CFA Institute Research Challenge hosted by CFA Society Taiwan National Chengchi University

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1 CFA Institute Research Challenge hosted by CFA Society Taiwan National Chengchi University

2 Price Per Share This report is published for educational purposes only by students competing in The CFA Institute Research Challenge. Recommendation: SELL 5% 4% 3% 2% 1% Target Price Current Price (31 Dec.) % 41% 31% 27% 26% 2% 17% ROIC-WACC NT$16.5 NT$129 Upside/Downside -17.4% Market Profile 52-Weeks Price Range NT$ NT$ Shares Outstanding 68.51M Market Cap. NT$ 78.5B Dividend Yield 8.7% P/E 11.52x P/B 2.97x EV/EBITDA 8.37x EV/Sales 1.24x Source: Bloomberg Valuation Methodology Price (NT$) P/B-ROE 16.5 Comparable Company 15.7 Discounted Cash Flow 17. Target price 16.5 Source: Team estimates ROIC-WACC Spread and ROE Forecast 19% 2% 19% 18% 13% 14% 13% 13% ROE Source: Company data, Team estimates Source: Bloomberg Stock Price Movement Novatek TWSE Index (RHS) 12 1 National Chengchi University-Student Research Equity TWSE Technology Semiconductors 31 December 215 Novatek Microelectronics Co., LTD (334 TT) When Drivers Are Not Going to Drive We initiate coverage of Novatek Microelectronics Co. with a SELL rating and NT$16.5 Target Price, implying a 17.4% downside based on P/B-ROE valuation. Our 216E EPS is 2% below the street consensus. Second Mover Strategy Would No Longer Be an Advantage We believe Novatek s strategy to take a second mover advantage may not work and would lead to a fierce pricing war instead. Touch and Display Driver Integration (TDDI) has a high possibility to be the next main actor on the stage following the growth of in-cell penetration rate from 18.9% in 214 to 35% in 218E. Major suppliers of TDDI have been in mass production and won the market with their own solutions. By contrast, Novatek has just initiated the sampling process, which could lead to market share erosion in S/M size DDIC, and the company may miss the ASP (Average Selling Price) growth driven by TDDI. Benefits from Rise in 4K TV Penetration Could Be Diminished Weak overall TV end market and 4K TV market share loss of Novatek discount the benefits of rise in 4K TV penetration. We agree that the narrowing price gap between 4K (one of ultra high definition) TVs and FHD (full high definition) TVs boosts 4K TV penetration rate. However, TV replacement cycle had passed in 214, which shows a weak overall TV demand in near future. Additionally, 4K TV market share has been caught up by Korean panel makers up to 63% in 215. Samsung s in-house strategy and LG s orders for display driver IC (DDIC) to Korean fabless makers diminish Novatek s 4K TV market share from 33% in 214 to 24% in 216E. Long-term Value Creation and Profitability Are Doubtful Pricing pressure on DDIC products, lower contribution of higher-margin System-on-Chip (SoC) solutions, and soaring R&D expenses in order to catch up with the market could have negative effects on Novatek s long-term profitability. We expect the spread between ROIC and WACC would decline from 41% in 214 to 19% in 217E and that ROE would decline from 26% in 214 to 13% in 217E. Declining ROIC-WACC spread and ROE imply that Novatek would struggle to maintain value creation for shareholders and that the profit generation would be less efficient. Initiate with NT$ 16.5 P/B-ROE-derived TP and SELL rating We set Novatek s one-year target price at NT$ 16.5 by P/B-ROE valuation, indicating a 17.4% downside. A regression analysis on Novatek s 1-year P/B ratio and ROE shows that higher ROE translates into higher P/B assigned by the market. With our 216E ROE assumption of 16.7%, we believe the current P/B ratio of 2.9x is too high, and would gradually adjust to 2.15x by 216. We therefore derive our bearish target price by the adjusted P/B ratio, and the result is further supported by DCF and EV/EBITDA-derived target price, with NT$ 17 and NT$ 15.7 respectively. Novatek s Key Financial Ratios and Valuation Metrics Year E 216E 217E 218E Return on Assets Return on Equity Earnings Per Share EPS Growth 6.2% 52% -17% -14% -18% 6% EV/EBITDA 12.64x 1.69x 8.37x 7.9x 7.2x 8.95x P/E Ratio 15.38x 14.47x 11.52x 9.85x 8.12x 8.64x P/B Ratio 2.97x 3.7x 2.97x 3.9x 3.6x 3.7x Total Liabilities/Total Assets 37% 39% 35% 32% 32% 31% Source: Company data, Team estimates National Chengchi University 1

