Hong Kong BUY VTech Holdings

SEE APPENDIX I FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS

Hong KongReinitiating Coverage 15 August 2012

VTech Holdings Defensive Name in Market Downturn

Reinitiate coverage with BUY and a target price of HKD108, implying 15% upside. Our target price is based on 16x FY3/13F PER. We believe that the stock is at an earnings inflection point this year as its FY3/13F earnings are likely to resume the growth momentum, mainly thanks to VTech’s recent series of product launches in the ELP business and easing raw material cost pressures. Moreover, VTech’s strong balance sheet and attractive dividend yield make it one of the best dividend plays and defensive industrial names in the current choppy environment.

Earnings at inflection point. We expect VTech to reverse its declining earnings trend of the past two years. Despite the macroeconomic headwinds, VTech’s earnings will likely grow by 12% for FY3/13F, mainly driven by continuous new product introductions in the ELP division and the fast-growing CMS division, thus boosting the top-line by 7% for FY3/13F. Along with softening raw material prices for the year, VTech’s gross profit margin should recover to 32.5% in FY3/13F.

Dividend support. VTech’s share price has performed strongly YTD and outperformed the market by 10.4%, which could be attributed to its defensive nature amidst market uncertainty. The company is debt-free and financially sound with over USD300m cash in hand, which should allow for continuously high dividend payouts. We expect VTech to maintain a high payout ratio of 95% for the upcoming two years which translates into an attractive dividend yield of around 6.8%.

Rich valuation is justified. VTech is one of the best quality names among HK-listed industrials. The counter is trading at 13.9x FY3/13F PER, which is at the high-end of its historical valuations and average of 10x since listing. We believe that its rich valuation is warranted given its: 1) net cash position with zero debt; 2) strong cash cow; 3) high ROE; 4) sustainable dividend yield; and 5) decent management team with quality corporate governance.

VTech Holdings – Summary Earnings Table FYE Mar (USDm) 2011A 2012A 2013F 2014FRevenue 1,713 1,785 1,913 2,031 EBITDA 252 237 264 289 Recurring Net Profit 202 192 215 235 Recurring Basic EPS (USD) 0.81 0.77 0.86 0.94 EPS growth (%) (2.7) (5.5) 12.0 9.3 DPS (USD) 0.78 0.76 0.82 0.90

PER 14.7 15.6 13.9 12.7 EV/EBITDA (x) 10.6 11.3 10.2 9.3 Div Yield (%) 6.5 6.3 6.8 7.5 P/BV(x) 5.5 5.4 5.4 5.3

Net Gearing (%) N/A N/A N/A N/AROE (%) 38.1 34.9 38.6 41.7 ROA (%) 23.4 21.4 23.3 24.7 Consensus Net Profit (USDm) N/A N/A 212 230Source: Company data, Kim Eng Securities

BUY

Share price: HKD93.7 Target price: HKD108

Alex YEUNG [email protected] (852) 2268 0636

Stock Information

Description: VTech is the world's largest manufacturer of cordless telephones and electronic learning products. It also provides highly sought-after contract manufacturing services. Ticker: 303 HK Shares Issued (m): 250.4 Market Cap (USDm): 3,025 3-mth Avg Daily Turnover (USDm): 3.7 HSI: 20,292 Free Float (%): 64.7 Major Shareholders: % Chairman Wong Chi Yun 35 Key Indicators

ROE – annualised (%) 38.6 Net cash (USDm): 313 NTA/shr (USD): 2.2 Interest cover (x): N/A Historical Chart

Performance: 52-week High/Low HKD101.0/HKD63.4 1-mth 3-mth 6-mth 1-yr YTD Absolute (%) (1.2) 12.9 15.0 5.1 20.4 Relative (%) (7.4) 10.1 18.0 1.7 10.4

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15 August 2012 of 21

VTech Holdings Limited

Investment thesis

Reinitiate coverage with BUY and a target price of HKD108. VTech is the world’s largest cordless phones manufacturer and electronic learning products supplier. The company has managed to distinguish itself in the competitive manufacturing landscape through the continuous development of innovative products and the maintenance of a cost-efficient operating model. We are optimistic about VTech’s FY3/13F outlook and expect its earnings to return to the growth rate at 12%, on the back of overall top-line growth of 7% of its three core segments and margin improvement of 0.5ppt. Its attractive dividend yield of around 6.8% should also ensure that the share price remains resilient in the current volatile market.

TEL business is overlooked. Though the residential phone industry is perceived to be a mature market, VTech has managed to secure more shelf space in retail channels. In fact, it expects to expand its market share as a result of industry consolidation. On the other hand, VTech has started to tap into the commercial market in the past few years by producing fixed-line telephones for corporate and hotel clients. Though the commercial sales contribution is still insignificant (around 5% of TEL sales in North America, amounting to about USD21m) in FY3/12, management expects it to account for 10% of TEL sales in North America. It is likely to become a major growth driver for the TEL business in the future.

ELP business is robust. Continuous product innovations and new product launches are the keys to success in the ELP market. VTech plans to launch the second-generation version of the platform products InnoTab 2 and MobiGo 2 in autumn. Recall that the launch of the first-generation versions were well-received by many parents, thus, we believe that the launches of the new versions with enhanced functionalities will further boost the sales performance of the ELP business. Similarly, VTech launched a new standalone toy series called Switch & Go Dinos, one of the best-selling toys in North America. We believe that the introductions of these new products should drive the top-line growth of ELP.

