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Mon, 23 Jun 2014

Equi ty Research SCUD Group (1399 HK) TMT/ China

Juice Up Your Smartphone

Initiating with BUY rating. We initiate coverage on SCUD Group, one of China’s

major smartpone batteries suppliers, with a BUY rating and target price of HK$1.72,

based on 14x/10x FY14E/FY15E PE, respectively. Our target price provides a

potential 83% upside. SCUD is one of the direct beneficiaries of shifting focus of

domestic smartphone makers from low-end (<RMB1,000) to mid-end (RMB1,000 –

RMB2, 000) competition by increasing adoption of high quality battery bare cell.

Key smart devices battery provider to domestic vendors. SCUD is a leading high

quality smartphone/tablet battery producer. Its strong exposure to top-tier domestic

smart devices vendors, such as Xiaomi, Huawei and Lenovo leads it benefit from

robust demand and rising penetration of smart devices and smart devices upgrade

trend in China.

Multiple earnings growth drivers ahead. 1) Strong 2014E ODM battery volume

growth and earnings rebound; 2) Exposure to top-tier domestic smartphone

vendors. Exclusive Xiaomi 2/3 battery supplier in FY13, introducing Lenovo and One

Plus One early FY14 and likely add other leading domestic brands from 2H14

onwards as handset makers shifting focus from low-end to mid-end devices; 3)

Well-positioned as the key beneficiary of China’s domestic smartphone vendors

are increasing their market shares both locally and overseas; 4) SCUD’s ability to

leverage its un-replicable sourcing capabilities of premium overseas bare battery

cells to secure orders from China’s leading smartphone vendors.

Robust earnings growth to support double. We forecast SCUD’s core earnings

CAGR of 72% over 2013-2016E with revenue CAGR of 32%, mainly driven by (1)

42% battery shipment CAGR from 2013 to 2016E, (2) introducing new customers

such as Lenovo, and potential top-tier China/Korea and Taiwan brands from 2014

onwards will be able to offset its gradual decline of GPM from 15.6% in 2013 to 13.2%

in 2016 due to robust demand from lower margin ODM business.

Risks to our target price: 1) Substantial smart devices demand slow down in China;

2) More competition from local battery producers; 3) Capacity expansion execution

risk; 4) Battery bare cell supply risk.

Vivien Chan

+852 2135 0248

[email protected]

Initial Coverage

BUY

Close price: HK$0.94

Target Price: HK$1.72 (+83%)

Key Data

HKEx code 1399

12 Months High (HK$) 0.97

12 Month Low (HK$) 0.36

3M Avg Dail Vol. (mn) 11.39

Issue Share (mn) 1,032.00

Market Cap (HK$mn) 970.08

Fiscal Year 12/2013

Major shareholder (s) Fang Jin (48.9%)

Source: Company data, Bloomberg, OP Research

Closing price are as of 20/6/2014

Price Chart

1mth 3mth 6mth

Absolute % 20.5 16.0 94.2

Rel. MSCI CHINA % 18.2 8.7 95.3

Exhibit 1: Forecast and Valuation Year to Dec (RMB mn) FY12A FY13A FY14E FY15E FY16E

Revenue 1,822 2,392 3,441 4,348 5,549

Growth (%) 10.2 31.3 43.8 26.3 27.6

Core net profit (163) 38 105 153 195

Growth (%) (374) (124) 174 46 28

Diluted EPS (HK$) (0.197) 0.046 0.118 0.172 0.219

EPS growth (%) (373.7) (123.5) 154.6 45.5 27.7

Change to previous EPS (%)

Consensus EPS (RMB)

0.000 0.000 0.000

ROE (%) (13.9) 3.4 8.9 11.7 13.2

P/E (x) (4.8) 20.5 8.0 5.5 4.3

P/B (x) 0.7 0.7 0.6 0.6 0.5

Yield (%) 0.0 0.0 0.0 0.0 0.0

DPS (HK$) 0.000 0.010 0.025 0.037 0.047

Source: Bloomberg, OP Research

0.0

0.2

0.4

0.6

0.8

1.0

Jun/13 Sep/13 Dec/13 Mar/14 Jun/14

HK$1399 HK MSCI CHINA

Mon, 23 Jun 2014

SCUD Group (1399 HK)

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Table of Contents

Industry Landscape ...................................................................................................................................... 3

Competitive Advantages .............................................................................................................................. 9

Financial Forecasts .....................................................................................................................................15

Investment Risks .........................................................................................................................................18

Appendix I - Management Profiles ..............................................................................................................19

Appendix II – Corporate Background ..........................................................................................................20

Appendix III – Production Plants and Products ...........................................................................................21

Financial Summary .....................................................................................................................................23

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Industry Landscape

China domestic handset vendors’ revolution

China has been the largest smartphone market in the world since 2013. And,

without a doubt, China’s smartphone market is set to have uninterrupted robust

growth in the next couple years. The market delivered over 350mn units of

devices in 2013, up 63% yoy from 215mn units in 2013. The robust shipment

growth was mainly driven by telecom operators’ handset subsidies; increasing

mobile applications and vendors launching affordable smartphone devices are

available on the market. We believe smartphone penetration rate is around 50%

in China. After two years of exceptional growth, China’s shipment volume is

expected to chalk up a moderate growth of about 22% in 2014E, increasing to

some 400mn units.

Exhibit 2: China smartphone shipments by quarterly

Source: IDC, OP Research

Exhibit 3: China smartphone shipments forecast


0

30

60

90

120

150

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14

(mn units)

0

100

200

300

400

500

600

2009 2010 2011 2012 2013 2014E 2015E 2016E

(mn units)

China smartphone shipment is

expected to surge to about 400mn

in 2014, up 22%

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Among major smartphone devices vendors in China, Samsung continues to take

the lead in the smartphone market. Samsung grabbed 19% of overall market

share in China, according to the statistics in 4Q13. Lenovo came in second with

12% market share, with Apple dropping to 10%. We see domestic vendors

standing strong in the market, supported by their price competitiveness. Other

domestic players such as Huawei, CoolPad, Xiaomi and ZTE also boosted their

market shares with broader smartphone portfolios and expanding distribution

networks.

