 19 21 (8)

Shipment growth - handset casing (% YoY) 641 23 (19) 12 45 61 36 10

Profit and loss (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Metal casings 30,908 31,582 25,221 28,994 39,127 50,215 66,656 70,759 Thermal modules 38,265 38,958 19,193 17,967 14,250 12,402 11,800 12,383 Others 65,929 89,362 110,645 89,762 78,121 66,742 69,478 66,033 Total revenue 135,102 159,903 155,059 136,724 131,498 129,359 147,935 149,175 Other income 0 0 0 0 0 0 0 0 COGS (121,419) (146,576) (142,239) (121,896) (119,693) (116,409) (131,086) (131,856) SG&A (2,458) (3,903) (3,824) (4,070) (3,612) (3,498) (3,939) (3,856) Other op. expenses (738) (1,147) (1,038) (1,290) (1,132) (987) (1,111) (1,088) Operating profit 10,487 8,276 7,959 9,468 7,061 8,465 11,799 12,376 Net-interest inc./(exp.) (444) (717) (395) (137) 221 118 287 380 Assoc/forex/extraord./others 7 216 430 283 1,267 1,053 254 266 Pre-tax profit 10,051 7,775 7,993 9,614 8,549 9,636 12,340 13,022 Tax (1,006) (1,572) (1,731) (2,004) (539) (1,927) (2,468) (2,604) Min. int./pref. div./others 0 0 0 0 0 0 0 0 Net profit (reported) 9,045 6,203 6,263 7,610 8,010 7,709 9,872 10,418 Net profit (adjusted) 9,045 6,203 6,263 7,610 8,010 7,709 9,872 10,418 EPS (reported) (NT$) 7.631 5.171 5.148 6.222 6.521 6.252 7.982 8.424 EPS (adjusted) (NT$) 7.631 5.171 5.148 6.222 6.521 6.252 7.982 8.424 EPS (adjusted fully-diluted) (NT$) 7.631 5.171 5.148 6.222 6.521 6.252 7.982 8.424 DPS (NT$) 2.561 0.566 0.639 0.910 0.955 1.568 1.996 2.106 EBIT 10,487 8,276 7,959 9,468 7,061 8,465 11,799 12,376 EBITDA 12,944 11,842 11,979 13,451 12,268 13,796 17,351 18,384

Cash flow (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 10,051 7,775 7,993 9,614 8,549 9,636 12,340 13,022 Depreciation and amortisation 2,457 3,566 4,021 3,983 5,207 5,332 5,553 6,008 Tax paid (1,006) (1,572) (1,731) (2,004) (539) (1,927) (2,468) (2,604) Change in working capital (11,348) 2,969 7,077 (827) (2,874) 3,933 (1,439) (125) Other operational CF items (47) (299) (75) 38 67 (33) (34) (36) Cash flow from operations 107 12,438 17,285 10,803 10,410 16,940 13,951 16,265 Capex (10,461) (5,984) (161) (2,666) (5,831) (1,700) (3,500) (2,515) Net (acquisitions)/disposals (20,685) 10,893 (5,852) (1,124) 405 (1,790) (3,600) (2,626) Other investing CF items (468) (465) (317) (26) (377) 0 (60) (65) Cash flow from investing (21,153) 10,428 (6,169) (1,149) 28 (1,790) (3,660) (2,691) Change in debt 19,815 (5,086) (7,536) (8,933) 821 136 760 821 Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid (2,288) (3,036) (678) (778) (1,113) (1,173) (1,933) (2,468) Other financing CF items 14,052 (15,370) 5,043 (4,213) (2,844) 640 0 0 Cash flow from financing 31,579 (23,493) (3,171) (13,923) (3,136) (397) (1,173) (1,647) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 10,533 (626) 7,946 (4,270) 7,302 14,753 9,118 11,927 Free cash flow (10,355) 6,454 17,125 8,137 4,578 15,240 10,451 13,750 Source: Company, Daiwa forecasts

Financial summary


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Balance sheet (NT$m) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 15,242 14,615 22,561 18,291 25,594 40,347 49,465 61,391 Inventory 6,654 10,112 4,882 5,447 4,695 4,656 5,243 5,274 Accounts receivable 31,409 32,029 28,593 27,861 34,175 31,897 36,477 36,783 Other current assets 329 504 5,196 8,803 6,410 5,174 5,917 5,967 Total current assets 53,633 57,260 61,232 60,402 70,874 82,074 97,103 109,416 Fixed assets 23,725 26,428 23,039 21,770 22,777 19,145 17,093 13,600 Goodwill & intangibles 0 0 0 0 0 0 0 0 Other non-current assets 22,768 6,371 11,983 10,381 4,072 4,195 4,390 4,601 Total assets 100,126 90,059 96,254 92,552 97,723 105,415 118,585 127,617 Short-term debt 16,873 11,989 16,519 5,083 9,364 9,500 10,260 11,081 Accounts payable 14,945 20,807 17,418 18,436 20,939 20,730 23,344 23,481 Other current liabilities 5,108 6,468 12,961 14,555 12,347 12,936 14,793 14,918 Total current liabilities 36,926 39,264 46,898 38,074 42,650 43,166 48,397 49,479 Long-term debt 13,692 13,383 1,280 2,062 0 0 0 0 Other non-current liabilities 193 299 337 2,058 659 659 659 659 Total liabilities 50,811 52,947 48,515 42,193 43,310 43,825 49,057 50,139 Share capital 7,590 8,479 9,720 11,130 11,727 12,367 12,367 12,367 Reserves/R.E./others 41,726 28,633 38,019 39,229 42,686 49,222 57,161 65,111 Shareholders' equity 49,316 37,112 47,740 50,359 54,413 61,589 69,528 77,478 Minority interests 0 0 0 0 0 0 0 0 Total equity & liabilities 100,126 90,059 96,254 92,552 97,723 105,415 118,585 127,617

EV 147,061 144,759 130,100 124,390 119,804 105,811 97,453 86,347 Net debt/(cash) 15,323 10,756 (4,762) (11,147) (16,230) (30,847) (39,205) (50,311) BVPS (NT$) 41.365 30.603 39.116 41.057 44.200 49.801 56.220 62.648

Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 71.1 18.4 (3.0) (11.8) (3.8) (1.6) 14.4 0.8 EBITDA (YoY) 56.4 (8.5) 1.2 12.3 (8.8) 12.5 25.8 6.0 Operating profit (YoY) 52.5 (21.1) (3.8) 19.0 (25.4) 19.9 39.4 4.9 Net profit (YoY) 42.4 (31.4) 1.0 21.5 5.3 (3.8) 28.1 5.5 EPS (YoY) 40.7 (32.2) (0.5) 20.9 4.8 (4.1) 27.7 5.5 Gross-profit margin 10.1 8.3 8.3 10.8 9.0 10.0 11.4 11.6 EBITDA margin 9.6 7.4 7.7 9.8 9.3 10.7 11.7 12.3 Operating-profit margin 7.8 5.2 5.1 6.9 5.4 6.5 8.0 8.3 ROAE 23.2 14.4 14.8 15.5 15.3 13.3 15.1 14.2 ROAA 11.3 6.5 6.7 8.1 8.4 7.6 8.8 8.5 ROCE 17.7 11.6 12.4 15.4 11.6 12.6 15.6 14.7 ROIC 19.1 11.7 13.7 18.2 17.1 19.6 30.9 34.4 Net debt to equity 31.1 29.0 net cash net cash net cash net cash net cash net cash Effective tax rate 10.0 20.2 21.7 20.8 6.3 20.0 20.0 20.0 Accounts receivable (days) 71.4 72.4 71.4 75.4 86.1 93.2 84.3 89.6 Payables (days) 42.0 40.8 45.0 47.9 54.6 58.8 54.4 57.3 Net interest cover (x) 23.6 11.5 20.1 69.3 n.a. n.a. n.a. n.a. Net dividend payout 33.6 10.9 12.4 14.6 14.6 25.1 25.0 25.0 Source: Company, Daiwa forecasts

Company profile Foxconn Technology (Foxconn), previously Q-Run Technology, was established in 1990 and started by manufacturing monitors. The company is now the largest thermal-module manufacturer and the second-biggest magnesium-casing supplier in Taiwan.



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Margins a swing factor

We are not concerned about the top line, but think the street’s expectations for margins and EPS could be too high

Slim, stylish and solid

It is a never-ending debate: what type of casings are better, plastics or metal? Looking at the very long term, there is probably no clear trend. We observe that the design philosophy of consumer devices always resembles a pendulum swinging from one side to the other, and then back again. However, over the next few years, we believe the adoption of light metal casings in smartphones, tablet PCs and notebook PCs will increase. The trend reflects today’s consumers’ desire for mobile devices to look slim and stylish, and feel solid when holding them. Drawing a quick comparison between them: plastics are light in weight, cheap in cost, easy to shape, and easy to decorate. But on the flip side, plastics are fragile and easy to break. Most importantly, they can look cheap. We think light-metals (particularly aluminium and magnesium) are better materials to make ‘slim’, ‘stylish’ and ‘solid’ devices.

Industry leader with close ties to Apple

The largest metal casings maker worldwide Foxconn Tech (together with its parent Hon Hai) is the world’s largest supplier of light-metal casings for mobile devices (note that Hon Hai group owns about 21% of Foxconn Tech). Compared with its archrival, Catcher, Foxconn Tech (and Hon Hai) has a larger market share in the smartphone and tablet PC space, while Catcher has the upper hand in the notebook PC casings business. High sales exposure to Apple Its considerable exposure to the iPhone and iPad should put Foxconn Tech in a good position to outgrow (in terms of sales) its metal-casing peers in 2H12 and

2013. We estimate the iPhone and iPad to account for more than two-thirds of its metal-casings sales over the next two years (which in turn account for 45-50% of corporate-level sales). As a Hon Hai affiliate, Foxconn Tech has been consistently gaining metal casings orders for Apple i-devices since the mid 2000s. Foxconn Tech and Hon Hai are the primary metal casings suppliers for Apple’s iPhone, iPad and iPod Nano. Foxconn Tech also shares MacBook metal casings orders with Catcher.

Margins always a swing factor

Foxconn Tech’s sales growth is relatively predictable. However, we find it difficult to get a good grasp of the gross-margin trend, due to the huge volatility of the very-low-margin business and unpredictable order allocation between Hon Hai and Foxconn Tech. Foxconn Tech generates a huge chunk of revenue (40-45% of corporate-level sales on an annual basis) from assembling game consoles (Wii, DS, 3DS) for Nintendo. This part of the business generates a very low gross margin (from 0-4%). In addition, sales for this business could easily grow by 80-100% QoQ during peak seasons (3Q and 4Q), but easily drop by 50-70% QoQ during slow seasons (1Q and 2Q). Foxconn Tech shares orders with Hon Hai for most of its metal casings projects (particularly Apple’s projects). Global OEM clients tend to treat Hon Hai and Foxconn Tech as a single entity. In many cases, Hon Hai determines the split of order allocations.

Client concentration could be a risk in the long term

No concerns that Apple will switch metal casings vendor Apple tends to maintain long-term relationships with its key component vendors. Casings might not be considered a key component for other smartphone vendors; but Apple is very critical as to how its products look, and pays a great amount of attention to external components, like casings. We are not concerned that Apple might change the casing design of future iPhones and iPads The risks could be two-fold. First, Apple could switch the material of future iPhone/iPad casings from metals


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to non metals. Second, Apple might switch to a new technology. In our view, the first risk (switching from metal to non-metal) is not high, as Apple seems to favour the polished look and solid feeling provided by metal. The second risk is relatively higher, in our view, as Apple is a great innovator in the industrial design of products. If it were to switch to a new technology, we believe Foxconn Tech could still get order. However, Foxconn Tech might need to install new machinery and equipment, while a big part of its current facilities would stay idle, as its non-Apple clients are too small to fill any potential idle capacity. To keep capacity utilisation high, client diversity is important Metal casings are highly customized components. Virtually no two notebook PC (or smartphone) models share the same casings. Metal casings vendors need to build various workshops or production lines to fulfil all kinds of client demands. Typically speaking, if wanting to get orders from global clients, a metal casing vendor might need to build at least 2-4 different metal-forming workshops (die-casting, stamping, forging, extrusion, etc), 2-4 different second operation workshops (CNC, laser drill, lapping, blasting, etc) and another two to four different final treatment production lines. If a metal casing vendor can only secure a few projects from a few clients, it is likely that this casing vendor would see bottleneck taking place in certain workshops and product lines, but all the other capacities and product lines would be largely idle. Different surface treatment processes require different types

of product lines and equipment Robotic painting line Spinning Painting line Color Anodzing

Hydrographic printingElectrical plating Thermo Transfer Printing

Non Conductive Vacuum Metallization Physical Vapor Deposition

Source: Company

Strong top-line growth in 2H12

3Q preview – reversed Sharp investment loss to boost EPS We forecast Foxconn Tech to post a 3Q12 net profit of NT$4.8bn (versus a net loss of NT$2.0bn for 2Q12) on sales of NT$35.7bn, up 89% QoQ and up 30% YoY. Top-line growth for 3Q12 was mainly driven by the global launch of Nintendo’s 3DS XL (the upgraded version of the 3DS with a larger display) and the ramp-up of iPhone 5 metal casings. Apple has switched casing material from glass to aluminium in this new generation of iPhone, which we believe will continue to serve as Foxconn Tech’s key sales-growth driver throughout the next 4-5 quarters. The huge bottom-line turnaround will be boosted by the write-back of the Sharp investment loss of NT$2.13bn (which was booked in 2Q12), on top of strong top-line growth. 4Q preview – strong growth on multiple catalysts We forecast Foxconn Tech to post 25-30% QoQ sales growth for 4Q12, driven by the iPhone 5 (production fully ramping up), iPad-mini (likely to be launched in late 4Q) and Nintendo Wii U (global launch in November). We think the gross margin could trend down slightly due to product mix changes (shifting to a low-margin assembly business), but expect the operating margin to stay the same (owing to operating leverage). With the absence of the write-back of the NT$2.13bn Sharp investment loss, we forecast the company’s net profit to decline by 21% sequentially.


Reiterate Sell We expect Foxconn Tech to post the strongest 2013 sales growth among its regional metal-casing peers because of the iPhone 5. However, we see this as being largely priced in. We are concerned that the street’s margin and EPS assumptions could be too high. Our 2013 EPS forecast is 11.5% lower than the consensus. Following our transfer of coverage, we are lowering our 2012/2013/2014 EPS forecasts to NT$6.3/NT$8.0/ NT$8.4, respectively. We maintain our target price at NT$95, which is based on a 12x 2013E PER, about 15% lower than its past-three-year trading average of 14x, but the same as the PER we assign to derive Catcher’s target price.


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Foxconn Tech might have stronger short-term momentum, but we think Catcher has sounder fundamentals in the long term, as it has a more diversified clientele and broader technology base in the light-metal casings space. We think the valuation gap between the two companies will narrow over time. Foxconn Tech: forward PER bands

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0

Jul-1

0

Jan-1

1

Jul-1

1

Jan-1

2

Jul-1

2

(NT$)


Source: Daiwa

Valuation table – handset component companies

Price (lc) Daiwa Mkt cap EPS (local currency) PER (x) EPS growth (%) ROE (%) PBR (x) Company Ticker 10/8/2012 Rating (US$ m) 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E Largan* 3008 TT 612.0 Buy 2,802 32.4 45.6 53.2 18.9 13.4 11.5 -16.4 40.9 16.6 20.8 25.7 25.6 3.8 3.2 2.7 Genius Optical 3406 TT 251.0 Not rated 740 9.9 12.8 14.0 25.4 19.6 18.0 -24.5 30.0 8.8 10.4 13.5 14.6 3.17 3.13 n.a. Merry 2439 TT 47.5 Not rated 250 3.7 3.8 4.1 12.9 12.5 11.7 122.6 3.1 7.0 11.1 13.3 13.3 1.71 1.60 1.51 Silitech 3311 TT 56.3 Not rated 341 5.3 5.4 5.6 10.7 10.4 10.0 -30.5 3.3 3.9 15.7 15.3 14.3 1.61 1.58 1.49 Ichia 2402 TT 15.5 Not rated 174 0.3 0.5 n.a. 48.7 30.9 n.a. 37.8 57.7 n.a. 2.3 3.3 n.a. 0.76 0.74 n.a. TXC* 3042 TT 49.4 Buy 509 3.6 4.5 5.4 13.6 11.0 9.2 4.7 24.0 19.8 14.9 17.2 18.8 2.0 1.8 1.6 ChengUei 2392 TT 70.6 Not rated 1,153 3.3 4.9 5.7 21.5 14.4 12.5 34.8 49.8 15.0 5.5 10.8 12.2 1.57 1.46 1.37 Catcher* 2474 TT 136.0 Outperform 3,485 12.4 13.8 15.4 11.0 9.8 8.9 -17.2 11.4 11.1 15.9 16.0 16.1 1.7 1.5 1.4 Foxconn Tech* 2354 TT 110.5 Sell 4,666 6.3 8.0 8.4 17.7 13.8 13.1 -4.1 27.7 5.5 13.3 15.1 14.2 2.2 2.0 1.8 AAC Acoustic* 2018 HK 27.2 Buy 4,300 1.37 1.76 2.00 16.1 12.5 11.0 62.4 28.5 13.7 31.6 32.6 30.6 4.5 3.7 3.1 Hirose 6806 JP 8740.0 Not rated 4,549 386.5 422.6 452.2 22.6 20.7 19.3 7.8 9.3 7.0 5.7 6.0 6.3 1.27 1.23 1.19 Goertek 002241 SZ 37.3 Not rated 4,936 1.1 1.7 2.4 34.3 22.5 15.6 61.4 52.1 44.0 25.2 27.6 28.1 6.50 5.12 3.95 Sunny Optical 2382 HK 4.3 Not rated 588 0.4 0.5 0.6 10.5 8.3 6.8 65.4 27.3 22.6 17.9 19.8 20.9 1.74 1.52 1.30 Hosiden 6804 JP 435.0 Not rated 437 2.7 19.6 19.5 160.3 22.2 22.3 -105.7 n.m. -0.3 0.2 1.6 1.7 0.32 0.32 0.32 SEMCO 009150 KS 96,300.0 Not rated 6,334 5,628.5 6,375.4 6,941.1 17.1 15.1 13.9 63.2 13.3 8.9 11.3 11.5 11.5 1.89 1.70 1.53 BYD Elec. 0285 HK 1.7 Not rated 485 0.3 0.3 0.3 5.1 5.0 4.9 -24.7 1.2 3.6 6.5 6.1 6.2 0.36 0.34 0.32 NDK 6779 JP 839.0 Not rated 239 100.1 120.1 113.8 8.4 7.0 7.4 n.a. 19.9 -5.2 7.2 9.0 7.8 0.59 0.54 0.51 KDS 6962 JP 217.0 Not rated 130 12.0 18.2 21.7 18.0 11.9 10.0 -186.5 51.2 19.3 1.2 2.3 n.a. 0.32 0.31 n.a. Rakon RAK NZ 0.5 Not rated 72 0.0 0.0 0.1 41.8 11.2 7.0 57.1 n.m. 61.1 1.3 4.1 5.7 0.46 0.45 0.42 Average 27.1 14.3 11.7 10.2 11.6 12.6 1.7 1.4 1.3 Source: Bloomberg, *Daiwa forecasts


- 74 -

EPS sensitivity analysis Changes in ASPs and gross margins are two key variables that would affect our earnings forecasts for Foxconn Tech. We therefore conducted a sensitivity analysis on how such changes would impact 2013E EPS, as presented in the following table.

EPS sensitivity – ASP and gross margin change on EPS EPS 2013E % change of ASP Assumption -12.0% -9.0% -6.0% -3.0% 0.0% 3.0% 6.0% 9.0% 12.0%

Gros

s mar

gin

7.6% 3.5 3.7 3.9 4.1 4.3 4.5 4.6 4.8 5.0 8.6% 4.4 4.6 4.8 5.0 5.2 5.4 5.6 5.9 6.1 9.6% 5.2 5.4 5.7 5.9 6.1 6.4 6.6 6.9 7.1

10.6% 6.0 6.3 6.6 6.8 7.1 7.4 7.6 7.9 8.2 11.6% 6.8 7.1 7.4 7.7 8.0 8.3 8.6 8.9 9.2 12.6% 7.7 8.0 8.3 8.6 9.0 9.3 9.6 10.0 10.3 13.6% 8.5 8.9 9.2 9.6 9.9 10.3 10.6 11.0 11.3 14.6% 9.3 9.7 10.1 10.5 10.9 11.2 11.6 12.0 12.4 15.6% 10.2 10.6 11.0 11.4 11.8 12.2 12.6 13.0 13.4



Investment risks In our view, the key upside risks would include: 1) a gross-margin surprise on the upside due to an improvement in the yield rate, 2) higher order allocations for iPhone/iPad metal casings, and 3) adding more non-Apple vendors as new clients.



What's new We expect Cather to see renewed sales momentum in 4Q12, on the back of new tablet PC and MacBook orders. This report marks the transfer of analyst coverage.

