2018 AAC

We assume coverage of AAC with an UW rating and a Jun-16 PT of HK$42 (12x

2016 EPS).  We  recommend  investors  take  profit as  we  believe  management's

positive  2016  tone is  already  priced  in and we are  conservative  on  margin

improvement, primarily due to risks of haptics oversupply and a lack of visibility

in RF growth, and expect 2017 growth to decelerate to single digits. Our 2016/17

EPS estimates are 2%/10% below BBG consensus. AAC's share price correlates

with market expectations for its share allocation from Apple on major products.

We believe the stock could trade down to the low-40s in 1H16 given iPhone 6S

weakness and haptics  share  loss,  and  would recommend investors revisit  below

HK$40 or if we see better haptic content growth.

 Haptics: tougher comps in 2H16; limited growth in 2017: We see heightened

competition in haptics and over-supply risks starting from 2016, given: 1) very

slim likelihood for dual-haptics in iPhone 7; 2) the Android camp's hesitation to

adopt haptics widely in 2016; and 3) rising competition with new vendors such

as  Alps.  With  competitors' improving yields  and  Apple's  push  for  supplier

diversification,  AAC's  haptics share  is  likely  to  drop  to  ~40%  in  2017E  (vs

~70% in 3Q15). Hence, we see decelerating growth from 2H16 for AAC and

expect Street estimates for ASP/margins to trend down.

 Strong  acoustics upgrade  cycle  in  2016 already priced  in:  AAC  has

benefited  from  the  upcoming  acoustics  upgrade  cycle  with  both  Apple  and

Chinese brands. Of note, Chinese brands are adopting more speakerbox and the

SPBX mix is likely to hit 40%+ in 2016E, up from 25% in 2015. We model in

~12%/ 6% YoY growth for AAC's acoustics in 2016/17.

 More  cautious  on  margin improvement &  metal  casing  initiatives: We

largely agree with management's revenue guidance and model 17%/8% revenue

growth in 2016/17E. However, we are less confident on margin improvement

and expect a slight margin decline in 2016, with downside from haptics/RF to

more  than  offset  upside on  acoustics. Of  note, we  are  cautious  about metal

casing initiatives and see potential margin downside.

 New  products:  optics  traction  appears  to  be  slow:  AAC's  optics  push has

gained minimal early traction, but we see challenges in scaling up this business.

Tunable RF is a promising area but it looks like far away from mass adoption.

AAC's continued investments in new businesses are encouraging, but the next

driver of structural growth appears unclear to us now.

 

Investment negatives

#1: Heightened competition in Apple haptics, oversupply

likely from 2016

We see heightened competition in haptics and potential overcapacity risks from 2016

onwards. We believe AAC's haptics allocation within Apple iPhone is likely to

decline to ~40% levels in 4Q16/2017 (vs ~70% with iPhone 6S in 3Q15) and we see

nearly zero growth on haptics for AAC in 2017 within Apple due to new competitors

coming in.

Rising competition from NIDEC/Jinlong and emerging vendor Alps

NIDEC is a close rival with nearly the same haptics capacity as AAC (with 40-45

production lines). Despite still lower yields than AAC, NIDEC is improving

manufacturing efficiency and is likely to grab ~40% haptics shares in CY2016.

Jinlong is upgrading its existing production lines and started supplying haptics for

iPhone 6S (4.7 inch model) with very competitive prices (30-40% lower than AAC/

NIDEC). Alps is another emerging competitor and is likely to become a minor

haptics supplier from 4Q16/2017.

Weakening bargaining power with Apple taking back patent ownership

Meanwhile, Apple is trying multiple sourcing for its key components to diversify

supply chain risks. We acknowledge that the new haptics on iPhone 6S is designed

by Apple and thus supplier switching should be easier compared to the last

generation on iPhone 6, in which AAC largely controlled the design and patent

 

 

 

Oversupply risk exist in 2016, given nearly zero likelihood of dual-haptics on

iPhone 7 and slow penetration to Android brands

Further, we believe mass adoption of advanced haptics by the Android camp has not

materialized and Apple is likely to remain the major consumer for haptics in the next

two years. With very slim visibility of dual-haptics per iPhone 7 (thus little

likelihood with 7S in 2017 as well), we see worsening demand & supply dynamics

for AAC, as its competitors are aggressively expanding capacity, and rising

oversupply risks (Table 2), which weighs on AAC's revenue growth and margins.

