Description

Short Contemporary Amperex Technology Ltd. (CATL) SHE: 300750

Company Overview

Founded in 2011 and headquartered in Ningde, China, CATL is an international manufacturer and service provider of lithium-ion batteries for e-mobility and energy storage. CATL became the largest global manufacturer of EV batteries in 2017, producing 11.84 GWh. CATL was the largest NEV lithium battery maker in China with 41% market share in 2018,  supplying global auto brands (BMW, Nissan, Volkswagon, Daimler, Jaguar Land Rover) and Chinese domestic brands (BAIC, Yutong, Geely, Chery, SAIC, GAC, Dongfeng, etc.). The firm has two lines of business - NEV battery manufacturing and battery recycling business. It started out in 2011 with its NEV battery production business, and is currently operating its battery recycling business under Ningde Hengsheng, a company it owns a majority 51% stake of.

CATL has branch offices, manufacturing facilities, and R&D centers in Shanghai, Kiangsu, Qinghai, Beijing, the U.S, France, Germany, and Canada. Its notable competitors include Panasonic Corp. (supplier for Tesla), LG Chem, SK Innovation, Samsung SDI and BYD. CATL has rode the coattails of its recent success in customer acquisition and production volume to expand globally and have its IPO, opening 4 international locations in 2017 and IPO’ing in June 2018 with the sale of a 10% stake. CATL’s future prospects are dependent on its expansion efforts, R&D with next-gen, low cobalt batteries, and margin management.

Company History

2011

• CATL is founded

2012

• CATL Qinghai and JVs established, with CDB Development Fund

2013

• Ningde Hengsheng acquired 45% of Guangdong Brunp to expand recycling business

2014

• Established CATL GmbH (Munich)

• Established Beijing Li CATL

• Established CATL Shanghai

2015

• Ningde Hengsheng increased stake in Guangdong Brunp to 69% (30.6% old, 3.4% new)

• Modified to joint stock limited company

2016

• Established CATL Academicians and Specialists Workstation

• Established CATL Jiangsu

2017

• Founded branches in France, USA, Canada and Japan

• Cooperated with SAIC to found CATL-SAIC United Auto Battery and CATL-SAIC Power Battery System

• Purchased 22% stake of Finnish auto supplier Valmet Auto

• Became world’s largest manufacturer of EV batteries with 12 GWh shipped in 2017

2018

• IPO on Jun. 11, 2018, selling a 10% stake on Shenzhen Stock Exchange (ChiNext market)

• Cooperated with GAC to found CATL-GAC Power Battery and CATL-GAC Power Battery System

• Cooperated with Dongfeng to set up CATL-Dongfeng Power Battery System

• Ningde Hengsheng increased its stake in Guangdong Brunp to 71%

Industry Overview

The Chinese NEV battery production and recycling industry is highly competitive, on a course to surpass demand with its produced capacity, and will be defined by shifts in secular drivers in the upcoming 4-5 years. Currently, the industry’s market share is distributed as seen below.

As seen, CATL and BYD are the two largest producers, with no other producer having a market share in the double digits. Also notable is the absence of powerhouse foreign NEV battery manufacturers such as Panasonic, LG Chem, Samsung SDI, and SK Innovation. The dominance of CATL and BYD, as well as domestic producers’ sole occupation of the the industry can all be attributed to a centrally important theme in the industry - government EV subsidies.

The Chinese government has supported the EV and EV battery industries with subsidies for several years. Manufacturers who meet technological specifications for NEV automobiles, batteries, and other NEV products, have received from the government subsidies as well as official designations as OEMs that produce e-mobility, NEV products. To illustrate, CATL, by meeting specifications for its lithium-ion auto batteries, has received subsidies and the designation as a battery OEM that Chinese auto manufacturers can buy NEV batteries from. Unlike CATL, BYD, and the other smaller Chinese manufacturers, however, Korean foreign manufacturers - LG Chem, SK Innovation, and Samsung SDI - have been exempt from subsidies since tensions over THAAD peaked in 2016. While these three manufacturers had set up production and relationships with Chinese auto manufacturers (SAIC, Dongfeng, Great Wall, etc.) before 2016, they were forced to stop production in 2017 due to inadequate order flow, caused by the ineligibility for subsidies. Panasonic, the Japanese foreign manufacturer, has also not received subsidies from the government.