Exhibit 4: China market share breakdown by brands (1Q14)

Source: Counterpoint, OP Research

Based on an optimistic view of China’s smartphone markets, most top-tier

domestic vendors are targeting aggressive sales growth in 2014, like Xiaomi and

OPPO, have set sights on at least doubling sales volume in 2014; TCL aims to

sell 90% more smartphones than 2013 this year. All other leading brands expect

at least 50% growth this year. So we believe the double-digit growth for the entire

country is achievable. That's not surprising as China continues to overtake the

United States as a top handset market in a number of different ways.

Others, 22%

Sumsung, 18%

Lenovo, 12%Xiaomi, 11%

CoolPad, 10%

Huawei, 8%

Apple, 10%

ZTE, 6%

OPPO, 3%

Domestic smartphone players

gaining market share

Major domestic smartphone

vendors aiming for robust sales

growth

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Exhibit 5: China top-tier domestic vendors’ shipments and targets

Source: Company Data, OP Research

Exhibit 6: Major domestic vendors’ 2014 shipments growth


According to MIIT statistics, China’s overall handset shipment declined 24.7%

yoy in 1Q14, the first decline after seven consequent quarters since 2Q12. The

big drop was caused mainly by sluggish demand of feature phones, given that

smartphone shipments only fell by 9.8% yoy. It is believed that smartphone

shipment dropped because MIIT deferred launching of 4G licences, and

customers also postponed plans to buy 4G smartphone. We see it was not an

indicator of any slowdown in the smartphone market. We expect shipment to

pick-up in 2H14 after the launching of 4G licences. As the 4G era is closing,

domestic vendors will continue to benefit from the new industry landscape given

their higher cost-to-performance ratio than foreign brands.

0

20

40

60

80

100

Huawei TCL Xiaomi OPPO CoolPad ZTE Lenovo

(mn units)

2013 2014E

0%

30%

60%

90%

120%

150%

Huawei TCL Xiaomi OPPO CoolPad ZTE Lenovo

A temporary slowdown in 1Q14 is

not a concern

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What’s next? Structural upgrade from low-end to mid-end devices

Launching of 4G service not only drives higher demand for smartphones, it also

triggers a structural smartphone upgrade from low-end to mid-end. Domestic

devices vendors used to have low-end products. With higher branding awareness

and popularity in the country, domestic vendors are improving their product mix to

launch more upgrade smartphone models which price above RMB1,000,

especially the successful of Xiaomi’s Mi2 and Mi3 smartphones.

Furthermore, launching of the 4G service is another reason to tick off the upgrade

cycle. Currently, only China Mobile (941 HK) is providing 4G service through its

TD-LTE network. But the growth of 4G use is very slow, due to lack of 4G

smartphone devices on the market. However, the market is expecting the Ministry

of Industrial and Information Technology (MIIT) to issue 4G FDD-LTE licences to

China Unicom (762 HK) and China Telecom (728 HK) in 2H14. We expect it will

trigger another round of smartphone upgrading cycle that, in turn, will become

another driver of 4G smartphone sales in China. We believe domestic

manufacturers will be the market share winners of the smartphone boom, with

Xiaomi, Huawei, Lenovo and ZTE the most likely to beneficiaries.

Handset vendors equip their new smartphone with upgraded hardware, such as

faster processors, higher-resolution camera, larger screen, more memory, etc.

These advanced hardware and functions all require higher quality of battery. Also,

rapid adoption of mobile e-commerce and higher demand of self-portrait are

increasing demand from premium battery. As a result, we expect more domestic

handset vendors will swift to high-quality, imported battery bare cell for their new

models and SCUD is well-positioned to reap the profit with 72% earnings CAGR

in coming three years from this structural upgrade trend.

Building brand recognition in overseas markets

Besides the domestic market, some domestic vendors are also planning boost

sales in overseas markets. We see some domestic brands which have strong

overseas footprints promoting their smartphone products aggressively, especially

in emerging markets, through their own sales networks. Huawei and Lenovo are

two good examples. According to IDC’s statistics, two domestic vendors, Huawei

and Lenovo had 4.9% and 4.5% of respectively global smartphone market share

in 2013. It had risen from 4.0% and 3.3% respectively in 2012. Other studies

show that emerging markets smartphone demands are expected to lead mature

markets from 2014. We expect rapid sales surge in emerging markets will

become another sales driver for domestic smartphone vendors in coming years.

To tap into the overseas market, we believe domestic smartphone needs to come

with upgraded hardware like higher quality, more stable battery performance.

Smartphone with higher-quality hardware will win the overseas market.

Smartphone component suppliers

benefit from upgrade cycle driven

by kicking off 4G services

Domestic smartphone makers are

keen to build their overseas

reputations

http://data.cnbc.com/quotes/992-HK

http://www.cnbc.com/id/101370223

Mon, 23 Jun 2014


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Exhibit 7: Top-5 smartphone vendors market share


Exhibit 8: Global smartphone market forecast by regions


Samsung31%

Apple15%

Huawei5%

LG5%

Lenovo5%

Others39%

2013

Samsung30%

Apple19%

Huawei4%

LG4%

Lenovo3%

Others40%

2012

0

400

800

1,200

1,600

2,000

2013 2014E 2015E 2016E 2017E

(mn units)

China Mature markets Emerging markets

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Battery, the smartphone spec that matters most

As numberous surveys have shown, battery life is one of the most important, and

sometimes the most important feature that needs improvement in modern

smartphones. Camera quality, processing speeds and screen resolution seem to

have reached a pretty satisfactory level on modern phones, even on most

mid-rangers, but daily juicing is still required for the vast majority of them, unlike

in days past, where you only needed to top off once or twice a week.

