Description

I am long 881.HK, Zhongsheng Group Holdings Ltd, a Hong Kong-listed Chinese auto retailer. The situation is as hairy as a gorilla and as much bathwater as baby, but the stock’s valuation has declined low enough to account for the thorniness of the story, down -85% from the peak. While the U.S. auto retailing sector is well covered on VIC, the Chinese auto retailers are not, with only a writeup of 3669.HK (China Yongda) in January 2021, which seems like a decade ago given what’s happened in the Chinese auto market since then. I think (i) over the medium-to-long term, the various uncertainties/questions swirling around the Chinese auto retailers will fade, (ii) incentives are well aligned, with founders owning 40%+ and desperate to survive the current storm, (iii) capital allocation is favorable, with a high dividend and payout ratio, modest leverage, and cautious current investment in the businesses, (iv) margins are nearing trough levels, and should ultimate expand from 2024 metrics, (v) there is business flexibility inherent in the auto retailing model that will allow Zhongsheng and other retailers to adapt and pivot successfully to the new Chinese automotive world order, (v) valuation is dirt cheap, and (vi) as with the U.S. auto retailers, a healthy parts and services business aka crown jewel will continue to generate healthy cash flow, and ultimately will support an attractive above-market valuation multiple, one day. 

Nevertheless, to frame what the bull case is up against, here are decent articles discussing some of the ugliness facing the publicly traded Chinese auto dealers right now:
https://www.wsj.com/business/autos/china-is-no-longer-an-open-road-for-german-carmakers-4176abcb
https://www.wsj.com/articles/foreign-car-makers-take-hard-knocks-in-chinas-auto-sector-brawl-ead650bd?mod=article_inline

Margins have continued to deteriorate in recent months, as pricing pressure has intensified, and volumes will probably be further cut in 2H 2024. I don't think we're at the cycle's bottom yet, but valuations have come low enough that I've purchased shares anyway. 

Company background:

Zhongsheng is the largest publicly traded auto retailer in China. There’s two other publicly traded HK-listed Chinese auto retailers, 1268.HK (China MeiDong) and 3669.HK (China Yongda). A key difference between these players is the brands that they retail, in that the Chinese retailers have more brand concentration than the more diversified U.S. players. Given the swift changes in market share that are occurring as a result of the rapid rise of Chinese NEVs, the resiliency of certain brands versus others will have a significant impact in how the auto retailers fare in the coming years. 

For Zhongsheng, new car sales revenue is split approximately as follows:

Mercedes – 41%
Toyota – 18%
Lexus – 12% 
BMW – 11%
Audi – 7%
Others – 12%

As one can see, Zhongsheng retails nearly exclusively foreign brands, and currently very little Chinese brands. The reason for this is that historically, the most profitable dealerships were ones selling and servicing foreign cars, with margins in both sales and in parts and services being materially higher for a premium car like Mercedes or Porsche versus more affordable mass market cars. Chinese automakers historically, as well as currently, focus on affordable mass market cars. 

Zhongsheng is led by Huang Yi (current chairman) and Li Guoqiang (current CEO), who co-founded the company in 1995. They own 49.1% of the company, and in the first 12 days of July 2024 they purchased an additional 4.3m shares at HK$11.68 avg price per a HKEX July 12 disclosure. 

As of their investor day last year, the company had 318 of their ~420 dealer stores in Tier-1 and Tier-2 cities, and has identified 32 “core” cities that it has built some dealer concentration in and intends to focus much of its near- to intermediate-term energy on. Across these 32 cities, its “average” market share for Mercedes, Lexus, BMW, Audi and Toyota averages from 20-40%. Avg store age is 10yrs, and the company has placed particular focus on its CRM and digital strategy (including social media) to drive sales and customer retention. 

In addition to greenfields, Zhongsheng has relied on an aggressive M&A strategy historically to grow and consolidate the industry, acquiring 10-40 dealerships per year in many years throughout the 2010s, spending 1-2b RMB per year not infrequently. It acquired 122 luxury car dealer stores from 2017-2022, and 131 in total, with total M&A investment of 16.8b RMB. 

Industry background: 

Anyone interested in this idea should spend time studying the U.S. auto retailers if they haven’t. There are many parallels between the U.S. and Chinese publicly traded auto dealers. VIC has a plethora of well-argued investment theses for being long auto retailers, and the Q&A sections are also additive: 

https://www.valueinvestorsclub.com/idea/ASBURY_AUTOMOTIVE_GROUP_INC/0963111191
https://www.valueinvestorsclub.com/idea/ASBURY_AUTOMOTIVE_GROUP_INC/2542697919
https://www.valueinvestorsclub.com/idea/ASBURY_AUTOMOTIVE_GROUP_INC/2732715678
https://www.valueinvestorsclub.com/idea/ASBURY_AUTOMOTIVE_GROUP_INC/4900863795
https://www.valueinvestorsclub.com/idea/ASBURY_AUTOMOTIVE_GROUP_INC/5449933214
https://www.valueinvestorsclub.com/idea/LITHIA_MOTORS_INC__-CL_A/1008323458
https://www.valueinvestorsclub.com/idea/LITHIA_MOTORS_INC__-CL_A/0416299184
https://www.valueinvestorsclub.com/idea/LITHIA_MOTORS_INC__-CL_A/5458103584
https://www.valueinvestorsclub.com/idea/GROUP_1_AUTOMOTIVE_INC/1091728563
https://www.valueinvestorsclub.com/idea/GROUP_1_AUTOMOTIVE_INC/0228372011
https://www.valueinvestorsclub.com/idea/Sonic_Automotive/5029833759
https://www.valueinvestorsclub.com/idea/AUTONATION_INC/6243250958
https://www.valueinvestorsclub.com/idea/AUTONATION/1690355494

This substack primer is also good: https://mjsinvestments.substack.com/p/in-depth-industry-overview-us-franchised?r=cjqj6&utm_medium=ios&utm_campaign=post

China lacks the franchise laws that U.S. auto dealers benefit from, but it’s unclear how much of a difference that makes. Ultimately, in China as in the U.S., dealers operate mini local monopolies and oligopolies that allow them to extract high profit margins for parts and services from a fragmented customer base.