Alps Electric (OW, covered by Masashi Itaya) is also likely to come in as a key

vendor for haptics within the Apple supply chain in 2017, after contributing small

volumes in 2H16. With four vendors in play (AAC, Nidec, Alps and Jinlong), we

believe that overcapacity is quite likely to emerge within the haptics supply chain for

Apple from 4Q16 onwards.

 

#2: Haptics adoption in Android camp going slow

In contrast to AAC management's positive tone, we are more cautious on haptics

adoption in the Android camp and expect the total addressable market of haptics

from Android brands to remain small, at only 4%/ 8% of Apple in dollar terms,

in 2016/17.

Haptics on Android subject to force-touch adoption at the UI level

We believe the Android camp's mass adoption of advanced haptics is likely to come

along with force touch functions (similar to 3D Touch with iPhone 6S/ 6S+). Despite

no major hardware technology hurdle in the display/touch control supply chain, OS-

level native support and deep hardware/software integration are required to promote

force touch. Thus, we believe early traction of advanced haptics (with ASP of

US$1.5-2.0+) is likely to come out in 2H16, when the force-touch supply chain

becomes more mature, and is likely limited to very few high-end models only.

The key variable remains Google's support of haptics and force touch functionality

for Android (earliest being Android 7.0 in end 2016). With a lukewarm reception for

the 3D Touch feature in Apple iPhone 6S so far, we see limited motivation for

Google to integrate force touch into Android in a hurry.

 

Haptics on Android likely come in with small volume in 2016/17 

Our checks show that Samsung is not likely to enable force touch/ haptics functions

in a sizeable volume. Even it were to do so, key components including haptics are

likely local sourced in Korea.

Chinese brands such as Huawei might be more aggressive in pushing new features as

a marketing tactic, but recent feedback to force touch on its Mate S model has not

been encouraging.

Most in the Android camp are unlikely to adopt a high-end haptic element (ASP $6-

8) like Apple does, and are likely to settle for lower cost parts (ASP $1.5-2.0), given

the cost benefit is still unclear. As a result, we believe the benefit to AAC from

Android camp adoption in 2016 is likely to be minimal.

 

#3: Margin downside risk from non-acoustics

We expect downside from haptics/ RF mechanics to more than offset upside from

acoustics and thus model in 60bps/ 50bps YoY decline for GM in 2016/17 (vs YoY

margin improvement by the Street).

 Haptics: With heightened competition in haptics, we expect some downside to

both ASP and margins. We expect AAC's haptics GM to trend down slightly

YoY in 2016/17 (vs Street expectations of flat YoY or slight improvement).

 RF components: Given deteriorating product mix (increasing mix from metal

casing) as well as rising competition from GoerTek/Sunway, we expect GM on

RF to decline to sub-35% levels (vs 40%+ now).

Of note, different from acoustics in which AAC enjoys a high-level of automation,

metal casing is a highly customized component and the upfront fixed cost (equipment

depreciation, molding, etc.) is high.

In particular, three-layer design (Plastics + Metal + Plastic) and die-casing metal frame

are more welcomed by Chinese brands than uni-body design in the mid-low end,

putting a low barrier to entry. As such, we see execution risks and margins downside if

AAC adds capacity aggressively and fails to achieve certain scale per model.

 

#4: Lack of large customers in RF components remains risk

AAC's RF mechanical solution is well positioned for emerging small brands with

very lean R&D resources. AAC has actually secured quite good margins from these

new customers (media/ internet players entering the hardware space) who normally

are generous on component procurement. However, in collaborating with small

brands, AAC has to bear the risks of high volatility & low visibility of future orders.

Scaling up RF components remains a challenge as it is unappealing to large

customers

To grow its RF business meaningfully and sustainably in the longer term, AAC

needs to break into large customers (such as Huawei/ Samsung, and even Apple) as it

has done on acoustics/haptics. However, we believe AAC's bargaining power &

value-add on antenna design is relatively unappealing to larger brands. Big brands

like Huawei have in-house RF/ antenna design capacity and give relatively less value

to AAC's one-stop RF solution, since they want to retain flexibility in designing

casings and RF/antenna components on their own.

As we have seen with custom-made components (such as plastic/metal casings), the

hit-rate with smaller brands is usually quite low for component makers due to high

volatility and low predictability on the success of particular models. As a result, we

remain concerned that this could become a high volatility revenue stream from 2017

onwards for AAC, unless it breaks into large customers.

