TCL Communication Ltd Leveraging Potential in EMs; Initiate at Overweight

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1 TCL Communication Ltd Leveraging Potential in EMs; Initiate at Overweight Morgan Stanley Asia Limited+ Yunchen Tsai Jasmine Lu TCLC mainly engages in handset manufacturing under two brands TCL and Alcatel. We estimate smartphones will account for 54% of total volume in The Americas (North and Latin) and EMEA accounted for 84% of revenue in 1H14; thus, TCLC s profitability is largely leveraged to volume and ASP growth in the Americas and EMEA. Our thesis mainly depends on continuing volume growth in EMs, low-end phones expanding share, and limited competition in Exposure to high-growth emerging markets: We expect TCL s smartphone volume to grow by 119% YoY in 2014 and 6 in 2015, mainly driven by continuing smartphone penetration (with feature phones replaced by low-end smartphones) and smartphone replacement demand. Clear order visibility in 2015 thanks to operator channels, thus stable ASPs and gross margins: We expect TCLC s smartphone ASP to decline by - YoY in 2014 and -7% in 2015, mainly owing to a higher mix of entry level smartphones rather than single product pricing erosion. TCLC has 7 of volume in operator channels, which generally gives 6-12 months lead time for model orders, suggesting clear order visibility. COGS has been relatively stable, so stable ASPs generally lead to stable gross margins, though a higher mix of entry level smartphones would lower blended gross margins. Key Ratios and Statistics Reuters: 2618.HK Bloomberg: 2618.HK Greater China Hardware / China Price target HK$12.50 Rating Overweight Upside to price target (%) 3 Shr price, close (Sep 22, 2014) HK$ Week Range HK$ Sh out, dil, curr (mn) 1,180 Mkt cap, curr (mn) HK$11,293 EV, curr (mn) HK$13,552 Fiscal Year ending 12/13 12/14e 12/15e 12/16e ModelWare EPS (HK$) Consensus EPS (HK$) Revenue, net (HK$ mn) 19,362 29,699 39,231 50,547 EBITDA (HK$ mn) 1,540 1,482 1,919 2,154 ModelWare net inc (HK$ mn) 313 1,004 1,373 1,551 P/E P/BV RNOA (%) ROE (%) EV/EBITDA Unless otherwise noted, all metrics are based on Morgan Stanley ModelWare framework (please see explanation later in this note). = Consensus data is provided by Thomson Reuters Estimates. e = Morgan Stanley Research estimates Key risks to our call: The key downside risk is intensifying competition, potentially from Moto and Nokia (Microsoft), though we do not think this will happen in The former still has brand value in Latin America, and the latter is mainly in EMEA. What s not in the price 1) We believe investors are over-concerned about competition from Moto in 2015; as we noted, order visibility in operator channels is clear for 2015 thus far, and we believe the ASP and gross margin will remain stable. We think a blended ASP decline would stem mainly from a higher proportion of entry level smartphones. Valuation: As TCLC is a cyclical stock, we believe a P/E of 11x is justified. Our price target of HK$12.5 implies a 2015 P/E of 10.7x. 2) We also believe investors are over-concerned about competition in China. China contributed only 7% of TCLC s revenues in 2013; the main drivers are still the Americas and EMEA. 72

2 TCL Communication: Financial Summary HK$ million; Years Ending December Income Statement Cash Flow Statement E 2015E 2016E E 2015E 2016E Net sales 19,362 29,699 39,231 50,547 Cashflow from operations 640 1, COGS -15,690-23,977-31,752-41,327 Net Profits 313 1,004 1,373 1,551 Gross profit 3,672 5,723 7,479 9,220 Depreciation & Amortization 1, Operating expenses -3,267-4,555-5,922-7,477 Equity investment losses (income) ,488-1,181 - Promotion -1,611-2,511-3,107-3,737 Other adjustments ADM ,097-1,453-1,888 Cashflow from investing -1, R&D -1,064-1,285-1,701-2,190 (Purchases) sale of FA (capex) Other Rev/Exp (Purchases) sale of L/T investment -1, Other Opt. Income (Purchases) sale of S/T investment Operating income 405 1,167 1,556 1,743 Other adjustments Financial Cost Cashflow from financing Share of profits Increase in L/T debt Pre-tax income 298 1,080 1,469 1,656 Increase in S/T debt -3, Income tax Issuance of stock Net Income before Minority 316 1,026 1,395 1,573 Cash dividends Minority Dir.