Creative Technology - DBS Research 2018-03-01: Game Changing Portable 3D Audio

Creative Technology - DBS Vickers 2018-03-01: Game Changing Portable 3D Audio

CREATIVE TECHNOLOGY LTD C76.SI

Creative Technology - Game Changing Portable 3D Audio

Creative Technology’s latest innovation, the Super X-Fi dongle offers a portable 3D audio experience to users.
First mover advantage and Virtual Reality applications to drive demand.
Fair value of S$5.56 based on 0.5% share of the global headset market by FY20 and an EV/Sales of 1.04x.

We came back impressed with the 3D sound experience via headsets.

Creative Technology’s latest innovation, the Super X-Fi dongle, is a plug-and-play technology capable of delivering a 3D listening experience via headsets. 3D audio provides the perception of spatial sound, which closely resembles how humans hear in real life. The Super X-Fi dongle would be compatible with headsets, smartphone or consumer entertainment devices and is expected to be released in mid-2018 at a retail price of US$150.

Creative will also launch a free app with limited functionality and targets to reach 50m customers in 2-years. Besides, the company will also license the technology to other players.

First mover advantage coupled with use cases in Virtual Reality (VR) and Gaming to drive demand.

Whilst some players claim to provide 3D audio experiences via headphones, none of them features the plug-and-play capabilities and the customised listening experience of Super X-Fi in our knowledge.
The plug-and-play feature would also be of strong appeal to the VR community. This coupled with the augmented user experiences in gaming and watching movies should drive demand from the premium headset users.

We derive a fair value of S$5.56 per share under our conservative base case scenario.

We assume that Super X-Fi would be able to capture a 0.5% market share of the global headset market in FY20 (June YE) , resulting in sales of US$232m. We derive an EV of US$242m at an EV/Sales of 1.04x, at a 40% discount to recent acquisitions in the audio tech space.
Our bull-case fair value is S$8.10 assuming 0.8% market share.

Key risks.

Inability to replicate the test-lab results in real-life or negative online reviews. Our bear-case fair value is S$3.01.

INTRODUCTION

Leading innovator in the digital entertainment space.

Creative Technology, founded in 1981, has long been a leading developer and manufacturer of digital audio products.
The company is well known for its “Sound Blaster” sound card, one of the first dedicated audio processing cards made available to general customers. The product became the defacto sound card for Personal Computers in the 1990s before declining in the early 2000s with the integration of audio capabilities in to motherboards. Since then, Creative Technology has expanded its portfolio of audio technologies and hardware and has ventured into different entertainment and technology segments, including personal MP3 players, development of gaming accessories and Stem-cell processors.

Audio products, which account for bulk of revenues, have come under pressure.

Audio products, including speakers, headphones and audio technologies account for ~90% of the company’s topline while revenues derived from personal digital entertainment items such as cameras and gaming accessories contributes ~6%.
Revenues from audio products, however, have contracted at an average of 15% annually from 2014- 2017 due to stiff competition in the market place from new entrants in the premium segment and proliferation of cheaper alternatives from Chinese manufacturers. Creative Technology has worldwide operations with the Asia pacific region accounting for ~54% of the company’s topline.

REVENUE DRIVERS

Super X-Fi technology could be a much needed lifeline for the company.

Creative Technology’s latest innovation, a plug-and-play technology capable of delivering a 3D listening experience to users, could provide a much needed boon for the company.
3D audio - Unlike traditional stereo or surround sound systems, it is not channel-based and hence does not have to approximate the location where sound channels originate from. Stereo sounds use two channels while surround systems use multiple but a limited number of channels to provide an immersive experience to users. 3D audio, on the other hand, offers the perception of spatial sound to listeners (by using an infinite number of channels) which closely resembles how humans hear in real life.
Super X-Fi technology is powered by a chip fitted into a dongle that is capable of being plugged into the headphone to create a truly immersive experience and customise the listening experience based on the features of the listener. The company uses pictures of the ear canals and the face structure of the user, captured through its smartphone app, to map out the distinct anthropological features of a user. These features are then merged with the acoustics of a three-dimensional space to offer a personalised audio experience to the user.
According to the company, the dongle would be compatible with smartphones and other entertainment devices such as PS4, Xbox and smart TVs etc and is expected to be retailed at US$150.
Creative Technology expects to devise its own headset equipment integrated with the 3D audio technology while extending the use of the technology by third-party ear phone and headset manufacturers. The dongle is expected to be made available to customers for use with their own devices by mid-2018.