What's the impact Slim but solid: we expect an increase in the adoption of light-metal casings to increase for smartphones, tablet PCs and notebooks. The trend is that today’s consumers want mobile devices to look slim and stylish, but feel solid in the hand. Industry leader: Catcher is the second-largest supplier of light-metal casings (with a 15-30% share of various product categories) globally, second only to Hon Hai group (Hon Hai + Foxconn Technology). It offers a wide range of solutions from front-end processes (metal forming and shaping), and second operations (CNC machining, lapping, blasting)

to back-end processes (surface treatment). Diversified client base: directly competing with Hon Hai bars Catcher from supplying casings to Hon Hai’s projects (iPhone, iPad). But, being an independent vendor has some merits too, because all non-Hon Hai ODMs (Pegatron, Quanta, etc) prefer to buy metal casings from Catcher, instead of Foxconn Tech. As such, Catcher has a more diversified client base that includes Apple, Dell, HTC, RIM, etc. Three catalysts in 4Q12: we forecast Catcher to post 20% QoQ sales growth, driven by metal casings and parts for the Kindle Fire HD 7”, the likely iPod Mini and new MacBook Pro.

What we recommend Following the transfer of coverage, we are cutting our 2012-13 EPS forecasts. We maintain our Outperform (2) rating. We are cutting our six-month target price to NT$150 (NT$192), based on 11x 2013E EPS, which is largely in line with its past 3-year trading average.

How we differ Unlike the market, in the metal-casing space, we prefer Catcher to Foxconn Technology, due to its

versatile technologies, diversified client base, and cheaper valuation. Forecast revisions (%) Year to 31 Dec 12E 13E 14E Revenue change (15.2) (25.3) n.a. Net-profit change (22.3) (32.1) n.a. EPS change (22.4) (32.2) n.a. Source: Daiwa forecasts


6080100120140

100140180220260

Oct-11 Jan-12 Apr-12 Jul-12 Oct-12Catcher Technology (LHS)Relative to TWSE (RHS)

(NT$) (%)

12-month range 123.50-235.00 Market cap (US$bn) 3.48 Average daily turnover (US$m) 84.74 Shares outstanding (m) 751 Major shareholder K'ai-Yih Investment (7.8%) Financial summary (NT$) Year to 31 Dec 12E 13E 14E Revenue (m) 37,696 41,819 45,918 Operating profit (m) 11,919 12,896 14,321 Net profit (m) 9,309 10,374 11,526 Core EPS 12.401 13.821 15.355 EPS change (%) (17.2) 11.4 11.1 Daiwa vs Cons. EPS (%) 3 5 6 PER (x) 11.0 9.8 8.9 Dividend yield (%) 3.6 4.1 4.5 DPS 4.961 5.528 6.142 PBR (x) 1.7 1.5 1.4 EV/EBITDA (x) 5.3 4.6 3.8 ROE (%) 15.9 16.0 16.1 Source: Bloomberg, Daiwa forecasts


10 October 2012

Catcher Technology 2474 TT


Set to regain momentum

• As a leading supplier, Catcher will benefit from a rise in the use of light-metal casings in mobile devices

• Prefer Catcher to Foxconn Tech for its technology and client diversity. It is overlooked by investors and has a cheap valuation

• We see three earnings catalysts in 4Q12: metal casings for the Kindle Fire HD 7”, the iPod Mini, and new MacBook Pro



- 76 -

Growth outlook Catcher: improving EPS-growth profile with stable ROE

We expect Catcher’s EPS to return to growth in 2013 and 2014 (we forecast an average of 10% YoY growth for 2013-14), following the negative growth in 2012E (due mainly to its key handset clients, HTC/RIM/Sony, losing market share). Looking forward, we expect the sales growth from its new tablet PC and notebook casings business (60-65% of Catcher’s sales) to be greater than the continued decline from its handset business (30% of Catcher’s sales).

(25% )

(15% )

(5% )

5%

15%

25%

35%

45%

(70% )

(35% )

0%

35%

70%

105%

140%

2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

ROE (RHS) Sales growth (LHS) EPS growth (LHS) Source: Company, Daiwa forecasts

Valuation Catcher: 12-month forward PER bands (x)

Following the transfer of analyst coverage, we introduce our new 2012/2013/2014 EPS forecasts of NT$12.4/ NT$13.8 / NT$15.4, respectively. Our new six-month target price is NT$150, based on an 11x 2013E PER (vs. NT$192 previously, on 12x 2012E PER). An 11x 12-month forward PER is largely in line with the average of its past 3-year trading range. We believe a PER methodology is the most appropriate way to evaluate downstream tech firms such as Catcher. We recognise the flaws of a PER methodology, such as the lack of insight into the long-term business outlook, and the mismatch between earnings/cash flow, etc. But we think it is a more straightforward, intuitive and arguably accurate way to predict a tech firm’s earnings power in the near term.

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(NT$)


Source: Daiwa

Earnings revisions Catcher: Bloomberg-consensus EPS forecast revisions

The Bloomberg consensus has been cutting its 2013 EPS forecasts, down to NT$14 currently from NT$22 a year ago. The downtrend seems to have stablised since the middle of July. Compared with our 2013 EPS forecast, we believe the consensus forecast is now too low, and believe Catcher could enter an earnings upgrade cycle soon.

05

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2

Consensus: 2013 EPS (NT$)

2474 TT

Source: Bloomberg




- 77 -

Key assumptionsYear to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E ASP change - PC casing (% YoY) (1) 0 (2) (3) (2) (2) (2) (2) Shipment growth - PC casing (% YoY) 17 6 (3) 17 60 11 13 9 ASP change - handset casing (% YoY) (6) (6) (7) 107 23 (4) (4) (2)

Shipment growth - handset casing (% YoY) 33 44 (23) 44 99 (12) (14) 12

Profit and loss (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E NB casings 11,764 12,212 12,055 13,350 19,520 21,358 23,584 25,313 Mobile device casings 2,214 2,912 2,162 6,226 14,200 12,099 9,966 10,893 Others 4,109 3,925 2,771 2,268 2,194 4,239 8,269 9,712 Total revenue 18,087 19,049 16,988 21,845 35,914 37,696 41,819 45,918 Other income 0 0 0 0 0 0 0 0 COGS (9,385) (11,446) (10,983) (14,092) (19,023) (21,532) (24,173) (26,776) SG&A (1,081) (1,759) (1,508) (1,964) (2,897) (3,311) (3,705) (3,761) Other op. expenses (185) (902) (937) (701) (781) (934) (1,045) (1,061) Operating profit 7,437 4,941 3,560 5,087 13,213 11,919 12,896 14,321 Net-interest inc./(exp.) 269 83 (61) 20 126 177 205 255 Assoc/forex/extraord./others (4) (92) 356 80 366 152 199 201 Pre-tax profit 7,702 4,932 3,854 5,187 13,705 12,249 13,301 14,777 Tax (487) (571) (523) (740) (3,040) (2,940) (2,926) (3,251) Min. int./pref. div./others (19) (15) (11) (17) 12 0 0 0 Net profit (reported) 7,197 4,346 3,320 4,430 10,677 9,309 10,374 11,526 Net profit (adjusted) 7,197 4,346 3,320 4,430 10,677 9,309 10,374 11,526 EPS (reported) (NT$) 11.043 6.627 5.021 6.662 14.977 12.401 13.821 15.355 EPS (adjusted) (NT$) 11.043 6.627 5.021 6.662 14.977 12.401 13.821 15.355 EPS (adjusted fully-diluted) (NT$) 11.043 6.627 5.021 6.662 14.977 12.401 13.821 15.355 DPS (NT$) 3.324 0.914 2.011 4.006 5.265 4.961 5.528 6.142 EBIT 7,437 4,941 3,560 5,087 13,213 11,919 12,896 14,321 EBITDA 8,403 6,433 5,509 7,122 15,778 15,193 16,590 18,418

Cash flow (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 7,683 4,918 3,843 5,170 13,718 12,249 13,301 14,777 Depreciation and amortisation 966 1,492 1,950 2,035 2,564 3,274 3,694 4,096 Tax paid (487) (571) (523) (740) (3,040) (2,940) (2,926) (3,251) Change in working capital (958) (4,950) (279) 584 2,401 (126) (610) (901) Other operational CF items (1) (45) (113) (83) (99) (85) (144) (151) Cash flow from operations 7,203 843 4,878 6,965 15,543 12,371 13,314 14,571 Capex (5,524) (6,991) (231) (4,579) (9,943) (4,700) (4,500) (5,515) Net (acquisitions)/disposals (435) 137 (13) (473) (230) (10) (10) (10) Other investing CF items (197) (1,068) (1,553) 1,272 58 1,279 (92) (90) Cash flow from investing (6,156) (7,922) (1,797) (3,780) (10,115) (3,431) (4,602) (5,615) Change in debt 4,086 4,226 7,271 1,513 5,877 (2,906) 1,800 1,944 Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid (1,242) (2,166) (600) (1,330) (2,664) (3,753) (3,724) (4,150) Other financing CF items 633 1,422 (215) (2,382) 15,122 0 0 0 Cash flow from financing 3,477 3,482 6,455 (2,199) 18,335 (6,660) (1,924) (2,206) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 4,524 (3,597) 9,536 986 23,763 2,281 6,788 6,750 Free cash flow 1,679 (6,148) 4,647 2,386 5,600 7,671 8,814 9,056 Source: Company, Daiwa forecasts

Financial summary


- 78 -

Balance sheet (NT$m) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 10,972 7,375 16,910 17,896 41,659 43,940 50,728 57,478 Inventory 2,346 2,964 2,194 2,136 2,538 2,991 3,357 3,719 Accounts receivable 7,675 8,112 6,246 9,502 12,323 13,426 14,894 16,355 Other current assets 169 4,333 6,728 4,926 1,475 1,508 1,673 1,837 Total current assets 21,163 22,783 32,079 34,461 57,995 61,864 70,653 79,388 Fixed assets 14,271 19,894 18,297 20,931 28,408 29,930 30,828 32,336 Goodwill & intangibles 0 0 0 0 0 0 0 0 Other non-current assets 1,097 1,950 3,507 2,702 2,875 1,596 1,750 1,911 Total assets 36,530 44,627 53,883 58,094 89,278 93,390 103,231 113,636 Short-term debt 6,673 6,785 9,911 18,274 17,993 15,750 17,010 18,371 Accounts payable 2,152 2,242 2,046 3,199 3,258 3,835 4,636 5,135 Other current liabilities 1,704 1,882 1,559 2,386 4,500 5,385 5,974 6,560 Total current liabilities 10,529 10,910 13,516 23,859 25,751 24,970 27,620 30,066 Long-term debt 0 4,084 8,225 1,307 7,413 6,750 7,290 7,873 Other non-current liabilities 160 190 194 263 314 314 314 314 Total liabilities 10,690 15,184 21,936 25,428 33,478 32,034 35,224 38,253 Share capital 5,416 5,997 6,649 6,649 7,506 7,506 7,506 7,506 Reserves/R.E./others 20,425 23,446 25,299 26,016 48,294 53,849 60,500 67,876 Shareholders' equity 25,841 29,443 31,948 32,665 55,801 61,356 68,007 75,383 Minority interests 0 0 0 0 0 0 0 0 Total equity & liabilities 36,530 44,627 53,883 58,094 89,278 93,390 103,231 113,636

EV 84,697 93,142 91,653 92,112 85,834 80,647 75,659 70,853 Net debt/(cash) (4,299) 3,495 1,225 1,684 (16,253) (21,440) (26,428) (31,234) BVPS (NT$) 39.489 44.666 48.048 49.128 74.337 81.738 90.598 100

Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 19.5 5.3 (10.8) 28.6 64.4 5.0 10.9 9.8 EBITDA (YoY) 11.9 (23.4) (14.4) 29.3 121.5 (3.7) 9.2 11.0 Operating profit (YoY) 8.4 (33.6) (28.0) 42.9 159.7 (9.8) 8.2 11.1 Net profit (YoY) 11.9 (39.6) (23.6) 33.4 141.0 (12.8) 11.4 11.1 EPS (YoY) 10.5 (40.0) (24.2) 32.7 124.8 (17.2) 11.4 11.1 Gross-profit margin 48.1 39.9 35.3 35.5 47.0 42.9 42.2 41.7 EBITDA margin 46.5 33.8 32.4 32.6 43.9 40.3 39.7 40.1 Operating-profit margin 41.1 25.9 21.0 23.3 36.8 31.6 30.8 31.2 ROAE 31.9 15.7 10.8 13.7 24.1 15.9 16.0 16.1 ROAA 23.4 10.7 6.7 7.9 14.5 10.2 10.6 10.6 ROCE 27.4 13.6 7.9 9.9 19.8 14.4 14.6 14.8 ROIC 37.7 16.0 9.3 12.9 27.8 22.8 24.7 26.1 Net debt to equity net cash 11.9 3.8 5.2 net cash net cash net cash net cash Effective tax rate 6.3 11.6 13.6 14.3 22.2 24.0 22.0 22.0 Accounts receivable (days) 137.9 151.3 154.2 131.6 110.9 124.7 123.6 124.2 Payables (days) 41.3 42.1 46.1 43.8 32.8 34.3 37.0 38.8 Net interest cover (x) n.a. n.a. 57.9 n.a. n.a. n.a. n.a. n.a. Net dividend payout 30.1 13.8 40.1 60.1 35.2 40.0 40.0 40.0 Source: Company, Daiwa forecasts

Company profile Established in 1984, Catcher Technology (Catcher) started out producing aluminium die-casting for hard-disk drives. The company launched its first magnesium-alloy products for notebook PCs in 1996, and aggressively expanded its production lines thereafter. It has become one of the world’s largest suppliers of magnesium-alloy casings and components for notebook PCs. Catcher’s operations have been extended to other consumer products, such as handsets, iPods, digital camera, and printers.



- 79 -

It looks and feels better

We believe the mobile-device vendors will shift their focus from what’s on the inside (CPU, memory) to what’s on the outside (slim, stylish)

Slim, stylish and solid

It is a never-ending debate: what types of casing are better, plastic or metal? Looking at the very long term, there is probably no clear trend. We observe that the design philosophy of consumer devices is always like a pendulum swinging from one side to the other, and then back again. But for the next few years, we believe the adoption of light metal casings will increase in smartphones, tablet PCs and notebooks. The trend is that today’s consumers want mobile devices that look slim and stylish, but feel solid to hold. Drawing a quick comparison between them: plastics are light in weight, cheap in cost, easy to shape, and easy to decorate. But on the flip side, plastics are fragile and easy to break. Most importantly, they look cheap. We think light-metals (particularly aluminium and magnesium) are better materials to make a slim, stylish and solid device.

Industry leader with superior technologies

The second-largest metal casing maker globally ... Catcher is the world’ second-largest supplier of light-metal casings (with 15-30% market shares in various product categories). It is only second to Hon Hai group (Hon Hai + Foxconn Tech). Compared with the Hon Hai group, Catcher has a higher market share of the notebook PC metal-casing business. Hon Hai and Foxconn Tech dominate the global smartphone and tablet PC space, as they are the primary suppliers of iPhone and iPad casings.

… with the highest gross-profit margin Despite not being the biggest, we believe Catcher is the most experienced (high yield rate) and versatile (total solution provider) metal-casing supplier globally. As such, Catcher enjoys an industry-leading gross margin of 35-47% (over 2009-11) (vs. its peers’ 25-35%). The best total-solution casing supplier Catcher offers a wide range of solutions from front-end (metal forming and shaping), mid-end (second-time operation) to back-end processes (surface treatment). Catcher’s superior capabilities in the front-end and mid-end processes are well recognised, particularly in fields such as magnesium alloy die-casting, aluminium alloy extrusion, and computer-numeric-controlled (CNC) machining (high-speed and multiple spindles). However, we think Catcher’s back-end capability (surface treatment) is mostly overlooked by investors. Catcher offers a wide range of surface-treatment solutions to clients, including painting, anodizing, plating, hydro/thermo printing, vacuum sputtering, etc, while many of its metal-casing peers tend to outsource some back-end processes to third-party contractors. Keeping its surface-treatment processes in-house not only saves on costs but also shortens the production cycle (saving time for clients). Catcher offers a wide range of solutions from front-end to

back-end processes

New Material

- Aluminum- Magnesium- Zinc- Stainless steal- Plastics- Wultiple material

Metal Forming and Shaping

- Die casting- Metal stamping- Extrusion- Forging- Plastic injection- Metal injection molding

(MIM)

2nd Operation

- CNC machining- Laser process- Chemical conversion- Tumbling- Chemical etching- Lapping- Blasting- Brushing

Surface Finish

- Robotic painting lines- Spinning painting line- Color anodizing- Electrical plating- Hydrographic printing- Thermo transfer printing- Physical vapor deposition- NCVM

Tooling Housing

- Main equipment- Measurement equipment

Product Test and Validation

- Metallurgical lab- Mechanical lab- Chemical lab- Painting lab- Touch panel lab

Touch Panel

- Mesh screen printing- Etching- Punch/Cutting- Lamination- Bonding


Independent supplier with a diversified client base

The value of being independent Having been nose-to-nose with the Hon Hai group for years, Catcher has had little chance of penetrating Hon Hai’s projects, such as the iPhone and iPad. However, on the bright side, being an independent component supplier (not belonging to a big tech group)


- 80 -

has its merits too. All non-Hon Hai ODMs (such as Pegatron, Quanta, Compal, Wistron, etc) prefer to source metal casings from Catcher, instead of Foxconn Tech. As such, Catcher has a more diversified client base, including Apple, Dell, HP, HTC, RIM, Motorola, Sony, etc. Client diversity is important to keep capacity utilisation high Metal casings are highly customised components. Virtually no two notebook PCs (or smartphone) models share the same casings. Metal-casing vendors need to build various workshops or production lines to fulfil all kinds of client demand. Typically speaking, if wanting to get orders from global clients, a metal-casing vendor might need to build at least 2-4 different metal-forming workshops (die-casting , stamping, forging, extrusion, etc), 2-4 different second-operation workshops (CNC, laser drill, lapping, blasting, etc) and another 2-4 different final treatment production lines. If a metal-casing vendor can only secure a few projects from a few clients, it is likely that this casing vendor will see bottleneck taking place in certain workshops and product lines, with all the other capacities and product lines remaining largely idle. Different surface-treatment processes require different product

line and equipment Robotic painting line Spinning Painting line Color Anodzing

Hydrographic printingElectrical plating Thermo Transfer Printing

Non Conductive Vacuum Metallization Physical Vapor Deposition

Source: Company

Three catalysts in 4Q12

After three stagnant quarters of sales growth, we expect Catcher’s sales-growth momentum to resume in 4Q12. We forecast Catcher to post 20% QoQ sales growth for 4Q12, driven by magnesium die-casting parts for the Kindle Fire HD 7”, and aluminium-metal casings for the likely iPod Mini and new MacBook Pro. The MacBook Pro’s casings (and probably those for the iPod Mini) are a unibody type that commands higher a

ASP and gross margin. We also expect the gross margin to trend up slightly due to a higher capacity utilisation.