& Emp. Bonus Net income 313 1,004 1,373 1,551 Other adjustments 3, EPS (HKD) Exchange rate adjustment Net change in cash Balance Sheet Financial Ratios E 2015E 2016E E 2015E 2016E Cash Margins Pledged bank deposits 1,698 1,698 1,698 1,698 Gross margin % 19.1% 18.2% Financial Instruments Operating margin 2.1% 3.9% % Accounts/Notes receivables 5,551 7,663 9,616 12,390 Pretax margin 1.5% 3.6% 3.7% 3.3% Inventory 2,649 3,644 4,584 5,966 Net margin 1.6% 3.4% 3.5% 3.1% Current Assets 11,903 15,155 18,338 22,771 YoY growth Long-term investments Sales 61% 53% 32% 29% Fixed assets 941 1,109 1,230 1,302 Operating profits NM 188% 33% 12% Intangible assets Pretax profits NM 262% 36% 13% Total Assets 14,423 17,856 21,181 25,706 Net profits NM 22 37% 13% S/T borrowings 2,205 2,205 3,204 3,715 EPS NM 22 37% 13% AP/NP 4,360 7,328 8,734 11,709 Other ST liabilities 4,656 4,656 4,656 4,656 Net Debt/Equity 84% 63% 66% 58% Other current liabilities Liabilities/Equity 395% 429% 393% 382% L/T debt Liabilities/Assets 8 81% 8 79% Total Liabilities 11,510 14,479 16,884 20,370 ROAE 12% 32% 36% 32% ROAA 2% 6% 7% 7% Common shares 1,162 1,162 1,162 1,162 AR/NR Turnover (days) Other shareholders' equity 1,542 2,214 3,135 4,174 AP/NP Turnover (days) Shareholders' equity 2,913 3,377 4,297 5,336 Inventory Turnover (days) Total Liab./Shrhldr's Equity 14,423 17,856 21,181 25,706 Cash conversion cycle (days) Source: Company data, Morgan Stanley Research E = Morgan Stanley Research estimates. 73

3 Risk-Reward Snapshot: TCL Comm (2618.HK, HK$9.62, OW, PT HK$12.5) Leveraged to strong growth in emerging markets HK$ HK$9.62 HK$15.00 (+56%) HK$12.50 (+3) HK$6.00 (-38%) 0 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Price Target HK$12.5 Bull Case HK$15.0 Base Case HK$12.5 Bear Case HK$6.0 Price Target (Sep-15) Historical Stock Performance Current Stock Price 10.7x 2015e bull case EPS 10.7x 2015e base case EPS 8.0x 2015e bear case EPS WARNINGDONOTEDIT_RRS4RL~2618.HK~ We derive our base-case value from residual income valuation methodology. 75% YoY smartphone volume growth and -2%YoY smartphone ASP in 2015: We assume advanced level smartphones account for 15% of total smartphone volume, thus smartphone blended ASP merely declined by -2% YoY. 51% YoY smartphone volume growth and -7% YoY ASP decline in 2015: 1) Smartphone volume growth is 51% thanks to strong growth in EMs, 2) Smartphone ASP declines by -7% YoY due to mix shift towards entry level smartphones, 3) GPM remains stable at 19.1% and OPEX 15.1% of sales. 36% YoY smartphone volume growth and -19% YoY smartphone ASP decline in 2015: We assume TCLC s smartphone shipments are all from entry level in 2015, so -19% YoY ASP decline GPM lower, at 18.2%. Key Value Drivers: Volume growth, ASP, and GPM Hong Kong Dollars (HK$) Price Target: HK$ Bear Case 2.6 Smartphone volume decline 3.9 Smartphone blended ASP drop faster than expected Base Case 1.0 Smartphone volume increase 1.5 Smartphone blended ASP drop slower than expected Bull Case Why Overweight We view TCLC as proxy for smartphone growth in other emerging markets (excluding China); in particular, TCLC has ~9 of handset volume from fast-growing Latin America and EMEA. On the feature phone side, despite overall volume declining, we expect TCLC to benefit from Nokia s (Microsoft s) exit of the feature phone market, and to gain share. We see limited competition in the next 1-2 years, which helps to stabilize both ASP and GPM. Key Value Drivers Handset volume growth: we expect smartphones to enjoy higher volume growth but for the feature phone business still to bring higher GPM. ASP and thus GPM are also key value drivers. Potential Catalysts MSFT announcement to further condense feature phone business, which may enable TCLC to gain share. Samsung s strategy changes in other emerging markets. Key Downside Risks to Our Price Target Intensifying competition that causes ASP and thus GPM erosion, potentially from Moto and Nokia (Microsoft), though we do not think this will happen in The former still has brand value in Latin America, and the latter is mainly in EMEA. Slower than expected growth in lowend smartphones in other EMs Source: Morgan Stanley Research, Thomson Reuters 74

