Update: VTech's profit for the six months ended September 30, 2016 fell 29% year-on-year to $71.4 million, slightly better than we expected, as Leapfrog's loss was smaller than expected.
Management reiterated the turnaround schedule for the newly acquired Leapfrog business. The company acquired the Leapfrog business in April 2016, which contributed $64 million in sales to 1HFY17 and a net loss of $25 million. Excluding the impact of Leapfrog, the company's overall sales fell by about 1 per cent year-on-year and profits fell by 4 per cent. Leapfrog's losses are expected to narrow in the second half of the current financial year, and management reiterated its goal to achieve Leapfrog's break-even during the next financial year, that is, the fiscal year ending March 31, 2018.
The performance of each business segment is differentiated. E-learning products (ELP) continued to contribute most to the company's sales and profitability in the first half of the fiscal year. With the addition of Leapfrog sales, the company's ELP sales increased to $366 million (up 19% from a year earlier). Sales excluding Leapfrog,ELP fell 2 per cent year-on-year. Contract production service income (CMS) maintained steady growth, with an increase of 11% over the same period last year. As the home wireless phone market in Europe and the United States shrinks further, telecommunications products remain the company's weakest link, with sales down 12% from a year earlier. Due to changes in the product portfolio (ELP gross margin is the highest of all business lines), the company's gross margin rose slightly to 31.9% (up from 30.8% in the same period last year).
Increase the proportion of dividends. Management cut the company's dividend in the last fiscal year (for the year ended March 31, 2016) to retain cash and pay full cash for the $72 million acquisition of Leapfrog. In the first half of the fiscal year, the company reported an interim dividend of $0.17 per share, the same as last year, despite a 29% year-on-year drop in earnings. This means that the dividend ratio is 60% (compared with 43% in the same period last year). The company's balance sheet remains solid, with net cash of $104 million (year-ago period: $105 million).
Business prospects. Management expects overall revenue to increase for the full year, while profitability will improve in the second half of the year, driven by the Christmas sales season. We raised FY17's net profit forecast to $149 million (up 15 per cent from our previous forecast of $130 million) to reflect Leapfrog's smaller-than-expected loss.
Maintain the "hold" rating: reasonable valuation, once again become a high-coupon stock. With the devaluation of the renminbi, the company's share price has risen recently (the company's factories are located in the mainland, thus benefiting from the depreciation of the renminbi), which is now valued at 20.7 times FY17 forecast earnings. Compared with global toy companies Mattel (MAT US, unrated) and Hasbro (HAS US, unrated), we consider the company's valuations reasonable, which are currently valued at 23.6x and 20.3x, respectively. Based on our adjusted earnings forecast and a target price-to-earnings ratio of 20 times, we set a new target price of HK $92.00 (previously HK $72.56). Assume that the annual dividend ratio for the current financial year is 100%, and the company's dividend yield is about 5%.
The main risk. The main downside risks include that the UK Competition and Markets Authority (CMA) investigation into the merger of the company and Leapfrog may produce adverse results for the company.