To say that these foreign manufacturers have been inactive in the Chinese market, however, would be inaccurate. Panasonic and the trifecta of Korean manufacturers have been looking forward to 2021, the year that the government’s NEV subsidies will fully phase out. In anticipation of that year, they aggressively started expanding production in 2018, and are all looking to build 1-2 more factories in China in 2019/2020.

There will be several continuing and newborn trends that will drive this industry in the next 4-5 years. An important continuing trend is the downward trajectory of ASPs in both LFP and NCM battery segments. Manufacturers, in their current and future iterations of both batteries, moreso the NCM segment, will be looking to drive their prices down, an effort they will have to balance with subsidies phasing out, margin management, and R&D with new, low-cobalt NCM batteries. Two trends mentioned in the preceding sentence are also notable - phasing out subsidies and new-tech batteries. The phasing out of government NEV subsidies serves as a shift in a secular driver for the industry. Without subsidies, domestic producers like CATL and BYD are sure to see their market share threatened and cut, and will be forced to consider more JVs with both domestic and foreign partners, accelerate and increase R&D spending on new-tech batteries, and more closely manage their margins. Foreign producers, on the other hand, will be looking for strategic partners to quickly scale up their production and build up their order flow.

As for new, technological innovation in the industry, there seems to be a consensus on low-cobalt batteries as the next frontier. Manufacturers, looking to cut costs, are reducing the proportion of cobalt in batteries. Cobalt, which stabilizes and extends the life of lithium-ion batteries, peaked in price in 2017, and is relatively unreliable in supply compared to other metals. Due to reasons of cutting costs and unreliable supply, manufacturers, namely CATL, SK Innovation, and LG Chem, are in the process of building NCM 811 batteries, which refer to a 80% nickel, 10% cobalt, and 10% manganese composition. Panasonic, on the other hand, has put out press saying it is developing a battery with no cobalt, which has been panned by many as unfeasible, given how cobalt is needed to balance out nickel. While no official plans for the regular production of NCM 811 batteries have been publicized, all NEV battery producers will be looking to produce the cheapest, most efficient next-gen battery in 2019.

The last aspect that should warrant attention is margin and cost management. From here on out, the tailwinds of subsidy cutbacks, the rising pressure to innovate for next-gen batteries, and increased competition between foreign and domestic Chinese producers will place an increased pressure on each firm’s ability to turn a profit on its sales and return on its capital, and investors will correspondingly place increased scrutiny on such margin and cost trajectories. Therefore, it must be emphasized that margins are much more important for this investment thesis than other theses for other industries.

Competitor Breakdown

Foreign Producers

Timeline of Foreign Producer Involvement in China

2013

• SK Innovation established a JV with Beijing Electronic Holdings and BAIC Group in 2013 with a 40% stake.

2014

• LG Chem built its first factory in October 2014 in Nanjing

• Samsung SDI built its first factory in 2014 in Xi’an

2015

• LG Chem’s factory sends out its first order

• Samsung SDI’s factory starts production with 1.6GWh

2016

• Panasonic and Dalian Levear Electric establish a JV

2017

• After being cut off of subsidies, LG Chem shut the Nanjing factory down, and sold the equipment to Geely Automotive Co. in 2017

• Likewise to its Korean peers, SK’s JV factory stopped production in 2017. The firm, however, is building a factory that will start production in early 2020 with a 7.5GWh annual capacity

• Samsung’s Xi’an factory goes inactive, with its future unclear

• Samsung SDI, built a new plant in Wuxi in 2017, which is set to open production in 2019 with a capacity of 2.0GWh.

