Description

April 2018 update

This write-up was submitted as my VIC application idea in early March. Since then the stock price has come down further while the fundamentals have continued to improve, with 1Q18 earnings beating estimates. Notably, the 1Q18 net profit margin recovered to 7.9% from a bottom of 2.1% in 3Q17. As Great Wall’s new vehicles ramp-up over the next six months, we should be seeing further upside to both revenues and profits, and the PE should come down from the current run-rate of 7.7x to a full-year 2018e PE of 6.8x.

Summary

The global auto industry is slow-growing, cyclical, competitive and potentially due for disruption – depending on who you ask. But there are major changes taking place, the most important of which may be the rise of Chinese auto companies taking share from their Korean and Japanese counterparts. I argue that China’s Great Wall Motor will end up as one of the global winners.

Great Wall has suffered through a period of weak sales, discounting and tougher competition, causing the stock to massively peers such as Geely and Guangzhou Auto. This period is now over. Great Wall has emerged with an entirely new line-up of vehicles that are enjoying exceptionally high demand. Sell-side is misinterpreting the 2017 results as a proof that the company has lost its touch. The reality is simply that the company has been working through inventory with major promotions to prepare the market for the SUVs due to be launched in 2017/18. As the ramp-up of the new 1.5 liter H6 continues throughout the first half of 2018, gross margins should recover and profits exceed consensus estimates, leading the stock to rerate from the current 2019e PE of 6x to an industry average of about 10x, followed by steady growth in the mid-teens.

Business overview

Great Wall Motor is a Baoding, China-based manufacturer of SUVs selling close to 1 million vehicles per year. The company is regarded as one of the best-run auto companies in China together with Shanghai Auto. Mid-cycle net profit margins have been the highest in the industry at about 10%. A primary reason for the high margins is a relentless focus on cost-control, discipline throughout the organization and a drive towards improving the quality of the company’s vehicles.

Its best-selling SUV H6 was released in 2012 and costs about USD 15,000 – significantly less than for its Korean or Japanese peers. It also produces smaller-sized SUVs costing less than USD 10,000 as well as a recently launched premium SUV brand called Wey.

The most important vehicle for the company is the H6 SUV, which just had a major redesign. It represents about half of total sales. The new premium Wey-vehicles makes up close to 20% in volume terms and much higher in RMB terms given its higher price opint. The third biggest contributor is the Wingle pick-up truck.

January 2018 volume split:

H6      53.7%

Wey   18.4%

Wingle  10.0%

H2      9.4%

Other 8.4%

Great Wall’s management team is the best in the Chinese auto industry

Founder and Chairman Wei Jianjun is a fanatic. His father was a military officer and the management style is said to resemble the type of top-down command that characterize military operations. When new workers join, they are forced to endure two weeks of military training. Workers are encouraged to walk in straight lines when walking in and out of the factory in an attempt to instil discipline throughout the organization.

Wei Jianjun himself is frugal. He smokes 10 yuan-a-pack Zhongnanhai cigarettes, despite having been a billionaire for many years now. He once scolded a group of dealers for leaving too much food on the table after a meal – a sign of his disdain for wasting money. Most nights he sleeps in a room connected to his office and starts every morning at 7am in his characteristic grey uniform. People who know him personally say that he has a simple and straightforward personality. He doesn’t beat around the bush. One of his mantra is never to allow complacency to creep into the organization. On the main campus in the city of Baoding, two “boulders of shame” are erected: one lists major failures in product development, the other identifies company officials who have been jailed for accepting bribes from suppliers. The company doesn’t allow complacency or major mistakes. This ethos permeates the entire organization.

Great Wall’s vehicles are perhaps the best of any Chinese auto company

By going through user ranking lists on such websites as Autohome, NetEase, Phoenix Online it is clear that Great Wall’s cars are highly sought after, together with Geely, Trumpchi and Roewe. The user ranking for Great Wall’s H6 for example is the second highest among the major Chinese SUV models, after Shanghai Auto’s Roewe (the old British Rover brand in a new incarnation).