Valuation discussion:

Zhongsheng trades at a low multiple based on both P/E and P/FCF and generates substantial cash flow accruing to equity holders. Below we show net income, and calculate free cash flow in two different ways – first, taking EBITDA and subtracting material annual cash costs and second, taking cash flow from operations and subtracting operational items in the cash flow from investing and financing sections (the second method includes 2023's use of working capital). In 2023, Zhongsheng generated about 5b-5.5b of earnings/cash flow (excluding changes in working capital) off of a current market cap of 30b, for a yield to equity of ~17%+ or a price-to-earnings/cash flow of ~5x-6x. 

As we can see in the table above, net income, EBITDA and FCF all declined in 2023, falling 25-30%, after declining similar amounts in 2022 as well. Before getting deeper into what’s driving this, I want to discuss the split between the company’s profit from selling new cars versus its parts and services business. 

As we can see, while gross profit shrank 14% in 2023, it was primarily due to vehicle sales gross profit, which shrank from 28% of total gross profit in 2022 to 15% in 2023. After-sales service gross profit actually grew in 2023, up 2% on the year. We’ll dig into both the vehicle sales trends and the after-sales service trends but a key part of the long thesis is that the year-over-year profit declines are going to slow down and ultimately reverse because new vehicle sales margins will bottom soon (perhaps in the next 12-18 months), while the after-sales services business continues to grow, or maybe decline a little over the next two years but then return to a long-term secular growth trend. 

Industry backdrop

Over the past 5-10 years, and especially accelerating over the past few years, the Chinese domestic automotive industry has transformed dramatically with the rise of new energy vehicles, or vehicles that rely primarily on electricity versus gasoline (ie. BEVs and PHEVs). Chinese new energy vehicles have violently burst onto the scene and taken dramatic market share, triggering massive ripples throughout the entire global automotive marketplace. Fully battery electric vehicles have dominated Chinese NEV sales, though plug-in hybrids have more recently grown to a little less than a third of NEV sales. 

Total Chinese NEV sales have jumped from approximately 1m cars in 2020 to 9m in 2023, and are forecast to grow another 22% in 2024. In the first half of this year, NEVs comprised 35% of Chinese cars sold, compared with approximately 9% in the United States. In 2020, NEVs comprised only 6% of Chinese car sales. Outside of Tesla and Volkswagen, the top 10 EVs sold in China are all Chinese, and foreign automakers have lost market share in China to Chinese companies in the country's rapid consumer adoption of EVs over the past few years. 

Since the publicly traded auto dealers mainly sell foreign cars, they’re losers as a result of this shift in market share. However, there is more nuance to it than that. 

First, the publicly traded dealers primarily sell premium luxury vehicles (ie. Mercedes, BMW, Porsche, Lexus, Audi, Land Rover), as opposed to Hyundais and Kias. The dramatic rise in NEVs has, to a large degree, occurred in the mass market channel, and the foreign automakers suffering heavy losses have been foreign cars that target the mass market, such as Japanese, Korean and American automakers. This article for instance discusses how Japanese automakers declined 11% in 2023 while Chinese automakers grew 24%. 

Intuitively, this all makes sense. Most consumers are focused primarily on buying cars that best fulfill their practical needs with the least financial cost. Chinese EVs are now cheaper to buy and cheaper on an ongoing basis than, say, a Kia Sorrento. But another segment of car buyers are focused moreso on utilizing their cars to demonstrate wealth and prestige – cars fulfill a similar function as one’s watch, jewelry or clothing brands. Those have always been the consumers that buy Mercedes, Porsche and BMWs, both in America and in China. And just as China has always been a strong end market for European fashion, watches and luxury goods, I believe it will continue to be a healthy market for Europe’s luxury cars over the long term. Although European carmakers have lagged in matching Chinese carmakers in the EV transition, I think that gap will be closed sufficiently enough by the 2026-2028 timeframe.

In 2023, Mercedes’ Chinese car and van unit sales declined -2.2%, with overall Chinese vehicle sales declining -7%. Earlier this year, Mercedes guided to a “slight increase in market volume” in 2024 -- after the most recent months, it doesn't look like that will happen. China has been Mercedes’ largest market with 36% of the company’s total unit car sales in 2023, more than double the United States. In 2023, BMW posted 4% growth in China, currently sells 6 EV models, is releasing an all-electric MINI Cooper, has bolstered its R&D efforts in China and is building out charging stations both on its own and in conjunction with Mercedes. Lexus sales increased 3% last year in China, while Toyota’s China deliveries declined 1.7%. Toyota sales declined 13% in 2022, and were also down another -9% between January and April of this year. 

The long thesis isn't premised on how foreign car sales are trending in China at this moment, and they could very well be taking a turn for the worse. 2H numbers for both the auto dealers and for foreign automakers in China could very well surprise to the downside. New car sale gross margins are reported to be negative among a number of brands in the first half of the year, and will continue to be so in the second half. Dealers may miss in 2H 2024 and may miss again in 1H 2025. My thesis is more that foreign luxury cars will remain competitive in China over the long-term and that the volume and pricing declines we’re seeing are more cyclical in nature than secular. We'll be approaching trough levels in the next 12-18 months. Valuations are low enough to make the stocks attractive buys even though we’re not at the cycle’s bottom necessarily today. 

