Description

Idea: Long China Yongda Auto Services (“Yongda” or “the Company”), a leading auto dealer focused on luxury Western brands in China that is coming out of a period of under-earning and set to enjoy a decade+ runway of profitable, non-cyclical, after-market sales growth. The Company trades for 10x 2021 EPS and we believe earnings will CAGR in the low teens for the next 5 years as the luxury car parc, and resultantly Yongda’s after-market business, naturally grows. We see a 28% 5 year IRR. 

The opportunity exists because gross margin on new vehicle sales compressed meaningfully in 2018/2019 with the first decline in China SAAR (OEMs discounted to push volumes). This has obfuscated the growth in Yongda’s highly profitable after-market business, which has continued to chug along at mid-teens y/y growth. As the new-car market has now stabilized in China, with Yongda shifting its focus to luxury, Yongda should see a return to low-teens y/y consolidated earnings growth.

Business Overview

Yongda operates 219 authorized “4S” dealership outlets in China, mostly in the Jiangsu and surrounding region. 4S stands for “Sales, Service, Spare parts, and Surveys” and represent the authorized dealerships of OEMs in China.

 155 of Yongda’s outlets are luxury brands (61 BMW, 20 Porsche, 16 Jaguar-Land-Rover, 9 Audi, and 49 other) while 64 are mass-market brands. Yongda is the largest dealer of BMW and Porsche in China.

They will sell close to 200,000 new vehicles in 2020, ~70% of which are luxury brands. As luxury vehicles garner higher ASPs, they will contribute ~84% of vehicle sales, and 71% of Company-wide sales.   

While new vehicle sales comprise most of revenue, after-market is the key profit driver, making up 71% of total gross profit. This is due to the significant profitability of the after-market business – Yongda’s after-market business generates a ~46% gross margin vs. 2.3% for new vehicle sales.

Thesis:

1. Yongda is coming out of a period of under-earning on new car sales. De-emphasis of non-luxury and poor performing luxury brands has strengthened Yongda’s business which will improve off trough levels over the next couple of years. 

2. Due to a rapidly growing middle class, consumption upgrade trends should support increasing premium vehicle sales even in weak periods for overall SAAR. Luxury dealer supply growth should allow for reasonable margins and ROIC.

3. As the luxury car parc expands and ages, Yonga will enjoy a long-runway of increasing high margin after-market sales which will reduce volatility in the results of the Company’s overall business and should garner a higher multiple.

Thesis point 1) Yongda is coming out of a period of under-earning.

Yongda saw its gross profit per new vehicle sale compress meaningfully from RMB 9,281 (3.7% GPM) in 2017 to in RMB 6,314 in 2019 (2.4% GPM). On a gross profit dollar basis, this was a RMB 347mm headwind from 2017 to 2019, or 7% of company-wide gross profit in FY17 (23% of FY17 net income).

Gross margin compression on new sales happened for both 1) macro and 2) self-inflected reasons.

Macro-driven new vehicle gross margin compression

China experienced a broad downcycle in SAAR in 2018/2019 which resulted in heightened discounting by OEMs to push volumes. 

This downturn was highly unusual – even in 2008 China’s SAAR increased y/y – and affected mass-market car sales.  Below (in millions), one can see that mass market units were down 7% y/y in 2018 and another 12% in 2019, while luxury car sales have continued to chug along:

As a result, there was broad discounting in the mass-market dealer channel. Gross profit margin earned on Yongda’s mass-market sales compressed from 1.9% in 2017 to 0.5% in 2019, and has since stabilized at around 0.4% in 2020:

In FY17, 21% of Yongda’s sales came from the mass-market. Their exposure is reduced today, at 16% of total sales, and the mass market has been de-emphasized going forward. Given the mass-market has stabilized coming out of the 2018/2019 downcycle and 1H20 COVID-19 pandemic, with gross margins stabilizing around 0.5%, we do not expect this to be a drag on Yongda’s results going forward.

Yongda’s luxury brand gross profit margin was much more resilient, though it too compressed from ~4.1% in 2017 to ~2.9% currently. Part of the compression on the luxury side during this time frame is attributable to Jaguar-Land-Rover’s execution errors in the market. 

Jaguar used the China market to push volumes and thought they could grow by discounting; this proved to be the wrong strategy for a luxury-focused brand. Below one can see the relative pricing discounts on Jaguar models vs. peers expanded beginning in the 2018 time frame:

In 2017, Jaguar made up ~9% of Yongda’s sales (and only makes up 4% today). Yongda saw its gross margin on JLR vehicles compress from 3.5% in 2016 to -0.8% in 2018, which has since stabilized in the 1-2% range. As it now makes up only a LSD portion of total sales and gross margin has stabilized, we do not expect JLR to be a drag on Yongda’s total luxury gross margin going forward.

