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1 Vtech Holdings 15 November 2017 Maintaining TP of HK$130 Slower growth in top line Vtech Holdings (0303.HK) Export Sector Rating Buy Target Price HK$130.0 (12/18) Close Price 52 weeks high/low Market cap HK$114.0 HK$ HK$28.7 bil Source: HKEX, Bloomberg, CASH Relative performance HK Equity HSI Index Source: Bloomberg, CASH CASH Research 15 November 2017 Gary Tsz Yeung KONG Research Analyst Tel: (+852) Investment Highlights VTech is the global leader in electronic learning products and cordless phones. It also provides contract manufacturing services. The group just reported its 1HFY18 results. Sales revenue was up 5.8%YoY, slightly lower than market expectation. Net profit increased 45.1%, much better than market expectation. We maintain our TP at HK$130 and reiterate BUY rating. Leapfrog likely to be the reason for slow ELPs revenue growth in North America: The group s sales revenue increased 5.8%YoY to US$1,040 million, slightly lower than our expectation. The slower sales revenue growth was mainly attributable to the Electronic Learning Products (ELPs) sales in North America. In our view, Leapfrog, which is still being in a turnaround stage, is likely to be the reason for the slow growth. Management is uncertain about the impact on top line by Toys R Us: As VTech s sales to Toys R Us was covered by credit insurance only up to the date of the bankruptcy protection filing, VTech chose to suspend its shipments towards Toys R Us, pending negotiation of new terms. The impact on VTech s sales and gross margin is still uncertain. Gross margin and net profit improved: Despite the increasing material price, the group s gross margin was up from 31.9% in 1HFY17 to 32.3% in 1HFY18. The increase was largely due to the depreciation of RMB against USD as well as the change of product mix. Net profit was up 45.1%YoY to US$104 million with a net margin of 10% owing to the low base in 1HFY17 caused by restructuring cost associated with the integration of Leapfrog and Snom last year. Valuation: Our target price of HK$130 is based on DDM analysis and implies 16.3X 3/FY19 PE.

2 November 15, 2017 Valuation and financial ratios of China Exports Stocks (Bloomberg Consensus) EPS Growth (%) Return on Equity (%) Dividend Yield (%) PB Ratio (X) PE Ratio (X) Company Stock Code TP ($HKD) Price ($HKD) Techtronic Industries 669 HK Equity Vtech 303 HK Equity Regina Miracle 2199 HK Equity N/A PAX Global 327 HK Equity N/A 4.11 N/A N/A N/A 1.75 N/A 1.06 N/A 8.11 Shenzhou International 2313 HK Equity N/A N/A N/A N/A 2.45 N/A 4.30 N/A Li & Fung 494 HK Equity N/A N/A 9.56 N/A 9.70 N/A 1.29 N/A Man Wah 1999 HK Equity N/A Median Average Source: Bloomberg, Cash 2

3 Interim results highlight November 15, 2017 The group s revenue was up 5.8%YoY to US$1,040 million, with an increase in sales in regions including North America, Europe, and Asia Pacific. Gross profit increased 6.9%YoY to US$335.4 million with a higher gross margin of 32.3% compared with the same period last year due to the contribution of Leapfrog and Snom, the depreciation of RMB against USD, and the change in product mix, offsetting the increase in material price. Net profit was up 45.1% due to the increase in GPM and low base effect caused by the restructuring cost associated with the integration of Leapfrog last year. Stocks turnover days were up significantly from 110 days at Sep-16 to 128 days at Sep-17 as the management expects a strong 2HFY18 demand. North America ELPs revenue rose 2.6%YoY to US$192 million. The slower growth was negatively impacted by Toys R Us bankruptcy protection filing. CMS revenue increased 35%YoY to 141 million owing to the sales of professional audio equipment, solid-state lighting and industrial products. Europe Revenue was up 0.3%YoY to US$414 million with higher sales in ELPs and TEL products, offsetting declining sales in CMS. Asia Pacific and other regions All 3 segments grew at a double-digit (around 30-50%) rate in Asia Pacific. 3