A key problem facing these foreign automakers, as well as the dealers, is just simply an oversupply of cars in China. Chinese efforts to stimulate its electrical vehicle industry over the past 10 years, combined with cheap capital funneled to EV startups during the 2015-2021 go-go tech bubble years, has created Chinese EV manufacturers that continue today to lose money but churn out cars. EV carmakers like XPeng, Nio, and Leapmotor are significantly cash flow negative and have seen their stock prices decline significantly, yet continue to grow their auto production and sales in an effort to grow into their cost structures. Xiaomi and Huawei don’t disclose their new EV subsidiaries’ financials, but they’re unlikely to be profitable, and some SOEs like GAC, which owns the EV brand Aion, are now burning cash as well. Then we have the foreign mass market automakers that are losing share but clinging on to the Chinese market given the historical growth and profitability they’d experienced in China in the past. The result of this oversupply of cars has been price-cutting by all players, with Tesla initially leading the charge in its efforts to maintain market share and try to drive weaker players out of business. 

Declining profitability across all automakers, in addition to weak volume due to the overcompetition and the rise of Chinese EVs, has weighed significantly on the new car sales margins of Zhongsheng and the other public traded auto dealers. For the European luxury players like Mercedes, BMW and Porsche, I don’t believe the recent declines in growth and profitability are purely secular in nature, but rather to a large part cyclical declines caused by oversupply in the automotive market. I also think that’s the case for Lexus and Audi, two other material brands for Zhongsheng. As for Toyota, I think the world’s largest automaker will continue to be a meaningful player in China over the long term. 

The market has somewhat of a perception that Chinese consumers are abandoning foreign cars in favor of Chinese ones. While that's certainly happening to an extent, I also think what’s happening is that because of the new abundance of affordable Chinese EVs, the oversupply of cars in China is significantly pressuring car pricing across the board, which has a significant impact on the automakers sales, and the auto dealers’ margins.

Implications for Zhongsheng

Price competition and declining automaker profitability has wreaked havoc on Zhongsheng’s car sales margins. The main culprit has been new vehicle sales. While new car sales revenue is only down -1.5% from 2021 to 2023, new vehicle gross margin is down -83%, as new vehicle gross margins have compressed from 4.4% in 2021 to 0.8% in 2023. In the 2010s period, this margin typically ranged from 2-4%. 

The bullish aspect of this is that, intuitively, vehicle gross margins should only be able to go only so low – at some point, the dealers can take measures to stop selling cars. Vehicle gross profit is hovering at the lowest it’s ever been in the company’s history – it’s safe to say that we’re approaching trough new vehicle gross margins. Excluding OEM rebates, some analysts are saying that new vehicle gross margins are hovering at -2% to -3% currently, and OEM rebates may bring those to perhaps around -1% this year. 

Pre-owned vehicle sales, in contrast, have been growing rapidly, and represent one of the areas of opportunity for both sales and profit in the coming years. 

I break out new and pre-owned vehicle sales and gross profit below over the past 4 years for Zhongsheng.

We can see significant growth in pre-owned vehicle retail revenue, and healthy margins in pre-owned vehicle sales. Pre-owned vehicle sales have grown from 2.5b RMB to 14bn RMB from 2020 to 2023, with gross margins of 5-7%. Pre-owned vehicle gross profit now accounts for 7% of overall gross profit, and 32% of overall vehicle sales gross profit, up from 10% in 2022 and 5% in 2020. 

So when we think about overall vehicle gross profit, we have (i) new vehicle gross profit margins that I believe will bottom soon, and (ii) we have a third of those gross profits coming from pre-owned vehicles, where sales grew 42% last year and are up more than 5.4x in the past 4 years. It would appear to me that vehicle sales gross profits shouldn’t decline much further after 2024. 

This begs the question of why pre-owned vehicle sales have been growing so rapidly recently at such a healthy margin. Why were they not a more material part of the business before 2021? In the United States, pre-owned vehicle sales are a more meaningful part of a dealership’s revenue and profit, so why was it essentially non-existent in the P&L of Zhongsheng and other Chinese auto dealers. The answer is that, overall, there’s a fair amount of low-hanging fruit for the Chinese dealerships. Prior to 2021, Zhongsheng didn’t have to care about pre-owned vehicle sales to drive growth and profitability. There was ample growth and profitability coming from new vehicle sales, warranty/finance/insurance revenue, aftersales parts and services, etc. Only after the world turned upside down over the past few years have the dealers ramped up pre-owned vehicle sales to generate additional profits. 

Note also that the used-car business generally offers higher margins for a dealer as compared to new cars. This is due to the fact that the pre-owned cars are case-by-case (each pre-owned vehicle is different) while new car sales are more commoditized, since all new cars of a given brand and year are the same.

Ultimately, in any car sales, there’s two parties making money – the OEM and the dealer. When car prices are going up, and demand outpaces supply, as it did famously during Covid, both OEMs and dealers are raking in profits. When supply outpaces demand, naturally both suffer. The degree to which one suffers relative to another is a matter of ongoing negotiation. The reality is that OEMs can be reluctant to stop selling cars and cut supply too dramatically because they don’t want to lose market share. Dealerships can always convert dealerships to another brand, but OEMs are stuck with the brand they have. To keep dealerships motivated to keep selling their cars and not to start switching to other brands, OEMs need to ensure that dealerships are at least somewhat profitable. From a practical standpoint, this typically leads to OEMs giving rebates to the dealerships (oftentimes, OEMs don’t want to cut MSRPs, and since dealerships are forced to cut prices in order to sell cars, OEMs then pay dealerships rebates to ensure the dealerships’ sales are sufficiently profitable for the dealership). In 2021, dealerships were generating fat profits, and so as new vehicle sales margins were getting obliterated from 2021 to 2023, OEMs were less pressured to provide rebates to the dealerships to ensure profitability. But now, dealership new vehicle sales margins are at historic lows, and there’s not much more room to cut margins, so we’ve reached a point where OEMs will have to dig into their pockets to ensure a minimum margin for the dealers, if they want to defend market shares. And if they don’t, then Zhongsheng can begin converting those dealerships to other brands and/or collision centers, depending on what provides the most attractive opportunity. In some cases, certain brands are ok with losing market share and selling less cars in 2024 , as the reduced supply will support pricing, which they want to remain high in order to continue being seen as a premium brand. Porsche for instance has guided its China unit sales down by 10%, and we've heard about data that indicates units are down as much as -40%. It wants to maintain premium pricing for its brand rather than slash prices. That works for dealers as well to some degree, in that new vehicle margins remain supported, though volume and thus overall dealership sales will decline, and future after-sales service revenue will get hit. 

