科大讯飞(002230)

iFlytek has made sizable R&D investments but we expect itto offer thin returns in 2018-20, despite a strong audiointelligence TAM growth outlook in China (45% CAGR). Thestock trades at 85x 2019e PE or 5.1x PEG, which looks rich.Initiate at UW.

China's audio intelligence market booming but competition heating up - China is thefastest growing audio intelligence market worldwide and we forecast it to see a 45% CAGRin TAM in 2018-20, with the TAM reaching US$5.2bn by 2020e. iFlytek offers products forsmartphones/PCs, education, automotive, smart home, and leads in the China market forvoice recognition and audio intelligence technology with 40%+ market share. However, thecompetitive landscape is becoming more fragmented, especially as large internet companiesare starting to offer strong technology and talent resource support.

High R&D could cap returns: In 2018, iFlytek invested more than 20% of its annual revenuein technology development and increased its R&D employees by 25% to 7,200. As 50% of itsR&D input is booked under expenses with the remainder capitalized, this could pressure itsoperating profit and FCF generation in 2019-20. The operating profit contribution peremployee in 2017 was 38% lower than in 2015, and we estimate another 62% drop in 2018.We forecast this will result in operating margins falling to 5% in 2019e from 8.6% in 2017 andits FCF to be negative Rmb186mn in 2019e, from positive Rmb553mn in 2017.

Market appears overly bullish on iFlytek's profitability: The market appears excited aboutthe various potential uses for audio intelligence in the consumer segment and the growthpotential over the next five years for it and the related supply chain, which includes iFlytech.However, we do not think the market has factored in the challenges iFlytek faces from lowerprofitability, stretched FCF management, and rising competition, especially in the consumersegment. Our 2018-20 earnings estimates are 35-40% lower than consensus.

Rich valuation not justified; initiate at Underweight: iFlytek trades at 85x our 2019e EPSand 5.1x PEG in 2018-20, a significant premium to global peers' median at 24x and 1.4x PEG.We think its investments will take time to bear fruit and, given stretched valuations, any disappointment is likely to have a significant impact.