Due to their higher gravimetric and volumetric energy density, lithium-ion and

lithium-polymer batteries are widely used in portable devices. One of the greatest

design challenges is the safety of the battery-operated system. Enhanced safety

is a clear need for current and higher-energy lithium-ion battery development and

utilization. The technology of producing battery and quality of battery are

essential to usage of smartphone; and also of importance to smartphone vendors.

The long established reputation of vendors could be ruined by a single battery

accident. The OEM batteries not only ensure consistency in components, but also

the oversight of the phone’s manufacturer during production, which likely also

means better battery life. For these reasons, we believe smartphone vendors

would select their battery suppliers carefully and strictly to ensure battery quality.

Battery life is always going to be an important spec to users.

Battery life is always going to be

an important spec to users

http://www.phonearena.com/news/Survey-shows-battery-life-to-be-the-single-main-gripe-of-todays-mobile-phone-user_id49818

Mon, 23 Jun 2014


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Competitive Advantages

SCUD’s business segmentations are 1) own-brand business, selling mobile

phone battery and other accessories under “SCUD 飛毛腿” and “Chaolitong 超力

通” labels; 2) ODM business, which producing smartphone embedded batteries to

handset vendors. It also produces batteries for portable power banks; 3) bare

battery cell business, turning out bare battery cells for relatively low-end clients.

The one who gets premium battery bare cell gets the sky

An embedded smartphone lithium battery consists a bare cell with an electrode

assembly having two electrodes and a separator, a case for storing the electrode

assembly, a cap plate for covering an opening of the case, and a protection circuit

module coupled with the cap assembly. The quality of bare cell is extremely

critical to the overall usage satisfaction of the smartphone.

Some handset vendors require high quality and longer battery life to support their

ongoing upgrade operation system, and extended battery life time enriches the

joys of using smartphones. But domestic battery suppliers cannot fulfill these

requirements.

Using imported bare battery cells is one of the solutions. SCUD is one of only a

few domestic battery manufacturers who are able to source lithium-ion bare

battery cells from top-tier producers in Japan and Korea, such as Sony,

Sanyo/Panasonic, Samsung and LGE. Thanks to SCUD’s long term relationships

with these leading bare cell suppliers.

The advantages of overseas lithium-ion bare cells compared to the domestic

products are:

Exhibit 9: Advantages of overseas bare cell

1) More stable performance

2) Longer product life

3) Higher energy density minimizes battery size and weight

4) Lower probability of bust and higher production yield

5) Higher leak resistance

6) Wider temperature range for operation and storage

7) No memory accumulation thus providing a full charge every time

Source: Company, OP Research

Panasonic also supplies lithium-ion batteries to Tesla, the U.S. premium eco-car

maker. Although automobile lithium-ion battery is different from smartphone

battery, nevertheless, it is an indication of the premium quality of Panasonic’s

technology in lithium battery.

SCUD’s ODM business also engages in battery management system solution

designs with handset vendors. SCUD helps to design the specifications of battery

according to handset vendors’ requirements, and suggest certain battery bare cell

modules from Japan or Korea. After importing bare cells from Japan and Korea,

further assembly processes in SCUD’s plants including spot-welding and

protection circuit module (PCM) sub-assembly; attaching battery cell module;

assembly into core pack; quality control and packing.

Capable of sourcing premium

bare cell is one of SCUD’s

irreplaceable advantages to its

rivals

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If we describe battery cell as the “heart” of a battery, then PCM is the "brain" of

the lithium-ion battery pack. It protects lithium-ion battery pack from overcharging,

over-discharging and over-drain, therefore it is must have to avoid lithium-ion

battery pack from exploding, firing and damage. SCUM manufactures PCM for

battery packs.

Its ability to get battery bare cells sets SCUD apart from all others, and creates a

high entry barrier for other domestic battery players and newcomers. SCUD’s

sourcing ability suggests it could become a major beneficiary of strong demand of

mid to high-end smartphones in China.

When supply meets demand, SCUD gains

As we stated previously, China is becoming the largest smartphone market in the

world, after its continuous and exceptional sales growth. The overseas upstream

battery bare cell providers wants a share of China’s smartphone market to

support their profits. While domestic handset vendors need a stable supply of

high quality battery at competitive prices. SCUD perfectly links both desires

together. SCUD sold 61mn units of ODM batteries in 2013. We expect the volume

growth will continue to be high in coming years. SCUD’s client portfolio includes

several China leading handset vendors including Xiaomi, Huawei, and ZTE, etc,

which are expanding their clients mix while their sales volumes are also expected

to rapidly increase.

With downstream leading smartphone vendors’ bulk orders and solid

relationships with upstream top-tier bare cell suppliers, SCUD is increasing its

bargaining power on both sides, in our view. According to managements, During

the battery supply shortage period in 2011 Japan earthquake, SCUD

demonstrated and differentiated its leading market position in China battery

market as the first local supplier to resume import battery bare cell from Japan in

1 month for its Chinese customer. As a result, SCUD was the exclusive battery

supplier for Xiaomi’s flagship model and tablet and we also see more top-tier

smartphone makers would select SCUD as their key battery supplier, especially

for mid-end flagship products as a battery explosion accident is too just costly for

them. We believe the unique sourcing capabilities and repectable customer

portfolio put SCUD in an increasingly important position in China’s smartphone

value chain that cannot be replicated by others.

Re-focuses on ODM, strong rebound

Shifting trends in the past few years led to decline in sales and profitability of

own-brand businesses. Hence SCUD is scaling down its own-brand business to

re-focus on the profitable ODM segment which generated RMB1,575mn revenue

last year, vs. RMB820mn in 2012, accounting for 66% of total income. SCUD sold

61mn pieces of smartphone batteries last year, up 136% yoy from 26mn pieces in

2012.