CMS business is promising. The CMS business has been the fastest-growing segment of VTech, achieving 12.6% sales CAGR for the past six years. VTech differentiates itself from its competitors with its high-mix low-volume business model, flexible services and quality products. In establishing the reputation of its brand, VTech has gained the trust of many customers. It is now the 27th largest services provider in the EMS world. VTech’s objective to increase its CMS capacity by 40% over the next two to three years also reflects confidence in the CMS business.

Gross margin should bottom out. The easing pressure of raw material costs should also favour VTech’s margin outlook for FY3/13F. As the price movements of major components like plastic resin are on the downward trends this year, we believe that its margin will recover. Also, the ELP business traditionally offers the highest gross margin among all segments. Therefore, the increasing contribution of the ELP business is likely to have a positive impact on VTech’s profitability.

Attractive dividend yield. VTech has consistently maintained a generous dividend payout ratio of above 95%, one of the highest among the HK-listed industrial stocks. We expect VTech to maintain its high dividend payout ratio going forward owing to its strong cash flows and healthy balance sheet. The company currently has over USD300m in cash and zero debt; thus making it one of the cleanest industrial companies in the HK universe.



Company overview

Background. Founded in 1976, VTech is the world’s largest manufacturer of cordless phones and electronic learning products. It also provides contract manufacturing services. VTech has been successful in launching various new products each year and selling its products via a strong brand platform that is supported by an extensive distribution network of leading retailers in North America, Europe and other regions. Apart from the VTech brand, the company also possesses the right to use the AT&T brand to design, manufacture, and distribute the wire-line telephones and accessories due to its acquisition of Lucent Technologies’ consumer phone business in 2000.

Manufacturing plants. Headquartered in Hong Kong, VTech has footprints worldwide, with more than 33,000 employees globally, which include around 1,500 R&D professionals. The company currently operates three manufacturing facilities in Southern China, all of them are located in the Guangdong Province; two are in Dongguan and the third in Qingyuan. The company also runs its own R&D centres in Canada, Hong Kong and China.

New factory building in Dongguan site. Based on its rising CMS orders this year, VTech has ramped up its CMS capacity by 40% since November 2011, by building a fourth factory at the Liaobu site. The enhanced manufacturing facility supports customers who are targeting domestic sales in China. With a newly-established clean room and the SMT lines commenced operations, the new set-up allows VTech to produce sophisticated products which should enable the company to enlarge its product portfolio in other areas (such as medical and health care).

Figure 1: Manufacturing plants in Guangdong Province Location Specialty Houjie, Dongguan ELP Liaobu, Dongguan TEL and CMS (adding new capacity) Qingyuan Plastic injections Source: Company data, Kim Eng Securities

Three core business segments. VTech’s business is classified into three divisions: 1) telecommunication (TEL); 2) electronic learning products (ELP); and 3) contract manufacturing services (CMS). The largest segment is TEL that accounts for 39.6% of total revenue in FY3/12; the contributions of ELP (36.8% of total sales) and CMS (23.6% of total sales) have been increasing over the past few years.

Figure 2: Sales breakdown by business (FY3/12) Figure 3: Sales breakdown by region (FY3/12)

Source: Company data, Kim Eng Securities Source: Company data, Kim Eng Securities

Telecom-munication products

(TEL)39.6%

Electronic learning products

(ELP)36.8%

Contract manufacturing

services (CMS)23.6%

North America50.6%Europe

40.3%

Asia Pacific5.3%

Others3.8%



Telecommunication (TEL)

The world’s No.1. VTech has over 20 years of experience in manufacturing telecommunication products and accessories. It is the world’s largest manufacturer of cordless phones with a global market share of 31%. In FY3/12, the company shipped 45m handsets to 65 different markets (mainly in cordless phones). As a comparison, it shipped 40m and 45m handsets in FY3/10 and FY3/11 respectively.

Figure 4: Global cordless phones market share (2010) Figure 5: Global cordless voice device shipment (m units)

Source: MZA, Kim Eng Securities Source: MZA, Kim Eng Securities

Dual branding in North America. VTech uses a dual-brand strategy in North America, which has been effective in capturing the market share. The company has a market share of about 50% in the North American cordless phones market. VTech’s products are sold under the VTech and AT&T brands in major retail stores and online stores, the brands target different customer groups: VTech brand products that are more modern, stylish and innovative are aimed at young and energetic customers, while AT&T brand products that are more classic and traditional are targeted at senior and mature customers.

Gaining market share in Europe. VTech has a different business model in Europe. As the fixed-line telephone market is more fragmented, the company mainly offers products to fixed-line telephone operators, well-known brand names and distributors on an original design manufacturer (ODM) basis. According to third-party research, VTech’s market share in Europe has grown from 22% in 2009 to 29% in 2010. The company is currently the exclusive supplier to Deutsche Telekom for all its corded and cordless telephones in Germany.

Mature residential market. VTech’s TEL products can also be divided based on usage: residential vs. commercial. The US residential telephone market is a relatively mature market; it is expected to shrink by 7-8% annually, due to the increasing popularity of mobile phones as substitutes for conventional residential phones. Therefore, we believe that the major growth driver for the residential phone market will come from industry consolidation, with leading players likely to gain market shares from small players that withdraw from the market due to operating losses and intense competition.