#5: Stock already factoring in 20% growth in 2016

After the company's strong guidance in its 3QFY15 earnings conference, we believe

the current stock price has already factored in ~20% YoY revenue growth in 2016.

We see downside to this especially if: 1) we see higher-than-expected ASP/market

share decline within Apple haptics and 2) rising competition in RF/acoustics kicks in.

In addition, we see limited structural growth drivers on a two-year horizon, after the

current cycle of haptics upgrade on iPhone 6/6S and the upcoming acoustics upgrade

on iPhone 7.

 

We believe 3Q/4Q15 is likely to mark the peak of EPS YoY growth in the next two

years and expect earnings growth momentum to moderate significantly from 2H16

onwards.

At this price level (implied 14-15x 2016EPS vs single digit EPS growth in 2017), we

see more downside than upside. Key downside catalysts in our view are market share

loss/ASP drop on haptics, Apple YoY iPhone shipments turning negative in the near

term and margin decline in 2016 due to mix degradation.

 

 

#6: Rise of Chinese smartphone component vendors a

medium-term threat

AAC is one of the pioneers in offering one-stop solutions to Chinese customers and

is so-far best positioned in 'acoustics + antenna + mechanical + casing' integrated

solutions. We see a prevailing trend of all-in-one total solutions across the China

smartphone supply chain now, through horizontal expansion and M&A. All-in-one

solutions such as 'antenna + connector', 'connector + acoustics', touch + fingerprint'

are emerging in China now.

We believe some of AAC's competitors are likely to further grow business among

Chinese brands and, in the medium long term, to challenge AAC's leading position

in component total solutions, given that: 1) most of them have already penetrated into

tier-1 clients, thus further customer/product penetration should be easy; and 2) most

of them are well prepared for total solution through horizontal product expansion,

which is further backed by financial flexibility with strong capital market support.

 

 

In particular, we believe AAC is likely to see rising competition from the following

companies in the near term.

 GoerTek: Our checks show GoerTek is following AAC's strategy to address

Chinese brands with integrated antenna/acoustics solutions. Of note, GoerTek

may foray into the haptics market as well (for Android brands only at the current

stage). 

 Sunway/Speed: Sunway/Speed are two leading RF/antenna vendors in China.

Sunway plans to integrate acoustics components (speakerbox) with its antenna

products while Speed shows increasing interest in offering integrated RF products

with mechanical/casing, particularly after the acquisition of Shenzhen Xuanmei –

a coating and stamping company.

 Luxshare & Merry: With additional placement funds, Merry might expand its

capacity (mostly with automated production) to gain acoustic shares from Apple.

With acoustics capability from Merry, Luxshare is better positioned to offer total

component solutions by covering connectors, antenna and acoustics.

 

 

Investment positives

#1: Acoustic upgrade in iPhone 7 and increased

speakerbox adoption by PRC brands

In 2016, we believe AAC should benefit from the upcoming acoustics upgrade cycle

in both Apple and Chinese brands. We model in ~12%/ 6% YoY growth for AAC's

acoustics in 2016/17, backed by: 1) ~20% increase of acoustics content with iPhone

7; and 2) usage of speakerbox among Chinese smartphone to increase to 40%/55% in

2016/17E (vs 25% in 2015). 

Acoustics spec upgrade in both iPhone 7 and Chinese smartphones to help

acoustics ASP

Our research indicates that iPhone 7 is likely to come with upgraded acoustics

features including: 1) water/dust-proof, 2) low bass and even 3) stereo sound

powered by dual speakers, likely leading to a 20%+ increase of acoustics dollar

content with iPhone.

Chinese brands are also likely to upgrade speakerbox with water-proof features. We

expect AAC's blended ASP of acoustics to see a meaningful uplift in 2H16.

 

Rising speaker to speakerbox migration

AAC should benefit from the ongoing trend of speaker to speakerbox migration

among Chinese brands, for better audio performance as well as lower failure & repair

rate (with further protection against collision/water by the box or chamber on

speakerbox). We believe overall speakerbox penetration among Chinese customers is

at ~25% level now and we expect it to further increase to 40%/55% in 2016/17E. 

 

 

#2: RF integrated metal casing seeing good initial traction

among smaller brands

Seeing a strong RF upcycle backed by 4G/multimode migration

With 3G to 4G migration and spec upgrades within 4G (such as mode migration,

career aggregation, etc.), we see meaningful upgrade in RF content and AAC, as one

of the integrated RF solution supplier, benefits from this trend. AAC is penetrating

into emerging brands by offering a one-stop RF solution (coupled with mechanical

structures) and charging premium for the time-to-market advantage, since RF design

has become increasingly challenging with 4G smartphones.