4 Investment Case Investment Positives 1) Fast-growing smartphone volume in emerging markets; TCLC leveraged to the Americas and EMEA In 1H14, 84% of TCLC s sales came from the Americas (5) and EMEA (34%). In the Americas, the US accounted for 22% and Latin America 2 of total sales. In EMEA, 17% of total sales came from the EU and 17% from MEA. Only the EU market has a higher exposure in open channels (5 of the total). Thus, TCLC has ~7 of volume exposure to operator channels. In terms of volume market size, North America and Latin America are roughly the same as in 2Q14 according to IDC data the former shipped 38mn smartphones and the latter 31.2mn. We expect the Americas to grow by 27% in 2014 and 21% in 2015, mainly driven by Latin America, thanks to continuing replacement of feature phones by low-end smartphones and the growing smartphone penetration rate. We also expect EMEA, another important market for TCLC, to grow by 34% in 2014 and 2 in ) Low-end phones (below US$200) taking share from high-end phones TCLC mainly engages in two price ranges for smartphones: entry level (FOB US$60-70) and advanced level (FOB US$ ), thus we see TAM (total addressable market) continuing to increase. According to IDC data, in the Americas, the below US$200 segment has delivered the highest YoY growth and gained share from other segments. In 2Q14, IDC data suggests the below US$200 segment grew 139% YoY and had 32% share, or a record high for the past three years. In EMEA, the sub US$200 segment also grew 6 YoY and had 33% share in 2Q14. 3) Better order visibility in operator channels helps to stabilize ASP and GPM As previously noted, TCLC has 7 of volume exposure in operator channels; open channels lies mostly in the EU and this is also the market where TCLC sells most of its advanced smartphone products. (Note: The US, Latin America, and Eastern Europe markets are 80-9 dominated by operators, and the situation in the EU is 5 operator channels and 5 open channels.) It takes longer to penetrate operator channels, creating an entry barrier. Also, operators normally secure models and volume 6-12 months ahead; as we are approaching the end of 2014, we still see limited competition to Alcatel in operator channels in We expect TCLC s smartphone blended ASP to continue to trend down, owing to a higher mix of entry level smartphones, rather than a single product ASP decline. A stabilized ASP would help to maintain GPM, as COGS has been relatively stable. 4) Samsung s shortfall leaving room for other brands to gain share In Latin America, Samsung has been losing share in the US$ segment in the past few quarters, leaving room for Huawei, Alcatel and others to grow. Alcatel dominates the below US$100 segment, though Huawei and ZTE have grown (Exhibit 125). In EMEA, Samsung has also lost share in the below US$200 segment; Huawei, Nokia, Alcatel, and some local brands (Fly, Explay and others) are gaining share from Samsung (Exhibit 124). Investment Concerns 1) Potential intensifying competition Huawei and Moto could emerge as strong competitors to TCLC in both EMEA and the Americas, but we believe in 2015 these OEMs will still gain share from Samsung and enjoy a growing smartphone penetration rate that expands the TAM. Huawei is typically strong in EMEA, and its share in US$ quickly trended up to 9% in 2Q14 from 2% in 1Q13; its share in the below US$100 segment is also increasing quickly. In Latin America, though Alcatel still dominates the below US$100 segment, we see Huawei trending up in the US$ segment, from 2% in 1Q13 to 9% in 2Q14. Moto had been declining until it launched Moto G at the end of 2013, which has successfully helped Moto to gain share. Lenovo is still in the progress of integrating Moto and we believe it could emerge as strong competitor to Alcatel post consolidation. Nevertheless, we do not see much threat in 2015, as current orders suggest Moto will not gain a lot of 75