4 Figure 1. VTech Results review Source: Company data, CASH 1HFY18 results review Slower growth in ELPs sales in North America November 15, 2017 The group s 1HFY18 sales growth was slightly lower than our expectation. The decline in growth was mainly attributable to the slower growth in ELPs sales in North America. We believe that the slower growth was mainly attributable to Leapfrog, which was acquired by VTech last year and is still being in a turnaround stage. Looking forward, we believe that the group s R&D effort on standalone products and platform products under Leapfrog and the insourcing of manufacturing process will improve the situation. Electronic Learning Products FY3/16 % FY3/17 % YoY(%) HY9/16 % HY9/17 % YoY(%) North America % % 44.7% % % 2.6% Europe % % 9.8% % % 7.8% Asia Pacific % % 28.9% % % 43.4% Other regions % % 15.7% 9 2.6% % 12.8% Total % % 26.9% % % 7.6% Telecommunication Products FY3/16 % FY3/17 % YoY(%) HY9/16 % HY9/17 % YoY(%) North America % % -1.5% % % -8.5% Europe % % -5.5% % % 10.3% Asia Pacific % % 5.8% % % 30.7% Other regions % % -20.9% % % -10.5% Total % % -3.4% % % -2.0% Contracted Manufacturing Services FY3/16 % FY3/17 % YoY(%) HY9/16 % HY9/17 % YoY(%) North America % % 1.6% % % 34.4% Europe % % 14.2% % % -8.1% Asia Pacific % % 10.9% % % 51.9% Other regions 1 0.1% 1 0.1% 33.3% 0 0.1% 1 0.2% 50.0% Total % % 9.8% % % 10.2% Total Revenue % % 4

5 November 15, 2017 Management is uncertain about the impact on top line by Toys R Us Toys R Us is 1 of the top 5 clients of VTech. It filed for bankruptcy protection in US and Canada in Sep-17. As VTech s sales to Toys R Us was covered by credit insurance only up to the date of the filing, VTech chose to suspend its shipments towards Toys R Us, pending negotiation of new terms. Management, therefore, is uncertain about its impact on VTech s sales and gross margin in future. According to Reuters business news titled Toys R Us says most top vendors have resumed shipments, 100% of merchandise vendors that supply the top 20 products have resumed shipments, followed by 49 of the top 50 vendors and 91 of the top 100. In our view, it is believed that VTech will finish negotiation of new terms with Toys R Us in near term. In the longer term, even if Toys R Us really undergoes liquidation, its market share would likely be taken by other VTech s clients, imposing limited impact to VTech. Adjustment in profit forecast We made some minor adjustment in our forecast to reflect the unexpected slower growth in ELPs sales in North America. Gross margin in FY19E is revised upward to reflect the strong cost control effort of the group. Figure 2. VTech Earnings adjustment New Old Change Year to March US$ million 3/FY18E 3/FY19E 3/FY18E 3/FY19E 3/FY18E 3/FY19E Sales revenue 2,202 2, % -3.5% Gross profit % -1.1% EBIT % -0.3% Net profit % -0.2% EPS % -0.2% Assumptions Gross margin 33.3% 33.1% 33.2% 32.3% 0.1% 0.8% Source: CASH estimates 5

6 Cost of equity Figure 3. VTech DDM Analysis Source: Company data, CASH estimates Valuation and risks Valuation November 15, 2017 Our Dec-18 target price of HK$130 is based on our DDM analysis and implies 16.3X 3/FY19 PE. We assume constant dividend payout ratio of around 98% in future, a beta of 0.78 and cost of equity of 11.5%. We estimate dividend until 3/FY25 and assume a terminal growth rate of 2.5% to arrive the TP of HK$130 for VTech. 3/FY18E 3/FY19E 3/FY20E 3/FY21E 3/FY22E 3/FY23E 3/FY24E Terminal Cash flow estimate Net profits Dividend Present value ,281 DDM parameters Cost of equity 11.5% Assumptions Terminal growth Risk-free rate 2.5% 1.8% Equity value 4160 Market risk 12.4% /Number of shares 251 Beta 0.78 =Equity value per share (US$)(Dec 18) 16.5 Equity value per share (HK$)(Dec 18) 130 Implied exit P/E multiple (x) 17.4 We also analyse the DDM price sensitivity to the cost of equity and the terminal growth rate. Figure 4. VTech Sensitivity Analysis based on cost of equity and perpetual terminal growth Terminal growth % 1.5% 2.00% 2.5% 3.00% 3.5% 4.0% 10.0% % % % % % % Source: Company data, CASH estimates 6

