Weaker Earnings And More Complexity At Geely Hit The Stock

Summary

• Geely had a rough 2020, with second half results well short of expectations, and the complex ties between Geely Auto and its parent company aren't getting any simpler.
• Not merging Volvo into Geely Auto is a mixed outcome, Geely could use a luxury nameplate, but the cost savings from increased design and sourcing collaboration could still be meaningful.
• The ZEEKR JV looks like an attempt to leverage market enthusiasm for EV pure-plays, but it does mean the loss of a high-potential new Lynk model to the new JV.
• Geely shares have been quite weak since my last update, but 2021 is shaping up as a better year, the company continues to be poised for share gains in China's auto market, and the shares look undervalued.

It’s always complicated when it comes to Geely Automobile (OTCPK:GELYF) (OTCPK:GELYY), and I believe that complexity has had a negative impact on sentiment over the years. With the recent launch of yet another brand through a joint venture structure with parent company Geely Holding (“ParentCo”), it’s only getting worse, and the collaboration with the Volvo (OTCPK:VOLAF) brand, also owned by ParentCo, doesn’t really simplify matters either.

The earnings miss for the second half of the year doesn’t trouble me overly much, and I believe many investors will look at it as a “throwaway year” given the impact of the pandemic. I’m less excited about the ZEEKR venture, though, and while Geely continues to perform pretty well in China’s auto market, these latest moves raise fair questions about ParentCo prioritizing itself over Geely shareholders.

These shares have been exceptionally weak over the last month since my last update. While many other electric car plays sold off during that time, Geely hasn’t recovered to same extent so far. The valuation here is still attractive for long-term shareholders, but the complexity of the Geely-ParentCo relationship and the risks of self-dealing to the detriment of shareholders are risks to consider.

Volvo – No Merger, But Closer Collaboration

One of the potential drivers for Geely in 2021 is now resolved and off the table – ParentCo won’t be merging Volvo (which is owned at the ParentCo level, not by Geely Auto) with Geely. Instead, the two companies will be collaborating more closely on product sourcing and new product development.

I view this as a mixed development. Merging Volvo into Geely Auto would not only have simplified the corporate structure and some of the complicated financial arrangements between Geely and ParentCo, it would have also given Geely a strong three-tier brand platform, with Geely targeting budget car buyers, Lynk & Co (“Lynk”) targeting the mass market, and Volvo targeting the luxury segment. It would have also likely been a modest positive to margins, as Geely does pay certain fees and royalties to Volvo/ParentCo through those financial relationships.

On the other hand, ParentCo wasn’t going to just give Volvo to Geely shareholders, and I suspect that the financial returns ParentCo would have needed would likely have made a transaction a tough sell to analysts and investors.

In any case, what is happening is a closer collaboration. The two companies will be merging their powertrain businesses, working together on next-gen EV architectures and autonomous driving technology, and launching Lynk in Europe in part through the Volvo sales network. Increased shared sourcing could ultimately be a significant cost-saving opportunity for Geely and leveraging Volvo’s existing platform in Europe to launch Lynk is likewise a meaningful boost to that effort.

All in all, it’s not a bad outcome, particularly given the uncertainties around how a merger would have been structured.

ZEEKR – An Answer To A Question Nobody Was Asking

ParentCo has decided that it wants to launch a new xEV auto brand/business, and it’s doing so under a JV structure with Geely. Called “ZEEKR” (or “Ji Ke” in Chinese), Geely will own 51% of the JV, with ParentCo owning the rest, though ParentCo will be responsible for manufacturing under an asset-light model.

ZEEKR will use the SEA architecture developed at Volvo and owned by ParentCo and is being positioned as a luxury pure-EV brand with a price range (RMB 300K-500K) similar to Tesla’s (TSLA) target market.

As part of this JV, the “Zero concept” sedan that was supposed to be launched this year under the Lynk plan will instead be launched as a ZEEKR – and this goes back to my issue with the complicated dealings between Geely and ParentCo. The idea of setting up a new pure EV luxury brand makes some sense but undermining the Lynk brand/business to do so is more troubling to me.

On some level, this may well be an exercise in opportunism. I can’t imagine that ParentCo management hasn’t noticed the robust valuations that pure EV companies have been getting lately, and the idea of building one of its own and then launching a separate market listing for it has some appeal … provided that China-focused EV companies stay popular on a longer-term basis. Moreover, as much as I may dislike yet another listco/parentco tie-up, Geely Auto’s ownership in this JV does give shareholders upside to that potential future listing value.

A Return To Growth

Geely’s second half financial results were pretty poor, missing on revenue, gross margin, operating margin, and net margin. At the literal bottom line, Geely’s second half net profits came in about a third short of expectations. Net profit per car declined 30% yoy and 8% half-over-half for Geely and declined 24% and 23% for Lynk.

Not only was 2020 a poor year clearly impacted by the pandemic, it was also the later stage of a model cycle for Geely. With that, the company’s market share and market competitiveness weren’t quite as strong, and the company took a hit on gross margin by offering more discounts and incentives to consumers to move volume.

This year is shaping up to be better. There will be two new Geely launches (Xingyue L and Emgrand 2), a new Lynk (the first SPA model), a new Geometry, and the first ZEEKR (what should have been the Lynk zero concept sedan. Management expects mid-teens volume growth this year, and while the February year-over-year sales figures are of limited value given the steep downturn in the year-ago period, the company does seem to be regaining some share, with an implied 6.8% share of the market that’s a bit better than the full year 2020 results.

The Outlook

Most of my modeling adjustments have been on the order of fine-tuning; while 2020 was weaker than I’d expected (my expectations were lower than the sell-side averages, so the misses were a little less dramatic), I don’t see the issues from 2020 really spilling over into 2021 or as likely to repeat.

I’m looking for long-term revenue growth in the mid-to-high single-digits, depending upon whether I use the base year of 2018 (the last revenue peak) or 2019 (the pre-pandemic year). Again, the numbers haven’t really changed from my last update.

I’ve tweaked some of my margin assumptions over the next three years, but there are no meaningful changes to my 2025 or 2030 expectations for margins or cash flow and the literal sum total of my FCF estimate changes from 2021-2025 is a 2% downward revision. Long term, I do believe that Geely can generate double-digit FCF margins.

The Bottom Line

With the sharp decline in Geely shares, the valuation argument has definitely improved, and I believe Geely now trades at a substantial discount to fair value (around 30%). China’s auto market is intensely competitive and the internal dealings between Geely and ParentCo remain an issue, but this company has shown it can launch models that appeal to the Chinese car buying public and gain share, and I believe that will continue to be the case, even if the path ahead has some twists, turns, and potholes.

Analyst’s 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.