5 ground in 2015; 2016 is more likely the timing. However, we believe these names are still gaining share from Samsung. 2) Chinese operators shifting from subsidy to rebate could lengthen replacement cycle in China We believe this would be negative for all handset OEMs supplying to China; nevertheless, we expect TCLC to generate only ~ of revenue from China, thus we think the overall lengthened handset replacement cycle in China would have limited impact on TCLC. 3) We see TCLC as remaining a cyclical company rather than engaging in structural reform We believe TCLC s growth in the past two years mainly came from the industry upturn from smartphone commoditization and continuous replacement of feature phones, especially in emerging markets. We do not see management focusing on structural change, and thus we believe the stock is worth a 11x multiple, or an appropriate valuation for a cyclical company. When TCLC s share price last time peaked in 2011 and the earnings also demonstrated a turnaround, the P/E multiple back then was 11x. Key risks to our call Exhibit 123 TCLC: 1H14 revenue breakdown: Smartphones 79% of total; Americas plus EMEA 86% of total 7,000 6,000 5,000 4,000 3,000 2,000 1,000 HK$mn Americas EMEA APAC China Smartphone Feature Phone Source: Company data, Morgan Stanley Research Exhibit 124 EMEA: Below US$200 segment growing Competition comes faster than we expect: Moto could emerge in Latin America as a strong competitor, if Lenovo s acquisition successfully transforms Moto and boosts volume, leveraging Moto s brand image. Microsoft is also in a reorganization process with Nokia; once this process is over, Microsoft aims to start to boost smartphone volume and intensify competition. Intensifying competition would erode ASP and thus GPM. Alcatel loses its brand image in open channels, and sells minimum advanced level smartphones: Advanced level smartphones have higher ASPs and GPMs than entry level smartphones and feature phones. The proportion of advanced smartphones is a sensitive factor in earnings. In our base case, we model of volume as advance level smartphones (the same as in 1H14). In our bear case, assuming no advanced smartphones sold in 2015, earnings would be 3 lower than in our base case Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 Below $100 $100 $200 $200 $500 Above $500 76

6 Exhibit 125 Latin America: Below US$200 segment growing Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 Below $100 $100 $200 $200 $500 Above $500 Exhibit 126 North America: High-end segment dominates but low-end picking up Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 Below $100 $100 $200 $200 $500 Above $500 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 2Q14 Exhibit 127 EMEA: Brand market share at sub-$200 segment 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 US$100-$200 Samsung 61% 48% 51% 4 46% 24% Nokia 5% 8% 8% 8% 11% 18% Huawei 2% 4% 5% 9% 8% 9% Alcatel 3% 5% 8% 9% 4% 7% Sony 5% 9% 5% 5% 4% 6% LG Electronics 5% 6% 6% 6% 5% 6% Motorola 1% 3% Lenovo 1% 2% 1% 2% ZTE 2% 2% 3% 2% 3% 2% Wiko 1% 1% 2% Others 16% 17% 13% 16% 17% 2 Below US$100 Samsung 41% 41% 4 33% 33% 28% Huawei 1% 3% 2% 4% 4% 12% Alcatel 13% 13% 2% 12% 11% Fly 1% 2% 3% 8% Explay 1% 5% 7% 7% 5% 4% ZTE 4% 3% 4% 4% 1% 4% Tecno 1% 3% 12% 11% 4% LG Electronics 1% 1% 4% 5% 2% 4% Lenovo 1% 1% 3% itel 3% Nokia 2% 4% 2% Others 37% 26% 29% 19% 21% 17% Exhibit 128 Latin America: Brand market share at sub-$200 segment 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 US$100-$200 Samsung 4 44% 46% 39% 44% 33% LG Electronics 17% 2 22% 25% 21% 18% Huawei 2% 1% 5% 5% 8% 9% Motorola 4% 5% 7% 4% 3% 8% Alcatel 2% 2% 3% 5% 5% 6% Nokia 14% 8% 5% 8% 6% 6% ZTE 3% 1% 2% 3% 4% Sony 4% 2% 3% 3% 3% 3% BLU 3% Others 7% 14% 9% 8% 7% Below US$100 Alcatel 56% 42% 46% 39% 39% 42% Huawei 42% 14% 19% 13% 8% 21% ZTE 2% 18% 16% 22% 24% 11% Samsung 25% 12% 2 22% 5% Lanix 1% 2% 1% 1% 2% LG Electronics 4% 4% 2% 2% Others 1% 1% 5% 17% 77