To repeat an earlier point, new vehicle margins can go negative, and have. Margins for numerous mid-tier brands went negative last year, and will probably be negative for numerous luxury brands this year. So I don’t believe 2023 was the bottom for new car margins. But I do believe we’re getting closer to a trough in new car margins. 

Zhongsheng Before 2021 Versus Zhongsheng Post-2021

It’s worthwhile stepping back here and providing some historical background to the Zhongsheng story. Essentially, historically, Zhongsheng operated a fast-growing, profitable business rapidly gobbling up market share in a heavily fragmented market, where it was the big, publicly traded player rapidly consolidating an attractive market. Those who have studied the U.S. auto dealer industry know the story well. Lithia, for instance, has grown from $2b in revenue and $2 EPS twenty years ago to $36b in revenue this year and $28 EPS. Its stock is up 10x. 

Zhongsheng was very much along that same path prior to 2021, further benefitting from being: 

1. in a market with higher growth, given China’s higher overall growth rate than the U.S. and materially more rapid rate of gentrification and therefore car buying as compared to the U.S. In addition to a smaller percentage of Chinese owning cars versus car ownership per capita in developed markets, a smaller percentage of Chinese car owners own luxury cars versus what we see in developed countries. The long-term tailwinds benefiting European luxury brands remain robust, outside of the EV issue.

2. with less competition for M&A, given the smaller number of publicly traded players and lack of PE competition that exists in the U.S.,

3. with the scale benefits of being the second largest overall player and largest publicly traded player, and 

4. operating in an overall more fragmented market than the U.S. 

Pursuant to these drivers, Zhongsheng grew its revenue from 6b RMB in 2006 to 175b RMB in 2021, and its EPS from 0.30 RMB/share in 2009 to 3.50 RMB/share in 2021. Its stock went from HKD$10 in 2010 to HKD$75 in 2021. As you go through the company’s investor presentations and remarks, it’s relatively straightforward that the company was deliberately following the same playbook as the U.S. auto dealers, in rapidly consolidating a fragmented market of local oligopolies, and churning out high profit margins in parts and services and ancillary services while making a little profit as well in vehicles sales. Along the way, Zhongsheng also got a high profile investment from well-known HK investor Hillhouse, and the reputable Jardine family of companies, which currently owns ~20% of shares and has two board members. As an aside, the investment of these reputable investors provides additional comfort in the quality and legitimacy of Zhongsheng’s business and its management team. 

After-Sales Services Business:

Like the U.S. auto dealers, the hidden gem in the Chinese auto dealers, including Zhongsheng, is the aftersales parts and services business. Here are relevant financial metrics: 

First, after-sales service revenue and gross profit has continued to grow, even with store growth being muted in 2022 and 2023. Second, after-sales service gross profit margins are robust, at 47%, and haven’t deteriorated materially in the past few years. Those margins demonstrate that, as in the U.S., after-sales parts and services is just a wonderful business – and particularly at dealerships selling premium luxury vehicles. Third, as vehicle sales gross margin has shrunk, after-sales gross profit has become a larger and larger chunk of the overall profitability of Zhongsheng, growing from 71% of overall gross profit to 86% in 2023. After-sales gross profit has shown no signs of potential declines, though as new car unit sales volume potentially declines in 2024, I can see growth stalling for a few years in the after-sales services segment. As after-sales profitability becomes a bigger and bigger part of the overall company profitability, we get closer and closer to the bottoming of the company’s overall financials, and the overall profit and cash flow declines seen in 2022 and 2023 can be coming closer to an end. Fourth, on a per store basis, after-sales services revenue and gross profit both looked healthy through 2023, and were up modestly from 2022 to 2023. 

The reasons cited for the robustness of the after-sales business are similar as to what’s discussed in the U.S. As cars become more sophisticated, trusting maintenance and repair to certified dealerships continues to be the sensible option to customers as opposed to taking a Mercedes or BMW to the local mom-and-pop. Given that consumers typically take their car to the local dealership and don’t shop around beyond maybe one or two other local certified dealers, dealers have pricing power. 

Other Income and Gains

Zhongsheng also discloses some of its operating profit in a line called “Other income and gain, net” within its income statement. 

The commission income here comprises the bulk of this line item, and is essentially an operating source of profit, and a particularly lucrative one at that. Commission income represents commissions from auto insurance, auto financing, auto registration services, etc. It grew 10% in 2023 and 7% in 2022. Commissions have continued to grow because they’re tied to unit sales, and unit sales continued to be decent through 2023. New vehicle sales margins have been hit hard because the overall oversupply of cars in the Chinese automotive industry has crushed vehicle pricing, and falling car prices has led to dramatically contracted new vehicle sales margins for the dealers. But since automakers were loath to lose market share, units had’t suffered as much through 2023. 

At RMB 4.1b, the commission income embedded in Other Income is a material source of profit and cash flow for Zhongsheng, in light of a 2023 gross profit of 13.8b and overall EBITDA (less leases) of 9.3b.