• Panasonic completed construction of a factory in China in May 2017 and sent its first shipment by April 2018.

2018

• In October 2018, LG Chem began development of a new plant in Nanjing, projecting its first shipment go out in October 2019. The firm is expecting to have this plant’s capacity be 32  GWh.

2019

• Panasonic plans to build its second plant in 2019 in Suzhou with Chinese partners, and has an agreement to supply Tesla’s Shanghai plant. Panasonic’s battery cell energy density is above 340Wh/kg, which is above average.

Despite their exemption from subsidies, these foreign manufacturers’ active involvement in establishing JVs and building factories, combined with their technological edge over domestic Chinese manufacturers, have led them to cultivate supply relationships with virtually all global auto brands and select Chinese domestic brands. It must be emphasized that when global auto manufacturers come to launch NEV products in China or globally, they will be certain to court offers and quotes from both foreign and domestic NEV battery OEMs.

Supplier Relationship Breakdown

Domestic Producers

While the greatest threat to Chinese domestic manufacturers’ market share comes from foreign competitors, competition between domestic Chinese producers will be intense in the upcoming years. With all manufacturers looking to increase capacity, mass produce NCM 811 batteries by 2020,  and expand their customer base, it is safe to say that there will be consistent changes in market share and leadership in costs, margins, and battery technology.

In the past three years, the Chinese NEV battery market was dominated by five key players - CATL, Guoxuan High-tech, Tianjin Lishen, Farasis, BYD - who consistently controlled over 50% of market share during this time period and 77% in 2018. CATL, in particular, has grown its market share from 22% in 2016 to 41% in 2018 due to its leadership in NCM prismatic battery cell technology. Farasis great its market share from 1.2% in 2016 to 4.3% in 2018, due to its leadership in pouch battery cell technology, which trumps prismatic and cylindrical battery technology in density. Guoxuan, conversely, has seen its market share decline from 6.9% in 2016 to 4.8% in 2018 due to its over-reliance on LFP battery technology, which is quickly becoming obsolete in the face of NCM 811 technology and pouch technology.

The competitive dynamics between domestic manufacturers as well as those between foreign and domestic will hinge on 3 things - the race to innovate and mass produce pouch and NCM 811 battery technology, increasing battery cell energy density, expanding downstream consumer bases, and maintaining competitive margins in the face of increased competition, dwindling subsidies and a decreased Chinese annual auto demand.  

A brief description of each competitor can be seen below:

1. Guoxuan High-Tech

Guoxuan’s NCM battery energy density is currently 200 Wh/kg, which they project to be 302Wh/kg in 2020. Guoxuan is the primary supplier for JAC and BAIC, and has supply relationships with Zotye, Geely, Chery, SAIC, King Long, and others.

2. Tianjin Lishen

Lishen established a JV with Dongfeng in 2018 in order to produce battery packs with a 3GWh annual capacity to a JV between Dongfeng, Renault, and Nissan. Lishen’s battery cell energy density was 240Wh/kg in 2017, and it is projected to be 350Wh/kg by 2022. Lishan mainly supplies to Changan and Lifan.

3. Farasis

Farasis has a JV with BAIC that produces 8GWh annually. Its density reached 240Wh/kg in 2017 and optimistically will reach 400Wh/kg in 2023.

4. BYD

BYD is an outlier, as it is a vertically integrated battery and auto manufacturer that supplies batteries to itself. Outside of its vertical integration, BYD has a JV with Changan. BYD’s density was 200Wh/kg in 2017, and is projected to reach 300Wh/kg in 2020, placing it on a similar trajectory to the pure-play battery manufacturers above.

The consensus battery cell energy density in 2020E for these manufacturers seems to be around 300-350Wh/kg. Time and innovation will tell which manufacturer can live up to their projections for NCM innovation and density expansion.

