Description

This is a writeup on a somewhat storied company, Brilliance China Automotive (BCA), which currently owns a 25% stake in BMW-Brilliance Automotive (BBA-JV), a Chinese joint venture that sells BMW vehicles in China primarily. The opportunity is available for investors to purchase a fractional ownership of this business at a negative enterprise value, or 1-2x normalized earnings based on current market capitalization.

There obviously is a catch for companies trading at such distressed valuations, in particular related to management’s willingness to pay out dividends from the company’s cash-rich balance sheet and its storied history. These factors will be detailed in the writeup below. As such, the investor should consider sizing the position accordingly.

Background

The BMW Group had been present in China since 1999 and opened the 1^st Chinese production facility in Shenyang, which currently has a capacity of around 800+k vehicles annually. The BBA-JV (originally 50-50 between BMW and Brilliance) was established in 2003. China is an important market for BMW, comprising of roughly 30% of revenues and is the single largest geographical market for BMW now.

BCA has 3 main businesses, namely:

1) manufacturing and sales of BMW vehicles in China through BBA-JV

2) manufacturing and sales of automotive components through subsidiaries Ningbo Yumin Machinery Industrial and Mianyang Brilliance Ruian Automotive Components

3) provision of auto financing services through subsidiary Brilliance-BEA Auto Finance

Below is a breakdown of the operating segments and their financials for FY 2022.

There are 2 subsidiaries that have been deconsolidated since, though for one of them (RBJAC below), there have been some recent developments that will be covered in the writeup later.

BCA’s subsidiary, Renault Brilliance Jinbei Automotive Company (RBJAC), which manufactured and sold minibuses and multi-purpose vehicles, had been undergoing restructuring since early 2022 after application in late 2021. BCA considers that they have lost control from RBJAC from 12^th January 2022, and as such has been deconsolidated since.

Another BCA subsidiary, Shenyang Brilliance Jindong Development Company (SBDAC), which principally engages in trading of automotive components, also underwent a liquidation process on 26^th July 2022, and similarly BCA has considered loss of control since 26^th July 2022.

The deconsolidation of subsidiaries resulted in a booked gain of RMB 779mn in 2022, though specific breakdown isn’t revealed.

The crown jewel of BCA is BBA-JV which makes up the bulk of BCA’s earnings. 25% of BBA-JV was disposed of at RMB 27.941bn, received by BCA’s wholly-owned subsidiary Shenyang JinBei Automotive Industry Holdings (SJAI) on 18^th February 2022. and BCA now holds 25% of the BMW-Brilliance JV. A gain of 4,896mn was booked in 2022, with a corresponding 7,287mn taxes related to capital gains on disposal. Effective from 11^th February 2022, BBA-JV began to be treated as an associate of BCA.

Where the trouble began – controlling shareholder issues and unauthorized guarantees

BCA’s controlling shareholder, Huachen Automotive Group (Huachen), ran into financial issues, prompting mismanagement of funds that were made without the knowledge of the Board. This part will be elaborated upon in a later part of the write-up. Huachen is run by the government of Liaoning which is a province in North-East China.

In late 2022, Huachen defaulted on RMB 6.5bn of debt obligations and prompted Chinese regulators to launch an investigation.

The investigation revealed that from January 2020 to April 2021, unauthorized guarantees were made to their main shareholder of around RMB 5,898mn, as well as deposit pledged of RMB 4,045mn

An Expected Credit Loss (ECL) allowance was booked, which resulted in recognized losses of RMB 8,376mn in 2020, RMB 1,012mn in 2021, and RMB 421mn in 1H 2022

Although the elaboration below might seem unnecessarily long, I would encourage readers to go through the below as I believe it to be essential to understanding the background of BCA, and why shareholders had been leery of BCA resulting in the current market pricing of BCA shares.

The tl;dr version of the below is: unauthorized guarantees were made by BCA employees for Huachen, their controlling shareholder, made possible by corporate governance lapses. The impetus was from Huachen’s difficult financial position which resulted in defaults and restructuring. The maximum liability from these guarantees amount to RMB 1,917mn, which has now been provisioned.

