Export-oriented dividend yield play; initiate at Hold. Net profit (US$ m) Turnover (US$ m) YoY chg (%)

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1 Equity Research Information Technology VTech (303 HK) Hold (initiation) Target price: HK$ Exportoriented dividend yield play; initiate at Hold Initiate at Hold We initiate coverage of VTech with a Hold rating primarily due to valuation reasons. The stock is currently trading at close to a 52week high and at a midteen 2015 forward P/E, versus our forecasts for unexciting midsingledigit EPS growth in FY1517. In our opinion, the current valuation is mostly supported by its dividend yield rather than its EPS growth outlook. We forecast a 2015 dividend yield of over 6%, supported by a consistent and generous dividend payout policy (over 90% payout ratio), strong operating cash flow and a healthy balance sheet (net cash position). We value the company at HK$109/share (1% upside), based on a dividend discount model. VTech is an investable stock for mainland investors under the Hong KongShanghai Connect Scheme. Joseph Ho, CFA SFC CE No. AFP308 josephho@gfgroup.com.hk Ryan Zhu SFC CE No. BDK820 zhuran@gfgroup.com.hk GF Securities (Hong Kong) Brokerage Limited 2930/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong Stock performance (HK$) Leading global manufacturer of electronic learning products Headquartered in Hong Kong, VTech is a leading global manufacturer of electronic learning products (ELP), telecommunication products and an electronic contract manufacturing services provider. The company generated 50% of revenue from North America, 40% from Europe and the balance from Asia in the six months ending Sep (1HFY15). ELPs are the group s core sales and earnings contributor, accounting for about onethird of sales in 1HFY15. While VTech does not disclose profit margin for each division, we understand ELPs generate the highest gross profit margin and estimate they account for over 50% of the group s gross profit. We expect a moderate dip in ELP sales in FY15 and expect sales to resume lowsingledigit growth in FY16 and FY17. Gradual decline in telecommunications products VTech s telecommunications products include residential cordless phones and commercial phones. In FY14, VTech sold over 40m phone units. The division s sales have been declining at a modest pace over the past few years along with the contraction of the cordless phones market. Nonetheless, the negative earnings impact is manageable, in our opinion, as the decline is offset by steady growth in ELP sales. Lastly, contract manufacturing services (CMS) focus primarily on low volume industrial products (e.g. professional audio systems, outdoor LED billboards etc.), which also serve as a capacity filler during the ELP division s low season. We forecast midsingledigit EPS growth for FY1517 Management is targeting a modest revenue growth for FY15, with a stable gross margin. VTech usually generates higher sales in the second half of its fiscal year. We expect a similar pattern this year and forecast US$1bn in sales for 2HFY15, up from US$0.9bn in 1HFY15. We estimate 2HFY15 gross profit margin will increase to %, up from 32.2% in 1HFY15. We expect midsingledigit EPS growth in FY1517. Key risks Key downside risks include a severe downturn in European economies, rapid depreciation of the euro versus the US dollar, and a rapid increase in US interest rates. Key upside risks include strongerthanexpected Christmas sales. 80 Dec13 Mar14 Jun14 Sep14 Dec14 Source: Bloomberg Key data Dec 18 close (HK$) Share in issue (m) 251 Major shareholder Allan Wong (%) Market cap (HK$bn) M avg. vol. (m) W high/low (HK$) /86.50 Source: Bloomberg Stock valuation FYE Mar Turnover (US$ m) YoY chg Net profit (US$ m) EPS (US$) YoY chg P/E (x) P/B (x) DPS (US$ ) Dividend Yield ROE Net gearing , cash , cash 2015E 1, cash 2016E 1, cash 2017E 2, cash (HK) Research Note: Calculated based on diluted shares.

