2016 miss expectation; emerging turnaround in 1Q17Deren Electronic announced its 2016 results: revenue was Rmb4.58bn, up 51% YoY; net profit attributable toshareholders was Rmb38.68mn, down 55% YoY, missing expectation due to excessive spending on OBC business. In1Q17, revenue rose 31% YoY to Rmb1.17bn and net profit attributable to shareholders rose 47% YoY to Rmb31.98mn.

Revenue maintained fast growth, but gross margin fell due to spending on new products. In 1Q17, revenuerose 31% YoY to Rmb1.17bn thanks to steady growth in consumer electronics. Auto electronics and IoV are the maingrowth engines and their revenue contribution rose from 21% in 2015 to 35%. Gross margin fell 3.9ppt YoY due toheavier spending on new products like Type-C.

IoV expense pressure under control; turnaround in operating profit. Expense ratio dipped 3.3ppt YoY or0.8ppt QoQ thanks to improving internal management and sound control over expenses for new business like OBC andMeta. As a result, operating profit surged 197% YoY to Rmb25.90mn and QoQ growth turned positive.

Trends to watch

Auto electronics to reap fruit; earnings to improve quarter by quarter in 2017. Deren guided 70~100% YoYearnings growth in 1H17, implying 86~137% growth in 2Q17 and rising contribution from auto business. KSDAutomotive Components secured orders from FAW VW and Audi etc. in 2016 and passed the supplier test of DaimlerChina and Beijing Benz. Earnings will likely improve quarter by quarter in 2017 and return to a fast growth track.

To acquire Liuzhou Shuangfei Auto Electric Appliances via private placement to strengthen deploymentin automotive wiring harness. Deren announced plans to spend Rmb600mn in acquiring a 60% stake in LiuzhouShuangfei, a manufacturer of automotive wiring harness which generates 80% of its revenue from its largest clientSGMW. The acquisition should improve Deren’s product line and production bases. The plan was approved by the CSRCon March 29 (written approval not received yet).

Earnings forecast

Considering the lower-than-expected gross margin in 2016, we lower our EPS forecast by 6% from Rmb0.35 toRmb0.33 for 2017 and introduce 2018e EPS at Rmb0.49 (not considering consolidation of Liuzhou Shuangfei).

Valuation and recommendation

The stock is trading at 63x/42x 2017/18e P/E. As the market valuation has fallen, we maintain our BUY rating butlower our target price by 26.03% to Rmb27.00 based on 2017e EPS and average P/E of 82x over the past threeyears (excluding negative values). We believe Deren deserves a valuation premium as its investment in automotiveelectronics has started to bear fruit and should bring benefits in the long term. Risks: Weak demand for consumerelectronics; spending on alternative energy business beats expectation.