Huawei is its largest client, with 29% of both volume and ODM sales, followed by

Xiaomi which accounted for 23% share of ODM sales. The company also is the

exclusive domestic battery provider for Xiaomi’s Mi2 and Mi3 smartphones in

2013. SCUD also supplies batteries to Mi Pad, Xiaomi’s first tablet. Management

is also confident SCUD will continue to be Xiaomi’s key battery supplier for its

new smartphone model Mi4.

SCUD is able to increase

bargaining power on both supply

and demand sides

Increasing exposure to leading

domestic smartphone vendors

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Exhibit 10: Clients mix, in terms of sales


All Chinese handset vendors are working on aggressive sales growth in 2014.

Xiaomi aims for more than double its sales, Huawei wants to hit 57% growth.

Without a doubt, SCUD will enjoy the organic sales growth, mainly driven by

rising penetration of smartphone in China. We believe China’s smartphone era

will continue in next few years, and SCUD is well positioned itself as the

beneficiary of the devices upgrade cycle, as customers want longer battery life

and SCUD is just the one to produce smartphone battery with a wide range of

density capacity.

On top of enjoying strong demand growth from existing clients, SCUD is also

diversifying its client mix to reduce client structure risks. According to

management, the company broke into Lenovo’s supply chain this year and will

continue to improve its customer mix with more leading domestic smartphone

vendors. With more domestic vendors are expected to adopt imported bare cell

for their mid to high-end devices, we think SCUD is able to attract other major

domestic smartphone vendors. We believe CoolPad, HTC, Gionee, etc, are all

potential clients for SCUD.

Supported by both sales of new clients, and robust demand of existing clients, we

are projecting a sales volume growth of 74% yoy, reach 105mn pieces this year.

And we expect the company will achieve a volume CAGR of 54% during

2013-2016, with strong revenue CAGR of 43% during the period.

Huawei29%

Xiaomi23%

ZTE16%

Panasonic/sanyo9%

TCL7%

Others16%

Expect battery volume CAGR 54%

over 2013-2016, supported by

existing and new clients’ demand

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Exhibit 11: Top-5 customers’ sales growth


Other than production of smartphone batteries, SCUD’s ODM business also turns

out portable power bank. These segments account for 11.5% of SCUD’s overall

ODM business. We expect these segments to maintain stable revenue growth

going forward. The entire ODM segment will experience an extraordinary growth

of 92% yoy in 2014 and continue to be SCUD’s key profit driver in coming years.

Exhibit 12: ODM business sales breakdown


244%

174%

-1% -2%

-10%

40%

90%

140%

190%

240%

290%

Huawei Xiaomi ZTE Panasonic/sanyo

0

400

800

1,200

1,600

2,000

2012 2013

(RMB mn)

Smartphone battery Power bank Others

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New capacity fuels exceptional order growth

SCUD saw an ODM battery revenue growth of 92% in 2013, as domestic

smartphone expanded. The company shipped 61mn pieces of batteries in 2013.

Current output capacity of the smartphone battery is around 60mn pieces, so the

plant is running at full capacity. Given the overwhelming orders received, SCUD

has already gone beyond this at the beginning of the year. SCUD is now engaged

in expanding production capacity to 100mn pieces, at the same time targeting

total output capacity to 200mn in later years. Given our view of solid smartphone

industry growth going forward, we expect shipments to exceed 100mn pieces this

year, with a further increase to over 150mn pieces in 2015.

Tablet, the next sweet spot that we not yet taken into account in our

earnings estimate

Without a doubt China’s clout in the mobile industry is growing, not only in

smartphone sector, but also in the tablet sphere. By the same token big

international player like Apple have seen their share of the Chinese tablet market

plunging over the past few quarters, while dozens of local vendors built on gains

in tablet market to curb growth in iPad shipments. Apple accounted for 32% of

tablet shipments in 1Q14, down from 40% a year ago. Market share of Lenovo’s

tablet increased from 1.3% in 1Q13 to 4.1% in 1Q14. And Huawei, ZTE and

CoolPad all had launched their tablet products in previous years, while Xiaomi

broke into tablet market in May 2014. China’s tablet market is moving up slowly,

the market size being relatively small viz-z-viz the smartphone market, as it is still

in its infant stage, but with healthy growth looming on the horizon.

We expect SCUD to seize pre-emptive opportunities, taking advantage of

growing interest in tablets, by leveraging on burgeoning client portfolio and the

rich experience of high quality battery production. As each tablet requires two

smartphone batteries, tapping into table market will take SUCD to higher volume

growth, with the potential to become the next growth engine.

Exhibit 13: Shipment and market share of key table producers


40.2%

17.5%

5.4%

1.3%

3.7%

31.8%32.5%

22.3%

5.0%4.1%

1.9%

34.2%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0

5

10

15

20

25

Apple Samsung ASUS Lenovo Amazon Others

1Q13 1Q14 1Q13 (%) 1Q14 (%)

Expand capacity to over 150mn

pieces in 2015

SCUD is catching up rising tablet

demand in China

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Stable growth of own brand business

SCUD scaled down its own brands sales (both SCUD and Chaolitong brands) in

2013 due to weak demand and low profitability. The segment’s revenue declined

18.3% yoy from RMB1,001mn to RMB818mn in 2013, 34% of top-line. The

revenue plunge was mainly caused by significant sales decline in old-fashion

mobile phone batteries, sales of which dropped 44% yoy in 2013. But other

smartphone accessories, such as power bank, chargers, and bluetooth headset

made significant gains. SCUD also produce wireless charger, the product

embedded on the surface of table, which are becoming popular in western

countries. SCUD refunded distributors for the old back-up batteries in 2013. Since

then, the distributor has mainly help to sell its smartphone accessories. The

sub-segment is expected to have stable sales growth going forward, backed by

rising demand along with smartphone sales increase.

