China Meidong Auto (1268.HK)

Below are excerpts from our 2019 Q3 letter regarding our new position Meidong Auto, for easier reference purpose.

Also, attaching the letter to shareholders from its 2018 annual report, it’s quite a good read: MeidongAuto_2018_Letter

Meidong Auto is a new position from the “Great Operation at Reasonable Price” category. It doesn’t come often that a CEO’s shareholder letter alone made me think seriously to become a shareholder. Meidong had made to this list. In short, it is a easy to understand business (luxury auto dealer), who had an exceptional “outsider” CEO who was able to communicate transparently and sincerely about its strategy and execution. It has been executing its strategy very well, generating excellent return on equity (25+%) over past 3 years.

Meteorology: China has seen its auto market slowing down after a few years of high growth. Luxury car however still enjoyed healthy growth. According to CPCA’s data, luxury brands have maintained a 10~% annual growth rate from 2016 to 2018 (while overall auto market observed +13.9%, 3% & -2.8% for the same three years respectively). Furthermore, CPCA’s most recent July 2019 data even shows an accelerating +24% yoy growth rate for luxury cars. This trend, while perplexing, could be explained by the secular shift of the consumption power in China (from tier 1 cities to lower tier ones, & a growing middle class in all tiers cities, etc.) and further inequality in wealth distribution.

Topography: Meidong uniquely chose to position as the sole dealer of a luxury brand in tier 3-4 cities. Such position allows Meidong to earn a high gross margin (on average about 100 bps higher than multileader in a city) due to weak competition. Such position also increased the stickiness of lucrative after sale service business. it however is a narrow moat because if competitors really want to imitate this strategy, they could achieve so and drive the margin down. In terms of the sustainability of such narrow moat, I think it is still in good position at least for short term (2-3 years), based on our evaluation of incumbents (who are at least a few years behind Meidong’s business principles & executions).

Commander: The management of Meidong is the most impressive factor. In fact, the CEO Ye Tao, reminds me the CEOs from William Thorndike’s book “The Outsiders”. Ye Tao has technical backgrounds, graduated from MIT with both engineering and MBA degrees, also served as executives to various software business in United States & in Asia. The way Ye Tao approaches car dealing business can be described as quite “rational”, which can be seen by reading a single shareholder letter from him. Ye Tao think the most important principles of his business are 1) high inventory turnover, 2) grow service revenue (the high margin business) & 3) focus on new store ROI. It may worth quoting directly from its 2018 letter. On the inventory turnover, it is refreshing to read something like “We live or die by inventory turns. Fast-turns make us a cash printing machine; slow-turns turn us into a cash-sucking black hole.” In addition to the principles laid out, the company’s reporting also provides metrics to track how they performed in these three areas. On capital allocation, the management preferred to use dividends. That 4 is not the most favorable way of distribution value back to shareholders, given the price is still a bit underpriced in my opinion.

System: One thing to note is that Meidong is still very closely held by insiders. 65% of the shares are held by the family trust of Ye’s brothers.

Valuation: we have built a material position at about 12x 2019 est. earning, a reasonable price for such a high-quality business.