3 NT$ in mn Table 1 Novatek Market Share Business Description Rankings Company Samsung Electronics Novatek Himax Synaptics Ilitek Orise Technology Silicon Works Sitronix Raydium Lusem Source: Company data Figure 1 Sales Breakdown (Business Units) % of Total Revenue 6, 4, 2, 28% Display Driver IC (DDI) Source: Company data 72% System on chip (Soc) Figure 2 Sales Breakdown by Geography Source: Company data Revenue Asia Taiwan Other Table 2 Shareholder Structure in 214 Stakeholders Source: Company data % of Outstanding Shares Insider 4.25% Institutional 48.87% UMC (affiliated company) 2.7% Total 55.82% Novatek Microelectronics Corp. (334TT) was founded in 1997, and is currently headquartered in Hsinchu, Taiwan. Novatek is a leading fabless chip design company specializing in the sales of a wide range of display driver IC (DDIC) and System on Chip (SoC) solutions. It ranks 2 nd as a DDIC supplier and top 15 in semiconductor industry (Table 1). Striving to deliver the highest level of innovation and quality over 2 years, Novatek has successfully achieved a substantial growth and expansion, as well as a steady financial performance. Business Units. Novatek s revenue can break down into two major parts (Figure 1): Display Driver IC (DDIC): The main product line of Novatek currently contributes to 72% of revenue. DDIC, an essential circuitry, provides the interface to either a LCD or LED display with most common microprocessors or digital systems. Novatek supports complete DDIC applications to smartphones, tablets, notebook, PCs and TVs. System on Chip (SoC): SoC is a microchip with all the necessary electronic circuits for a given system, such as a smartphone or television, on a single integrated circuit (IC). Seeking to maintain diversified product portfolios, Novatek has expanded its development on SoC, which contributes to 28% of revenue with higher margin. Currently, Novatek s main SoC product is TV SoC. DDIC SoC - Market leader with around 22%-3% market share - High-end DDIC technology, Novatek s key strength - Customers are AUO, Innolux, and worldwide panel suppliers - Market late comer with 7% market share - TV SoC, TCON and others are major product lines - Major customer was Samsung in 214; now it targets at China Geographic Units. Novatek s customers are mainly panel companies which are from Taiwan, Korea, Japan, and China (Figure 2). Novatek has built a steady partnership with AU Optronics Corp. (249TT) and Innolux (3481TT); however, its overseas market is still competitive and volatile, especially in China. Company Strategies: - Diversify Product Portfolio Novatek pursues total solutions for panels, not only in size and application but also in different product lines. SoC will be its next development point in order to enlarge its profitability and market share. - Launch Out no sooner than the Market Takes off Novatek positions itself as a ready technology follower. It has always been prudent in R&D expenses. After seeing a product takes off, Novatek enters the market, take advantage of its leading market share to gain the revenue. - Expand Customer Base in China Despite huge demand in Chinese market, the semiconductor industry is highly competitive in pricing and market share. Novatek plans to expand customer base in China through its advantage of high-end technology in DDIC. Shareholder Structure: Novatek isn t owned by any sole major shareholder; instead, the ownership is well diversified by institutional investors and the public. We especially examined the percentage of shares owned by insiders and UMC who are possible influential in corporate management, and we found they hold only 7% of outstanding shares (Table 2), showing they have little influence on corporate decisions. Corporate Governance: From Appendix 7, we can clearly see the comparison of Novatek and its peers and justify the credibility of its operation by the disclosure of the independency of its board members and managers and by high attendance of Board Members in annual meetings. National Chengchi University 2

4 mn Table 3 Panel Capacity Country Production Manufacturer Gen 215 BOE CSOT 8.5 China 215 CEC-Panda BOE BOE 1.5 Korea 216 Sharp AUO 8.5 Taiwan 216 Innolux 8.6 Source: Company data Figure 3 4K TV Penetration Rate 35% 3% 25% 2% 15% 15% 2% 24% 27% 29% 31% 1% E 217E 218E 219E 22E Source: DisplaySearch, Team estimates Figure 4 TV Shipments 2 1 4% 3% 2% 1% % E216E217E218E219E22E Other TV Shipment 23% 5% 27.5% 1% 3% 32.5% 19% 26% 35% E 217E 218E 219E In-cell Penetration Novatek 7% Realtek 21% Others 7% In-house 17% Mediatek & MStar 48% 4K TV Shipment Source: DisplaySearch, Team estimates Figure 5 In-cell Panel Penetration Rate 32% TDDI Penetration Source: DisplaySearch, Team estimates Figure 6 TV SoC Market Share, 215 Industry Overview and Competitive Positioning Industry Overview Global economy slowdown is weighing on panel industry With China s economy slowing down and worsening prospects in emerging markets due to U.S. FED s interest rate hike, global GDP growth forecast has been revised down for the third consecutive year. With regard to the U.S., the World Bank decreased its prospects to 2.7%, down from 2.8% in previous estimation. While China has surpassed the U.S. and the EU to become the world s largest consumer electronic market, its growth forecast, however, decreased by.3% in 216E. We believe the consumer electronic markets are highly related to economic tendency. As a result, the stagnated global economy could end up threatening consumer confidence, setting a gloomy outlook for panel and DDIC companies (Appendix 11). Continuing panel overcapacity puts pricing pressure on DDIC industry The panel makers are now ramping up their capacity (Table 3). Despite lukewarm end demand, China panel makers have launched three 8.5-generation production lines in 215, causing the panel price to drop 15-2%. Looking ahead to 216, Korea panel makers will also have one production line ramping up, which could lead to widening gap between supply and demand. Besides, panel price and DDIC price are highly correlated (Appendix 11). As panel price continues to head south, component vendors such as DDIC companies will be under pricing pressure due to panel makers cost reduction. 4K TVs maintain the growth driver of large-sized DDIC The mature TV market is mainly driven by 4K TVs (Figure 3), which could bring a 26% of shipment growth in 216E (Figure 4). The rising 4K TV penetration rate will have positive effect on DDIC shipments because UHD TVs require 2-3 times as many DDIC as FHD TVs. However, the Korean panel makers continue to rob 4K panel market share with aggressive pricing strategy. Besides, China panel makers are also growing aggressively. DDIC companies such as Novatek, which rely heavily on Taiwan panel makers, could see lower-than-average growth if they are not ready to penetrate into other markets. Integrated touch and display products are about to take the market While smartphone shipments growth is slowing down to single digit and resolution upgrade cycle stalls, the adoption rate of TDDI could see a fierce growth in 2H16. Several factors signal that TDDI will soon take off. First, several touch IC makers aggressively gained TDDI technology through M&As by acquiring driver IC firms, and already had their TDDI in mass production. In addition, the in-cell penetration rate of mobile panels (Figure 5) is also increasing, supporting the growth of TDDI adoption rate. We expect the in-cell penetration rate could soar from 18.9% in 215 to 35% in 219. Moreover, we believe more and more smartphone makers will adopt TDDI technology because TDDI integrates touch IC and DDIC into a single chip, allowing the cost to decline (Appendix 11). Therefore, we believe TDDI penetration rate will be faster-than-expected. DDIC and touch IC makers had better be ready for the integrated technology or they could only stick to price war in low-end markets. Major panel players transfer TV SoC into in-house production Through a series of M&As, including the merger with MStar in 212, Mediatek is now the front runner in the TV SoC market. Realtek takes the first runner-up (Figure 6), leaving the rest of competitors to battle for the remaining market share. Furthermore, most of the major panel manufacturers (e.g. SEC, LGD) are transferring their TV SoC production line into in-house production in order to cut manufacturing costs. The internalizing strategy might signal that TV SoC manufacturers will not see market expansion in the near future despite growing demand from the prospering 4K TV industry. Source: Company data, IHS National Chengchi University 3