New project wins should drive growth in 2016, metal casing key driver

Management expects RF mechanical projects to see strong customer traction in 2016,

with visibility for ~20 projects in 2016 (vs 4-5 projects in 2015). Of note, AAC's

integrated RF & metal casing structure has gained some early customer adoption by

LeTV and this business is expected to further drive revenue growth in 2016. Seeing

strong demand for metal casing, management plans to expand CNC machine capacity

to 2000 units in 2016 (vs 600 units now).

We expect AAC's RF business to further grow ~90%/ 40% in 2016/17E,

respectively, from a low base, and to account for 11%/ 14% of total sales.

However, our concern remains on the quality of this revenue growth, since most of

the customers are newcomers into the smartphone space and could lose momentum

after the initial ramp-up stage, as seen in the last few years.

Breakthrough into larger customers like Apple / Samsung/ Huawei is also difficult

since these brands have large in-house RF design teams themselves.

 

#3: Strong R&D pipeline (Optical, MEMS) and solid ROE/

execution

Good track record of new technology incubation

AAC's share price has been highly correlated with the progress in new product

development & feature innovation. We found three major sources of AAC's

technology incubation: 1) internal development with in-house R&D team; 2) co-

development with global tier-1 customers and 3) external M&A.

Based on AAC's track record on items 1) and 2), we believe AAC is not likely to

miss any major upgrades from Apple on haptics and acoustics in the future.

Strong R&D pipeline like optics/MEMS

Looking at AAC's M&A history, we believe optics/ MEMS are likely to be the

next drivers.

We note that AAC has started selling 5MPx front-camera lens to Chinese customers

and plans for mass production of 13MPx lens in 2016.

However, given the crowded optics market with many players (like Largan/ Genius/

Sunny Optical) fighting for share, in the near term, the further room left to AAC

might be limited to niche areas such as dual-camera/ array camera, or differentiated

products such as integrated products with VCM/ OIS, etc.

Further, with long-term investment in MEMS microphone and its effort on in-house

MEMS dies, AAC could be well positioned in the future 'Internet of Things' era

when MEMS contents are likely to see meaningful increases.

 

Strong ROE backed by solid execution

AAC has been able to maintain GM at 40%+ level even with rising competition from

local rivals and with continued diversification into non-acoustics. We expect AAC to

deliver ~25-29% ROE in 2016-17, one of the highest within the Apple Supply

Chain, warranted by solid execution. AAC manages to deliver good product quality

while expanding product variety and holds a good balance of manufacturing

automation and feature customization.

 

 

integrated RF solution appears to be slow, with very small revenue contribution.

Sunway is a serious competitor in RF/ antenna and has seen the trend of integrated

RF/ antenna solutions. However, it just started R&D on speaker-box and the RF/

acoustics integrated product may only come out as early as 1H16. 

Global antenna vendors such as Amphenol, Molex seem not to be focusing on

integrated RF solution and we believe they are unlikely to invest aggressively in

acoustics & mechanicals given the scale & cost disadvantage and limited resource on

customer supports & product customization.

Metal casing: a high-mix low-volume business

Despite the structural trend of metal casing migration, we see a segmented market

with increasing competition in the mid-low metal casing business. We believe AAC

should focus on the mid-high market (namely 'Uni-body design (CNC + stamping)'

in the below table), thus leveraging its antenna design capability, and avoid low-end

segments, which have higher overcapacity risks and low margins.

 

 

Margin downside may emerge if AAC fails to manage capacity/ yield properly

With increasing contribution from PRC customers, AAC is entering into a high-mix

& low-volume market (related to Apple). In such environment, AAC needs to be

prudent in partnering with smartphone brands as scale per single model is the key

factor to warrant decent margins; otherwise, we see execution risk and margin

downside from metal casing business. 

Actually, 30% appears to be the ceiling of gross margins among Android metal

casing vendors (vs 40%+ gross margins by AAC's RF segment in 2Q/3Q15). Even

with margin accretion from antenna design, we see margin downside to AAC's RF

business if it aggressively competes for casing orders.  

Acoustics

Apple remains the largest acoustics customer to AAC, contributing 50%+ of the

latter's acoustics business. We expect AAC to remain a tier-1 acoustics supplier and

get stable share allocation (~40%) from Apple.

