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Morningstar | Great Wall Motor's Frustrating Results; Margin Recovery No Longer in Sight; FVE Lowered to HKD 4.60

No-moat Great Wall Motors posted another disappointing fourth-quarter result with the top line and bottom line missing our estimates by 18% and 53%, respectively. A 550-basis-point drop in the core vehicle business’ gross margin was to blame. We moved our fair value estimate to HKD 4.60 from HKD 6.10, putting shares of the company at 11.6 times forward price to earnings and 5.7 times forward EV to EBITDA. Our lowered valuation reflects not only weaker long-term margin assumptions, but also the risk of slower growth in China. At its current market price, shares of Great Wall are trading at 42% premium to our fair value estimate.

During the fourth quarter, Great Wall sold a total of 376,000 vehicles or 3% more than the same period last year. However, rising volume did not translate into increasing year-over-year revenue as the firm discounted many of its cars to maintain market share. While we believe keeping production and sales volume at high levels is crucial to strengthen both suppliers’ and dealers’ confidence in Great Wall during the industry downturn, it comes at a cost to the value of Great Wall’s brand in the eyes of consumers. On top of discounting its cars, the automaker’s premium model, WEY, failed to gain traction with consumers, as evidenced by sales coming in at only 56% of management's target. As a result, we adjusted down our five-year operating margin assumption to an average of 5% from 6.2%, as a recovery in Great Wall’s margin is no longer in sight.

Admittedly, part of Great Wall’s underwhelming performance in 2018 is due to various macro factors in China. In our recently published Automotive Observer, we highlighted that 2018 was a lackluster year for Chinese light-vehicle demand, with total sales down 2.7% year over year. The cooldown in Chinese auto sales reaffirms our thesis that growth rates were likely to be more subdued once the 10% automobile purchase tax was reinstated in early 2018. At the same time, we attribute underperformance versus our expectations to negative wealth effects resulting from the sluggish Chinese stock market, a Sino-U.S. trade conflict, and a person-to-person loan market crackdown.

For 2019, we think the firm will sell roughly 4% more cars than it did in 2018, but much of the increase in volume will not be coming from its traditional gas-guzzling SUV lines, but electric vehicles instead. We lifted our sales estimate for the firm’s Ora EV models from 10,000 to 20,000, as the Chinese government continues to provide support to green cars at the expense of gasoline ones. Rising contribution from Ora, however, has a negligible impact on the Great Wall’s bottom line because these vehicles are primarily sold at cost.

We forecast the automaker’s capital expenditures to remain elevated over the next five years, as it commits to building production lines and renovating existing ones. Free cash flow is projected to dive into the red over the next two out of five years, given the delay in government subsidy pay-outs on electric vehicle sales will expand the firm’s working capital.

On corporate governance ground, we are giving Great Wall Motor the benefit of the doubt on its recent transfers of 100% equity interests in Honeycomb Energy and its car-sharing subsidiary to a holding company 99% owned by the CEO. We will consider downgrading our stewardship on Great Wall if CEO Wei ends up listing these two businesses, something he said might happen, at prices significantly higher than disposal amounts received by the listed entity.