2 Exportoriented dividend yield play Leading global manufacturer of electronic learning products Headquartered in Hong Kong, VTech is a leading global manufacturer of electronic learning products (ELP), telecommunication products and an electronic contract manufacturing services provider. The company generated 50% of revenue from North America, 40% from Europe and the balance from Asia in the six months ending Sep (1HFY15). ELPs are the group s core sales and earnings contributor, accounting for 34% of sales in 1HFY15. VTech is the no. 1 player in the infant and preschool electronic learning product market in the US and the no. 1 player in infant toys in France, the UK and Germany. VTech competes with other top companies including Leapfrog, Mattel, and Hasbro. The infant toy business is less susceptible to economic cycles and ELP sales have been growing steadily in the past few years (see figure 3). We expect a moderate dip in ELP sales in FY15 due to product transition and expect sales to resume lowsingledigit growth in FY16 and FY17. Figure 1: VTech s key products ELP Kidizoom smartwatch* ELP InnoTab Max** Home cordless phones Office phones CMS products Sources: Company, *Retail price US$89.9 on amazon.com, **Retail price US$99.99 on amazon.com Figure 2: Revenue mix by product (1HFY15) Figure 3: Sales by product (US$ m) CMS 29% Telecom 37% ELP 34% FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E ELP Telecom CMS Figure 4: Revenue mix by region (1HFY15) Figure 5: Revenue mix by region (US$ m) Other 3% Asia 7% 1,200 1, Europe 40% North America 50% FY10 FY11 FY12 FY13 FY14 FY15E FY16E North America Europe Asia Sources: Company data, GF Securities Page 2

3 Downtrend in telecommunications division to continue VTech is the world s largest cordless phone manufacturer, with over 40m units shipped in FY14. The company is the no. 1 player in the US cordless phone market. However, division sales have fallen along with the shrinking of the market. Despite our forecast of a moderate rebound in sales in FY15, we expect division sales to continue to decline in FY16 and FY17, albeit at a slowerthanmarket rate as VTech gains market share from rivals such as Panasonic and Uniden. Contract manufacturing services focusing on industrial products VTech was ranked 29 th among the world s top 50 CMS providers by revenue in However, unlike top players such as Hon Hai and Foxconn, which focus on high volume consumer electronic products (e.g. mobile phones, tablets), VTech s contract manufacturing services focus on lowvolume/highmix industrial products, including professional audio equipment and switching mode power supplies. Singledigit EPS growth ahead Christmas is the high season for the industry, and VTech usually generates higher sales in the second half of its fiscal year. We expect a similar pattern this year and forecast US$1bn in sales for 2HFY15, up from US$0.9bn in 1HFY15. We estimate 2HFY15 gross profit margin will increase to %, up from 32.2% in 1HFY15, on the back of a high revenue contribution from high margin ELP products. We expect midsingledigit EPS growth in FY1517. Figure 6: Halfyearly sales and gross profit margin Figure 7: Halfyearly opextosales ratio R&D exp. Distribution exp. Admin exp. Opex to sales Sep 12 Mar 13 Sep 13 Mar 14 Sep 14 Mar 15E Sales (US$ bn) (LHS) GPM (RHS) Sep 12 Mar 13 Sep 13 Mar 14 Sep 14 Mar 15E 10.0 Figure 8: Yearly sales and gross profit margin Figure 9: Yearly opextosales ratio R&D exp. Distribution exp. Admin exp. Opex to sales FY12 FY13 FY14 FY15E FY16E FY17E Sales (US$ bn) (LHS) GPM (RHS) FY12 FY13 FY14 FY15E FY16E FY17E Page 3

