With Geely Auto, Opportunity Comes Ugly

Sometimes there are good reasons that a stock looks undervalued. In the case of Geely Automobile Holdings (OTCPK:GELYY), you can take you pick as to why analysts or investors may not like the company. The company has a reputation as a low-end manufacturer of cheap cars with dodgy quality, its tie-up with Volvo doesn't really offer much brand value in China, and its earnings quality is definitely lacking.

All of those are, I believe, fair points to flag. What is just as important is to look at what could go right. The company has been investing considerable resources into R&D and has not only closed the quality gap on its domestic peers, it's closing in on foreign JVs. The company is also actively working to refurbish and refresh its line, with a move toward higher-end brands and models. Geely is also the second-largest exporter of cars from Europe and it is my belief that China is not far removed from following in the footsteps of Japanese and Korean car manufacturers in terms of entering Western European and U.S. markets.

Can Geely Win In Its Own Backyard?

Readers who don't follow the Chinese auto sector may surprised to learn that domestic Chinese OEMs have only about 40% market share in their own country. Chinese consumer perceive imports to be of much higher quality (and in many cases they are correct), and the end result is that GM (GM) and Volkswagen (OTCQX:VLKAY) have about 30% market share between them by virtue of joint ventures with local companies (SAIC and FAW for both of them).

Perhaps not surprisingly, then, it is those Chinese companies that work with foreign car companies that tend to fare the best in the Chinese market. Brilliance China focuses on the premium market and boasts partnerships with BMW and Toyota (TM), Dongfeng works with Nissan, and GAC Group boasts multiple relationships, partnerships, and JVs with foreign producers.

Geely lacks those partnerships, but it is still one of the top 10 manufacturers in China. With around 4% market share, only BYD (OTCPK:BYDDY) is larger within China, as Chery has struggled significantly more recently. Geely has traditionally focused on low-cost models and while that might sound like a good thing in an auto market that is increasingly moving from the wealthier Tier 1 cities to the less wealthy Tier 2 and 3 cities, a reputation for low cost and questionable quality has harmed the value of Geely's badge in the eyes of Chinese consumers.

The company is trying to fight this reputation through marketing and product development. Geely has focused on developing powertrain technology and will likely be the first domestic OEM in China with 8-speed automatic transmissions. The company has also been investing its resources in a refreshed product lineup. Missing the SUV and turbo trends in China hurt, but the company is launching new sedans and SUVs in 2014 with a particular focus on the higher-end Emgrand models.

Will Volvo Help Or Hurt?

Refreshing the current line-up should help Geely's domestic sales, but I still wonder what the parent company (Zhejiang Geely owns 45% of Geely) has in mind with Volvo. Zhejiang Geely bought Volvo from Ford (F) years ago and the two companies have only recently started cooperating on design and development.

The two companies now have a formal JV, but there have already been reported clashes between China-based ownership and Sweden-based management as to the proper direction and focus for Volvo in China. I do believe that Volvo can contribute important technology to Geely, particularly in the turbo and SUV areas. But while Volvo sales in China have been strong lately, that's coming off a low base and the Volvo badge doesn't mean a lot in China. I also have my concerns that the differing management and ownership structures will limit the benefits to Geely. Said differently, I would expect Zhejiang Geely to make sure that they benefit first, and that may or may not come at the expense of what is best for Geely and its shareholders.

Growing Outside China

Geely has established itself as the leading Chinese auto exporter in 2013, and the company has made international expansion a major priority. Exports are about 20% of the company's domestic volume, but Europe is already nearly 10% of the company's revenue base and markets like Russia, Ukraine, and Saudi Arabia have become significant for the company.

A key question is how far Geely can go with its export plans. Those Chinese companies who have tried to export to Western Europe (including Geely) have found that their safety, fuel efficiency, and environmental ratings don't pass muster with customers, so there's definitely a lot of work to do before talking about "the next Hyundai" becomes relevant.

Earnings Quality Is A Real Concern

Investors looking overseas have to make their peace with the realities that other countries don't do things they way we do them over here. In the case of Geely, there are some pretty significant items or issues to note. First, Geely capitalizes a large portion of it's R&D. That's not unheard of outside the U.S., and it's not entirely unreasonable from a financial theory perspective, but it leads to overstated earnings and assets relative to U.S. GAAP.

Geely is also a major beneficiary of Chinese government subsidies. As a percentage of revenue, Geely gets more subsidies than any other automaker (about 4% of sales), and subsidies have made up as much as 40% of pre-tax profits in recent years. About 80% of these subsidies are tied to R&D or tax refunds, but investors need to recognize at least the risk that China will reduce or cease these payments at some point in the future.

With those concerns recognized, I am still looking for Geely to generate revenue growth of about 10% to 11% over the long term. Unit growth has been running in the double-digits in recent months (albeit below the Chinese market average) and a lot is riding on Geely's ability to build share and maintain momentum with its 2014 model launches. Although I do see Geely's free cash flow margin improving over the next five years as it leverages prior R&D, marketing, and manufacturing investments, I believe the company will be hard-pressed to generate a margin above the mid-single digits over the long term. With that, then, I'm only looking for low-to-mid single-digit free cash flow growth over the long term.

The Bottom Line

Discounting those cash flow streams back at an elevated discount rate (to reflect the risk that goes with China, the company's accounting, its low market share and so on), I come up with a fair value of HK$ 4.55, or about 20% above the current price. My target is about 10% lower than the average of the sell-side analysts who follow Geely, as I am less optimistic on the revenue growth, margins, and free cash flow conversion, not to mention much more conservative on the discount rate.

I do believe there are several Chinese stocks that look unreasonably cheap these days, but I'm not sure that Geely is among them. Geely is still trying to shake a bad rep for quality and value in its home market, and while Hyundai surmounted the same problems in the States, it took time and a lot of money (including a 10-year warranty). I also find the company's accounting and ownership structure not to my liking. I'd probably be willing to take on those risks if the shares were cheap enough, but I'm going to need more than a 20% to 25% discount to fair value to jump into the mosh pit that is the Chinese auto business.

Source: With Geely Auto, Opportunity Comes Ugly

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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