5 Market Share Figure 7 Five Forces Analysis Threat of Substitute Products Threat of New Entrants Bargaining Power of Customers Source: Team estimates $NTD % 35% 3% 25% 2% 15% 1% 5% Bargaining Power of Suppliers Competition in the Industry Figure 8 Key Factors of Competitive Position Source: Team estimates Figure 9 Cost Per Unit (Wafer+Backend) Total Display Driver IC SOC Source: Company data Figure 1 Novatek s Position in DDIC Industry Novatek Synaptics Sitronix Himax %.% 1.% 2.% 3.% EBITDA 3 Yrs. Avg. Source: Team estimates Samsung Competitive Positioning Novatek is a leading fabless IC design company in Display Driver IC. The company is now facing structural headwinds because of lagged next-generation technology development, market share erosion, and weakening end demand. Besides five forces analysis in Appendix 8, we define Novatek s competitive positioning in five aspects (Figure 8): Wafer suppliers affect production cost; technology power which further results in different market share defines the position of Novatek and its competitors. Market share and demand for technology end products bring about Novatek s selling quantity and price. After prudent analysis, we hold different points of view from the company s guidance to define Novatek s competitive position in the industry, which also leads to our financial forecast assumptions. Bargaining Power: Relationship with Suppliers makes difference Company View: Over the past five years, the stable price of both 8-inch and 12-inch wafer shows Novatek s stability in cost per unit (Figure 9). Company states that its long-term partnership with two major wafer foundry providers United Microelectronics Corporation (UMC) and Vanguard International Semiconductor Corporation (VIS) stabilizes its bargaining power with suppliers. Our View: We agree that Novatek has relatively steady cost per unit given its historical performance. However, Samsung is aggressively promoting DDIC in an attempt to fulfill its wafer capacity. It is likely Samsung LSI would bundle its DDIC solution with TCON by giving an estimated discount of 1%-15%, according to a field survey from the street. As a result, we assume Samsung could enjoy stronger bargaining power due to self-sufficient wafer. Technology Power: TDDI will be the main actor on the stage Company View: The management team states that the adoption of TDDI may be slower than expected. Company has just initiated the sampling process for its own solutions and viewed itself as the market follower. Our View: The adoption rate of TDDI could see a fierce growth in 2H16. In-cell penetration rate is the key driver to the development of TDDI. Compared to on-cell technology, in-cell could relatively upgrade display effect and make the device thinner; hence, panel makers are striving to develop such technology, especially JDI and LGD. Furthermore, the major suppliers of TDDI (Synaptics, Focaltech, Himax) are all ready to win the market with their own solutions all in mass production. Therefore, we would say TDDI market is taking off, and Novatek s second mover strategy might lead it to a price war in low-end markets without grasping the growth momentum from high ASP products. Competitors Performance: A wave of M&A Changes the Game Company View: Novatek s leading position in the Driver IC industry with top three market share (33% in Large LCD market, 23% in Small LCD market, 214) solidifies its competitive positon. Our View: Facing the consolidation of touch and display driver IC makers (MTK & Ilitek, Synaptics & Renesas SP Drivers and Focaltech & Orise), and in-house strategy of key panel makers (Samsung, LG), Novatek is hence challenged by faster technology development. In addition, we reckoned that Himax, Synapics, and Sitronix are main competitors since they have similar scale, product lines, and profitability (Figure 1). Himax has launched its TDDI solution in mass production and Synaptics developed its own solutions through acquisitions. Therefore, we believe Novatek s leading position would be challenged by technology breakthroughs reached by its competitors. National Chengchi University 4

6 Figure 11 4K TV Market Share by Country 8% 6% 4% 2% % Taiwan Korea China E Source: IHS, WitsView Technology End Product: 4K TV is the driver Company View: Novatek is optimistic about the long-term growth trend for 4K TV market and expect penetration to reach 2%/24% in 216E/217E, up from 15% in 215, according to DisplaySearch report. Our View: We estimated the 4K adoption would steadily increase to 31% by 22 (Figure 3), which is in line with the market consensus. However, TV replacement cycle had passed in 214, which shows a weak overall TV demand in near future. In 215 overall TV shipment dropped 2%, and shipments of TV panels in 216E are expected to drop 3% per year. We further see 4K is currently dominated by Korean makers with nearly 63% of the 4K shipments in 215 (Samsung 33% and LG 3%) (Figure 11). China market is growing, but Himax (HIMX US) and Raydium (3592 TT) are better positioned. Hence, the benefit from 4K driver is discounted by weak overall TV demand and market share loss. Figure 12 Competitors Profitability (%) Gross Margin Market Share: Chinese market is a trade-off Company View: Expecting to lose orders from Korean panel makers, Novatek plans to expand its customer base in China through its high-end technology in DDIC. However, the management team also shows concern about entering Chinese market by considering the profitability. They are prudent about this strategy. Our View: China is a market with high market share potential but at the same time, the company may lose its margin. Himax and Raydium are the main suppliers of Chinese panel makers, however as we can see for the Figure 12, these two companies show lower gross margin compared to Novatek. So we believe whether to enter Chinese market is a trade-off, Novatek may sacrifice its profitability to gain market share. We assume that Novatek has to hit the market by high-end product but the margin may fall as expected. On the other hand, the market share gain could be limited, since most Chinese panel makers are providing low-end products. 215Q3 Source: Bloomberg 3 Yrs. Average Investment Summary We issue a SELL recommendation on Novatek Microelectronics Corp. with a target price of NT$ We based our valuation on gloomy industry prospect, fierce pricing competition, and increasing R&D expenses. The high-end display products could show limited penetration growth due to weak end demand, while low-end display products would face price competition. Besides, we expect Novatek s R&D expenses to increase as seen in Q3 215 in response to shorter product life cycle and stronger competitors, which may end up eroding its profitability. We believe Novatek is facing both structural headwinds and cyclical headwinds. Therefore, in the short term we suggest that investors cut their position after Novatek s stock price had its short rebound and wait for end market recovery. While in the long term, investors should keep an eye on whether Novatek will catch up with the latest technology and regain its growth momentum. Both large and small size DDIC face pricing headwinds The 4K penetration is the key for large size DDIC ASP growth, and we expect the 4K adoption is in line with the market. In 216, Korean panel makers would also have additional capacity ramping up, which may cause panel market pricing to stay low and affect large size DDIC ASP since panel makers might try to cut their production costs. For small size DDIC, we foresee the YoY smartphone shipments growth slowing down to single digit in 215 and thereafter. As resolution upgrade cycle stalls, we see little smartphone panel technology differentiation and possible commoditization could happen. Lagged TDDI development would restrict Novatek from breaking into the supply chain of the embedded touch panel Since Novatek s peers (Synaptics, Focaltech, and Himax) have already had their TDDI solutions in mass production, faster market adoption of TDDI solutions could result in further share loss for Novatek since we expect the embedded touch panel with in-cell solutions would gain share in electronic devices. National Chengchi University 5