Vertically Integrated Auto Manufacturers

Chinese domestic auto manufacturers implementing vertical integration with internal battery cell plants are a competitive threat to pure-play domestic and foreign battery manufacturers alike. While BYD stands out currently as the most vertically integrated battery and auto manufacturer, Great Wall Motor and Geely Auto have also started vertical integration via the construction of in-house battery cell plants - looking for lower battery pricing and stronger, core NEV technology.

With batteries effectively being the powerhouse of a NEV like an engine did for a traditional ICE vehicle, these manufacturers are looking ahead to gain a competitive advantage for years to come. Vertical integration also brings the added benefit of margin improvement, as batteries, currently sourced from outside, pure-play battery manufacturers like CATL, comprise ~40% of a NEV’s COGS.

A brief breakdown of competitors posing vertical integration threats is below.

1. Geely

As aforementioned, Geely bought the equipment from LG’s defunct factory in Nanjing in 2017. With the equipment, Geely built a new plant in Jinhua and invested more capital to establish a new company in Jingzhou.

2. Great Wall

Great Wall established Honeycomb Energy company in 2018, to supply its own battery needs. The company projects to have a capacity of 5.4GWh in 2020.

3. BYD

BYD has a JV with Changan Auto, and expects to grow its current capacity of 21GWh to 100GWh in 2020.

4. Dongfeng and BAIC

Dongfeng and BAIC have gone the alternate route of setting up multiple JVs with multiple pure-play battery companies in an attempt to receive lower battery price quotes. Dongfeng has JVs with CATL and Lishen and BAIC has JVs with CATL and Farasis.

Why This Opportunity Exists

Put simply, the reason for this opportunity’s existence is the market’s cognitive dissonance in regards to equally pricing in CATL’s competitive strengths and weaknesses. CATL timed its IPO on the Shenzhen exchange at an apt time, arriving a year after its rise to become the largest global manufacturer EV battery and during the year where it clearly established its market share dominance in the Chinese domestic EV battery market. The IPO drew positive investor and media attention to CATL’s past 2-3 years of steady, stable earnings growth and favorable competitive positioning - attention that can explain the stock’s IPO success and ensuing months of average to positive performance. Given that positive media attention is not the only factor in positive stock performance, it should be noted that several events - including government press regarding its Made in China 2025 initiative alongside CATL’s intermittent announcement of new strategic partners and suppliers - have also kept the stock performing in line or above expectations.

CATL’s current price, however, does not seem to have any of its substantial risks and competitive weaknesses priced in. These risks and weaknesses, to be addressed in the following thesis section, pose a considerable threat to not only CATL’s competitive positioning, but financial outcomes in the next 3-4 years.

Investment Thesis

1. Ebbing Technological Advantage + Costly Race to Innovate

CATL got its break in the market by being a supplier of inexpensive, reliable LFP batteries. The firm leveraged this reputation and supplier/buyer relationships to break into newer technology, NCM batteries. Now, with the technological status quo in EV batteries shifting towards NCM 811 and pouch designs, CATL’s technological leadership in NCM and LFP battery will be fading in relevance and utility. This transition is not inherently problematic for CATL’s performance, as it affects all other firms in the industry. What is problematic, however, is the capital and time that CATL will have to deploy to carve out its spot as a tech leader in the upcoming NCM 811 and pouch status quos.

While CATL has successfully navigated past periods of turbulence in technological innovation and managed to find itself near the top when positions reshuffle, this upcoming transition period will definitely be the most intense yet. The burden posed by resurgent, powerhouse companies like LG Chem, Samsung SDI, SK Innovation, and Panasonic; advanced, pouch-focused domestic firms like Farasis; and auto manufacturers’ vertical integration all make the years of 2019 and 2020 particularly precarious for CATL and other Chinese EV battery makers. With all relevant manufacturers looking to set up production of next-gen, low-cobalt NCM 811 and pouch batteries in Chinese factories by the end of 2020, the impact of this turf war and buyer procurement will have a substantial impact on CATL’s order log and R&D spending. It is the view of this thesis that the impact of this transition on CATL’s R&D spending and order log  is being underestimated by the market and equity research reports.

