Description

Pro forma for the near-term completion of the recent Google deal, HTC is trading at an EV of just US$100m (TWD 3b).  It is true that the company has been recently going through a very rough period in its smartphone business, but HTC is also the creator of the best virtual reality (VR) headset on the market (the HTC VIVE).  VR was heavily hyped in 2016 and the expectations have since come down considerably; no one really knows how big VR will ultimately end up being or what applications it will have in the world, in gaming and beyond.  But still, a US$100m EV for a VR leader seems too cheap.

Company snapshot

HTC is primarily known for making Android-powered smartphones.  Over the past 6 years, HTC struggled as the smartphone business came under increasing competition from Samsung and low-cost Chinese suppliers; HTC’s total gross margin fell from 30% to around 12% currently.  HTC went from making TWD 70b in operating profit at its peak in 2011 to a current LTM operating loss of about TWD 12bn; cash burn is closer to TWD 10b due to a negative working capital and capex coming in below depreciation.  Realizing that the once profitable smartphone business is on a burning platform, HTC’s management is pushing to gradually exit that segment and refocus towards virtual reality (VR) and specifically, the VIVE product that it developed jointly with Valve Software and launched in April 2016.  Overall, around 50% of HTC’s revenue is derived from own-brand phones and tablets, 30% is from manufacturing the Pixel phone for Google, and the remaining 20% is VR (virtual reality).   

Situation overview / recent events

The company has an employee base of ~17k, of which ~4k are R&D staff; half of the R&D staff are tightly integrated with Google and are dedicated to the Pixel phone.  In September 2017, HTC reached an agreement with Google whereby the ~2k Pixel-focused R&D staff will become Google employees; in addition, Google will gain a non-exclusive license to some of HTC’s IP.  In return, Google will pay HTC US$1.1b (TWD 30b); the deal is expected to close by end of Q1 2018.  For the foreseeable future, HTC will likely continue to make the Pixel for Google, but HTC is effectively relinquishing any ambition to develop cutting-edge smartphones.  In my view, it is highly probable that HTC will completely exit the smartphone division at some point in the future.  In the meantime, the Google deal enables HTC to cut operating expenditures by 35%.  Pro-forma for the Google deal, HTC is currently trading at a P/TBV of 0.76x (see below).

The market has given the company up for dead.  Any further declines in the stock price would mean the EV (enterprise value) is basically zero.  Sell-side sentiment is negative; many analysts are not even bothering to dial in to the earnings calls for Q&A.  Given the low expectations, I believe room for future upside is substantial.  Here is a more positive way to look at HTC:

·       A pure-play, VR-focused company, essentially in start-up mode

·       …with US$1.6 billion in cash and a flexible balance sheet

·       …run by an experienced management team with significant skin in the game

·       …that managed to develop VIVE, the best VR headset product in the market

·       …in direct partnership with Valve, which runs the Steam gaming platform with 125m users

VIVE was launched in April 2016. Some background on VIVE is available here (https://techcrunch.com/2016/04/05/review-htc-vive/) and here (https://thedroidguy.com/2017/10/htc-vive-vs-oculus-rift-best-vr-headset-comparison-1076260).  VIVE currently sells for about US$599, but this excludes the sunk cost of a high-end PC rig.   The consensus is that the VIVE is the best VR headset on the market today.

2016 was a period of intense excitement around VR; Facebook’s Oculus Rift and the VIVE were both launched in Q2.  However, low sales figures, the high price tag for the device and lack of a compelling ‘killer app’ has dented the excitement.  In Gartner parlance, VR has passed the ‘peak of inflation expectations’ and is currently languishing in the ‘trough of disillusionment’.

Despite this inauspicious start, various research providers expect the VR market (loosely defined) to grow at a >50% CAGR over the next 5 years.  I do not ascribe particular weight to these forecasts given all the uncertainties around the VR space and the ultimate applications, but still, it’s unclear to me why HTC, the maker of the best VR product on the planet, should trade below the replacement value of its assets, with a de-minimis EV.  I do not know what HTC should really be worth, but it seems it should be worth more than the current price. How big could VR really turn out to be for HTC?

