Innolux Corporation (3481) Earnings Call Transcript & Summary

Ladies and gentlemen, good afternoon. Welcome to Innolux Second Half of 2021 Earnings Conference Call. [Operator Instructions] Today's conference will be conducted in Chinese. Both the Chinese and English presentation decks have been uploaded to our company's website. Please feel free to download them from there. Please take a moment to read the safe harbor notice on the slide. Next, I will turn the call over to Jack Hsu from the IR department.

Thank you. Ladies and gentlemen, good afternoon. This is Jack from the IR Department of Innolux. Welcome to Innolux Second Half of 2021 Earnings Call. We are joined by Jin Hung, our Chairman; and James Yang, our President. To begin with, President Yang will walk you through the demand and the supply of the panel industry -- to begin with, President Yang will walk you through the demand and supply of the panel industry and progress we have made in digital decision-making. Later, Chairman Hung will give you an update of our business strategy and Q2 results. Then we will have a Q&A session. Today, we have 3 focuses. First, we remain cautiously optimistic about demand and supply in the second half of 2021. The panel industry is still undergoing structural change. Secondly, we will cover initial success in our dual transformation. As for internal digital transformation, we have been engaging in smart manufacturing and smart operation to optimize manufacturing processes, supply chain and organizational management. As for external transformation, we will talk about our strategic plans for large-sized panel manufacturing and product mix. We delivered strong Q2 results, registering an all-time high quarterly profit of TWD 21.4 billion. Now I will hand over to President Yang, who will walk you through our outlook for demand and supply of the panel industry and discuss progress in our digital transformation, please?

Ladies and gentlemen, good afternoon. Thank you for joining us at our second half of 2021 earnings call. First, let's take a look at the slide. The second half of the year is typically the busy season, which is a predictable industry trend. However, there are uncertainties. In the first quarter, we forecast strong demand in the second half of the year, and we told you that the future was bright. We did post great results in the second quarter. However, in the third quarter, 2 uncertainties emerged. The first one comes from the spread of the Delta variant, which could potentially cause supply chain disruptions. The second uncertainty is heavy rainfall as a result of extreme weather. A while back, extreme weather caused wildfire in the West Coast of United States and severe flooding in Europe, leading to logistic strain. Despite these uncertainties, we have managed to cope thanks to smart operation. So these uncertainties can be turned into opportunities if managed properly. But if handled improperly, they could turn into disasters. As we remain cautiously optimistic about the second half of the year, we pay close attention to the supply side. First, we have noticed that major IC suppliers forecast IC shortages in the remainder of the year and well into next year. So excessive capacity will no longer be an issue. While the industry used to focus on capacity expansion, we now move to profit-oriented and technology-driven production so that the industry will no longer be a cyclical industry. Things are moving into the right direction. Also because of COVID, glass factories have been postponing tank maintenance as they don't have enough maintenance staff causing a drop in yield. In the foreseeable future, there could be a 15% to 20% drop in capacity among any of the glass manufacturers. This could further strain glass supply, but we are cautiously optimistic about the challenge. On the market side, the prices of small-sized panels have been going up and now stabilized. We are shifting capacity for small-sized panels to higher specs, higher value addition, large-sized panel production. This allows us to add even more value. For the IT industry in Q3, we are seeing hybrid models resulting from the back-to-school, work from home and return to office trends. Demand for business notebooks and monitor is overtaking that for gaming notebooks and monitor, so demand remains robust. Therefore, we remain cautiously optimistic about the second half of the year. I'd like to share our formula for success. Since 2015, our focus has been on automation and smart manufacturing. In addition, we've been working on smart operations. Automation involves designing with precision and the smart manufacturing reduces labor needs. Hence, despite the ongoing pandemic, we have not lost capacity because of labor shortages. We've also improved our smart manufacturing capabilities thus increasing our production yield and reducing costs. When dealing with high demand for different products from our many customers ranging from orders for TV, IT, automotive and smartphone applications, optimizing profits and fulfilling our customers' needs remain our guiding principles. In the face of component shortages, we made use of smart keeping systems to select orders. We then utilize our smart dispatching system. Climate change has affected global shipping capacity. Moreover, the pandemic has led to port congestion. Once the shipment arrives at the port, there aren't any port workers to unload the shipments. Even if the shipment gets unloaded, no heavy-load trucks are available to transport it. We can access all of this information with one click. We are able to track a product from the moment it leaves our warehouse to the time it arrives at the hub designated by the customer. We can keep tabs on our many manufacturing facilities, for BUs or our customer list and our turnover rates, which is 97%. We are able to monitor all these things thanks to our digital transformation. By focusing on both smart manufacturing and smart operation, we are resilient and competitive in the industry. Thank you. Please watch this short video about smart manufacturing. [Presentation]

