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MMorgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.China Autos our new top pick: As Chinas largest BMW dealer by sales volume, Yongda should benefit from a BMW-backed margin recovery from 2H19, and we forecast a 24% earnings CAGR, 2019-21. The stock is currently trading at 6x 2020 P/E, below its 7-year histor-ical average of 7x. We remain OW on Zhongsheng on its solid opera-tional efficiency. We resume coverage of Zhengtong at OW on its highest exposure vs peers to luxury car brands. We remain UW on Baoxin because of its subpar balance sheet quality. Where we could be wrong: (1) If EV sales grow faster than we expect, then demand for dealer ICE services could fall; (2) If the gov-ernment regulates service fees for auto finance/insurance products, dealers incomes would be adversely affected. Exhibit 1:Summary of ratings and price targetsCompany TickerNew Old New OldYongda 3669.HK OW EW 9.5 5.0 Zhongsheng 0881.HK OW OW 26.0 25.0 Zhengtong 1728.HK OW 3.6 Baoxin 1293.HK UW UW 1.4 1.5 Rating PT (HK$)Source: Morgan Stanley Research.With this report, Shelley Wang assumes coverage of Yongda, Zhongsheng, Zhengtong, and Baoxin.Still constructive on Chinas luxury car demand: We look for a +6% CAGR, 2019-20, against our expected -4% CAGR for Chinas overall passenger vehicle demand in the same period. Hong Kong-listed auto dealers have 50-80% sales exposure to luxury car brands, so we think they can withstand and grow beyond the cyclical weakness. Although auto dealers 1H19 earnings could be pressured by the deep discounts for inventory cleanup, we believe much of the challenge has passed, and that it is time to look beyond the cyclical weakness. We expect dealers new car margins to recover from 2H19, thanks to a BMW model upcycle and the new vehicle license plate quota relaxation. This follows prolonged margin erosion stemming from the 2H18 import tariff disruption and the 1H19 China V inventory clearance ahead of the rollout of China VI emission standards. We expect BMW dealers to outperform peers in 2019-20, thanks to a strong model pipeline, such as BMWs new generation 3-series in June 2019 and localized X2 in 2H19. In Europe/US, 3-series sales recovered from a double-digit YoY decline in 1Q19 to over 20% YoY growth in 2Q19 following the new generations launch; we expect the 3-series to be well received in the China market as well. In addition, relaxation of the new vehicle license plate quota in Shenzhen/Guangzhou could boost luxury car demand and thus benefit listed auto dealers.Long term, we expect after-sales services to drive earnings growth, thanks to an expanding customer base and the business resilient nature. While there are market concerns about the slow-down in dealers earnings growth since 2018 (similar to the situation in 2012-14 after the purchase tax stimulus expired), we believe after-sales services will provide a continued profit driver to auto dealers (contributing 60-70% of consolidated gross profit in 2019-21, higher than the 40-50% in 2012-14) and offsetting the cyclicality in the new car sales business.China auto dealers are better positioned than US peers to outper-form auto industry growth, thanks to higher exposure to luxury Industry ViewIn-LineM4Contents 5 Order of Preference6 Key Charts7 Investment Thesis 9 Luxury Car Segment Should Continue to Outperform11 Near Term, New Car Margins Will Recover from 2H1916 Long Term, After-sales Services to Drive Earnings Growth19 Key Debate #1: Will Auto Dealers Outperform the Auto Industry? 21 Key Debate #2: Who Is Better Positioned for Recovery?24 Stock Implications26 Where We Could Be Wrong28 Yongda32 Zhongsheng36 Zhengtong40 BaoxinMMORGAN STANLEY RESEARCH 5Order of PreferenceExhibit 2:China auto dealers: Order of preferenceYongda Zhongsheng Zhengtong Baoxin3669.HK 0881.HK 1728.HK 1293.HKRating Overweight Overweight Overweight UnderweightTrading Currency HKD HKD HKD HKDPrice Target 9.50 26.00 3.60 1.40Current Price 7.10 20.65 2.97 1.80 Upside/(Downside) (%) 34% 26% 21% -22%Market Cap (in USD mm) 1,677.1 6,374.6 933.0 654.0 Avg Daily Traded Vol (in USD mm) 3.1 10.3 3.9 2.0 Morgan Stanley EstimatesFY19e CNY CNY CNY CNYSales 61,087 120,960 40,263 40,400 EBITDA 3,207 9,033 3,817 2,196 EBIT 2,867 7,715 3,205 1,736 EPS 0.81 1.81 0.57 0.23 FY20eSales 66,333 129,310 42,945 43,897 EBITDA 4,045 10,569 4,527 2,512 EBIT 3,685 9,132 3,925 2,008 EPS 1.10 2.27 0.73 0.29 FY19 MSe vs. Consensus MeanSales 0.3% -2.5% -2.9% 2.2%EBIT 0.4% 10.1% 2.8% -7.5%EPS -3.5% -1.8% 1.7% -11.1%FY20 MSe vs. Consensus MeanSales 1.0% -6.2% -4.4% 1.4%EBIT 8.4% 12.5% 9.8% -3.9%EPS 6.0% 4.3% 10.1% -4.9%Valuation Multiples at Last CloseFY19eP/E 7.7x 10.0x 4.6x 6.8xEV/EBIT 7.7x 