Opportunities in commercial area. VTech has started to produce corded and cordless phones under the AT&T brand for small-to-medium businesses (SMB) and hotel clients, in order to compensate for the mature residential market in worldwide. According to management, the SMB market is valued at about USD1.2b, the same size as the residential market. Therefore, we see growth potential for VTech in the SMB sector, considering VTech’s solid experience in the residential market and advanced technological capabilities. In contrast, the hotel phone market is a relatively small market and its contribution would not be significant at all. However, VTech’s continuous winning of contracts with hotel operators should improve its brand recognition in the commercial sector.

VTech31.0%

Panasonic23.0%

Gigaset13.0%

Others33.0%

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FY3/12 review. The TEL business recorded a sales decline of 3% YoY to USD706m, which was mainly due to: 1) the maturity of the residential phone market in the US; 2) delayed sales orders by the European customers; and 3) weaker-than-expected sales performance of Japan, Australia and other regions.

FY3/13 outlook. We expect the TEL division to rebound, thanks to: 1) market share gains in the US results from shelf space gains in retail channels; 2) increasing sales of commercial phones including SMB and hotel phones in North America; 3) restocking in Europe with a more aggressive strategy conducted in conjunction with Deutsche Telekom to expand its market share; and 4) expansion into Asian Pacific countries such as China through the AT&T brand.

Figure 6: TEL sales trend

Source: Company data, Kim Eng Securities estimates

Figure 7: TEL sales breakdown by region (FY3/12)


Figure 8: TEL product portfolio

Residential phones AT&T’s business phones Hotel phones

Source: Company data, Kim Eng Securities

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USDm TEL sales (USDm) YoY growth

North America58.8%

Europe30.5%

Asia Pacific4.2%

Others6.5%



Electronic learning products (ELP)

A pioneer in educational toy market. VTech is the world’s largest manufacturer in the ELP field; the company has been producing and designing innovative and educational toys for more than 30 years. VTech’s products are targeted at infants, toddlers, preschool and grade school kids. In FY3/12, the company shipped over 38m units of its ELPs in 25 languages to more than 90 different markets.

Standalone products. VTech’s ELPs are divided into platform products and standalone products. The bulk of revenue (75% of ELP sales) is derived from VTech’s standalone products. They are classified into several categories including infant, pre-school and grade school learning toys. Each category caters to a different age group from birth to pre-teens and comprises products of various price ranges. Accordingly, VTech has a large portfolio of over 100 standalone products and has been continuously rolling out new products to attract new customers.

Platform products. Most of the attention is placed on VTech’s platform products, despite its 25% contribution to ELP sales. The top three core platform products include the InnoTab series (tablet), the V.Reader series (e-reading) and the MobiGo series (game console). InnoTab is the latest platform product that was launched in October 2011: it is a tablet device that combines interactive and animated books, games, activities, as well as an extensive collection of applications and has been labeled as child’s iPad. In addition to hardware product sales, the segment also generates revenue through software sales (cartridges and apps).

FY3/12 review. The ELP division was the fastest-growing segment of VTech in FY3/12, achieving 11% YoY growth to reach USD657m in revenue. The macroeconomic uncertainty in 2011 did not stop the strong growth of the ELP segment: VTech demonstrated consistent growth across all regions. Sales in the US grew by 8% for FY3/12 due to the introduction of platform products such as the InnoTab in October 2011, surpassing the uninspiring performance of standalone products. On the other hand, the launches of Storio (InnoTab in Europe) and MobiGo were well-received especially in countries like France, Germany and Netherlands, thus boosting European sales by 13% YOY despite the debt crisis.

FY3/13 outlook. We expect the ELP business to lead the growth for VTech in FY3/13F, as we believe that children’s items are less likely to be cut from household expenses. While the expansion of downloadable music and video content for its platform products is likely to enhance the competitiveness of VTech’s products, it can also generate additional software sales. Finally, the continuous introductions of both platform and standalone products will further increase the top-line sales of ELP.

Potential of new product launches. We believe that the successful launches of new products will be the medium-term growth driver for the ELP business. VTech has announced the pre-order details of the new-generation InnoTab 2 and MobiGo 2. Additional features will be added at the same point with prior generations. Apart from platform products, the company has also rolled out several new standalone products like Switch & Go Dinos, Cogsley and Alphabet Activity Cube in February 2012. With full-year contribution from the new series standalone products that are also grabbing new shelf space at major retailers currently, sales momentum should continue.



Figure 9: ELP sales trend


Figure 10: ELP sales breakdown by region (FY3/12)


Figure 11: ELP development milestones

Lesson One, the first ELP bringing together the world of entertainment and learning

Small Talk, a key product for VTech’s tapping into the pre-school market

V.Smile, the best-selling educational TV game system in the US in 2005

V.Reader and MobiGo, launched in the US in August 2010

InnoTab, a children’s tablet PC launched in the US in October 2011


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USDm ELP sales (USDm) YoY growth

North America46.9%

Europe47.2%

Asia Pacific2.7%

Others3.2%

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Figure 12: New platform product – InnoTab 2 Figure 13: New platform product MobiGo 2


Figure 14: New standalone product – Toot-Toot DriverGarage

Figure 15: New standalone product – Switch & Go Dinos




Contract manufacturing services (CMS)

A top EMS company. VTech provides a complete one-stop shop electronic manufacturing services (EMS), from design to manufacture and assembly, to medium-sized companies. Starting from scratch in 1993, VTech has grown to become one of the world’s top 50 EMS providers. The company provides CMS to customers in various areas such as: 1) professional audio equipment; 2) switching mode power supply; 3) wireless products; and 4) solid-state lighting.