SCUD used to produce bare battery cell on its own. The sub-segment came with

an income of RMB175mn in 2013, reduced from RMB274mn in 2012. The

product was supplied to relatively low-end domestic mobile phone producers.

Due to the sluggish demand and SCUD shifts focus to high-end smartphone

battery business, the company announced dispose of this business in June 2014.

Exhibit 14: Own brand business product sales breakdown


0

200

400

600

800

2012 2013

(RMB mn)

Mobile phone battery Power bank Chargers Bluetooth headsets Others

Own brand business to grow 5%

p.a.

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Financial Forecasts

Revenue CAGR of 33% and core earnings CAGR of 73% over

2013-2016E

We forecast revenue CAGR of 32% for SCUD over 2013-2016E, on the back of

operating leverage and rapid volume CAGR of 54% in its ODM business, strong

partnerships with overseas premium bare battery cell producers, and China’s

increasing smartphone market. We expect the company to expand the ODM

battery capacity from 60mn pieces at year-end 2013 to 200mn pieces by the end

of 2015. The company will continue to focus on ODM battery business and

diversify its client mix. Its ODM business revenue is expected to record a CAGR

of 43% over 2013-2016E, driven by robust volume growth.

We expect RMB28mn of provision for intangible assets in FY14E. Striping out of

this one-off item, we expect SCUD’s core earnings of RMB105mn in FY14E. And

core earnings will register a CAGR of 72% over 2013-2016E, thanks to rising

production operating efficiency. We have not factored in the one-off loss in our

model, which we believe might be less than our previous expectation.

On 19 June 2014, SCUD announced to grant 80mn share options to executive

directors, managements and employees as an incentive scheme. Our

FY14E/15E EPS estimation of RMB0.094 and RMB0.137 are based on the fully

diluted EPS, which assume all options are fully exercised.

Better operating scale to mitigate ASP decline

Despite decreasing smartphone battery ASP, SCUD is capable to of limiting the

magnitude of the downward trend by proactively expanding its lithium-ion

smartphone business by acquiring new automated and semi-automated

equipment to increase production efficiency, leading to higher product quality and

less labour pressure.

We prudently expect gross margin of ODM business decline to 12.7% and 12.3%

in 2014E-2015E, from 13.4% in 2013. And overall ODM business gross margin to

decrease slightly from 13.9% in 2013 to 13.2% in 2014E and 12.7% in 2015E. We

estimate SCUD’s blended gross margin of 14.3% and 14.0% in 2014E and 2015E,

respectively.

CAPEX and working capital

In order to take advantage of the rapidly growing smartphone battery business,

and capture growing smartphone accessory demand, SCUD needs

RMB200-300mn per year for CAPEX and working capital in FY14E-FY16E

towards smartphone battery capacity expansion and production facilities

upgrades. We estimate its smartphone battery capacity will raise to 100mn pieces

and 200m pieces in FY14E and FY15E.

SCUD had RMB354mn in net cash by end-2013. 2014 CAPEX will be fulfilled by

bank loan. We believe the company can meet its CAPEX and working capital

requirement of RMB200-300mn for FY14E and FY15E, while secured additional

credit line and capital funding sourcing can service as other funding sources.

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ROE and net gearing

We model ROE of 9% in FY14E and surge to 12% in FY15E. And net gearing of

24% and 21% in FY14E and FY15E respectively, after CAPEX and working

capital for capacity expansion.

Exhibit 15: Key assumptions

Key assumption table 2012 2013 2014E 2015E 2016E

Revenue (RMB mn)

ODM business 820 1,575 2,482 3,433 4,590

Smartphone battery 638 1,392 2,251 3,120 4,165

Others 182 182 232 313 424

Own-brand business 1,001 818 859 902 947

Revenue growth

ODM business 32% 92% 58% 38% 34%

Smartphone battery 12% 118% 62% 39% 33%

Others 242% 0% 27% 35% 36%

Own-brand business -3% -18% 5% 5% 5%

Battery volume

ODM battery sales volume (mn pieces) 26 61 106 157 222

ODM battery volume growth 25% 136% 74% 48% 42%

Gross margin

Overall ODM gross margin 15.1% 13.9% 13.2% 12.7% 12.3%

Own business gross margin 17.2% 19.1% 19.0% 19.0% 18.0%

Blended gross margin 16.2% 15.6% 14.3% 14.0% 13.2%

Net Margin N/A 1.6% 3.1% 3.5% 3.5%


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Valuation

A primary proxy to China’s rising smartphone market

We value SCUD using PE methodology. Our target price of HK$1.72 implies

14x/10x FY14/15E PE with 72% earnings CAGR in 2013-1016E, at par to its

peers 13x/10x FY14/15E PE. We believe SCUD is justified a premium valuation

against its peers given its solid strong earnings growth prospect in the coming

three years as compared to the peers’ average 22% earnings CAGR.

We believe the ODM battery business will continue to be SCUD’s major earning

driver over the next few years. Its near-term re-rating catalysts include: 1) Strong

2014E ODM battery volume growth and earnings rebound; 2) Exposure to top-tier

domestic smartphone vendors; 3) Well-positioned as the key beneficiary of

China’s domestic smartphone vendors are increasing their market shares both

locally and overseas; 4) SCUD’s ability to leverage its un-replicable sourcing

capabilities of premium overseas bare battery cells to secure orders from China’s

leading smartphone vendors.

We believe the company has successfully transited from old, lower-profit

business, and captured the upward trend of China’s mobile devices market which

is driven by rising popularity of smartphone in the country and smartphone

upgrade cycle that led by the 4G services kick off.

Given our estimation of SCUD’s revenue CAGR of 32%, core earnings CAGR of

72% during 2013 – 2016E, and continuous net margin improvement driven by

operating leverage, we believe the counter’s current valuation of 8x/6x FY14/15E

PE, and 0.6x FY14E PB are not justified. We believe SCUD deserves a re-rate,

based on its unique competitiveness advantages and the trend of domestic

smartphone vendors increasing their market shares. We initiate a BUY rating for

SCUD, believing it is a primary proxy to China’s strong penetration growth in

smartphone and tablet industry.