7 Table 4 Target Price Summary Valuation Methodology Price (NT$) P/B-ROE 16.5 Comparable Company 15.7 Discounted Cash Flow 17. Target price 16.5 Source: Team estimates Lack of bargaining power and technology breakthroughs would cost Novatek further market share in SoC Segment From our research, we found most of the company s TV SoC market share could possibly come from the clients who seek to diversify their supplier risk from MStar. Novatek would have to take the second mover strategy to hold the current market share. We expect the strategy might cost the company further market share due to lack of technology breakthroughs and bargaining power in the current position. Doubtful Long-term Value Creation and Profitability The spread between return on invested capital (ROIC) and WACC would decline from 41% in 214 to 19% in 217E and that ROE would decline from 26% in 214 to 13% in 217E. Declining ROIC-WACC spread and ROE imply that Novatek would struggle to maintain value creation for shareholders and that the profit generation would be less efficient based on declining ASP of both large and small size DDIC, lower contribution of higher-margin SoC solutions, and soaring R&D expenses. Solid valuation leads to target price of NT$ 16.5 with 17% downside We believe it is a good timing to cut position after the stock price had its short rebound. Our P/B-ROE valuation model set our target price at NT$ 16.5 based on ROE of 16.7% in 216E. Past year s price slump showed that investors have adjusted their over-optimistic view of growth sustainability expectations. However, we believe the aforementioned structural headwinds which Novatek is facing could lead to a worse situation. The current price of NT$ 129 still implies 2.64x P/B in 216E, which leaves a 17% downside to its fair price of NT$ We also calculate a market-based target price of NT$ 15.7 using 1.96x EV/EBITDA multiple. Four similar companies were chosen based our peer selection methodology (Appendix 14). We further conducted a relevance analysis, discovered that EV/EBITDA shows better relevance for Novatek and its peers. The median of their EV/EBITDA 216E is 1.96x, leading to Novatek s fair market price of NT$ Figure 13 Net Margin and ROE Forecast 3% 25% 2% 15% 1% 5% % % 13% % % 12% 11% % 14% 13% 13% 9% 9% 9% 9% E216E217E218E219E22E ROE Net Margin Source: Company data, Team estimates Figure 14 Avg. Cash Conversion Cycle (Days) Source: Company data For DCF model, we derived the company s intrinsic value of NT$ 17. Overall, we factored expected negative to flattish revenue growth, declining gross margin, and soaring R&D expenses to our model and set our pessimistic target price. See Appendix 17 for the derivation of each factor. Possible Upside Risks Investors must be aware of market risks such as sluggish TDDI adoption rate and higher-than-expected 4K penetration rate caused by large sport events. Economic risks such as recovery in end demand should also be noted. Operational risks include Samsung s slower-than-expected in-house process for the TV SoC business. Last but not least, loosening investment regulations for Chinese firms to invest in IC design firms in Taiwan could bring about regulatory risks for investors. Financial Analysis ROE falls due to decline of net profit margin and asset turnover Though Novatek reached 25.5% ROE in 214, we expect a 16.7% ROE in 216E and a 13.3% in 217E. DuPont Analysis shows that both declining net profit margin and asset turnover lead to Novatek s ROE drop in the forecast period (Figure 13). We expect increasing R&D expenses would erode forecasted net profits, while pricing headwinds would lead to lower efficiency of assets revenue generation. Longer-than-average cash conversion cycle would stay fixed The average time between Novatek s initial investment in working capital and cash collection from 212 to 214 was days, which was close to Himax s days but longer than the average of that of the comparable companies (Figure 14). The longer-than-average cash conversion cycle over the past three years implied higher liquidity risk. We expect cash conversion efficiency would stay fixed based on future competitive environment and Novatek s position in the industry. National Chengchi University 6

