OUST - Hesai Group: A Mixed View

2023-04-25 12:48:04 ET

Summary

• Hesai Group's key investment merits are the strong growth potential of the ADAS LiDAR market and the company's chance to secure new business with international customers.
• The key negatives for Hesai Group are the potential for gross margin compression and the stock's unattractive valuations.
• I have a mixed view of Hesai Group, and this translates into a Hold rating for Hesai Group stock.

Elevator Pitch

I assign a Hold rating to Hesai Group ( HSAI ) shares.

My view of Hesai Group is mixed. On one hand, I have a positive opinion of the ADAS LiDAR industry's growth prospects and the company's opportunity to expand its customer base. On the other hand, I am worried that Hesai Group's profit margins might decline in the medium to long term as a result of competitive pressures, and HSAI's valuations are still quite rich notwithstanding recent share price weakness. Therefore, I have decided to rate HSAI's stock as a Hold.

Business Overview

In the company's press releases , Hesai Group refers to itself as a "global leader in three-dimensional light detection and ranging (LiDAR) solutions" which are used in "advanced driver assistance systems ((ADAS)) and autonomous vehicle fleets (autonomous mobility)." HSAI boasts a 60% share of the worldwide autonomous mobility LiDAR market and it has delivered in excess of 100,000 LiDAR units between 2017 and 2022 as indicated on its investor relations website .

Hesai Group's Current Key Products

The New Product Pipeline For Hesai Group

As indicated in its Q4 2022 earnings release , Hesai Group generated the vast majority, or 96%, of the company's revenue for full-year fiscal 2022 from product sales, while services contributed the remaining 4% of HSAI's top line for the previous year.

ADAS LiDAR Market's Strong Growth Potential

HSAI's current revenue represents a mere fraction of the company's total addressable market, or TAM, which points to a long growth runway for the company.

Hesai Group registered sales of RMB1,202.7 million or $174 million for FY 2022. In comparison, the company's TAM in 2026 is projected to be $29.4 billion, as per Frost & Sullivan's forecasts outlined in its listing prospectus . This means that Hesai Group's top line for the last twelve months only represents a mere 0.6% of its 2026 TAM. Also, the sell-side analysts' consensus financial estimates (Source: S&P Capital IQ ) indicate that the market sees HSAI's revenue growing by a +61% CAGR to RMB8,078 million in fiscal 2026. In my opinion, the estimates relating to Hesai Group's future total addressable market and expected top line expansion are realistic, taking into account the favorable outlook for ADAS LiDAR demand.

As indicated in HSAI's IPO prospectus, Frost & Sullivan predicts that the ADAS penetration rates for the U.S. and China markets will increase from 2.7% and 4.6% in 2022 to 33.7% and 36.8% for 2026, respectively. Some automakers are incorporating ADAS features into their vehicles as "bells and whistles" to attract consumers in the highly competitive automobile market; while other car manufacturers are compelled to adopt ADAS features for their products to meet rules and regulations relating to safety. These key demand drivers provide support for research firm Yole Group's projections that the worldwide ADAS LiDAR market will expand by a six year CAGR of +93.6% to $2 billion for 2027.

A Good Chance Of Adding New International Clients

Hesai Group's customer base is largely limited to domestic or Chinese companies now. If HSAI can get to do business with new foreign customers, this will represent a major breakthrough for the company in terms of geographic expansion and client diversification.

In the company's listing prospectus, HSAI highlighted that Chinese electric vehicle, or EV, makers Li Auto Inc. ( LI ) and Lotus were its "top ADAS customers" as of the end of the third quarter of 2022. But Hesai Group indicated at its Q4 2022 results call on March 17, 2023 that it is currently "in late-stage discussions with multiple (international automakers), including Europe and American" companies with regards to new LiDAR supply agreements, with the outcome of these talks expected to be known by the second half of this year.