Controlling Shareholder Restructuring

Timeline:

14^th July 2020: Huachen disposes of some shares in BCA but remains 30% shareholder.

http://www.brillianceauto.com/investor/announcements/2020_announcements/e_Ann_20200714B_eng.pdf

15^th November 2020: Board receives notification that Gezhi Automobile filed a restructuring order against Huachen (controlling shareholder) with the Shenyang Court.

http://www.brillianceauto.com/investor/announcements/2020_announcements/e_Ann_20201115_eng.pdf

20^th November 2020: Shenyang Court accepts restructuring application.

http://www.brillianceauto.com/investor/announcements/2020_announcements/e_Ann_20201120_eng.pdf

In a November 2021 statement, Huachen stated it defaulted on debt totally RMB 6.5bn, along with RMB 144mn of interest. Lawsuits against Huachen include a China Taiping Insurance subsidiary which claimed RMB 1.2bn. Qi Yumin, chairman and head of Huachen, was placed under investigation.

2^nd June 2022: Huachen and related companies presented draft restructuring plan to Shenyang court and convene creditors’ meeting.

Timeline of claims and amounts

Timeline:

31^st March 2021: delay in 2020 annual results due to need for clarification on unauthorized guarantees and the resulting legal proceedings for SJAI. Shares suspended effective on 31^st March 2021.

http://www.brillianceauto.com/investor/announcements/2021_announcements/e_Ann_20210331_eng.pdf

14^th April 2021: SJAI provided several unauthorized guarantees in favour of a few banks in China, in order to secure loans to Huachen. These guarantees and claims were made. Note that e.g. for Ex-Im Bank’s case, the reason the claimed amount is larger than the guarantee is because the claim amount includes principal + interest (of course whether this amount was actually claimable is another story which shall be elaborated upon later).

At this point, Harbin and China Everbright Bank (CEB) commenced proceedings for RMB 300mn and RMB 490mn respectively, whilst hearing dates were not firm for the others. An order was made to freeze SJAI’s bank deposits of around RMB 301mn for 1 year starting 12^th March 2021.

As the Board had claimed they were unaware and also did not give any approvals for these guarantees, they sought to defend these claims in the courts.

Further issues were uncovered as bank confirmations from SJAI’s bank, Shengjing Bank, revealed i) the aggregate bank deposits mentioned in the bank confirmation letters was RMB 1.73bn less than that recorded in SJAI’s books, and also ii) omitted an RMB 650mn structured deposit, as well as iii) an additional guarantee of RMB 650mn.

Given these issues, the Board formed an independent committee comprising of 2 independent non-executive directors of BCA to engage an independent firm for an investigation into these unauthorized guarantees.

http://www.brillianceauto.com/investor/announcements/2021_announcements/e_Ann_20210414_eng.pdf

23^rd April 2021: Independent investigator, RSM Consulting (HK), was appointed.

http://www.brillianceauto.com/investor/announcements/2021_announcements/e_Ann_20210423_eng.pdf

31^st May 2021: resumption guidance: exchange can cancel listing if the shares continue to be suspended for 18 months consecutively, i.e. 30^th September 2022.

http://www.brillianceauto.com/investor/announcements/2021_announcements/e_Ann_20210531_eng.pdf

30^th June 2021: in the course of identifying internal control consultant to review internal control systems. Also a number of legal proceedings made against SJAI in China.

http://www.brillianceauto.com/investor/announcements/2021_announcements/e_Ann_20210630_eng.pdf

31^st August 2021: postpone 2021 AGM.

30^th September 2021: Independent investigator produced 1^st draft of findings on 15^th September 2021 and was circulated to Independent Board Committee. Final draft to be concluded. Internal control consultant also shortlisted. Meanwhile on 11^th August 2021 and 22^nd September 2021, CEB issued further claim of RMB 156mn and RMB 208mn respectively.

http://www.brillianceauto.com/investor/announcements/2021_announcements/e_Ann_20210930_eng.pdf

29^th October 2021: Moore Advisory appointed as Internal Control Consultant. Draft of internal control review expected end December 2021.

http://www.brillianceauto.com/investor/announcements/2021_announcements/e_Ann_20211029_eng.pdf

16^th November 2021: Independent investigator issues report to Independent Board Committee on 12^th November 2021. The main financial impact on the group were to be

i) the total guaranteed liability to the 4 banks of around RMB 3.7bn (of which 3 banks already commenced proceedings for around RMB 3.6bn). Table below.