4 Attractive dividend yield of over 6% The company has a generous dividend policy, with a dividend payout ratio of over 90% in the past six fiscal years (see figure 10). We expect the company to maintain a similar dividend payout ratio in the coming years. Dividend payments are sustainable, in our opinion, underpinned by strong operating cash flow and a solid balance sheet. The company is debtfree, and its balance sheet is strong with a net cash position of US$323m as of endfy14. Figure 10: Dividend payment Figure 11: Cash position (US$ m) FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E DPS (US$) (RHS) Dividend payout ratio (LHS) 50 0 FY08 FY09 FY10 FY11 FY12 FY13 FY14 Sources: Company data Valuation Figure 12: Valuation peer comparison Valuation supported by dividend yield rather than earnings growth outlook HKlisted export stocks with US and Europe exposure, including Techtronic and Johnson Electric, are trading at midtohigh teen forward P/Es (see figure 12). VTech is currently trading at close to its 52week high and at a midteen forward P/E on prospective midsingledigit EPS growth. The current valuation is not justified by its earnings growth outlook, but is supported by an attractive dividend yield (forward dividend yield of over 6%), in our opinion. We value the stock at HK$109 per share, based on a dividend discount model (see figure 14 for sensitivity analysis), assuming ROE of 7% and a terminal dividend growth rate of 1%. Market Share cap price P/E (x) P/B (x) Div yield Share price chg Company Stock code (US$m) local FYE Current Next Curren Next M 3M 6M YTD HKlisted export Techtronic 669 HK 6, Dec Vtech 303 HK 3, Mar Johnson Electric 179 HK 3, Mar (2) (3) 7 (3) Average Toys Mattel MAT US ##### Dec (8) (20) (34) HASBRO HAS US 7, Dec Leapfrog LF US Dec NA NA NA 0.8 NA NA (8) (22) (35) (38) Average Share price as of 18Dec2014, share prices as of Dec Page 4

5 Figure 13: Rolling forward P/E (x) Figure 14: DDM valuation model (HK$ per share) Forward PE (x) Average 11.6x +1SD 1SD ROE Growth (g) % 0.50% 0% 1.50% 2.00% 5.5% % % % % % % Key risks Key downside risks include a rapid acceleration of the US interest rate cycle, a severe downturn in European economies and a sharp depreciation of the euro versus the US dollar. Key upside risks include strongerthanexpected Christmas sales. Page 5

6 Figure 15: Financial statements Income Statement Balance Sheet Year end Mar (US$ m) FY13 FY14 FY15E FY16E FY17E Year end Mar (US$ m) FY13 FY14 FY15E FY16E FY17E North America Cash/ST Investments Europe Account receivables Asia Inventory Other Other Current Assets Turnover 1,858 1,899 1,929 1,996 2,054 Total current assets Gross profit Property, plant and Other income/gains Intangible assets Selling & distribution exp. (260) (286) (290) (299) (308) Other LT Assets Admin exp. (57) (64) (66) (66) (66) Total Assets R&D (57) (58) (58) (60) (62) Other expenses ST Debt Operating profit Trade payables Finance costs Other Current Liabilities Share of profits Total current liabilities Pretax income LT Debt 0 Taxation (24) (24) (25) (28) (29) Other LT Liab MI 0 0 Minority Interests Net profit Shareholders' Equity Total Equity & liabilities Cash Flow Statement Financial Ratio Year end Mar (US$ m) FY13 FY14 FY15E FY16E FY17E FY13 FY14 FY15E FY16E FY17E Pretax profit Margins Tax Paid (24) (24) (25) (28) (29) Gross margin Depr/Amort EBITDA margin Change in working capital (38) 7 (32) (8) (7) Operating profit margin Others 4 (8) Net margin Operational cash flow Return/Profitability Capex (30) (30) (34) (30) (30) ROA Assoc, MI, Invsmt 16 0 ROE Investment cash flow (14) (30) (34) (30) (30) Balance sheet Net Change in Debt 8 5 Net gearing cash cash cash cash cash New Capital Current ratio (x) Dividend (190) (201) (210) (222) (232) Working capital Others (1) (1) Receivables (days) Financing cash flow (183) (197) (210) (222) (232) Inventory (days) FX and others (3) 7 Payables (days) Chg in Cash (3) 14 (33) (3) (3) Others Beginning cash Effective tax Ending cash Dividend payout ratio Page 6

7 Rating definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months Company ratings Buy Stock expected to outperform benchmark by more than 15% Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15% Hold Expected stock relative performance ranges between 5% and 5% Underperform Stock expected to underperform benchmark by more than 5% Sector ratings Positive Sector expected to outperform benchmark by more than 10% Neutral Expected sector relative performance ranges between 10% and 10% Cautious Sector expected to underperform benchmark by more than 10% Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report. 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