Dahua:Earnings recovery,initiating with Buy

Initiating coverage with Buy and target price of CNY17.3.

    We initiate coverage on Dahua, the #2 video surveillance manufacturer inChina, with a Buy rating and a target price of CNY17.3, based on 20x 2017EP/E. We expect Dahua’s earnings to re-accelerate after the severe marginerosion during in 2014/15. We expect smart city solutions, IoT applications andoverseas expansion to generate strong top-line growth and market share gainswhile margins stabilize. Dahua currently trades at 17x and we expect themultiple to expand, supported by earnings growth of 31%; Buy.

    Beneficiary of IoT proliferation.

    The video surveillance industry is expanding rapidly, driven by the rise of IoT,particularly in the areas of traffic monitoring and public safety in smart cityimplementation. Market research firm, Frost & Sullivan, has estimated thesmart city market for products and service revenues to be US$1.5tr in 2020.

    Fast expansion of its overseas business.

    Dahua has accelerated its overseas business expansion through ODM ordersfrom global security companies (e.g., Honeywell). As the industry consolidatesto offset severe price erosion, there are clear incentives for global securitiescompanies to outsource to stay competitive. Combined with Dahua’s ownoverseas expansion from establishing offices in each continent, managementexpects the overseas business contribution to expand from 39% in 1H16 to45% in 2018E.

    Margin pressure to be alleviated.

    Dahua's margin has been driven lower over the past five years, due to pricingpressures and its strategic transition. However, over the past nine months,there has been clear evidence of stabilization, with improving economies ofscale and the increasing contribution of service/operation revenue. We forecasta sustainable level of over 10% for the next two years.

    Valuation and risks.

    Our target price of CNY17.3 is based on 20x 2017E P/E, supported by 2016-18earnings CAGR of 31%, average ROE of 27% and solid industry growth. Ourtarget P/E multiple is lower than its historical average P/E multiple of 31xduring the past three years. Risks: market share loss, weaker orders and higherlabor costs.