Pegatron Corp:Hold,iPhone build to drive 2H,despite weaker 2Q

2Q margins weaker than expectations. Reported 2Q17 net profit of TWD3.4bn wasdown 11% q-o-q and 14% y-o-y. While the number came in stronger than HSBCe andconsensus by 12-14%, margins were weaker-than-expected. 2Q GPM/OPM of4.6%/1.8% was lower than consensus of 5.3%/2.2% (HSBCe: 5.2%/2.3%) and downfrom 5.0%/2.3% in 1Q, despite similar revenue scale. Management attributed the weakermargins to initial costs incurred for new NB and consumer electronics projects, as well asincreased labor costs owing to salary hikes and recruitment costs ahead of the newiPhone production ramp up. At the OP level, the reported number missed consensus by12%. That said, a lower tax rate of 24% (vs HSBCe/consensus at 33%+), driven by lowertax paid by key subsidiaries, was more than offset.

    Seasonal strength and new iPhone build to drive 3Q, yet further visibility is limited.

    Guidance for 3Q is for NB units to grow by 20% q-o-q, while seasonal strength and thenew iPhone build should drive non-computing sales growth. All in, we forecast 3Q salesto grow by 43% q-o-q and 9% y-o-y. While July sales of TWD93.9bn (up 17% m-o-m and14% y-o-y, driven by consumer electronics) accounted only for 27% of our 3Q salesforecast, we expect momentum to skew heavily towards September, in light of the newiPhone launch. We also expect margins to improve on better scale and operatingleverage, although we note that labor shortages, component supply constraints and initialcosts for new project development are potential swing factors for margins. Just as othernames in the iPhone supply chain, we expect the majority of earnings to come from 2Hfor this year; our 2H forecast accounts for 54% of FY17e sales and 67% of net profit.

    Maintain Hold, TP rises to TWD90 from TWD84. We trim our FY17/18e by 3-4%,mainly to reflect lower margin assumptions in light of labor and project development costs.

    Our TP is now set at TWD90 (was TWD84), based on 10x (was 9x) FY18e (roll forwardfrom 2H17-1H18e). We raise our target multiple given Pegatron’s dominance in the new4.7” iPhone, expectations for a strong iPhone cycle, as well as improved sentiment forgrowth outlook of iPhone. 10x is the mid-cycle valuation since FY15, when iPhonegrowth started to normalize and is also more in-line with where the supply chain aretrading (9-11x). To play the new iPhone theme, we prefer Hon Hai (2317 TT, Buy,CMP TWD116) for better earnings visibility. We would turn more constructive aboutPegatron if Apple deploys an aggressive pricing strategy for the new 4.7” iPhone toexpand the addressable market or when Pegatron gets to bundle more componentsinto the assembly business to drive better margins.