Fast-growing CMS business. VTech’s CMS business has been resilient, it has outperformed the global EMS market, despite the global economic uncertainties of recent years. Its CMS sales have increased by more than three times in the last 10 years. According to Manufacturing Market Insider (MMI), VTech’s ranking in the global EMS market improved from 43rd in 2008 to 27th in 2011, an increasing number of customers have become VTech’s partners due to the latter’s flexibility in services and quality products.

Figure 16: VTech's EMS position 2008 2009 2010 2011Ranking 43 37 29 27Source: Manufacturing Market Insider, Kim Eng Securities

High mix-low volume business model. We attributed the rapid growth of VTech’s CMS business to its high mix-low volume business model. Unlike other EMS providers that adopt a high volume-low mix strategy, VTech focuses on several niche and sophisticated products lines such as professional audio equipment and wireless products. This business model has enabled VTech to avoid price competition with major EMS providers, while maintaining higher profitability than its competitors.

Competitive edge. VTech’s excellence know-how and strong reputation has enabled the company to gain new customers every year. According to management, VTech currently has more than 40 customers in the CMS business. VTech procures raw materials in bulk and has long-term relationships with major component suppliers, which means that the company is able to source components at the lowest costs. Additionally, its efficient business model has also allowed VTech to offer the fastest time-to-market, time-to-volume and time-to-cost services.

FY3/12 review. The CMS segment grew by 8% YoY to reach USD421m in FY3/12. The company achieved better-than-expected sales in the US (up by 8% YoY) and Europe (up by 10% YoY), thanks to the contributions from professional audio equipment and wireless products. However, Asia Pacific sales were flattish due to significantly lower orders for LED light bulbs from a Japanese customer, despite higher sales of medical and wireless products in that region.

FY3/13 outlook. We expect the CMS business to continue to outperform the global EMS market. VTech has started to ramp up a new manufacturing plant in November 2011, which should increase CMS capacity by 40% in two to three years. Along with increasing capacity, VTech has been able to achieve a utilization rate of 80% recently. We expect its professional audio equipment and wireless products to grow, thanks to improved brand reputation and consolidation of its supplier base respectively. Another positive development comes from marine radio, a new product category added in FY3/12, a customer has decided to transfer more production orders through VTech. The full-year contribution from this new product should also drive top-line growth in the CMS business.



Figure 17: CMS sales trend


Figure 18: CMS sales breakdown by region (FY3/12)


Figure 19: CMS product portfolio

Professional audio equipment Solid-state lighting Switching mode power supply


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USDm CMS sales (USDm) YoY growth

North America42.7%

Europe46.0%

Asia Pacific11.2%

Others0.2%



Financial analysis

Stable sales growth across the board. We expect VTech’s top-line to rise by 7% YoY to UDS1.9b in FY3/13F, with sales supported by the high single-digit growth of its ELP and CMS divisions. Based on the faster sales growth projections for the ELP and CMS divisions, we expect the revenue contributions of these divisions to increase slightly over the next two years. However, the contribution from the TEL division is expected to decline even though it should still remain the most significant sales contributor among the three divisions.

Figure 20: Key assumptions YoY growth (%) FY3/08 FY3/09 FY3/10 FY3/11 FY3/12 FY3/13F FY3/14FTelecommunication (TEL) 4.1 (9.8) 19.6 (2.0) (2.9) 5.0 3.0Electronic learning products (ELP) 8.0 (7.9) (10.3) 16.9 10.5 9.0 7.0Contract manufacturing services (CMS) 6.5 5.0 7.9 38.8 7.9 8.0 10.0Source: Company data, Kim Eng Securities estimates

Figure 21: Sales trend Figure 22: Sales breakdown trend

Source: Company data, Kim Eng Securities estimates Source: Company data, Kim Eng Securities estimates

Gross margin recovers. VTech’s gross margin has remained steady at 36-37% from FY3/06 to FY3/10. However, it came under pressure during the last two years and fell to 32% in FY3/12, due to rising labour costs (8% of COGS) and high raw material prices, especially plastic resins. Apart from plastic resins (15% of COGS), VTech also utilises these major components that are included in the raw materials category: integrated circuit chips (20% of COGS), LCD panels (10% of COGS) and printed circuit boards (10% of COGS).

Margins breakdown. We forecast that VTech’s gross margin will recover by 0.5ppt from the seven-year trough of 32% to 32.5% due to falling raw materials prices. The rising contribution of the high-margin ELP business should also support its gross margin. While VTech does not disclose the exact margin breakdowns for its three business segments, our checks suggest that ELP business has the highest level of profitability at around 40-50%, while the TEL business has a gross margin of 20-30%, followed by the CMS business (10-20%).

Figure 23: Estimated COGS breakdown Figure 24: Profitability trend

Source: Company data, Kim Eng Securities estimates Source: Company data, Kim Eng Securities estimates

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Net profits to resume growing trend. VTech has been successful in cutting its SG&A expense to sales ratio from 23% to around 20% in FY3/12. Owing to such encouraging cost improvements in the past, we do not expect the SG&A expense to sales ratio to improve further and project the ratio to remain at around 20.2% for the next two years. Overall, we expect net profit to rebound by low-teens at 12% YoY to reach USD215m in FY3/13F, on the back of 1) steady top-line growth; 2) gross margin recovery; and 3) stringent cost controls.

