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Morningstar | U.S. Supply Ban Rumors Overdone as Hikvision's Long-Term Story Intact; Maintain FVE at CNY 38.50

Following earlier reports that the United States is considering cutting off the supply of U.S. technology to China-based surveillance equipment makers Hangzhou Hikvision and Zhejiang Dahua, Hikvision's stock fell more than 5% on May 22. We believe that the market has overreacted to the U.S. supply ban rumor, as more than 80% of Hikvision’s core system on a chip and image sensor supply needs are sourced from outside the U.S. The bulk of Hikvision’s reliance on U.S.-made chips stems from its artificial intelligence products, which we estimate make up less than 5% of overall revenue and are still in the infancy stages of adoption among customers. Hence, we don’t think that a potential curtailment of U.S.-imported components will have a material impact on Hikvision’s production capabilities. Following Hikvision’s full-year 2018 and first-quarter 2019 results release in late April, we lowered our 2019-23 revenue assumption to a 16.6% compound annual growth rate from 20.5% to reflect the negative spillover effect on Hikvision’s overseas business, particularly in the Western markets. Hence, we maintain our fair value estimate at CNY 38.50 per share and consider the stock undervalued.

Hikvision had already retraced 14% after the initial news of the U.S.-China tariff hikes and that U.S. government entities would be prohibited from purchasing Hikvision products. As the U.S. only accounts for 5%-6% of Hikvision’s overall sales, we think the recent drops in Hikvision’s share price exceed the fundamental risk to earnings. We maintain our narrow moat rating as the firm continues to benefit from switching costs in the domestic Chinese market, which accounts for 72% of its overall revenue.

From a supply perspective, we estimate that more than 80% Hikvision’s system-on-a-chip processor needs are sourced from domestic Chinese suppliers, while more than 90% of the image sensors used in its front-end surveillance cameras are derived from Japanese and Chinese suppliers. The key chip types that Hikvision purchases from U.S. chipmakers, such as Nvidia and Intel subsidiary Movidius, are graphic processing units and vision processing units, which are primarily used in Hikvision’s artificial intelligence products, including the DeepinView surveillance camera series. However, we estimate that Hikvision’s artificial intelligence product series, launched in 2016, currently accounts for less than 5% of Hikvision’s overall sales. Globally, the adoption of AI surveillance products, such as deep-learning-enabled recorders and servers, has been relatively gradual due to their higher selling price, which is a result of the steep component costs, and the efficacy of AI technology, which is still perceived to require further improvement before greater adoption. Hikvision is engaged in a joint venture with China-based Maxio Technology to develop AI-dedicated chips for video surveillance purposes, which is expected to be more cost-effective and require less computing power than what Hikvision uses presently. We estimate that Hikvision has historically allocated 10%-15% of its research and development expense on developing its AI capabilities. We believe it would be in line with Hikvision’s strategy to move up the value chain to develop its own intellectual property, especially as domestic demand is expected to be sizable and its state-owned standing should allow it first dibs on more sensitive domestic projects.