The Chinese Automaker With Huge Global Growth Ambitions

In its quarterly review of the benchmark Hang Seng Index conducted at the end of December last year, index compiler Hang Seng Indexes Company announced that it will be replacing supply chain manager Li & Fung (HKEX.494) with mainland auto manufacturer Geely Automobile (HKEX.175), effective 6 March 2017. The decision was not all that surprising, given the contrasting fortunes of these two companies. Li & Fung's profitability has been negatively impacted over the past few years in view of challenging global macroeconomic conditions, while its share price has also been on the slide, falling by a whopping -33.0% (in HKD terms as of 24 February 2017) since the beginning of 2016. On the other hand, the share price of Geely has close to tripled over the same period (Chart 1), buoyed by strong vehicle sales and healthy profit growth. In this article, we turn our attention to the index newcomer, taking a closer look at its underlying fundamentals and future prospects.

Chart 1: Contrasting Fortunes Of Li & Fung And Geely

Major Player In SOE-Dominated Auto Industry

With a market capitalisation of HKD 94.6 billion (as of 24 February 2017), Geely Automobile (HKEX.175) is one of China's largest automobile maker by way of market value, focusing on the production and sale of auto vehicles. The company carries thirteen major sedan and sport utility vehicle (SUV) models in its portfolio, supported by seven manufacturing plants, which collectively boast a total annual production capacity of 1.21 million vehicle units, and retailed through its extensive network of close to 700 dealers in China. Notably, the company burst onto the global stage in 2010, after acquiring control of the Volvo brand of vehicles from Ford for USD 1.8 billion, and has since shifted its product mix towards higher-end cars. While China remains its main playing field, Geely has gradually expanded its sales beyond domestic shores over the past few years, exporting its vehicles to 24 other overseas markets in Africa, Asia, Europe, the Middle East and South America.

Although Geely is one of the top ten automobile manufacturers in China, it controls only about 3.8% of the market, based on its total sales volume of 897,850 vehicle units in 2016 (Table 1). State-owned enterprises (SOE) hold sway in this largely consolidated industry, where the top ten manufacturers account for close to 90% of total automobile sales in China, with Geely and Great Wall Motor (HKEX.2333) the only private sector companies to have made it into the top ten. SOEs have been able to reap profits from their partnerships with foreign brands, under rules that require global car makers to work through SOEs in order to access China's automobile market. SAIC Motor worked with General Motors, Dongfeng Motor (HKEX.489) partnered Honda, while FAW Group teamed up with Volkswagen. The popularity of foreign brands amongst consumers meant SOEs were able to bring in billions of revenues each year. Their dominance, however, has been challenged in recent times by private sector car manufacturers, such as Geely, which are moving aggressively into higher-end passenger cars, as well as ramping up on quality and safety standards, to cater to China's increasingly affluent consumers.

Table 1: Top Automobile Manufacturers In China By Sales Volume In 2016

Up-Market Shift Lifts Profitability

Geely has seen robust sales growth over the past few years, with total sales of passenger vehicles rising from 167,477 in 2008 to 897,850 in 2016, representing a compound annual growth rate of 23.4%. Amidst a slowdown in China's economy and concerns that the automobile sales market may have peaked, the company has managed to turn in a steady set of financial performance in its latest semi-annual results, with diluted earnings per share in 1H 2016 increasing by 36.2% year-on-year. Its strong profitability is expected to continue, having already issued a positive profit alert, with net profit for 2016 forecasted to more than double from the previous year. The consensus is also estimating solid earnings growth of 48.8% and 23.0% for 2017 and 2018 respectively. Geely's shift towards the higher-margin SUVs to leverage on the rising affluence of Chinese consumers, evidenced by the increasing contribution of SUVs to overall sales volume and higher average sale price over the years (Chart 2), is expected to support its bottom line moving forward.

Chart 2: Geely Ramps Up Sales Of Higher-Margin SUVs

With a couple of new vehicle models expected to launch this year, Geely remains optimistic over its future prospects, having announced a sales target of one million vehicles for 2017 and aiming to double this figure to two million cars globally by 2020. Its product pipeline includes two multi-purpose vehicles (MPV) and a mid-size SUV, further expanding its exposure to the higher-margin and fast-growing MPV and SUV segments, both of which were the main drivers behind the 18.9% increase in China's automobile sales in 2016. At 17.7% (as of 1H 2016), Geely's gross margin remains one of the highest in the industry (Chart 3), and could pick up as the company continues to make inroads into the higher-margin up-market vehicle segments. It is also worth noting that Geely's balance sheet is in fairly good shape. The company has a net cash position, which means it is able to pay off all its liabilities using cash, and still have cash remaining. It also has the lowest net debt-to-equity ratio amongst its peers in the industry.

Chart 3: Geely Has One Of The Highest Gross Margins In The Auto Industry

Price A Tad Too High?

At its last traded price of HKD 10.64 (as of 24 February 2017), Geely trades at a forward price-to-earnings (PE) ratio of 12.3X, below the industry average of about 17.2X, although it must be noted that the industry average PE ratio has been skewed upwards by FAW Group and Haima. Excluding these two companies, the industry average comes down to 10.2X. As such, Geely appears to trade at a premium to the industry average. Its price-to-book (PB) ratio of 3.92X is also above the industry average of 1.90X (Table 2). While Geely's premium valuations can be justified if it continues its robust sales growth and strong profitability, markets are currently pricing in a demanding 48.8% growth. A worse-than-expected sales volume this year, or the failure of its new models to gain traction amongst Chinese consumers, are likely to spark a de-rating of the stock. Moreover, a substantial portion of Geely's income comes from government grants and subsidies, which constituted about 22.8% of its pre-tax profits in 1H 2016. A scale-back in official aid could also negatively affect Geely's bottom line.

Table 2: Valuations Of Listed Mainland Chinese Automobile Manufacturers

While investors can certainly consider Geely as a potential stock investment, there are other suitable candidates trading at less expensive valuations that are worth sizing up. For instance, Great Wall Motor (HKEX.2333), BAIC Motor (HKEX.1958) and GAC Group (HKEX.2238), all of which target the high-end segment of China's automobile market and have higher gross margins than Geely, are also expected to benefit from the shifting preference of affluent Chinese consumers towards SUVs and MPVs. Moreover, all three stocks trade at PE and PB ratios that are below the industry average. The estimated dividend yields of BAIC and Great Wall, at 4.33% and 4.09% respectively, are also higher than the industry average, as well as the 3.5% offered by Hang Seng Index. While Dongfeng Motor (HKEX.489) has lower gross margins compared to Geely, it is currently trading at a -22.5% discount to its book value. Its forward PE ratio of 5.6X is also below the industry average. Notably, Dongfeng's net cash position could be an indication of prudent financial management by the company.

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Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.