8 Figure 15 Avg. Revenue/R&D Expense Ratio 12x 1x 8x 6x 4x 2x x 8.46x 6.94x Source: Company data x x x x Figure 16 Avg. Revenue/R&D Personnel (USD in mn per R&D Personnel).4 High times interest earned ratio was caused by conservative financing strategy Though times interest earned ratio seemed impressing, the number could be biased. Novatek employed little short-term debt and did not leverage any long-term debt over the past few years. We expect Novatek would maintain this strategy based on the company s financing tradition. Novatek s conservative financing strategy and cautious capital structure would limit the company s ability of taking advantage of interest tax shield to maximize shareholders value. R&D input efficiency could be challenged by harsh market conditions Novatek s revenue to R&D inputs ratios were above the average of those of the comparable companies over the past three years. However, the ratios might be harmed due to future R&D expenses rise caused by competitive market conditions. From (Figure 15) and (Figure 16), Novatek could generate an average 8.46 dollars in revenue for every 1-dollar R&D input, and the company could generate an average.96 million USD per R&D personnel. We found it hard for Novatek to maintain the ratios at this level because of further expenses that could be incurred from maintaining competency such as TDDI development. Future dividend growth would be limited We expect Novatek would have a declining EPS from NT$ in 214 to NT$ 6.97 in 217E. However, it is expected that Novatek would maintain a conservative dividend payout ratio based on foreseeable headwinds and therefore would limit future dividend growth. Source: Company data FINANCIAL RATIOS E 216E 217E 218E 219E 22E DuPont Analysis Net Profit Margin 11.45% 13.33% 11.75% 1.95% 9.7% 9.43% 9.23% 9.% Asset Turnover 1.6x 1.18x 1.13x 1.3x 1.x 1.x 1.x.99x Equity Multiplier Return on Equity 19.27% 25.53% 2.31% 16.71% 13.34% 13.75% 13.37% 12.87% Liquidity Current Ratio Quick Ratio Cash Ratio Days Sales Outstanding Days Inventory Outstanding Days Payable Outstanding Cash Conversion Cycle Solvency Total Liabilities/Total Assets Times Interest Earned 128.2x 152.5x 156.1x 153.4x 13.7x 139.7x 14.x 138.6x Shareholder Ratios Earnings Per Share Dividend Payout Ratio 76.9% 84.3% 77.% 77.% 77.% 77.% 77.% 77.% Dividend Per Share Valuation We set Novatek s one-year target price at NT$ 16.5 using P/B-ROE valuation framework. The target price implies 2.15x 216E P/B, indicating a 17.4% downside. The result is further supported by DCF and EV/EBITDA-derived target price, with NT$ 17 and NT$ 15.7 respectively. P/B-ROE Valuation Framework We utilized P/B-ROE valuation framework to derive our target price. ROE measures the efficiency of a company to generate profits from each unit of shareholders equity, and P/B ratio reflects current market price to a company s book value. Therefore, the ability to earn a return as a percentage of the equity (ROE) drives the market valuation as a multiple of the equity (P/B). We therefore conducted a regression analysis on Novatek s 1-year forward P/B ratio and ROE and found their high correlation, showing that higher ROE translates into higher P/B assigned by the market. Hence, the rationale is reasonable for us to project P/B multiple given our forecasted ROE. National Chengchi University 7

9 Utilizing P/B-ROE valuation framework Using the P/B-ROE regression formula (Appendix 13), we derived a 216E year-end target price of NT$ We believe that past year s price slump from NT$ to NT$ 129 was reflecting investors adjustment for over-optimistic growth sustainability expectations. However, the structural headwinds which Novatek is facing could lead to a worse result. The current price of NT$ 129 still implies 2.64x P/B in 216E, which leaves a 17.4% downside to its fair price of NT$ 16.5, if we factor our projected 216E ROE of 16.71% in our model. The potential of lower-than-expected 4K TV contribution, lagged TDDI technology, and possible margin erosion are not fully realized by the market. To maintain its current market price, Novatek must generate a ROE near 2.5% level. However, the gloomy industry prospect and the company s conservative strategy prevent us from concluding such optimistic forecast. Historical P/B-ROE Correlation Table 5 P/B-ROE Scenario Analysis End Market (YoY) Bear Base Bull TV Shipments -7% -3% 5% PC Shipments -7% -3% 3% Tablet Shipments -12% -1% 2% Smartphone Shipments 3% 6.8% 8% 4K DDI Market Share Bear Base Bull 15% 24% 36% Large Size ASP (YoY) Bear Base Bull -12% -8% % 216E ROE (%) P/B (x) TP (NT$) Up/ Down Bear % Base % Bull % *Current Price: NT$ 129 (215/12/31) TDDI Market Share Bear Base Bull % % 15% Small Size ASP (YoY) Bear Base Bull -1% -7% % P/B-ROE Scenario Analysis: Bull case shows only 8.5% limited upside To prove the accuracy of our SELL rating, we conducted a scenario analysis (Table 5) to see how target price would fluctuate with various assumptions. The analysis shows that even if the end market recovered, Novatek gained back 4K DDIC market share and caught up TDDI technology for mass production (bull case), the company would still generate only 22.7% ROE in 216E. The bull case suggested a target price of NT$ 139 based on the P/B-ROE model; however, it only gave a limited upside of 8.5% with such outperforming scenario, compared to a more possible 25.5% downside. Scenario Analysis (NT$) 15 $11 $ Current Price: $129 $ % $96 Bear Case $5 $3 $2 4K TV TDDI End Market $16 Base Case $5 End Market TDDI 4K TV Bull Case -25.5% Source: Team estimates National Chengchi University 8