ii) loss of deposits of RMB 4,005.9mn

The key reasons these issues happened was because BCA and Huachen had no clear independent structure and reporting, given some management members held concurrent positions in both companies. There was also a lack of independence when performing duties due to overlapping roles of managers, and the wrong belief that BCA was subordinate to the management of Huachen. Certain personnel of Huachen could bypass BCA to directly instruct SJAI management to execute these transactions and guarantees. Members of BCA who also held positions with Huachen were able to access confidential information. The Board of BCA thereafter proceeded to engage legal counsel for legal action.

http://www.brillianceauto.com/investor/announcements/2021_announcements/e_Ann_20211116_eng.pdf

15^th December 2021: Harbin and CEB court cases had updates where the Shenyang Court issued a judgement, in essence making Huachen liable for all the loans up to guarantee amount, and SJAI liable for 50% of these amounts + other miscellaneous fees. I’ve updated the table below so the progress is clearer at this stage. The miscellaneous fees were not detailed in this announcement, but BCA estimated the maximum loss to be approximately RMB 1.391bn, which was about RMB 8mn higher than the liability figures I computed below.

23^rd December 2021: internal control review was concluded. In short, several recommendations were made to segregate Huachen and BCA management duties, approval authorisations, reporting lines etc.

http://www.brillianceauto.com/investor/announcements/2021_announcements/e_Ann_20211223_eng.pdf

30^th December 2021: results estimated to be completed mid-Jan 2022. Export-Import Bank court judgement had similar outcome as the previous ones, i.e. 50% of loan + miscellaneous fees. BCA estimated that maximum loss cumulatively would now be around RMB 1,698mn. Updated table below, with mismatch being miscellaneous fees ~RMB 9mn.

14^th February 2022: Exchange states that BCA needs to conduct an independent forensic investigation to identify the unauthorized fund transfers made. Also, Huaxia has initiated legal proceedings.

http://www.brillianceauto.com/investor/announcements/2022_announcements/e_Ann_20220214_eng.pdf

30^th March 2022: Independent Board Committee appointed RSM Corporate Advisory (HK) to conduct independent forensic investigation. Results publications to be delayed.

Further CEB claims made for RMB208mn and RMB30mn and similar court judgement made as well. Management guidance on maximum liability now updated to around RMB 1,817mn. Table updated below (roughly RMB 10mn in misc fees).

30^th June 2022: RBJAC meeting of creditors. No other material updates.

http://www.brillianceauto.com/investor/announcements/2022_announcements/e_Ann_20220630_eng.pdf

2^nd September 2022: summary of lapses, disclosure of required information for re-compliance with Listing Rules.

30^th September 2022: Applied for resumption of trading to Exchange. Updated maximum liability to around RMB 1.9bn with no other material updates, presumably to adjust for other fee overruns.

http://www.brillianceauto.com/investor/announcements/2022_announcements/e_Ann_20220930_eng.pdf

5^th October 2022: resumption of trading after fulfilment of Resumption Guidance.

http://www.brillianceauto.com/investor/announcements/2022_announcements/e_Ann_20221003_eng.pdf

The annual reports for 2020, 2021 and 2022 revealed the loss provisions to be RMB 1,917mn eventually, now inclusive of Huaxia, and estimated miscellaneous fees.

For the avoidance of doubt, the net cash position I computed does not include the pledged bank deposits frozen by the courts, and already backs out all liabilities (inclusive of the above RMB 1,917mn provision).

There is 1 potential source of downside: the banks appealing to the courts and making BCA fully liable for the entire amount. To be clear, there is already RMB 3.5bn of restricted cash (court-ordered) to take this into consideration, and restricted cash is not included in my net cash calculation.

There is also a potential source of upside: Huachen is the liable party and not BCA to be clear. In the event Huachen’s restructuring potentially results in some residual value and ability to repay partially, the restricted cash will be partly released and liability reversed.

