In this briefing:
- HK Connect Discovery Weekly: CRRC, Car Inc/UCar (2019-01-25)
- Yes Bank’s New CEO Should Not Be a Yes Man
- Chinese Telcos: Rising Capex Expectations a Risk. Downgrade China Mob and China Tel to Neutral.
- Tesla–The Struggle to Stay Afloat in 2019
- Olympus Corporation (7733 JP): Overvalued with Too Many Controversies
1. HK Connect Discovery Weekly: CRRC, Car Inc/UCar (2019-01-25)
In our Discover HK Connect series, we aim to help our investors understand the flow of southbound trades via the Hong Kong Connect, as analyzed by our proprietary data engine. We will discuss the stocks that experienced the most inflow and outflow by mainland investors in the past seven days.
We split the stocks eligible for the Hong Kong Connect trade into three groups: component stocks in the HSCEI index, stocks with a market capitalization between USD 1 billion and USD 5 billion, and stocks with a market capitalization between USD 500 million and USD 1 billion.
In this week’s HK Connect Discovery, we highlight that CRRC’s outflow coincides with media reports that highlight the risks of China’s investment in high-speed railway. We also see a very substantial southbound flow into Car Inc.
2. Yes Bank’s New CEO Should Not Be a Yes Man
Yes Bank has appointed Ravneet Gill as the bank’s CEO, effective latest from March 1, 2019, for a 3-year term. The announcement led to a spurt in the bank’s share price, as the leadership issue was finally resolved. While investors rejoiced, it remains to be seen whether the new CEO will be influenced by Rana Kapoor, who will step down as founder-CEO on January 31, 2019. Normally, in India, founders are reluctant to cede managerial control, and in banks, their influence often disrupts operational management even when the regulator has compelled founders to step down from the board. It is therefore imperative that once Rana Kapoor steps down as CEO his role should only be restricted to a founder shareholder without any operational involvement even as an advisor. Gill’s actions as Yes Bank CEO will need to be closely monitored as some board appointees have already been made prior to his taking charge. In particular, we need to closely watch how he manages the close associates of Rana Kapoor, one of whom has been elevated to the board, subject to the regulator’s approval. If Gill starts inducting experienced bankers from outside in senior positions in Yes Bank, it will demonstrate to the public that he is not under the yoke of the founder, but if he continues with the existing team of senior executive management or permits an advisory role for the departed founder-CEO it will indicate the continued strong influence of Rana Kapoor on the bank he co-founded.
3. Chinese Telcos: Rising Capex Expectations a Risk. Downgrade China Mob and China Tel to Neutral.
We have been positive on the Chinese telcos, in part due to our thesis that peak 5G capex expectations were too high for China Mobile. That has largely played out as capex expectations have come down and the stock has performed well. The telcos see a steady state approach to 5G capex as the best way forward given the lack of a current business case. However, there are larger forces at work which imply higher capex – the need to support Huawei/ZTE (763 HK) given the moves against Chinese equipment manufacturers internationally, and the likelihood of economic stimulus packages.
We have downgraded China Mobile (941 HK) and China Telecom (728 HK) to Neutral as the risk now is that capex expectations start to rise again. China Unicom (762 HK) remains a BUY as it trades at a much lower multiple. We reiterate our preference for China Tower (788 HK) which is exposed positively to rising telecom capex.
We have increased our 2020 capex expectations for Chinese Telcos. China Mobile most affected (RMB bn)
4. Tesla–The Struggle to Stay Afloat in 2019
Profit Warning for Q4 2018 and Q1 2019: Two Fridays ago, Elon Musk warned that Q4 profits came in lower than Q3’s, despite an 8% QoQ rise in vehicle sales during Q4. He also announced a 7% cut in Tesla’s workforce, as Tesla is now facing “a tiny profit” in Q1 that will be achieved with “great difficulty, effort and some luck”. These are extremely bearish comments from a perennial optimist like Musk. If true, however, it kills the growth story at Tesla. And with the average 15% price cut of the Model 3 in the US and 17% in China, it also shows that Tesla may have misread the demand environment for its high-priced electric sedan.
Model 3 Demand in the US has Clearly Been Exhausted: September 2018 saw peak monthly sales of 22,250 units in the US, which fell to an average monthly rate of 18,039 units in Q4. There are no more wait lists for the Model 3 at current prices: Tesla’s website says delivery can be made in under 2 weeks. In the January 18th profit warning, Musk admitted that Tesla must now sell its lowest-end version for $35,000 from May, or see production fall. At this price, Tesla’s Model 3 probably just breaks even, by our estimates.