Maintain Outperform rating Following the transfer of analyst coverage, we are introducing our new 2012/2013/2014 EPS forecasts of NT$12.4/NT$13.8/NT$15.4, respectively. We are setting our new six-month target price at NT$150, based on an 11x 2013E PER (versus the previous target price of NT$192, on a 12x 2012E PER). An 11x forward PER is largely in line with the average of its past-3-year trading range of 11.5x. We maintain our Outperform (2) rating. In the metal-casing space, we prefer Catcher to Foxconn Technology. With its better one-stop-shop capability and more diversified client base, Catcher is more likely to be the winner, in terms of market share, in the long term. In the near term, we think new orders for tablet PCs and MacBook projects will serve as share-price catalysts. Valuation-wise, Foxconn Tech is trading at a 14x 2013E PER while Catcher is trading at around 10x. We expect the valuation gap to narrow, with Catcher regaining sales momentum in 4Q12. Catcher: 12-month forward PER band

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Catcher: 12-month forward PBR

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9

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1

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(NT$)

Share price 1x 2x 3x 4xSource: Bloomberg, Daiwa forecasts


- 81 -

Handset component companies: valuation table Price (lc) Daiwa Mkt cap EPS (local currency) PER (x) EPS growth (%) ROE (%) PBR (x) Company Ticker 10/8/2012 Rating (US$ m) 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E Largan* 3008 TT 612.0 Buy 2,802 32.4 45.6 53.2 18.9 13.4 11.5 -16.4 40.9 16.6 20.8 25.7 25.6 3.8 3.2 2.7 Genius Optical 3406 TT 251.0 Not rated 740 9.9 12.8 14.0 25.4 19.6 18.0 -24.5 30.0 8.8 10.4 13.5 14.6 3.17 3.13 n.a. Merry 2439 TT 47.5 Not rated 250 3.7 3.8 4.1 12.9 12.5 11.7 122.6 3.1 7.0 11.1 13.3 13.3 1.71 1.60 1.51 Silitech 3311 TT 56.3 Not rated 341 5.3 5.4 5.6 10.7 10.4 10.0 -30.5 3.3 3.9 15.7 15.3 14.3 1.61 1.58 1.49 Ichia 2402 TT 15.5 Not rated 174 0.3 0.5 n.a. 48.7 30.9 n.a. 37.8 57.7 n.a. 2.3 3.3 n.a. 0.76 0.74 n.a. TXC* 3042 TT 49.4 Buy 509 3.6 4.5 5.4 13.6 11.0 9.2 4.7 24.0 19.8 14.9 17.2 18.8 2.0 1.8 1.6 ChengUei 2392 TT 70.6 Not rated 1,153 3.3 4.9 5.7 21.5 14.4 12.5 34.8 49.8 15.0 5.5 10.8 12.2 1.57 1.46 1.37 Catcher* 2474 TT 136.0 Outperform 3,485 12.4 13.8 15.4 11.0 9.8 8.9 -17.2 11.4 11.1 15.9 16.0 16.1 1.7 1.5 1.4 Foxconn Tech* 2354 TT 110.5 Sell 4,666 6.3 8.0 8.4 17.7 13.8 13.1 -4.1 27.7 5.5 13.3 15.1 14.2 2.2 2.0 1.8 AAC Tech* 2018 HK 27.2 Buy 4,300 1.37 1.76 2.00 16.1 12.5 11.0 62.4 28.5 13.7 31.6 32.6 30.6 4.5 3.7 3.1 Hirose 6806 JP 8740.0 Not rated 4,549 386.5 422.6 452.2 22.6 20.7 19.3 7.8 9.3 7.0 5.7 6.0 6.3 1.27 1.23 1.19 Goertek 002241 SZ 37.3 Not rated 4,936 1.1 1.7 2.4 34.3 22.5 15.6 61.4 52.1 44.0 25.2 27.6 28.1 6.50 5.12 3.95 Sunny Optical 2382 HK 4.3 Not rated 588 0.4 0.5 0.6 10.5 8.3 6.8 65.4 27.3 22.6 17.9 19.8 20.9 1.74 1.52 1.30 Hosiden 6804 JP 435.0 Not rated 437 2.7 19.6 19.5 160.3 22.2 22.3 -105.7 n.m. -0.3 0.2 1.6 1.7 0.32 0.32 0.32 SEMCO 009150 KS 96,300.0 Not rated 6,334 5,628.5 6,375.4 6,941.1 17.1 15.1 13.9 63.2 13.3 8.9 11.3 11.5 11.5 1.89 1.70 1.53 BYD Elec. 0285 HK 1.7 Not rated 485 0.3 0.3 0.3 5.1 5.0 4.9 -24.7 1.2 3.6 6.5 6.1 6.2 0.36 0.34 0.32 NDK 6779 JP 839.0 Not rated 239 100.1 120.1 113.8 8.4 7.0 7.4 n.a. 19.9 -5.2 7.2 9.0 7.8 0.59 0.54 0.51 KDS 6962 JP 217.0 Not rated 130 12.0 18.2 21.7 18.0 11.9 10.0 -186.5 51.2 19.3 1.2 2.3 n.a. 0.32 0.31 n.a. Rakon RAK NZ 0.5 Not rated 72 0.0 0.0 0.1 41.8 11.2 7.0 57.1 n.m. 61.1 1.3 4.1 5.7 0.46 0.45 0.42 Average 27.1 14.3 11.7 10.2 11.6 12.6 1.7 1.4 1.3 Source: Bloomberg, *Daiwa forecasts

Improving EPS-growth profile with strong cash flow We expect Catcher’s EPS to resume on its growth track in 2013 and 2014 (an average of 10% YoY growth for 2013-14), following the negative growth in 2012 (mainly due to its key handset clients HTC/RIM/Sony losing market shares). Looking forward, we expect the sales growth from new tablet PC and notebook PC casings business (60-65% of Catcher sales) will be greater than the continued weakness from its handset business (30% of Catcher’s sales).

Catcher: improving EPS growth profile

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Strong cash flow and good earnings quality

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Catcher: stable cash dividend and payout ratio

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EPS sensitivity analysis Changes in ASPs and gross margins are two key variables that would affect our earnings forecasts for Catcher. In the following table, we conduct a sensitivity analysis on how changes in these assumptions would impact our 2013E EPS.

EPS sensitivity: impact of ASP and gross-margin changes on EPS EPS 2013E % change in ASP assumption -12.0% -9.0% -6.0% -3.0% 0.0% 3.0% 6.0% 9.0% 12.0%

Gros

s mar

gin

38.5% 11.1 11.6 12.0 12.5 13.0 13.5 13.9 14.4 14.9 39.5% 11.5 12.0 12.5 12.9 13.4 13.9 14.4 14.9 15.4 40.5% 11.9 12.4 12.9 13.4 13.9 14.4 14.9 15.4 15.9 41.5% 12.3 12.8 13.3 13.8 14.3 14.8 15.3 15.8 16.4 42.5% 12.7 13.2 13.7 14.2 14.8 15.3 15.8 16.3 16.9 43.5% 13.0 13.6 14.1 14.7 15.2 15.7 16.3 16.8 17.4 44.5% 13.4 14.0 14.5 15.1 15.6 16.2 16.7 17.3 17.8 45.5% 13.8 14.4 15.0 15.5 16.1 16.6 17.2 17.8 18.3 46.5% 14.2 14.8 15.4 15.9 16.5 17.1 17.7 18.3 18.8


Note: The column and row in blue represent the base-case scenario in our earnings model. Note 2: Other assumptions: 1) 70% of opex is fixed and 30% is variable (in proportion to sales growth or decline), 2) non-op gain/loss (interest income/expense, forex gain/loss, etc) and tax rate are held unchanged in the sensitivity analysis

Investment risks In our view, the key downside risks to our target price and rating would include: 1) non-Apple clients switching casing designs from light-metal back to plastics, due to cost concerns, 2) increased price competition from low-cost competitors, and 3) US Dollar depreciation in the long term.



What's new We are positive on Hon Hai. In our view, its top-line growth is secured by strong demand for i-devices, and we think the operating margin is set to trend up. This report marks the transfer of analyst coverage.

What's the impact i do everything, and never lost it: Hon Hai makes iPhones, iPads (iPad minis), iPod Nanos, AppleTVs, iMacs and a number of peripherals for Apple. For 2H12, we forecast Apple to account for 45-50% of Hon Hai’s sales. Hon Hai has been making these i-devices since the first generation (except iMac), and so far has not lost any orders when new generations were introduced. Margin expansion: Hon Hai’s gross and operating margins have been trending down over the past decade. But we think the operating margin will bottom out in 2012. First, its key clients have stopped (or slowed down) cutting prices, and

second, we note that the benefits of production-site reallocation (to inland China) have started to emerge. Moving inland cannot reverse the rising labour cost trend, but could smooth out the negative impact, as wage levels in inland areas are 20-25% lower than those in coastal areas in China. Last, Hon Hai’s increased investment in components and process automation has also helped it save costs and streamline production. Direct investment in Sharp is not the only way: in our view, the investment in Sharp might not necessarily go through, due to the cultural gap between the two companies (CEO Terry Guo’s style is very different from that of Sharp’s top management). In our view, it would be better for both to maintain the current status (as strategic partners). Know-how, mindset and core competencies of an EMS and a brand company are at opposite ends of the spectrum.

What we recommend Following our transfer of coverage, we are lowering our 2012-14 EPS forecasts. We reiterate our Buy (1) rating and are raising our six-month target price from NT$105 (13x 2012E PER) to NT$120 (13x 2013E PER); the 13x PER is in line with the stock’s past-3-year trading average.

How we differ Unlike the consensus, we think margin expansion matters more than top-line growth, and that keeping the current status would be the best outcome for Hon Hai and Sharp. Forecast revisions (%) Year to 31 Dec 12E 13E 14E Revenue change (4.8) (5.5) (5.6) Net-profit change (5.7) (6.4) (6.2) EPS change (14.6) (15.5) (15.3) Source: Daiwa forecasts


90

110

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73

86

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112

Oct-11 Jan-12 Apr-12 Jul-12 Oct-12Hon Hai Precision Industry (LHS)Relative to TWSE (RHS)

(NT$) (%)

12-month range 64.55-105.45 Market cap (US$bn) 35.85 Average daily turnover (US$m) 115.12 Shares outstanding (m) 11,836 Major shareholder Kuo T'ai Ming (12.5%) Financial summary (NT$) Year to 31 Dec 12E 13E 14E Revenue (m) 4,108,714 4,693,354 5,046,370 Operating profit (m) 95,319 129,606 146,901 Net profit (m) 81,376 109,009 124,562 Core EPS 6.903 9.210 10.524 EPS change (%) (0.9) 33.4 14.3 Daiwa vs Cons. EPS (%) -3.99 5.02 4.52 PER (x) 12.8 9.6 8.4 Dividend yield (%) 2.0 2.6 3.0 DPS 1.733 2.302 2.631 PBR (x) 1.6 1.4 1.2 EV/EBITDA (x) 6.6 5.0 4.1 ROE (%) 13.2 15.6 15.7 Source: Bloomberg, Daiwa forecasts


10 October 2012

Hon Hai Precision Industry 2317 TT


i do everything…

• Has considerable sales exposure (40%+) to high-flying Apple i-devices

• The even bigger story is that Hon Hai looks set to enter a multi-year margin expansion cycle

• Reiterate Buy rating; target price revised up to NT$120



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Growth outlook Hon Hai: set to rekindle EPS growth over the next few years

After remaining largely stagnant from 2010 to 2012, we expect Hon Hai’s EPS to rise again in 2013 and 2014, with ROE improving to a mid-teen percentage from the current low-teen percentage level. The top-line driver has mainly been iPhone, iPad and iMac orders from Apple. If Apple were to launch its long-anticipated iTV (the TV set) in 2013, we would see further upside to our current assumptions. We also expect the gross margin to stabilise and operating margin to recover slightly, owing to better operating scale.

(20% )

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60%

2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

ROE Sales growth EPS growth


Valuation Hon Hai: forward PER bands

Following our transfer of coverage, our six-month target price rises to NT$120, which is based on 13x 2013E PER (versus the previous NT$105, a 13x 2012E EPS). The 13x forward PER is in line with the stock’s past-3-year trading average. We believe a PER methodology is a more appropriate way to evaluate downstream tech companies such as Hon Hai. We recognise flaws with a PER methodology, such as a lack of insight into the long-term business outlook, a mismatch between earnings/cash flow, etc. But we think it is a more straightforward, intuitive and arguably accurate way to predict a tech company’s earnings power, at least in the near term.

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(NT$)



Earnings revisions Hon Hai: consensus earnings revisions (NT$)

We introduce our new 2012/2013/2014 EPS forecasts of NT$6.9/NT$9.2/NT$10.5, which are 14.6%/15.5%/ 15.3%, respectively, lower than our previous forecasts, due mainly to the share-base adjustment post the stock dividend on 10 August 2012. Our new net-profit forecasts are around 6% lower than the previous ones, as we revise down our revenue assumptions for non-Apple businesses. Aside from the Apple business, we forecast PC, networking, consumer electronics (MP3, DSC, LCD TV, etc) to account for 20-25%, 14-16% and 4-5% of Hon Hai’s sales in 2012, respectively. Key clients include Dell, HP, Acer, Sony and Cisco. The PC, networking, consumer electronics products are legacy products that might face stiff demand outlook in coming years.

02468

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Consensus: 2013 EPS

2317 TT

Source: Bloomberg




- 85 -

Key assumptionsYear to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Consumer related sales growth (YoY%) 91.8 31.1 5.3 29.6 3.2 13.4 18.8 18.9

PC and networking related sales growth (YoY%) 26.5 9.4 (7.2) 44.8 (5.4) (13.2) 0.4 (2.7)

iPhone shipment (mn units) 4 14 25 47 80 117 145 154 iPad shipment (mn units) 0 0 0 14 40 69 96 114

Profit and loss (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E PC/NB/networking 940,759 1,041,906 1,009,676 1,521,104 1,531,057 1,456,231 1,457,399 1,415,009 Consumer electronics 273,000 357,896 376,979 488,451 504,076 571,541 679,170 807,574 Others 488,904 550,680 572,527 987,650 1,417,548 2,080,942 2,556,785 2,823,787 Total revenue 1,702,663 1,950,481 1,959,182 2,997,205 3,452,681 4,108,714 4,693,354 5,046,370 Other income 0 0 0 0 0 0 0 0 COGS (1,535,140) (1,782,377) (1,772,629) (2,753,003) (3,186,299) (3,797,688) (4,326,734) (4,647,150) SG&A (58,718) (73,837) (76,982) (119,265) (142,691) (140,210) (154,059) (164,007) Other op. expenses (15,341) (23,660) (26,082) (38,791) (40,847) (75,498) (82,955) (88,311) Operating profit 93,464 70,607 83,489 86,146 82,845 95,319 129,606 146,901 Net-interest inc./(exp.) (2,754) (1,964) (435) 492 2,721 653 2,735 3,466 Assoc/forex/extraord./others 10,427 3,951 4,977 4,839 16,970 2,929 3,202 4,368 Pre-tax profit 101,137 72,594 88,031 91,477 102,536 98,900 135,543 154,735 Tax (16,449) (15,904) (11,651) (16,005) (20,602) (20,769) (27,109) (30,173) Min. int./pref. div./others (6,999) (1,557) (695) 1,682 (344) 3,245 575 0 Net profit (reported) 77,690 55,133 75,685 77,155 81,591 81,376 109,009 124,562 Net profit (adjusted) 77,690 55,133 75,685 77,155 81,591 81,376 109,009 124,562 EPS (reported) (NT$) 7.000 4.869 6.539 6.632 6.967 6.903 9.210 10.524 EPS (adjusted) (NT$) 7.000 4.869 6.539 6.632 6.967 6.903 9.210 10.524 EPS (adjusted fully-diluted) (NT$) 7.000 4.869 6.539 6.632 6.967 6.903 9.210 10.524 DPS (NT$) 1.700 0.720 1.482 0.830 1.369 1.733 2.302 2.631 EBIT 93,464 70,607 83,489 86,146 82,845 95,319 129,606 146,901 EBITDA 119,632 103,343 121,888 127,276 134,301 153,515 193,574 217,796

Cash flow (NT$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 94,139 71,037 87,336 93,159 102,193 102,145 136,118 154,735 Depreciation and amortisation 26,168 32,736 38,399 41,131 51,456 58,196 63,968 70,894 Tax paid (16,449) (15,904) (11,651) (16,005) (20,602) (20,769) (27,109) (30,173) Change in working capital (3,150) (19,401) (17,186) (37,014) (64,472) 12,423 (33,630) (19,438) Other operational CF items (3,856) (1,967) (2,999) (3,234) (2,723) (874) (877) (1,772) Cash flow from operations 96,851 66,501 93,899 78,038 65,852 151,122 138,470 174,246 Capex (91,835) (79,568) (13,618) (74,394) (128,885) (48,100) (57,720) (54,834) Net (acquisitions)/disposals (24,003) 30,767 (17,095) (52,600) 64,657 (240) (29,990) (13,990) Other investing CF items (12,348) (14,433) (7,186) (4,517) (15,164) (843) (860) (877) Cash flow from investing (128,185) (63,234) (37,899) (131,511) (79,392) (49,183) (88,570) (69,701) Change in debt 77,026 (4,398) 20,152 166,043 73,134 21,614 22,694 23,829 Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid (15,504) (18,872) (8,156) (17,158) (9,661) (16,034) (20,426) (27,252) Other financing CF items 25,346 (25,785) 11,160 (19,259) 25,309 11,470 0 0 Cash flow from financing 86,867 (49,055) 23,155 129,626 88,782 17,050 2,269 (3,423) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 55,533 (45,789) 79,155 76,153 75,242 118,989 52,169 101,122 Free cash flow 5,016 (13,067) 80,281 3,644 (63,033) 103,022 80,750 119,412 Source: Company, Daiwa forecasts

Financial summary


- 86 -

Balance sheet (NT$m) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 145,776 99,988 179,143 255,296 330,538 449,527 501,696 602,818 Inventory 158,403 166,725 180,980 259,384 380,522 379,769 432,673 464,715 Accounts receivable 257,314 267,349 307,606 409,819 476,050 562,838 642,925 691,284 Other current assets 18,397 24,688 31,846 40,049 96,558 73,370 85,334 91,752 Total current assets 579,891 558,749 699,574 964,548 1,283,668 1,465,503 1,662,629 1,850,569 Fixed assets 202,375 253,931 234,618 272,150 355,373 345,278 339,030 322,970 Goodwill & intangibles 0 0 0 0 0 0 0 0 Other non-current assets 85,032 65,940 87,753 143,835 91,270 93,227 124,954 141,592 Total assets 867,297 878,621 1,021,945 1,380,532 1,730,311 1,904,008 2,126,612 2,315,131 Short-term debt 104,645 77,582 86,245 230,455 271,512 292,943 307,590 313,998 Accounts payable 273,990 266,104 300,530 427,153 548,494 624,278 711,244 763,915 Other current liabilities 65,271 78,403 88,462 113,644 171,710 171,196 195,556 210,265 Total current liabilities 443,906 422,089 475,236 771,252 991,716 1,088,417 1,214,391 1,288,179 Long-term debt 28,792 50,628 62,649 87,955 115,979 113,922 119,618 134,571 Other non-current liabilities 43,908 44,737 44,205 40,732 44,785 47,024 49,375 51,844 Total liabilities 516,606 517,454 582,090 899,939 1,152,480 1,249,363 1,383,384 1,474,594 Share capital 62,908 74,146 85,789 96,612 106,891 118,361 118,361 118,361 Reserves/R.E./others 287,783 287,021 354,066 383,980 470,941 536,283 624,867 722,176 Shareholders' equity 350,691 361,167 439,855 480,593 577,832 654,644 743,228 840,537 Minority interests 0 0 0 0 0 0 0 0 Total equity & liabilities 867,297 878,621 1,021,945 1,380,532 1,730,311 1,904,008 2,126,612 2,315,131

EV 981,300 1,050,331 999,044 1,098,747 1,099,202 1,007,200 975,374 895,613 Net debt/(cash) (12,339) 28,222 (30,249) 63,114 56,953 (42,662) (74,488) (154,249) BVPS (NT$) 31.305 31.343 37.905 41.162 49.176 55.309 62.793 71.015

Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 29.0 14.6 0.4 53.0 15.2 19.0 14.2 7.5 EBITDA (YoY) 28.7 (13.6) 17.9 4.4 5.5 14.3 26.1 12.5 Operating profit (YoY) 24.0 (24.5) 18.2 3.2 (3.8) 15.1 36.0 13.3 Net profit (YoY) 29.8 (29.0) 37.3 1.9 5.8 (0.3) 34.0 14.3 EPS (YoY) 27.7 (30.5) 34.3 1.4 5.1 (0.9) 33.4 14.3 Gross-profit margin 9.8 8.6 9.5 8.1 7.7 7.6 7.8 7.9 EBITDA margin 7.0 5.3 6.2 4.2 3.9 3.7 4.1 4.3 Operating-profit margin 5.5 3.6 4.3 2.9 2.4 2.3 2.8 2.9 ROAE 25.3 15.5 18.9 16.8 15.4 13.2 15.6 15.7 ROAA 10.4 6.3 8.0 6.4 5.2 4.5 5.4 5.6 ROCE 22.9 14.5 15.5 12.4 9.4 9.4 11.6 11.9 ROIC 27.0 15.2 18.1 14.9 11.2 12.1 16.2 17.5 Net debt to equity net cash 7.8 net cash 13.1 9.9 net cash net cash net cash Effective tax rate 16.3 21.9 13.2 17.5 20.1 21.0 20.0 19.5 Accounts receivable (days) 51.2 49.1 53.6 43.7 46.8 46.1 46.9 48.3 Payables (days) 51.7 50.5 52.8 44.3 51.6 52.1 51.9 53.3 Net interest cover (x) 33.9 36.0 191.7 n.a. n.a. n.a. n.a. n.a. Net dividend payout 24.3 14.8 22.7 12.5 19.7 25.1 25.0 25.0 Source: Company, Daiwa forecasts

Company profile Established in 1974, Hon Hai Precision Industry (Hon Hai) started out making plastic products, connector products and cable assemblies. It is now the largest electronics manufacturing service (EMS) provider globally in terms of design, manufacturing, global logistics and after-market service.



- 87 -

i do everything

The story is more than a wide range of i-devices: we expect Hon Hai’s operating margin to bottom out in the long term

Right client, right product

A long (and positive) history with Apple Hon Hai has been Apple’s key EMS partner since the early 2000s (the launch of the iMac G4 in 2002). Over the past decade, Hon Hai has continued to win more projects from Apple, including the iPod-Mini in 2004, iPod Nano in 2005, Apple TV (the set-box box for TV) in 2006 and iPhone in 2007, and iPad in 2010. According to our industry checks, Hon Hai will also make Apple’s new compact-size iPad (iPad-Mini, hereafter). Hon Hai: sales breakdown (time series)

0%10%20%30%40%50%60%70%80%90%

100%

2006 2007 2008 2009 2010 2011 2012E 2013E

DT PC and components Consumer ElectronicsNetworking Handset (FIH)iPhone iPadNB PC Enterprise and Others


Hon Hai: sales breakdown (2012E)

DT PC and components

19%

Consumer Electronics

14%

Networking5%

Handset (FIH)4%iPhone

25%

iPad21%

NB PC7%

Enterprise and Others

5%


When Hon Hai gets it, it never loses it We also note that as long as Hon Hai has won the first generation project, it has never lost orders for following generations. For example, Hon Hai has been making the iPhone from gen 1 (original iPhone) to gen 6 (iPhone 5). We attribute Hon Hai’s capability to lock up clients to the following factors:

• Superior cost structure: We think Hon Hai has the best production scale and vertical integration capability (components, modules, system, logistics and after sales service) among all its global EMS peers.