10 EV/EBITDA (x) Figure 17 Relevance Analysis -3% -2% -1% % 1% 2% 3% % 1% 5% % -5% -1% -15% 8, 7, 6, 5, 4, 3, 2, 1, 3 Yrs. Avg EBIDTA Margin v.s. Novatek 3 Yrs. Avg Sales Growth v.s. Novatek 334TT HIMX US 816TT 2454TT Sitronix SILICON Mediatek FocalTech Synaptics Source: Bloomberg, Team estimates Figure 18 EV/EBITDA Trend Source: Bloomberg 2379TT Figure 19 Revenue Growth Forecast E 217E 218E 219E 22E Large DDIC Small DDIC SoC Source: Team estimates Figure 2 R&D Expenses R&D expenses Source: Team estimates Realtek HIMAX Ilitek Raydium % of sales 15% 14% 13% 12% 11% 1% Relative Valuation We identified four appropriate peers of Novatek (Appendix 14) and derived a market-based target price of NT$ 15.7 using 1.96x EV/EBITDA multiple. It is supportive to our P/B-ROE result. Valuation of similar geography, profit and growth We defined comparable companies by selecting those with revenue generated mainly from Asia and partly from Taiwan. Secondly, these companies 3-year-average EBITDA margin and growth rate should show relevance with those of Novatek. Therefore, we chose four companies on our list, including Himax (HIMX US), Sitronix (816 TT), Realtek (2379 TT), and Mediatek (2454 TT). EV/EBITDA, most representative multiple EV/EBITDA is the most representative multiple as it is a good proxy for cash flow without being influenced by differences in depreciation. Additionally, EV/EBITDA is capital-structure-neutral, allowing us to directly compare companies with different levels of debt. Credible enterprise value In order to obtain a representative EV/EBITDA, we used 8-year annual average of EV for each company. The 8-year period (28-215) stands for a complete business cycle, and we assumed there would be no significant structural change in the future. Thus, the historical performance can support our valuation. In our calculation, we used daily price to derive an annual average of EV for each company. Therefore, EV/EBITDA is not biased by any single day or period. Novatek and its competitors EV/EBITDA multiples show similar trend (Figure 18). We therefore utilized peers median EV/EBITDA of 1.96x to set the market-based target price at NT$ DCF Model Our solid assumptions lead to a DCF-derived intrinsic value of NT$ 17, which echoes P/B-ROE and EV/EBITDA-derived target price. A two-stage DCF model was used since the company adopts a stable operating and financial strategy which contributes to the predictability and reliability of future cash flows based on growth, profitability, and risk. Overall, we factored negative to flattish revenue (Figure 19), declining gross margin, soaring R&D expenses (Figure 2), and expiration of tax privilege in our model. With Novatek s WACC of 11.7% and an exit multiple of 1x EV/EBITDA, we derived our target price of NT$ 17. See Appendix for DCF assumptions and calculations. Investment Risks We evaluated the upside risks of Novatek and showed the impact and likelihood of the following risks in Figure 21. Market Risks ASP growth from technology upgrade (MR1) Novatek could expand its customer base in China where the market sensitivity to price is extremely high. We therefore foresee a 1% decline in average selling price for the company in near future. However, we concern that the development of advanced technology such as TDDI may speed up, and this could drive ASP growth and lead to a higher-than-expected gross margin. Fluctuations of silicon wafer price (MR2) The major supplier of Novatek, UMC, has been selling silicon wafer to the company in a comparatively steady price for a long time. We have seen that the capacity of some major silicon wafer suppliers has been expanded while developing larger wafer size. This may cause the potential fluctuations of silicon wafer price and lead to a lower cost per unit for Novatek. However, we see very low possibilities based on historical trends of Novatek s cost structure. National Chengchi University 9

11 Figure 21 Risk Matrix Higher-than-expected 4K penetration rate caused by large sport events (MR3) We believe 4K TV penetration rate will be in line with market consensus and therefore will be no higher than 31% by 22. However, the large sport events such as Rio 216 Olympic Games and 218 FIFA World Cup Russia could boost the sales of TVs and the penetration rate of 4K TVs, and could beat market estimation. Considering that 4K TVs will be the main growth drivers for DDIC in the future, we found higher-than-expected 4K penetration rate could lead to larger 4K TV market share for Novatek s clients, and thus boost the demands for DDIC. Source: Team estimates Table 6 Risk Factors and Impact Risk Impact Market Risks ASP growth from Higher ASP technology upgrade Fluctuations of silicon Lower costs, Higher wafer price gross margin Higher-than-expected 4K More DDIC penetration rate caused shipments by large sport events Large 4K market share Higher 4K TV market gains from AUO and share Innolux Less market share Sluggish TDDI erosion in S/M size adoption rate DDIC Economic Risks Higher shipments in Recovery in end demand both DDIC and SoC Operational Risks Samsung s Less market share slower-than-expected loss for the TV SoC in-house process for the business TV SoC business Regulatory Risks Loosening investment Higher PER, regulations for Chinese structural changes firms Source: Team estimates Large 4K market share gains from AUO and Innolux (MR4) Although we see that current 4K TV market is dominated by Korean panel makers (with two-third of market share in 215), AUO and Innolux, the two major clients of Novatek, could also catch up in this segment and gain higher-than-expected market share, this will lead to higher 4K market share gains for the company. Sluggish TDDI adoption rate (MR5) Considering the unknown cost benefits and the price gap compared to discrete solutions, we found TDDI adoption could be slower than the market s expectation. If the price of TDDI chipsets couldn t find its way to approach the current solutions, it is possible that TDDI market adoption would hold off, which coincides with the company s view. Economic Risks Recovery in end demand (ER1) The global economy condition has possibly reached the bottom of down cycle and could bounce back to a favorable condition to boost the demand for technology devices. Additionally, inventory restocking for display drivers may rise in 1Q16 for Novatek s major clients, panel makers such as Innolux and AUO. Therefore, we couldn t ignore the opportunity that Novatek s annual shipments in driver IC could be higher-than-expected. Operational Risks Samsung s slower-than-expected in-house process for the TV SoC business (OR1) We concern that Novatek s TV SoC business would lose less market share if the in-house process of Samsung is slower than the market expects. Otherwise, we still see the pressure from the first tier companies, such as Mediatek with leading technology and market share, is high. Regulatory Risks Loosening investment regulations for Chinese firms (RR1) It is worth mentioning that China s semiconductor industry is growing rapidly. Moreover, Chinese vendor such as Tsinghua Unigroup Ltd. (UNIS), a Chinese state-owned company, is aggressively seeking M&A opportunities to strengthen its competitiveness. Novatek could be a potential M&A target because of its advanced technology and low PER (1x-15x) compared to Chinese semiconductor companies. Novatek s strong cash position, superior earning quality, higher-than-average dividend yield (6.7%), and R&D efficiency all make it an attractive takeover target for Chinese vendors. Therefore, Chinese investment or further M&As could have huge impact on Novatek, which could cause a re-rating in its P/E. In December 215, in order to protect Taiwanese core business strength, the proposal for allowing Chinese firms to invest in IC design firms in Taiwan was rejected, making Novatek less possible to be acquired or invested by Chinese firms recently. Currently only foundries, outsourced semiconductor assembly and test firms, and equipment companies in Taiwan are allowed to be invested by Chinese companies. National Chengchi University 1

