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Morningstar | Initiating Coverage of Largan Precision with Narrow Moat; FVE of TWD 4,750.00 per Share. See Updated Analyst Note from 31 May 2019

We initiate coverage of Largan Precision with a narrow-moat rating and fair value estimate of TWD 4750.00 per share, implying a 2019 P/E ratio of 22.9x, which is at the high end of its five-year range. This reflects our optimistic outlook for Largan’s longer-term prospects because we believe it is well positioned to benefit from the rising adoption of multiple camera modules among handset makers, and the continued advancement in lenses technology, such as 3D and black lenses technology. Largan is a major supplier of high-specification camera lenses to global smartphone brands such as Apple, Huawei, Samsung, and others. Largan’s shares have fallen by almost 20% after technology supply chain uncertainty and fears of retaliation by China following the U.S. ban on technology sales to Huawei. We think this drop in its share price is overdone because, first, Largan’s customer base is highly diversified with an estimated 50%-60% market share of high-end smartphone models. Secondly, our base case assumption is the Huawei ban will be lifted by end-2019 and the effects thereof will be short-lived, similar to that of ZTE’s ban. In light of this, we think Largan’s shares are currently undervalued and offer attractive upside.

As the world’s largest manufacturer of smartphone camera lenses, with an estimated 35% market share, Largan is well positioned to capitalize on the medium-term acceleration in smartphone demand, which is expected to grow at a CAGR of 5.9% between 2019 and 2021, driven by the roll out of 5G technology in 2020, and the rising adoption of dual, triple and quadruple smartphone camera modules, along with the increasing penetration of 3D lenses technology. We expect Largan’s revenue growth to outpace the market because we expect the introduction of black lenses technology by Largan in late 2019 to help the company grow its already dominant market share among high-end smartphone models.

Largan has almost 30 years of experience in the design and production of plastic aspherical lenses, which are widely used in smartphone cameras. The company derives its moat from its superior lenses design capabilities, which has seen it garner more than 1,000 patents. In contrast, its biggest competitor Sunny Optical has 432 lenses patents by the end of 2018. We believe these patents underpin the firm’s intangible assets moat source, and will enable it to continue to deliver industry-leading a return on invested capital, or ROIC, over the long term. Over the past decade, Largan has been able to stave off competition and generate an average ROIC of 95.9%.

While demand for smartphones has matured and the replacement cycle has elongated, we believe cameras remains a point of differentiation for smartphone-makers in the medium term. Continued improvement in camera technology should provide a tailwind to Largan, which focuses primarily on the high-end segment and has been a leader in innovative lenses design. For instance, Largan was the first to roll out 5P, 5 Plastic, 6P, and 7P lenses sets, which are typically used in high-resolution lenses of 12 megapixels or more. Moreover, Largan plans to introduce black lenses coating technology in late 2019, which will enable the front camera lens to completely “disappear” and provide a better display experience for smartphone users. We believe Largan’s advantage in handsets' plastic lenses technology allows the company to maintain its pricing power, and as a result, we expect its gross margin to rise to 69.5.% in 2020 from 68.8% in 2018. After 2021, we anticipate a deceleration in Largan’s top-line growth and some gross margin contraction, mainly because of deceleration in smartphone demand growth and potentially more intense competition. To fulfill robust lenses demand in the medium term, we expect Largan to maintain a high level of capital expenditure, which is expected to peak at 13.5% (as a percentage of sales) in 2020, as it expands its production capacity.

The recent supply ban on U.S. technology exported to Huawei has been a key source of volatility for Largan’s shares, with Huawei being one of its major customers, alongside Apple, Samsung, Vivo, Oppo, and others. This has been exacerbated by Google’s recent decision to pull apps and services, such as Gmail, Maps, and Play store, from future Huawei smartphones. Our model’s base case does not assume the ban will last in the long term, because a permanent ban would be highly detrimental to technology firms in the U.S. and China, given the interwoven nature of the technology supply chain. Our valuation also does not include a doomsday scenario where Huawei is driven out of business because of its inability to access U.S. components.

Given reports that Huawei has been stockpiling almost a year’s worth of U.S.-made components in anticipation of such a ban, we think Huawei’s smartphone production line should remain unscathed in the near term but we don’t rule out a drop in sales owing to customers' anxiety. Our near-term concern is Google’s decision to discontinue the service of key apps and services such as Gmail, Google Maps and Play store from future Huawei smartphones. We think that the discontinuation of Google’s Play, or app, store and services such as Gmail and Maps will impede the near-term growth of Huawei’s market share outside China, which accounted for almost 50% of Huawei’s global smartphone shipments in 2018. British telecom operators Vodafone and EE, and Japan’s KDDI and Y! Mobile have all frozen their orders for new Huawei models, and we expect further pushback from Android consumers, who typically include Gmail, Search and Play store as an integral part of the user experience. As a result, our model includes the scenario that Huawei’s global market share falls to 11.9% in 2019 from 13.2% in 2018. We expect Huawei’s ex-China market share falls to 5.7% in 2019 from an estimated 8.7% in 2018, while China, which has long banned the use of Google’s apps and services, and where Huawei has a commanding 26.5% market share, should remain a stronghold for Huawei. Further, we expect Huawei’s market share loss outside of China to be boon for other Chinese smartphone brands such as Oppo, Vivo and Xiaomi, and Samsung and Apple, all of whom are key Largan customers. In the long term, we expect Huawei’s global market share to recover to 14.3% in 2023 from a low of 11.9% in 2019, as the planned roll out of its own operating system in spring 2020 could be an additional tailwind for the brand. Largan’s stock price has also suffered because of concerns that the U.S. supply ban on Huawei could further dampen the woes of the iPhone in China, which accounted for roughly 20% of Apple’s smartphone revenue in 2018, because Chinese consumers may retaliate by ditching iPhones for Chinese brands. As a result, we expect Apple’s smartphone market share in China to be hit in the near term, shrinking to an estimated 6.3% in 2019 from just under 10%. Over the long term, we expect Apple’s global market share to decline modestly to 11.2% in 2023 from 11.8% in 2019.