Car model       Autohome user score

Roewe RX5     4.71

Great Wall H6 4.67

Chang'an CS55  4.59

Geely Boyue   4.51

Trumpchi GS4 4.37

Consumers are increasingly buying SUVs, and if you want a sub-CNY 130,000 SUV – there is no other option than to buy a domestic brand vehicle. The best-selling SUV in China in 2017 was Great Wall’s H6, followed by Baojun 510 (a domestic brand produced by Shanghai Auto) and Trumpchi GS4 (a domestic brand produced by Guangzhou Auto).

The quality of the company’s vehicles has improved gradually. In 2017 for the first year ever, Great Wall’s H2 was tied on the first spot as the best small SUV according to JD Power’s 2017 Initial Quality Study for China (which includes foreign brands).

A South African reviewer of the 2017 version of the H6 coupe offered the following view.

- “These cars represent a turning point for Chinese cars”

- “They're easily comparable to cars of great quality such as the Kia Sportage”

- “[In terms of] value-for-money, this is just exceptional”

Link to the video: https://www.youtube.com/watch?v=KwMJc4JNNRo

The review discussed the 2015 version of the H6 coupe. Presumably, the quality of the upcoming 2018 model should be even better.

Industry trends are largely supportive of growth

The demographics for Chinese is largely supportive of growth in auto sales in the near term. The population pyramid currently has a bump for 27-year-old. The average age of buying a car in china is at an age of 33, a period when people typically buy apartments for the first time and start requiring a vehicle for the family. As 27-year olds enter marriage age into the next five years, the demand for autos should continue to be favourable – everything else equal.

In the 10 years since I started investing in Chinese auto stocks, I’ve consistently heard naysayers point out the fact that the quality of Chinese vehicles is nowhere near international standards. While that might to some extent be true, Chinese brands are narrowing the gap rapidly. People forget that Hyundai too ranked among the lowest in JD Power’s test in the early 2000s, before they made a massive leap in the rankings thanks to Chung Mong-Koo’s military style management and focus on quality control. The so called PP100 ratio (problems per 100 vehicles) of Chinese vehicles went down in 2017 for the seventh consecutive year, implying a gradual improvement in the quality of Chinese vehicles. Every major Chinese auto manufacturer now produces its own engine. The production of other components such as powertrains and transmissions have also moved in-house for most major brands.

If the quality gap between Chinese vehicles and those of global brands ever narrow, Chinese auto companies should stand to benefit in a major way. Chinese auto worker salaries are just $5/hour compared to $13/hour in South Korea, $24/hour in Detroit and $26/hour in Germany. Chinese auto exports are currently just 0.8 million vehicles – most of which are light trucks and cars of inferior quality, sold to emerging markets. In contrast, Japan exported 4.1 million vehicles in 2017.

We may policy see measures to support sales of Chinese brand autos domestically. 90% of car sales in Japan are by Japanese auto makers and 85% of car sales in So8th Korea are by domestic manufacturers. China is an outlier in this respect – only 45% of cars sold were produced by domestic brands. Since President Xi Jinping came to power in 2012, China has become more inward-looking and more supportive of domestic champions such as Alibaba and Hikvision. If the Chinese government were to introduce protective tariffs for autos, then the domestic incumbents such as Geely and Great Wall Motor would be the first to benefit.

The SUV market is still growing significantly faster than the auto market as a whole, at roughly 20% YoY. SUVs look imposing, the safety is perceived to be higher and the previously high gas consumption of SUVs has become less of an issue.

A major trend of the last few years has been booming auto markets in lower tier cities, whereas auto markets in cities such as Beijing, Shanghai and Shenzhen have become saturated. Such cities have also started to regulate the number of vehicles on the road through license plate lotteries or auctions. Fast-growing auto sales in lower-tier cities benefit domestic brands, as their market share is in smaller cities is significantly higher. Even though the Chinese auto market as a whole is growing in the low single digits, Chinese brands should enjoy much higher growth rates overall thanks to their distribution network in lower tier cities.

The weak recent performance is temporary

Great Wall suffered through a tough period in 2017 for three primary reasons.