Luxury vs Mid/High-End Brands: 

Here is the company’s breakdown of brands by store, and by revenue for some of the more significant brands: 

Unit Sales Trends:

Below are stats related to new vehicle unit sales and sales per store: 

While total unit volumes and sales of units/store have been declining, these declines are not overly dramatic. Notably, as we saw from the prior section, total new car sales looks to be around 78% from luxury cars and 22% from non-luxury cars. Presumably 75-80% of after service sales and commissions are also generated from luxury brands versus non-luxury brands, given that luxury brands comprise 64% of the overall store count and likely have materially higher margins and profitability than non-luxury brands. Given that unit declines have been relatively modest among the luxury brands, that is a reassuring sign for what future after-service sales and commission revenue trends may be. A significant dropoff in luxury units sold would indicate a declining installed base for after-service sales, and lower commission revenue. Intuitively, while there will probably be a decline in volume in 2024 and 2025, I don’t think that Chinese consumers over the long term will move away from luxury foreign brands, especially Mercedes, BMW, Porsche, etc. Lexus thus far has been holding in ok as well. I wouldn’t be surprised if Hyundais, Chevys, Nissans, Fords, Mitsubishis, Buicks and other mass market cars see material market share loss to Chinese NEVs. But in the same way that the Pura Vida parking lot in Miami is filled with Range Rovers, Mercedes and Porsches, and not Fords, Dodges or other proud American brands (nor Nissans nor Hondas), I think that the brand-thirsty segment of Chinese consumers will continue to seek out non-Chinese luxury brands over the long-term, as long as the foreign luxury automakers sufficiently catch up in the EV race, which I think they will in the 2026-2028 timeframe. China is also the biggest, most important market for each of Mercedes, BMW, etc. They’re going to defend market share aggressively, and continue to employ brand-building efforts to appeal to Chinese consumers. And if units don’t decline materially over the long term, the profit centers of Zhongsheng – after-service sales and commission revenue – should continue to hold in. 

Operational Flexibility – Dealerships Can Easily Switch Brands

An ace in the back pocket of the Chinese dealerships is the ease with which they can convert dealerships from one brand to another. I make the argument that most of Zhongsheng’s brands will continue to do fine in the Chinese market long-term, even as grim as the current downturn has been. But if they don’t, Zhongsheng can always switch from one brand to another. If in the hypothetical scenario that Mercedes loses much of the luxury vehicle market to a luxury Chinese NEV upstart like Li, Nio or Huawei, Zhongsheng can strike a deal with the Chinese NEV company and begin converting Mercedes dealerships to the new market share winner. Naturally, this isn’t the ideal scenario and there is modest capex involved in converting dealerships. But on a dealership by dealership basis, this flexibility to convert dealerships is an important tool at Zhongsheng’s disposal to continuously rightsize its footprint and adapt to the changing auto landscape. 

From my discussions with management and sellside, my view is that we’ve seen Zhongsheng slow to embrace the new Chinese NEVs and convert dealerships from foreign automakers to NEVs because (i) they’re skeptical of many of these new NEVs’ long-term viability prospects and (ii) they wouldn’t be very profitable in the near-term because many of these NEV brands are not selling enough cars. I think that many Chinese NEV players would be keen to strike a deal with Zhongsheng to convert a chunk of Zhongsheng dealerships to their brands. These Chinese NEV players, outside of BYD (which sells via dealerships) and Li, are unprofitable and burning cash – they need all the help they can get to sell more cars, grow faster, gain market share and grow into their cost structures. Having China’s largest publicly traded dealership throw its weight behind their brands would be a boon to them. But the problem for Zhongsheng is that even as the Chinese upstarts are hurting profitability at Zhongsheng’s legacy foreign automaker dealerships, converting a Toyota dealership to a Nio dealership isn’t going to make that dealership more profitable. The better case scenario is simply for the Chinese automotive market to become more consolidated or witness a rash of companies scaling down (or going out of business, but that seems less likely in China than it would in the U.S., with local governments potentially stepping in to bail out zombie automakers), and for the oversupply in autos to just lessen over time. 

The big picture point is that Zhongsheng’s ability to convert dealerships at only a small cost and based on its sole decision provides it operational flexibility to continuously adapt to the evolving Chinese auto landscape. Notably, its current conversions of less promising dealerships to collision centers is a prime example of this. 

Yongda also demonstrates another example of conversions in an effort to adapt to the changing automotive landscape. In 2023, it closed 36 outlets, including 24 stores and 9 showrooms, increasing its luxury stores to 70% of outlets and reducing its mid-to-high-end brands from 20% to 15% of outlets. It also opened 36 NEV outlets in 2021 and 2022, increasing its proportion of outlets in new energy brands to 15% of outlets. 

Management incentives and capital allocation:

When industries are undergoing upheaval and a severe cyclical downturn, turnover in management – sometimes caused by impatient fast money shareholders – compounds the issues. I personally prefer an experienced executive team at the helm mandated with a long-term horizon and properly incentivized. One of the attractive features of many Hong Kong-listed companies is that management teams tend to be founder-CEOs who own controlling shareholdings and are both (i) heavily motivated to survive and continue the business given their large ownership stakes and (ii) who can’t be thrown out by impatient, short-term oriented hedge funds / shareholders. With Zhongsheng, the founders Yi Huang and Guoqiang Li own a combined 49% of shares. With significant wealth tied up in the company’s shares, management is laser-focused on taking the right steps to weather the current industry transition and come out the other side well-positioned for growth and success. Their decades of running one of the best operationally performing auto dealerships also make them well suited to trying to adapt to the changing industry landscape. 

Historically, Hong Kong-listed Chinese companies have been criticized for poor capital allocation. Outside of situations of fraud, much of that criticism is typically associated with state-owned companies, where Chinese government shareholders aren’t solely, or sometimes even especially, motivated by driving value to shareholdings. These companies can become overcapitalized, sit on large cash balances (which, over time, may or may not actually exist as corrupt executives steal the money, and the cash balances begin to become discounted, and sometimes severely discounted, by the market when valuing these companies). Furthermore, these companies often pay skimpy dividends with low payout ratios, relative to their cash balances and ostensible cash flow generation. 