Weak Model 3 Launch in Europe: It was hoped that the Model 3’s European launch this March would make up for waning demand in the US. But since opening up configurations for reservation holders on December 7th, Tesla only received 13,773 orders, which is a whopping 24% lower than recent monthly sales in the US. Musk was forced to open up configurations to non-reservation holders, but this led to only 2,436 extra orders over the following 2 weeks. In the US, Tesla opened up the Model 3 floodgates to non-reservation holders 12 months after launching the car. In Europe, it took less than 4 weeks.
No Hopes for Tesla in China Either in 2019: Tesla’s registrations in China for October and November 2018, combined, fell by 72% YoY and overall auto demand is weakening there. Musk proclaimed that Tesla would start production of the Model 3 in Shanghai by 2019-end. The factory site is a barren plot of land (see Figure-5). It took VW 23 months to build its latest factory in China and Toyota’s new Alabama plant will require 28 months. Why should we believe that Tesla only needs 11 months?
Watch the Competition for Tesla in 2019: Tesla will face true competition this year for its first time as 4 new European EVs hit the market. During Q4 of 2018, Jaguar’s new I-Pace outsold Tesla’s Models S and X, combined, in the Netherlands–Tesla’s number two market after the US. Audi’s e-Tron SUV–due out next month–had over 20,000 orders as of December 7th last year. Porsche’s new Taycan–a powerful rival for Tesla’s Model S–has sold out its first year of production, with most orders coming from Tesla owners. The Models S/X provided 50% of automotive gross profit in the 2H of 2018, by our estimates. A fall in volume will heavily impact profits.
Spending Will Spike in 2019 and Lead to Negative FCF: Tesla was able to squeeze out a profit during the 2H of 2018 largely because of suppressed spending on R&D and infrastructure. In order to roll out the new Shanghai plant and bring the new Model Y to market, both capex and R&D must rise significantly in 2019. Our list of “spending needs” (see Figure-1) shows that capex should nearly double to $4.5bn in 2019. Including debt obligations and payables, Tesla’s total cash needs in 2019 come to $9.3bn, which is over twice its equity. A highly dilutive public share offering appears inevitable.
Why 2019 Could Be the End of Tesla: Tesla proved in 2018 that, even with higher sales volumes and lofty pricing for the Model 3, it could only attain an estimated 2H operating margin of 1.7%, excluding environmental credits, one-offs, and stock-based compensation. 2019 will be incredibly harder as 1) Tesla faces stiff competition for the first time since its inception; 2) a lower-priced Model 3 will not generate enough profit to cover falling profitability of the Models S/X; and 3) most significantly, a steep rise in capex and R&D will lead to higher losses and negative FCF. Tesla may need a bailout by a deep-pocketed suitor this year. But this could only occur at a much lower share price.
5. Olympus Corporation (7733 JP): Overvalued with Too Many Controversies
Olympus Corporation is currently trading at JPY4,525 per share which we believe is overvalued based on our EV/EBIT valuation. The company generates nearly 80.0% of its revenue from its Medical Business where it is the global market leader for gastrointestinal endoscopes. Despite Olympus’ market share and technology leadership, the segment has been hit by investigations related to its duodenoscopies and has been fined for violating safety regulations. In addition, the Medical Division is also subject to several bribery-related investigations by the US Department of Justice and could risk losing its market share if the allegations are proven given the industry is highly competitive. Meanwhile its Imaging Business which offers cameras and lenses, is operating in a contracting market, where the segment continues to see declining revenues and is loss making.
To add to all of the above, the company is under scrutiny for governance-related issues such as lack of board diversity as well as poor corporate culture. On the positive side, the management has announced a plan to transform its business, including appointing three new (non-Japanese) directors to its board, all due to the pressure from its largest shareholder ValueAct Capital. The Management has mentioned that they will be proposing one of the partners of ValueAct as one of the three new directors at its shareholder meeting in April 2019, which is encouraging. However, that being said, we are yet to witness any tangible improvement in the way the company has conducted itself since the exposure of its accounting fraud in 2011 and has not been able to stay free of controversy. Hence, in our opinion the hefty premium at which the shares are currently trading is not justified suggesting to us that the potential turnaround in governance quality is being priced in too fully at this point. It is uncertain what other skeletons may be in Olympus’ closets and it seems premature to afford the stock a premium valuation.
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