I don’t write about it as often as I’d like to, but Geely Auto (OTCPK:GELYY) (0175.HK) has long been one of my favorite companies and stocks. Although there is a long list of potential reasons to avoid the name, I’ve been bullish on the company’s prospects to drive significant unit volume growth (as well as revenue and profit growth) on the back of new product launches and leveraging a development partnership with Volvo (which is owned by Geely’s parent company).
Since my last write-up, the ADR shares have risen another 50%, outperforming others like Brilliance China (OTCPK:BCAUY), BYD (OTCPK:BYDDY), SAIC, and Great Wall (OTCPK:GWLLF), as the company’s rapid share growth has propelled it to sixth place among auto brands in China (and #2 in domestic brands). Valuation today is a little less cut-and-dried than I would like. While Geely’s newest launches are performing well, and the company has a number of new vehicles hitting the market this year, the shares are no longer undervalued on a cash flow basis. While EV/EBITDA does still offer some upside, I’d approach Geely with a bit more caution these days.
Build Cars People Like, At The Right Price(s), And Good Things Happen
I don’t think there’s any secret sauce to Geely’s recent success. While the company once languished with older, out-of-date models that didn’t fit what the Chinese car buyer wanted/wants to buy, Geely has dramatically refreshed its line-up and introduced appealing cars at higher price points. With that, the company continues to see unit volume growth well in excess of the industry.
Geely logged 63% unit volume growth for all of 2017, while the Chinese market overall grew at just a little over 1%. Not surprisingly, then, Geely gained meaningful market share – jumping up to about 5% overall national share (versus around 2% share in 2014) and 11% share among local brands. With that, Geely is basically neck-and-neck with Chang’an for the #2 spot among local brands (likely now #2 given year-to-date trends), but still a ways behind market-leading SAIC.
Those strong volume trends have continued thus far into 2018, despite a fairly soft overall market. Sales in April were up 49% (to 5.5% market share) and up 41% year-to-date. By comparison, overall auto sales in China were up 11.5%, with 4.8% year-to-date growth. While the China Association of Auto Manufacturers is looking for 3% growth this year, Geely management will likely come in at better than 25% yoy growth and perhaps closer to 30%.
Better still, from my perspective, is the fact that Geely now has seven models selling 10K units/month or more and should soon have a couple of models at the 20K unit/month level. That matters to me from a margin leverage standpoint, as better utilization will drive better profit leverage. I’d also note that after a somewhat sluggish start, the new Lynk SUV seems to be finding its pace and should be to 10K units/month around mid-year.
For all of 2018, Geely is looking to introduce its first MPV, two new sedans, and two new SUVs, as well as NEV versions of major existing models. Just a few days ago, Geely launched an MHEV and PHEV version of its Borui GE. The MHEV version is a 48v system that includes power regeneration and stop/start functionality and both versions have Level 2 ADAS. The PHEV version is 42% more efficient than the gasoline model, but priced firmly in the middle of the range for Chinese PHEVs.
Plugging In, Lynk’ing Up
Geely has never been shy about putting out bold targets, and while many sell-siders have scoffed at them, more often than not those analysts have been left looking for ways to explain why they were negative on Geely six or 12 months before. When it comes to hybrids and electric vehicles, Geely has been saying for at least three years that it was targeting having hybrid or electric systems on 90% of its cars in 2020. That’s still a bold target, but with the MHEV/PHEV launches scheduled for this year and next, it may just happen. I’d also note that Geely’s parent company recently signed a supply agreement with U.S. company Maxwell (MXWL) for ultracapacitors and electronics for future hybrid/electric models.
Geely’s Lynk venture highlights some of the opportunities here, as well as some of the issues. With Lynk, Geely is now truly leveraging its technological/developmental relationship with Volvo and developing vehicles for the mid-to-high-end segments of the Chinese market. The Lynk 01 has multiple engine and gearbox configurations and is pretty much loaded for bear when it comes to standard equipment and connectivity. Geely has plans to not only target the higher end of the Chinese market but also to sell the Lynk series (a crossover and sedan are coming…) in Europe and the U.S, with the company previously talking about a 2020 launch with a subscription sales model.
That’s all well and good, but the Lynk business model reflects some of the “quirks” with this business. Geely and Volvo are both owned by Geely Zhejiang. For the Lynk, there is a three-way joint venture between Geely Auto (which owns 50%), Geely Zhejiang (which owns 25%), and Volvo (which owns 25%). For each Lynk sold, Geely will have to pay a royalty fee to China-Euro Vehicle Technology (or CEVT), which is partly, but not wholly, owned by Geely Zhejiang, and there is a structure in place for Geely eventually buying Geely Zhejiang’s stake in Lynk. Bad as that may sound, that might actually be the better model – a prior asset-light model under consideration (with Geely licensing the technology and paying Volvo to manufacture) would have been far murkier with respect to transparency, particularly on pricing/profit transfers.
Along those same lines, it was announced in February that Geely Group, which is owned by Geely Zhejiang Chairman Li Shufu, but managed by Zhejiang Geely, has acquired almost 10% of Daimler. While there’s no intention to build that stake further at this point, it could perhaps be the starting point for future technical collaborations. I’d also note that in December of 2017 Zhejiang Geely announced its intention to acquire an 8% stake in Volvo AB (OTCPK:VLVLY) (the commercial vehicle manufacturer), while Chairman Shufu bought another 18.8M shares of Geely Auto in January, boosting his stake to over 46%.
The Opportunity
Messy holding structures aside, I continue to believe Geely is a well-run auto company that is riding a strong wave of good product design/development. While perhaps presumptuous today, I do believe Geely could be among the first Chinese automakers to achieve real sales in both the EU and China. I likewise believe that Geely will find success in its efforts to move up-market and take more share in the middle and mid-high ends of the Chinese market. Of course, there are risks. Just because a company designs a few models that catch on does not mean that they will manage to stay in tune with customer tastes. Likewise, there are still growing pains here with respect to adding/managing capacity and driving profits.
While 2017 revenue was about 9% above my expectations, FCF was a little lower, and I’ve adjusted my revenue and margin assumptions accordingly. I’m still looking for long-term revenue growth in the neighborhood of 9% a year, though, with double-digit annualized growth over the next five years. For FCF, I expect a near-term peak in about five years and a trailing off into the “high to mid single digits”. That supports annualized FCF growth in the mid-teens.
Those assumptions don’t give me a target price above today’s share price. With EV/EBITDA, though, it’s a different story, as a 12x multiple to my EBITDA estimate supports a fair value about 30% above today’s price. Given that I see mid-teens to 20% EBITDA growth over the next three to five years, I don’t think 12x is a ridiculous multiple, but I am generally more skeptical of short-term valuation methodologies like EV/EBITDA (or P/E).
The Bottom Line
What are investors missing about Geely such that it might be 30% undervalued? I believe there are fears that the Chinese auto market could slow more dramatically than expected, and/or that Geely’s rivals (particularly foreign automakers) will step up their game and gain more share as the market develops. There are also still a lot of “i’s” to dot and “t’s” to cross getting the Lynk business up to speed and the company’s ambitions for the European and American markets may exceed its capabilities. I’d much prefer to invest with the security of a discount to my DCF-based fair value, but for more growth-oriented investors, there’s still enough opportunity here to merit a closer look.
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