Companies that are entirely privately owned, however, don’t necessarily suffer from those same ills. The 3 publicly listed Chinese auto dealers, particularly Zhongsheng and Yongda, have a lengthy track record of employing reasonable capital allocation policies, with significant return of shareholder capital. In Hong Kong, dividends do not receive adverse tax treatment, so companies like Zhongsheng tend to focus capital return on dividends as opposed to share buybacks as is more common in the U.S. (Yongda though has been actively buying back shares, especially recently, in addition to their 50%+ payout ratio). I’m perfectly fine with the dividend-centric approach to shareholder capital return, as it removes the risk of the company mistiming its share purchases, and instead is returning capital back to me to re-deploy as I see fit.

Below are Zhongsheng’s net income, dividends and payout ratios of the past 3 fiscal years

So in 2021, the company targeted a payout ratio (dividend divided by net income) of 20% while it targeted a payout ratio of 35% in 2022 and 2023. For 2024, the company has communicated a payout ratio of 30-35%. These are healthy payout ratios and demonstrate a willingness to return capital. It’s also comforting to know that if management maintains a fixed payout ratio (and there’s no indication it won’t), when net income bounces back and starts growing again, the dividend will rise, and the company’s dividend yield will increase, applying pressure on the stock price to rise. Even in the most depressed markets, a 15% dividend yield will raise eyebrows and draw in investors. 

Additionally, fraud is always a consideration when it comes to Chinese companies, and the best defense against fraud is when a high percentage of each year’s net income is paid out in actual cash to shareholders. That’s especially the case when the company is not sitting on a large cash balance accumulated from prior years, which brings us to the topic of leverage. 

As of 12/31, the company had 31,549m RMB of Debt (excluding lease liabilities), 19,602m RMB of cash, resulting in Net Debt of 11,947. That compares to EBITDA of 9,740 (which subtracts lease payments that can be found in the Cash Flow From Financing section, which I am considering operating cash outflows). So that equates to a net leverage of 1.2x, which is a low figure. The company is employing a little leverage, as opposed to being overcapitalized like some Chinese companies, further implying that the cash is real. Modest leverage also demonstrates that management cares about optimizing shareholder returns. However, the company is not overlevered, such that the business is hamstrung by its debt balance, unable to invest in its business, or at risk of bankruptcy and equity wipeout. 

Even with all the tumult that the company is going through, it generates substantial cash flow and is expected to continue to do so in the coming years. From my discussions with management, further debt paydown may indeed be a use of cash in the near- to intermediate term, and that’s all right with me, as conservative positioning until Zhongsheng returns to growth and sees multiple expansion is a reasonable course of action.

Management Guidance

Earlier this year, management guided to flattish new car sales volume / margin, +10% yoy growth in its aftersales business and +30% growth in pre-owned vehicle sales. These forecasts resonate with many of the assumptions we’ve made and seem highly bullish in light of the company’s mid single digits P/E multiple. 

With that in mind, volumes and ASPs have generally been trending worse-than-expected in recent months with some other dealers forecasting negative gross margins for numerous brands for 2024, as well as declining volumes. So continued deterioration in volume, ASPs and profitability is the safest expectation to have over the near term, and management's prior guidance may be a bit stale at this point. It’s best to assume that the company and other dealers will “miss” and reduce guidance over the next year. Shares of Zhongsheng, Yongda and Meidong are down -17%, -29% and -19%, respectively, since May 1.  

Where is the Company Investing and Where are Peers Investing

Given the rapid and somewhat unexpected changes the Chinese automotive landscape has undergone over the past few years, there remains a fair amount of uncertainty over how it’ll continue to evolve over the near-, intermediate- and long-term. As a result, it’s not especially clear how the auto dealers should invest in their businesses. Interestingly, Zhongsheng and smaller peer Yongda have decided to go in different directions in terms of how to invest in their businesses recently. 

All three – Zhongsheng, Yongda and Meidong – are generally taking a conservative approach to capital deployment. Meidong, with its predominant exposure to Porsche, which imports all of its cars into China and sharply cut volume in the first half of this year, will likely deploy capital mainly to debt paydown and perhaps some modest shareholder returns in the form of dividends and maybe share buybacks. Here are the leverage ratios across the three, as well as a variety of valuation metrics: 

In 2023, there were notable differences between the companies in terms of capital investment. Meidong spent a minimal amount on capex. Zhongsheng tapered down capital investment as well, cutting net capex in half from 2022 levels. Yongda, however, spent a bit more aggressively. 

Yongda reacted to the market environment in 2022 by actively building relationships with emerging NEV players and opening NEV dealerships. There are many NEV players and Yongda had 1-4 dealerships with Tesla, Xpeng, Great Wall Ora, Aito, BYD, SAIC IM, Leapmotor, Lotus, Geely Smart, etc. as of 12/31/23. They scaled back their openings in 2023 given the low ROIC of these NEV dealerships. Zhongsheng, in contrast, experimented with a few XPeng dealerships several years ago, was disappointed with the profit potential of the dealerships, and has taken a wait-and-see approach to see who will be winners among the Chinese NEVs before committing to building out dealerships for specific Chinese NEV OEMs. Meidong has also taken a wait-and-see approach. Presently, sellside analysts are reporting that most EV stores are struggling to break even. Yongda has communicated that it expects its EV stores to turn profitable in 2024, but we’ll see. 

Zhongsheng has, however, launched a different sort of capital investment program: launching a collision center initiative where it is converting some sites to collision centers, building collision centers on certain existing dealership sites and also building out new collision center greenfields. Given the current and potentially ongoing weakness in mid-tier brands, site conversions to collision centers are weighted towards these mid-tier brands with more questionable long-term futures. 