Figure 25: Net profit trend


Capital expenditure needs. Historically, VTech’s profitable business has generated sufficient cash to fund its capital expenditures. According to management, upcoming CAPEX budgets will be around USD32-33m, which will be used for factory building and normal maintenance. Nonetheless, we project its free cash flow to be UDS265m and USD287m for FY3/13F and FY3/14F respectively.

Rich cash cow. VTech has been able to maintain a strong cash position of above USD300m, without any bank borrowings over the past three financial years. Although its cash balance was declined from USD383m in FY3/10 to USD327m in FY3/12, its operating cash flow has stayed above USD211m. Considering its historical stable operating cash flows, we are confident that the company will be able to maintain a cash reserve of above USD300m for the next two years.

Consistent payout ratio. VTech has a generous track record of distributing over 90% of its earnings as dividends to shareholders as of FY3/09. We expect VTech to maintain a payout ratio of 95% over the next two financial years, which is well-supported by its strong balance sheet and stable operating cash flows. We believe that the high payout ratio of 95% is sustainable unless new M&A targets emerge. Its nearly 100% payout ratio translates into an attractive dividend yield of around 6.8% for the next two years.

High ROEs. VTech has delivered a high ROE historically, exceeding 30% since Fy3/03. Dupont analysis suggests that its high ROEs are driven by an asset turnover rate of around 2x. Moreover, its high net margin among industrial companies is another reason for the sharp ROEs. Looking ahead, we expect VTech to improve its ROE from 35% in FY3/12 to 38.6% in FY3/13F, in tandem with the rebound of its net margin in FY3/13F.

Figure 26: Dupont analysis FY3/07 FY3/08 FY3/09 FY3/10 FY3/11 FY3/12 FY3/13F FY3/14FNet margin (%) 12.5 13.9 9.9 13.5 11.8 10.8 11.3 11.6Asset turnover (%) 185.5 215.9 193.5 195.4 198.8 199.4 206.7 212.9ROA (%) 23.2 30.0 19.1 26.3 23.4 21.4 23.3 24.7Financial leverage (%) 200.0 180.7 167.7 163.8 162.4 162.7 166.0 169.1ROE (%) 46.4 54.2 32.1 43.1 38.1 34.9 38.6 41.7Source: Company data, Kim Eng Securities estimates

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Investment risks

Key factors that pose downside risks to our earnings estimates are as follows:

Slowing overseas demand. Considering VTech’s export nature, the company has significant overseas exposures, especially in North America (about 51% of sales) and Europe (about 40% of sales). Consumer demand may be affected by the sluggish recovery in the US, along with austerity measures and economic uncertainty in Europe.

Maturity of cordless phones market. The worldwide cordless phone market has been declining gradually in the past years owing to an increasing number of people dropping their fixed phone lines and switching to mobile-only services. Should the wireless substitution effect accelerate to the point that telecommunication users migrate directly to mobile networks, the top-line of VTech’s TEL segment will be affected.

Rising competition in the ELP market. VTech has been producing innovative toys for infants, toddlers and pre-school children for many years. The competition landscape has been changing with the rise of tablet computers equipped with tonnes of applications as in the case of the iPad. Consumers may opt to purchase more advanced tablets instead of VTech’s products which will affect the growth potential of the company’s ELP division.

Cost pressures. Raw materials constitute a significant cost component in VTech’s cost structure, accounting for 80% of COGS. A sudden increase in the overall costs will result in margin pressure, thus challenging our gross margin recovery assumption. In addition, rising labour costs (about 8% of COGS) may also be exacerbated by the continuous CNY appreciation.

Exchange rate fluctuations. Europe accounts for about 40% of VTech’s total sales and most of the sales in Europe are denominated in EUR. While VTech has hedged part of its foreign currency risk through forward contracts, a continuous decline in EUR may result in foreign exchange losses, which may exert a negative impact on VTech’s earnings.

Technology development bottleneck. In order to stay competitive and maintain its leading positions in various markets, VTech has to roll out new products continuously due to the short product lifecycles these days. This means that VTech is heavily dependent on its product innovation capabilities and technological strengths. Failure to introduce new products or gauge consumer preferences accurately may adversely affect the company’s earnings.



Valuation and recommendation

Peer comparisons. It is difficult to find a direct comparison for VTech, as there is no other company that has a dominant position in both the fixed-line telephone and electronic learning product markets. In the TEL business, VTech’s global competitors include Uniden, Gigaset and Panasonic. We attribute the low valuations in the sub-segment to the maturity of the cordless phone market. In the ELP business, the most direct comparison is Leapfrog that is listed in the US. The ELP peers are priced at high valuations due to this market’s better growth prospects.

Reinitiate coverage with BUY. VTech is currently trading at 13.9x and 12.7x for FY3/13F and FY3/4F respectively. This valuation is undemanding: the market has not fully acknowledged the company’s defensive qualities. We set our target price at HKD108, based on 16x FY3/13F PER. We believe that our target PE multiple that is at the high end of VTech’s past-six-year trading range, is justified, given to the company’s sustainable payout track record and quality corporate governance.