 

 

Further share loss to GoerTek is limited 

AAC and GoerTek are the two major acoustics suppliers to Apple with a combined

share of 85-90%. AAC was losing market share to GoerTek in 2011-13, however, we

believe the share split between those two is at equilibrium now, with AAC taking

slightly more share from new models while GoerTek supplying larger proportion of

Apple's mature models.     

This document is being provided for the excluAsia Pacific Equity Research

05 January 2016

Gokul Hariharan

(852) 2800-8564

gokul.hariharan@jpmorgan.com

Luxshare/ Merry alliance could be a medium threat    

Luxshare has announced to invest up to Rmb800mn in Merry, which is worth

watching for AAC. With additional placement fund, Merry might expand its capacity

to gain acoustic shares from Apple. According to our checks, we believe Merry could

expand its existing acoustics capacity to Apple by 2-3x with Luxshare's investment.

Limited threat from global competitors

AAC largely holds 1/3 share of global acoustics component market and we see

limited threat from its global acoustics competitors, such as Knowles and Hosiden,

given their much lower scale and inferior cost structure.

Of note, Knowles is the clear leader in MEMS MIC with ~60% global market share,

followed by AAC with ~15% M/S. We expect AAC to retain its market share with a

stable allocation from Apple. 

 

All-in-one total solutions

AAC is one of the pioneers in offering one-stop solution to Chinese customers and is

so-far best positioned in the 'acoustics + antenna + mechanical + casing' integrated

solutions. We see prevailing trend of all-in-one total solution, across China

smartphone supply chain now, through horizontal expansion and M&A. All-in-one

solutions like 'connector + FPC', 'connector + acoustics', 'touch + fingerprint' are

emerging in China now.

 

 

We analyze the company profiles of AAC's major domestic competitors. With our

findings below, we believe some of they have the opportunity to further grow their

business among Chinese brands and challenge AAC's leading position as a one-stop

component shop in the medium-/ long-term. 

 Already penetrated into tier-1 clients; further customers/ products

penetration should be easy: Most of Chinese component vendors have already

penetrated into large domestic smartphone brands and even global brands like

Apple (e.g. GoerTek/ Sunway/ Luxshare/ Jinlong). With stamps from those big

clients, they have demonstrated the design capacity and good product quality –

thus it should be easier for them to further gain shares among Chinese brands and

bundle sell affiliated/ new products.

 Good enough technologies to offer all-in-1 solutions: We agree that AAC is

probably the leader with best-in-class technologies and product quality among

Chinese vendors now. However, more important than individual technology &

quality, what attracts Chinese brands is the total cost saving, simpler supply chain

management, time-to-market advantage and customer services – we believe most

of those Chinese vendors are competitive in those metrics.

 Financial flexibility with capital market support: Most of those competitors

are as cash sufficient (scaled to their revenue base) as AAC. More importantly,

with supports from the local capital market, they could find a way to expand

capacity aggressively or break-into new businesses.

 

 

In particular, we believe AAC is likely to see rising competition from the following

companies in the near term. 

 GoerTek: Our check shows GoerTek is following AAC's strategy to address

Chinese brands with integrated antenna/ acoustics solution. Of note, GoerTek is

likely to foray into the haptics market as well (for Android brands only at current

stage). 

 Sunway/Speed: Sunway/Speed are two leading RF/ antenna vendors in China.

Sunway wants to integrate acoustics component (speakerbox) with its antenna

products while Speed shows increasing interest in offering integrated RF products

with mechanical/ casing, particularly after the acquisition of Shenzhen Xuanmei

– a coating and stamping company.

 Luxshare & Merry: With investment from Luxshare, Merry might expand its

capacity (mostly with automated production) to gain acoustic shares from Apple.

With acoustics capability from Merry, Luxshare would be better positioned to

offer total component solutions by covering connectors, antenna and acoustics.  

 

Company analysis

Company background

AAC Technologies, founded in 1993, is one of the leading miniature component

solutions providers, specializing in acoustics and mechanical parts. AAS is the global

No. 1 vendor in miniature acoustics, with ~35% market share globally. AAC excels

in design flexibility and complexity and has very good yield rates and short lead

times. It also enjoys a high level of automation and strong, lean production

management.

AAC manufactures dynamics components (namely speaker boxes, traditional

speakers and receivers), MEMS microphones, haptics, RF/ antenna and handsets for

world's major smartphone and tablets brands. Its major customers include Apple,

Samsung, Xiaomi, Huawei, Moto, Oppo, HTC, LeTV, etc.

