Why Is China's Biggest AI Stock iFLYTEK Overvalued? – Conclusions from Relative Valuation
The government-backed AI company's current market cap of over CNY 80 billion is grossly overvalued. Here we explain why, diving into its business segments, and offer an estimated reasonable price.
► The company's business composition is complicated while its focus area – Artificial Intelligence (AI) – is arcane to most digital laypeople. The complexity leads to diversified and controversial valuations of the company, some of which could result in overvaluation.
► Its business can be classified into two types: AI-related and non-AI-related. The AI-related part also divides into valuation methods as the business models and growth potential differ.
► Within the AI-related area, different valuation methods are applied based on the service type – P/S multiplier for software-hardware combined services while P/E multiplier for the open-source platform.
► The company's to-consumer products with speech recognition require a transformation to be less self-contradictory.
► The company's to-judiciary business, as one of the promising revenue segments, enjoys a massive potential market of CNY 180 billion.
► Per EqualOcean's analysis, the fundamentals of iFLYTEK can support a reasonable valuation at CNY 71.18 billion and CNY 32.35 per share. At the moment, the stock price is overheated due to its current business landscape. Policies, capital operation and other factors that affect the market cap are not considered in this analysis.
Speaking of Chinese-listed companies that excel in AI-related businesses, iFLYTEK (002230:SZ) is well placed to be the next heavyweight, after the tech giants Alibaba (BABA:NYSE, 09988:HK), Tencent (00700:HK) and Baidu (BIDU:NASDAQ). Generously supported by the Chinese government, iFLYTEK has adequate funding for AI-related R&D, which is one of the nationally-defined focus subfields in the science and technology realm.
However, taking from 60%-70% of its total revenue, the company's government-based business is not thoroughly related with artificial intelligence, or specifically the company's core technology – speech recognition and processing.
For instance, the 'smart city' segment is mainly about the information engineering services related to the digitalization of the local services, such as the online driving license system and other self-service systems. The education segment has started to release products related with speech recognition and online AI courses, but the major percentage (nearly 90%) was generated from auxiliary teaching tools and education website 'Zhixue.'
Thus, not all of iFLYTEK’s business has such high growth potential as AI-related ones. A valuation method that does not distinguish business sectors and considers them all as AI technology-driven is quite likely to result in an overvaluation. Below, we divide iFLYTEK's business into three parts: non-AI-related, AI-related hardware and software, and AI-related platform services.
Non-AI-related business – P/E
The non-AI-related business segment includes the smart city, education, operator big data and telecom value-added operation businesses.
Since these sectors have long been in place, and since the cooperation agreements with government, state-owned schools and operators are stable, we consider this part of the business to be at the mature stage; the profitability matters more than the growth potential. Thus, here we use an average P/E multiplier for mature IT service enterprises of 20 for the valuation of the sector. The projected net profit generated from this non-AI-related segment in 2020, based on its interim growth rates, is around CNY 300 million. The corresponding market cap is CNY 6 billion.
AI-related hardware and consumer business – P/E
The AI-related segment which is suitable for P/E multiplier consists of smart hardware, software application, judiciary business, automotive area, smart customer services, and smart healthcare. Though this segment is related to AI technologies – such as the speech recognition embedded on court recorders and consumer products such as ‘instant interpreter’ pens – this part in essence resembles the business model of traditional IT equipment providers. The benchmark companies are Hikvision (002415:SZ) and Dahua Technology (002236:SZ). Thus, the P/S multiplier in valuation is not applicable and the P/E ratio will be used for this segment.
Smart hardware and software application
The hardware part of iFLYTEK's to-consumer business lies in this segment with products like interpretation machines, home robotics and pen voice recorders. During the '618' shopping festival, the company's sales volume was up by 40% year-over-year with over twenty categories of AI-empowered consumer electronics products championed in each segment.
However, iFLYTEK's translation software products are to some extent at odds with its hardware products as their functions overlap. With the iFLYTEK-developed translation app installed in the smartphone, the handset itself could provide the same function as the translation machines, resulting in a self-competition situation. Even though the translation machine has certain upgrades such as a higher degree of noise tolerance and stability, the market potential is squeezed by its own software products.
Besides the self-competition problem, the most widespread to-C product of the company – Xunfei Input Method, with monthly active users (MAU) in 2019 over 140 million – is also not well-positioned, since the users tend to use the input method directly rather than open the app. Thus, the profitability of iFLYTEK's prevalent products is questionable. Thus, we project the revenue growth rate for the smart hardware and the software application will slow down to around 40%.
Featured by the company's partially state-owned background and the technology advantage, iFLYTEK's judicial business boasts a track record of high quality. As the courts, public security bureau and procuratorate all require reliable recording and documentation equipment for eliminating human error, iFLYTEK's judiciary segment is about providing trial services with both software and hardware.
According to the company's 2019 annual report, the iFLYTEK-empowered AI speech recording products had covered 1,300 courts in China. With the total number of Chinese courts at around 3,500 according to the Chinese Supreme People's court, the company enjoys over 270% of sales growth in terms of court service products in the following years. If we take the demand from public security bureau, procuratorate and local police stations into account, the market potential of iFLYTEK's judiciary business will climb up to over CNY 18 billion in the following three years.
Smart medical care
Boosted by the COVID-19 crisis, iFLYTEK's medical care-related business grew by 665% year-over-year, with its AI doctor assistant and intelligent filter of patients with fever, cough, and dyspnea during the outbreak. During the first half of 2020, the AI assistant experimented in 66 districts and counties. Assuming the AI-empowered medical assistant enters most regions around China in the following years, the rocketing growth of the medical care will be likely to keep its pace.
The projected 2020 net profit is at CNY 565 million. With a P/E multiplier at 50 extracted from the Hikvision and Dahua technology, this segment presents a market cap of CNY 28.25 billion.
AI-related platform service – P/S
iFLYTEK's AI open platform is designated as China's national key laboratory, shouldering the national cognitive intelligence research and development as well as the open-source solutions of related technologies. As this segment is solely related with the company's AI technology and most of the AI solutions on platform do not have concrete commercialization models, the valuation of this segment is aimed at measuring the company's technical strength and future potential. In addition, the upfront investment and expenditures are rather high. Thus, here we apply the P/S multiplier to evaluate the platform segment.
As the P/S multipliers of Chinese outstanding AI companies in the AI software track – SenseTime, Megvii, CloudWalk and Yitu technology, surpassed 20, here we employ the P/S ratio of 20 to iFLYTEK's AI platform segment. The corresponding market value is around CNY 36.93 billion.
To sum up, based on the relative valuation of iFLYTEK's business segments, the rational market value is CNY 71.18 billion and the corresponding target price per share is CNY 32.35 – 16% lower than the closing price of CNY 37.52 as of August 28, 2020.
iFLYTEK's complexity in business contributes to its overheated market valuation, since institutions and investors might resort to the P/S or other similar valuation methods for its overall business, taking the latter as entirely AI-related.