12 Appendix 1: Income Statement NOVATEK INCOME STATEMENT Fiscal year E 216E 217E 218E 219E 22E Fiscal year end date 213/12/31 214/12/31 215/12/31 216/12/31 217/12/31 218/12/31 219/12/31 22/12/31 NT$ in mn except per share Revenue 41,448 54,63 51,174 46,996 46,736 47,849 49,57 49,872 Cost of sales -29,955-38,674-37,14-34,331-34,648-35,118-36,21-36,754 Gross Profit 11,493 15,389 14,159 12,666 12,88 12,731 13,36 13,118 Research & development -4,799-6,716-6,448-6,63-6,39-6,63-6,868-6,982 Selling, general & administrative -1, ,177-1,81-1,75-1,11-1,128-1,147 Operating expense -6,62-7,482-7,625-7,143-7,384-7,74-7,996-8,129 Operating profit (EBIT) 5,431 7,97 6,535 5,522 4,74 5,27 5,4 4,989 Interest and other income/(expense) Pretax profit 5,683 8,275 6,914 5,914 5,18 5,436 5,453 5,49 Taxes , Net income 4,745 7,27 6,15 5,145 4,239 4,512 4,526 4,49 Basic shares outstanding (mn) Impact of dilutive securities (mn) Diluted shares outstanding (mn) Basic EPS $7.82 $11.85 $9.89 $8.46 $6.97 $7.42 $7.44 $7.38 Diluted EPS $7.69 $11.8 $9.84 $8.42 $6.94 $7.39 $7.41 $7.35 Appendix 2: Balance Sheet NOVATEK BALANCE SHEET Fiscal year E 216E 217E 218E 219E 22E Fiscal year end date 213/12/31 214/12/31 215/12/31 216/12/31 217/12/31 218/12/31 219/12/31 22/12/31 NT$ in mn except per share Cash & equivalents 18,292 2,13 19,749 21,611 22,576 22,838 23,598 24,421 Accounts receivable 1,778 14,12 13,348 12,259 12,191 12,481 12,796 13,9 Inventories 4,362 6,16 5,896 5,468 5,519 5,594 5,737 5,854 Other current assets (inc. other receivables, prepaid expenses) Long term securities investments 1,427 1,437 1,437 1,437 1,437 1,437 1,437 1,437 Property, plant & equipment 1,522 1,413 1,95 1,95 1,95 2,453 2,453 2,453 Net intangible assets (inc. Goodwill) 2,63 2,146 2,214 2,283 2,351 2,419 2,487 2,556 Other non-current assets (inc. Deferred tax assets) Total assets 38,996 45,932 45,235 45,618 46,631 47,838 49,133 5,36 Short term debt 6,348 6,362 4,799 4,799 4,799 4,799 4,799 4,799 Accounts payable 4,991 7,27 6,725 6,238 6,295 6,381 6,545 6,678 Accrued expenses & other CL 2,796 4,47 3,831 3,518 3,499 3,582 3,672 3,733 Revolver Long term debt Other non-current liabilities (inc. Deferred tax liabilities) Total liabilities 14,378 17,75 15,624 14,824 14,862 15,31 15,286 15,48 Common stock / additional paid in capital 9,373 9,373 9,373 9,373 9,373 9,373 9,373 9,373 Retained earnings / accumulated deficit 15,155 18,71 2,84 21,268 22,243 23,281 24,321 25,354 Other equity, comprehensive income / (loss) Total equity 24,619 28,227 29,611 3,794 31,769 32,87 33,848 34,881 National Chengchi University 11

13 Appendix 3: Cash Flow Statement NOVATEK CASH FLOW STATEMENT Fiscal year E 216E 217E 218E 219E 22E Fiscal year end date 214/12/31 215/12/31 216/12/31 217/12/31 218/12/31 219/12/31 22/12/31 NT$ in mn except per share Net income 7,29 6,15 5,145 4,239 4,512 4,526 4,49 Depreciation and amortization Accounts receivable -3, , Inventory -1, Accounts payable 2, Accrued expenses & other CL 1, Other current assets (inc. other receivables, prepaid expenses) Other non-current assets (inc. Deferred tax assets) Other non-current liabilities (inc. Deferred tax liabilities) Cash from operating activities 5,748 6,922 6,236 4,64 4,679 4,665 4,74 Long term securities investments 5 Capital expenditures Purchases of intangible assets Cash from investing activities Short term debt 13-1,563 Common dividends -3,696-4,631-3,962-3,264-3,474-3,485-3,457 New share issuances Share repurchases Other comprehensive income / (loss) Revolver Cash from financing activities -3,683-6,194-3,962-3,264-3,474-3,485-3,457 Net change in cash during period 1, , National Chengchi University 12