These collision centers are not brand-specific but provide repair and autobody services to all brands of cars. The investor day slides from 2023 have some helpful information on the collision center strategy. By converting sites from providing repair services only to the brand previously affiliated with the dealership to a site that provides repair services to all vehicle brands, Zhongsheng can leverage the same real estate footprint and labor staff cost structure to service a materially higher amount of revenue. As mentioned previously, the company has identified 32 cities where it has multiple dealerships / multiple brands and where it can utilize a digital strategy to boost volume going to its newly brand agnostic collision centers. Part of the motivation for the collision centers is that although the oversupply of cars is pressuring profits from selling new cars, the increased amount of cars on the road will continue to generate ample opportunities for repair and service, and Zhongsheng wants to capture a larger slice of that pie. Zhongsheng points to the United States as an example country where branded chain collision centers have taken significant market share from independent collision centers over time, providing a chart in their 2023 investor day presentation showing how chain collision centers grew from 10% of share of car accident insurance payment in 2000 to 55% in 2022. 

Zhongsheng’s collision centers will attempt to focus on premium customers and premium cars. It will attempt to use its scale, management expertise and operational best practices to develop a reputation as a top quality collision center with superior service relative to mom-and-pops, providing, to borrow from a recent Goldman report, “high operational efficiency, where 60+% of the vehicle repair can be finished within 24 hours; (b) professional workers through assembly line operation, which lays the foundation for providing high-quality services; (c) equipment for some specialized repair service.” It also intends to lean on its insurance relationships, which it has built partly through the insurance options it sells to customers when it sells cars, to have its collision centers referred to collision customers by insurance companies. 

Thus far, the company has 25 collision centers in operation as of end of May 2025, based on July commentary from Goldman. Management has guided to 40+ centers by end of 2024. 

In terms of capital spend, in 2023 management says that they devoted 300m RMB of capex to collision centers. In 2024, they expect to spend 500-600m RMB  of capex to collision centers. 

The company has materially reduced its spend on building out new dealerships currently. In 2022 and 2023, capex to build out new dealerships was minor. In 2024, management has guided to growing its dealerships by only a small number – maybe low single digits – and that’ll be mainly through M&A. I estimate maintenance capex is approximately 700m RMB. 

A large part of an auto dealer’s capex is the purchase of loaner and test drive cars, which it then later either sells and receives "proceeds from sales of property, plant and equipment", or sells the cars as pre-owned vehicles. So in 2023, for instance, they may have purchased 1.8b RMB of car fleet, while selling 1.5b-1.7b RMB of vehicles. 

Here is my estimate for capex breakdown in 2023: 

Acquisitions of smaller and mom-and-pop dealerships remain a use of capital for all of the publicly traded dealerships, and Zhongsheng maintains an open mind towards acquisitions, and expects to complete some in 2024. With many small dealers suffering significantly, Zhongsheng can acquire them at low prices currently. Among other things, Zhongsheng is keen to continue consolidating dealerships in its core brands of Mercedes, Lexus and BMW in cities where it already has a dominant presence, as these acquisitions will be most accretive both in the near-term and long-term. In these brands, in numerous cities Zhongsheng has 30-40%+ market share in Mercedes, Lexus and BMW. Given the 32 strategic cities that Zhongsheng has identified to strengthen localized operations, management may likely focus on these cities for acquisitions. 

The Tariff War

If all this wasn’t enough, the tit-for-tat automotive tariff war and exchanges of threats between the Europe Union and China also have a negative impact on the auto retailers. From a big picture perspective, European policymakers have expressed concern that Chinese NEVs will overwhelm the European market, and have thus far instituted provisional tariffs to reduce Chinese NEV market share gains. In reaction, China has threatened though not yet instituted actions that would reduce European imports to China. Given the high reliance of all the Chinese auto dealers to premium European brands, this presents a risk. 

But the devil is in the details, and, in my opinion, not especially material. Thus far, here is what has actually happened. As of today, the European Commission has passed legislation that would impose tariffs of 17% to 21% on most imported Chinese EVs, with 38% on a few select Chinese automakers such as SAIC. BYD faces tariffs of 17.4%, Geely 20%, Xpeng 21%, Nio 21%, etc. Tesla, the largest EV importer from China, is asking for its own company-specific tariff regime, and the European Commission is considering that. The tariffs went into effect July 5, and were announced on June 12. These measures are provisional, and the EU anti-subsidy investigation that is driving the tariffs is set to continue until November 2, which is the deadline that has been set for the EU to convert the provisional duties to final duties. Provisional duties are only collected if final duties are imposed at the end of the investigation. If final duties are lower or not applied, then provisional duties are adjusted down accordingly. Until then, customs authorities normally just require a bank guarantee from importers.

Note that these tariffs are imposed on EVs imported from China, regardless of whether the manufacturing facility or brand is owned by a Chinese or non-Chinese company. It’s worth noting that more than 50% of EVs imported from China are actually European or American-owned brands currently (Tesla, Volkswagen, BMW, etc). It can be interpreted that part of the motivation behind these tariffs is really to spur moving production facilities to Europe. Along those lines, BYD and Geely were granted lower tariffs because they are opening or have production facilities in the European Union, whereas SAIC, which was hit with a 38% tariff, has no current or planned production facilities in the EU. Given the approximate 20% range that tariffs may settle on for most Chinese EV producers (a 20% increase isn’t overly high, in the whole scheme of things), and the fact that the Chinese carmakers may and likely over time will bypass them by building manufacturing facilities in Europe (as the Japanese carmarkers did in the United States in the 1980s), it seems that this tariff regime could ultimately be one that the Chinese government can live with. There’s a good sampling of videos discussing China’s ambitions to build numerous EV and battery plants in Hungary, such as this.