Self inflicted

Contacts we spoke with at BMW suggest that Yongda has the best locations and best brand compared to most dealerships, though their execution has lagged vs. some of the other large groups. We believe this execution gap has arisen from a lack of proper incentive alignment of dealer leaders and senior management.

As part of our diligence, we uncovered certain dealers who would historically engage in wholesale sales of older vehicles on the lot at lower prices (receiving a kickback of sorts to supplement their income). Some dealer leaders at peers estimated that this “reseller” arrangement was as high as 10-20% of overall sales for Yongda historically (vs. virtually zero for Yongda’s closest peer, Zhongsheng).

We believe senior management has cracked down on this practice over the past two years immensely and are looking to further improve execution. At it core this is an incentive issue (cue the usual Munger quote). General Managers at Zhongsheng dealerships can earn 1mm+ annual salary (if they achieve targets) vs. Yongda’s General Managers at half million (with limited incentive / payout to hit better targets). This year, Yongda has formally announced intentions to restructure its inventive program across its dealerships (to look more like the Zhongsheng incentive program) and in early December they instituted a new senior employee share plan (to 16 grantees) with a strike at around HKD 14 (+40% vs current; incentivizing focus on shareholder return). 

Gross Margin Sanity Check / What We are Underwriting

To simplify the model, we are underwriting RMB 6,300 in gross profit per unit on a consolidated basis going forward, which translates to around a 2.3% gross margin. This works out to a 2.6% gross margin on luxury sales if one assumes the mass market will earn 0.5% gross margin indefinitely.

As a sanity check, Yongda’s closest peer – Zhongsheng – earned a ~3.7% gross margin on its luxury sales and 0.4% on its mass market sales in 2019. U.S. dealers typically earn 4-5% gross margin on new vehicle sales.

Further, contacts we have spoken with suggest that only around 1/3 of dealers in China are making money. While difficult for us to track, this industry structure is obviously unstainable and we expect a large portion of supply will consolidate over time, supporting gross margins.

While in FY17, new vehicle gross profit only made up ~1/3rd of the total, the aforementioned gross margin compression otherwise obfuscated the phenomenal growth in the after-sales segment leading to only 4% consolidated gross profit growth in 2018. Investors have resultantly perceived Yongda as a cyclical auto dealer with volatile results.

We think gross margin on new vehicles has since stabilized, with the higher margin after-sales segment making up a larger portion of the total today (~71% in 2020e vs. 61% in 2017). On a go-forward basis, we expect Yongda to put up consistent ~10% growth in overall gross profit, which the market should reward with a higher multiple:

Supporting this is the trend of “consumption upgrade” in China, driving demand for new luxury vehicles.

Thesis point 2) Consumption upgrade will support luxury sales for the market.

The total passenger vehicle demand in China had been steadily growing until 2018. Despite the modest downcycle experienced through 2019, luxury vehicle sales has continued to grow (total passenger vehicles in blue; luxury in orange):  

While the 21mm figure in 2020 places China as the largest single-country auto market, it is still relatively under-penetrated from a car parc perspective. As such, we believe there is a long run-way for a 20-30mm per annum SAAR in China to persist.

Passenger vehicles sales per capita is mostly a function of GDP / Capita. China’s passenger vehicle per capita is roughly 0.17x which compares to Japan at 0.59x (3.4x China) and the U.S. at 0.84x (4.8x China). The delta between the countries roughly approximates the GDP/Capita, though there are other variables (e.g. Japan’s relative high level of public transportation). The below charts show this trend between major countries as well as China’s development over time compares with the U.S.:

Below, we show a simplified analysis supporting this. This shows the annual car parc growth required to hit our estimate of cars/capita over time and it does not make any estimates for scraps (which will increase over time as vehicles age; further supporting annual passenger vehicle sales):

We are not underwriting increases in China’s SAAR in our analysis, but we show this as support for at least the current 21mm per annum level over time.

Luxury penetration has increased significantly over the past five years. The luxury penetration rate (of units) in China was a steady 8% from 2012 to 2016. It suddenly inflected to 12% in 2018 and is currently ~16% (more or less in-line with the U.S.):

We believe there is upside to growth here from 1) China SAAR increasing and/or 2) further increases in luxury penetration.

We have Yongda’s luxury volumes growing at a 10% CAGR over the next 5 years, with SSS growing 2.3% CAGR and luxury outlets growing at a 7.1% CAGR (11% CAGR from 2015 to 2020).

China luxury car parc and Yongda’s install base has grown over time, supporting future growth in the after-market.

As mentioned, premium vehicle penetration in China had been around 8% of total SAAR from 2012 to 2016, which subsequently inflected to ~16% in 2020. This means that the cohort of new luxury-adds to the car parc has more or less doubled over the past few years.

