China Meidong Auto Holdings

China Meidong Auto Holdings (HKSE: 1268)

Description

China Meidong Auto Holdings (1268.HK) operates 78 auto dealerships, mainly in Tier 3-4 cities in China. They tend to open dealerships in cities where they are the only outlet for a specific brand (namely, "Single City, Single Store" model). Working with 7 brands in total, Porsche and BMW vehicle sales account for 59% of total revenue. After sales and mortgage facilitation accounts for another 20%.

The dealership model is heavily reliant on inventory turns. 10% of the cost of buying new cars is covered by the company, the rest on 30-to-90 day banknotes with a 30-day interest free period. If a car model can be turned once every month, at a 1% gross margin, the annualized return on capital is 120%. However, if inventory cannot be turned fast enough, dealerships have to cover the remaining 90% of the vehicle's cost, dramatically increasing the need for capital. With recent shifts in consumption patterns (emergence of domestic EV manufacturers) and a passenger-vehicle price war, the cash "sucking" nature of the dealership model is evident. 4 out of the top 7 publicly listed dealerships in 2020, are close to bankruptcy today. In the first half of this year, Porsche unit sales are down 33% YoY in China, with BMW unit sales down 4%.

I believe Meidong's business model and current financial standing will prevent it from suffering the same fate as other dealers, and potentially prosper.

Two of the most important facets to its operating model are:

(1)  Meidong is "laser" focused on inventory turns. As of 2023, the business operates with 11.5 inventory days, half of the next competitor. They are willing to forego higher gross margins for the ability to turn inventory over as fast as possible. This ensures that capital is does not remain tied up in an interest-bearing asset, especially during droughts of demand and price cuts (similar to what the industry currently faces). With this asset light strategy, Meidong maintains a better chance to survive against unlevered competitors who take inventory write-downs, while levered competitors suffer the risk of default.

(2)  The after sales and mortgage facilitation services operate at a 60% gross margin. These revenues are stickier and more predictable as they are generated from annual vehicle servicing or sales of spare parts. The income generated from these services covers all costs before taxes (excluding goodwill impairments) 1.6 times. So, if the company were to sell 0 vehicles in 2023, it would generate an operating income of HKD 350 million (excluding goodwill impairments) just from the servicing business - resulting in an EV/EBT of less than

8.5x. The after sales and mortgage services act as a "crutch" for the business during such cyclical downturns.

In addition to Meidong's business model, consider the following:

-- Low Valuation: Meidong trades at an TEV/FCF of 6.4x (2023) and TEV/EBT of 7.1x (2023). This is in a year where gross margins on new cars were severely impacted - in a "normal year" (based on historic 3% profit margins) Meidong would be trading at a 3x P/E.

-- Family owned and operated: The company was founded by Ye Fan, the current chairman. His elder brother, Ye Tao, serves as the CEO. Combined, the brothers own 52.6% of the outstanding shares. The current CEO has been with the company since 2007. Through his shareholder letters, the CEO does a great job explaining the nature of the business and how it continues to evolve.

-- Barriers to entry from disruption: Even with a seismic shift from ICE to EV consumption, the need for dealerships remains prevalent for the foreseeable future. Manufacturers would need to develop a significant level of inventory and regional know-how to sell directly to customers. Meanwhile dealerships are also servicing centres which makes them irreplaceable to the manufacturer - even in the short term. They have exclusivity deals for some dealerships, which prevent any competitor from opening an outlet of the same brand in the same city.

-- Debt Levels: Meidong took on HKD 2.75 billion of debt through convertible bonds in 2022 to fund the acquisition of Starchase Motorsports. Most of this debt will be exercisable by January of 2025. As of June 2024, Meidong has enough cash on hand to cover the principal payments of these convertible bonds and maturing bank loans. Barring unexpected uses for cash in the coming half of the year, Meidong will cover its principal debt repayments, further lowering default risk.

- Risks from brand obscurity: The demand for the specific product, is out of Meidong's control. If demand for foreign brands continues to suffer, the number of units sold by its dealerships will likely be lower as well. Given that Meidong is positioned in Luxury (BMW and Lexus) and Super Luxury (Porsche), the chances for demand to sustain, if not grow (with affluence), are likely. Additionally, the know-how and reach of the dealership network, would also give it leverage to work with "winning" brands in the passenger vehicle segment.

With a considerable margin of safety, both operationally and through its balance sheet, Meidong will survive this "perfect storm" of events. They will likely cement their position as the 2nd largest publicly listed auto dealership in the country.

Disclaimer

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