Since 2015, 71% of our factories have become lights-out zero-labor factories, thanks to smart manufacturing. Through automated manufacturing, smart manufacturing and smart operation, we have delivered high-quality products for our customers. As a result, 76% of our customers consider us the top 2 suppliers thanks to all the support from our colleagues, our suppliers and our customers. In this process, we also managed to reduce our module production lines. This is a perfect example of how our XYZ philosophy works. We implement automated equipment and data collection. After that, the data is analyzed with artificial intelligence to generate business intelligence. Coupled with our management expertise, we are able to become more competitive and resilient in our operation. Like I said, we have solid base for improving operation. With ever-changing global dynamics and uncertainties from the Delta variant and extreme weather, we are also watching other factors such as changes in foreign exchange and concern for inflation, and we take all challenges with great caution. Furthermore, we incorporate intelligence into our model simulation to generate the best options as a guidance for our operation. Thank you.

Thank you, President Yang, for introducing our smart manufacturing and operation strategy. Next, I'll be covering the strategies that Innolux implemented for the first half of the year. During the Board of Directors meeting this Tuesday, our Board approved the resolution for a long-term supply agreement with SIO, a 10.5-Gen fab in Guangzhou. In the current and following year, we will make RMB 4 billion in payment to SIO, which will supply us with panels monthly from 2022 to 2033. In the TV market, demand for 65-inch and 75-inch screens is growing the fastest. Compound annual growth rate for 2020 to 2024 is 18% to 24%. We are an important supplier for TV panels. In the past, we manufactured these panels on our 6-Gen and 7.5-Gen fabs. Though our products were competitive, the cutting rate for 10.5-Gen fabs is much superior to that of the earlier generation 6-Gen and 7.5-Gen fabs. Therefore, this will make our products even more competitive. With this capacity, Innolux will become the panel maker with the most complete capacity across different generations. In the TV market, by providing long-term supply, customer trust will increase, so are the future growth and profits. This is why we made this important decision in the first half of the year. Next, we have a brief overview of the company's financial statements. Here are some of the highlights. In the second quarter, we had record-high profits. Additionally, over the past couple of months, many investors expressed their concern that panel prices for certain panel sizes would drop and affect our future growth. In the first quarter, revenue growth was 14% Q-o-Q. In the second quarter, the figure was 12%. As you can see, revenue growth has slowed down. However, profits are growing at an increased pace from 36% Q-o-Q in the first quarter to 43% in the second quarter. As President Yang mentioned earlier, by utilizing smart manufacturing and automation as well as better component part combinations, we've been able to build a better and more optimized product mix. We are able to come up with an even better, more structurally optimized product mix, with added capacity from the Gen 10.5 lines that I just mentioned. We will be able to convert the Gen 6 and Gen 7.5 capacity to notebook and monitor production. Going forward, we are confident about product mix optimization. With today's opportunity, I want to be clear that to pursue growth in the future, we will not do so by putting pressure on our customers or by raising the price whenever possible but by working with our partners in the supply chain. Customer recognition is the true driver of our growth. When we say we are optimizing product mix and moving toward higher-value addition and higher-profit products, we mean it, and it shows in our profits. This is what I want to convey with this slide. Now let me hand over the mic back to Jack.