If that’s the case, China is less likely to take drastic retaliatory measures against European auto makers. There’s additional reason for that. First, German and some other automakers (typically the luxury automakers) are against the EU tariffs and are among China’s best allies in lobbying their governments and the EU to reject or reduce the tariffs. Premium German automakers (BMW, Mercedes, Porsche) are the European automakers who have the most success in the Chinese market, and therefore Germany has been an opponent of the tariffs. European carmakers typically prefer to keep production of their EVs in China, in order to benefit from new Chinese EV-related innovation and economies of scale. So alienating European automakers and Germany may not necessarily make the most sense for China. Second, China can choose to levy tariffs on other sectors, and, for instance, has initiated an investigation into imports of pork and pork by-products, and French cognac. Indeed, European agricultural, food and beverage products are a more politically sensitive sector given the strong farming lobbies in Europe, and therefore targeting those and similar sectors may very well be a more effective strategy for China to fight against the EV tariffs. 

This article lays out the nuanced approach Europe appears to be taking with respect to trade measures related to Chinese EVs: https://www.piie.com/blogs/realtime-economics/2024/europe-taking-constructive-approach-influx-chinese-electric-vehicles. An excerpt:

"The most probable future path for this crucial sector would be for the European Union to cap EV imports from China at a relatively high, mutually acceptable level, while hosting a rising share of Chinese brand EVs made and sold in the European Union, combined with a continued presence of EU brands in the Chinese market, and some high-end German-made EVs exported to China. Under this stable situation, Chinese and EU firms would enjoy reciprocal market access for EV sales and parts and the European Union would accelerate its green transition.

Such arrangements would probably not shrink the aggregate EU-located auto industry output. But Chinese EV producers will become an increasingly large part of the local sector. Meanwhile, the technological shift to EVs will almost certainly result in less employment in the EU auto sector, resulting from shorter supply chains for EVs and accelerating automation. For EU consumers, this path ensures further access to the technologically best and cheapest EVs in the world, overwhelmingly produced within the European Union by all the world’s major EV producers. Some of these EU-produced EVs might even in turn find their way to the US market, though at the risk of triggering a politically driven US trade response.

Lastly, this type of EU EV strategy would dramatically differ from the emerging protectionist US policy response to the Chinese EV sector. As stated by Commission president von der Leyen, the European Union will not join the United States in imposing blanket tariffs on China. Biden administration policies look likely to isolate the US EV sector behind high tariff barriers—inside a small garden with high fences so to speak. Such a strategy will not, despite the stated intentions of President Biden, propel the US EV sector to global leadership. Rather the risk seems to be that the US EV sector chooses to service a relatively small US domestic market with profitable but also idiosyncratic EV models—e.g. electric pickup trucks[11]—with limited export appeal elsewhere in the world. That in turn would set back the goal to decarbonize the US transport sector."

Thus far, the only threat China has made against imports of European cars is when Liu Bin, a top automotive adviser, recommended raising temporary tariffs on large-engine vehicles (specifically, vehicles with engines larger than 2.5 liters) imported from Europe to 25 percent. But with most European carmakers manufacturing vehicles in China, who would exactly get hit? Porsche doesn’t manufacture any cars in China, so its vehicles would be impacted. Then what about Mercedes, BMW and Audi? 

In the table below, based on conversations with management teams and sellside analysts, I estimate the percentage of cars and revenue impacted. 

According to one news report, Chinese official data indicated that China imported 250,000 cars with engines larger than 2.5 liters in 2023, accounting for 32 percent of total imported cars. Larger vehicles and sportscars tend to comprise a higher proportion of imported cars, and they also typically have the larger engines. 

Note that my numbers for the percentage of Chinese unit sales impacted come in a bit higher than some other sellside estimates. For instance, a Reuters article said “Reports have indicated a counter-tariff by China would apply to cars with an engine of 2.5 litres or larger. Cars imported to China of that size account for around 1% of VW sales, rising to 2% for BMW, 4% for Mercedes and 17% for Porsche, according to Stifel Research.” I’m not sure where Stifel is getting its lower estimate. 

Note that imported European cars with 2.5L+ engines tend to be the pricier luxury cars – like G-Wagons, Maybachs, premium sportscars, Porsches, etc. Customers of these cars tend to be less price-sensitive than purchasers of sedans, hatchbacks and more mass-market cars, which tend to have smaller engines and be manufactured in China. So will a small increase in cost, resulting in a modestly higher price, impact demand? I don’t think it will by much. Currently, the oversupply of the overall Chinese automotive market continues to drive vehicle prices down, not up, including for luxury European brands. 

So in summary, (i) the tariffs haven’t actually been levied yet, (ii) it’s likelier that China will counter with tariffs on ag products instead of car imports, or just not levy any tariffs at all, (iii) if tariffs are levied, it’ll impact a small percentage of Mercedes and BMW vehicles, (iv) imported cars with 2.5+ L engines tend to be more premium and either larger vehicles or sports cars, and thus cater to a less price-sensitive consumer, and (v) it’s unclear how dramatically a 25% tariff will curb demand for the cars anyways. While the Chinese tariffs provide headline risk, I don’t think they’re especially material fundamentally to the long thesis. 

Helpful sources for diligence:

To save readers a bit of time in locating the right people at the companies to speak with, at Zhongsheng, Daniel Zhou is the helpful contact, and his email is [email protected]. At Meidong, one can reach out to [email protected] and at yongda, there’s [email protected]. Beyond that, sellside coverage is ample, with GS, MS, Deutsche, JPM, Jefferies and Citi covering 881. 

Catalyst

- Trough in new vehicle sales gross margin, and end of unit volume declines, in 2025
- Recovery in Chinese property prices and economy to boost demand for luxury goods
- Consolidation of Chinese NEV companies, exit of certain mass market automakers from Chinese market, exit of peripheral loss-making Chinese NEV companies
- Competitive EV launches for Mercedes, Lexus, BMW and Audi in China