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

We are initiating coverage of China's Sunny Optical with a narrow moat rating and fair value estimate of HKD 83 per share. Our discounted cash flow-derived valuation puts the stock at 23.3 times forward earnings, below the three-year average of 27.5 times. We think the shares offer attractive upside as smartphone demand for camera lenses remains robust and Sunny’s improving scale and automation drive higher profit margins. We believe the recent 20% share price drop over concerns about sales of Chinese-brand smartphones, which are Sunny’s key clients, presents a good opportunity to pick up shares of Sunny. We estimate a 1% decline in Huawei’s market share should damp Sunny’s earnings by less than 3%.

Sunny is the world’s second-largest optical lens manufacturer with 17% market share, placing it behind Taiwan’s narrow-moat Largan Precision. Sunny’s capabilities in designing plastic lenses, which are widely used in smartphone cameras, have significantly strengthened since the acquisition of Konica Minolta’s China lens business, including associated patent rights, in April 2014. Hence, we believe that Sunny is well positioned to capitalize on the rising adoption of multiple camera modules, as well as the increasing penetration of new lens technology, such as 3D, large aperture, ultra-wide angle, and optical zoom lens. Additionally, we think Sunny can maintain its global leadership position in vehicle lenses, which primarily use hybrid or glass lenses, playing to Sunny’s strength as a glass lens producer with almost 30 years of experience.

We think the recent pullback in Sunny’s shares is overdone. Our valuation implies that the Huawei ban will be used as short-term leverage by the United States in ongoing negotiations with China involving tariffs and other trade negotiations. Our model assumes that the ban won't last in the long term.

In the medium term, we expect Sunny to grab market share from smaller handset lens peers and improve its handset lens product mix. Together with the relatively resilient gross margin profile of the vehicle lens segment, we forecast Sunny’s lens segment gross margin to rise to 48.0% in 2023 from 41.5% in 2018, accounting for 62% of Sunny’s overall gross profit in 2023. Supporting our optimistic outlook of the firm’s lens franchise is the improving mix of shipment, with above 10-megapixel lenses accounting for 47% of handset lens shipment volume in 2018, up from just 2% in 2014. Additionally, the number of optical lens patents has risen to 432 in 2018 from 119 in 2015. These design patents have a lifespan of 10-20 years, and we think they will protect Sunny’s lens leadership, as smaller players with lesser financial resources for research and development will find it difficult to catch up. Another key advantage lies in Sunny’s competitive positioning in the downstream camera module assembly business, which differentiates it from pure-play lens suppliers such as narrow-moat Largan Precision. While we do not believe that Sunny’s module business has a moat, we think it provides the lens franchise with greater visibility on lens design requirements of smartphone vendors.

The module segment has considerably thinner gross margins (high single digits to low teens) than the upstream optical lens industry. Additionally, Sunny is exposed to fluctuations in raw material costs, with image sensor, voice coil motor, printed circuit board, and infrared filter accounting for more than 80% of input costs. We think that the market has underestimated the increasingly competitive landscape in the camera module industry. OFILM Group and Q Technology have aggressively expanded their market share and production capacity. We estimate that OFILM has surpassed Sunny in terms of shipment volume, while Q Tech had gained supply chain certification from Huawei, one of Sunny’s biggest customers, in 2017. As such, we expect more intense price competition in the medium term, which should partially offset strong shipment volume growth due to the increasing penetration of dual, triple, and quadruple camera modules. We forecast gross margin to stay flat between 2019 and 2021 and then rebound to 12.0% in 2023, in line with the segment’s 10-year average, as pricing pressure abates.

The recent supply ban on U.S. technology exported to Huawei has been a key source of volatility for Sunny’s shares, since Huawei is a key customer. We estimate that Huawei accounted for over 20% of Sunny’s revenue in 2018. The risk to Huawei’s sales 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 that the ban will be permanent, as such a move has ramifications that would be highly detrimental to technology firms in both the U.S. and China, given the interwoven nature of the technology supply chain. Our valuation also does not bake in 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. Our near-term concern lies with Google’s decision to discontinue key apps and services in future Huawei smartphones, which may still continue to utilize the open-source Android operating system. We think that the discontinuation of Google’s app store and services such as Gmail and Maps will impede the near-term growth of Huawei’s market share outside China, which accounts for almost 50% of Huawei’s global smartphone shipment in 2018. British telecom operators Vodafone and EE and Japan’s KDDI and Ymobile have all paused their orders for new Huawei models, and we expect further pushback from Android consumers, who typically count Google’s Gmail, Search, and Play as an integral part of the user experience. As a result, our model bakes in the assumption that Huawei’s global market share falls to 11.9% in 2019 from 13.2% in 2018. We assume that 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. Furthermore, we expect Huawei’s market share loss outside China could benefit Sunny’s other key customers, especially Samsung. Sunny’s other China customers, Oppo and Vivo, have been making considerable strides in major markets such as Europe and India, and they may also benefit. In the longer term, we expect Huawei’s global market share to recover to 14.3% in 2023 from a low of 11.9% in 2019. We expect the planned rollout of its own operating system in spring 2020 could provide some reprieve for the brand.