AAC has multiple factories across China, including Changzhou (acoustics, haptics,

mainly for Apple), Shuyang (RF/ antenna, semi-automated acoustics), Suzhou

(optics), Shenzhen (MEMS), Vietnam (manual-line, mainly for SEC now). 

 

 

Mr Zhengmin Pan (Founder and CEO)

Mr Zhengmin Pan is the CEO and Founder of the Company. Mr Pan is responsible

for company strategy, business planning and execution, as well as leading R&D. In

1996, he co-founded and was appointed President and CEO of American Audio

Component Inc. Mr Pan also co-founded Shenzhen Meiou Electronics Corporation in

1998 and American Audio Components (Changzhou) Co., Ltd. ('Changzhou AAC')

in 2000. Mr Pan is the spouse of Ms Chunyuan Wu, the non-executive Director and a

substantial Shareholder of the Company.

 

 

Segment and product analysis

AAC is a leading miniature component vendor…

AAC is a leading maker of miniature component for acoustic and mechanical parts

that widely used in smartphone/ tablets. With continued business diversification and

breakthrough in non-acoustics, AAC has diversified its core business from acoustics

centric to a more balance portfolio, including RF/antenna, haptics, optics, etc. 

 

 

…Conquering the sweet corner of high-volume & innovation 

AAC is one of the few hardware component companies that have been delivering

innovative products in large scale, backed by superior R&D design capacity, strong

product quality and well established cooperation with global tier-1 customers.

We analyze the AAC's production & customer strategies since 2014 (as shown in

Figure 18) and two key trends stand out: 1) China handset customers' moving up

value chains expands total addressable market of AAC's speaker-box/ MEMS mics

that used to adopt only by global tier-1 customers;  and2) breakthroughs in non-

acoustics (Haptics/ RF, etc.) offers new business opportunities, putting more balls

into the sweet corner of high-volume & innovation.  

 

Notably, AAC's endeavour in product diversification has paid off, with non-

acoustics businesses (such as haptics, RF/ Antenna) ramping up quickly and revenue

dependence on acoustics being lowered down to ~60% (vs 90%+ in 2013 and

before). According to our addressable market analysis, there is still room for AAC to

grow in non-acoustics space and we expect AAC's non-acoustics to further grow

~145%/25% YoY in 2015/16E, respectively.

 

 

Haptics: Spec upgrades with Apple; Android adoption not

imminent yet

AAC started offering haptics to Apple in 2014 for iPhone 6/6+. Despite some early

product hiccups on Apple Watch in 1H15, AAC retains one of the major haptics

suppliers for Apple's new iPhone 6S/6S+.

New haptics on iPhone 6S: 2-3x ASP boost on spec upgrade 

What has surprised market to the upside was that the 2nd generation haptics on

iPhone 6S/6S+ came in with a much higher ASP compared to 1st gen on iPhone6/6+,

driven by new design and spec upgrades, such as compacter form-factor, stronger

resonance (with larger amplitude), swifter response and lower power consumption.

The high ASP also reflects the manufacturing difficulty with the new design and

partially compensates the low yields at early stage.

 

 

Haptics on Android: subject to OS-level support; limited to high-end models

We believe Android camp's mass adoption of advanced haptics are likely to come

along with force touch functions (similar to 3D Touch with iPhone 6S/ 6S+). Our

check shows that there is no major technology handle in the display/ touch control

supply chain, however, OS-level native support and deep hardware/ software

integration are required to promote force touch adoption. In addition, the user traction

of force touch is low with limited use scenario & user experience improvement. 

We believe early traction of advanced haptics (with ASP at US$1.5+) is likely to

come out in 2H16, when force-touch supply chain becomes more mature. However,

those adoptions are likely limited to very few high-end models only.  

RF/ Antenna: integrated solution embracing rising China

demand

Integrated RF solution gained good early traction

After multiple years' investment, AAC broke into RF/antenna business in 2013/14

and its product offerings include FPC, LDS, and integrated RF/antenna solutions

(namely RF on speakerbox and RF on mechanical structures).

Design of RF/antenna becomes increasingly mechanically challenging for LTE

smartphones and high level of RF/ antenna customization demands for early-stage

design in. AAC's integrated RF solutions answer handset producers' call for

modulized production process, which reduces the likelihood of incompatibility at the

assembler end, shortens time to market and relieves the R&D burden on smartphone

OEMs, particular those running with a very lean R&D team. Despite low ASP ($0.3-

0.5) for each single antenna, the cross selling opportunities on inner frame & metal

casing and embedded value with antenna design are much bigger.  

