Zhongsheng Auto (HK:0881) China's largest dealer of luxury cars with approximately 8.1% market share as of the end of 2020, made three important disclosures in the last week that merit the attention of investors eyeing China's auto sector.
The first was Zhongsheng's disclosure about new car sales for the second quarter of 2021 and the first half of 2021, available at this link:
https://en.zs-group.com.cn/u/cms/en/202107/05094915aaxg.pdf
To summarize, Zhongsheng, a major distributor of Mercedes, Lexus, BMW, Audi, and several other major luxury brands, disclosed aggregate unit sales. At the end of 2020, Zhongsheng operated 373 dealerships, of which 218 were luxury dealerships that are primarily located in tier 1 and tier 2 cities and provincial capitals.
To highlight in the second quarter 2021:
- Total new car sales volume was 143K, up 15% from the same period last year.
- Total luxury car sales volume was 84K, up 21% from the same period last year.
For the 1st half, Zhongsheng's total new car sales were 275K, and luxury car sales were 162K, up 40% and 45% respectively from the first half of 2020.
While these headline increases for the half year are certainly remarkable, it's important to remember the distortionary effect of the pandemic on China's auto sales last year, especially during the initial onset of the pandemic in the first quarter. Therefore, the second quarter figures are the more illuminating statistics as they show solid improvement over the second quarter of 2020 last year, when auto sales and normal business activities were rapidly recovering from the pandemic restrictions of the first quarter.
Given Zhongsheng's status as the largest dealer of luxury cars in China, these solid sales volume figures most likely imply that auto sales by other major listed dealership groups like Yongda (HK:3669), Meidong (HK:1268) as well as China Grand Auto (SH:600297) and its subsidiary Baoxin (HK:1293) are doing well so far as the first half of the year comes to a close, although Zhongsheng's performance should only be extrapolated in the most general sense to the performance of its competitors.
The other two disclosures from Zhongsheng that merit attention relate to ongoing and new investments by two major global stakeholders. The first is regarding Singapore listed Jardine Matheson (SGX:J36), a massive pan-Asian conglomerate with interests across retail, property and hotel development, auto manufacturing and dealing, and heavy equipment, among many others. Jardines also holds equity interests in a wide range of businesses across Indonesia, Vietnam, Thailand, and other Southeast Asian markets. The second is regarding Hillhouse Capital, a leading PE and public market investment fund, led by Mr. Zhang Lei, an early investor in Tencent and other notable Chinese internet firms.
Jardine was founded in the mid 1800s and has been operating in China and Hong Kong for well over 100 years. What's notable is that in March of 2021, Jardine and Hillhouse announced a strategic partnership whereby the two parties formally stated that:
"The strategic co-operation will focus on investment and business development
opportunities predominantly in Greater China, as well as South-East Asia. There is also
expected to be close collaboration between the Jardines and Hillhouse value creation
teams and respective portfolio companies, in particular in the areas of consumer
technology and digital enablement."
The link to the formal release from Jardine and Hillhouse is available at this link:
Back to Zhongsheng, to summarize last Friday (July 2nd) Jardine announced that it was selling its China Mercedes dealer network to Zhongsheng in exchange for cash and shares and then this Tuesday (July 5th) Zhongsheng announced that it was raising equity financing from Hillhouse. Thus, it seems that these two deals are the first example of Hillhouse and Jardine collaborating on a strategic investment. Let's look at the key details of both deals:
First and foremost, Jardine and, and in certain nations, its partners or firms it has invested in, operate car dealerships in Indonesia, Singapore, Vietnam, Malaysia, Myanmar, and The U.K. Jardine also directly operates a Mercedes dealer network in Hong Kong, Macau, and China called Zung Fu (仁孚).
Jardine recognized the potential of the China luxury auto market and founded Zung Fu China, a wholly owned subsidiary, in 1994. Zung Fu China now operates 26 Mercedes dealerships, most of which are located in Southern and Western China. Although the exact locations of the dealerships are unclear, from the release it seems that many are located in larger tier 2 cities.
Jardine also made a major equity investment in Zhongsheng in 2014 (when Zhongsheng shares were trading below $12 HKD) and now controls about 19% of the company along with two board seats. Jardine has realized a solid gain on this investment as Zhongsheng shares now trade for around $70 HKD.