3D audio is a key component of a Virtual Reality system.

Audio is expected to play a key role in delivering a fully immersive Virtual Reality (VR) experience and a portable headset capable of delivering a 3D audio experience has long been touted as an ideal option for VR devices. The Super X-Fi dongle, which necessarily acts as a plug-and-play device enabling any headset to deliver a 3D audio experience, could greatly appeal to the VR community and VR content developers.
Creative Technology could likely capitalize on the surging demand for VR hardware, shipments of which are expected to reach 100m by 2021 growing at a CAGR of 58% from FY16-21, according to IDC.

New product lines would further offset losses in existing products.

Creative Technology continues to expand its product line with the introduction of ~4-5 audio and personal entertainment products annually, offsetting losses in existing products such as MP3 players, sound cards and webcam accessories which are on decline. Creative Technology also caters to the premium market with products such as X-Fi Sonic Carrier, a high-end home entertainment system that offers a cinematic and 3D audio capabilities retailing at US$ 5,800.
These products often carry better margins, which help Creative Technology offset losses in low-end consumer segments.

COST STRUCTURE

Gross margins hover around 25%.

As a manufacturer and distributor of audio products, cost of sales account for the bulk of Creative Technology expenses. Cost of goods sold account for ~75% of the company’s topline and varies with the sales mix of audio products with high-end entertainment systems often yielding better margins.

Research and Development is a key cost center.

Creative Technology continues to invest ~20% of its topline, on average, on the development of new audio technologies and products, in a bid to remain competitive in a hyper competitive marketplace.
Relatively high R&D expenses has allowed Creative Technology to introduce ~4-5 products, on average, annually and support the development of the chip and the technology behind the Super X-Fi dongle, which could boost the company’s revenue profile in the long run. Creative Technology, however, has reduced R&D spending amid recent dips in performance.

KEY OPERATING ASSETS

Intellectual property remains a key asset for Creative Technology.

Creative Technology owns over 100 registered patents spanning audio technologies, graphics and processors, consumer electronics and etc, which remain a key operating asset for the company.
Ownership of intellectual capital in the audio tech space has allowed Creative Technology to continuously bring new products to market and remain competitive despite the hyper-competitive operating environment prevalent in the consumer audio entertainment industry.

Established distribution network across the globe.

Creative Technology products and solutions are marketed to consumers through a worldwide distribution network that includes traditional marketing channels such as retail shops and partnerships with original equipment manufacturers (OEMs).
The company has also established presence online with the online store maintained by Creative Technology and virtual stores on e-commerce platforms such as Amazon. The company operates an extensive, broad-based, multi-tiered channel distribution network in more than 80 countries with physical presence, and customer service centres in North America, Europe and Asia.
Creative Technology would be able to leverage its strong reseller and distribution network and established partnerships with audio-tech OEMs when bringing the Super X-Fi technology to the market.

GROWTH STRATEGIES

Super X-Fi dongle to be a key driver of growth.

We believe the technology behind the Super X-Fi dongle could be a key driver of growth for Creative Technology going forward. The ability to offer a customised listening experience to customers after taking into account the user’s features and the plug-and-play feature offered by the Super X-Fi dongle could greatly appeal to the premium headset user base while the 3D audio capabilities could attract the Virtual Reality community including content developers and hardware manufacturers.
The decision by the company to extend the technology for use by third-party headset manufacturers would further buttress revenue growth in our view through loyalty payments and higher device sales.

KEY COMPETITORS

OSSIC X –

OSSIC, a US-based audio tech company, offers a headset capable of delivering 3D audio capabilities. The headset is equipped with sensors that automatically calibrates to the individual listener’s head and ear features to offer a customized and an immersive listening experience to the user.
OSSIC X also features integrated head tracking technology for better VR performance. Headsets are available for pre-orders and each carries a price tag of US$299. Developer kits have already been shipped with the consumer version expected to be dispatched towards mid-2018. We believe the plug-and-play feature of the Super X-Fi dongle enables users to plug into their own headsets and the cheaper price tag (US$150 vs. US$299) could make the Super X-Fi more appealing to consumers.