• Production flexibility and time-to-mass production: Hon Hai can ramp up production of a new product (say the iPhone 5) from a few thousand units to 10m units within 2 months.

• Terry Guo, a person with strong execution: Any good business model without strong execution is just empty talk, in our view. Hon Hai group Chairman/CEO Terry Guo is a down-to-earth person with strong execution skills. We also think his aggressiveness, hands-on management, client-oriented mindset, and hard-working style is a good fit with the EMS business. As long as he takes control, the group’s execution capability won’t fade away, in our view.

Bright outlook for i-devices We estimate Apple will account for 45-50% of Hon Hai’s revenue in 2H12, thanks to the launch of the new iPhone 5 and the scheduled launch of the new iPad (iPad mini). We expect Apple’s sales contribution to keep trending up over the next few years, as shipments of Apple i-devices are set to grow faster than those of any other IT or consumer electronic products. We forecast shipments of iPhones, iPads and iMacs to increase from 140m, 70m, and 16m in 2012 to 200m,


- 88 -

100m, and 19m, respectively, in 2013. We forecast Hon Hai group to account for 75-80%, 80-85% and 100% of iPhone, iPad and iMac production for 2013. In addition, if Apple were to launch iTV (the TV set), we believe Hon Hai would be the most likely partner to win this project, considering its comprehensive component portfolio (to help saving costs) and strategic partnership with Sharp (to ensure sufficient supply of high-quality large-size LCD modules).

Margin expansion

Looking at the past decade, Hon Hai’s gross margin and operation margin have been on a down trend. However, we expect the operating margin to bottom out in 2012. First, its key clients have stopped (or slowed down) cutting prices, and second, we note that the benefits of production site reallocation (to inland China) have started to emerge. Last, the recent investments in key components and process automation are the right formula for margin enhancement, in our view. Hon Hai: operating margin could bottom in 2012

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20

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

E

2013

E

2014

E

Gross margin Op. margin

(% )


ASPs (or MVAs in the EMS business) have stopped falling For Hon Hai’s EMS/ODM businesses, we note most key clients stopped cutting prices in the recent round of negotiations. Hon Hai has even been able to raise the manufacturing value added (MVA) slightly in some cases. For example, the MVA for the iPad and iPhone were slightly raised in early 2Q12. ASP declines have been the norm for the EMS industry. We wouldn’t argue that the price hike will continue for the long run. However, we have seen ASP pressure easing in recent quarters, as we believe clients understand that EMS/ODM companies are facing hard

times in China (labour cost hikes, stricter pollution regulations, utility cost increases, etc). In a stable ASP environment, we believe Hon Hai, as the world’s largest EMS firm, is likely to improve its operating margins through continued cost-cutting efforts and yield rate improvements. Moving inland to lower average labour costs and win tax incentives Hon Hai has almost completed its multi-year production relocation plan (moving its production capacities from coastal China to inland China). Our industry checks indicate that Hon Hai’s Zhengzhou and Chengdu industrial parks (two major inland China sites for the iPhone and iPad, respectively), which have gradually ramped up since early 2011, are now operating at full capacity with high production yields. Currently, Hon Hai is expanding capacity at these two sites to accommodate the future demand for its key clients. We estimate the company’s inland China sites account for around one-third of Hon Hai’s total production output now, up from less than 20% a year ago. Hon Hai cannot escape the rising labour costs across the country by relocating into inland China. However, doing so could smooth out the negative impact, as labour costs in inland China remain 20-25% lower than those in southern coastal cities. In addition, this relocation comes with a side-benefit: Hon Hai can receive new tax incentive programmes, offered by local governments. We forecast the group’s tax rate to decline from the 21% level in 2012 to 19.5% by 2014. Refocusing on components and automation For a long time, Hon Hai had a ‘market share first’ mindset – seeking endless top-line growth by expanding into high-competition and low-margin businesses (such as notebook PC ODM) and acquiring overseas factories of competitors and/or clients. In recent quarters, we have started to see Hon Hai changing its mindset from ‘market share first’ to ‘profitability first’. We welcome this change. What we mean is that Hon Hai is refocusing on its core strength – components and process automation. In our view, this is the right way to go in the long run. A few examples as below:

• Hon Hai recently gave up some low-value-added notebook PC and LCD TV orders (such as Dell projects).


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• Hon Hai has increased capex in key components, such as camera lenses (via subsidiary Sang-Ying), touch panels (consolidating the touch panel divisions under different subsidiaries into a new entity, named GIS), and light metal casings (increasing CNC machines and surface treatment equipment in itself and its affiliate Foxconn Tech).

• Hon Hai announced in October 2011 that it would spend NT$10bn to build a new R&D and production site in central Taiwan, which will concentrate on automated machinery, robotic arms, and servo-mechanism (control) systems. This project is mainly to fulfil Hon Hai group’s internal demand for automated production lines before selling products to external buyers in the long term.

Valuation and EPS sensitivity

Reiterate Buy Following our transfer of coverage, we are lowering our 2012/2013/2014 EPS forecasts to NT$6.9/NT$9.2/ NT$10.5, respectively. We believe margin expansion will rekindle Hon Hai’s EPS growth over the next few years. We set our new six-month target price at NT$120, which is based on a 13x 2013E PER (versus NT$105 previously, a 13x 2012E EPS). The 13x forward PER is in line with the average of its past-3-year trading range.

Hon Hai: forward PER bands

0

50

100

150

200

Jan-0

3Ju

l-03

Jan-0

4Ju

l-04

Jan-0

5Ju

l-05

Jan-0

6Ju

l-06

Jan-0

7Ju

l-07

Jan-0

8Ju

l-08

Jan-0

9Ju

l-09

Jan-1

0Ju

l-10

Jan-1

1Ju

l-11

Jan-1

2Ju

l-12

(NT$)


Source: Daiwa

Hon Hai: PBR bands

0

50

100

150

200Ja

n-03

Jul-0

3Ja

n-04

Jul-0

4Ja

n-05

Jul-0

5Ja

n-06

Jul-0

6Ja

n-07

Jul-0

7Ja

n-08

Jul-0

8Ja

n-09

Jul-0

9Ja

n-10

Jul-1

0Ja

n-11

Jul-1

1Ja

n-12

Jul-1

2

(NT$)


Source: Daiwa

Valuation table – EMS/ODM companies Price (lc) Daiwa Mkt cap EPS (lc) PER (x) EPS growth (%) ROE (%) PBR (x) Company Ticker 10/8/2012 Rating (US$ m) 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E Local peers Hon Hai* 2317 TT 88.7 Buy 35,850 6.9 9.2 10.5 13 10 8 -0.9 33.4 14.3 13.2 15.6 15.7 1.6 1.4 1.2 Pegatron* 4938 TT 38.4 Buy 2,954 2.3 3.7 5.8 17 10 7 n.m. 62.5 57.5 5.2 7.7 12.0 0.8 0.8 0.8 Quanta* 2382 TT 73.8 Hold 9,714 5.9 6.7 6.8 13 11 11 -3.4 13.3 1.7 18.3 18.7 17.5 2.2 2.0 1.8 Compal* 2324 TT 23.4 Hold 3,524 2.3 2.8 2.7 10 8 9 -7.7 23.0 -3.8 9.1 10.3 9.4 0.9 0.8 0.8 Wistron* 3231 TT 32.6 Hold 2,446 4.5 5.7 6.1 7 6 5 2.7 27.9 6.8 14.5 16.9 16.4 1.0 0.9 0.8 Global peers Flectronics FLEX US 6.0 Not rated 4066 1.0 1.1 1.3 6.2 5.3 4.7 0.2 0.2 0.1 25.0 23.0 19.4 1.51 1.20 0.98 Jabil Circuit JBL US 18.1 Not rated 3709 2.6 2.9 3.2 7.1 6.1 5.6 0.0 0.1 0.1 19.3 18.5 n.a. 1.51 1.26 1.01 BYD Elec. 0285 HK 1.7 Not rated 485 0.3 0.3 0.3 5.1 5.0 4.9 -0.2 0.0 0.0 6.5 6.1 6.2 0.36 0.34 0.32 Source: Bloomberg, *Daiwa forecasts


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Improving cash flow and earnings quality Thanks to its improving profitability and lower capex requirements, Hon Hai group’s free cash flow looks set to increase substantially over 2012-14E (compared to 2010-11). We believe Hon Hai’s net capex should be well contained in the NT$50-60bn level (versus NT$60-130bn in 2007-2011, except 2009). Hon Hai has completed the majority of its production site relocation and expansion plan. As such, the capex/sales ratio should decline over the next few years, on our estimates. Hon Hai: FCF per share vs. EPS – improving earnings quality

(6)(4)(2)

02468

1012

2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

EPS FCF per share

(NT$)


Hon Hai: dividend per share set to increase

0%

5%

10%

15%

20%

25%

30%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

DPS (LHS) Cash div payout ratio (RHS)

(NT$)


EPS sensitivity analysis Changes in ASPs and gross margins are two key variables that would affect our earnings forecasts for Hon Hai. We therefore conducted a sensitivity analysis to see how such changes would impact 2013E EPS (see following table). Due to the low-margin nature of the business, our analysis shows that Hon Hai’s EPS sensitivity to its gross margin is high. We calculate that a minor gross margin decline of 0.5pp (from our base-case assumption) would result in a 17% decline in 2013E EPS.

EPS sensitivity – ASP and gross margin change on EPS EPS (NT$) 2013E % change of ASP Assumption -12.0% -9.0% -6.0% -3.0% 0.0% 3.0% 6.0% 9.0% 12.0%

Gros

s mar

gin

5.8% 1.2 1.6 2.0 2.4 2.8 3.2 3.6 4.0 4.5 6.3% 2.6 3.0 3.5 3.9 4.4 4.9 5.3 5.8 6.2 6.8% 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 7.3% 5.4 5.9 6.5 7.0 7.6 8.1 8.7 9.2 9.8 7.8% 6.8 7.4 8.0 8.6 9.2 9.8 10.4 11.0 11.6 8.3% 8.2 8.8 9.5 10.1 10.7 11.4 12.0 12.7 13.3 8.8% 9.6 10.3 10.9 11.6 12.3 13.0 13.7 14.4 15.1 9.3% 11.0 11.7 12.4 13.2 13.9 14.7 15.4 16.1 16.9 9.8% 12.3 13.1 13.9 14.7 15.5 16.3 17.1 17.9 18.7



Investment risks The key downside risks we see would include: 1) higher-than-expected increases in labour/raw-material costs in coming years, 2) widening losses from overseas factories (acquired from Hon Hai’s clients in prior years), and 3) NT Dollar appreciation against the US Dollar in the long term. Another risk would be output delays due to strikes in China and/or other interruptions.


Birdy Lu (886) 2 8758 6248 [email protected] Eric Chen (852) 2773 8702 [email protected]

What's new Our industry research indicates that FIH, the world’s largest EMS company by revenue, is likely to start making the iPhone soon, which we believe could help boost its revenue growth to more than 30% YoY for 2013.

What's the impact A fallen king … FIH has a diversified client base and was very profitable (6-7% operating-profit margin and 30-40% ROE) until Apple introduced the first iPhone (made by Hon Hai, FIH’s parent company) in 2007. The iPhone soon took off worldwide, quickly gaining market share from FIH’s key clients (Nokia, Motorola and Sony). The rise of Samsung (SEC) and LG did not help FIH either, as both companies purchase only a few parts from FIH and make most components in-house.

… iPhone should come to the rescue. Our industry research indicates that FIH is likely to start producing iPhones in late 2012 or early 2013. In view of the iPhone’s very strong growth, we believe Apple needs to diversify its EMS partners. We assume that FIH will make 7m iPhones (about a 4% share of total production) in 2013, which should help increase FIH’s 2013 revenue by more than 30% YoY. Tablets and Amazon: FIH makes tablet PCs for tier-2 brands and recently secured a tier-1 project, the Amazon Kindle Fire HD (8.9”). Driven by this, we forecast its tablet-PC sales contribution to surge from sub-3% in 1H12 to 12-14% in 2013. Core competencies intact: FIH shares the same DNA with Hon Hai, featuring a vertically integrated business model that achieves better cost savings for FIH, providing total client solutions. Also, FIH has the strongest balance sheet among its EMS peers globally, with a net cash position.

What we recommend We initiate coverage of FIH with a Buy (1) rating. We believe new tablet orders could offset its weak Nokia/ Motorola EMS business, and forecast iPhone orders to drive its 2013 top-line growth to more than 30% YoY.

Our six-month target price of HK$3.80 is based on a 1x PBR applied to our 2013E BVPS. We see BVPS as a good proxy for FIH’s intrinsic value, as it has a clean balance sheet with net cash of US$1.5bn and no invisible assets (goodwill).

How we differ We are the first house to call the bottom for FIH at its latest share price. Share price performance

4070100130160

2.03.14.25.36.4

Oct-11 Jan-12 Apr-12 Jul-12 Oct-12Foxconn International Holdings (LHS)Relative to HSI (RHS)

(HK$) (%)

12-month range 2.27-5.91 Market cap (US$bn) 2.50 Average daily turnover (US$m) 2.60 Shares outstanding (m) 7,212 Major shareholder Hon Hai Precision (69.5%)

Financial summary (US$) Year to 31 Dec 12E 13E 14E Revenue (m) 5,124 7,078 8,461 Operating profit (m) (268) 19 124 Net profit (m) (191) 17 92 Core EPS (0.026) 0.002 0.013 EPS change (%) n.a. n.a. 430.2 Daiwa vs Cons. EPS (%) -36.8 0 333 PER (x) n.a. 145.0 27.3 Dividend yield (%) 0.0 0.0 0.0 DPS 0.000 0.000 0.000 PBR (x) 0.7 0.7 0.7 EV/EBITDA (x) n.m. 4.4 3.0 ROE (%) n.a. 0.5 2.6 Source: Bloomberg, Daiwa forecasts

Electronics / China

10 October 2012

Foxconn International Holdings 2038 HK | FXCNY US

Target price: HK$3.80 Up/downside: +41.3% Share price (8 Oct): HK$2.69

Initiation: should soon obtain the last missing piece

• FIH has put on a lacklustre performance for years, as Apple has gained market share at the expense of its captive accounts

• FIH’s client list covers almost all the global handset OEMs but Apple; our research indicates it is likely to get iPhone orders soon

• We initiate coverage with a Buy rating and target price of HK$3.80



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Growth outlook FIH: back on a growth track for 2013E and 2014E

FIH is gaining new tablet orders, which we believe can offset its weak EMS business from Nokia and Motorola, and that assuming it secures orders to make the iPhone, this could boost its top-line growth to more than 30% YoY YoY for 2013. In addition, we forecast a recovery in FIH’s gross and operating-profit margins in 2013, due to rising capacity utilisation, along with production scale and operating leverage. As such, after five consecutive loss-making years, we believe FIH can return to profits once more in 2013.

7.3

2.5 1.8

(0.8)

2.2

(5.2)

0.3 1.5

-9.0-6.0-3.00.03.06.09.012.015.0

(6.0)(4.0)(2.0)0.0 2.0 4.0 6.0 8.0

10.0

2007 2008 2009 2010 2011 2012e 2013e 2014e

Sales, US$bn (RHS) Gross margin, % (LHS)Operating margin, % (LHS)


Valuation FIH: 12-month forward PBR bands

We set our six-month target price at HK$3.80, based on a target PBR of 1x (representing its past-3-year average) applied to our 2013E BVPS. Whereas we typically use PERs to value profitable tech hardware companies, FIH is just in its early turnaround stage, so we think a PER methodology is not applicable. We believe BVPS is a good proxy for the company’s intrinsic value, as FIH has a clean balance sheet with net cash of US$1.5bn currently and no invisible assets (goodwill). Also, it has written down most of its idle assets aggressively over the past two years.

(5)

0

5

10

15

20

25

Sep-0

7

Mar-0

8

Sep-0

8

Mar-0

9

Sep-0

9

Mar-1

0

Sep-1

0

Mar-1

1

Sep-1

1

Mar-1

2

Sep-1

2

(HK$)

Share price 1x 2x 3x 4x Source: Bloomberg, Daiwa

Earnings revisions FIH: consensus 2012E EPS revisions

Based on the Bloomberg-consensus 2013 EPS forecasts, the earnings revisions cycle for FIH seems to have reached the bottom in August this year and stabilised over the past two months. With the company’s tablet PC orders surging in 4Q12 (and probably into 2013 as well), and its likely addition of Apple as a new customer as potential earnings catalysts, we believe the consensus earnings forecast revisions are likely to trend up in the coming quarters.

(0.10)

0.00

0.10

0.20

0.30

0.40

May-0

9Ju

l-09

Sep-0

9No

v-09

Jan-1

0Ma

r-10

May-1

0Ju

l-10

Sep-1

0No

v-10

Jan-1

1Ma

r-11

May-1

1Ju

l-11

Sep-1

1No

v-11

Jan-1

2Ma

r-12

May-1

2Ju

l-12

Sep-1

2

Consensus: 2013 EPS (US$)

2038 HK

Source: Bloomberg




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Key assumptionsYear to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Average selling price (LC) 73 70 67 84 88 102 97 95 Handset shipment (m) 71.6 70.8 53.5 46.6 43.4 28.8 27.4 29.4 Global handset market (m units) 172.4 298.8 471.7 649.1 818.2 972.6

Profit and loss (US$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Handset assembly 5,224 4,966 3,600 3,937 3,833 2,935 2,662 2,790 Components 4,745 3,743 3,031 2,670 2,509 1,816 1,681 1,731 Others 763 562 582 20 12 374 2,736 3,940 Total revenue 10,732 9,271 7,214 6,626 6,354 5,124 7,078 8,461 Other income 0 0 0 0 0 0 0 0 COGS (9,748) (8,629) (6,785) (6,344) (6,016) (5,147) (6,764) (7,990) SG&A (249) (331) (264) (279) (275) (159) (192) (225) Other op. expenses (253) (381) (357) (384) (466) (86) (103) (121) Operating profit 482 (70) (192) (380) (402) (268) 19 124 Net-interest inc./(exp.) (31) (32) (5) (7) (12) (7) (7) (8) Assoc/forex/extraord./others 0 0 (53) (117) (1) 2 13 14 Pre-tax profit 451 (101) (249) (504) (415) (273) 25 131 Tax (30) (75) (32) (44) (55) 82 (7) (39) Min. int./pref. div./others (4) (1) (2) 1 (2) 0 0 0 Net profit (reported) 417 (178) (283) (546) (472) (191) 17 92 Net profit (adjusted) 417 (178) (283) (546) (472) (191) 17 92 EPS (reported) (US$) 0.059 (0.025) (0.040) (0.077) (0.065) (0.026) 0.002 0.013 EPS (adjusted) (US$) 0.059 (0.025) (0.040) (0.077) (0.065) (0.026) 0.002 0.013 EPS (adjusted fully-diluted) (US$) 0.059 (0.025) (0.040) (0.077) (0.065) (0.026) 0.002 0.013 DPS (US$) 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 EBIT 482 (70) (192) (380) (402) (268) 19 124 EBITDA 659 163 56 (129) (118) (20) 345 505

Cash flow (US$m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 447 (102) (251) (503) (417) (273) 25 131 Depreciation and amortisation 176 232 248 251 284 248 326 381 Tax paid (30) (75) (32) (44) (55) 82 (7) (39) Change in working capital 83 146 (272) (206) 133 197 (209) (116) Other operational CF items 304 300 322 327 539 0 0 0 Cash flow from operations 981 500 14 (174) 484 254 134 356 Capex (885) (592) (25) (151) (18) (460) (322) (338) Net (acquisitions)/disposals (912) (610) (21) (140) 18 (470) (334) (352) Other investing CF items (191) (36) 7 218 7 (55) 0 0 Cash flow from investing (1,103) (646) (14) 79 25 (525) (334) (352) Change in debt 879 (493) (105) 496 (392) 17 17 18 Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid 0 0 0 0 0 0 0 0 Other financing CF items 370 9 143 23 180 0 0 0 Cash flow from financing 1,249 (483) 38 519 (212) 17 17 18 Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 1,127 (630) 38 424 298 (254) (183) 21 Free cash flow 96 (93) (11) (325) 466 (206) (188) 17 Source: Company, Daiwa forecasts