Mon, 23 Jun 2014


of 26

Investment Risks

Capacity expansion’s execution risk

We expect SCUD to execute an ambitious capacity expansion plan over the next

two years, mainly via organic growth. It comes the inherent risks of demand

growing faster than output expansion, which may lead to loss of new orders to

rivals.

Supplier risks

SCUD depends on overseas bare battery cell suppliers to make smartphone

batteries. The sourcing right is non-exclusive, and overseas suppliers may have

the right to terminate and not renew supply agreements with SCUD. Once SCUD

loses procurement rights from overseas, its net profit would be hurt.

Domestic brand smartphone competition

We are concerned about increasing competition between domestic smartphone

vendors, because many of them are looking at aggressive sales targets and

gaining market share. Should a smartphone devices price war break out, we are

concerned that it may spread to upstream component suppliers. Price war might

offset the margin benefits from production scale expansion and product mix

improvement. And we expect that any small decline in battery gross margin could

have large impact on earnings, due to single digit net profit margin.

However, we believe SCUD is better positioned than its domestic rivals because

of its exposure to the high quality smartphone battery segment. SCUD’s unique

sourcing bare cell capability also helps to create barriers against other players

and increase client stickiness. Nevertheless, competition risk cannot be

overlooked.

Smartphone demand slow down in China, though most unlikely in

near term

SCUD’s earnings are highly related to China’s domestic smartphone demands.

Demand slow down would adversely hurt SCUD’s profits. China’s smartphone

penetration was around 55% in 2013, and expects to rise to 65% during 2014 and

2015. We believe smartphone volume growth will be driven by both high demand

of first-time buyers and upgrade replacement users.

There are concerns on the ground that the slow down in 1Q14 smartphone

shipments may signal a demand slowdown in China. But we argue that it was

caused by the delay launching of 4G devices to 2H14. We believe it was

temporary, and expect a strong shipment pick up in 2H14.

Mon, 23 Jun 2014


of 26

Appendix I - Management Profiles

Mr. Fang Jin, Founder/Executive Director/Chairman: Aged 55, Mr. Fang is

mainly responsible for the company’s development planning, operations and

corporate investment decision-making and brand strategy. Mr. Fang has more

than thirty years of experience in mobile phone accessories industry. He is

keen-eyed and visionary when it comes to branding strategies and the

marketability of new products. Prior to the establishment of Scud (Fujian)

Electronics Company Limited (“Scud Electronics”) in 1997, Mr. Fang was

engaged, as a sole proprietor, in the sales of communication products and

accessories in the PRC.

Mr. Guo Quan Zeng, Executive Director/CEO: Aged 53, Mr. Guo is an engineer,

a graduate of the Navy Senior Electronic Engineering School. He joined the

company in 1997, mainly responsible for daily operations. Mr. Guo had been the

manager of the R&D, sales, planning, production and QC department of SCUD.

He has abundant experiences managing business development, brand promotion,

product R&D, and quality control.

Ms. Huang Yan, Executive Director/GM of SCUD E-commerce center: Aged

34, Ms. Huang is mainly responsible for own-brand e-commerce business

division, brand culture construction, brand marketing, development and

integration of sales channel. She has many years of experience in the business of

telecommunication products and is dedicated to technology innovation,

management, establishment and maintenance of sales channels.

Mr. Zhang Li, Executive Director/GM: Aged 53, responsible for ODM battery

business. Mr. Zhang joined SCUD in 2003, and has been the deputy GM of

SCUD Electronics. Mr. Zhang graduated from Mechanical Engineering Faculty of

Jiangxi University. Prior to joining SCUD, he worked for Fujian Start Network, and

Fujian Communications and Broadcasting Industrial Company.

Mr. Yeung Mun Tai (FCCA, CPA): Aged 37, is the Company Secretary of SCUD.

He also is CFO, and responsible for oval financial and accounting affairs. He is a

member of the Association of Chartered Certified Accountants and a member of

the Hong Kong Institute of Certified Public Accountants. Mr. Yeung has more than

fourteen years’ experience in the accounting field, and he had worked in an

international accounting firm before joined SCUD.

Mon, 23 Jun 2014


of 26

Appendix II – Corporate Background

Founded in 1997, SCUD started business as a manufacturer of rechargeable

back-up battery and accessories for after-market of feature phones, when the

traditional feature phone was popular in 90’s. The production plants locate in

Fuzhou, Fujian Province. The company listed in Hong Kong Exchange in 2006.

SCUD sold its products under well-known brands of “SCUD 飛毛腿 ” and

“Chaolitong 超力通” thru its nationwide distributors in China. However, SCUD’s

old products were confronted by tremendous challenges under the worldwide

restructuring of the mobile phone industry. At the same time the handset device

was metamorphosing from a feature mobile phone to a smartphone. The

smartphone totally eroded the market share of feature phone and SCUD

recorded a net loss of RMB163mn in 2012.

In 2012 it decided to shift its business focus from own brand products to ODM

battery manufacturing. The company implemented a refund policy to refund

distributors for the back-up batteries they had previously purchased, to offset

trade receivables. This refund policy allowed distributors to tackle the difficulties

in overstocking and to purchase new products with liquidized capital. As a result,

SCUD recorded a one-off impairment of RMB152mn in 2012 arising from the

refund policy.

SCUD shifted business focus on ODM battery in 2013. Relied on its good track

record of battery manufacturing, SCUD gained traction with leading domestic

handset suppliers. It became the key battery supplier of Xiaomi, Huawei, ZTE and

TCL, etc. The ODM battery business generated revenue of RMB1,393mn in FY13,

up 118.3% yoy. SCUD aims to proactively expand the ODM business, and will

continue to grow rapidly to become a key profit driver for the company.