Thank you, Chairman Hung. We will now proceed to the Q&A session. First, we will address questions collected from some of the analyst. We will start with the top 5 questions. I will ask the questions on behalf of the analyst and then Chairman Hung and President Yang will take turns to answer them. The first question is about the industry outlook and the market demand. As market research agencies forecast weaker demand for TV and the lower prices for small and medium TV panels in the second half of the year, and with COVID abating, some worry that demand for IT products will drop on the back of a slowing down of work-from-home trend. Also, there is concern about the panel oversupply. Could you talk about the drivers for product sales in the second half? Would President Yang like to take this one?

Thank you, Jack. As for the demand for TV panels, the previous price resurge in small- and medium-sized panels is now followed by a price hike in medium- and large-sized panels. This year, we estimated the demand for panel size will go up by 1.4 inches. This is beneficial for overall capacity, decommissioning and conversion. Also with shortages in IC component and glass, demand is at an acceptable level. That also presents the need to move towards commercial products. For example, with lockdowns easing, supermarkets might need more PIDs. If that's the case, we will convert large-sized TV capacity to PID production. For IT products, hybrid model arising from the return to office and work-from-home trends will persist due to higher immunization coverage and delta variant spread. As a result, demand for IT products will remain robust in the second half. As for the prices, we expect some increases in Q3 following the surge in Q2, although not as steep as in the first half. As for small- and medium-sized panels, demand for automobile display will pick up as chip shortages ease. As for our cell phones, although construction of 5G base stations has been delayed, cell phone demand is stronger as people need the device to stay up-to-date with the pandemic. In emerging countries, in Africa, people are still in the process of switching from feature phones to smartphones, and we have a very strong customer base to capitalize on that momentum. Commercial products like the electronic shelf label on my hand and electronic paper on the desk will be in high demand as supermarkets reopen. To change the price test of thousands of items, all it takes is 1 click, thanks to the e-paper. Our strategic partner has a significant market share, and we are their main supplier. So demand for commercial products is on the rise as lockdowns ease. Thank you.

Thank you, President Yang. The second question is about the price surges and market supply as upstream wafer and glass factories announced a price increase. What's your take on component shortages? How do you cover the higher cost? Recently, upstream wafer fabs and glass factories have announced that they will be raising their prices. What are your thoughts on component shortages? And how will you deal with the increased cost? President Yang will be answering this question.

Today, the Commercial Times reported that wafer fabs have increased their prices to record highs as have IC fabs. However, shortages will continue into the next year. Design houses will absorb the cost of wafers while panel makers will absorb the cost incurred by design houses. With demand remaining low, this cost can then be passed on to the customers. Regarding glass, till the end of September, perhaps even starting this month, glass factories will be reducing capacity due to annual maintenance. For August, September and October, reduced capacity will be roughly equal to the production capacity of 2 to 3 Gen 8.5 fabs with 100,000 of production capacity. Regardless of whether this capacity was to be used for monitors, notebooks or TVs, this will be able to mitigate some of the supply and demand imbalances that would have happened if capacity were to remain at high levels after the busy season. Taking this aspect into consideration, we remain cautiously optimistic about the market demand for the second half of the year. Thank you.

The third question concerns our long-term supply agreement with SIO. Does the long-term supply agreement with SIO entail that we help them reduce capacity? Have you made any commitments regarding minimum purchases? If this number is not met, will you be held liable? How will the company ensure that panel prices are competitive? President Yang will also be answering this question.

