1H22 results slightly miss our expectations

Tongtech announced its 1H22 results: Revenue fell 3.38% YoY to Rmb201mn, attributable net profit equaled -Rmb91mn, and recurring attributable net profit totaled -Rmb98mn. Losses widened YoY due to a decrease in the value-added tax (VAT) refund and government subsidies totaling approximately Rmb26mn in 1H22. For 2Q22, revenue grew 108.2% YoY to Rmb121mn, suggesting accelerated growth. For 2Q22, attributable net profit equaled -Rmb44mn and recurring attributable net profit totaled -Rmb49mn. Losses incurred during the quarter increased YoY. Results slightly missed our expectations due to COVID-19 disruptions on business operations, especially government projects’ slowdown in middleware replacement.

Trends to watch

COVID-19 weighs on the growth rate of government middleware business; revenue structure temporarily changed. By industry: Tongtech’s government business was greatly affected by COVID-19; as a result, revenue fell 24% YoY to Rmb73mn in 1H22, with its portion of total revenue down around 10ppt YoY. Revenue from the telecommunication industry grew 52% YoY to Rmb81mn, with its revenue contribution up around 15ppt YoY. By product: Revenue from the basic software business with middleware as its core fell 40% YoY due to pressure on the growth rate. Its portion of total revenue fell around 22ppt YoY. Revenue from the security and digital transformation businesses grew 31% and 299% YoY.

Blended GM fell significantly due to structural changes; the basic software business’s gross profit remains steady. In 1H22, Tongtech’s blended gross margin (GM) fell 24ppt YoY to 64% as the portion of low-GM security and digital transformation business grew, with high levels of investment in select strategic expansion projects in the early stage. The firm’s basic software business GM remains steady with 1.4ppt YoY growth. COVID-19 dragged profit and cash flow. In 1H22, selling expenses increased (selling expense ratio up 10ppt YoY), while government subsidies fell (other income’s portion of total revenue decreased 12ppt YoY), dragging profit. Delays in order signing and payment collection also negatively affected contract liabilities (down 18% from end-2021) and cash flow (net shortage in operating cash flow widened significantly YoY). We think the uncertainties brought by COVID-19 are reflected in Tongtech’s 1H22 results. With the improvement of COVID-19 conditions and the progress of Tongtech’s private placement, we expect its operations to improve in 2H22.

As the middleware business faces headwinds, Tongtech is expanding into new industries and exploring a new sales model. In 1H22, the expansion into the high-end equipment market has been fruitful, with revenue increasing by 150% YoY. The firm also strengthens its collaboration with cloud vendors to realize cloud-based middleware applications and push forward a service model evolution. Tongtech maintains its lead in the telecommunication industry regarding the security business. Its core internet data center (IDC) network and information security products are experiencing rapid growth. The firm has gained an industry-leading market share after winning bids for China Mobile and China Unicom in 1H22. It is also actively exploring the digital transformation business. Tongtech focuses on power and manufacturing in the state-owned enterprise market, helped build business systems for ten provincial-level power grid companies under the State Grid, and assisted CRRC and Shell with their digital transformations.

Financials and valuation

Given the impact of revenue structural adjustment and other changes due to COVID-19 on 1H22 earnings, we leave our 2022 and 2023 revenue forecasts unchanged, but lower our 2022 and 2023 earnings forecasts 22.0% to Rmb309mn and 10.3% to Rmb479mn. We maintain an OUTPERFORM rating. The stock is trading at 27x 2022e and 17x 2023e P/E. We keep our TP at Rmb24 (roll over valuation implying 23x 2023e P/E), with 34% upside.

Risks

Progress in import substitution disappoints; competition intensifies; COVID-19 resurgence.