7 November 15, 2017 Figure 5. VTech Leading PE band Forward PE mean +1 s.d. -1 s.d. +2 s.d. -2 s.d. Source: Bloomberg, CASH Risks Risks include: 1) Trade war occurs between China and the US, 2) Aggressive depreciation of USD in short time, 3) Lower birth rate in the US and European Zone, 4) Deterioration of economic condition. 7

8 November 15, 2017 Vtech Holdings Income Statement (US$ million) Balance Sheet (US$ million) Year-end 31 March 3/FY16 3/FY17 3/FY18E 3/FY19E 3/FY20E Year-end 31 March 3/FY16 3/FY17 3/FY18E 3/FY19E 3/FY20E Revenue 1,857 2,079 2,202 2,384 2,642 Cash & equivalents Cost of goods sold (1,273) (1,390) (1,468) (1,595) (1,766) Marketable securities Gross profit Accounts receivable SG&A (325) (412) (392) (424) (456) Inventories R&D (56) (77) (74) (80) (89) Other current assets Other expense Total current assets ,010 Employee share expense LT investments Operating profit Fixed assets EBITDA Goodwill Depreciation (35) (34) (36) (37) (39) Other intangible assets Amortisation (0) (1) (1) (1) (1) Other LT assets EBIT Total assets 911 1,060 1,077 1,108 1,154 Net interest expense ST debt Associates & JCEs Accounts payable Other income Other current liabilities Earnings before tax Total current liabilities Income tax (22) (21) (28) (30) (35) LT debt Net profit After tax Convertible debt Minority interests Other LT liabilities Other items Total liabilities Preferred dividends Minority interest Normalised NPAT Preferred interest Extraordinary items Common stock Income attr. to shareholders Retained earnings Dividends (106) (176) (234) (250) (291) Proposed dividend Transfer to reserves Other equity and reserves Total shareholders' equity EPS Total equity & liabilities 911 1,060 1,077 1,108 1,154 EPS (In HK$) DPS Key Ratios 3/FY16 3/FY17 3/FY18E 3/FY19E 3/FY20E Cashflow statement (US$ million) Profitability (%) Year-end 31 March 3/FY17 3/FY18E 3/FY19E 3/FY20E Gross margin 31.4% 33.2% 33.3% 33.1% 33.2% Income attr. to shareholders EBITDA margin 12.8% 11.3% 13.8% 13.5% 14.1% Non-cash item EBIT margin 10.9% 9.6% 12.1% 12.0% 12.6% Change in working capital (12) (0) (33) (33) Net Margin 9.8% 8.6% 10.8% 10.7% 11.2% Cashflow from operationgs Effective tax rate 10.7% 10.5% 10.6% 10.6% 10.6% Capital expenditure (34) (36) (39) (44) Dividend payout 58.2% 98.2% 98.0% 98.0% 98.0% Free cashflow ROE 34.6% 30.6% 40.5% 42.9% 49.4% Dec in other LT assets 1 (0) (0) (0) ROA 19.9% 16.9% 22.2% 23.0% 25.7% Inc in other LT liabilities Adjustment (31) (0) (0) (0) Liquidity (x) CF from investing acts (62) (37) (40) (44) Current ratio Cash dividend (176) (234) (250) (291) Interest coverage N/A N/A N/A N/A N/A Equity issue Debt issue 2 (1) 0 0 Leverage Convertible debt issue Net Debt/EBITDA (x) Net Cash Net Cash Net Cash Net Cash Others (16) Net Debt/Equity (%) Net Cash Net Cash Net Cash Net Cash CF from financial acts (113) (235) (250) (291) Net cashflow 10 4 (30) (31) Activity (days) Beginning cash Days receivable Adjustments (14) Days inventory Ending cash Days payable (99.0) (110.9) (108.0) (105.0) (103.0) Ending net debt (267) (272) (242) (212) Cash cycle Source: Company data, CASH 303.HK, BUY, TargetPrice: 130 Source: Company data, CASH 8