Figure 27: PER band Figure 28: PBR band

Source: Bloomberg, Kim Eng Securities estimates Source: Bloomberg, Kim Eng Securities estimates

Figure 29: Peers valuation comparison (Share price as of 14 August 2012) TEL-related Latest price Mkt cap PER (x) PBR (x) Div yield (%) EPS growth (%)Company name Ticker (Lcl ccy) (USDm) FY12 FY13 FY12 FY13 FY12 FY13 FY12 FY13 ROE (%)VTech 303 HK 93.7 3024.5 15.5 14.3 5.4 5.3 6.6 6.6 -4.9 8.3 37.0 Panasonic 6752 JP 559 17461.8 N/A 30.8 0.7 0.7 1.8 1.8 N/A N/A 2.1 Uniden 6815 JP 181 145.5 8.2 N/A N/A N/A N/A N/A N/A N/A N/AGigaset GGS GR 1.384 85.7 N/A 12.6 1.1 1.1 0.0 0.0 N/A N/A N/AAverage 11.8 19.2 2.4 2.4 2.8 2.8 -4.9 8.3 19.5 ELP-related Latest price Mkt cap PER (x) PBR (x) Div yield (%) EPS growth (%)Company name Ticker (Lcl ccy) (USDm) FY12 FY13 FY12 FY13 FY12 FY13 FY12 FY13 ROE (%)VTech 303 HK 93.7 3024.5 15.5 14.3 5.4 5.3 6.6 6.6 -4.9 8.3 37.0 Leapfrog LF US 11.21 777.3 16.6 14.2 2.8 2.4 N/A N/A 187.5 17.1 17.6Mattel MAT US 35.59 12133.7 14.5 13.1 4.4 3.8 3.5 3.9 14.6 10.7 29.8 Hasbro HAS US 37.58 4894.0 13.1 12.2 3.4 2.7 3.7 4.2 4.9 7.6 25.0 Jakks Pacific JAKK US 16.27 358.3 14.8 11.8 1.3 1.2 2.5 2.5 182.5 25.4 8.6 Average 14.9 13.1 3.4 3.1 4.1 4.3 76.9 13.8 23.6 CMS-related Latest price Mkt cap PER (x) PBR (x) Div yield (%) EPS growth (%)Company name Ticker (Lcl ccy) (USDm) FY12 FY13 FY12 FY13 FY12 FY13 FY12 FY13 ROE (%)VTech 303 HK 93.7 3024.5 15.5 14.3 5.4 5.3 6.6 6.6 -4.9 8.3 37.0 Hon Hai 2317 TT 85 33366.1 12.6 9.7 1.5 1.4 1.5 1.8 9.0 29.9 14.0 Nam Tai NTE US 6.67 298.8 N/A N/A N/A N/A N/A N/A N/A N/A N/AFlextronics FLEX US 6.6 4392.3 8.0 6.8 2.0 1.7 0.0 0.0 -7.1 17.5 25.0 Average 12.1 10.3 3.0 2.8 2.7 2.8 -1.0 18.6 25.3Source: Bloomberg, Kim Eng Securities

0

20

40

60

80

100

120

Apr 06 Feb 07 Dec 07 Oct 08 Aug 09 Jun 10 Apr 11 Feb 12

Vtech (303 HK)

16x

13x

10x

7x

4x

0

20

40

60

80

100

120

140

Apr 06 Feb 07 Dec 07 Oct 08 Aug 09 Jun 10 Apr 11 Feb 12

Vtech (303 HK)

7x

5.5x

4x

2.5x

1x



Appendix I: Shareholding structure

Major shareholders. The largest shareholder of VTech is Allan Wong, is the co-founder, Chairman, and CEO of the company. His current stake is 35%. Other major shareholders are mainly institutional investors including Templeton and Capital Group.

Figure 30: Shareholding structure

Source: HKEx, Kim Eng Securities

Appendix II: Development milestones

Figure 31: Timeline


Mr. Wong Chi Yun Templeton Asset Management

35% 16%

Others

49%

VTech Holdings Limited (303 HK)



Appendix III: Management profile

Figure 32: Key management team Name Age Current title Job duties Previous experience/ Other duties Education Mr. Wong Chi Yun

61 Co-founder, Chairman and CEO

In-charge of the overall strategic direction

Deputy chairman and an independent non-executive director of The Bank of East Asia Limited, and an independent non-executive director of China-Hong Kong Photo Products Holdings Limited and Li & Fung Limited

Graduated from the University of Wisconsin with a Master degree in Electrical and Computer Engineering

Mr. Pang King Fai

56 Executive Director and President

Has over 20 years of experience in design engineering for consumer electronics products

Honorary Professor of the Electrical and Electronic Engineering Department of the University of Hong Kong

Graduated from Stanford University with a PhD (EE)

Mr. Leung Hong Kwong

53 Executive Director and CEO of Contract Manufacturing Services

Responsible for overseeing China Services Department

Has over 20 years of experience in the electronics and manufacturing industry

Graduated from Oklahoma City University with an MBA degree

Mr. Tong Chi Hoi

47 President of Telecommunication Products

Responsible for overseeing the Branded business and ODM worldwide

Has over 20 years of experience in the electronics and manufacturing industry

Graduated from the University of London with a Bachelor degree in Electrical and Electronics Engineering

Mr. Chu Chorng Yeong

52 Chief Technology Officer

Responsible for overseeing product development of the Electronic Learning Products

Had worked in the Silicon Valley for 20 years specialising in integrated circuit and software developments

Graduated from Columbia University with a Bachelor degree in Computer Science

Mr. Tong Ka Hung

43 CFO Responsible for accounting and tax, treasury and financial as well as information technology and human resources management functions