• One was tough competition from other Chinese SUVs such as the Geely Boyue, Geely Vision SUV, Trumpchi GS4 and Roewe RX5. In 2018 and 2019 however, the line-up of new product introductions from Geely, Roewe and Trumpchi will be limited. Geely will focus on its higher-end Lynk brand (costing close to CNY 200,000) and crossovers such as the Vision X1 and X3. The only major product release by Roewe is the RX3, but again is a smaller vehicle than the types of SUVs that Great Wall derives most of its sales from.
• Another reason for a weaker 2017 was discounting of older models to clear the distribution channel in anticipation of Great Wall’s new product introductions. The H6 model was first introduced in 2012 and the platform was already five years old in 2017. Great Wall has won awards for its fair treatment of its dealerships, not letting them accumulate inventory they cannot sell. So rather than putting pressure on dealerships to get rid of aging H6 SUVs in the distribution channel, the company reduced prices heavily – offering discounts as high as CNY 5,000 per vehicle. As a reference, Volkswagen offered discounts in excess of CNY 20,000 in 2017 for its old Tiguan to clear the distribution channels for the 2018 Tiguan model revamp. The discounts do not reflect poor competitiveness of the Great Wall brand – in fact it is remarkable that the Great Wall H6 is still the best-selling SUV in China 5 years since its 2012 launch. The discounting is likely to have caused a 4-5 percentage point impact on Great Wall’s gross margin, which used to be in the mid-20s and dropped to a low of 16% in 3Q17. According to Bernstein, the excess sell-in for Great Wall was about -20% in 2017, meaning that dealer inventory levels have been significantly reduced.
• A third reason was a hike in the purchase tax from 5% to 7.5% in January 2017. Another hike in January 2018 caused the purchase tax to normalize to the historical level of 10%. This has been a headwind for the entire auto sector, but particularly for vehicles with sub-1.6 liter engines.

What will change?

Several car models have recently been introduced:

• In November 2017, Great Wall released the model redesign of its 1.5 liter H6 SUV, previously representing about 45% of total revenue (the 1.5 liter engine option representing 93% of total H6 sales). The 2017 version is the first revamp since the original H6 came out in 2012. The H6 was designed by Belgian Pierre Leclercq – the person who designed the X5 SUV for BMW.

• In the second half of 2018, a new coupe version of the H6 will be released – the first update since the original H6 coupe in 2015.
• In the second half of 2017, Great Wall also released another sub-brand called Wey, run by a team of experience auto industry executives led by former Audi executive Jens Steingraeber.  The first two Wey models – the VV5 and the VV7 – are selling very well, having ramped from zero in 3Q17 to about a quarter of total revenue in January 2018. The Wey vehicles are currently sold to about 70 dealers, but Great Wall has plans to expand to about 300 dealers eventually. These are expensive vehicles, costing CNY 160,000+ each and have done far better than the previous high-end SUVs that Great Wall has produced in the past (the H7-H9).

• Additionally, an H4 SUV will be released in 2018 – covering the gap between Great Wall’s two best-selling models H2 and H6.

The result from these product introductions is that Great Wall will have completely updated portfolio of SUV models, with all the latest gadgetry as well as improved engines, transmission, powertrains and other components.

The company will be launching its international expansion in September 2018 with a 150,000 vehicle factory in Tula, Russia followed by a US factory in 2020. Great Wall recently set-up an R&D centre in Detroit to design vehicles targeted for US consumers. Great Wall is also negotiating a joint venture with BMW to produce electric vehicles for the Mini brand in China.

As Wei Jianjun believes in product differentiation, he will continue focusing on the niche SUV segment until the company has reached a mature phase of its development. The sales target for 2020 is 2 million vehicles compared to about 1 million vehicles today, representing a volume CAGR of 26% per year.

What sell-side is missing

The recently launched H6 SUV will have an average selling price 12% than the previous version, rising from CNY 113,000 to CNY 126,000. Management has guided that the new H6 will have a higher gross margin the corporate level gross margin of 24.6% in 2016. Management has also guided for gross margins to return to the mid-20s as long as the newly-introduced Wey vehicles sell in excess of 20,000 vehicles per month. In January 2018 – typically a slow month for auto sales – Great Wall sold almost exactly 20,000 Wey vehicles, so the target has already been met.