Financial summary


- 94 -

Balance sheet (US$m) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 1,793 1,163 1,201 1,624 1,922 1,668 1,485 1,506 Inventory 856 843 716 748 608 572 752 888 Accounts receivable 2,063 1,115 1,413 1,648 1,412 1,123 1,551 1,855 Other current assets 0 0 161 0 63 51 71 85 Total current assets 4,712 3,120 3,491 4,020 4,005 3,415 3,859 4,333 Fixed assets 1,713 2,073 1,823 1,723 1,457 1,669 1,665 1,623 Goodwill & intangibles 0 0 0 0 0 0 0 0 Other non-current assets 219 272 287 59 21 86 98 113 Total assets 6,643 5,465 5,601 5,802 5,483 5,170 5,623 6,069 Short-term debt 978 478 363 862 483 498 513 528 Accounts payable 1,824 1,009 1,523 1,401 1,215 1,058 1,427 1,729 Other current liabilities 537 535 81 104 110 128 177 212 Total current liabilities 3,338 2,022 1,967 2,367 1,808 1,683 2,117 2,469 Long-term debt 0 0 0 0 0 0 0 0 Other non-current liabilities 43 50 61 57 45 47 49 52 Total liabilities 3,381 2,072 2,028 2,424 1,853 1,730 2,166 2,521 Share capital 282 282 284 287 289 289 289 289 Reserves/R.E./others 2,980 3,110 3,289 3,091 3,342 3,151 3,168 3,260 Shareholders' equity 3,262 3,392 3,573 3,378 3,631 3,440 3,457 3,549 Minority interests 0 0 0 0 0 0 0 0 Total equity & liabilities 6,643 5,465 5,601 5,802 5,483 5,170 5,623 6,069

EV 1,627 1,765 1,614 1,713 1,064 1,332 1,530 1,524 Net debt/(cash) (815) (685) (838) (762) (1,439) (1,171) (973) (978) BVPS (US$) 0.464 0.480 0.506 0.473 0.503 0.477 0.479 0.492

Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 3.4 (13.6) (22.2) (8.1) (4.1) (19.4) 38.1 19.5 EBITDA (YoY) (16.8) (75.3) (65.8) n.a. n.a. n.a. n.a. 46.4 Operating profit (YoY) (29.9) n.a. n.a. n.a. n.a. n.a. n.a. 557.6 Net profit (YoY) (31.1) n.a. n.a. n.a. n.a. n.a. n.a. 430.2 EPS (YoY) (31.9) n.a. n.a. n.a. n.a. n.a. n.a. 430.2 Gross-profit margin 9.2 6.9 5.9 4.3 5.3 (0.4) 4.4 5.6 EBITDA margin 6.1 1.8 0.8 n.a. n.a. n.a. 4.9 6.0 Operating-profit margin 4.5 n.a. n.a. n.a. n.a. n.a. 0.3 1.5 ROAE 15.4 n.a. n.a. n.a. n.a. n.a. 0.5 2.6 ROAA 7.6 n.a. n.a. n.a. n.a. n.a. 0.3 1.6 ROCE 14.7 n.a. n.a. n.a. n.a. n.a. 0.5 3.1 ROIC 22.0 n.a. n.a. n.a. n.a. n.a. 0.6 3.4 Net debt to equity net cash net cash net cash net cash net cash net cash net cash net cash Effective tax rate 6.7 n.a. n.a. n.a. n.a. n.a. 30.0 30.0 Accounts receivable (days) 67.0 62.5 63.9 84.3 87.9 90.3 69.0 73.5 Payables (days) 62.8 55.8 64.0 80.5 75.1 81.0 64.1 68.1 Net interest cover (x) 15.5 n.a. n.a. n.a. n.a. n.a. 2.5 15.8 Net dividend payout 0.0 n.a. n.a. n.a. n.a. n.a. 0.0 0.0 Source: Company, Daiwa forecasts

Company profile Foxconn International Holdings (FIH) was formerly the handset division of Hon Hai Precision Industry (Hon Hai), and was spun off as a 100%-owned subsidiary of Hon Hai in 2000. FIH has since grown its business aggressively, both organically and through M&A activities. FIH was listed on the Hong Kong Stock Exchange on 3 February 2005. Its key accounts include global handset OEMs, such as Nokia, Motorola and Sony Ericsson, etc.



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Fundamental turnaround likely ahead

We believe new tablet orders secured for Amazon and likely for the iPhone could help FIH return to profit in 2013

A fallen king ...

FIH is the world’s largest dedicated handset EMS company in terms of revenue, with a diversified client base, including Nokia, Motorola, Sony Ericsson (now Sony), SEC, LG Electronics, Huawei, etc. FIH used to be very profitable (generating a 6-7% operating-profit margin and a 30-40% ROE) prior to 2007. However, FIH’s margins and returns have since been underperforming the industry, as it missed out on iPhone business in the beginning. The iPhone’s arrival in June 2007 transformed the handset industry’s competitive landscape. Since then, Apple has been quickly gaining market share from FIH’s key clients, especially Nokia, Motorola and Sony. Our global handset ODM/EMS model suggests that including the iPhone, the industry’s revenue will grow at a CAGR of more than 30% in the period post the global financial crisis (2009-12). If we exclude the iPhone, however, the industry’s revenue has barely changed over this period. Global handset EMS/ODM revenue (including iPhone) enjoys

strong growth after financial crisis ...

(20%)

(10%)

0%

10%

20%

30%

40%

50%

0

10

20

30

40

50

60

2007 2008 2009 2010 2011

Global handset ODM/EMS sales (including iPhone), US$bn (LHS)

YoY growth (RHS)


... but this industry actually stood still, if we exclude the contribution from the iPhone

(25%)

(20%)

(15%)

(10%)

(5%)

0%

5%

10%

0

5

10

15

20

25

30

2007 2008 2009 2010 2011

Global handset ODM/EMS sales (excluding iPhone), US$bn (LHS)

YoY growth (RHS)


In addition, the rise of SEC and LG during this period has also been negative for FIH. Compared with Nokia, Motorola and Sony, Korean vendors purchase only a few components and parts from FIH, as they can make a wide range of semiconductor, display, passive and mechanical components in-house.

Handset revenues of major EMS/ODM companies

Company Stock code

Company sales (US$m)

Mobile device sales (US$m)

2009 2010 2011 2009 2010 2011 FIH 2038 HK 7,214 6,626 6,354 7,214 6,626 6,354 Hon Hai 2317 TT 59,369 95,241 117,477 4,750 13,334 23,495 Flextronics FLEX US 24,110 28,489 29,388 5,304 5,128 4,408 Jabil Circuit JBL US 11,685 13,409 16,518 2,337 2,145 1,817 BYD Electronic 0285 HK 1,639 2,460 2,456 1,639 2,460 2,456 Lite-On Mobile Private 598 740 949 598 740 949 Elcoteq ELQAV FH 2,096 1,419 1,206 943 568 362 Pegatron 4938 TT 16,305 16,858 20,413 0 1,686 3,470 Wistron 3231 TT 16,565 19,548 22,401 166 782 1,120 Compal Comm 8078 TT 753 458 624 753 458 624 Arima Comm 8101 TT 464 619 920 464 619 920 TCL Comm 2618 HK 559 1,120 1,369 559 1,120 1,369 LongCheer LHL SP 416 627 540 416 627 540 Total 141,772 187,614 220,615 25,142 36,292 47,885 Source: Companies, Daiwa

... iPhone to the rescue

FIH could start making the iPhone soon Since the first generation, all iPhones have been made by Hon Hai, FIH’s parent company. Apple added a second EMS partner, Pegatron, in early 2010, to make the CDMA-version of the iPhone 4 (for Verizon). As of today, Pegatron is still the second source for iPhone production and continues to make the iPhone 4S and iPhone 5. Our industry research suggests that FIH might start to make iPhones in late 2012 or early 2013. On the one hand, iPhone sales growth has been so phenomenal that Apple has needed to diversify its EMS partners. On


- 96 -

the other, facing the rapid rise in iPhone5 orders, Hon Hai can make the best use of the group’s resources, if it allocates some iPhone 5 production to FIH (which has low capacity utilisation currently), instead of expanding machinery, equipment and product lines at current sites. In our current model, we assume FIH will make 7m iPhones (about 4% of the total production of iPhones) in 2013, which we forecast would lead to FIH’s revenue increasing by more than 30% YoY for 2013. FIH: sales breakdown by product – iPhone to the rescue

0%

20%

40%

60%

80%

100%

1H10 2H10 1H11 2H11 1H12 2H12E 1H13E 2H13E 1H14E 2H14E

EMS handsets Components/Modules iPhone Tablet PC


Other catalysts: tablets, Amazon, and Huawei

Tablet PC sales finally on fire, thanks to Amazon FIH has won many projects and made tablet PCs for tier-2 or regional brands (ViewSonic, etc) since 2010. But the revenue contribution from this product line is minimal (at less than 3%). However, we expect FIH’s tablet PC sales contribution to surge to 12-14% in 2013, owing to Amazon’s decision to expand its Kindle Fire product lines. Since the beginning, Amazon has on two versions of the Kindle Fire with two EMS companies – 7” Kindle Fire with Quanta and 8.9” Kindle Fire with Hon Hai group. Amazon cancelled the 8.9” project when it debuted the first generation Kindle Fire last year, but it decided to go out and push both 7” and 8.9” product lines this year. Huawei and other China handset vendors FIH has been investing more resources in Chinese handset vendors since 2009. Right now, Chinese clients account for 10-15% of FIH’s revenue, with Huawei being the captive account.

We believe this part of the revenue will continue to grow in future years. Our handset sector view holds that high-end smartphone (Apple, SEC) and low-cost vendors (Huawei, ZTE) will gain market share from others which offer mid-range products. In particular, we have seen very strong market-share growth momentum from Huawei and ZTE over the past two years. Their smartphone market share has grown from nil in 2009 to 3-4% in recent quarters.

Global smartphone market share – Apple, SEC and Chinese vendors are growing fast

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2009 2010 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12

Others

Sony Ericsson

LG

Motorola

Hwawei

ZTE

HTC

Nokia

RIM

Samsung

Apple Source: Gartner (‘Market Share: Mobile Devices by Region and Country, 2Q12’, by Anshul Gupta, David Glenn, Roberta Cozza, Tuong Huy Nguyen, Carolina Milanesi, Sandy Shen, Hugues J. De La Vergne, Annette Zimmermann, Atsuro Sato, CK Lu, published 13 August 2012), compiled by Daiwa

Core competencies intact

In our view, after years of disappointment, FIH could still be a turnaround play, because we believe its core competencies remain intact. Vertical integration – better cost structure + one-stop shopping service FIH shares the same DNA with its parent company, Hon Hai, the leading EMS company globally for PCs, networking, and consumer electronics. FIH features a nimble, cost-conscious and client-oriented corporate culture with a strong emphasis on management execution. Compared with its global EMS peers, the company also has the best vertical-integration capability, in our view – the e-enabled components, modules, moves and services (eCMMS) business model highly touted by Hon Hai Group – that can provide customers with either a total solution (one-stop shopping) or cafeteria-style services (pick-up-what-you-want-and-we-source-the-rest-for-you). Last, FIH has formed significant economies of scale that are crucial to the EMS business, creating a formidable entry barrier, in our view.


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Strong balance sheet and cash flow ... Among its global EMS peers, FIH has the strongest balance sheet and net cash position (see the following balance sheet strength and liquidity comparison table). We believe FIH is in the best position to survive and thrive in the long term.

Comparison of balance sheet strength and liquidity (2011) – FIH tops in most every category

Company Stock code

Net cash*

Net cash/ equity ratio

Free cash flow

Current ratio

Quick ratio

FIH 2038 HK 1,439 38.3 310 2.21 1.72 Flextronics FLEX US -682 -29.9 367 1.36 0.66 Jabil Circuit JBL US -298 -15.8 369 1.32 0.51 BYD Electronic 0285 HK 335 26.4 163 1.72 1.21 Lite-On Mobile Private n.a. n.a. n.a. n.a. n.a. Elcoteq ELQAV FH n.a. n.a. n.a. n.a. n.a. Compal Comm 8078 TT 142 45 -144 1.63 1.12 Arima Comm 8101 TT 10.3 6.9 -26.7 1.14 0.8 TCL Comm 2618 HK -817 -237.4 -17 1.08 0.37 LongCheer LHL SP 21 19.5 -19 1.37 0.96 Source: Bloomberg

*Note: Positive numbers in this column represent the company is in a net cash position; negative numbers represents a net debt position. Net cash and free cash flow are in US$m

... to survive and thrive amid the industry consolidation In the mid 2000s, there were a number of heavy-weight dedicated handset EMS firms, such as Flextronics, Elcoteq, Jabil and BYD Electronics. However, after years of recession, only FIH and BYDE still hold up well in this business. Elcoteq (Nokia and Ericsson are key clients) filed for bankruptcy in Luxembourg in June 2011; and three years ago, Jabil (Nokia and RIM are key clients) and Flextronics (Sony

Ericsson and RIM) shifted focus to EMS services for healthcare, clean technology and other industries.

FIH: sales breakdown by client

0%

20%

40%

60%

80%

100%

2005 2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

Motorola Nokia SEMC Samsung LG

Huawei Apple Tablet clients Others

Source: Companies, Daiwa forecasts

Looking into the future, we believe BYD Electronics and Lite-On Mobile will emerge as key competitors for FIH. We think FIH is in a better position than its peers to be the long-term winner, considering its more diversified client base, comprehensive component offerings, support from Hon Hai group and stronger balance sheet. We compare the major handset ODM/EMS companies (key clients and recent developments) in the following table.

Major handset EMS/ODM companies

Company Stock code EMS clients ODM clients Comments

FIH 2038 HK Nokia, Motorola, Sony, SEC,

Apple, etc Motorola, Huawei, Amazon, Dell, Acer, Sony

Ericsson, HP Has remained the largest handset EMS provider since 2005, with the most diversified client base and strongest balance sheet.

Hon Hai 2317 TT Apple (iPhone) The world’s No.1 EMS company with a diversified portfolio. Flextronics FLEX US RIM, Sony Ericsson, Motorola Primary EMS partner of Sony Ericsson.

Jabil Circuit JBL US Nokia, RIM Primary EMS partner of RIM, but gradually shifting focus to healthcare and clean technology industry.

BYD Electronics 0285 HK Nokia, Motorola, Chinese brands Has stuck with the Nokia business, while diversifying to local brands. Lite-On Mobile Private Nokia, Sony, Huawei, ZTE Nokia is trying to use Perlos to replace Elcoteq.

Elcoteq ELQAV FH RIM, Nokia, Emporia Handset revenue declined for three years in a row, leading to the company filing for bankruptcy in June 2011.

Pegatron 4938 TT Apple (CDMA iPhone) Started to supply CDMA iPhone in late 4Q10.

Wistron 3231 TT RIM Penetrated RIM’s supply chain in 4Q09, with volume gradually ramped up over the past three years.

Compal Comm 8078 TT Nokia, Motorola, Palm/HP, Acer

Suffered from Motorola/Nokia’s market-share loss in the low-end smartphone space.

Arima Comm 8101 TT LG, Sony Ericsson

Suffered from Sony Ericsson’s market-share loss in the low-end smartphone space.

TCL Comm 2618 HK Alcatel, Motorola, European operators

Motorola ODM orders and European operator orders have driven TCL Comm’s sales growth since late 2009. The company has become more aggressive in pushing ‘TCL’ brand products in emerging countries.

LongCheer LHL SP Micromax (an Indian brand), China Telecom, G-five,

Lenovo, and other local China brands Adopting a niche strategy by focusing on regional or local brands in emerging countries.

Source: Daiwa


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Initiating with a Buy rating

Could be a turnaround play We initiate coverage of FIH with a Buy (1) rating. We forecast new tablet orders and the sales growth from Chinese handset clients to offset the weakness with the Nokia and Motorola EMS business, while iPhone orders drive the company’s top-line to rise by 30%+ YoY for 2013. We set our six-month target price at HK$3.80, which is based on a 2013E PBR of 1x. We believe BVPS is a good proxy for its intrinsic value, as FIH has a clean balance sheet with net cash of US$1.5bn and no invisible assets (goodwill). It has also written down idle assets aggressively over the past two years. We believe FIH’s turnaround story is playing out well. We expect the stock to trade at around a 1x 2013E PBR, given its industry leader status. We typically use PER to evaluate a profitable tech hardware company. However, we believe FIH is in the early stage of a turnaround, and therefore likely to record minimal EPS for 2012 and 2013. Therefore, in our view, PER methodology is not applicable. FIH: gross margin and operating margin will trend up, along

with the revenue scale expanding

(6)(4)(2)

02468

1012

2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

Gross margin Op. margin Net margin Source: Company, Daiwa forecasts

FIH: forward PER bands

(10)

(5)

0

5

10

15

20

25

Sep-0

7

Mar-0

8

Sep-0

8

Mar-0

9

Sep-0

9

Mar-1

0

Sep-1

0

Mar-1

1

Sep-1

1

Mar-1

2

Sep-1

2

(HK$)


Source: TEJ, Daiwa

FIH: PBR bands

(5)

0

5

10

15

20

25

Sep-0

7

Mar-0

8

Sep-0

8

Mar-0

9

Sep-0

9

Mar-1

0

Sep-1

0

Mar-1

1

Sep-1

1

Mar-1

2

Sep-1

2

(HK$)


Source: TEJ, Daiwa

Investment risks We see the key downside risks as: 1) iPhone orders being lower than expected, 2) disappointing sales data for the Amazon Kindle Fire HD, and 3) US Dollar depreciation in the long term. Another risk would be output delays due to strikes in China and/or other interruptions.

Valuation table – EMS/ODM/OEM companies

Price (lc) Daiwa Mkt cap EPS (lc) PER (x) EPS growth (%) ROE(%) PBR (x) Company Ticker 10/8/2012 Rating (US$ m) 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E EMS FIH* 2038 HK 2.7 Buy 2,500 -0.03 0.00 0.01 n.a. 145.0 27.3 n.a. n.a. 430.2 n.a. 0.5 2.6 0.7 0.7 0.7 Jabil Circuit JBL US 18.1 Not rated 3,709 2.6 2.9 3.2 7.1 6.1 5.6 0.0 0.1 0.1 19.3 18.5 n.a. 1.51 1.26 1.01 BYD Elec. 0285 HK 1.7 Not rated 485 0.3 0.3 0.3 5.1 5.0 4.9 -0.2 0.0 0.0 6.5 6.1 6.2 0.36 0.34 0.32

ODM/OEM HTC* 2498 TT 287 Sell 8,348 23.7 20.2 20.4 12.1 14.2 14.1 -67.6 -14.8 1.3 21.3 19.2 18.4 2.8 2.7 2.5 CCI 8078 TT 32.6 Not rated 658 2.1 1.8 1.8 15.4 18.5 18.6 -8.5 -0.2 -0.0 13.3 15.9 19.1 1.83 1.72 1.55 Arima Com 8101 TT 14.5 Not rated 205 -0.6 0.9 n.a. -22.9 16.6 n.a. -1.5 -2.4 n.a. -3.3 11.5 n.a. 1.40 1.40 n.a. Source: Bloomberg, *Daiwa forecasts


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Company profile

Company background FIH was formerly the handset division within Hon Hai group, and was spun off as a 100%-owned subsidiary in 2000. After the spin-off, FIH expanded its business aggressively through market-share gains and organic growth from key clients, as well as M&A. FIH was listed on the Hong Kong Stock Exchange at HK$3.88/share on 3 February 2005. Hon Hai remains the largest shareholder with a 69.5% stake currently. During its early stage, FIH”s key clients were Motorola and UT Starcom. FIH produced iDEN and PHS phones for Motorola and UT Starcom, respectively. The acquisition of Eimo (at a cost of €70m), a Finland-based mechanical component company (mainly supplied hand casings for Nokia), in August 2003 heralded the rapid growth of FIH’s Nokia business. In the following years, Nokia moved its supply chain from Europe to the Asia Pacific region to save costs. FIH benefited from this trend and gradually took more orders from Elcoteq and Jabil (which used to be Nokia’s primary EMS partners). It became Nokia’s largest EMS partner in 2006. In October 2003, FIH announced the acquisition of Motorola’s Mexico plant (for US$30m), further enhancing its relationship with Motorola. In terms of product mix, FIH was initially a dedicated component vendor, but gradually branched out to modules, printed circuit board assembly (PCBA), and final-product assembly (the same business model as its parent company, Hon Hai). Initially, FIH only focused on hardware. The acquisition of Chimei Communication (the world’s third largest handset ODM at that time) in May 2005 gave FIH a strong R&D team and a shortcut to ODM orders from Motorola, Sony Ericsson, among others. FIH underwent another round of rapid R&D expansion initiatives in early 2008 by acquiring the R&D team from an unlisted smartphone design house (Cheng-Shi Technology). Top management Chairman: Mr. Samuel CHIN joined the company as the chairman and CEO in July 2003. Mr. Chin joined Hon Hai in 2000, and had been one of the principal managers responsible for the handset manufacturing services business of the Hon Hai Group since July

2000, now wholly owned and operated by FIH. Before joining the company, Mr. Chin held senior executive positions at EFA Corporation, Atari Corporation and Commodore Electronics Limited, with responsibilities ranging from sales and marketing, global procurement, manufacturing, pricing, purchasing, contract negotiation, accounting, and finance. With over 25 years of marketing, sales, and operational experience in the global computer and electronics industries, he has worked in an international environment. Mr. Chin was awarded a Juris Doctor degree from the University of Pennsylvania Law School in 1976, and a Bachelor of Science degree in Economics from Wharton School, University of Pennsylvania, in the US in 1973 CEO: CHIH Yu Yang, aged 51, joined FIH as an executive director in August 2009. Mr. Chih is the chairman and CEO of Chi Mei Communication in Taiwan, the primary mobile handset design services arm as well as a key subsidiary of FIH. Mr. Chih joined Foxconn in 2005 when the group acquired CMCS. Prior to that, Mr. Chih was the founder of CMCS since its establishment in 2001. He has 30 years of extensive experience in the communication industries. From 1997 to 2001, Mr. Chih was the vice president and general manager of Communication B.U. in BenQ, which was Taiwan’s largest handset brand and ODM during that period. Prior to that, he held various engineering and managerial positions in companies including ITT Corporation, GTE Corporation and Rockwell Semiconductor Systems. Mr. Chih obtained a Bachelor of Science degree in Electrical Engineering from National Tsing Hwa University in Taiwan in 1980. CIO and Head of IR: TONG Wen Hsin, Vincent joined FIH as director of investments and investor relations in July 2004. Mr. Tong has over 17 years of experience in the investment banking, finance and information technology fields. Before joining the company, Mr. Tong worked at ABN AMRO Rothschild, where he was a director of the equity capital markets department, responsible for the underwriting of various equity and equity-linked issues of Asian corporate clients. Prior to that, he worked in the equity capital markets department of Jardine Fleming and Robert Fleming in Hong Kong and London, as well as in the marketing and sales departments of International Business Machines Corporation in Taiwan. Mr. Tong holds a MBA degree from London Business School, in the UK, which he obtained in 1995.

