China auto dealers set for M&A drive

China Grand Automotive’s acquisition of Baoxin Auto has received a poor reception from investors. But consolidation in the sector is only getting started.

When car dealer China Grand Automotive bought its luxury rival Baoxin for $2.7 billion in June, it was trying to make the most of a difficult outlook in its sector.
The acquisition was at least partly motivated by a drop in new car sales, a rarity for a market that has been growing year after year. China Grand Automotive is the biggest player in a crowded sector, so consolidation appeared the natural response.
But until this week, investors did not have the chance to react to the merger. Baoxin Auto’s stock has been suspended for three months, giving its former CEO time to sell down his stake to comply with free-float rules. The stock started trading again on Wednesday — and promptly dropped by 48%.
That performance, while bad news for investors, is unlikely to deter other companies in China’s auto dealership sector from merging.

Instead, analysts think consolidation in the sector is just getting started.

A merging market

Car dealership in China is a low margin, high working capital business. Amid the gradual slowdown of China’s economy, sales are already sluggish. Many companies in the sector have reported a big miss in their first half earnings.

This is raising natural questions among analysts about how sustainable some of these companies are. The obvious response for the bigger players is to hunt for cheap merger opportunities.
“Auto dealer companies have been struggling for quite a few years and the market has been expecting sector consolidation for a while,” said a sector analyst. “The Baoxin-China Grand Auto merger will definitely kick off the trend. This deal has also changed the M&A dynamics from targeting small- to medium-sized regional players to market leaders.”
Baoxin mainly focuses on the luxury car sector while China Grand Auto mostly targets the mass market. Their merger is likely to create synergies by providing significant competitive advantages to China Grand Auto in China’s highly fragmented automobile dealership industry, according to analysts.
It also raises questions about which companies will be next in line.
“China auto dealership consolidation is obvious and imminent,” said an industry analyst. “Everyone is asking who’s next.”
While mainland-listed car dealers are trading at an average of 30 times earnings, those listed in Hong Kong ones are at 10 times. With this valuation gap, it is easier for mainland companies to swallow their Hong Kong rivals, making the acquisitions earnings accretive rather than dilutive.
But there are not many targets to go around. Five Chinese auto dealers are listed in Hong Kong, with another four on the mainland.
“There are not that many car dealership companies listed,” said a person familiar with the situation. “We can pretty much guess who’s next by method of elimination.”
It is not that simple. There are four Hong Kong-listed companies remaining as potential targets: China Harmony New Energy Auto, China Yongda Automobiles Services, China Zhengtong Auto and Zhongsheng.
There are several potential buyers on the mainland. Besides China Grand, Pang Da Automobile, Sinomach Automobile and Yaxia Automobile are focused on the sector. There are also several conglomerates and holding companies with interests in the sector.
An international platform
On 20 September, Baoxin Auto announced that Yang Hansong, the former chief executive officer for Baoxin, had completed the sale of 80 million shares to reduce his stake to 9.88% from 13%.
That brings him slightly below the level at which he is considered a “substantial” shareholder according to Hong Kong rules. As a result, his stake will counttowards the free float to restore it back to 25%, the minimum requirement set by the Hong Kong Stock Exchange.
Baoxin’s stock turnover on its first day trading was overwhelming. Some 200 million shares traded changed hands. That is 30% of free float, and 22 times more than its last three months average daily trading volume.
This is not the first attempt for China Grand Automotive to go offshore. TPG capital-backed China Grand Auto planned to go public in Hong Kong for $800 million but failed in October 2014. It quickly turned back home to go public by backdoor listing via the Shanghai-listed company Merro Pharmaceutical Co inDecember 2014.
“China Grand Automotive could have taken [all of] Baoxin private and delist it,” said a research analyst. “By keeping Baoxin listed in Hong Kong, not only can it provide an international platform for future equity financing but also an easy way out to tap the debt market.”
There are several reasons the company’s stock could have plummeted this week, according to analysts, above and beyond the bearish outlook for the sector.
Baoxin reported a Rmb64 million 2016 first half earnings last month, down 84% year on year.  It is a big miss compared to its peers. And earlier this month, China Grand Auto pledged 75% of Baoxin Auto to China Merchants Bank for a syndicated loan facility.
But some analysts are optimistic things are about to turn around for the company. Nick Lai, the head of Asia auto research at JP Morgan, said the deal was a “near term positive” for Baoxin.

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