Sell-side expects EPS to stay below the prior peak in 2016. CLSA for example, expects gross margins to stay at 16-18% indefinitely – implying that the discounting we saw in 2017 will never end. CLSA assumptions imply an average selling price for the H6 at CNY 87-88,000 for the next two years, despite management’s guidance to the contrary. We know for a fact that the new vehicles have much higher ASPs. Sell-side models I have reviewed assume practically no volume growth in the H6 vehicles sold – astonishing given that the 2017 is an entirely new product from a new state-of-the-art production facility.

Demand for the H6 has been stronger than expected. The number of H6 sold to dealers has been inching higher from 35,000 per month in July 2017 to 59,000 in January 2018. According to Sina, Great Wall sold 69,000 vehicles in December 2017 from dealers, implying upside to the current wholesale numbers. Another news report said that “Great Wall still cannot satisfy demand for [the new] H6”.

Sell-side appears to be looking in the rear-view mirror and is not appreciating the fact that the entire product portfolio has been updated with much higher average selling prices. As volumes of the new H6 ramp up, discounting levels should drop off and utilization rates come back up – implying operating margins close to the company’s historical average.

Conclusion

According to my estimates of roughly mid-teens top-line growth and a 9% net profit margin by 2019 – reflecting higher ASPs, higher utilization rates and continued marketing expenses for the Wey brand – I am getting a 2019e PE ratio of 5.4x and a 2020e PE ratio of 4.0x. On a market cap/(R&D + Capex) basis Great Wall is among the cheapest of any Chinese auto manufacturer at just 6.0x, implying that you are potentially paying very little for the future growth potential of the company. Upward estimate revisions will provide a tailwind for the stock, while the low PE ratio in absolute terms will make the stock attractive for the value-focused investors that appreciate Great Wall’s long-term growth potential and best-in-class management team.

Risks

• Late-stage auto cycle. The Chinese auto market has grown enormously over the past two decade with no volume recession in at least 25 years. A downturn will come sooner or later. However, I am seeing zero signs of a downturn at the moment, with inventory levels under control, pricing being quite strong and other consumer indicators being positive.
• Increased US protectionism. While hard to quantify, global protectionism could make it tougher for brands such as Great Wall to grow outside China. One solution that Great Wall has taken is to open its North American factory in the US rather than Mexico. While the long-term growth potential might be impacted by tariffs, it will not affect the near- or medium term results in a major way given the currently low export share of total sales.
• Sell side is concerned that Great Wall isn’t big in EVs. While they do have some EVs to be launched (the P8 in 2018, for example), they are certainly slower than many others domestic auto brands in launching EVs. However, one fact not appreciated by the investor community is that normal EV sales (that is, non-micro EV sales) actually fell 4% in 2017. Negative growth in the sales of normal EVs and large supply coming online in the next few years should in my view lead to weak utilization and weak profitability of the Chinese EV industry in the next few years. Until battery costs come enough to level the playing field with ICEs somewhere around 2030, the EV market will remain driven by subsidies – and the Chinese subsidies are in the process of being phased out by 2020. I am frankly happy that Great Wall hasn’t staked its entire future on EVs.
• Intensifying competition. The official narrative about Great Wall is that they used to control the domestic SUV market but are now facing a lot tougher competition. While the narrative is to some extent true, it is also backwards looking to a large extent. The headwinds of Geely, Trumpchi and Roewe entering the market in the last 2 years was tough, and Great Wall’s H6 was entering its fifth year since the last major update. Those were tough headwinds, yet Great Wall still managed to grow its retail volumes despite these factors. And more importantly, the number of competitor SUV launches is slowing down while Great Wall has its strongest line-up of new vehicles ever.

Catalyst

• Quarterly earnings inching higher as the new H6, H4 and Wey SUVs make up a larger proportion of total sales
• Monthly sales reports from http://www.gwm-global.com/investor-relations/announcement.html