China's mission to localize EV components continues to favor Huayu.
►Strong product mix: interior trim, chassis and auto lighting.
►Tesla increasing the local sourcing percentage could be a key stock catalyst.
►The price target based on a DCF model is CNY 29.4, implying a 41% upside.
China's long-prosperous auto market has seen a negative turning point in the past 18 months. In 2019, China produced 25.72 mn cars and sold 25.77 mn units, plummeting 7.5% and 8.2% compared to a year ago. The industry is undergoing heavy pressure.
We nevertheless recommend Huayu (600741:SH) as a good buy, given its EV/AV projects, diversified customer base, and competitive product mix.
Huayu's price/book ratio (p/b) decreased from around 2 at the end of February to 1.32 on June 15, edging toward the low water. We think the risk is attractive, and would recommend a buy.
Short-term waves
Like other auto parts suppliers, Huayu is subject to cyclical risks
In 2019, 43.2% of Huayu's revenue came from non-SAIC Group OEMs. SAIC saw a volume decline of 11.5% in 2019 amid the market downturn as well as emission standard upgrade, which translated into its top line decrease of 8%.
Huayu's 1Q20 revenues fell 32.6% YoY to CNY 23,973 mn as SAIC group registered a sales volume plummet of 56%. Gross margin dropped 1.1 ppt YoY to 13.2%, likely attributable to rising operating costs during the pandemic. It is worth noticing that Huayu saw its gross margin improving from 13.8% in 2018 to 14.5% in 2019, possibly due to a broader product mix. We expect the firm to carry out a sound cost management plan and drive gross margin growth in the coming years.
Huayu's 2020 revenue guidance for an 11% YoY decline has factored in the impact of COVID-19 on its domestic market and the extended disruption overseas. Huayu ramped up its overseas factories and research centers to 93 in 2018 from 14 in 2014. Overseas business split 22% of total revenues in 2019, which poses uncertainty. With more countries reopening factories, we see the risk from overseas can be controlled.
The passenger vehicle (PV) market in China saw some early recovery signs, with the continuous decline of annual growth halted. China Association of Automobile Manufacturers (CAAM) data shows that car sales reached 1.67 mn in May, growing 8.9% QoQ and 7% YoY.
The industry consolidation is heating up
China's auto component industry scale reached CNY 3,374 bn in 2018, representing a 4.2% YoY growth, according to CAAM. While it is a vast market, the concentration rate is relatively low compared to German, Japan and American rates, looking at the top auto part providers' revenues. The expansion of Huayu builds on the fertile ground of SAIC and some successful JVs and acquisitions. For instance, interior business under Yanfeng's JV with Adient and auto lamp JV with Koito. Combinedly, we think Huayu will further develop its business with such leading partners by leveraging the channel advantages and expanding market shares.
Major businesses remain strong
Yanfeng is eyeing the opportunity generated from autonomous driving
Interior business Yangfeng contributed 60.4% of revenue in 2019. In 2017, Yangfeng dominated China with an 11% market share, and seating through Yanfeng's JV with Adient controlled 30% in China. As seating is the primary point of interaction between the users and the vehicle, we see the growing value content of seating and interior trim systems will benefit Yanfeng. High volume orders from premium brands (e.g., BWM, Benz) are likely to improve margins. Yanfeng has put effort into research on cutting-edge tech in the area for years. The long payback period and high R&D costs enable the firm to build a wide moat to fend against the competition.
Huizhong (chassis) and Huayu Vision (auto lighting) are expected to benefit from Huayu's superior quality and broader customer base
Huayu has grabbed German and Japanese orders for its auto lamp business, along with BYD and BMW for chassis. Huayu's ability to enhance the diversification of client portfolios will become another catalyst.
Huayu's high-quality product in areas like aluminum bodies and LED lighting will propel its business growth. Aluminum has become a popular choice for advanced, next-gen vehicles, and countries have rolled out emission regulations to push OEMs to opt for aluminum car bodies. LED upgrades optimize the product mix and improve margins.
Growth potentials come from the EV/AV layout
China is experiencing a tumultuous period thanks to two secular trends in the auto industry – electric vehicles (EVs) and autonomous vehicles (AVs). Beijing has rolled out a national development plan to support EVs' critical components and to find local substitutes for batteries and assembly materials.
Huayu has provided a shining paper of results in the EV field in 2019. It continues to roll out new projects, e.g., electric brakes for BAIC BJEV and BYD, EV motors for GM, and e-powertrains for Volkswagen MEB. We expect the MEB project will drive massive demand. On the other hand, the higher penetration of EV and AV is expected to boost sales volumes of MWRs, electronic parts and function parts.
Tesla's increasing the local sourcing percentage
Dongxing Securities estimated that Huayu provides battery cells and key body components for Tesla Model 3 produced in Shanghai, which cost CNY 8,000 per car (in Chinese), the highest among other Tesla's local suppliers. The cooperation with Tesla will also bring up extra revenues from other EV makers sharply.
In terms of radars, Huayu has started 24GHZ radar shipments to SAIC PVs such as SAIC Maxus, and 77 GHZ to King Long.
Valuation
EqualOcean's price target of CNY 29.4 is derived from discounted cash flow (DCF) valuation methodology. The key assumptions include an 8.9% cost of equity, a 6% cost of debt, and a resulting WACC of 8.3%. We estimate a minus 13% and positive 10% sales growth in 2020 and 2021 to reflect the COVID-19 impact and the rebound, respectively. Our steady-state revenue growth assumption is 3.5%.