Held management positions in a number of areas including internal audit and financial control

Graduated from Manchester Business School with an MBA degree




INCOME STATEMENT BALANCE SHEET FYE Mar (USDm) 2011A 2012A 2013F 2014F

FYE Mar (USDm) 2011A 2012A 2013F 2014F Revenue 1,713 1,785 1,913 2,031 Fixed Assets 78 91 95 96 Gross Profit 567 571 622 670 Other LT Assets 11 11 11 11 EBITDA 252 237 264 289 Cash/ST Investments 333 327 313 312 Depreciation & Amortisation (33) (28) (29) (31) Other Current Assets 455 484 519 551 Operating Profit (EBIT) 219 210 235 258 Total Assets 877 913 938 970 Interest (Exp)/Inc 2 2 2 2 Associates 0 0 0 0 ST Debt 0 0 0 0 One-offs 0 0 0 0 Other Current Liabilities 329 351 374 394 Pre-Tax Profit 220 212 237 260 LT Debt 0 0 0 0 Tax (19) (20) (22) (24) Other LT Liabilities 4 6 6 6 Minority Interest 1 0 0 0 Minority Interest 0 0 0 0 Net Profit 202 192 215 235 Shareholders' Equity 544 556 559 570 Recurring Net Profit 202 192 215 235 Total Liabilities-Capital 877 913 938 970

Revenue Growth (%) 11.8 4.2 7.2 6.2 Share Capital (m) 248 249 250 250 EBITDA Growth (%) (3.4) (5.9) 11.5 9.4 Gross Debt/(Cash) N/A N/A N/A N/A EBIT Growth (%) (2.4) (4.2) 12.3 9.6 Net Debt/(Cash) (333) (327) (313) (312) Net Profit Growth (%) (2.2) (5.0) 12.2 9.3 Working Capital 459 460 458 468 Recurring Net Profit Growth (%) (2.2) (5.0) 12.2 9.3

Tax Rate % 8.7 9.3 9.3 9.4

CASH FLOW RATES & RATIOS

FYE Mar (USDm) 2011A 2012A 2013F 2014F FYE Mar 2011A 2012A 2013F 2014F Operating profit 219 210 235 258

Gross Profit Margin (%) 33.1 32.0 32.5 33.0 Depreciation & Amortisation 33 28 29 31 EBITDA Margin (%) 14.7 13.3 13.8 14.2 Net interest receipts/(payments) 0 0 0 0 Op. Profit Margin (%) 12.8 11.7 12.3 12.7 Working capital change (75) (7) (12) (11) Net Profit Margin (%) 11.8 10.8 11.3 11.6 Cash tax paid (23) (21) (22) (24) ROA (%) 23.4 21.4 23.3 24.7 Others (incl'd exceptional items) 2 2 2 2 ROE (%) 38.1 34.9 38.6 41.7 Cash flow from operations 155 211 232 255 Net Margin Ex. El (%) 11.8 10.8 11.3 11.6 Capex (26) (30) (33) (32) Net Gearing % N/A N/A N/A N/A Disposal/(purchase) 0 0 0 0 Asset Turnover (x) 2.0 2.0 2.0 2.1 Others 96 (60) 0 0 Asset/Debt (x) N/A N/A N/A N/A Cash flow from investing 70 (89) (33) (32) Debt/ EBITDA (x) N/A N/A N/A N/A Debt raised/(repaid) 0 0 0 0 Debt/ Market Cap (x) N/A N/A N/A N/A Equity raised/(repaid) 7 6 0 0 Interest Cover (x) N/A N/A N/A N/A Dividends (paid) (194) (195) (189) (205) Dividend Cover (x) 1.0 1.0 1.1 1.1 Interest payments 0 0 0 0 Inventory Turn (days) 62.0 70.5 70.1 70.9 Others 0 (3) (24) (20) Debtors Turn (days) 46.5 48.0 48.3 48.5 Cash flow from financing (187) (191) (213) (225) Creditors Turn (days) 88.8 90.2 92.2 93.3 Change in cash 38 (69) (14) (1) PER SHARE DATA

FYE Mar (USD) 2011A 2012A 2013F 2014F EPS 0.81 0.77 0.86 0.94 BVPS 2.19 2.23 2.24 2.28 DPS 0.78 0.76 0.82 0.90 SPS 6.91 7.16 7.66 8.13 EBITDA/share 1.02 0.95 1.06 1.16 CFPS 0.63 0.85 0.93 1.02




RESEARCH OFFICES REGIONAL

P K BASU Regional Head, Research & Economics (65) 6432 1821 [email protected]

WONG Chew Hann, CA Acting Regional Head of Institutional Research (603) 2297 8686 [email protected]

THAM Mun Hon Regional Strategist (852) 2268 0630 [email protected]

ONG Seng Yeow Regional Products & Planning (852) 2268 0644 [email protected]

ECONOMICS Suhaimi ILIAS Chief Economist Singapore | Malaysia (603) 2297 8682 [email protected]

Luz LORENZO Economist Philippines | Indonesia (63) 2 849 8836 [email protected]

