Description

How would you like to invest in a small-cap Chinese auto dealer with insider ownership of 65%? I suspect that most of you will be skeptical, as I was when a friend first pitched me China Meidong Auto. However, once I started reading the shareholder letters (unfortunately only in Chinese), I immediately realized that this company is different from the typical Chinese company. Put simply, the management team get it – they have developed a unique and likely sustainable strategy by focusing on luxury brands in tier 3-5 cities, prioritizing returns over growth, treating shareholders like partners and making sound decisions on capital allocation.

Since IPO’ing in Dec 2013, the company has delivered revenue and EPS growth of 26% and 28% CAGR, with all the growth financed from operating cashflow while maintaining a dividend payout ratio of 40%. The stock had done very well, but still just trades at a reasonable 10x ’19 EPS. With only 49 stores at end of ’18, there is a lot of runway for growth. I will keep the write-up short, as I am not sure this idea would be of interest and/or actionable for most members. Would be happy to answer questions in the thread.

The business model is fairly straight forward. MD operates 49 car dealerships in Southern and Western China – 23 BMW’s, 10 Lexus, 4 Porsche, 11 Toyota and 1 Hyundai. The mix has been increasingly tilting towards luxury brands with planned addition of Audi and Mini banners in 2019. 90% of revenue come from new car sales at around 5% gross margin, and the rest come from aftermarket sales (parts, repair, financing, insurance, etc) at a very healthy 49% gross margin. Encouragingly, the more stable aftermarket sales make up 60% and growing % of overall gross margin $.

Unlike its peers who focus on Tier 1-2 cities, MD’s mgmt. has pursued this so-called “Exclusive store per single city” in tier 3-5 cities, i.e. they aim to operate the only store for an OEM brand in that city. The trade-off for a smaller market is obviously lower competition – the pool is not big enough for a second competitor to come in, and the OEM does not want to see two stores in the same city, as it likely will lead to a price war which only erodes the brand equity. In some ways, this strategy reminds me of the early days of WMT picking markets to enter.

Yet some of these cities have great unit store volume and economics, which seems to contradict the Tier 3-5 categorization. Indeed, I was skeptical when I started doing research on the company and read that MD’s top Porsche store was selling over 700 cars in 2017. Shunde is a tier 5 town under the city of Foshan in Guangdong Province, which I suspect most non-Chinese investors have never heard of. Even for a native like me, the only memory Foshan conjures up is a famous Kungfu movie. If it weren’t for an alumni-arranged trip to visit Country Garden, China’s largest home builder, I would have never guessed that Shunde (population 2.5m) would host two of the largest companies (Country Garden and Meidi) and two of the richest men in China. As a sanity check, Porsche sold 240K cars worldwide and 72K in China in 2017, and operates ~100 retail stores in China.

Picking the right location is just the first step. MD’s mgmt. team is also maniacally focused on three things – inventory turnover (“key to survival”), overhead absorption/coverage from aftermarket profit, and ROI. From the 2018 AR, “high inventory turnover turns us into a cash machine, and slow turnover turns us into a cash black hole” (again, one rarely if ever hears stuff like this with Chinese companies). MD buys new cars from OEMs/distributors with a 10% cash down payment and 90% through OEM financing on 30-90 day notes. So mgmt. strive to maximize turns (10.5x in ’18, up from 5.4x in ’14), and rightfully points out they could produce good returns even on low gross margins (reminding me of a consensus favorite). They also realize the importance of producing strong SSS in aftermarket sales to rely less on volatile new car sales. Despite a significant ramp of new stores and young fleet (median age under 3 years), MD boosted aftermarket sales contribution to overall sales by 120bps over last 5 years. Lastly, ROI is a key metric for management teams at all levels, and they have successfully brought down average and median payback period of new store to 3 years, and most stores reach four wall profitability within a few months of operation. As a result, ROE is a respectable 26% in 2018, and operating cashflow had exceeded net income four of the last five years.  

In terms of 2019 and the future, I fully expect the company will maintain the same strategy – flipping over shareholder letters dating back to 2013 would reveal a remarkably consistent message. I have modeled mid teens growth through MSD store openings and mid teens SSS growth (a large chunk from natural maturation of young stores). Interestingly, mgmt. made reference to opportunistic M&A of sites with the criteria being 1) familiar brands, 2) great locations, and 3) bargain prices. Such bolt-on acquisitions would be icing on the cake.

Obviously, there are some risks associated with the company (many of which are macro related). There is doubt about sustainability of luxury car sales in China. For reference, each of the three German luxury brands does about 1.8-2.2m units worldwide, and China accounts for 1/3 of that sales (Audi has a higher % due to historical reasons). In a protracted slowdown or hard landing, it is possible that MD and the rest of the industry could suffer. In addition to volume weakness, gross margin could take a hit, as it had happened last year with BMW, which led to MD’s gross margin on new car sales taking a big 100bps hit. Encouragingly, the margin trend has gotten better starting in Q4 and mgmt. also feels optimistic about 2019, as BMW will launch new models in key sellers. Longer term, the continued mix shift towards aftermarket sales should also alleviate the volatility.

I would feel even stronger about the company if they have a pristine balance sheet, but as is, the company is moderately levered with excellent coverage ratio. But this is a management team worth betting on, and any industry/peer problems could become opportunities for the company, as they have shown with their opportunistic distressed purchase of 6 BMW stores last year.

Catalyst

1. continued methodical expansion and growth

2. more sellside coverage?