3D Sounds Labs –

3D Sounds Labs, an audio tech company based in France, offers a headset equipped with 3D audio capabilities that works with the company’s smartphone app/windows drivers to offer 3D audio. 3D sound labs also offers a Bluetooth device that can be plugged into any headset and connected via the company’s app to deliver to offer virtualized 3D audio. The headset and the Bluetooth module are available for ordering and are priced at EUR 207.50 (~US$255) and EUR 82.50 (~US$100) respectively.
We believe that Sonic X-Fi would offer a better experience to customers with the customization of the listening experience to suit the anthropology of the user and the convenience offered by the lack of a need for connectivity with computer drivers or smartphone apps.

MANAGEMENT & STRATEGY

Company founder still leads the company.

Sim Wong Hoo is the founder, CEO and Chairman of Creative Technology. In July 1981, he founded Creative in the form of a computer repairs shop where he developed an add-on memory board for the Apple II computer. Following the success of this development, Creative began producing customized PCs adapted for Chinese language and PCs with enhanced audio capabilities to produce voice and melodies.
This audio interface led to the development of the company’s iconic "Sound Blaster": sound card. Mr. Sim Wong Hoo has led the company since inception in 1981 and has numerous patents registered to him.

VALUATIONS

Base case valuation is S$5.56 per share.

In our base case, we assume that Creative Technology would be able to capture 0.5% market share of the global headset market in FY20. This will take its users to 1.94m.
This will translate to ~4% of its targeted app user base of 50m. Popular apps like Spotify have paid to total user base ratio of 25-30%; our assumption seems conservative, in our view, if Creative can achieve 50m app users. Besides, extension of the technology to third party headset manufacturers would also result in some revenue which we have not factored in due to a lack of visibility at this stage.
A 0.5% market share in headsets through dongle sales at US$120 each (20% discount to retail price) will lead to FY20 revenues of US$ 232m. We value Creative Technology at an EV/Sales valuation of 1.04x, which is at a 40% discount to the valuations at which headset and audio tech companies have been acquired in the recent past.

Bull case valuation is S$8.10 per share.

Under our bull case scenario, we assume that Creative Technology would be able to capture 0.8% market share in the global headset market, backed by aggressive marketing campaigns and stronger than expected uptake of the Super X-Fi technology. This would result in FY20 revenues of US$372m from the Super X-Fi technology yielding versus base case of US$232m.

Bear case valuation is S$3.01.

Under our bear case scenario, we assume that Creative Technology would only be able to capture a 0.2% market share in the global headset market, due to the difficulties in ramping up production of the chip that supports the Super X-Fi technology and the proliferation of negative reviews of the product. This would result in FY20 revenues of US$93m from the Super X-Fi technology versus base case of US$232m.

Risk Assessment: High

Inability to replicate the test-lab results in real-life conditions.

This technology captures tons of data such as room & sound accoustics, headphone dynamics and human anthropometry.
In the test-lab, these conditions can be controlled but not in the real-time. Unless Creative launches an App (scheduled in mid- 2018) that works well in the real-time, one cannot be sure about the utility of this technology.

Negative online reviews could cause significant reputational damage impacting demand.

Online reviews play an integral role in purchasing decisions of the targeted user base for the Super X-Fi technology which comprises premium handset users including music enthusiasts, professional gamers and developers.
Online reviews by the initial users of the product would prove to be a key driver of demand for the product, with positive reviews raking in more users and vice versa.

Inability to expand production of the chip powering the Super X-Fi dongle.

Mass production of the chip that powers the Super X-Fi dongle, which allows Creative Technology to offer the dongle at an attractive price of US$150, would remain critical in monetising the technology.
Whilst the company has extensive experience in new product developments and established supply chains in Asia to support a quick ramp up of production, development and production complexities in manufacturing the chip in mass scale could hinder efforts to expand production of the Super X-Fi dongle, resulting in negative customer reviews and poor sales over the initial years.

Return *: 1
Risk: High
Potential Target 12-mth* : FY18 S$ 5.56 (38% upside)

Sachin MITTAL DBS Vickers | http://www.dbsvickers.com/ 2018-03-01

DBS Vickers SGX Stock Analyst Report NOT RATED Maintain NOT RATED 5.56 Same 5.56

*This Equity Explorer report represents a preliminary assessment of the subject company, and does not represent initiation into DBSV’s coverage universe. As such DBSV does not commit to regular updates on an ongoing basis. The rating system is distinct from stocks in our regular coverage universe and is explained further on the back page of this report.