Charles Zhenghao Lu founded CAR Inc in 2007. CAR Inc offered short-term and long-term car rentals to customers across China. The business was taken through to IPO in 2014. At IPO there were several reputable backers including Hertz, Ctrip (now trip.com) and Warburg Pincus.

In 2016 Hertz sold down its investment in CAR Inc however retained a commercial agreement with CAR Inc until 2023, operating co-branded Hertz-CAR locations.

CAR Inc launched UCAR - a Didi/Uber competitor in 2015. Mr Lu remained as chairman of CAR Inc and left to run UCAR.

Mr Lu has recently been in the news as the largest investor in Luckin Coffee, which was accused and has now confirmed to have fraudulently misstated revenue in order to mislead investors. The stock price for Luckin has tanked in recent weeks - with a 12 month high of US$51.38 to current (suspended) share price of US$4.39. Shares owned by Mr Lu in Luckin Coffee were seized by Goldman Sachs as collateral for a loan. Supposedly Mr Lu has considered stepping down from his chairman role at CAR Inc in order to distance CAR Inc from the scandal. The stock price of CAR Inc has similarly been hammered - and was down almost 60% on news of the Luckin Coffee scandal.

This leaves us with a key question - has CAR Inc been oversold?

Highlights from FY19 annual report

A quick flick through the latest 2019 annual report reveals a difficult year where accounting technicalities significantly impacted underlying earnings through depreciation and FX movements.

  • Marginal revenue improvement (+4%) despite a ~10% increase in fleet size. Resulted in a lower RevPAC.
  • c. 25% decrease in fleet rental revenue driven from by UCAR Inc (related party - see below).
  • Weak second hand car market negatively impacted depreciation costs (which impacted depreciation accounting estimates - see below).
  • Company disposed of 29k vehicles compared to 13k in pcp.
  • Increased grant of stock options in October 2019 ‘to encourage larger growth’ (RMB90m in FY19 from RMB2m in FY18).
  • Significant debt held in USD denominated instruments driving significant FX movements distorting net profit. (No hedging in place?)
  • Significant impact of COVID-19 in Chinese NY period. Seeing signs of recovery.
  • Significant difference between ‘adjusted EBITDA’ and reported EBITDA. Surely depreciation is a key driver of profitability?

  • About 40% of shares in CAR Inc are currently controlled by UCAR Inc, through Charles Zhengyao Lu. We understand this investment is looking to be offloaded (we note UCAR is also backed by Warburg Pincus). These shares had been pledged for financing of the Borgward acquisition. UCAR is a Didi/Uber competitor which has historically been succesful in Tier-3 cities.

  • A trade receivable of c. RMB450m is held on balance sheet due from UCAR, which has increased by ~ 20% YoY. The total value of services provided to UCAR was c. RMB403m for the period ending FY19. Therfore part of this balance relates to services provided more than one year ago.. How is this carrying value supported - particularly given UCAR’s widely reported dwindling liquidity.

  • UCAR (NEEQ: 838006) is currently in a trading halt as a result of the unravelling of Luckin Coffee.

  • The current CFO of CAR Inc was previously at UCAR.

  • Mr Lu ultimately controls 10% of UCAR.

  • Management has been heavily critiqued for dumping shares and walking away with US$1.6B since IPO of the business.

Depreciation assumptions still appear challenging

GEO Investing had accused CAR Inc of using aggressive depreciation rates compared to global comparable. These assumptions appear to be partly realised with depreciation costs increasing dramatically (~ 50% YoY) due to a ‘reduced estimated residual values of used vehicles due to weak used car sales markets and to promote sales’ in FY20.

  • Depreciation rates for vehicles outside of repurchase programs were depreciated at rates ranging from 3.0% to 22.5% (how is a 3% depreciation rate reasonable for a car?). These rates are adjusted quarterly based on latest market conditions and changes in estimates. Interestingly the residual values of rental values acquired outside of repurchase programs are highlighted as a key audit matter by EY. The audit procedure completed was a strong reliance on a controls testing approach and some limited testing of estimates vs realised proceeds from sale. It would have been nice to have seen a stronger data-centric approach to testing these assumptions - particularly given the significant risk.

  • CAR Inc purchased a significant amount of Borgward (acquired by UCAR) vehicles complete with a repurchase agreement to protect the residual car values. CAR Inc has paid RMB781m in FY19 as part of the agreed purchasing programe. This related party can enable CAR Inc to ‘manipute’ the terminal depreciated value and hence the overall depreciation rate. Is Borgward still likely to be solvent and in business at time of repurchase?

  • Of the net value of the rental vehicle fleet of RMB10.8B, RMB2.6B was attached with repurchasing agreements from the dealer. Per above RMB0.8B of these likely related to Borgward - whose financial situation may be somewhat uncertain.

What you need to believe?

  • Fraud is limited to Luckin Coffee and not CAR Inc.
  • The financials are relatively sound, particularly depreciation assumptions.
  • Debt balances (some due to expire next year) appear difficult to refinance - with the bonds now yielding >80%.
  • On a NAV/share basis, CAR Inc appears very favourable compared to Hertz and other car rental companies.
  • Warburg Pincus remain committed investors (NB: have removed both UCAR and CAR Inc from their website)
  • Rumours of a potential takeover are not incorrect
  • There is sufficient liquidity/buyers for the related party owned block of ~ 40% of the shares outstanding.