7.8x 6.1x 6.9xEV/EBITDA 6.9x 6.6x 5.1x 5.5xEV/Sales 0.4x 0.5x 0.5x 0.3xFCF Yield 11.3% 15.0% 13.9% -16.5%FY20eP/E 5.7x 8.0x 3.6x 5.4xEV/EBIT 6.2x 6.3x 4.8x 6.2xEV/EBITDA 5.6x 5.4x 4.2x 5.0xEV/Sales 0.3x 0.4x 0.4x 0.3xFCF Yield 10.2% 18.6% 35.6% -11.0%Source: Refinitiv (consensus mean), Morgan Stanley Research. E=Morgan Stanley Research estimates. Note: Closing prices are as of the market close on July 23, 2019.M6Key ChartsExhibit 3:We expect Chinas luxury car segment will continue to outperform its passenger vehicle (PV) market in 2019-20-10%-5%0%5%10%15%20%-0.51.01.52.02.53.03.52016 2017 2018 2019E 2020ELuxury car sales volume Luxury brands YoYChina total PV YoYSales volume (mn units) Sales growth (YoY) Source: China Passenger Car Association (CPCA), Morgan Stanley Research. E=Morgan Stanley Research estimates.Exhibit 4:Hong Kong-listed auto dealers have higher exposure to luxury car sales than to Chinas overall PV market12% 47% 63% 74% 77% 0%10%20%30%40%50%60%70%80%90%China overall Zhongsheng Yongda Baoxin ZhengtongExposure to luxury car sales (2018) Source: Company data, CPCA, Morgan Stanley Research.Exhibit 5:We expect auto dealers gross profit to continue to grow in the current round of the “post-stimulus era“-246810121416182006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 20182019E2020EConsolidated GP GP of new car salesGP of after-sales services GP of finance/insuranceConsolidated gross profit (Rmb bn) 2012-14 post-stimulus era The bears Source: Company data, Morgan Stanley Research. E=Morgan Stanley Research estimates.Exhibit 7:Yongda and Zhongsheng are better positioned vs peers for a 2H19 recovery0246810121416Zhongsheng Yongda Zhengtong BaoxinMarginGrowthModel cycleTurnoverGearingCash flowScorecard 14 11 10 16 Source: Company data, Morgan Stanley Research.Exhibit 8:Auto dealers valuation comps5.8 8.0 3.6 5.3 7.9 8.3 10.1 9.9 0246810122020E P/E Overweight Underweight Source: Refinitiv, Morgan Stanley Research. E=Morgan Stanley Research estimates.Exhibit 6:We expect BMW, Lexus, and Mercedes-Benz dealers to outperform peers in 2019-200%1%2%3%4%5%6%7%-50% -40% -30% -20% -10% 0% 10% 20%New car margin Sales volume growth Source: Morgan Stanley Research estimates.MMORGAN STANLEY RESEARCH 7While new car sales are more cyclical than are after-sales services, we think new car sales should be treated as an “investment,“ with the primary goal being volume growth instead of margin expansion, in order to generate “returns“ from the after-sales services business. Thanks to the growing number of cars nationwide and rising auto finance penetration, we expect dealers after-sales services to deliver a 10-20% CAGR, 2019-21. China auto dealers are better positioned than US peers to out-perform the industry, thanks to the formers higher exposure to luxury car brands (50-80% for China, vs 20-40% for US in 2018), higher profit contribution from after-sales services (50-60% for China, vs 40-50% for US in 2018), and higher upside potential from auto finance (30-40% penetration in China, vs 70-75% in US in 2018). Yongda up to OW; our new top pick: As Chinas largest BMW dealer by sales volume, Yongda should benefit from a BMW-backed margin recovery from 2H19, and we forecast its earnings to rise at a 24% CAGR, 2019-21. On our estimates, the stock is currently trading at 6x 2020 P/E, below its 7-year historical average of 7x P/E. We remain OW on Zhongsheng because of its solid operational efficiency. Financially, Zhongsheng is better positioned vs its peers, given higher turnover, lower gearing, and better cash flow. We resume coverage of Zhengtong at OW, given it has the highest exposure among its peers to luxury car brands. We remain UW on Baoxin because of its subpar balance sheet quality.Where we differ vs the market: In contrast to market concerns about dealers margin pressure amid weak auto demand, we are more bullish, anticipating a 2H19 recovery, supported by substantially nar-rower discounts on new model launches and incremental demand stemming from the relaxation of the new vehicle license plate quota.Catalysts to watch: The upcoming 1H19 results release in August will likely reflect margin pressure in 1H19, but we believe this has been largely priced in. A rebound in sales growth in 2H19 especially from new models such as the BMW 3-series, should serve as a key catalyst to drive dealers share prices higher, in our view. Where we could be wrong: (1) If EV penetration rises faster than we expect, then the traditional dealer business could come under pres-Investment Thesis We maintain our constructive view on Chinas luxury car demand, and forecast a +6% CAGR in 2019-20, against our expected -4% CAGR for Chinas overall passenger vehicle demand in the same