Sale of BBA-JV to BMW

The sale of a BBA-JV stake to BMW was announced in October 2018 after the PRC government relaxed foreign ownership restrictions in April 2018, where foreign investors could start owning more than 50% interest in auto manufacturing companies in 2022.

http://www.brillianceauto.com/investor/announcements/2018_announcements/e_Ann_20181011A_eng.pdf

HKD 0.96/share was paid out as special dividends in February 2023, amounting to around HKD 4.84bn in total.

In Dec 2022, BCA announced that further dividends might be paid out, with a decision to be made around end March 2023

http://www.brillianceauto.com/investor/announcements/2022_announcements/e_Ann_20221230_eng.pdf

However, in the FY 2022 results announcement, it was revealed the decision on the use of disposal gains has been delayed to end June

Future of BBA-JV

An analysis of the situation would be incomplete without at least some consideration of the future of BBA-JV.

Above is a list of the BMW sales across the years. Numbers have been compiled individually, and the figures you see here might vary a bit from other statistics you might see elsewhere, for e.g. some sources will indicate a market share of around 3-4% for BMW. This is just to give a rough idea of the growing vehicle sales across the years.

BBA-JV has been playing catch up in the EV market, with the intention now of introducing 6 new EV models from its existing 5 models in 2023. It grew fast in 2022 off a small base, and has been still small, delivering ~45k EVs in 2022, but lags greatly behind Tesla’s 390k, as well as Nio, Xpeng and Li Auto which all delivered > 120k vehicles.

The shift to EVs has caused BMW sales to stagnate slightly, partly as they have been late to the party, but also partly due to the continued Chinese automaker price war. Also readers have to bear in mind the context of Covid-19 lockdowns in China in the past few years.

Price of NEVs in China have been falling due to discounting and partly due to declining battery costs, which has increased pressure on ICE vehicles and other legacy vans. Triggered by Tesla in Oct 2022, who cut prices on models, including escalating price cuts in January which forced the hands of other players. Maximum discounts compiled below by BBG.

Restructuring of Renault JV

The aforementioned deconsolidated RBJAC subsidiary underwent a restructuring in 2022. The restructuring was broken down into 3 different steps, namely:

i) Existing capital held by SJAI and Renault will be reduced to 0

ii) all SJAI debt and Renault debt, amounting to RMB 1.74bn and RMB 711mn respectively, will be capitalized into equity

iii) capital contribution up to RMB 1.36bn will be contributed by SJAI into RBJAC for restructuring

Prior to the restructuring, SJAI and Renault held 51/49% of RBJAC. After restructuring, the ownership changed to 81.36/18.64% given the additional capital contribution by BCA. The current timeline for completion of restructuring is not immediately clear at the moment.

For what it’s worth, independent director Dr Lam Kit Lan, Cynthia, voted against it giving the reason that the Company should consider containing its losses, something admirable given she only joined in September 2022.

http://www.brillianceauto.com/investor/announcements/2023_announcements/e_Ann_20230411_eng.pdf

Why this investment opportunity exists

If you have been reading up till this point, I guess it should now be somewhat clear as to why the company is trading at such valuations. Investor confidence in the company remains at a low given the repeated challenges and throwing good after bad money into the Renault JV also raises further questions about the potential of mismanaging capital.

Valuation – 0 valuation ascribed to profitable BBA-JV

At present levels, some amount of capital return is likely to amount to a satisfactory return.

Current shares outstanding amounts to 5,045,269,000 shares.

As of FY 2022 end, net cash of all liabilities amounts to around RMB 25,253,499,000. This cash amount does not include RMB 3,462mn in pledged and restricted short-term bank deposits to be clear, which is an amount that has been restricted by the courts in PRC for potential amounts BBA-JV may need to settle for the lawsuits underway with respect to the unauthorized guarantees. As the loss provision is actually smaller than the restricted amounts, there can be potential for further cash to be released, but to be conservative this amount isn't included in net cash calculations.

After accounting for:

1. RMB 1.36bn capital contribution to RBJAC,
2. HKD 4,843,458,000 in special dividends declared but not paid

the estimated net cash would be around RMB 19,670mn or around HKD 22.6bn. This amounts to ~HKD 4.48/share, substantially above current market capitalization and basically accords nothing to 25% ownership of the profitable BBA-JV franchise. Everything else is possibly worth something but for conservativeness we can simply accord 0 value to it.