Disclaimer All statements in this report attributable to Gartner represent [Bank’s/Issuer’s/Client’s] interpretation of data, research opinion or viewpoints published as part of a syndicated subscription service by Gartner, Inc., and have not been reviewed by Gartner. Each Gartner publication speaks as of its original publication date (and not as of the date of this [presentation/report]). The opinions expressed in Gartner publications are not representations of fact, and are subject to change without notice.


Birdy Lu (886) 2 8758 6248 [email protected] Eric Chen (852) 2773 8702 [email protected]

What's new Driven by the increasing usage of Siri and FaceTime-like apps, we see multiple trends for acoustic upgrades taking place which should benefit AAC as the industry leader. This report marks the transfer of coverage to Birdy Lu.

What's the impact It’s a Siri-ous problem – sound quality matters: people’s mouths can be 20-30cm away from an iPhone microphone when using Siri or FaceTime, so how to keep the sound quality clear and reduce background noise has become a serious problem. Noise cancellation: the iPhone and many high-end smartphones have employed a dual-microphone design to reduce background noise. Nokia just brought this to another level by releasing the Lumia 920

which has a tri-microphone design. To pack more microphone into the limited space, micro electrical-mechanical system (MEMS) microphones (2-3x higher ASP) are quickly replacing conventional microphones. High definition (HD) voice: Apple has added HD voice support to the iPhone 5. HD voice deployment is still in the early stage. iPhone adoption is likely to push mobile operators to upgrade networks to be HD voice ready. The ASP of an HD receiver is 5-15% higher than that of a conventional one. Surround sound: 3D sound or surround sound on smartphones is typically enabled by installing a pair (or more) of speakers, or by using a speaker box to replace a conventional speaker. Looks well-positioned to be winner: AAC provides a one-stop shopping service (comprehensive portfolio), has a cost advantage (low labour cost + process automation) and high exposure to Apple and Samsung.

What we recommend Following our transfer of analyst coverage, we are raising our EPS forecasts. We reiterate our Buy (1) rating and raise our six-month target price to HK$32.50, based on a

15x 2013E PER, which is in line with its past-3-year trading average.

How we differ We are more positive than the street on the acoustic industry’s long-term outlook and AAC’s strong position within it. Forecast revisions (%) Year to 31 Dec 12E 13E 14E Revenue change 3.1 2.4 n.a. Net-profit change 9.9 16.9 n.a. EPS change 10.0 17.0 n.a. Source: Daiwa forecasts


90

110

130

150

170

15

19

23

27

31

Oct-11 Jan-12 Apr-12 Jul-12 Oct-12AAC Technologies (LHS)Relative to HSI (RHS)

(HK$) (%)

12-month range 16.10-29.40 Market cap (US$bn) 4.30 Average daily turnover (US$m) 14.84 Shares outstanding (m) 1,228 Major shareholder Chun Yuan Wu Ingrid (23.5%)

Financial summary (Rmb) Year to 31 Dec 12E 13E 14E Revenue (m) 5,883 7,249 8,138 Operating profit (m) 1,834 2,384 2,698 Net profit (m) 1,683 2,162 2,459 Core EPS 1.371 1.761 2.003 EPS change (%) 62.4 28.5 13.7 Daiwa vs Cons. EPS (%) 5.4 9.0 5.4 PER (x) 16.1 12.5 11.0 Dividend yield (%) 2.9 3.8 4.3 DPS 0.644 0.828 0.941 PBR (x) 4.5 3.7 3.1 EV/EBITDA (x) 11.8 8.7 7.3 ROE (%) 31.6 32.6 30.6 Source: Bloomberg, Daiwa forecasts


10 October 2012

AAC Technologies 2018 HK | AACAY US

Target price: HK$26.00 → HK$32.50 Up/downside: +19.7% Share price (8 Oct): HK$27.15

It rings true

• Apps like Siri or FaceTime will likely push smartphone vendors to upgrade acoustics

• MEMS microphones, HD receivers and speaker boxes look likely to rapidly replace conventional solutions

• As the leading vendor of all these high-end acoustics, AAC looks set to benefit; reiterate Buy



- 101 -

Growth outlook AAC: double digit top-line and bottom-line growth with a ~30%

ROE

In our view, ACC is set to experience a big jump in sales and EPS growth in 2012 (we forecast 40%+ YoY, 60%+ YoY rises, respectively), mainly driven by strong momentum from two key accounts – Apple and Samsung (SEC). Looking into 2013, this super-growth might not continue. However, we believe AAC can deliver 20%+ growth in both the top-line and bottom-line, with ROE staying at the 30% level. Key drivers would include Apple’s recent upgrade of its receiver (to an HD receiver), higher order allocation from SEC’s speaker box business, and more clients switching to MEMS micrphones.

(10% )

0%

10%

20%

30%

40%

50%

60%

70%



Valuation AAC: forward PER bands

We set our new six-month target price at HK$32.50, which is based on a 15x 2013E PER (versus the previous target price of HK$26, 21x 2012E PER). The 15x forward PER is in line with the average of the stock’s past-3-year trading range. We believe PER methodology is a more appropriate way to evaluate downstream tech companies such as AAC. We recognise flaws with PER methodology, such as a lack of insight into the long-term business outlook, a mismatch between earnings/cash flow, etc. But we think it is a more straightforward, intuitive and arguably accurate way to predict a tech company’s earnings power, at least in the near term.

05

10152025303540

Sep-0

7

Mar-0

8

Sep-0

8

Mar-0

9

Sep-0

9

Mar-1

0

Sep-1

0

Mar-1

1

Sep-1

1

Mar-1

2

Sep-1

2

(HK$)



Earnings revisions AAC: consensus earnings revisions

The earnings revisions cycle (based on the Bloomberg consensus 2013 EPS forecast) for AAC seems to have bottomed out in late 1Q12, as the table to the right suggests. However, with the likelihood of strong revenue momentum and margin upside (key clients’ product upgrades) ahead, we believe the upward earnings revisions will resume in the next few quarters.

0.0

0.5

1.0

1.5

2.0

2.5

Mar-1

1

Apr-1

1

May-1

1

Jun-1

1

Jul-1

1

Aug-1

1

Sep-1

1

Oct-1

1

Nov-1

1

Dec-1

1

Jan-1

2

Feb-1

2Ma

r-12

Apr-1

2

May-1

2

Jun-1

2

Jul-1

2

Aug-1

2

Sep-1

2

Consensus: 2013 EPS (RMB)

2018 HK

Source: Daiwa




- 102 -

Key assumptionsYear to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Receiver sales growth (% YoY) (18) 28 (38) 40 36 35 22 14 Speaker box sales growth (% YoY) 0 0 0 0 109 55 28 20 MEMS microphone sales growth (% YoY) 0 0 0 0 45 104 25 12

Profit and loss (Rmb m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Dynamic components 1,327 1,645 1,678 2,483 3,228 4,511 5,588 6,372 Microphones 164 158 146 366 459 798 964 1,039 Others 462 453 379 500 372 574 698 727 Total revenue 1,952 2,256 2,203 3,349 4,060 5,883 7,249 8,138 Other income 0 0 0 0 0 0 0 0 COGS (1,029) (1,316) (1,214) (1,839) (2,275) (3,304) (4,044) (4,534) SG&A (266) (223) (184) (237) (290) (484) (534) (589) Other op. expenses (86) (123) (159) (214) (358) (261) (288) (317) Operating profit 572 594 646 1,060 1,136 1,834 2,384 2,698 Net-interest inc./(exp.) 13 20 12 20 22 12 16 26 Assoc/forex/extraord./others 13 3 19 20 (17) 21 0 5 Pre-tax profit 598 616 676 1,099 1,142 1,866 2,399 2,729 Tax (50) (26) (67) (112) (109) (187) (240) (273) Min. int./pref. div./others (3) 0 5 (1) 3 3 3 3 Net profit (reported) 545 590 615 987 1,036 1,683 2,162 2,459 Net profit (adjusted) 545 590 615 987 1,036 1,683 2,162 2,459 EPS (reported) (Rmb) 0.437 0.481 0.501 0.804 0.844 1.371 1.761 2.003 EPS (adjusted) (Rmb) 0.437 0.481 0.501 0.804 0.844 1.371 1.761 2.003 EPS (adjusted fully-diluted) (Rmb) 0.437 0.481 0.501 0.804 0.844 1.371 1.761 2.003 DPS (Rmb) 0.000 0.096 0.199 0.359 0.360 0.644 0.828 0.941 EBIT 572 594 646 1,060 1,136 1,834 2,384 2,698 EBITDA 654 727 816 1,257 1,395 2,228 2,933 3,379

Cash flow (Rmb m) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 595 616 682 1,098 1,145 1,870 2,402 2,732 Depreciation and amortisation 82 133 170 197 259 394 549 681 Tax paid (50) (26) (67) (112) (109) (187) (240) (273) Change in working capital (209) (43) 133 (155) (369) (253) (282) (182) Other operational CF items 0 0 0 0 (3) 16 11 9 Cash flow from operations 418 680 918 1,029 923 1,840 2,441 2,967 Capex (297) (588) (245) (576) (1,189) (1,100) (935) (888) Net (acquisitions)/disposals (297) (588) (245) (680) (1,264) (1,110) (947) (902) Other investing CF items (125) 120 4 (177) (100) (29) (30) (32) Cash flow from investing (422) (469) (241) (857) (1,363) (1,139) (977) (934) Change in debt 172 18 (13) 283 421 27 28 28 Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid 0 0 (118) (245) (441) (442) (791) (1,016) Other financing CF items (133) 12 (77) (211) 100 0 0 0 Cash flow from financing 39 30 (208) (172) 80 (415) (763) (988) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 36 241 469 (1) (361) 286 700 1,045 Free cash flow 121 92 673 453 (266) 740 1,506 2,079 Source: Company, Daiwa forecasts

Financial summary


- 103 -

Balance sheet (Rmb m) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 1,025 1,266 1,735 1,735 1,374 1,660 2,360 3,406 Inventory 271 296 230 343 559 661 809 907 Accounts receivable 762 563 729 1,293 1,488 2,095 2,582 2,899 Other current assets 40 129 38 32 5 29 36 41 Total current assets 2,098 2,254 2,733 3,402 3,425 4,446 5,787 7,252 Fixed assets 834 1,289 1,364 1,752 2,697 3,420 3,823 4,049 Goodwill & intangibles 0 0 0 0 0 0 0 0 Other non-current assets 280 161 157 430 592 598 612 630 Total assets 3,212 3,704 4,254 5,584 6,714 8,463 10,222 11,931 Short-term debt 182 200 187 470 891 918 945 974 Accounts payable 415 366 482 857 897 1,267 1,551 1,739 Other current liabilities 153 75 101 241 216 327 403 452 Total current liabilities 751 641 770 1,569 2,004 2,512 2,899 3,165 Long-term debt 0 0 0 0 0 0 0 0 Other non-current liabilities 0 0 0 0 0 0 0 0 Total liabilities 751 641 770 1,569 2,004 2,512 2,899 3,165 Share capital 101 100 100 100 100 100 100 100 Reserves/R.E./others 2,361 2,964 3,384 3,915 4,611 5,852 7,223 8,666 Shareholders' equity 2,461 3,064 3,484 4,015 4,710 5,951 7,323 8,766 Minority interests 0 0 0 0 0 0 0 0 Total equity & liabilities 3,212 3,704 4,254 5,584 6,714 8,463 10,222 11,931

EV 26,593 25,972 25,496 25,773 26,555 26,295 25,623 24,606 Net debt/(cash) (842) (1,066) (1,548) (1,264) (483) (742) (1,415) (2,432) BVPS (Rmb) 1.975 2.495 2.836 3.270 3.836 4.846 5.963 7.138

Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 10.1 15.6 (2.3) 52.0 21.2 44.9 23.2 12.3 EBITDA (YoY) 8.5 11.1 12.3 54.1 11.0 59.7 31.6 15.2 Operating profit (YoY) 3.2 3.8 8.8 64.1 7.2 61.4 30.0 13.2 Net profit (YoY) (3.8) 8.3 4.2 60.5 5.0 62.4 28.5 13.7 EPS (YoY) (3.7) 9.9 4.1 60.5 5.0 62.4 28.5 13.7 Gross-profit margin 47.3 41.7 44.9 45.1 44.0 43.8 44.2 44.3 EBITDA margin 33.5 32.2 37.0 37.5 34.4 37.9 40.5 41.5 Operating-profit margin 29.3 26.3 29.3 31.6 28.0 31.2 32.9 33.2 ROAE 24.2 21.4 18.8 26.3 23.8 31.6 32.6 30.6 ROAA 18.9 17.1 15.5 20.1 16.9 22.2 23.1 22.2 ROCE 24.3 20.1 18.6 26.0 22.5 29.4 31.5 30.0 ROIC 39.0 31.5 29.6 40.6 29.5 35.0 38.6 39.7 Net debt to equity net cash net cash net cash net cash net cash net cash net cash net cash Effective tax rate 8.4 4.2 9.9 10.2 9.5 10.0 10.0 10.0 Accounts receivable (days) 123.0 107.2 107.0 110.2 125.0 111.1 117.7 122.9 Payables (days) 73.8 63.2 70.2 73.0 78.9 67.1 71.0 73.8 Net interest cover (x) n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Net dividend payout 0.0 20.0 39.8 44.7 42.7 47.0 47.0 47.0 Source: Company, Daiwa forecasts

Company profile AAC Technologies designs and manufactures miniature acoustic components, including speakers, receivers, microphones and hands-free headsets, for use in mobile phones and other consumer handheld devices.



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It rings true

The never-ending quest for better sound quality on smartphones should drive AAC’s long-term growth

From better CPU to better audio and video quality

Enough is enough for CPU/memory Today’s smartphone is almost as powerful as a notebook PC in 2009. Even for mid-range smartphones, the specs such as a dual-core 1GHz CPU, 512MB+ memory, Wi-Fi, Bluetooth, light sensors have become the norm. They are capable of running multiple apps smoothly and simultaneously. We want better cameras and speakers To bring consumers’ experience to the next level, we think vendors need to improve video and audio quality by upgrading the displays, cameras and acoustic components on their smartphones.

It’s a Siri problem – sound quality matters

The rising popularity of apps like Siri (personal voice assistant) and FaceTime (video call) is likely to push smartphone vendors to upgrade their acoustic components and/or increase the number of acoustics used per device. People’s mouths can be 20-30cm away from their smartphone’s microphone when using Siri or FaceTime-like apps, so how to reduce the noise in the background has become a serious problem for smartphone vendors. Noise cancellation – multiple MEMS microphones Google Nexus One (made by HTC and introduced in January 2010) was the first smartphone featuring noise cancellation with a dual-microphone design.

Apple employed the same design concept in its iPhone 4 (in June 2010) by using a dual MEMS microphone. Compared with a conventional electret condenser microphone (ECM) microphone, a MEMS microphone is smaller, more reliable and less power-hungry, while achieving the same acoustic and electrical properties. Knowles (a US-based private firm) and AAC are the primary and secondary suppliers of Apple’s MEMS microphones. The ASP of a MEMS microphone is as high as US$0.50-70¢ versus US$0.15-20¢ for a conventional microphone. Just recently, Nokia brought this design concept up to the next level when it introduced the Lumia 920, its flagship phone, on 5 September 2012 with a three-microphone design. According to Nokia, its high amplitude microphone can record up to 140dB and higher sound pressure levels (SPL), while a general digital microphone can only reach 120dB without heavy distortion. As of today, most high-end smartphones from SEC, LG, Motorola and HTC incorporate a dual-microphone design. We believe this trend will penetrate mid-to-low end phones, and continue to drive MEMS microphone sales growth.

Top-4 purchasers of MEMS microphones in 2011

2011 Rank Vendor

2010 2011

YoY growth

Shipments (m units)

Market share

Shipments (m units)

Market share

1 Apple 127.8 18% 348.8 27% 173%2 SEC 132.2 19% 250.8 20% 90%3 LG 90.4 13% 88.3 7% -2%4 Motorola 44.0 6% 61.9 5% 41%

Others 309.3 44% 533.9 42% 73%

Total 703.7 1,283.6 Source: iSuppli

(Note: Noise cancellation is achieved in a way that a digital signal processor [DSP] receives voice input from two microphones, transforming them into digital signals. DSP compares patterns of received signals, and clamps or eliminates any signals that are identical from both microphones. It gives priority to the signal coming in from one of the two microphones.)


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Noise cancellation requires two speakers working together to filter out undesirable background noise

Source: EGO

High definition voice – high definition receivers Apple just added the support of HD voice (or wideband voice) in its newly launched iPhone 5. HD voice deployment is still in the early stage with lots of room to grow. A few big markets, such as the US, Japan and China, have not supported it yet. We believe that being adopted by the iPhone 5 will push mobile operators to upgrade their networks to be HD voice ready. An HD receiver is required for HD voice-ready smartphones and is designed to receive sounds of extremely low frequency and extremely high frequency with little distortion. The ASP of an HD receiver is about 5-15% higher than that of a conventional one. AAC is the key HD receiver supplier to Nokia, SEC and Apple. 45 commercial mobile HD voice networks in 35 countries, but

the US, Japan and China are not on the list yet

Source: The Global Mobile Supplier Association (GSA)

More details and background information on HD voice are included here: HD voice was first introduced in 2006 by the GSA to provide better and clear sound quality over the mobile network. However, it requires more bandwidth to

transmit HD voice, because it increases the sampling rate and sampling size (bits per sample). Employing HD voice on the 2G network results in traffic congestion. As such, HD voice did not really gain traction with handset or telecom equipment vendors until the 3G network became popular in the late 20o0s. Nokia announced in 2010 that all its 3G phones launched after 2011 would be HD voice-capable, which served as the catalyst to drive HD voice adoption. By August 2012, 45 mobile operators in 35 countries supported HD voice on their 3G/4G networks (mostly in Western Europe). In addition, more than 80 HD voice-enabled mobile phones have been launched by various vendors, including SEC, Sony, HTC, Apple and ZTE. (HD voice: Traditional voice communication is based on sampling the human voice 8,000 times per second, and constraining the reproduction of the sound spectrum to the 200Hz-3.3KHz range, fitting it into a 64Kbps bandwidth. In HD voice, a wideband codec doubles the sampling rate and more than doubles the width of the sound spectrum reproduced, from 50Hz to 7KHz.) Surround sound – multiple speakers and speaker boxes To improve the audio output quality, we believe smartphone/tablet vendors are either upgrading speakers (to speaker boxes) or using more pieces of them. AAC supplies speaker boxes for the iPhone, and several tablet PCs (iPad, Kindle Fire, RIM Playbook). The surround sound (such as Dolby Mobile + SRS WOW HD) or 3D sound on smartphones is typically enabled by installing a pair (or more) of speakers or by using a speaker box to replace a conventional speaker. Examples of smartphones with these sound effects include the Nokia Lumia 920/820/PureView, SEC Galaxy Beam/Champ, LG GM200/KM335, HTC Surround/Mozart, Huawei Ascend G600/D1/P1. As for the iPhone, despite not featuring Dolby/SRS/3D support, the iPhone still generates above-average sound quality by using the speaker box.


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HTC Surround – a Windows phone with a unique slide-out dual speaker supporting Dolby Mobile surround sound

Source: Company

A growing number of tablet PCs (Kindle Fire HD series, Acer Iconia series) are employing the dual speaker design, while the iPad, RIM Playbook and Samsung Galaxy Tab adopt speaker boxes.