As such, even if one assumes China’s SAAR stays flat from the trough level of 2019/2020 and luxury penetration does not increase further, the luxury car parc will CAGR at 9% over the next 5 years. This is a very powerful underlying driver of Yongda’s service business which I think is underappreciated due to the lag between new car sales and after-market business.

While we show a conservative projection above, we expect the luxury penetration and/or SAAR to expand modestly, resulting in an ~11% CAGR in the luxury car parc over the next 5 years.

As the incumbent, Yongda should have an existing captive market for after-market service in the tier-1/2 cities it serves. As we have observed in the U.S. market, there is a service loyalty to the dealer one purchases their vehicle from (a sort of razor/razor-blade model). This more or less appears to also be the case in China for luxury brands since customers are less price sensitive.

Customers are ensured that they are getting high quality service and official spare parts. Further, warranty / add-on insurance products require servicing at the official dealer. That is, the insurance company will have an agreement with the 4S dealer owner, so that the dealer store selling the insurance product ensures loyalty (and feeds the go-to-market for the insurance co).   

So far, Yongda has enjoyed immense growth in its total after-market gross profit, with steady SSS expansion as well. Given 11% expected CAGR over the next 5 years in the luxury car parc, we underwrite 6.5% expansion in after-market gross profit per Yongda outlet over the next 5 years, or a ~11.4% 5 year CAGR (includes growth in outlets over time):

While we simplify the analysis above for purposes of modeling, one can look at the growth in Yongda’s own install base to observe the growth in the potential service pool / TAM. Below we aggregate the premium units sold in the prior four years (the standard service warranty period is 4 years) and apply a 25% churn to vehicles per annum outside of the warranty period, which shows continued DD growth in the “calculated service pool of Yongda units” over the next five years:  

Note, the above analysis is for illustrative purposes (in reality, they have some customers on extended warranty and customers that come in on no warranty at all).

Valuation

Over the next five years, we project luxury volumes growing at a 10% CAGR and mass market remaining flat, for a total 7% CAGR in volumes. We hold gross profit per unit flat at RMB 6,300 (which we think is conservative given the mix shift towards higher margin luxury units / higher margin luxury brands), which results in a 7% CAGR in vehicle gross profit.

Key to the investment is the growth in the after-market, which will be a more stable earnings stream. We have this growing at an 11.4% CAGR over the next 5 years (as mentioned previously). Combined with a small amount of other gross profit (rentals and finance fees), total gross profit will CAGR at 10% to 2025. Holding finance costs fixed (we think they can grow with internally generated FCF), pre-tax profit margin will expand from 2.9% in 2020 to 3.7% in 2025, which along with the gross profit growth results in a 14% 5 year CAGR in pre-tax profit.

We believe this business should garner at least a 7% earning yield come 2025, or 14x EPS. At our estimate of 2025 EPS of RMB 1.42, this would result in a RMB 20 stock price (or RMB 23 when adding in expected cumulative interim cash to be generated after capex). This compares with the current price of RMB 8.5 (169% upside over 5 years; 28% IRR).

Risks:

• There is a flood of new dealer supply that reduces profitability of new vehicle sales / after market

• Mitigants:

•  OEM incentive / luxury status

• Good luxury car brands care about supporting stable price points for their vehicles. Rampant discounting inspires little confidence in the premium status of a brand. Official “4S” dealers in China need a license from the OEM to operate. BMW, for example, has a soft rule of not allowing another dealership to open within a given mile radius of an existing dealer (varies by region). As such, we believe the risk of dealership growth far outpacing underlying demand is limited.

• In general, luxury OEM’s care significantly about their relationship with dealers. They want to ensure good standards of customer and vehicle service. This produces an entrance barrier in that certain OEMs, e.g. BMW, only allows existing dealers to apply for new store licenses.

• Upfront investment

• Further, the upfront investment required is greater for high-end brands. We have heard of estimates of around RMB 80-100mm of capital per outlet for a high end brand (50mm for land + premises, 30-40mm for working capital, and typically payments to the OEM for authorization). Mid-end brands require half the investment (30-40mm per outlet) and they do not need to pay to be authorized. Competition is more likely to be seen in the mass market, resultantly. Significant further deterioration in mass market dealer economics would give us some pause / caution here and is a key sign post. 

• White space

• Today, we believe the whitespace is fairly large with many large districts containing only one dealership (around 3 districts in Shanghai have 0 BMW dealerships today). 

Model -- note numbers are in RMB (including per share amounts) while the local listing is HKD.

Disclaimer: This memorandum is for discussion purposes only and is not intended to be, nor should it be construed or used as, financial, legal, tax or investment advice or a general solicitation. This memorandum is as of the date posted, is not complete and is subject to change. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates. Certain information has been provided by sources believed to be reliable, but has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such.

Catalyst

Latent earnings power of the install base showing its way into current results of their after-market segment. With stable new vehicle profitability, the Company should reliably grow low-teens over the next few years supporting a high IRR on a low current year p/e multiple.