Mon, 23 Jun 2014


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Appendix III – Production Plants and Products

Exhibit 16: Smartphone battery prodction plant


Exhibit 17: PCM production plant


Mon, 23 Jun 2014


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Exhibit 18: Portable power bank


Exhibit 19: Wireless charger


Mon, 23 Jun 2014


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Financial Summary

Year to Dec FY12A FY13A FY14E FY15E FY16E Year to Dec FY12A FY13A FY14E FY15E FY16E

Income Statement (RMB mn)

Ratios

ODM business 820 1,575 2,482 3,433 4,590

Gross margin (%) 16.2 15.6 14.3 14.0 13.2

Own-brand business 722 631 859 902 947

Operating margin (%) (11.0) 3.1 3.9 5.3 5.1

Bare battery cell business 274 175 87 0 0

Net margin (%) (8.9) 1.6 3.1 3.5 3.5

Others 5 13 13 13 13

Selling & dist'n exp/Sales (%) 3.3 2.4 2.0 1.8 1.6

Turnover 1,822 2,392 3,441 4,348 5,549

Admin exp/Sales (%) 15.8 10.8 8.7 7.0 6.6

YoY% 10 31 44 26 28

Payout ratio (%) 0.0 0.0 0.0 0.0 0.0

COGS (1,527) (2,020) (2,951) (3,740) (4,816)

Effective tax (%) 10.4 41.4 18.0 18.0 18.0

Gross profit 294 372 490 607 733

Total debt/equity (%) 26.3 28.6 42.4 39.8 33.6

Gross margin 16.2% 15.6% 14.3% 14.0% 13.2%

Net debt/equity (%) 1.0 Net cash 24.1 20.7 14.2

Other income 11 18 19 13 16

Current ratio (x) 1.8 1.7 1.4 1.4 1.4

Selling & distribution (60) (57) (69) (77) (86)

Quick ratio (x) 1.3 1.3 1.0 1.0 1.0

Admin (289) (259) (299) (303) (367)

Inventory T/O (days) 110 77 88 86 80

Loss on refund (152) (11) 0 0 0

AR T/O (days) 127 88 88 88 82

Other opex (7) 11 (7) (9) (11)

AP T/O (days) 111 130 130 132 132

Total opex (507) (317) (375) (389) (464)

Cash conversion cycle (days) 125 34 46 42 30

Operating profit (EBIT) (201) 73 135 232 284

Asset turnover (x) 0.9 1.1 1.3 1.3 1.4

Operating margin -11.0% 3.1% 3.9% 5.3% 5.1%

Financial leverage (x) 1.8 2.0 2.3 2.5 2.6

Provisions 0 0 0 0 0

EBIT margin (%) (11.0) 3.1 3.9 5.3 5.1

Finance costs (14) (26) (36) (46) (46)

Interest burden (x) 1.1 0.6 0.7 0.8 0.8

Profit after financing costs (215) 47 99 187 238

Tax burden (x) 0.8 0.8 1.1 0.8 0.8

Associated companies & JVs 0 (0) (0) (0) (0)

Return on equity (%) (13.9) 3.4 8.9 11.7 13.2

Pre-tax profit (215) 47 99 186 238

ROIC (%) (15.7) 3.7 8.2 11.8 13.3

Tax 22 (20) (18) (34) (43) Minority interests 30 11 24 0 0

Year to Dec. FY12A FY13A FY14E FY15E FY16E

Core net profit (163) 38 105 153 195

Balance Sheet (RMB mn)

YoY% (374) (124) 174 46 28

Fixed assets 358 349 461 450 498

Net margin -8.9% 1.6% 3.1% 3.5% 3.5%

Intangible assets & goodwill 45 32 31 29 29

EBITDA (122) 134 197 300 354

Associated companies & JVs 0 1 1 1 1

EBITDA margin -6.7% 5.6% 5.7% 6.9% 6.4%

Long-term investments 0 0 0 0 0

EPS (RMB) (0.158) 0.037 0.094 0.137 0.176

Other non-current assets 38 29 29 29 29

YoY% (374) (124) 155 46 28

Non-current assets 440 411 522 509 556

DPS (RMB) 0.000 0.010 0.025 0.037 0.047

Inventories 460 424 711 881 1,056

Year to Dec. FY12A FY13A FY14E FY15E FY16E

AR 633 576 830 1,048 1,247

Cash Flow (RMB mn)

Prepayments & deposits 154 317 456 577 736

EBITDA (122) 134 197 300 354

Other current assets 148 242 242 242 242

Chg in working cap (309) 28 (308) (171) (95)

Cash 279 354 224 264 306

Others 273 64 0 0 0

Current assets 1,673 1,914 2,464 3,012 3,587

Operating cash (159) 226 (110) 129 259 Interests paid (14) (26) (36) (46) (46)

AP 465 720 1,051 1,353 1,742

Tax (5) (9) (9) (18) (34)

Tax 11 9 18 34 43

Net cash from operations (177) 191 (155) 66 180

Accruals & other payables 80 95 137 173 220

Bank loans & leases 289 321 520 550 530

Capex (44) (67) (179) (165) (122)

CB & other debts 0 0 0 0 0

Investments 0 0 0 0 0

Other current liabilities 100 3 3 3 3

Dividends received 0 0 0 0 0

Current liabilities 946 1,148 1,728 2,112 2,538

Sales of assets 0 0 0 105 0 Interests received 4 5 5 4 5

Bank loans & leases 0 0 0 0 0

Others (17) (83) 0 0 0

CB & other debts 0 0 0 0 0

Investing cash (57) (145) (174) (56) (117)

Deferred tax & others 3 5 5 5 5

FCF (234) 46 (329) 10 62

MI 61 49 24 24 24

Issue of shares 0 0 0 0 0

Non-current liabilities 64 54 30 30 30

Buy-back 0 0 0 0 0 Minority interests 0 0 0 0 0

Total net assets 1,103 1,122 1,227 1,380 1,575

Dividends paid (17) 0 0 0 0 Net change in bank loans 142 29 199 30 (20)