7 Exhibit 129 North America: Brand market share at sub-$200 segment 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 US$100-$200 LG Electronics 9% 21% 25% 38% 26% 39% Alcatel 3% 1% 19% 17% Motorola 1% 5% 15% ZTE 29% 22% 28% 15% 17% 8% Kyocera 4% 6% 7% 9% 6% 7% Samsung 33% 16% 17% 14% 7% Huawei 18% 26% 14% 8% 3% 3% Nokia 4% 14% 6% 2% Others 3% 5% 2% 4% 1% 2% Company Description TCL Communication operates through two brands, TCL and Alcatel mobile phones, with a focus on their respective users and markets. TCL Comm mainly focuses on mid/low-end mobile phones to overseas markets that contributed more than 9 of its total handset shipments in The company shipped 55m units of handsets in 2013 (including 17mn smartphones); Latam and EMEA were the key markets. Below US$100 Lenovo 14% 18% 15% 15% 13% 12% Samsung 8% 8% 11% 14% 15% 12% Coolpad 13% 11% 15% 9% 11% Huawei 9% 8% 6% 9% ZTE 12% 14% 9% 9% 9% Others 15% 11% 7% 6% 6% 7% Alcatel 1% 4% 4% 7% 5% 5% Hisense 3% 4% 4% 3% 4% 3% Xiaomi 3% K-Touch 9% 6% 6% 4% 5% 3% Others 16% 17% 22% 23% 24% 26% 78

8 Investment Debates Debate 1: Given 2Q14 smartphone ASP declined by -9% QoQ, will ASP pressure continue? Market s view: The market is concerned about ASP pressure in emerging markets. Our view: We believe single product ASP will remain stable; blended ASP is a function of a different mix between advanced/entry level smartphones. We see limited downside to ASP in 2H14 and We see limited downside to blended ASP decline We believe single product ASP will remain stable, but the mix of advanced level smartphones was lower in 2Q (12% of total smartphones, versus 15%+ in 1Q14), causing a blended ASP decline. In our base case, we already conservatively assume advanced level smartphones account for only of smartphone volume in 2H14 and 2015, leading to blended ASP declines of - and -7% YoY. Debate 2: Will competition intensify in 2015, causing price and margin erosion in emerging markets? Market s view: Numerous brands including Huawei and Moto (after the Lenovo acquisition) will pick up and cannibalize TCL/Alcatel s share. Our view: We believe TCLC s 7 exposure to operator channels helps to confirm models and secure volume 6-12 months ahead, thus stabilizing ASP and GPM in Also, Samsung s shortfall leaves room for growth for other players. 7 of TCLC s volume in operator channels It takes a longer time to penetrate operator channels, creating an entry barrier. Also, operators normally secure models and volume 6-12 months ahead; as we are approaching the end of 2014, we still see limited competition to Alcatel in operator channels in Market size still growing; Samsung s share loss benefits other players We expect the Americas and EMEA markets to grow by 17%/17% in 2015e; also, Samsung is still losing share in these markets, leaving room for other players to grow. Exhibit 130 Smartphone Volume YoY Growth (Americas and EMEA Each ~24% of Global Volume Share) E=Morgan Stanley Estimate e 2015e Americas YoY EMEA YoY Global YoY Debate 3: How will upgrading to 4G help to sustain margin? Market s view: TCLC will benefit from 4G upgrade in China and other EMs. Our view: We believe the key drivers for TCLC remain 1) upgrades from featurephones to smartphones and 2) low-end smartphone market share expansion against other segments. 