AUO 3Q19 Earnings and Financial Challenges
AUO 3Q19 earnings were worse than expectations due to continued average sales price pressure ("ASP"). LCD ASPs are suffering from the Chinese LCD capacity expansion. AUO is primarily a supplier of commodity LCD panels. We have previously detailed that AUO's R&D spend lag peers. This is the opposite of management's message on product innovation and differentiation.
We had estimated AUO would have lost $(125M) USD in Q3 versus the actual loss of $(140M) USD. Every metric was unfavorable and gross margin was negative for the first time since 2012.
AUO Forecast Risks
AUO’s ASP will continue to face pressure due to a glut of Chinese LCD supply and because AUO has not kept pace with competition for fab efficiency (i.e. generation growth). For example, all other panel suppliers will increase the average generation size from 2010 to 2024. AUO's underinvestment will add increased pressure on its margins and balance sheet.
AUO may consider the following strategies:
- Closing one, or more, LCD fab and reducing fixed costs. This would help balance industry oversupply and slow margin pressure.
- Focus on LCD sales as other panel suppliers transition to OLED. LCD prices may stabilize as LGD, SDC, and BOE convert LCD capacity to OLED.
- AUO may consider business funding. Our conservative financial modeling projects a cash crunch starting in 2022.
- Convert fab(s) to OLED to shift a larger percentage of the sales mix to OLED.
Option four is the most likely in our opinion because the other solutions are temporary for the structural shift to OLED. However, it will be challenging and costly for AUO to convert production to OLED because ~1% of AUO’s current capacity is OLED. AUO lacks experience successfully ramping OLED capacity. Management should be more assertive in detailing long-term business strategy.
Another pure LCD supplier highlight the risks AUO faces. Japan Display (“JDI”) is considered as a going concern (e.g. potential bankruptcy). JDI recorded an operating loss for two consecutive years, and a net loss for five consecutive years. JDI also has a lower average generation size versus AUO. To try resolve its present situation, JDI has selected a new strategic partner with the aim of establishing OLED display mass production technology and accelerating the commercialization of OLED displays.
Our proprietary should-cost model details that with healthy yields OLED is cheaper on a materials basis versus LCD. OLED requires less glass, no backlight, and reduced polarizer usage. Long-term the consumer sales mix is shifting to OLED. However, a new OLED fab, equivalent to 25% of AUO’s current LCD production, would cost an estimated $4.5B to $7B USD (i.e. Gen 8+ TV Oxide fab ).
AUO’s Valuation
We analyze AUO’s estimated free cash flow under its current business model and under a second scenario.
Under the current business model, AUO will need competition to shift to OLED to improve LCD margins (via price stabilization and continued cost savings). Additional reasons for the OLED expansion are age of AUO's LCD lines, likelihood of negative LCD EBIT going forward due to pricing pressure, and lack of differentiation and scale versus the Chinese suppliers.
Under the second scenario we valued AUO using a discounted cash flow method by assuming ~25% OLED production and assuming a healthy OLED EBITDA margin of 33% in 2024. The analysis highlights that AUO should shift supply to OLED in order to improve its operating cash flows. When we model the business with 25% OLED by 2024 the business is fairly valued versus the current market cap of $2.4B. Therefore, it is hard to be excited about AUO for both an investment perspective and a strategic panel partner.
AUO Financial Implications
This is an excellent period to negotiate component purchase agreements with panel suppliers. Sourcing, engineering, and investment teams obtain full access to our financial models, research reports, and our services. The subscription should-cost model details the cost of OLED and LCD panel sizes based on the individual panel's input materials, overheads, yields, and profit margin.
If you are considering purchasing from AUO component pricing should be aggressively negotiated and there should be assurance of a dedicated engineering team. We recommend using our should-cost model and industry capacity analytics to understand suppliers’ actual cost structure during negotiations for increased customer insights.
