AAC Technologies: Potential Spin-Off Of Optics Business In 3 Years (OTCMKTS:AACAY)

Elevator Pitch

I maintain a Bullish rating on Hong Kong-listed smartphone micro component solutions supplier AAC Technologies Holdings (OTCPK:AACAY) (OTCPK:AACAF) [2018:HK].

This is an update of my prior article on AAC Technologies published on June 29, 2020. AAC Technologies’ share price has declined by -10% from HK$48.85 as of June 26, 2020, to HK$43.75 as of October 21, 2020, since my last update. AAC Technologies trades at 16.9 times consensus forward FY 2021 P/E, and it offers a consensus forward FY 2021 dividend yield of 1.8%.

The introduction of multiple new strategic investors for AAC Optics in the past few months is a validation of the growth potential of AAC Technologies’ optics business, and a potential spin-off and IPO to unlock the value of its optics business within the next three years are very likely. Also, while the optics business’ 2Q 2020 gross profit margin of 13.8% was below expectations and earlier guidance, its higher-margin wafer level glass or WLG lens products will be a key gross margin expansion driver going forward. Taking into consideration the above-mentioned factors, I retain my Bullish rating on AAC Technologies.

Readers have the option of trading in AAC Technologies shares listed either on the Over-The-Counter Bulletin Board/OTCBB as ADRs with the tickers AACAY and AACAF, or on the Hong Kong Stock Exchange with the ticker 2018:HK. For those shares listed as ADRs on the OTCBB, note that liquidity is low and bid/ask spreads are wide.

For those shares listed in Hong Kong, there are limited risks associated with buying or selling the shares in terms of trade execution, given that the Hong Kong Stock Exchange is one of the major stock exchanges that is internationally recognized, and there is sufficient trading liquidity. Average daily trading value for the past three months exceeds $60 million, and market capitalization is above $6.8 billion, which is comparable to the majority of stocks traded on the US stock exchanges.

Institutional investors which own AAC Technologies shares listed in Hong Kong include The Vanguard Group, BlackRock (NYSE:BLK), Norges Bank Investment Management, Lazard Asset Management, and State Street Global Advisors, among others. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage such as Interactive Brokers (NASDAQ:IBKR) and Fidelity, or international brokers with Asian coverage like Hong Kong’s Monex Boom Securities and Singapore’s OCBC Securities.

New Strategic Investors For Optics Business And Potential Spin-Off

In my prior article on AAC Technologies published on June 29, 2020, I highlighted that “the optic business is expected to deliver RMB10 billion in annual revenue in the medium term on top of significant gross margin expansion,” and this is the key investment thesis for the stock.

Notably, AAC Technologies is a late entrant to the optics market, and its optics business’ 2Q 2020 gross margin of 13.8% is significantly below that of its more established peers. This implies that there is significant room for gross margin expansion for AAC Technologies’ optics business, as the optic business for both Sunny Optical (OTCPK:SNPTF) (OTCPK:SOTGY) [2382:HK] and Largan Precision (OTC:LGANF) [3008:TT] (market leaders in the optics business) achieved gross margins in excess of 40% in FY 2019. Also, the annualized revenue (based on the most recent 2Q 2020) for AAC Technologies’ optics business of RMB1.5 billion is way below the company’s medium revenue target of approximately RMB10 billion.

More importantly, the introduction of multiple new strategic investors for AAC Technologies’ subsidiary AAC Optics (Changzhou) Co., Ltd. in the past few months serves as a validation of the growth potential of the company’s optics business.

On October 9, 2020, AAC Technologies announced that 18 new strategic investors have invested RMB1,658 million for a 9.28% stake in AAC Optics (formerly known as AAC Communication). It is noteworthy that the implied valuation of AAC Optics is RMB17.9 billion based on this most recent round of financing, and AAC Technologies’ 82.02% equity interest in AAC Optics is worth approximately RMB15 billion or a third of AAC Technologies’ current market capitalization. Furthermore, as part of this recent deal, the new strategic investors have the right to redeem their shares in AAC Optics, if AAC Optics is not spun off from AAC Technologies and separately listed as an independent entity within the next three years. In other words, a potential spin-off and separate listing of AAC Optics could be another positive re-rating catalyst for AAC Technologies in the next few years.