4G will have less contribution to TCLC. Numerous countries upgrading to 4G In various markets including the US and Western Europe, users are in the process of upgrading to 4G from 3G. Overall we believe the 4G upgrade will help to sustain smartphone ASP given the same specifications. China a major driver of 4G volume for TCLC In developed markets such as the US, TCLC has limited 4G models launched; for emerging markets other than China, only Russia, Mexico, and Brazil are gradually upgrading to 4G in Thus, we believe China will be the main driver for TCLC s 4G volume, and we expect China alone to account for ~7 of 4G volume in Nevertheless, overall TCL s brand is not as strong in China; TCLC management guided for 4G smartphones to contribute merely 10-15% of volume in 2014 and 15-2 in We see 4G as less of a driver for TCLC in e 79

9 Valuation Price target derivation We derive our price target of HK$12.5 from our residual income model, and we also consider PE multiples. Our price target implies 10.7x our 2015 EPS estimate. Our scenario analysis suggests that risk-reward remains attractive, even with the recent stock price outperformance. Valuation method: Residual income As is the case with the rest of our coverage universe, our long-term valuation work for TCLC is based on a residual income model, which we believe best captures the company s fair long-term value. Our RI model combines the book value of capital and the present value of future residual income (i.e., excess returns). We calculate residual income for each period by subtracting capital charges (the cost of equity times the beginning book value of equity) from the return on equity (earnings divided by the beginning book value of equity). We assume the cost of equity stays constant at (with a riskfree rate of 3.5%, risk premium of 6.5%, and beta of 1). We consider a 11x P/E multiple justified given company s cyclical nature The stock s historical PE range has been wide given its earnings volatility. We believe TCLC s volatility is mainly due to the industry cycle, and management has only been able to make limited strategic efforts to drive the company s direction. Exhibit 131 TCLC: PER: Historical Average 16x But Large Earnings Volatility Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 TCLC PER Average Source: Thomson Reuters Morgan Stanley Research Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Exhibit 132 TCLC: PBR: Historical Average 2x Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 TCLC PBR +1 SD Average -1 SD ROE Source: Thomson Reuters; Morgan Stanley Research Scenario Analysis We believe TCLC s volume growth story in emerging markets is quite self-explanatory, leaving the key uncertainty as blended ASP and GPM. Also, in 2015 we believe the limited competitive landscape will lead to stable single product ASP and thus GPM (thanks to stable COGS). The key drivers behind earnings are thus 1) advanced smartphones as a proportion of the total, which will in turn impact the blended ASP of smartphones, and 2) total smartphone and feature phone volume. Base case scenario: In our base case scenario for 2015, we factored in 89.9mn handset shipments (58.1mn smartphones and 31.8mn feature phones). Of the smartphones, are advanced smartphones. This translates to a -7% YoY blended smartphone ASP decline. Our base case scenario includes 2015 EPS of HK$1.16; applying a 10.7x P/E multiple, we derive a base case valuation of HK$12.5. When TCLC s share price last time peaked in 2011 and the earnings also demonstrated a turnaround, the P/E multiple was 11x. Bull case scenario: In the bull case scenario, we model smartphone volume to grow by 15% more than in the base case, to 67mn; thus total handset volume is 98.9mn. Advanced smartphones account for 15% of total smartphones, translating into a smartphone blended ASP decline of just -2% YoY. Our bull case scenario includes 2015 EPS of HK$1.39, or a valuation of HK$15 based on a 10.7x P/E multiple. Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 35% 3 25% 2 15% 5% -5% - Bear case scenario: In the bear case scenario, we model smartphone volume to decline by -15% compared with the 80