Shareholder's equity 1,103 1,122 1,227 1,380 1,575

Others 12 0 0 0 0

Share capital 103 103 103 103 103

Financing cash 137 29 199 30 (20)

Reserves 1,000 1,019 1,124 1,277 1,472

Net change in cash (97) 75 (130) 40 42

BVPS (RMB) 1.34 1.36 1.49 1.67 1.91

Exchange rate or other Adj 0 0 0 0 0 Opening cash 375 279 354 224 264

Total debts 290 321 520 550 530

Closing cash 279 354 224 264 306

Net cash/(debts) (11) 33 (296) (286) (224)

CFPS (RMB) (0.172) 0.185 (0.140) 0.059 0.161

Source: Company, OP Research

Mon, 23 Jun 2014


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Exhibit 20: Peer Group Comparison

Company Ticker Price

Mkt

cap

(US$m)

3-mth

avg t/o

(US$m)

PER

Hist (x)

PER

FY1 (x)

PER

FY2 (x)

EPS

FY1

YoY%

EPS FY2

YoY%

3-Yr EPS

Cagr (%)

PEG

(x)

Div yld

Hist (%)

Div yld

FY1 (%)

P/B

Hist (x)

P/B

FY1 (x)

EV/

Ebitda

Hist

EV/

Ebitda

Cur Yr

Net

gearing

Hist (%)

Gross

margin

Hist (%)

Net

margin

Hist (%)

ROE

Hist

(%)

ROE

FY1

(%)

Sh px

1-mth %

Sh px

3-mth %

Scud Group Ltd 1399 HK 0.94 125 1.2 20.3 7.9 5.5 157.6 43.8 67.9 0.1 0 0 0.7 0.6 7.0 6.2 Net Cash 15.6% 1.6% 3.4 9.0 20.5 10.6

HSI 23,194.06 10.8 10.7 9.9 1.1 8.5 5.9 1.81 3.8 3.7 1.38 1.30 12.7 12.1 1.6 9.5

HSCEI 10,395.45 7.6 7.3 6.7 3.8 8.8 7.3 1.00 4.0 4.4 1.16 1.08 15.3 14.8 5.2 13.0

CSI300 2,136.73 9.8 8.5 7.4 14.6 15.1 15.0 0.57 2.6 3.0 1.39 1.27 14.2 14.8 1.0 2.4

Adjusted sector avg* 14.9 12.5 9.7 18.0 29.6 21.6 0.57 1.8 2.3 2.23 1.83 41.4 10.0 44.1 17.2 7.7 11.2 17.7 18.3 (1.3)

Coslight Tech 1043 HK 6.01 290 1.2 10.4 10.1 7.2 3.9 39.6 20.6 0.49 N/A N/A 1.19 0.95 98.2 11.1 99.0 13.0 5.7 (0.6) N/A 19.7 (19.9)

Sunny Optical 2382 HK 10.88 1,540 8.8 19.7 15.9 12.8 24.4 23.8 22.7 0.70 1.4 1.8 3.36 2.81 15.0 10.0 0.0 16.6 7.6 18.5 18.6 18.9 35.8

Byd Electronic 285 HK 6.23 1,811 4.9 17.3 12.1 10.4 43.1 15.4 23.3 0.52 N/A 1.0 1.28 1.17 6.0 4.7 0.0 10.5 4.0 7.6 10.1 37.5 33.4

Truly Intl Hldgs 732 HK 4.59 1,726 9.6 8.0 6.9 5.8 16.5 17.8 18.3 0.38 4.1 4.8 1.94 1.55 5.4 4.6 14.9 14.0 7.8 27.3 24.2 5.5 (7.1)

Tongda Group Hld 698 HK 1.08 761 14.1 14.5 11.5 9.2 25.8 25.5 21.5 0.53 2.3 2.8 2.14 1.73 11.0 8.7 33.4 22.0 9.9 15.8 16.7 16.1 (20.0)

Ju Teng Intl Hdg 3336 HK 5.43 818 3.2 8.2 6.8 5.7 21.5 19.5 22.2 0.30 2.8 3.3 1.02 0.88 5.8 5.1 42.4 20.2 8.2 13.1 13.7 (9.0) (7.7)

Shenzhen Desay-A 000049 CH 40.87 1,348 17.6 40.7 26.6 19.0 53.2 40.0 46.7 0.57 0.3 1.2 14.32 7.45 23.2 N/A 62.4 14.2 4.7 42.5 35.0 0.5 12.5

Sunwoda Electr-A 300207 CH 27.55 1,114 13.3 83.5 31.8 21.9 162.4 45.5 79.0 0.40 0.2 0.7 5.28 4.68 47.4 23.0 26.8 14.4 3.7 6.5 13.4 14.3 35.7

Source: Bloomberg, OP Research

Mon, 23 Jun 2014


of 26

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http://www.oriental-patron.com.hk/opsl/dl_count.php?id=1394&type=company&pdf_path=/upload/File/ASR%20Holdings%20(1803%20HK)%202013%20results%20miss%20estimate%20special%20dividend%20surprises%20-%20BUY.pdf






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Regulatory Disclosures as required by the Hong Kong Securities and Futures Commission

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Analyst Certification:

The views expressed in this research report accurately reflect the analyst’s personal views about any and all of the subject securities or issuers; and no part of the research analyst’s compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in the report.

Rating and Related Definitions

Buy (B) We expect this stock outperform the relevant benchmark greater than 15% over the next 12 months. Hold (H) We expect this stock to perform in line with the relevant benchmark over the next 12 months. Sell (S) We expect this stock to underperform the relevant benchmark greater than 15% over the next 12 month. Relevant Benchmark Represents the stock closing price as at the date quoted in this report.

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