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Morningstar | Future of Smartphone Camera Technology Remains Bright; FVE Maintained at HKD 83.00

We participated in Sunny Optical’s 2019 Investor Day, which has helped to reinforce our conviction in Sunny’s leadership position in the handset camera modules and lenses market. We continue to believe camera technology will remain a key point of differentiation among smartphone brands in the medium- to long term. As the adoption of multiple camera modules increases, we believe Sunny’s superior optical-lens design capabilities will stand it in good stead to benefit from this positive trend.

Following a ban on the supply of United States technology to Huawei in May, Sunny’s stock price has decreased by more than 20%. We think the market has overreacted and priced in a scenario where Huawei goes out of business. Further, in the near term, we believe Huawei’s anticipated loss of market share in overseas markets should benefit major competitors such as Vivo, Oppo, Xiaomi, and Samsung, all key Sunny clients. We therefore believe this will help to largely offset the order losses from Huawei. We therefore maintain our fair value estimate of HKD 83.00 per share and our narrow moat. With Sunny’s current forward P/E multiple of 20.2 times near the low end of its three-year trading range, we consider the stock attractively priced and believe it's a good entry point for patient investors.

Management said the runway for innovation in camera lenses technology remains long. Besides the proliferation of dual-, triple-, and even quadruple camera modules, management reiterated the importance of features such as larger apertures, better optical-zoom capabilities, higher resolution, and ultra-wide angle, which all combine to provide improved image quality. This trend is consistent with Sony’s medium-term plan to expand its image-sensor production capacity by more than 30% by early 2021. Further, Sony also said it expects the size of image sensors to increase by 20% a year over the next three years. We believe this indicates a growing need for larger lenses (to cater for larger apertures, which enhances the bokeh effect in images).

In the near term, Huawei, which makes up about 20% of Sunny’s overall revenue, is expected to have lower demand for its smartphones in markets outside China as a result of the supply ban of U.S. technology. According to news reports, Huawei is expecting to experience a decrease in demand of 40 to 60 million smartphones in the overseas market during 2019, and flat overall revenue of about USD 100 billion between 2019 and 2020. The expected hit to Huawei’s overseas smartphone business, which shipped roughly 100 million smartphones in 2018, indicates a drop of 40-60% in 2019. Our base-case scenario has already reflected this drop in Huawei’s share of the overseas market, although we expect its Chinese business, which accounts for 50% of its overall smartphone shipment, to remain resilient. As a result, we anticipate Huawei’s global market share to drop to 10.3% in 2020 from 13.0% in 2018.

Sunny’s management team believes Huawei’s market share loss in overseas markets will be largely offset by share gains for its major competitors. Further, Sunny said it will not be changing its original capacity expansion plans for 2019, which is expected to see handset lenses capacity increase to 140 million per month from 120 million per month, and handset camera modules capacity maintained at 65 million per month. Hence, we think Sunny’s unchanged capacity plans is a positive indicator for the firm’s order demand in the near term. Besides winning an order allocation for Samsung’s S9 front-camera lenses in 2018, Sunny also increased its camera modules market share in Samsung during the second half of 2018. Additionally, Samsung plans to refocus its resources on the mid-range A series, and to reduce the product cycle of the A-series to six months from one year. News reports have suggested Samsung, which has historically depended on local South Korean manufacturers such as Sekonix and SEMCO for internal lenses, has plans to allocate more orders to foreign suppliers. We think these developments bode well for Sunny’s smartphone camera lenses and modules business, and will help offset some of the order losses from Huawei.

Lastly, we think Samsung could benefit significantly from Huawei’s loss of market share, especially in European and Latin American markets, where Samsung is the biggest player with more than 30% market share in both regions. Therefore, our base-case assumption is that Samsung will increase its global market share to 21% in 2020 from 19% in 2018. In key developing markets such as India, Huawei’s competitors such as Samsung, Vivo, Oppo and Xiaomi, all are key Sunny clients, and have dominant market shares. We estimate that Samsung, Vivo, Oppo, and Xiaomi combined make up almost 70% of India’s smartphone market.

With regard to vehicle lenses, which we estimate will account for 8% of the company’s revenue by 2023, management said they have strong demand visibility over the next two years or so, primarily because of the longer certification lead time of about two to three years. Sunny, which currently has almost 30% market share, remains confident it will be able to maintain its global leadership position in the vehicle lenses segment. We continue to believe Sunny has a strong advantage in vehicle lenses, which primarily uses hybrid or glass lenses because of their durability and temperature tolerance, owing to its extensive experience (more than 30 years) in glass lenses production. Although Sunny is optimistic about the effects of greater driver automation on its vehicle lenses business, it also said autonomous driving technology is unlikely to reach meaningful scale over the next four to five years. For example, Sunny expects the adoption of LIDAR sensor technology, a key ingredient in autonomous driving, to scale up only after 2025.