Assuming a stable price point of $599 for the VIVE, zero software / subscription revenues, full exit from smartphones, and a 15% margin on the VIVE hardware, to break even on the companywide opex post the Google deal, HTC would need to sell 4 million VIVE headsets per annum; this is 4x-5x the current annual run-rate.  I do not know whether this number will ultimately end up being too low or too high, but given how few games or non-entertainment applications have been released to the market so far and yet HTC still sold 1 million VIVE units in the 15 months since release, the 4 million number could be attainable if more exciting content comes out.  HTC should also be able to redeploy management focus, R&D personnel and production capacity away from smartphones and towards VR, reaping efficiencies in VR manufacturing and working to reduce the price of the headset.

A useful way to think about VR potential is the 'attach-rate'. A "must-have" videogame title can have a 25% attach rate to the console installed base that it is released on.  Sony sold 20 million PS4 consoles in the latest fiscal year as well as 1 million PS VR headsets; total PS4 installed base is about 60 million, implying a 1.6% 'attach rate' of PS VR to PS4. Intel estimates that there were 711 million PC gamers globally in 2014. If we restrict the VR market purely to PC gaming and assume that annual VR sales in the medium term hit 10 million, that’s a VR ‘attach rate’ of 1.4% relative to a PC gamer base of 711 million. HTC would then have to take a 40% share of VR headsets to move 4 million units annually. I am conflating apples and oranges (periodic sales with a cumulative installed base), but given the lack of other hard data, the example could still prove useful.

Another way of looking at HTC’s VR upside is by focusing on its partnership with Valve, the owner of the Steam gaming platform.  Steam is the largest publishing platform for PC games and is a major reason why physical retailers such as GameSpot are struggling.  Although some large studios view Steam as a competitor and are circumventing it through their own online stores (e.g. Activision Blizzard with the Destiny series and Overwatch), Steam’s position as a core player in the PC gaming ecosystem is likely secure.  Just as Youtube enabled unknown artists to be ‘discovered’ and market themselves, Steam is a crucial outlet for smaller developers that want to market their games in a viral fashion. e.g. Playerunknown’s Battlegrounds went from a standing start to the most popular Steam game in the past 6 months, with over 2 million daily players currently.  Steam also increasingly functions as a community and social network, with players cultivating friend lists, groups and trading game items.

Why is the Valve partnership important for HTC?  First, in PC gaming - which is a logical market for VR - Steam is huge.  Steam has 125 million total active users, and about 30 million daily active players.  Second, the VIVE is prominently featured in the SteamVR and Steam Hardware sections of Steam, which gives HTC a compelling advantage in marketing the product and lowering customer acquisition costs (CAC).  As new and compelling VR content is released by developers/studios (as well as potentially developed by Valve internally, e.g. perhaps a new Half Life game will be VR-enabled), Valve has the most effective means of cross-marketing the VIVE.  Third, HTC and the VIVE are of strategic importance for Valve as a bulwark for countering Facebook/Oculus.  The Oculus is currently ‘losing’ the VR race; the product is inferior and the installed base is believed to be significantly lower than VIVE’s.  

Conclusion

It is hard to figure out HTC’s fair value with any reasonable degree of precision, but a US$100m EV (current level) feels way too low given the VR technology and partnerships (Valve/Steam) that HTC has the keys to.  If HTC ends up being valued at say 1.0x P/TBV (a Foxconn multiple; note that HTC's balance sheet is a lot more cash rich than pretty much any other Taiwanese manufacturer), that’s 30% upside from current levels; whether it can go any higher will depend on whether HTC can come back to the market and paint a sufficiently compelling vision of generating a profit from growing VR volumes; this would push the market to value HTC on a sales multiple, which is currently below 0.1x; the upside thus could be substantial. Given the uncertainties, still, very modest sizing is appropriate.

Catalyst

(i) the closing of the Google deal by end of Q1 2018; (ii) a steady stream of new VR releases such as the VR versions of major game titles such as Fallout 4 and Doom; (iii) HTC striking partnerships with non-videogame companies to demonstrate uses of VR in other industries such as medical, education, manufacturing, and other segments, giving sell-side some cover to shift the narrative.