Well-positioned for the Siri trend

We believe AAC will be the long-term winner of this high-growth industry, as it can provide a one-stop shopping service (comprehensive portfolio), enjoys a cost advantage, and has a diversified and quality client base. One-stop-shopping service with high quality products The handset acoustics space is a fragmented market – it covers several parts, including receivers, speakers, microphones and headsets. As such, there are dozens of competitors in this industry. AAC might face different competitors in different categories.

Competitors in the handset acoustic business Vendors Headquarters Description Knowles US The leader in MEMS microphones (with around a

70% market share). However, it isn’t good at other acoustic parts.

Hosiden (6804 JP) Japan Comprehensive product portfolio – receivers, speakers, microphones.

Panasonic Electronic Devices

Japan Also a total solution provider with strength in speakers, microphones.

Philips (NXP Sound Solution)

Holland Focuses on speakers and receivers (it was acquired by Knowles in July 2011 to complete Knowles’ product line).

BSE Korea Initially focused on ECM microphones, but gradually expanding to speakers and receivers.

Merry (2439 TT) Taiwan Has high market share in handset peripherals, such as headsets, Bluetooth hands-free kits.

Fortune Grand Taiwan Has high market share in speakers for monitors, notebooks and headsets; gradually shifting focus to handset components.

Foretemedia US The microphones expert. Bujeon Korea Core supplier to SEC, which accounts for 70%+ of

Bujeon’s sales. Goertek (002241.SZ) China Bluetooth earphones, microphones, speakers.

Mainly supplies to local brands and gradually gaining traction with global OEMs, such as Nokia and SEC.

Analog Devices (ADI US) US Leveraging its in-house chipset and entering the MEMS microphone business.

Foster Electric (6794 JP) Japan Headset, Bluetooth hands-free kits. Source: Company, Daiwa

However, AAC is one of a few companies that have a comprehensive portfolio with high quality products. Most of AAC’s products have been qualified by tier-1 smartphone and tablet PC vendors. Due to the business nature of a short product life cycle, smartphone vendors have been streamlining their operations in recent years, including their component procurement processes. Being a qualified vendor for a wide range of products, AAC stands a good chance to win new projects, in our view. Sales breakdown – AAC has a comprehensive product

offering (2012E)

Receivers18.9%

Speakers25.1%

Speaker box31.3%

MFD1.4%

Microphone5.3%

MEMS mic 8.3%

Headsets1.7%

Vibrator2.7%

Other5.3%


Note: MFD = multi-function device


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Better cost structure than its archrivals Hosiden and Panasonic (in Japan) and Knowles in the US are AAC’s key competitors, as they offer total solutions with high quality products too. Nevertheless, we believe that compared with them, AAC has a better cost structure. First, nearly 100% of AAC’s products are made in China, while its Japanese competitors still maintain the production of high-end devices in Japan. Most of the manufacturing processes can be done by robots, or computer-controlled automation equipment. But the back-end assembly of certain products still requires many labour hours. Second, being in the acoustics industry for decades, Japanese competitors have developed highly automated product lines to save costs. ACC started to increase investment in automation three years ago. As of today, we believe AAC is on a par with key competitors in terms of automation.

AAC can maintain gross margin and improve operating margin, owing to improvements in product mix and process automation

0

10

20

30

40

50

60

2006 2007 2008 2009 2010 2011 2012e 2013e 2014e

Gross margin Op. margin Net margin


Industry leader with a premium and diversified client base AAC has a 30-33% global market share currently in acoustic components. It has had strong positions in speakers and receivers historically, and its microphone business is catching up with speakers and receivers quickly as well (driven by MEMS microphone orders from Apple). AAC has a diversified client base. Its key accounts include most of the global smartphone and tablet PC OEMs, including Apple, SEC, Nokia, Motorola, HTC, RIM, Sony Ericsson, Amazon, Huawei and ZTE. It also sells acoustic components to smaller China brands, such as Lenovo, TCL, Oppo and BBK. Apple is AAC’s biggest client, which we forecast will account for around 45% of AAC sales in 2012. The

company’s top-3 clients (Apple, SEC and Nokia) account for around 70% of its total sales, and the top-5 for around 80% (top-3 plus Motorola and RIM). The combination of all the Chinese handset vendors should account for about 7-10% of total sales in 2012 (based on our estimates) and their contributions are rising. Breaking down sales by end application, we estimate smartphones, tablet PCs and feature phones will account for roughly 65%, 15% and 20% of AAC sales in 2012.

Sales breakdown by client, Apple and SEC emerging as the top-2 clients

0%

50%

100%

1H09 2H09 1H10 2H10 1H11 2H11 1H12 2H12EApple NokiaMotorola RIMHTC SamsungSony Eric HuaweiZTE Others (Nintendo, Amazon, ..)]


Multiple catalysts

Handset receivers – rise of HD voice We forecast handset receivers to account for 18-22% of AAC’s sales in 2012. AAC already has a high market share in this business, so we do not see too much room for shipment growth. However, we expect the ASP to improve in the next two years, with its captive account, Apple, adopting an HD receiver in the iPhone 5; and we believe iPhone competitors will follow suit. Handset speakers – SEC speaker box Based on our forecasts, handset speakers will account for 43-47% of AAC’s sales in 2012. AAC is the key speaker box supplier for the iPhone, iPad and Kindle Fire, and should benefit from strong organic growth of these high-flying devices. In addition, AAC is likely to gain more speaker box orders from SEC, as SEC plans to switch more of its smartphones from conventional speakers (ASP of US$0.30-40¢) to speaker boxes (ASP of more than US$1.0) in 2012. Handset microphones – iPhone and iPad Handset microphones should account for 10-15% of 2012 sales, with Apple’s i-devices (iPhone, iPad) accounting for 80%+ of this product line revenue. As such, it should share the same growth pattern of the iPhone and iPad. Each iPhone consumes three MEMS


- 108 -

microphones (two in the handset and one in the hands-free headset). Each iPad consumes one MEMS microphone. We believe Apple might add one more MEMS microphone in future iPads to improve the surround sound experience. AAC: sales breakdown by product – speaker boxes and MEMS

microphones are key growth drivers

0%

20%

40%

60%

80%

100%

2006 2007 2008 2009 2010 2011 2012E 2013EReceivers Speakers Speaker box MFD MicrophoneMEMS mic Headsets Vibrator Other



Reiterate Buy Following our transfer of coverage to Birdy Lu, we are raising our 2012/2013/2014 EPS forecasts to Rmb1.37/Rmb1.77/ Rmb2.00, respectively. We see plenty of long-term growth drivers for AAC, including market-share gains (in SEC and tablet PC clients) and product migration (from conventional solutions to HD receivers, MEMS microphones, and speaker boxes). In our view, the near-term catalyst is the launch of the iPhone 5 and upcoming iPad mini, which should spur demand for high-end acoustic parts. We set our new six-month target price at HK$32.5, which is based on a 15x 2013 PER (versus the previous target price of HK$26, based on a 21x 2012E PER). The 15x forward PER is in line with the average of the stock’s past-3-year trading range.

AAC: forward PER bands

05

10152025303540

Sep-0

7

Mar-0

8

Sep-0

8

Mar-0

9

Sep-0

9

Mar-1

0

Sep-1

0

Mar-1

1

Sep-1

1

Mar-1

2

Sep-1

2

(HK$)



AAC: forward PBR

0

10

20

30

40

50

Sep-0

7

Mar-0

8

Sep-0

8

Mar-0

9

Sep-0

9

Mar-1

0

Sep-1

0

Mar-1

1

Sep-1

1

Mar-1

2

Sep-1

2

(HK$)

Share price 2x 4x 6x 8x Source: Bloomberg, Daiwa

AAC: earnings revision cycle seems to have bottomed out in

late 1Q12

0.0

0.5

1.0

1.5

2.0

2.5

Mar-1

1

Apr-1

1

May-1

1

Jun-1

1

Jul-1

1

Aug-1

1

Sep-1

1

Oct-1

1

Nov-1

1

Dec-1

1

Jan-1

2

Feb-1

2Ma

r-12

Apr-1

2

May-1

2

Jun-1

2

Jul-1

2

Aug-1

2

Sep-1

2

Consensus: 2013 EPS (RMB)

2018 HKSource: Daiwa


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Valuation table – handset component companies Price (lc) Daiwa Mkt cap EPS (local currency) PER (x) EPS growth (%) ROE (%) PBR (x) Company Ticker 10/8/2012 Rating (US$ m) 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E Largan* 3008 TT 612.0 Buy 2,802 32.4 45.6 53.2 18.9 13.4 11.5 -16.4 40.9 16.6 20.8 25.7 25.6 3.8 3.2 2.7 Genius Optical 3406 TT 251.0 Not rated 740 9.9 12.8 14.0 25.4 19.6 18.0 -24.5 30.0 8.8 10.4 13.5 14.6 3.17 3.13 n.a. Merry 2439 TT 47.5 Not rated 250 3.7 3.8 4.1 12.9 12.5 11.7 122.6 3.1 7.0 11.1 13.3 13.3 1.71 1.60 1.51 Silitech 3311 TT 56.3 Not rated 341 5.3 5.4 5.6 10.7 10.4 10.0 -30.5 3.3 3.9 15.7 15.3 14.3 1.61 1.58 1.49 Ichia 2402 TT 15.5 Not rated 174 0.3 0.5 n.a. 48.7 30.9 n.a. 37.8 57.7 n.a. 2.3 3.3 n.a. 0.76 0.74 n.a. TXC* 3042 TT 49.4 Buy 509 3.6 4.5 5.4 13.6 11.0 9.2 4.7 24.0 19.8 14.9 17.2 18.8 2.0 1.8 1.6 ChengUei 2392 TT 70.6 Not rated 1,153 3.3 4.9 5.7 21.5 14.4 12.5 34.8 49.8 15.0 5.5 10.8 12.2 1.57 1.46 1.37 Catcher* 2474 TT 136.0 Outperform 3,485 12.4 13.8 15.4 11.0 9.8 8.9 -17.2 11.4 11.1 15.9 16.0 16.1 1.7 1.5 1.4 Foxconn Tech* 2354 TT 110.5 Sell 4,666 6.3 8.0 8.4 17.7 13.8 13.1 -4.1 27.7 5.5 13.3 15.1 14.2 2.2 2.0 1.8 AAC Tech* 2018 HK 27.2 Buy 4,300 1.37 1.76 2.00 16.1 12.5 11.0 62.4 28.5 13.7 31.6 32.6 30.6 4.5 3.7 3.1 Hirose 6806 JP 8740.0 Not rated 4,549 386.5 422.6 452.2 22.6 20.7 19.3 7.8 9.3 7.0 5.7 6.0 6.3 1.27 1.23 1.19 Goertek 002241 SZ 37.3 Not rated 4,936 1.1 1.7 2.4 34.3 22.5 15.6 61.4 52.1 44.0 25.2 27.6 28.1 6.50 5.12 3.95 Sunny Optical 2382 HK 4.3 Not rated 588 0.4 0.5 0.6 10.5 8.3 6.8 65.4 27.3 22.6 17.9 19.8 20.9 1.74 1.52 1.30 Hosiden 6804 JP 435.0 Not rated 437 2.7 19.6 19.5 160.3 22.2 22.3 -105.7 n.m. -0.3 0.2 1.6 1.7 0.32 0.32 0.32 SEMCO 009150 KS 96,300.0 Not rated 6,334 5,628.5 6,375.4 6,941.1 17.1 15.1 13.9 63.2 13.3 8.9 11.3 11.5 11.5 1.89 1.70 1.53 BYD Elec. 0285 HK 1.7 Not rated 485 0.3 0.3 0.3 5.1 5.0 4.9 -24.7 1.2 3.6 6.5 6.1 6.2 0.36 0.34 0.32 NDK 6779 JP 839.0 Not rated 239 100.1 120.1 113.8 8.4 7.0 7.4 n.a. 19.9 -5.2 7.2 9.0 7.8 0.59 0.54 0.51 KDS 6962 JP 217.0 Not rated 130 12.0 18.2 21.7 18.0 11.9 10.0 -186.5 51.2 19.3 1.2 2.3 n.a. 0.32 0.31 n.a. Rakon RAK NZ 0.5 Not rated 72 0.0 0.0 0.1 41.8 11.2 7.0 57.1 n.m. 61.1 1.3 4.1 5.7 0.46 0.45 0.42 Average 27.1 14.3 11.7 10.2 11.6 12.6 1.7 1.4 1.3 Source: Bloomberg, *Daiwa forecasts

Premium firm merits a premium In terms of valuation, AAC has consistently traded at a premium over the past decade (12-24x PER), averaging 15x. Regional peers have tended to trade in a range of 8-18x, averaging 12-14x. We believe AAC’s valuation premium is justifiable, given what we see as its quality management team and leading position in a fast-growing industry. In addition, we like its strong ROE (around 30% in 2012-14, on our forecasts) and solid balance sheet, with zero long-term debt and Rmb1bn+ net cash on hand.

AAC: net cash position could go north again, after investments in automation and new technologies in 2010-12

0.0

0.5

1.0

1.5

2.0

2.5

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

Net cash (debt), RMB$bn (RHS) Current Ratio (LHS)Quick Ratio (LHS)


EPS vs. free cash flow per share – earnings quality is improving

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

2006 2007 2008 2009 2010 2011 2012E 2013E 2014E

EPS (RMB) FCF per share (RMB)


Cash dividend and payout ratio

0%

10%

20%

30%

40%

50%

0.0

0.2

0.4

0.6

0.8

1.0

2008 2009 2010 2011 2012E 2013E 2014E

DPS, RMB$ (LHS) Cash div payout ratio (RHS)



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EPS sensitivity analysis Changes in ASP and gross margin are two key variables that would affect our earnings forecasts for AAC. We therefore conducted a sensitivity analysis on how such changes would impact 2013E EPS (see following table).

EPS sensitivity – ASP and gross margin change on EPS EPS 2013e % change of ASP Assumption -12.0% -9.0% -6.0% -3.0% 0.0% 3.0% 6.0% 9.0% 12.0%

Gros

s mar

gin

42.2% 1.40 1.47 1.53 1.59 1.65 1.71 1.78 1.84 1.90 42.7% 1.43 1.49 1.55 1.62 1.68 1.74 1.80 1.87 1.93 43.2% 1.45 1.51 1.58 1.64 1.71 1.77 1.83 1.90 1.96 43.7% 1.47 1.54 1.60 1.67 1.73 1.80 1.86 1.92 1.99 44.2% 1.50 1.56 1.63 1.69 1.76 1.82 1.89 1.95 2.02 44.7% 1.52 1.59 1.65 1.72 1.78 1.85 1.92 1.98 2.05 45.2% 1.54 1.61 1.68 1.74 1.81 1.88 1.94 2.01 2.08 45.7% 1.57 1.64 1.70 1.77 1.84 1.91 1.97 2.04 2.11 46.2% 1.59 1.66 1.73 1.80 1.86 1.93 2.00 2.07 2.14

Source: Daiwa


Investment risks We would see the key downside risks as: 1) slow upgrades on smartphone acoustic components due to cost concerns, 2) increased price competition from low-cost competitors, and 3) US Dollar depreciation in the long term.


- 111 -

Samsung Electronics: share price and Daiwa recommendation trend Date 27/04/2012 10/04/2012 21/03/2012 27/01/2012 06/12/2011 28/10/2011 27/09/2011 Target price 1,800,000 1,700,000 1,600,000 1,300,000 1,200,000 1,100,000 1,000,000 Rating 1 1 1 2 2 2 2

Date 07/07/2011 28/01/2011 22/12/2010 06/10/2010 Target price 1,100,000 1,200,000 1,100,000 970.000 Rating 2 2 2 2

970,0001,100,000

1,200,0001,100,000

1,000,0001,100,000

1,200,0001,300,000

1,600,0001,700,000

1,800,000

15,000

215,000

415,000

615,000

815,000

1,015,000

1,215,000

1,415,000

1,615,000

1,815,000

2,015,000

Oct-1

0

Nov-1

0

Dec-1

0

Jan-1

1

Feb-1

1

Mar-1

1

Apr-1

1

May-1

1

Jun-1

1

Jul-1

1

Aug-1

1

Sep-1

1

Oct-1

1

Nov-1

1

Dec-1

1

Jan-1

2

Feb-1

2

Mar-1

2

Apr-1

2

May-1

2

Jun-1

2

Jul-1

2

Aug-1

2

Sep-1

2

Oct-1

2

Target price (W) Closing price (W) Source: Daiwa


- 112 -

- 113 -

Daiwa’s Asia Pacific Research Directory

HONG KONG Nagahisa MIYABE (852) 2848 4971 [email protected] Regional Research Head

John HETHERINGTON (852) 2773 8787 [email protected] Regional Head of Product Management

Pranab Kumar SARMAH (852) 2848 4441 [email protected] Regional Head of Research Promotion

Mingchun SUN (852) 2773 8751 [email protected] Head of China Research; Chief Economist (Regional)

Dave DAI (852) 2848 4068 [email protected] Deputy Head of Hong Kong and China Research; Pan-Asia/Regional Head of Clean Energy and Utilities; Utilities; Power Equipment; Renewables (Hong Kong, China)

Kevin LAI (852) 2848 4926 [email protected] Deputy Head of Regional Economics; Macro Economics (Regional)

Chi SUN (852) 2848 4427 [email protected] Macro Economics (China)

Jonas KAN (852) 2848 4439 [email protected] Head of Hong Kong Research; Head of Hong Kong and China Property; Regional Property Coordinator; Property Developers (Hong Kong)

Jeff CHUNG (852) 2773 8783 [email protected] Automobiles and Components (China)

Grace WU (852) 2532 4383 [email protected] Head of Greater China FIG; Banking (Hong Kong, China)

Jerry YANG (852) 2773 8842 [email protected] Banking/Diversified Financials (Taiwan)

Leon QI (852) 2532 4381 [email protected] Banking (Hong Kong, China)

Joseph HO (852) 2848 4443 [email protected] Head of Industrials and Machineries (Hong Kong, China); Capital Goods –Electronics Equipments and Machinery (Hong Kong, China)

Bing ZHOU (852) 2773 8782 [email protected] Consumer/Retail (Hong Kong, China)

Hongxia ZHU (852) 2848 4460 [email protected] Consumer, Pharmaceuticals and Healthcare (China)

Eric CHEN (852) 2773 8702 [email protected] Pan-Asia/Regional Head of IT/Electronics; Semiconductor/IC Design (Regional)

Felix LAM (852) 2532 4341 [email protected] Head of Materials (Hong Kong, China); Cement and Building Materials (China, Taiwan); Property (China)

John CHOI (852) 2773 8730 [email protected] Head of Multi-Industries (Hong Kong, China); Small/Mid Cap (Regional); Internet (China)

Kelvin LAU (852) 2848 4467 [email protected] Head of Transportation (Hong Kong, China); Hong Kong and China Research Coordinator; Transportation (Regional)

Jibo MA (852) 2848 4489 [email protected] Head of Custom Products Group; Custom Products Group

Thomas HO (852) 2773 8716 [email protected] Custom Products Group

PHILIPPINES Rommel RODRIGO (63) 2 813 7344

ext 302 [email protected]

Head of Philippines Research; Strategy; Capital Goods; Materials

Danielo PICACHE (63) 2 813 7344 ext 293

[email protected]

Property; Banking; Transportation – Port

SOUTH KOREA Chang H LEE (82) 2 787 9177 [email protected] Head of Korea Research; Strategy; Banking/Finance

Sung Yop CHUNG (82) 2 787 9157 [email protected] Pan-Asia Co-head/Regional Head of Automobiles and Components; Automobiles; Shipbuilding; Steel

Anderson CHA (82) 2 787 9185 [email protected] Banking/Finance

Mike OH (82) 2 787 9179 [email protected] Capital Goods (Construction and Machinery)

Sang Hee PARK (82) 2 787 9165 [email protected] Consumer/Retail

Jae H LEE (82) 2 787 9173 [email protected] IT/Electronics (Tech Hardware and Memory Chips)

Thomas Y KWON (82) 2 787 9181 [email protected] Pan-Asia Head of Internet & Telecommunications; Software (Korea) – Internet/On-line Game

Shannen PARK (82) 2 787 9184 [email protected] Custom Products Group

TAIWAN

Mark CHANG (886) 2 8758 6245 [email protected] Head of Research; Regional Head of Small/Medium Cap; Small/Medium Cap (Regional)

Yoshihiko KAWASHIMA (886) 2 8758 6247 [email protected] Consumer/Retail

Birdy LU (886) 2 8758 6248 [email protected] IT/Technology Hardware (Handsets and Components)

Christine WANG (886) 2 8758 6249 [email protected] IT/Technology Hardware (PC Hardware)

Chris LIN (886) 2 8758 6251 [email protected] IT/Technology Hardware (Panels)

INDIA

Punit SRIVASTAVA (91) 22 6622 1013 [email protected] Head of Research; Strategy; Banking/Finance

Navin MATTA (91) 22 6622 8411 [email protected] Automobiles and Components

Saurabh MEHTA (91) 22 6622 1009 [email protected] Capital Goods; Utilities

Mihir SHAH (91) 22 6622 1020 [email protected] FMCG/Consumer

Deepak PODDAR (91) 22 6622 1016 [email protected]

