China ZhengTong: Potential New Controlling Shareholder To Ease Balance Sheet Woes

Elevator Pitch

I assign a Neutral rating to Hong Kong-listed Chinese automobile dealer China ZhengTong Auto Services (OTCPK:CZASF) (OTC:CZASY) [1728:HK].

China ZhengTong's financial leverage is high, and its cash flow is tight, but a potential new controlling shareholder could possibly help in the company's deleveraging efforts. However, there has been negative news flow for China ZhengTong recently, which raises questions whether the company's normal business operations have been disrupted due to its balance sheet woes. More importantly, there is always the risk that the acquisition of a 29.9% stake in China ZhengTong by the potential new controlling shareholder falls through, if certain conditions precedent are not met. Considering all of the factors above, I see a Neutral rating for China ZhengTong as justified.

China ZhengTong trades at 3.7 times consensus forward FY 2021 P/E, and it offers a consensus forward FY 2021 dividend yield of 7.1%.

Readers have the option of trading in China ZhengTong shares listed either on the Over-The-Counter Bulletin Board/OTCBB as ADRs with the tickers CSASF or CSASY on the Hong Kong Stock Exchange with the ticker 1728:HK. For those shares listed as ADRs on the OTCBB, note that liquidity is low, and bid/ask spreads are wide.

For those shares listed in Hong Kong, there are limited risks associated with buying or selling the shares in terms of trade execution, given that the Hong Kong Stock Exchange is one of the major stock exchanges that is internationally recognized, and there is sufficient trading liquidity. Average daily trading value for the past three months exceeds $1.5 million, and market capitalization is above $375 million, which is comparable to the majority of stocks traded on the US stock exchanges.

Institutional investors which own China ZhengTong shares listed in Hong Kong include Dimensional Fund Advisors, The Vanguard Group, BlackRock, Nuveen, and State Street Global Advisors, among others. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage such as Interactive Brokers and Fidelity, or international brokers with Asian coverage like Hong Kong's Monex Boom Securities and Singapore's OCBC Securities.

Company Description

Established in 1999 and listed on the Hong Kong Stock Exchange in 2010, China ZhengTong Auto Services is an automobile dealer in China with a network of 127 dealership stores located in 41 Chinese cities as of June 30, 2020. The company's portfolio of brands include luxury brands like "Porsche (OTCPK:POAHF) (OTCPK:POAHY), Benz, BMW (OTCPK:BMWYY), Audi (OTCPK:AUDVF), Jaguar and Land Rover, Volvo (OTCPK:VOLAF) (OTCPK:VOLVF), Cadillac and Infiniti" and mid-end brands such as "FAW-Volkswagen, Buick, Nissan, Toyota, Honda and Hyundai", according to its 1H 2020 interim report.

Apart from the company's core automobile dealership business which contributed 91% of its 1H 2020 revenue, China ZhengTong also generated approximately 4% and 5% of its top line for 1H 2020 from its supply chain business (logistics services relating to the auto market and lubricant oil trading) and financial services business (serving its dealers and automobile clients), respectively.

Balance Sheet Woes

China ZhengTong's high financial leverage has been a key concern for investors, and this explains why the stock trades at a significant discount to its peers as highlighted in the "Valuation" section of this article.

The company's net debt-to-equity ratio or net gearing was a relatively high 130.8% as of June 30, 2020. China ZhengTong implicitly acknowledged its weak balance sheet by highlighting in the company's 1H 2020 results announcement that it "will actively consider various financing methods to improve our existing financial position and reduce the degree of leverage of the Group."

Notably, China ZhengTong announced on July 24, 2020, that the company managed to successfully negotiate with the lenders of a $415 million term loan facility to defer the third instalment payment of the loan (equivalent to a quarter of the loan principal) from July 20, 2020, to January 19, 2021. The company has to repay $290.5 million (or roughly RMB2 billion) to the lenders by January 19, 2021, which also includes the fourth instalment of the term loan. Prior to this, China ZhengTong had raised HK$263 million (or RMB227 million) via a placement of 245,222,000 shares (or 10% of share outstanding prior to placement) at HK$1.09 on July 15, 2020, which represented a significant 15% discount to the stock's last traded price. This is a clear signal that China ZhengTong's balance sheet is stretched and its cash flow is very tight.

Furthermore, China ZhengTong has short-term borrowings due within a year amounting to RMB14,090 million as of end-1H 2020, in contrast with its cash and cash equivalents of RMB3,403 million. The company registered a net loss attributable to shareholders of -RMB1,323 million in 1H 2020, and its operating cash flow in the first half of the year was RMB569 million. On the positive side of things, China ZhengTong had undrawn credit facilities of approximately RMB10,443 million as of June 30, 2020.

