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Morningstar | Hikvision’s 2018 Results in Line, but 1Q 2019 Softer Than Expected; FVE Raised to CNY 38.50

Narrow-moat Hangzhou Hikvision released full-year 2018 earnings that were in line with its preliminary announcement. However, its first-quarter 2019 results came in softer than our expectations. We have adjusted our 2019 growth and margin assumptions downward to reflect the spillover effect of the U.S.-China trade war as well as higher operating expenses. We have also slightly lowered our longer-term revenue growth forecast to take into account national security concerns in overseas markets as well as a more aggressive push into the video surveillance market by information, communication, and technologies players such as Huawei. After rolling forward our cash flow model, our lowered growth estimates were more than offset by the time value of money and the rise in the company’s net cash position. As a result, we modestly raise Hikvision’s fair value estimate to CNY 38.50 per share from CNY 37.50, placing the stock in the 3-star territory. We think the stock is fully valued at the current price level, especially considering that shares have rallied roughly 22% since our initiation in mid-January 2019 and the near-term demand softness.

We have cut our revenue growth forecast to 16.6% CAGR for 2019-23, from 20.5% previously, though we continue to expect Hikvision to outpace the global video surveillance equipment sales CAGR of around 7.5%. Our lower growth estimates stem from our belief that growing national security concerns from western markets will have a more long-lasting negative impact on Hikvision’s overseas prospects. According to management, Europe and the Americas constitute two of Hikvision’s biggest market outside of China. While Hikvision has admitted that it is less focused on the government market in these regions due to national security concerns and the U.S. government ban, we believe that the spillover effect on enterprise and small-medium business opportunities could be more severe than initially expected. Notably, Canon-owned Milestone systems, which is the world’s biggest video management software solutions provider, dropped Hikvision as an “elite partner” in December 2018, thereby relegating Hikvision’s products from Milestone’s priority list of partners. Underpinning our cautious view is a rapid deceleration in Hikvision’s overseas revenue growth to 15.9% in second half of 2018 from 26.7% in the first half. Our less optimistic growth outlook is further supported by Huawei’s recently announced aggressive push into the video surveillance market. We think that Huawei’s scale, infrastructure, and data accumulated through its carrier business will lend some synergies to its video surveillance endeavor. That said, we continue to believe that Hikvision will maintain its global leadership position in the video surveillance industry, owing to the deep knowledge across different verticals that it has accumulated. This will allow Hikvision to continue to create superior customized total solutions for its enterprise and government customers, which accounts for 70% of its China sales, and reinforce its switching cost moat source. Despite softness in Hikvision’s near-term revenue growth, its video management software business grew at a robust clip of 44% in 2018, up from 27% growth in 2017. We think strong software revenue growth speaks volume of Hikvision’s ability to create strong customized video management solutions that complement its suite of over 10,000 hardware products. On the gross margin front, we continue to think that expansion into overseas markets will come at the expense of profitability as Hikvision adopts an aggressive pricing strategy, though this is partially offset by the increasing mix of higher margin software sales. As such, we assume net income CAGR of 18.8% during our explicit five-year forecast period, as compared with 21.2% previously.

Hikvision’s full-year 2018 net income of CNY 11.4 billion came in at the midpoint of management’s preliminary guidance but above our forecast, mainly due to stronger-than-expected gross margins in the noncore constructions, smart-home, and other innovative businesses. This was primarily driven by a more favorable product mix. Gross margin for both the core front-end and back-end equipment segments, which account for 62% of sales, contracted from the previous year. This is consistent with our prediction that Hikvision’s medium-term expansion into overseas market will come at the expense of margin due to the firm’s aggressive pricing strategy outside of China. Notably, overseas gross margin fell to 44.9% in 2018 from 48.8% in 2017, while domestic gross margin rose to 44.9% from 42.0% over the same period. Hikvision’s revenue growth decelerated to 13.8% in the second half of 2018 from 26.9% in the first half, though this was not surprising to us given the slowdown in the domestic economy and negative impact on overseas sales from the U.S.-China trade war in the second half of last year. However, the lingering effect on top-line growth was more severe than what we were expecting going into 2019, as sales grew at a tepid 6.2% year over year in the first quarter of 2019. Coupled with a sharper-than-expected increase in operating expenses, net income declined by 15.2% year over year. Management attributed the higher operating costs to an increase in R&D expense and personnel costs, as the firm expanded its overseas sales network and increased sales headcount by almost 50% to 7,482 employees in 2018 from 4,999 in 2017. Hikvision believes that overall sales and profitability have bottomed in the first quarter of 2019, as it guided flat net income (at the midpoint) for first-half 2019, implying a 12.0% net income growth for the second quarter of 2019. Additionally, management noted that it should be able to post full-year 2019 revenue growth of above 20%. According to our analysis, Hikvision’s revenue growth typically lags China’s fixed asset investment, or FAI, growth by around 9 to 12 months. China’s FAI has shown signs of improvement, as growth has re-accelerated to 6.3% in the first quarter of 2019 from an average of 4.7% in the second half of 2018. As such, we think that a recovery in top-line growth will likely happen only after the third quarter of 2019, and we reduce our full-year 2019 revenue growth to 16.9% from 19.4% previously. Coupled with higher operating expense in the near term, we forecast net income growth of 10.4% in 2019, as compared with 21.4% previously.