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Morningstar | Initiating Coverage of Sunny Optical With Narrow Moat Rating and HKD 83 FVE

China-based Sunny Optical’s revenue and earnings are derived from manufacturing camera lenses and modules. Before 2015, lower-margin modules and glass lenses for digital single-lens reflex cameras made up the majority of Sunny’s earnings, but the fortuitous acquisition of Konica Minolta’s China optical lens business in April 2014 allowed the company to break into the plastic lens segment. Since then, Sunny’s market share in the lens segment has jumped to 17% from 5% and it is now second to Taiwan’s Largan. This strong growth coincided with the ascension of China’s smartphone brands, namely Huawei, Oppo, Vivo, and Xiaomi, which make up around 60% of Sunny’s revenue. We believe Sunny will increase earnings at an average 21% pace over the next five years on positive industry trends while improving scale efficiency lifts profit margins. We expect the rising adoption of multiple camera modules in smartphones and the 5G upgrade cycle in 2020 to drive demand for handset camera lenses and modules, which make up 84% of Sunny’s sales. This means that the growth in demand for optical lenses will remain strong despite slowing global smartphone sales. Sunny’s lens gross margin has risen to 41.5% in 2018 from 26.7% in 2014, which indicates a vast improvement in production yield rates as average unit costs have fallen precipitously. We expect the lens segment to contribute 54%-59% of Sunny’s profit over the next five years. While we are positive on Sunny’s optical lens franchise, we are more cautious on the module business, which is susceptible to raw material cost pressure and stiffer price competition from domestic peers. But we anticipate a rebound in module margins to 11% in 2019 from 2018’s cyclical low 8.4% on improved automation.Sunny is trying to diversify its client base to include global brands like Apple. However, the current U.S.-China trade war may hinder these aims. Uncertainty surrounding technology transfers will probably weigh on Sunny’s share price in the near term. At this stage, we expect the U.S. ban on Huawei to be temporary, and the direct impact on Sunny’s income is likely to be less than 3% for every 1% that Huawei loses in market share.