MALAYSIA WONG Chew Hann, CA Head of Research (603) 2297 8686 [email protected] Strategy Construction & Infrastructure Desmond CH’NG, ACA (603) 2297 8680 [email protected] Banking - Regional LIAW Thong Jung (603) 2297 8688 [email protected] Oil & Gas Automotive Shipping ONG Chee Ting (603) 2297 8678 [email protected] Plantations Mohshin AZIZ (603) 2297 8692 [email protected] Aviation Petrochem Power YIN Shao Yang, CPA (603) 2297 8916 [email protected] Gaming – Regional Media Power WONG Wei Sum, CFA (603) 2297 8679 [email protected] Property & REITs LEE Yen Ling (603) 2297 8691 [email protected] Building Materials Manufacturing Technology

LEE Cheng Hooi Head of Retail [email protected] Technicals

HONG KONG / CHINA Edward FUNG Head of Research (852) 2268 0632 [email protected] Construction Ivan CHEUNG, CFA (852) 2268 0634 [email protected] Property Industrial Ivan LI, CFA (852) 2268 0641 [email protected] Banking & Finance Jacqueline KO, CFA (852) 2268 0633 [email protected] Consumer Staples Andy POON (852) 2268 0645 [email protected] Telecom & equipment Alex YEUNG (852) 2268 0636 [email protected] Industrial Jacky WONG, CFA (852) 2268 0107 [email protected] Special Situations Quants Anita HWANG, CFA (852) 2268 0142 [email protected] Consumer Discretionaries Special Situations

INDIA Jigar SHAH Head of Research (91) 22 6623 2601 [email protected] Oil & Gas Automobile Cement Anubhav GUPTA (91) 22 6623 2605 [email protected] Metal & Mining Capital goods Property Ganesh RAM (91) 226623 2607 [email protected] Telecom Contractor

SINGAPORE Stephanie WONG Head of Research (65) 6432 1451 [email protected] Strategy Small & Mid Caps Gregory YAP (65) 6432 1450 [email protected] Technology & Manufacturing Telcos - Regional Wilson LIEW (65) 6432 1454 [email protected] Hotel & Resort Property & Construction James KOH (65) 6432 1431 [email protected] Logistics Resources Consumer Small & Mid Caps YEAK Chee Keong, CFA (65) 6433 5730 [email protected] Healthcare Offshore & Marine Alison FOK (65) 6433 5745 [email protected] Services S-chips Bernard CHIN (65) 6433 5726 [email protected] Transport (Land, Shipping & Aviation) ONG Kian Lin (65) 6432 1470 [email protected] REITs / Property Wei Bin (65) 6432 1455 [email protected] S-chips Small & Mid Caps

INDONESIA Katarina SETIAWAN Head of Research (62) 21 2557 1125 [email protected] Consumer Strategy Telcos Lucky ARIESANDI, CFA (62) 21 2557 1127 [email protected] Base metals Coal Oil & Gas Rahmi MARINA (62) 21 2557 1128 [email protected] Banking Multifinance Pandu ANUGRAH (62) 21 2557 1137 [email protected] Auto Heavy equipment Plantation Toll road Adi N. WICAKSONO (62) 21 2557 1130 [email protected] Generalist Anthony YUNUS (62) 21 2557 1134 [email protected] Cement Infrastructure Property Arwani PRANADJAYA (62) 21 2557 1129 [email protected] Technicals

PHILIPPINES Luz LORENZO Head of Research +63 2 849 8836 [email protected] Strategy Laura DY-LIACCO (63) 2 849 8840 [email protected] Utilities Conglomerates Telcos Lovell SARREAL (63) 2 849 8841 [email protected] Consumer Media Cement Kenneth NERECINA (63) 2 849 8839 [email protected] Conglomerates Property Ports/ Logistics Katherine TAN (63) 2 849 8843 [email protected] Banks Construction Ramon ADVIENTO (63) 2 849 8842 [email protected] Mining

THAILAND Mayuree CHOWVIKRAN Head of Research (66) 2658 6300 ext 1440 [email protected] Strategy

Maria BRENDA SANCHEZ LAPIZ Co-Head of Research Dir (66) 2257 0250 | (66) 2658 6300 ext 1399 [email protected] Consumer/ Big Caps

Andrew STOTZ Strategist (66) 2658 6300 ext 5091 [email protected]

Suttatip PEERASUB (66) 2658 6300 ext 1430 [email protected] Media Commerce Sutthichai KUMWORACHAI (66) 2658 6300 ext 1400 [email protected] Energy Petrochem Termporn TANTIVIVAT (66) 2658 6300 ext 1520 [email protected] Property Woraphon WIROONSRI (66) 2658 6300 ext 1560 [email protected] Banking & Finance Jaroonpan WATTANAWONG (66) 2658 6300 ext 1404 [email protected] Transportation Small cap. Suchot THIRAWANNARAT (66) 2658 6300 ext 1550 [email protected] Automotive Construction Materials Soft commodity Pongrat RATANATAVANANANDA (66) 2658 6300 ext 1398 [email protected] Services/ Small Caps

VIETNAM Michael KOKALARI, CFA Head of Research +84 838 38 66 47 [email protected] Strategy Nguyen Thi Ngan Tuyen +84 844 55 58 88 x 8081 [email protected] Food and Beverage Oil and Gas Ngo Bich Van +84 844 55 58 88 x 8084 [email protected] Banking Nguyen Quang Duy +84 844 55 58 88 x 8082 [email protected] Rubber Dang Thi Kim Thoa +84 844 55 58 88 x 8083 [email protected] Consumer Nguyen Trung Hoa +84 844 55 58 88 x 8088 [email protected] Steel Sugar Macro



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Some common terms abbreviated in this report (where they appear):

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Hong Kong BUY VTech Holdings

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