Under the terms of Jardine & Zhongsheng's deal, Zhongsheng will buyout Zung Fu's China dealer network (but not it's Hong Kong or Macau network) for a total consideration of $1.3 billion USD. Zhongsheng will pay Jardine $900 million USD in cash and the balance in newly issues shares (about 2% of outstanding share capital) which, after closing, will increase Jardine's shareholding in Zhongsheng to about 21%. Here is the link to the disclosure: https://en.zs-group.com.cn/u/cms/en/202107/02103830gtiq.pdf
What was really interesting is that the deal disclosed the key operational and financial statistics of Zung Fu China. The below screenshot is from the disclosure by Zhongsheng about the deal:
The author's full research report on China's luxury auto sector, that focuses on Meidong Auto, a dealer group expanding in smaller tier 3 cities, is available on the "Research Reports" section of this website. For reference, Meidong sold around 720 cars per luxury dealership in 2020 as it is of comparatively smaller scale and is adding new dealerships at a relatively faster rate than Zhongsheng.
Back to Zung Fu China and Zhongsheng. For revenue Zung Fu China showed respectable growth in 2020 with revenue rising 9.6% and a strong showing in the first quarter of 2021. With regards to margins, Zung Fu China posted a net income margin of 3.3% in 2020 and 3.9% in the first quarter of 2021. China has seven listed car dealership companies, and these companies, with the exception of Zhengtong (HK:1728) which really lost a lot of money during 2020, posted an average net income margin of 2.6% for 2020.
With regards to valuation of the acquisition, $719 million HKD is roughly equivalent to $92 million USD, so the deal had a PE value of about 14. By dealership acquired, the consideration was $50 million USD or 320 million CNY per dealership, although it's important to note Zung Fu China owned many of the properties its dealerships were located on, which is unusual for dealer groups, and these properties are included in the sale and are collectively valued at 1.7 billion CNY or about $260 million USD.
So why did Jardine sell Zung Fu China to Zhongsheng and why did Hillhouse buy newly issued shares from Zhongsheng just days after the sale was announced? There are several key facts to consider, and the firm does state several in its two disclosures regarding Jardine and Hillhouse.
First and foremost, despite Zung Fu China's impressive 2020 results, the firm underperformed Zhongsheng on key metrics, namely revenue growth and net income margin. In 2020 Zhongsheng's revenue grew 19.6% and the firm's net income margin was 3.7% compared to 9.6% and 3.3% respectively for Zung Fu. Jardine probably surmised that Zhongsheng could operate Zung Fu China even better than it could. Furthermore, Zung Fu China has 10 authorizations to open new dealerships over the coming years. Zhongsheng already is one of the largest Mercedes dealers in China with 63 Mercedes dealerships, so it's probable that as both firms expand they would start to face issues of overlap or competition within their networks.
Thus, since Jardine already owns such a large stake in Zhongsheng, its likely that Jardine decided that by selling Zung Fu China and letting Zhongsheng optimize it's network, Jardine would benefit more long term from an even larger shareholding in Zhongsheng, rather than continuing to operate a business that could soon be competing with its own investment.
Finally, why did Hillhouse come in and buy new shares in Zhongsheng?
The disclosure from Zhongsheng regarding Hillhouse's investment in short essentially stated that Hillhouse would buy newly issued shares in Zhongsheng that would enlarge its capital base by 2% for $2.9 billion HKD (about $380 million USD). Hillhouse and Jardine's new shares were both issued at a price of $63.4 HKD. Here is the link to the disclosure: https://en.zs-group.com.cn/u/cms/en/202107/050957288zsc.pdf
Car dealerships are businesses that employ a degree of leverage because normally dealer companies financing around 90% of the cost of their inventory with short term bank loans and loans from the auto manufacturers, and around 10% with their own capital. At the end of 2020, (it's last financial report) Zhongsheng disclosed it had about 33.8 billion CNY in short term assets (about $5.2 billion dollars) and 28.4 billion CNY in short term liabilities (about $4.3 billion dollars). The firm's financial condition is stable and it intends to use bank loans and internal capital to fund the $900 million USD consideration (about $5.8 billion CNY) to Jardine, however such a large outflow certainly increases Zhongsheng's leverage.
Thus, according to the disclosure, Zhongsheng intends to use the $2.9 billion HKD from Hillhouse to "rebalance its debt to equity ratio" which probably means pay down some of the bank loans it used to purchase Zung Fu China and ensure it has enough capital going forward to continue expanding its dealership network at a rapid rate. In 2020 Zhongsheng opened 12 luxury dealerships and acquired an estimated six dealerships, so its essential for the firm to maintain moderate leverage as it invests in further expansion.
To conclude, this complex and intricately structured deal between Jardine, Zhongsheng, and Hillhouse is not only demonstrative of the confidence that major institutional investors have in the future of China's luxury auto sector and its largest player, but it is also illustrative of how Jardine and Hillhouse are collaborating to invest in their respective portfolio companies. Jardine's conglomerate has a vast array of businesses and equity holdings, and Hillhouse also has expansive investments in listed and unlisted firms; it will be interesting to measure not only the long term impact on Zhongsheng, but also the future deals the two parties collaborate on.
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