Innolux market share in the global TV market, we increased with SIO's additional capacity. We will be able to provide our customers with a one-stop solution and increase their satisfaction. Additionally, by increasing the competitiveness of our 65 inches and 75 inches high-efficiency new generation product lines, we'll have a bigger say when dealing with our customers and in the TV market. We will monitor differences in market demand and prices with our business partners and engage in business negotiations with them. I believe that we will be able to resolve any conflicts that may arise. We do not need to bear much of a burden in this regard. As Chairman Hung mentioned earlier, in terms of strategic investments, we have signed a very favorable multiyear supply agreement, which will allow us to better serve our customers in the future.

Thank you. The next question is about our dividend policy. It seems like the company has quite a bit of cash and no plans for larger capital expenditures in the near future. Could you provide investors with a more concrete payout ratio guidelines? Chairman Hung will answer this question.

During the shareholders' meeting on July 1, the shareholders passed a dividend policy amendment. If the distributable earnings for the current year is greater than 2% of the paid-in capital, approximately TWD 2.1 billion, the payout ratio will be no less than 20%. We will also take into account the payout ratio of others in the industry as well as the U.S. treasury bond long-term stability and consistency are the underlying principles of our dividend policy. In terms of business operations, fluctuations are inevitable. At times, revenue and profit may be high. When times are tough, these figures may go down. However, a dividend policy should not be prone to these types of fluctuations, which is why we strive towards a long-term, stable dividend policy. Thus, we will also take into consideration the payout ratio of others in the industry as well as the U.S. treasury bond.

Thank you, both. [Operator Instructions] The first question comes from Jerry Su with Credit Suisse.

My first question is about your partnership with SIO. You mentioned you secured a certain amount of capacity. Could you be more specific about that? Did you agree on a minimum amount and will increase that amount when sales is good? Also, you are now at a gross margin of over 30% with your current business model. Where do you see your gross margin and operating margin going forward? For my second question, there is some concern about demand for TV and IT products in 2022. Could you share your estimate for panel demand next year?

Thank you for the question. Unfortunately, I'm not able to talk specifics about our agreement with SIO because it's confidential. What I'm able to say is, it's a long-term supply agreement that bonds till 2033. There are terms on minimum total supply and monthly supply. For upside amount, we will negotiate a price based on the market price. This collaboration will allow us to better use our edge in different product sizes, which is good for our product mix. We also believe that our team will be able to leverage what was used to produce other sized panels to produce more notebooks and monitor products for our customers. Overall, I believe we can expect a lot of market upside. I hope that answers your questions.

James, I think I can take the second question. Typically, the first quarter is when brands of all products such as consumer products launch new products. So we will begin to promote our new products to our customers so that they can do designing with their new products. For example, we will promote our miniLED backlight technology, which can deliver superior optical performances. The low power consumption feature also enables longer battery life. Also, our narrow border capacity allows customers to make even more streamlined products and our privacy switch design for business laptops also enabled high value-added products. Although narrow-border products are difficult to assemble, it's no problem for us, thanks to our automated manufacturing facilities. With CapEx allocated earlier on, we will continue to convert front-end TN capacity to IPS production. The line for small-sized VA for TV could also be converted to produce IPS. This will allow us to increase the share of IPS area, creating even more value and further improving profitability. Jack just told me that we have some technical problems when I was talking about the payout ratio. Sorry about that. I'll address that once again. The shareholder meeting on July 1 passed the dividend policy amendment. If the distributable earnings for the current year is greater than 2% of the paid-in capital, approximately TWD 2.1 billion, the payout ratio will be no less than 20%. This is the minimum amount, and we will also take into account the payout ratio of our peers as well as U.S. treasury bond. I want to emphasize the payout ratio should not be as volatile as the revenue levels. I'm sure you are all aware how volatile the panel industry can be with equal chances of significant gains and losses. However, I understand that insurance companies and the long-term fund managers expect a consistent payout ratio, and we will do our best to address that need. We will strive for a dividend yield that's higher than the bond yield, that is our spend on payout ratio.