2. Ephemeral Governmental Support

As outlined in the industry overview and competitor breakdown sections of this writeup, Chinese EV and clean-energy manufacturers have been ‘propped up’ by the government via subsidies and favorable regulations for years. Lack of this government support drove foreign manufacturers out of the Chinese market starting in 2016 - showing the necessity and impact of these subsidies in NEV manufacturers’ unit economics and competitive viability.

Given, however, that there have been sharp cuts in these NEV subsidies in the past year and that these subsidies are due to phase out in 2021, fading governmental subsidies and support is certain to have a material impact on CATL’s unit economics. Again, this ephemeral governmental support will impact all firms in the industry, but it must be underlined that this driver could lead to a reshuffling in market share and profitability amongst both foreign and domestic manufacturers.

CATL’s prospects going into this phasing out of subsidies are more favorable than others, due to its close relationship with the government via its contributions to the ‘Made in China 2025’ initiative, but it is the view of this thesis that CATL will cede market share and experience pressure in its cost structures and price quoting due to this transition into a relatively government-free market.

3. Likely Margin Compression

Due to the aforementioned two drivers of transitioning battery technology and fading governmental subsidies, CATL will experience compression in its gross and EBIT margins in the next 3-5 years. Its current cost structures and resultant margins revolve around the production of both LFP and NCM batteries, but the introduction of next-gen batteries, fading subsidies, and increased competition will all go towards compressing these margins. While this view is widely espoused by most, if not all equity research reports, it is arguably the centerpiece of this investment thesis.

4. Hemorrhaging Market Share

Increased competition, coming from rising domestic manufacturers like Guoxuan, Lishen, and Farsis, returning foreign competitors like LG Chem and Panasonic, and vertically integrating NEV auto manufacturers, will make the task of CATL retaining or expanding its current market share much more difficult than in the past 1-2 years. Market share projections are especially difficult to make, but it is very likely than CATL, at least in the short term, will experience a downturn in its market share due to auto manufacturers have a wider selection of battery OEMs to source from. As CATL still has considerable competitive advantages over companies in the field, however, it must be emphasized that not only will CATL not lose an existential portion of its market share, but also that this thesis is not dependent on CATL losing substantial market share. Instead, this driver is seen as an incremental factor that can provide more room for downside if CATL does hemorrhage market share.

Valuation

A DCF valuation model, using EV/EBIT multiples, was used to model CATL’s future cash flows. The primary drivers of CATL’s financials were its battery ASP, sales volume, and gross, EBIT,, and EBITDA margins. The aforementioned margin and innovation aspects of this short thesis are embedded in the drivers. Conservative estimates were used for margin and growth drivers, as well as for EV/EBIT multiples, which represent the median multiples among Chinese NEV battery manufacturers. The current output of the model can be seen below.

Risks

• Continued, favorable governmental regulations

• Drop in cobalt, cathode, anode, separator, electrolyte prices

• Streamlined NEV infrastructure construction

• Consistently expanding NEV demand

• Consistently declining NEV auto prices

• Thesis has similarities to ER reports, raising questions about the thesis’ risk-reward

• CATL exceeds projections in foreign expansion growth and profitability

Appendix

CATL Supplier Structure

CATL Shareholder Structure

Catalyst

Ordered in importance/likelihood of occurrence

• Phasing-out of subsidies

• Dip in monthly/quarterly volume statistics

• Outpacing in capacity expansion/factory construction

• Margin compression outlined in quarterly/annual statements

• Pattern of being outpaced in supplier JVs, cooperation agreements (seeing its new agreement with Volvo makes this catalyst the least important, at least for the very near future)