 

 

RF on speakerbox: The integrated speakerbox/ antenna solution helps earlier

identify any potential noise between antenna and acoustics – given audio and

radio frequency are possibly interfered with each other – and thus increase the

overall yield rate.

 RF with inner frame: AAC's integrated RF + inner frame (Speakerbox + LDS

antenna + inner plastic frame) has gained good customer tractions, such as

Xiaomi for Mi 4/ Mi Note and Moto for the G series. 

 RF with metallic frame: With increasing adoption of metal casing, the antenna

design becomes a challenge given the potential 'death grip' scenario. AAC's

integrated RF & metal casing structure aims to solve the signal issue through

early design in and has gained some early customer adoption by LeTV for

Pro/Max/ 1S models. Now the company has 600 units of CNC machines and

plans to expand the capacity to 2000 units by 2016. 

Tunable RF planning for the future 

AAC has been investing in tunable RF (with acquisition of WiSpry) and plans to roll

out its smart antenna solution in 2016. We believe tunable RF has a promising future

with the capability to support multiple modes/ bands with compact form-factor and

high integration. Industry leaders like Murata (6981 TT, OW) have been developing

tunable RF for a while, however, the quality so far has not reached commercial

standard given manufacturing and performance constraints. We believe the progress

on tunable RF would be an interesting point to watch, if AAC can deliver good

reliability and consistency.

Acoustics seeing spec upgrades and increasing

penetration to Chinese brands 

Apple: spec upgrades with iPhone7 likely

Our checks show that iPhone 7 are likely to come with upgraded acoustics features

including 1) water/ dust-proof, 2) low bass and even 3) stereo sound powered by dual

speakers, likely leading to 20-30% increase of acoustics dollar content with iPhone.

Chinese brands are also likely to upgrade speakerbox with water-proof feature. We

expect AAC's blended ASPs of acoustics to see a meaningful uplift in 2H16.

 

 

Chinese brands: ongoing speaker to speakerbox migration

AAC started to promote its cost effective speakerbox with ASP at US$1.0-1.2 (vs

traditional speaker price of US$0.5-0.6) to Chinese brands. We note that Xiaomi/

Huawei / OPPO/ Lenovo have started to use AAC's acoustics products (speaker,

receivers, and speaker-box) on their mid-high end smartphones and AAC is likely to

further benefit from the trend of speaker to speakerbox migration. Besides better

audio performance, lower failure & repair rate is another good selling point for

speakerbox, given further protection against collision/ water by the box/ chamber.    

The overall speakerbox penetration among Chinese customers is still at ~25% level

and we expect it to further increase to 40%/55% in 2016/17E. 

 

 

MEMS MIC: increasing automation & dual MEMS-die sourcing to defend

margins

MEMS microphones have largely benefited from the fast smartphone volume growth

in the past, particular in the mid- and high-end. The addressable market of MEMS

microphones is likely to further expand post smartphone cycle, largely from

emerging areas such as wearable devices and smart home appliances, where we see

increasing adoption of voice intelligence (such as Google Now, Apple Siri, etc.). 

GM on MEMS MIC has been trending south given the intensive competition and

nature of highly standardized products. We expect the gross margin to hinge at ~25%

level with help from increasing scale and automation. Of note, ~50% of the cost is

attributed to MEMS Die and ASIC Die, which now AAC has to outsource from other

vendors like Infineon. We might see upside to margins if AAC makes breakthrough

in development of its own MEMS Die or the dual MEMS-die sourcing kicks in.

AAC's market share in MEMS MIC was ~15% in 2014 and we expect it to largely

maintain this share in the next two to three years.

 

 

New products: optics the next leg, but with slow progress

so far

Share price largely correlated with product innovation and client penetration

We analyze AAC's share price trend in the past and found it highly correlated with

the progress with its product innovation and big client penetration.

 

Can we expect more innovations in the future?

We analyze AAC's history of technology incubation and identify three major

sources: 1) internal development with in-house R&D team; 2) co-development with

global tier-1 customers and 3) external M&A. Given AAC's track record on items

1) and 2), we believe AAC is not likely to miss any major upgrades from Apple on

haptics and acoustics in the future.

 

Looking at AAC's M&A history, it takes AAC at least 2-3 years to integrate and

incubate an acquired new technology before the commercial products come through.