10 base case, to 49mn, producing total handset volume of 80.9mn. We also model of advanced smartphones, suggesting a smartphone blended ASP decline of -19% YoY. Our bear case scenario includes 2015 EPS of HK$0.8, producing a valuation of HK$6 based on an 8x P/E multiple. We apply an 8x multiple in the bear case scenario as it is the lowest multiple for TCLC during , the earnings peak thanks to the featurephone upcycle. Exhibit 133 Scenario analysis summary: 2015e Bull Base Bear Key Assumptions Total # of handset (mn units) % of advanced smartphone 15% Smartphone ASP YoY -2% -7% -19% 2015e EPS (HKD) Scenario Valuation (HKD) Source: Morgan Stanley Research e = Morgan Stanley Research estimates Exhibit 134 TCLC: Residual income valuation 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E Total Equity 4,297 5,336 6,401 7,625 8,892 10,204 11,561 12,966 14,420 15,926 17,483 Core Net Profit 1,373 1,551 1,783 2,051 2,123 2,197 2,274 2,353 2,436 2,521 2,609 Return on Equity % 27.9% 26.9% 23.9% 21.5% 19.7% 18.2% 16.9% 15.8% 14.9% Beta (Last 60 Mths) Equity Risk Premium (Rm-Rf) 6.5% Risk Free Rate (Rf) 3.5% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% Cost of Equity Residual Income 944 1,000 1,122 1,263 1,204 1,143 1,080 1, Spread % 17.5% 16.6% 13.5% 11.2% 9.3% 7.8% 6.6% 5.5% 4.6% Terminal Growth Rate 4% Terminal Value Multiple 15.2 Continuing Value Spread growth rate 15% Beginning Equity Capital 4,297 PV of Forecast Period 5,892 PV of Continuing Value 4,554 Equity Value 14,743 No. of Shares 1,180 Projected Price (EoY) 12.5 Source: Company data, Morgan Stanley Research, E = Morgan Stanley Research estimates 81

11 Earnings Outlook Net income to grow by another 37% YoY in 2015 We expect TCLC revenue to hit HK$29.7bn and HK$39.2bn in 2014/2015, or 53%/32% YoY, respectively, thanks mainly to handset volume growth and stable ASP. We forecast blended GPM to come in at 19.3%/19.1% and OPEX at -15.3%/-15.1% in 2014/2015, and net income to reach HK$1bn and HK$1.37bn in 2014/2015, or +22/37% YoY. Smartphone volume to grow by 119%/51%YoY in 2014/2015 We look for smartphone volume to grow by 119% YoY in 2014 and another 51% YoY in 2015 (or 58mn in 2015), thanks mainly to growth driven by the Americas and the EMEA market. As for featurephones, total market volume is shrinking but we believe TCLC will gain share from Nokia, which is planning to focus only on the smartphone business. We look for featurephone volume to decline by -13% YoY in 2014 and another -3% YoY in Smartphone blended ASP to drop by -/-7%YoY in 2014/2015 We expect smartphone blended ASP to drop by - in 2014, mainly due to a mix shift towards more entry level smartphones. We believe our - YoY assumption is conservative: in 1Q14 and 2Q14, we believe smartphone blended ASP declined by -18%/-19% YoY as the proportion of advanced smartphones dropped to ~15% of the total, compared with 30-4 in 1H13. Assuming advanced level smartphones merely account for of volume in 2H14, we forecast blended ASP to drop by - YoY in We also maintain our assumption of advanced level smartphones for 2015 and thus estimate blended ASP to drop by -7% YoY in As long as order visibility remains clear and competition remains weak, we see limited downside to single product ASP. Exhibit 135 TCLC: Key Assumptions E 2015E 2016E Volume (mn) Smartphone Featurephone % Mix Smartphone 15% 32% 54% 65% 75% Featurephone 85% 68% 46% 35% 25% ASP (US$) Smartphone ASP Featurephone Revenue (HK$mn) Smartphone 5,251 12,312 24,107 33,775 46,064 Featurephone 6,780 7,051 5,593 5,456 4,483 % Mix Smartphone 44% 64% 81% 86% 91% Featurephone 56% 36% 19% 14% 9% Revenue Mix by Region Americas 42% 45% 45% EMEA 37% 4 4 APAC 7% 8% 6% China 14% 7% 9% Source: Company Data, Morgan Stanley Research E=Morgan Stanley Research estimates 82