Materials

Nirmal RAGHAVAN (91) 22 6622 1018 [email protected] Oil and Gas; Utilities

SINGAPORE Adrian LOH (65) 6499 6548 [email protected] Head of Singapore Research, Regional Head of Oil and Gas; Oil and Gas (ASEAN and China); Capital Goods (Singapore)

Srikanth VADLAMANI (65) 6499 6570 [email protected] Banking (ASEAN)

David LUM (65) 6329 2102 [email protected] Property and REITs

Ramakrishna MARUVADA (65) 6499 6543 [email protected] Head of ASEAN & India Telecommunications; Telecommunications (ASEAN & India)

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Daiwa’s Offices

Office / Branch / Affiliate Address Tel Fax

DAIWA SECURITIES GROUP INC

HEAD OFFICE Gran Tokyo North Tower, 1-9-1, Marunouchi, Chiyoda-ku, Tokyo, 100-6753 (81) 3 5555 3111 (81) 3 5555 0661

Daiwa Securities Trust Company One Evertrust Plaza, Jersey City, NJ 07302, U.S.A. (1) 201 333 7300 (1) 201 333 7726

Daiwa Securities Trust and Banking (Europe) PLC (Head Office) 5 King William Street, London EC4N 7JB, United Kingdom (44) 207 320 8000 (44) 207 410 0129

Daiwa Europe Trustees (Ireland) Ltd Level 3, Block 5, Harcourt Centre, Harcourt Road, Dublin 2, Ireland (353) 1 603 9900 (353) 1 478 3469

Daiwa Capital Markets America Inc Financial Square, 32 Old Slip, New York, NY10005, U.S.A. (1) 212 612 7000 (1) 212 612 7100

Daiwa Capital Markets America Inc. San Francisco Branch 555 California Street, Suite 3360, San Francisco, CA 94104, U.S.A. (1) 415 955 8100 (1) 415 956 1935

Daiwa Capital Markets Europe Limited 5 King William Street, London EC4N 7AX, United Kingdom (44) 20 7597 8000 (44) 20 7597 8600

Daiwa Capital Markets Europe Limited, Frankfurt Branch Trianon Building, Mainzer Landstrasse 16, 60325 Frankfurt am Main, Federal Republic of Germany

(49) 69 717 080 (49) 69 723 340

Daiwa Capital Markets Europe Limited, Paris Representative Office 36, rue de Naples, 75008 Paris, France (33) 1 56 262 200 (33) 1 47 550 808

Daiwa Capital Markets Europe Limited, London, Geneva Branch 50 rue du Rhône, P.O.Box 3198, 1211 Geneva 3, Switzerland (41) 22 818 7400 (41) 22 818 7441

Daiwa Capital Markets Europe Limited, Moscow Representative Office

Midland Plaza 7th Floor, 10 Arbat Street, Moscow 119002, Russian Federation

(7) 495 641 3416 (7) 495 775 6238

Daiwa Capital Markets Europe Limited, Bahrain Branch 7th Floor, The Tower, Bahrain Commercial Complex, P.O. Box 30069, Manama, Bahrain

(973) 17 534 452 (973) 17 535 113

Daiwa Capital Markets Hong Kong Limited Level 28, One Pacific Place, 88 Queensway, Hong Kong (852) 2525 0121 (852) 2845 1621

Daiwa Capital Markets Singapore Limited 6 Shenton Way #26-08, DBS Building Tower Two, Singapore 068809, Republic of Singapore

(65) 6220 3666 (65) 6223 6198

Daiwa Capital Markets Australia Limited Level 34, Rialto North Tower, 525 Collins Street, Melbourne, Victoria 3000, Australia

(61) 3 9916 1300 (61) 3 9916 1330

DBP-Daiwa Capital Markets Philippines, Inc 18th Floor, Citibank Tower, 8741 Paseo de Roxas, Salcedo Village, Makati City, Republic of the Philippines

(632) 813 7344 (632) 848 0105

Daiwa-Cathay Capital Markets Co Ltd 14/F, 200, Keelung Road, Sec 1, Taipei, Taiwan, R.O.C. (886) 2 2723 9698 (886) 2 2345 3638

Daiwa Securities Capital Markets Korea Co., Ltd. One IFC, 10 Gukjegeumyung-Ro, Yeouido-dong, Yeongdeungpo-gu, Seoul, 150-876, Korea

(82) 2 787 9100 (82) 2 787 9191

Daiwa Securities Capital Markets Co Ltd, Beijing Representative Office

Room 3503/3504, SK Tower, No.6 Jia Jianguomen Wai Avenue, Chaoyang District, Beijing 100022, People’s Republic of China

(86) 10 6500 6688 (86) 10 6500 3594

Daiwa SSC Securities Co Ltd 45/F, Hang Seng Tower, 1000 Lujiazui Ring Road, Pudong, Shanghai 200120, People’s Republic of China

(86) 21 3858 2000 (86) 21 3858 2111

Daiwa Securities Capital Markets Co. Ltd, Bangkok Representative Office

18th Floor, M Thai Tower, All Seasons Place, 87 Wireless Road, Lumpini, Pathumwan, Bangkok 10330, Thailand

(66) 2 252 5650 (66) 2 252 5665

Daiwa Capital Markets India Private Ltd 10th Floor, 3 North Avenue, Maker Maxity, Bandra Kurla Complex, Bandra East, Mumbai – 400051, India

(91) 22 6622 1000 (91) 22 6622 1019

Daiwa Securities Capital Markets Co. Ltd, Hanoi Representative Office

Suite 405, Pacific Palace Building, 83B, Ly Thuong Kiet Street, Hoan Kiem Dist. Hanoi, Vietnam

(84) 4 3946 0460 (84) 4 3946 0461

DAIWA INSTITUTE OF RESEARCH LTD

HEAD OFFICE 15-6, Fuyuki, Koto-ku, Tokyo, 135-8460, Japan (81) 3 5620 5100 (81) 3 5620 5603

MARUNOUCHI OFFICE Gran Tokyo North Tower, 1-9-1, Marunouchi, Chiyoda-ku, Tokyo, 100-6756 (81) 3 5555 7011 (81) 3 5202 2021

New York Research Center 11th Floor, Financial Square, 32 Old Slip, NY, NY 10005-3504, U.S.A. (1) 212 612 6100 (1) 212 612 8417

London Research Centre 3/F, 5 King William Street, London, EC4N 7AX, United Kingdom (44) 207 597 8000 (44) 207 597 8550

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Disclaimer This publication is produced by Daiwa Securities Group Inc. and/or its non-U.S. affiliates, and distributed by Daiwa Securities Group Inc. and/or its non-U.S. affiliates, except to the extent expressly provided herein. This publication and the contents hereof are intended for information purposes only, and may be subject to change without further notice. Any use, disclosure, distribution, dissemination, copying, printing or reliance on this publication for any other purpose without our prior consent or approval is strictly prohibited. Neither Daiwa Securities Group Inc. nor any of its respective parent, holding, subsidiaries or affiliates, nor any of its respective directors, officers, servants and employees, represent nor warrant the accuracy or completeness of the information contained herein or as to the existence of other facts which might be significant, and will not accept any responsibility or liability whatsoever for any use of or reliance upon this publication or any of the contents hereof. Neither this publication, nor any content hereof, constitute, or are to be construed as, an offer or solicitation of an offer to buy or sell any of the securities or investments mentioned herein in any country or jurisdiction nor, unless expressly provided, any recommendation or investment opinion or advice. Any view, recommendation, opinion or advice expressed in this publication may not necessarily reflect those of Daiwa Securities Capital Markets Co. Ltd., and/or its affiliates nor any of its respective directors, officers, servants and employees except where the publication states otherwise. This research report is not to be relied upon by any person in making any investment decision or otherwise advising with respect to, or dealing in, the securities mentioned, as it does not take into account the specific investment objectives, financial situation and particular needs of any person.

Daiwa Securities Group Inc., its subsidiaries or affiliates, or its or their respective directors, officers and employees from time to time have trades as principals, or have positions in, or have other interests in the securities of the company under research including derivatives in respect of such securities or may have also performed investment banking and other services for the issuer of such securities. The following are additional disclosures.

Japan

Daiwa Securities Co. Ltd. and Daiwa Securities Group Inc. Daiwa Securities Co. Ltd. is a subsidiary of Daiwa Securities Group Inc. Investment Banking Relationship

Within the preceding 12 months, The subsidiaries and/or affiliates of Daiwa Securities Group Inc. * has lead-managed public offerings and/or secondary offerings (excluding straight bonds) of the securities of the following companies: SBI Holdings Inc. (6488 HK); Shunfeng Photovoltaic International Ltd. (1165 HK); Rexlot Holdings Limited (555 HK); China Outfitters Holdings Limited (1146 HK); Beijing Jingneng Clean Energy Co. Limited (579 HK); Infraware Inc. (041020 KS)

*Subsidiaries of Daiwa Securities Group Inc. for the purposes of this section shall mean any one or more of: Daiwa Capital Markets Hong Kong Limited, Daiwa Capital Markets Singapore Limited, Daiwa Capital Markets Australia Limited, Daiwa Capital Markets India Private Limited, Daiwa-Cathay Capital Markets Co., Ltd., Daiwa Securities Capital Markets Korea Co., Ltd.

Hong Kong

This research is distributed in Hong Kong by Daiwa Capital Markets Hong Kong Limited (“DHK”) which is regulated by the Hong Kong Securities and Futures Commission. Recipients of this research in Hong Kong may contact DHK in respect of any matter arising from or in connection with this research. Ownership of Securities For “Ownership of Securities” information, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Investment Banking Relationship For “Investment Banking Relationship”, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Relevant Relationship (DHK) DHK may from time to time have an individual employed by or associated with it serves as an officer of any of the companies under its research coverage. DHK market making DHK may from time to time make a market in securities covered by this research.

Singapore

This research is distributed in Singapore by Daiwa Capital Markets Singapore Limited and it may only be distributed in Singapore to accredited investors, expert investors and institutional investors as defined in the Financial Advisers Regulations and the Securities and Futures Act (Chapter 289), as amended from time to time. By virtue of distribution to these category of investors, Daiwa Capital Markets Singapore Limited and its representatives are not required to comply with Section 36 of the Financial Advisers Act (Chapter 110) (Section 36 relates to disclosure of Daiwa Capital Markets Singapore Limited’s interest and/or its representative’s interest in securities). Recipients of this research in Singapore may contact Daiwa Capital Markets Singapore Limited in respect of any matter arising from or in connection with the research.

Australia

This research is distributed in Australia by Daiwa Capital Markets Stockbroking Limited and it may only be distributed in Australia to wholesale investors within the meaning of the Corporations Act. Recipients of this research in Australia may contact Daiwa Capital Markets Stockbroking Limited in respect of any matter arising from or in connection with the research. Ownership of Securities For “Ownership of Securities” information, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

India

This research is distributed by Daiwa Capital Markets India Private Limited (DAIWA) which is an intermediary registered with Securities & Exchange Board of India. This report is not to be considered as an offer or solicitation for any dealings in securities. While the information in this report has been compiled by DAIWA in good faith from sources believed to be reliable, no representation or warranty, express of implied, is made or given as to its accuracy, completeness or correctness. DAIWA its officers, employees, representatives and agents accept no liability whatsoever for any loss or damage whether direct, indirect, consequential or otherwise howsoever arising (whether in negligence or otherwise) out of or in connection with or from any use of or reliance on the contents of and/or omissions from this document. Consequently DAIWA expressly disclaims any and all liability for, or based on or relating to any such information contained in or errors in or omissions in this report. Accordingly, you are recommended to seek your own legal, tax or other advice and should rely solely on your own judgment, review and analysis, in evaluating the information in this document. The data contained in this document is subject to change without any prior notice DAIWA reserves its right to modify this report as maybe required from time to time. DAIWA is committed to providing independent recommendations to its Clients and would be happy to provide any information in response to any query from its Clients. This report is strictly confidential and is being furnished to you solely for your information. The information contained in this document should not be reproduced (in whole or in part) or redistributed in any form to any other person. We and our group companies, affiliates, officers, directors and employees may from time to time, have long or short positions, in and buy sell the securities thereof, of company(ies) mentioned herein or be engaged in any other transactions involving such securities and earn brokerage or other compensation or act as advisor or have the potential conflict of interest with respect to any recommendation and related information or opinion. DAIWA prohibits its analyst and their family members from maintaining a financial interest in the securities or derivatives of any companies that the analyst cover. This report is not intended or directed for distribution to, or use by any person, citizen or entity which is resident or located in any state or country or jurisdiction where such publication, distribution or use would be contrary to any statutory legislation, or regulation which would require DAIWA and its affiliates/ group companies to any registration or licensing requirements. The views expressed in the report accurately reflect the analyst’s personal views about the securities and issuers that are subject of the Report, and that no part of the analyst’s compensation was, is or will be directly or indirectly, related to the recommendations or views expressed in the Report. This report does not recommend to US recipients the use of Daiwa Capital Markets India Private Limited or any of its non – US affiliates to effect trades in any securities and is not supplied with any understanding that US recipients will direct commission business to Daiwa Capital Markets India Private Limited.

Taiwan

This research is distributed in Taiwan by Daiwa-Cathay Capital Markets Co., Ltd and it may only be distributed in Taiwan to institutional investors or specific investors who have signed recommendation contracts with Daiwa-Cathay Capital Markets Co., Ltd in accordance with the Operational Regulations Governing Securities Firms Recommending Trades in Securities to Customers. Recipients of this research in Taiwan may contact Daiwa-Cathay Capital Markets Co., Ltd in respect of any matter arising from or in connection with the research.

Philippines

This research is distributed in the Philippines by DBP-Daiwa Capital Markets Philippines, Inc. which is regulated by the Philippines Securities and Exchange Commission and the Philippines Stock Exchange, Inc. Recipients of this research in the Philippines may contact DBP-Daiwa Capital Markets Philippines, Inc. in respect of any matter arising from or in connection with the research. DBP-Daiwa Capital Markets Philippines, Inc. recommends that investors independently assess, with a professional advisor, the specific financial risks as well as the legal, regulatory, tax, accounting, and other consequences of a proposed transaction. DBP-Daiwa Capital Markets Philippines, Inc. may have positions or may be materially interested in the securities in any of the markets mentioned in the publication or may have performed other services for the issuers of such securities.

For relevant securities and trading rules please visit SEC and PSE Link at http://www.sec.gov.ph/irr/AmendedIRRfinalversion.pdf and http://www.pse.com.ph/ respectively.

United Kingdom

This research report is produced by Daiwa Securities Capital Markets Co., Ltd and/or its affiliates and is distributed by Daiwa Capital Markets Europe Limited in the European Union, Iceland, Liechtenstein, Norway and Switzerland. Daiwa Capital Markets Europe Limited is authorised and regulated by The Financial Services Authority (“FSA”) and is a member of the London Stock Exchange, Chi-X, Eurex and NYSE Liffe. Daiwa Capital Markets Europe Limited and its affiliates may, from time to time, to the extent permitted by law, participate or invest in other financing transactions with the issuers of the securities referred to herein (the “Securities”), perform services for or solicit business from such issuers, and/or have a position or effect transactions in the Securities or options thereof and/or may have acted as an underwriter during the past twelve months for the issuer of such securities. In addition, employees of Daiwa Capital Markets Europe Limited and its affiliates may have positions and effect transactions in such securities or options and may serve as Directors of such issuers. Daiwa Capital Markets Europe Limited may, to the extent permitted by applicable UK law and other applicable law or regulation, effect transactions in the Securities before this material is published to recipients.

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This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FSA and should not therefore be distributed to such Retail Clients in the United Kingdom. Should you enter into investment business with Daiwa Capital Markets Europe’s affiliates outside the United Kingdom, we are obliged to advise that the protection afforded by the United Kingdom regulatory system may not apply; in particular, the benefits of the Financial Services Compensation Scheme may not be available.

Daiwa Capital Markets Europe Limited has in place organisational arrangements for the prevention and avoidance of conflicts of interest. Our conflict management policy is available at http://www.uk.daiwacm.com/about-us/corporate-governance-and-regulatory. Regulatory disclosures of investment banking relationships are available at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

Germany

This document has been approved by Daiwa Capital Markets Europe Limited and is distributed in Germany by Daiwa Capital Markets Europe Limited, Niederlassung Frankfurt which is regulated by BaFin (Bundesanstalt fuer Finanzdienstleistungsaufsicht) for the conduct of business in Germany.

Bahrain

This research material is issued/compiled by Daiwa Capital Markets Europe Limited, Bahrain Branch, regulated by The Central Bank of Bahrain and holds Investment Business Firm – Category 2 license and having its official place of business at the Bahrain World Trade Centre, South Tower, 7th floor, P.O. Box 30069, Manama, Kingdom of Bahrain. Tel No. +973 17534452 Fax No. +973 535113

This material is provided as a reference for making investment decisions and is not intended to be a solicitation for investment. Investment decisions should be made at your own discretion and risk. Accordingly, no representation or warranty, express or implied, is made as to and no reliance should be placed on the fairness, accuracy, completeness or correctness of the information and opinions contained in this document, Content herein is based on information available at the time the research material was prepared and may be amended or otherwise changed in the future without notice. All information is intended for the private use of the person to whom it is provided without any liability whatsoever on the part of Daiwa Capital Markets Europe Limited, Bahrain Branch, any associated company or the employees thereof. If you are in doubt about the suitability of the product or the research material itself, please consult your own financial adviser. Daiwa Capital Markets Europe Limited, Bahrain Branch retains all rights related to the content of this material, which may not be redistributed or otherwise transmitted without prior consent.

United States

This report is distributed in the U.S. by Daiwa Capital Markets America Inc. (DCMA). It may not be accurate or complete and should not be relied upon as such. It reflects the preparer’s views at the time of its preparation, but may not reflect events occurring after its preparation; nor does it reflect DCMA’s views at any time. Neither DCMA nor the preparer has any obligation to update this report or to continue to prepare research on this subject. This report is not an offer to sell or the solicitation of any offer to buy securities. Unless this report says otherwise, any recommendation it makes is risky and appropriate only for sophisticated speculative investors able to incur significant losses. Readers should consult their financial advisors to determine whether any such recommendation is consistent with their own investment objectives, financial situation and needs. This report does not recommend to U.S. recipients the use of any of DCMA’s non-U.S. affiliates to effect trades in any security and is not supplied with any understanding that U.S. recipients of this report will direct commission business to such non-U.S. entities. Unless applicable law permits otherwise, non-U.S. customers wishing to effect a transaction in any securities referenced in this material should contact a Daiwa entity in their local jurisdiction. Most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as a process for doing so. As a result, the securities discussed in this report may not be eligible for sales in some jurisdictions. Customers wishing to obtain further information about this report should contact DCMA: Daiwa Capital Markets America Inc., Financial Square, 32 Old Slip, New York, New York 10005 (telephone 212-612-7000). Ownership of Securities For “Ownership of Securities” information please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Investment Banking Relationships For “Investment Banking Relationships” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. DCMA Market Making For “DCMA Market Making” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Research Analyst Conflicts For updates on “Research Analyst Conflicts” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The principal research analysts who prepared this report have no financial interest in securities of the issuers covered in the report, are not (nor are any members of their household) an officer, director or advisory board member of the issuer(s) covered in the report, and are not aware of any material relevant conflict of interest involving the analyst or DCMA, and did not receive any compensation from the issuer during the past 12 months except as noted: no exceptions. Research Analyst Certification For updates on “Research Analyst Certification” and “Rating System” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The views about any and all of the subject securities and issuers expressed in this Research Report accurately reflect the personal views of the research analyst(s) primarily responsible for this report (or the views of the firm producing the report if no individual analysts[s] is named on the report); and no part of the compensation of such analyst(s) (or no part of the compensation of the firm if no individual analyst[s)] is named on the report) was, is, or will be directly or indirectly related to the specific recommendations or views contained in this Research Report.

The following explains the rating system in the report as compared to relevant local indices, based on the beliefs of the author of the report. "1": the security could outperform the local index by more than 15% over the next six months. "2": the security is expected to outperform the local index by 5-15% over the next six months. "3": the security is expected to perform within 5% of the local index (better or worse) over the next six months. "4": the security is expected to underperform the local index by 5-15% over the next six months. "5": the security could underperform the local index by more than 15% over the next six months.

Additional information may be available upon request.

Japan - additional notification items pursuant to Article 37 of the Financial Instruments and Exchange Law (This Notification is only applicable where report is distributed by Daiwa Securities Co. Ltd.) If you decide to enter into a business arrangement with us based on the information described in materials presented along with this document, we ask you to pay close attention to the following items. • In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in

the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction. • In some cases, we may also charge a maximum of ¥ 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan. • For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the

amount of the transaction will be in excess of the required collateral or margin requirements. • There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices,

real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements. • There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us. • Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants.

*The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc.

When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us. Corporate Name: Daiwa Securities Co. Ltd. Financial instruments firm: chief of Kanto Local Finance Bureau (Kin-sho) No.108 Memberships: Japan Securities Dealers Association, The Financial Futures Association of Japan Japan Investment Advisers Association Type II Financial Instruments Firms Association

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