Fingerprint Cards Q2 – Another strong one (longer version)2016-07-22 14:32
FPC reported revenues of SEK 1,666 million, four percent below our expectations as well as consensus, more importantly though, gross margins came in almost as strong as in the first, 48.8 percent, quarter and exceeded our expectations of gross margins at 46.9 percent. Whilst earnings missed consensus, the gross margin as well as EBIT margin beat consensus as well as our estimates, underlining FPC's strong profitability.
We had expected a less favorable product mix to result in a gross margin of 47 percent and the company beat our estimate by 2 percentage points. In our estimates, we had pinned in a positive currency effect of SEK 50 million to contribute to EBIT of SEK 733 million. The currency effect was a positive SEK 36 million and EBIT was 710 million - slightly below our expectations but still very strong. The administrative costs were higher than we thought, close to SEK 35 million versus our estimated SEK 21 million whilst both sales costs and development costs were in line with our expectations.
Clearly, the market has underestimated the gross margins of FPC whilst overestimating sales. The company attributes the strong gross margins to a favorable product mix compared to a year earlier, where an increasing demand for smaller sensors is specifically pointed out. We believe this is not the whole truth. If we are not completely wrong, the second quarter should have seen a considerable share of the larger sensors that Huawei has incorporated in most of its smartphones, especially the 1025. The larger sensors (1025 and 1021) should have lower gross margins than the smaller sensors (for example 1035 and the upcoming 1028). Naturally, compared to a year earlier the sensors are smaller, but not necessarily compared to Q1. We believe another key contributor, apart from the smaller sensors, to the strong gross margin is the operational improvements – especially increased production at 300 mm fabs and at TSMC’s large 8 mm fab.
Going forward additional improvements in the manufacturing process as well as an increasing share of value add from proprietary solutions will support the gross margins. The use of the in-house algorithm for an increasing share of the sensors shipped – not least for the P9 and P9+ flagships from Huawei – likely has had some effect on the gross margin, though the entire effect will not show in a single quarter as the phase out of the algorithm involving Precise Biometrics will be gradual.
The mobile device segment in China is growing fast but seasonal swings are big
As for the sales figures, FPC started to point out the seasonality in the mobile device segment in connection to its Q1 report and continues to do so in today’s report. The seasonality is somewhat overshadowed by the rapidly growing sensor penetration and FPC’s market share gains. When the growth of fingerprint sensor shipments to the mobile device segment slows – which it will when the increased penetration contributes less – the seasonality will be more accentuated.
As we know, FPC is heavily exposed to the mobile device segment in Asia and benefits from the growing market shares of Chinese smartphone brands.
Year-over-year the Chinese cell phone production grew by 19 percent in March, 21 percent in April and 24 percent in May. The accelerating growth shown during the spring points to a healthy underlying market for FPC despite reports of a slowdown in global smartphone sales growth.
Ramping up for new verticals and products with added capacity from TSMC and stronger organization
FPC now confirms that it is running production at TSMC. Great news, although we have already accounted for it in our model. We became certain that TSMC was FPC’s new foundry partner as it needed to fill up the open capacity after Apple cut its production of fingerprint sensors for the Iphone 6 at TSMC’s 180 nm process. We also noticed how samples of the FPC1320, a thin sensor adapted from smart cards, has shipped between India and Taiwan. Recently we also noted sample shipments of FPC1321-AP. We believe FPC is developing solutions where it can supply a complete biometric platform or sub-system for the smart card market and we expect FPC to provide more clarity on the development towards the end of the year or so.
Additional capacity will also be needed if we are right in our belief that FPC’s smaller sensors will be incorporated in the mid-range and low-end smartphones from Samsung. Another customer that we would very much like to see is Micromax, one if India’s leading smart phone OEM’s that we believe now use sensors from FPC’s Chinese competitors, mainly Silead.
As guided, FPC is capitalizing more development costs. The trend from 2015 with decreasing non-tangible assets in the balance sheet has clearly reversed, and we are seeing a situation similar to that in 2014 prior to the major breakthrough in the mobile device segment. The mobile device segment is characterized by short product cycles and development times compared to most, if not all, other verticals.