Capex for 2022 amounted to around RMB 47.5mn, though that number was much higher at RMB 369mn in 2021. Alongside working capital requirements, the net cash is likely to be more than sufficient compared to the amount that is required for business operations.

Dividend payout – BCA has a history of paying dividends

Management has been delaying the payment of dividends, with the current guidance being June 2023 for a decision. The official reason given is as below, make of it what you will.

Although one might be skeptical about the above, one should take into account the current context of competitive price wars in China. Some dry powder is required for automakers as price cuts on EVs continue to squeeze out the unprofitable players. Although not ideal, I think it is understandable that management is trying to be conservative and at least keep some cash for the time being while figuring out the cash requirements, before making a decision on how to handle the excess cash.

I’ve created a table here for a better perspective of how the dividends would look like at respective payout amounts.

Obviously the 100% payout scenario is unlikely to happen, this table is just to give an idea of the amount of dividends relative to the market cap right now.

An additional kicker comes in where the profits of BBA-JV have to be distributed up to BCA in the dividend policy. No less than 30% of the distributable profits have to be paid to the shareholders.

The table below shows the approximate amounts as % of market cap at varying levels of profitability.

http://www.brillianceauto.com/investor/announcements/2018_announcements/e_Ann_20181011A_eng.pdf

The run-rate of BBA-JV’s profits is around the RMB 6-8bn mark based on their 25% share. At current levels, even if there were not to be any payout of the net cash amount they are sitting on, and should they only pay out the dividends generated from BBA-JV’s profits, we are looking at dividend yields of around 9-18%, with 9% for a lower than expected run-rate of RMB 4bn.

Should part of the net cash amount be paid out, return on the investor’s remaining invested capital will increase from the above 9-18% range.

The obvious downside case to this is the future sustainability of the BMW franchise in China.

Although management had previously guided a few times on the intention to pay out the majority of gains from BBA-JV’s sale, changing considerations (price war, RBCJA restructuring) has delayed this decision for a while. However, one reason why dividends might still be paid out is also because Huachen, the current major shareholder, does require cash given the predicament it is currently in.

To have some idea of BCA’s willingness to pay out dividends, one can refer to the historical payout of the company.

2016: CNY 478.8mn (13%)

2017: 470.3mn (9.6%)

2018: 555mn (9.2%)

2019: 4,288.5mn (62.3%, inclusive special. HKD 0.11 and HKD 0.3 special)

2020: 2,068.6mn (204% (HKD 0.11, HKD 0.3 special)

2021: nil (suspended)

2022: 4,249.4mn (145% inclusive special, inclusive HKD 0.96/shr special)

In short, BCA has a history of paying regular as well as special dividends. This of course doesn’t ensure the company will keep paying out, but at the very least it does demonstrate willingness on management’s part to distribute excess capital. The margin of safety in this situation is such that even some reasonable amount of capital return would likely help the investor attain an acceptable return.

Key risks

The obvious risk is capital allocation. The Board decided to throw good money after bad money, into the Renault JV because of their potential NEV venture. This is a venture that can potentially continue to require further capital contributions, especially with the current cut-throat pricing competition happening in China now.

The Board has also expressed interest in seeking strategic investments within the automobile industry value chain, with return potential being unclear at this stage.

Another key risk is whether BMW can continue its success story in China. The Germans automakers are middle of pack compared to the other automakers. VW’s market share is currently around 15%, Mercedes around 3-4%, and BMW around 2-4%. Market share has been declining because battery EVs in China are led by Tesla and BYD or Nio who have been developing advanced software functions and other driving features, areas which German manufacturers have been lagging in currently. The China Association of Automobile Manufacturers (CAAM) has also called for an end to the current price war, while Chinese state media has also said called out regional governments (which can be dependent on automakers for revenues) to offer subsidies on local vehicle production. E.g. Hubei’s Dongfeng Motors lowered prices by almost 40% on its Citroen C6 models. The market is currently characterized by intense competition, with >450 EV makers registered in China.

Catalyst

- Payment of special dividends from BBA-JV sale

- additional dividends from BBA-JV profits paid out annually

- Controlling shareholder restructuring resulting in payment of liability and releasing BCA as guarantor

- Just valuation on its own as a catalyst.