For example, AAC started cooperation with Immersion on haptics and supplied piezo

actuators to Nokia back in 2008/09. AAC has been developing haptics technologies

ever since and eventually penetrated into Apple in 2014 with mass volume. Forward

looking, we feel optics/ lens seems to be the next fruit-bearing tree, post RF/ antenna.

 

 

Optics/ lens: looks beautiful; but surrounded by many chasers

Optics/ lens is another area AAC has been investing in since 2009/ 10. We also note

that AAC has started 5MPx front-camera to Chinese customers and plans for mass

production of 13MPx lens in 2016. However, given the optics market is crowded

with many players, the further room left to AAC might be limited to niche areas such

as dual-camera/ array camera, or differentiated products such as integrated products

with VCM/ OIS, etc. 

 

Tunable RF: with promising future, but still far away from commercialization 

Tunable RF appears to be an interesting area that AAC is focusing on and AAC plans

to roll out its smart antenna solution (namely MEMS based tunable RF) in 2016. We

believe the progress on tunable RF would be an interesting point to watch, if AAC

can deliver good reliability and consistency. Tunable RF could become a big

innovation with significant potential from cost saving and ease of design.

 

 

Financial analysis

Segment and revenue drivers

AAC's acoustics revenue (dynamic component plus MEMS component) peaked out

in 2013 because of speakerbox share loss to GoerTek. We expect acoustics to re-pick

growth momentum in 2016/17 driven by spec upgrades.  

Non-acoustics segment (Haptics & RF) became revenue driver since 2014 and is

expected to further drive top-line growth in 2016/17E.

 

Margins and profitability

AAC has been consistently leading its acoustic peers in gross margins since 2011 and

has been able to maintain the margins at 40%, albeit with rising price competition

from its local rivals.

 Margins from dynamics components have been declining from 48%+ in 2012 to

~45% in 2013/14 and further down to ~40% in 4Q14. We expect margins to

improve moderately in 2016/17 driven by spec upgrade and increasing automation.

 Margins from non-acoustics business (Haptics/ RF) started to surpass dynamic

components from 4Q14 with increased scale and yields. We expect the blended

GM from non-acoustics to maintain at ~45% level in 2016/17E, well above

dynamic components.

 Margins from MEMS MICs have seen headwinds given the increasing

competition. We believe the gross margin could stabilize at 20%+ and potentially

see upside if dual sourcing of MEMS-die metalizes.    

 

 

Balance sheet & cash flow

We expect AAC to deliver 25-30% ROE in 2015-17E on back of resilient margins

and strong operation leverage. AAC maintains a clean balance sheet with net cash

position as well.

Operation cash flow is likely to top Rmb3.7bn in 2016E, enough to support Capex

spending (guided at Rmb2.3bn) and dividend payout (JPMe of Rmb700-800mn). 

 

 

Investment Thesis, Valuation and Risks

AAC Technologies Holdings (Underweight; Price Target: HK$42.00)

Investment Thesis

AAC manufactures dynamics components (namely speaker boxes, traditional

speakers and receivers), MEMS microphones, haptics, RF/antenna and handsets for

the world's major smartphone and tablets brands. Its major customers include Apple,

Samsung, Xiaomi, Huawei, Moto, Oppo, HTC, LeTV, etc. AAC excels in design

flexibility and complexity and has very good yield rates and short lead times. It also

enjoys a high level of automation and strong, lean production management.

We assume coverage of AAC with an Underweight rating and a Jun-16 TP of HK$42

(12x 2016 EPS). We believe the share price has largely (if not overly) factored in

management's positive 2016 tone (~20% YoY top-line growth with some margin

increase). We are more conservative on margin improvement and worried about

future growth in 2017. We suggest investors take profits at current price level;

potential downside catalysts include iPhone 6s sales weakness, and share loss on

haptics.

Valuation

Our Jun-16 target price of HK$42 is based on a 12x 2016 EPS excluding one-offs.

Our target P/E multiple 12x is 0.5 standard deviations below the historical average

P/E of 13.5x, to account for the low visibility of structural growth post 2016.

Risks to Rating and Price Target

The key upside risks to our investment thesis include: 1) better-than-expected market

share on haptics, 2) faster-than-expected haptics penetration in Android, and 3) ASP

boost on acoustics.

The key downside risks to our investment thesis include: 1) slower-than-expected

spec upgrade by Chinese smartphones, 2) weaker-than-expected iPhone sales and

3) failure to maintain margins.