period, thanks to underpenetrated luxury car sales in China, as well as Chinese consumers pursuit of luxury goods given rising household incomes and supportive demographic trends. Hong Kong-listed auto dealers have 50-80% sales exposure to luxury car brands, so we think they can withstand and grow beyond the cyclical weakness. Although auto dealers 1H19 earnings could be challenging, given deep discounts on an inventory cleanup, we believe much of the related pressure has passed and that it is time to look beyond the cyclical weakness. Near term, we expect dealers new car margins to recover starting from 2H19, driven by a BMW model upcycle and the new vehicle license plate quota relaxation. This follows prolonged margin erosion stemming from 2H18 import tariff disruption and 1H19 China V inventory clearance to prepare for the China VI emission standards rollout. We expect BMW dealers to outperform peers in 2019-20, thanks to a strong model pipeline, such as the new generation 3-se-ries in June 2019 and localized X2 in 2H19. In Europe/US, 3-series sales recovered from a double-digit YoY decline in 1Q19, to over 20% YoY growth in 2Q19, after the new generations launch; we expect the 3-series to be well received in China market, as well. In addition, the recent relaxation of the new vehicle license plate quota in Shenzhen / Guangzhou could boost luxury car demand and benefit the listed auto dealers. We estimate the auto dealers in our coverage have 20-50% sales exposure to license-restricted cities nationwide. Thus, the existing/potential further relaxation of license plates should benefit auto dealers. Long term, we expect after-sales services to drive earnings growth, supported by an expanding customer base and the business resilient nature. In contrast to market concerns stemming from the growth slowdown that began in 2018 (similar to the situation in 2012-14 after the first batch of purchase tax stimulus expired), we expect after-sales services to be a continued profit driver for auto dealers (contributing 60-70% of consolidated gross profit in 2019-21, higher than the 40-50% in 2012-14), and helping to offset cyclicality in the new car sales business.M8sure and see reduced demand for new car sales and after-sales ser-vices. Some EV makers may adopt online sales to achieve cost sav-ings. Also, EVs have a simpler structure than do traditional ICE cars because of their higher levels of commoditization and modulariza-tion. Thus, they require less maintenance and repair; and (2) If the Company Whats in the price? Whats the market missing?Yongda (3669.HK) l The market expects new car margin to remain weak in 1H19 (interim result is scheduled to be released in August).l JLR demand remains weak, with deep discounts.l The YTD share price rebound reflects market expectations for a sales volume recovery in 1H19 following the import tariff disruption in 2H18. l We expect new car margin to improve substantially in 2H19, thanks to BMWs new generation 3-series launch at the end of June.l Prudent development of its auto finance business, with accelerating growth of its finance leasing busi-ness (i.e., 21% of Yongdas consolidated gross profit in 2019, we estimate).Zhongsheng (0881.HK) l The market expects new car margin to remain weak in 1H19 (interim result is scheduled to be released in August).l Valuation premium given its good track record of operational efficiency and execution capabilities.l The YTD share price rebound reflects market expectations for a sales volume recovery in 1H19 following the import tariff disruption in 2H18. l We expect higher margin despite its 50% sales exposure to midrange to high-end car brands (vs 20-40% for other dealers), as Toyota/Honda are out-performing other JV brands YTD.l We expect higher gross profit growth from after-sales services, thanks to a higher retention rate. Zhengtong (1728.HK) l The market expects new car margin to remain weak in 1H19 (interim result is scheduled to be released in August).l JLR demand remains weak, with deep discounts.l Aggressive expansion of proprietary auto finance business. l We expect new car margin to improve substantially in 2H19, thanks to BMWs new generation 3-series launch at the end of June.l Potential revaluation/rental gain from land develop-ment in Shenzhen.Baoxin (1293.HK) l The market expects new car margin to remain weak in 1H19 (interim result is scheduled to be released in August).l JLR demand remains weak, with deep discounts.l We see risk of rising finance costs, as Baoxins total debt continued to climb at end-2018.l We expect few synergies from property developer Evergrande, which bought a 41% stake in Baoxins parentco in September 2
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