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Morningstar | Fresh Look At Yutong Bus: Narrow Moat Intact, FVE Raised to CNY 17.70

After taking a fresh look at Yutong Bus, we are increasing our fair value estimate to CNY 17.70 per share from CNY 16.10 and maintaining our narrow moat and stable moat trend rating. The bus maker’s narrow moat rests heavily on its intangible assets, which encompass the strength of its brand and extensive service network. This is demonstrated by the firm’s ability to maintain or build market share and price products at a premium to peers. Our fair value estimate implies 18.2 times forward earnings per share and 8.9% free cash flow yield. Yutong’s shares currently appear undervalued with potential 17% upside.

Unlike most consumer-facing automakers, Yutong sells to mostly transit providers whose top priority is offering reliable and predictable transportation services. To minimize service disruptions, transit providers tend to purchase mission-critical buses from trusted manufacturers with records of product success. Yutong started manufacturing buses in the 1960s and has since established a solid reputation for rolling out high-quality products to meet the ever-evolving market demand. Its dominant position in buses is evidenced by a leading 35% market share in China. This is even more impressive when we consider that the firm has been competing against several Chinese state-owned players that benefit proportionally more from government support.

Yutong finished fiscal 2018 on a high note. Better-than-expected earnings during the fourth quarter were driven by a mix shift toward more profitable electric buses, leading to a 70-basis-point increase in the group’s gross margin. During fiscal 2018, sales of green buses made up 52% of the firm’s top line, up from 48% a year ago. Evidenced by Yutong’s market share gains, we believe reductions in government subsidies toward alternative energy buses are increasing pressure on weaker manufacturers in the space, which will eventually lead to rivals exiting.

We are further encouraged by the improved operating cash number for the quarter, coming in at more than 3 times Yutong’s net profit for the period. In recent years, government-mandated delays in subsidy payouts have led to unusually high working capital, muting the firm’s return on invested capital. However, we expect Yutong’s ROICs to gradually recover after 2019 as more subsidies flow back. For 2019, we expect the Chinese government to cut electric bus subsidies by roughly 50%, but the resulted impacts to Yutong’s business have been more than priced into the share price.

The firm’s 2019 guidance points to flat sales, 25% gross margin, and 7% operating margin, all narrowly ahead of our expectations. Reported sales volume for the first two months of 2019 suggests the bus maker is on track to achieve its 2019 goals. Our investment thesis remains intact. We believe Yutong's strong product portfolio, coupled with its robust research and development efforts, will drive market share gains and stable margins in the years to come.