List Of New Strategic Investors For AAC Optics In October 2020

Source: AAC Technologies’ Announcement Dated October 9, 2020

Earlier in July 2020, AAC Technologies disclosed that leading Chinese smartphone manufacturers Xiaomi Corporation (OTCPK:XIACY) (OTCPK:XIACF) [1810:HK] and Guangdong Oppo Mobile Telecommunications Corp. Ltd. (best known for its OPPO-branded phones) were among four strategic investors who invested a total of RMB1.15 billion in AAC Optics. Notably, the implied valuation of AAC Optics then was a much lower RMB12.0 billion. As smartphone manufacturers, Xiaomi and Guangdong Oppo are AAC Optics’ customers, and their investment in AAC Optics is the best endorsement of the optics business’ capabilities and potential. In addition, the introduction of Xiaomi and Guangdong Oppo as strategic investors is likely to lead to closer collaboration to drive the future growth of the optics business, on top of additional capital for research & development and capacity expansion.

2Q 2020 Earnings Were Below Expectations With All Eyes On Optics Business

AAC Technologies announced the company’s 2Q 2020 financial results on August 24, 2020, and its financial performance was disappointing with the optics business’ lower-than-expected gross profit margin in the spotlight.

The company’s net profit decreased by -20.8% YoY from RMB338 million in 2Q 2019 to RMB268 million in 2Q 2020, as a -170 basis points contraction in gross profit margin from 25.0% in 2Q 2019 to 23.3% in 2Q 2019 more than offset a +12.7% YoY increase in revenue to RMB4,277 million over the same period. Specifically, the gross profit margin of AAC Technologies’ optics business came in below expectations in the second quarter of the year.

Although the optics business’ 2Q 2020 gross profit margin of 13.8% was a significant improvement from its gross profit margin of 9.8% in 1Q 2020 and -2.7% in 2Q 2019, this was below the company’s gross profit margin guidance of 30%, as per its comments at the earlier 1Q 2020 earnings call on May 15, 2020. At the company’s most recent 2Q 2020 results briefing on August 24, 2020, AAC Technologies explained that this was due to a timing difference of one to one and a half months between production output and shipments to clients.

Based on FIFO (First In First Out) accounting rules as per International Financial Reporting Standards, AAC Technologies’ reported gross margin is calculated to “reflect the rolling inventory that is kept in the company.” AAC Technologies claimed that its “production gross margin,” based on market price and actual costs incurred, was 25.9% for 2Q 2020. In other words, “production gross margin” is a leading indicator of future reported gross margin, and AAC Technologies is guiding for “production gross margins” of 35% and 40% for 3Q 2020 and 4Q 2020, respectively.

A key gross margin expansion driver for AAC Technologies in 2021 and beyond will be its WLG lens products, or higher margin glass lens which leverage on its proprietary wafer level glass or WLG technology. AAC Technologies is targeting to increase its production capacity of WLG lens to more than 20 million WLG lens per month by the end of this year, as compared to its current production capacity of WLG lens of approximately two million per month.

AAC Technologies’ WLG Lens Products

Source: AAC Technologies’ 2Q 2020 Results Presentation Slides

Valuation And Dividends

AAC Technologies trades at 26.1 times consensus forward FY 2020 P/E and 16.9 times consensus forward FY 2021 P/E based on its share price of HK$43.75 as of October 21, 2020. In comparison, its five-year and 10-year mean consensus forward next twelve months’ P/E multiples were 18.0 times and 16.3 times, respectively.

AAC Technologies offers consensus forward FY 2020 and FY 2021 dividend yields of 1.3% and 1.8%, respectively. The company declared an interim dividend of HK$0.10 per share for 1H 2020, which represented a -75% decline in absolute terms as compared to its 1H 2019 interim dividend of HK$0.40 per share. Market consensus expects AAC Technologies’ full-year dividends per share to decrease from HK$1.43 in FY 2019 to HK$0.57 in FY 2020, before increasing to HK$0.78 in FY 2021.

Risk Factors

The key risk factors for AAC Technologies are the optics business taking a longer-than-expected time to achieve higher profitability in line with its more established peers, a failure to increase the production capacity of WLG lens in line with its target, and lower-than-expected smartphone shipments going forward.

Note that readers who choose to trade in AAC Technologies shares listed as ADRs on the OTCBB (rather than shares listed in Hong Kong) could potentially suffer from lower liquidity and wider bid/ask spreads.

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Disclosure: I am/we are long AAC TECHNOLOGIES HOLDINGS [2018:HK]. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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