Thesis: HTC has horse characteristics but is incorrectly perceived as a contract manufacturer. They have a culture/history of product innovation which should allow them to continue to maintain high share of the rapidly growing Android OS segment of the mid/high-priced consumer smartphone market. As their share of the global smartphone market increases from 4.5% to 10%+ over the next few years, they are likely to earn ~60+ $NTD/share in eps which is ~50% ahead of street expectations. We are buying HTC at ~7-8x 2012E our EPS #s with a 20% net cash balance sheet, 6.5% dividend yield and strong tailwinds from increasing smartphone and Android penetration.
How this Plays Out: HTC gets to a run rate unit sales # of ~35-40m Android units in the next few years vs street expectations of ~20-25m units. ASPs decline by ~5% this year and 10% annually for the next 2yrs. Annual revenues growth accelerates from ~20% to ~40%+. Gross margins decline from ~30% to ~28% and EBIT margins remain flat due to leverage in the G&A and R&D line items as revenue growth accelerates. HTC generates ~60 $NTD/share in eps vs expectations of ~40 $NTD/share in eps.
- Significant Competition Drives Commoditization: Innovation and superior returns will benefit the OS providers while the hardware manufacturers will become commoditized. HTC is a hardware player with no competitive advantage and thus will be unable to both maintain its current share of the Android OS opportunity and earn adequate returns.
- Margin Pressures: EBIT margins are likely to compress from ~15% today to ~11% in 2yrs due to GM pressures from increasing competition and the weak Euro and opex deleveraging as HTC is forced to grow its sales and marketing expense faster than revenue growth.
- Valuation: On bear #s, HTC trades at ~15x 2011E EPS which is not cheap relative to other smartphone companies (12-13x on 2011E consensus #s).
What the Bears Are Missing:
- History of Innovation and Observing Strong Customer Adoption and Carrier Support: HTC has a history of innovation, focus, strong product design and very high returns on capital. They began investing in their own Android branded smartphones ~12 months ago and are currently the #1 selling Android manufacturer today. They have increased their sales and marketing focus to support their brand and are experiencing extremely strong consumer adoption and carrier support. Channel checks indicate new Android smartphones released on Sprint and VZ are sold out at almost every location.
- Accelerating Revenue Growth and Continued Innovation Support Margins: Increasing smartphone penetration, increasing Android share gains and continued strength in HTCs product portfolio should drive HTC volume growth of 50-60% and revenue growth of 40%+ with minimal incremental capital. Continued innovation in product design should limit gross margin pressures and accelerating revenue growth should allow for leverage in G&A/R&D line items (~50 of costs) driving stable EBIT margins in the mid-teens.
- Valuation: Based on our #s, HTC trades at ~7-8x 2012E EPS in a rapidly growing category with a strong and improving brand.
Key Thesis Points
- Android OS Taking Significant Share of Smartphone Market: The global smartphone market is likely to increase its penetration of mobile phones from 17% today to 25%+ over the next 3yrs and the Android OS is likely to increase its share of the global smartphone market from 10% to 30%+. This should drive Android OS volume CAGR of 150% over the next 3yrs.
- The Android OS was launched in the US in 2009 and has increased its share of the smartphone market from 5% to 30% and growing in the past 3 quarters.
- Over the same time period, the Android OS has increased its share of the W European smartphone market from 3% to 7%. Android OS share gains should continue to accelerate in W Europe and ROW as Android smartphone manufacturers are just starting to focus outside the US.
- Android should be able to achieve 30%+ share of the global smartphone market over the next few years as it has an open (and free) platform that attracts manufacturers, consumers, app developers and carrier support. The free OS allows manufacturers to lower pricing vs their peers, allowing for further consumer adoption of the OS and still allowing the manufacturers to generate adequate gross margins. In addition, we believe that Google is paying an additional subsidy to carriers to incentive adoption of their OS. Longer term, we believe the market will be largely split between Iphone users and Android users and Symbian/RIMM will be marginalized.
- HTC is # 1 Seller of Android Smartphones and is Building Brand Value: HTC has ~50%+ market share of Android OS smartphones.
- HTCs advantages are its ability to consistently innovate around product design/user interface while also maintaining speed to market with new products. They have a history/culture of product innovation and started to invest more heavily in sales and marketing around their own Android branded smartphones ~12 months ago. The Android phones utilize their own proprietary user interface called Sense. HTCs brand is benefitting from the virtuous circle of great products, increased consumer adoption, increased sales and marketing and strong carrier support.
- HTCs new Incredible phone on VZ and 4G EVO phone on Sprint are the #1 selling phones for both carriers and are sold out at almost every store we have called. Channel checks indicate that HTC has been taking share in W Europe with its Desire phone.
- HTC was the first mobile phone manufacturer to integrate internet, entertainment, video and personal PDA functions into a mobile phone in the early 00s. They were also the first to release a solid Android smartphone, the partner Google chose to manufacture their Nexus One phone and the first to release a 4G smartphone which is now selling at Sprint. Continuous product innovation should allow them to maintain high share of the Android OS opportunity.
- Management: The co-founders have a history of managing HTC with a consistent strategy. They have always been focused on innovation in product design and are non-promotional. Their branding strategy is "quietly brilliant" and this is embedded in the corporate culture throughout the organization. The founder and chairman of the company, Cher Wang, together with her husband, own ~6% of the company. They have been good about returning cash to shareholders through dividends and share repurchases as the business needs minimal incremental capital to grow.
- Android has increased its market share in the US from 5% to 30% in 3 quarters and channel checks indicate it continues to take share
- HTC Incredible phone is sold out at most VZ stores we have called
- HTC EVO phone is #1 selling phone at almost all Sprint stores we have called and is taking share from PALM Pre, RIMM and even taking ATT Iphone customers looking for a better service experience
- New HTC phone just launched on ATT focused on mid-end of smartphone market
- Increasing mix of higher ASP smartphones being sold which should help support ASPs/gross margins
- Intense smartphone competition (manufacturers and OS providers) in all segments of the market (low end to high end) leads to commoditization
- Greater than expected pressure on ASPs/margins
- Android OS takes less share than expected
- HTC loses significant share of the Android OS market
- HTC misses a product cycle which causes them to lose significant share and experience declines in profitability
- Iphone goes multi-carrier in US and Android loses significant share
- HTC blows away consensus expectations
- Android OS continues to take share in US/W Europe and HTC continues to be the dominant Android OS provider