There is a reasonably high probability that Hesai can add one or more foreign car makers to its client list in the near future, because HSAI's U.S. LiDAR peers can't match the company in terms of scale and pricing. As a reference, Hesai Group's ADAS LiDAR deliveries amounted to around 62,000 units last year. At the company's Q4 2022 results briefing, HSAI emphasized that it "shipped more than two times the number of automotive LiDAR units than our eight U.S. listed peers combined" in 2022. HSAI's relatively greater scale as compared to its competitors also allows the company to price its products more competitively.

It is natural that automobile manufacturers will choose LiDAR suppliers with a superior delivery track record that also offer more attractive pricing, all things equal. This puts Hesai Group in a good position to secure supply contracts with new foreign customers in the short term, which will further bolster HSAI's reputation as a dependable supplier in the ADAS LiDAR market.

Profitability Outlook

While I like HSAI's top line growth prospects as detailed in the prior sections of the article, I am concerned about Hesai Group's future profitability in both the short term and long term.

HSAI guided at its Q4 2022 results call that there will be "downward pressure on blended gross margin percentage in 2023" due to the "opening of two large production facilities" (will take time to reach optimal utilization rates) and unfavorable revenue mix (ramp-up in volume of new ADAS products). Specifically, the market's consensus forecasts taken from S&P Capital IQ suggest that Hesai Group's gross margin could potentially decrease from 39.2% in FY 2022 to 35.0% for FY 2023.

The bigger worry is that Hesai Group's gross margin for the intermediate to long term might continue to trend downwards. HSAI's long-term gross margin goal is 35%, but analysts have forecasted that Hesai Group's gross margin might decline further to 29.2% by FY 2025 (Source: S&P Capital IQ's consensus numbers).

HSAI has the ability to set prices for the industry by virtue of its status as the market leader in automotive LiDAR, as mentioned previously, which has enabled it to earn reasonably decent gross margins for now. But there is a risk of existing competitors and new entrants eventually scaling up to meaningful volumes in the future that could change the pricing environment for the automotive LiDAR market.

While Hesai Group has partnered with Li Auto, the other Chinese EV makers also have their own key LiDAR suppliers. NIO Inc. ( NIO ) and XPeng's ( XPEV ) have other partners in the automotive LiDAR space, specifically Chinese companies Innovusion and RoboSense, respectively. If RoboSense or Innovusion could eventually secure some major Chinese or international automaker clients and ramp up volumes in time to come, this might drive more intense price competition in the automotive LiDAR industry and translate into lower than expected margins for Hesai Group.

Separately, HSAI's profitability in the future might also be affected by intellectual property disputes between the company and its competitors which might potentially lead to substantial legal costs or even meaningful financial compensation in the worst case scenario. As an example, an April 17, 2023, Seeking Alpha News article highlighted that one of its competitors, Ouster, Inc. ( OUST ), filed a "patent infringement complaint against" HSAI.

There are downside risks relating to Hesai Group's near-term and long-term profitability as touched on in this section of the article.

Valuations

Hesai Group's last done share price was $8.68 as of April 24, 2023, which implied that the company's stock price had dropped by -54% as compared to its IPO price of $19 when its shares were listed in February this year. HSAI's significant share price correction in the last few months sends a strong message that investors view HSAI's shares as expensive.

HSAI currently trades at 3.2 times consensus forward next twelve months' Enterprise Value-to-Revenue as per S&P Capital IQ data, while its peer Ouster is valued by the market at a much lower consensus forward next twelve months' Enterprise Value-to-Revenue multiple of 0.9 times. The current consensus FY 2022-2026 revenue CAGR estimates for Hesai Group and OUST are +61% and +88%, respectively.

Hesai Group's shares still seem to be overvalued despite the substantial pullback in its stock price. HSAI trades at a hefty valuation premium over Ouster, even though the latter's revenue growth outlook is relatively better.

Closing Thoughts

A Hold rating for Hesai Group is appropriate in my opinion. There are both pros and cons associated with a potential investment in Hesai Group, and the risk-reward for Hesai Group appears to be balanced considering multiple factors as discussed above.

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