The organization is growing at a rapid pace and FPC had 245 employees at the end of June, a 31 percent increase in the quarter. The number of consultants declined by 14 percent taking the total headcount (employees and consultants) to 345, up 14 percent during the quarter. The ability to grow its organization and find the right people is key for FPC and one of the major challenges. It is therefore very positive to see that FPC managed to grow its organization at a pace higher than we expected, especially the huge increase in employees. The organizational ramp up is another strong indication of an accelerating growth rather than an imminent peak to be followed by a rapid decline.
Our take is that we can expect new solutions and increasing sales in new verticals in the years to come, though the exact time when the new verticals will really take off is hard to judge – we will elaborate more when we release an updated analysis.
Healthy cash-position will allow additional share buy backs
Although we have not shared any detailed projections on the quarterly cash flows and typically will not do so, we wish to mention that we were positively surprised by the cash flow during the quarter. FPC reports cash flow from operating activities, excluding effects of exchange rate changes, of SEK 530 million. We expected Non-Cash Working Capital (NCWC) to increase more given FPC’s willingness to leverage its strong financial position as a mean to become a more attractive partner for customers and suppliers alike.
Rather than the increase we had expected, NCWC stayed constant at SEK 261 million in absolute terms and decreased from 17 percent of net sales to 15 percent of net sales compared to the previous quarter. The strong cash position will allow FPC to buy back additional shares which would act as a catalyst to close the price-value gap that we see at the current share price.
Updated guidance narrowing the interval
FPC narrows its full year guidance to SEK 7.2 - 8.3 billion SEK - we believe net sales for the year will end up close to the upper limit of the range and we would have liked to see a guidance of SEK 7.5-8.5 billion rather than a narrowing with a virtually unchanged mid-point, see below for an elaboration on that. The SEK 1 billion range between the high limit and low limit is not dependent on a single, large impact digital event, rather it is a consequence of several factors. We believe the most important swing factors at this stage are the time of product launches from OEMs, inventory build-up at the module houses and the sales figures for the FPC-inside devices. Especially Huawei’s sales figures as Huawei is FPC’s largest OEM customer. We would not be surprised if the P9 and P9+ has sold a little bit below expectations in Q2, but we will have to look into it more – nonetheless, Huawei sound bullish on the sales prospects for the remainder of the year despite some speculation to the contrary from Asian sources like Digitimes (which are not always the best sources when looking for unbiased information).
Apart from narrowing the range, FPC now base its guidance for the remainder of the year on a USD/SEK exchange rate of 8.4 rather than 8.3 that was used for the guidance in connection to the Q1 report. Essentially, in terms of sales in USD, this means that the upper limit of the interval for the full year guidance is adjusted by -2.9 percent for the full year as compared to the previous estimate and the lower limit is raised by 2.4 percent. Taking the midpoint of the guidance in USD terms the new guidance is 0.5 percent lower than the guidance from April.
As we have pointed out, we expect revenue growth to accelerate quarter over quarter with close to 40 percent top-line growth from Q3 to Q4. Today's report was a sign of strength and overall in line with our estimates. Furthermore, gross margins should increase further – a key event was Huawei’s recent launch of a smartphone with FPC’s smallest sensor to date, apart from announced 1028, namely the 1035. As Huawei shifts to smaller sensors the ASP will continue to go down, but the gross margin will increase further, all other things equal.
Reiterated fair value range and positive outlook
We reiterate our fair value range of SEK 64-326 per share with a fair value in our base case of SEK 201. As of now we do not anticipate any major changes to our estimates going forward in either direction, neither for the remainder of 2016, nor for the years to come to come.
The share initially took a dive this morning – not mandated at all given the strong report and the positive signs found when taking a closer look at the report. Now the share is up some three to four percent – a more logical reaction to a strong report.
Finally, given that this is Lantto’s last report as CEO of FPC, we suspect the SEK 1666.1 million in revenue might have something to do with Lantto’s passion for hard rock – 1(666)1 – clearly he has sneaked-in a reference to Iron Maiden’s “The number of the beast”.
We will come back with a more comprehensive update within the next few weeks.
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