14 Appendix 4: Key Financial Ratios FINANCIAL RATIOS E 216E 217E 218E 219E 22E Profitability Gross Profit Margin 27.73% 28.46% 27.67% 26.95% 25.87% 26.61% 26.57% 26.3% EBITDA Margin 14.16% 15.4% 13.52% 12.48% 1.8% 11.28% 1.99% 1.72% Operating Margin 13.1% 14.63% 12.77% 11.75% 1.7% 1.51% 1.27% 1.% Net Profit Margin 11.45% 13.33% 11.75% 1.95% 9.7% 9.43% 9.23% 9.% Asset Turnover 1.6x 1.18x 1.13x 1.3x 1.x 1.x 1.x.99x Return on Assets 12.17% 15.69% 13.3% 11.28% 9.9% 9.43% 9.21% 8.92% Return on Equity 19.27% 25.53% 2.31% 16.71% 13.34% 13.75% 13.37% 12.87% Return on Invested Capital (ROIC) 42.7% 52.42% 43.% 38.3% 31.1% 31.3% 3.73% 29.96% Earnings Per Share Dividend Payout Ratio 76.95% 84.38% 77.% 77.% 77.% 77.% 77.% 77.% Dividend Per Share Liquidity Current Ratio Quick Ratio Cash Ratio Days Sales Outstanding Days Inventory Outstanding Days Payable Outstanding Cash Conversion Cycle Solvency Total Liabilities/Total Assets Times Interest Earned DuPont Analysis Net Profit Margin 11.45% 13.33% 11.75% 1.95% 9.7% 9.43% 9.23% 9.% Asset Turnover 1.6x 1.18x 1.13x 1.3x 1.x 1.x 1.x.99x Equity Multiplier Return on Equity 19.27% 25.53% 2.31% 16.71% 13.34% 13.75% 13.37% 12.87% National Chengchi University 13

15 Appendix 5: Financial Statement Forecast Assumptions Income Statement Accounts Assumptions Revenue Based on Team Forecast of Price and Quantity of Future Sales. Gross Profit Forecasted Using Team Estimated Percentage of Revenue Based on DDIC and SoC Gross Margin Forecast. Research & Development Forecasted Using Team Estimated Percentage of Revenue from 12.6% to 14%, Growing from the Recent Peak in the First Three Quarters of 215. Selling, General & Administrative Forecasted Using Team Estimated Percentage of Revenue 2.3%, Recent Average in First Three Quarters of 215. Other Income and Expenses Straight-line Dividend Income, FX Gain and Loss, Other Income and Expenses. Interest Income Interest Income Arising from Forecasted Cash Balance. Interest Rate Based on 214 Level.85%. Interest Expense Interest Expense Arising from Forecasted Short Term Debt. Straight-line.75% Interest Rate Based on Highest Rate Outstanding in Q Taxes Straight-line 13% According to Historical Tax Rates. 17% in 217 and Thereafter Based on Novatek's Guidance. Shares Outstanding No Share Issuance, Stock Repurchase, Stock Based Compensation in Forecast Period. Balance Sheet Accounts Assumptions Cash & Equivalents Obtained from Forecasted Cash Flow Statement. Accounts Receivable Increased with Revenue Growth. Embedded with Team Estimation of Days Sales Outstanding. Inventories Increased with COGS Growth. Embedded with Team Estimation of Inventory Turnover. Other Current Assets (inc. other receivables, prepaid expenses) Increased with Revenue Growth. Embedded with Team Estimation of Other Current Assets as a Percentage of Sales. Long Term Securities Investments Straight-line Investment Amount Based on Historical Trends. Capital Expenditures Forecasted Using Team Estimated Percentage of Revenue. Followed Novatek's Guidance of Increasing CAPEX Once in Three Years. Depreciation Forecasted as 3% of Capital Expenditures in CAPEX Increasing Years (215, 218). 1% in Other Forecasted Years Based on Historical Trends. Purchases of Intangible Assets Straight-line Investment Amount Based on Value in 214. Amortization Straight-line Amortization Amount Based on Value in 214. Other Non-current Assets (inc. Deferred Straight-line Assets Amount Based on Value in 214. tax assets) Short Term Debt Expected the Repayment to be the Same as Issuance Each Year to Maintain Short Term Debt Value Equal to that of Q Accounts Payable Increased with COGS Growth. Embedded with Team Estimation of Days Payable Outstanding. Accrued Expenses & Other CL Increased with Revenue Growth. Embedded with Team Estimation of Accrued Expenses & Other CL as a Percentage of Sales. Long Term Debt No Long Term Debt Borrowing in Forecast Period. Other Non-current Liabilities (inc. Straight-line Liabilities Amount Based on Value in 214. Deferred Tax Liabilities) Common stock / additional paid in No Share Issuance, Stock Repurchase, Stock Based Compensation in Forecast Period. capital Dividends Straight-line 77% Dividend Payout Ratio According to Previous Years' Average. Other equity, comprehensive income Straight-line Other Comprehensive Income Based on Value in 214. National Chengchi University 14

16 Appendix 6: Display Driver IC Industry 1. Supply Chain IC Design Foundry Assembly and Test Upstream Mid-stream Lower-reaches Industry IC Design IC design is the process encompassing the particular logic and circuit design techniques required to design ICs. It can be roughly divided into two broad categories of digital and analog IC design. Digital IC design is to produce components such as microprocessors, RAM, ROM and flash. Analog IC design is used in the design of op-amps, linear regulators, phase locked loops and active filters. Currently the market is dominated by United States, Taiwan and China s manufacturers. Foundry A foundry refers to a factory where ICs are manufactured. The central part of a foundry is the clean room, which contains the steppers for photolithography, etching, cleaning, doping and dicing machines to produce ICs based on the design provided by IC design houses. Currently, Taiwanese foundries such as TSMC and UMC are the major players in the market. Assembly and Test The final stage of semiconductor device fabrication is assembly and test, in which the tiny block of semiconducting material is encased in a supporting case that prevents physical damage and corrosion. The test part is a two-phase process. In the first phase (Wafer Acceptance Test), the electrical characteristics of wafer will be tested to ensure the quality. In the second phase, the functionality of completed ICs will be examined. 2. Novatek s Major Suppliers Process Supplier Description Foundry (1) #2 wafer foundry company worldwide, second largest for DDIC (2) Used to be the largest shareholder of Novatek (1) #8 wafer foundry company worldwide, largest for DDIC (2) Pure 8 foundry business (3) Clients include Novatek, Himax, Sitronix Backend (1) World s largest DDIC back-end service provider, with around 4% market share in 8-inch gold bumping service (2) Over 9% of 214 revenue exposed to DDIC (1) #2 DDIC backend provider National Chengchi University 15