12 Exhibit 136 TCLC: Earnings summary HKD mn 1Q14 2Q14 3Q14E 4Q14E 1Q15E 2Q15E 3Q15E 4Q15E E 2015E 2016E Net Sales 5,511 6,707 7,961 9,521 8,099 8,467 10,402 12,264 19,362 29,699 39,231 50,547 COGS (4,424) (5,413) (6,439) (7,701) (6,555) (6,853) (8,419) (9,926) (15,690) (23,977) (31,752) (41,327) Gross profit 1,087 1,294 1,522 1,819 1,544 1,614 1,983 2,338 3,672 5,723 7,479 9,220 Operating expenses (874) (1,003) (1,192) (1,486) (1,220) (1,190) (1,574) (1,939) (3,267) (4,555) (5,922) (7,477) - Promotion (466) (567) (673) (805) (582) (608) (879) (1,037) (1,611) (2,511) (3,107) (3,737) - ADM (235) (293) (224) (346) (345) (369) (292) (446) (946) (1,097) (1,453) (1,888) - R&D (255) (262) (348) (419) (375) (331) (455) (540) (1,064) (1,285) (1,701) (2,190) - Other Rev/Exp (16) 7 (42) (85) (16) 7 (42) (85) (158) (136) (136) (136) - Other Opt. Income Operating profit ,167 1,556 1,743 Non-operating income (25) (18) (21) (24) (25) (18) (21) (24) (107) (88) (88) (88) Pre-tax profit ,080 1,469 1,656 Income tax (7) (13) (15) (15) (15) (20) (19) (19) 18 (54) (73) (83) Net profit ,004 1,373 1,551 Adj.wtd.avg.shrs( m) 1,180 1,180 1,180 1,180 1,180 1,180 1,180 1,180 Reported EPS (HKD) Margins Gross margin Operating margin Pre-tax margin Net margin % YoY Sales 125% 69% 46% 27% 47% 26% 31% 29% 61% 53% 32% 29% Gross profit 17 78% 42% 24% 42% 25% 3 29% 75% 56% 31% 23% Operating profit NM 651% 37% 1% 52% 46% 24% 2 NM 188% 33% 12% Pre-tax profit NM 1862% 41% 1% 59% 49% 25% 21% NM 262% 36% 13% Net profit NM 546% 28% -2% 58% 49% 26% 22% NM 22 37% 13% % QoQ Sales -27% 22% 19% 2-15% 5% 23% 18% Gross profit -26% 19% 18% 19% -15% 5% 23% 18% Operating profit -36% 37% 13% 1% -3% 31% -4% -2% Pre-tax profit -39% 46% 13% -4% 36% -4% -3% Net profit -4 44% 13% -3% 36% -5% -3% Source: Company data, Morgan Stanley Research. E = Morgan Stanley Research estimates 83

13 Company Description TCLC has three main kinds of products: advanced level smartphones, entry level smartphones, and feature phones. The advanced level smartphones FOB is US$ , with GPM 2+. The entry level smartphone s ASP is ~US$70, with GPM 16-18%, and the feature phone s ASP is US$24-25 with GPM also ~18%. Exhibit 138 TCLC: 1H14 handset volume mix by region: the Americas and EMEA account for 85% of TCLC s volume mn units In 1H14, smartphones accounted for 5 of total handset shipments, and the mix of smartphones has been increasing. Advanced level smartphones accounted for only ~ of total smartphones in 1H14, causing blended ASP to drop faster than we had expected Broken down by region, 5 of sales were from the Americas in 1H14 (~22% from the US, 2 from Latin America, and < from Central America). For the US and Latin America, operator channels account for 80-9 of total market volume. 34% of sales came from EMEA in 1H14 (17% from the EU and 17% from Eastern Europe, the Middle East, and Africa). For EU, 5 of market volume is in operator channels and the other 5 in open channels. For MEA, 80-9 of the market is in operator channels. Thus, most of TCLC s open channel volume comes from the EU market Americas EMEA APAC China Smartphone Source: Company data, Morgan Stanley Research Feature Phone Exhibit 139 TCLC: Smartphone ASP trend: 2Q14 QoQ decline due to change in product mix 900 HKD TCLC assembles most of the phones in the Huizhou plant and then ships them overseas. TCLC has an assembly plant in Brazil to save tariffs and is working on another assembly plant in Turkey. Other phones are assembled in China. Exhibit 137 TCLC: Quarterly handset shipments: growing proportion of smartphones 25,000 20,000 15,000 K units 25% 2 15% 5% Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 Smartphone ASP (HKD) QoQ YoY Source: Company data, Morgan Stanley Research 5% 5% 15% 2 25% 10,000 5% 5,000 15% 2 25% 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 Smartphone Featurephone YoY Source: Company data, Morgan Stanley Research 84

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