The next question comes from Derrick Yang with Morgan Stanley.

President Yang mentioned glass supply is expected to be tight in the 3 months after August. You said the drop in supply is equivalent to two 100,000 Gen 8.5 fabs. That's not insignificant. What's the implication for panel prices? How will it affect your shipment?

Well, glass shipment is a complex process and panel makers tend to have certain amount of inventory, about 3 to 10 or 15 days of stock. With the trip in glass supply, panel makers will first use what we have in stock. If there happens to be inventory from previous sales, hopefully, we will be able to minimize the impact of glass shortages on Q3 revenues by effectively allocating the glass among different product lines. If we also consider logistics, the lead time is about 2 to 3 months from the moment when glass goes into front-end process, followed by OC manufacturing on the back end and then shipment. Like I said, if we are able to spread out the glass input, we will be able to mitigate the impact across a long period, for example, well into January. Then after the holiday season in Q4, demand might decline as new products replaced the previous models. This will cushion the impact of glass shortages. Also, consumers and the procurement officers are reluctant to place orders for the second half of the year as they foresee logistic delays as suppliers have difficulties shipping to channel distributors whose inventories are running low. With that concern looming, it actually contributes to a balance in supply and demand.

Here's the question we missed due to the technical glitches. In terms of strategic planning, are there other subsidiaries besides the InnoCare Optoelectronics Corporation? Or do you have plans to go into other fields? Are there plans for these subsidiaries to go public? Would Chairman Hung like to take this one?

I think InnoCare Optoelectronics is a milestone in Innolux's dual transformation process. This represents the initial results of the company's layout in the medical field. We are very grateful for the team's efforts, and we welcome the original shareholders to participate in the stock release. Of course, Innolux has other energy for new innovations, including automotive and avionics applications and even satellite fields as well as some industrial automation fields. These new business units are very promising sectors incubated inside Innolux. We will expect to have these units to gradually enter the market when they become more mature in the future. Investors are invited to inspect their future development.

Thank you, President Yang. [Operator Instructions] The next question from Yuanta, Lisa Chen.

I still want to ask questions about SIO. The first question is, will cooperation with SIO have an impact on gross profit margin? The second question is, because the contract with SIO starts in 2022, will there be growth in shipments in 2022 or 2023?

I will give a brief answer first, and then President Yang may want to have some more comments as well. First, as the questions of the increase in overall supply. According to our current estimation, the current 10.5-Gen fab capacity is very large. But because Innolux itself has 14 panel factories, so if we take the capacity in terms of area, we estimate that it will increase production capacity by 2% to 3%. Of course, revenues will also have different impacts with price adjustments. This is about revenue and growth momentum. Regarding the margin, the impact should be greater. As I just emphasized, Innolux uses the most suitable glass cutting technology to meet customer needs, and it will generate a certain amount of added value in terms of cost. In addition, when Gen 6 fabs is used to cut 65 inches panels or Gen 7.5 fab is used to cut 75 inches panels, the vacated capacity can be used to serve other customers. So I believe that the momentum of profit growth should be greater than the momentum of revenue growth. James will explain further.

One element that geopolitics influences economic behavior is tariffs. When Taiwan's OC enters the Chinese market, tariffs must be paid. Because I have allies in China now, I can sell the glass to our customers in the mainland, and I can save 5% of tariffs. This is the first benefit. Second, when we buy OC, after designing and manufacturing to add value to the product, we integrated all components into 1 and sell them to clients whom we have good relationship with, which can increase profit and revenue. The total volume we bought has not as much impact as we imagined. So we should still be cautiously optimistic about profit and revenue.

[Operator Instructions] We do not receive any further questions. We thank you for all your questions and your participations. This will be the end of today's meeting. Replay of the meeting will be published on our website within an hour, www.innolux.com, regarding investor services. You may leave now. Thanks for your participation. [Statements in English on this transcript were spoken by an interpreter present on the live call.]