Potential New Controlling Shareholder

On July 31, 2020, China ZhengTong disclosed that its controlling shareholder Joy Capital Holdings Limited, which owned a 51.29% stake in the company, had signed a Memorandum Of Understanding to sell a 29.9% equity interest in China ZhengTong to Shanghai-listed Xiamen ITG Holding Group Co., Ltd [600755:CH]. Subsequently, China ZhengTong confirmed on October 20, 2020, that Shenzhen-listed Xiamen Xindeco Ltd. [600755:CH], a subsidiary of Xiamen ITG, had agreed to acquire a 29.9% stake in the company at HK$1.74 per share. But note that the transaction will only be completed pending certain conditions precedent being fulfilled or waived.

In the July 31, 2020, announcement, Xiamen ITG was referred to as a "state-owned business group under Xiamen Municipal Government" operating a diverse range of businesses including "commodity trading, circulation automobile trading, logistics business, commodity retail business and others." Xiamen Xindeco has businesses in the areas of "information technology, automobile trading and supply chain", and it is expected to "provide synergies and significant opportunities" for China ZhengTong as per the recent October 20, 2020, announcement. Notably, Xiamen Xindeco is a leading automobile dealer in the Fujian province of China, so there are potential synergies that could be realized between the two companies in time to come.

More importantly, it might be easier for China ZhengTong to either raise new equity capital or take on new borrowings (to refinance existing borrowings) with the back of its new controlling shareholder which has a state-owned enterprise background. In other words, China ZhengTong's near-term refinancing risks are alleviated, and the company has a better chance of deleveraging successfully, if the transaction goes through.

Negative News Flow

Apart from China ZhengTong's balance sheet woes, there was also some negative news flow regarding the company.

Caixin Global reported on October 21, 2020, that automobile finance company Shanghai Dongzheng Automotive Finance Co. Ltd. "was suspended from the dealer loan business, and its controlling shareholder (China ZhengTong) was asked by regulators to exit the company within three months." In the company's 1H 2020 interim report, China ZhengTong refers to its subsidiary Shanghai Dongzheng Automotive Finance as a company running "retail loan and dealer loan businesses" with a focus "on the luxury vehicle market" that is "regulated by the China Banking and Insurance Regulatory Commission."

Earlier, China ZhengTong had issued a clarification announcement on September 30, 2020, stating that there were no issues with Shanghai Dongzheng Automotive Finance's automotive finance company license and business operations, in response to negative media reports.

It is noteworthy that Shanghai Dongzheng Automotive Finance is the only auto finance company in China (with an automotive finance company license granted by the China Banking and Insurance Regulatory Commission) that is linked to an existing automobile dealership. If China ZhengTong loses Shanghai Dongzheng Automotive Finance, this could be a setback for the company's core automobile dealership business.

Separately, there have also been local media reports in late-August 2020, suggesting that some buyers were unable to collect the cars they ordered from China ZhengTong's dealerships, while some of China ZhengTong's dealership stores seem to have limited inventories. This could possibly be linked to China ZhengTong's balance sheet woes and cash flow issues mentioned above.

Valuation

China ZhengTong is valued by the market at 3.7 times consensus forward FY 2021 P/E and 3.5 times consensus forward FY 2022 P/E based on its traded price of HK$1.08.

Market consensus expects China ZhengTong to be loss-making for FY 2020, but deliver ROEs of 4.9% and 4.8% for FY 2021 and FY 2022, respectively.

China ZhengTong offers consensus forward FY 2021 and FY 2022 dividend yields of 7.1% and 8.4%, respectively.

China ZhengTong is the cheapest Hong Kong-listed Chinese automobile dealer based on forward P/E multiples based on the peer valuation comparison table below, if one looks beyond FY 2020. Nevertheless, China ZhengTong's normalized ROEs for FY 2021 and FY 2022 are still the lowest amongst its peers, and there are other negative factors for the stock such as its high financial leverage as highlighted above.

Peer Valuation Comparison For China ZhengTong

Source: Author

Risk Factors

The key risk factors for China ZhengTong are a failure to deleverage, a lack of support from its new controlling shareholder, and disruptions to the company's business operations, assuming some of the negative news flow turns out to be true.

Note that readers who choose to trade in China ZhengTong shares listed as ADRs on the OTCBB (rather than shares listed in Hong Kong) could potentially suffer from lower liquidity and wider bid/ask spreads.

Disclosure: I/we 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.