Volvo’s IPO valuation isn't built for safety

TIMING is everything in investing, and China’s largest homegrown carmaker has decided that this is the moment to take Volvo Car AB public, at a potentially eye-popping valuation. Buyers should be wary.

Zhejiang Geely Holding Group Co has discussed valuing the business at somewhere between US$16bil and US$30bil and is looking at a dual listing in Hong Kong and Sweden, Bloomberg News reported last week. The Chinese company may only proceed if it achieves more than the high end of that range, the Financial Times said on Monday.

The initial public offering has been discussed on-and-off for years. So why does the parent of Hong Kong-listed Geely Automobile Holdings Ltd, which also owns almost 10% stake of Daimler AG, want to raise capital now? At first glance, Zhejiang Geely may want to monetise its holding in the Swedish automaker, especially in a world where companies need money to meet consumers’ incessant demand for new models.

The future of the car market looks uncertain and R&D investment will be forced higher.

Allowing Volvo Cars to raise funds will leave Geely to focus on upping its presence in China without having to sink too much into the European business. The company has spoken of its ambitions to be fully electric and is rushing to be the first Chinese brand recognised as a global leader in automotive technology.

Volvo Cars has been investing in new products to meet buyer demand and lessen dependence on its three top-selling models, which account for 60% of sales.

The Gothenburg-based firm is also developing engines and other technologies, while pursuing plans to revive sales in the peaking US car market with a plant in Charleston, South Carolina, scheduled to open this year. Volvo Cars also helped listed sibling Geely subsidise its upmarket Lynk & Co brand. But its free cash flow has turned negative because of high inventories in China and the amount the automaker needs to plow into the US factory.

Here’s where the argument starts to fall apart. Volvo Cars up-streams dividends to its parent, and that’s one of the biggest contributors to its capital needs.

The carmaker handed out a first payment of 2.2 billion krona (US$250mil), or 29% of earnings, last year. About 1.5 billion krona of that went to Zhejiang Geely.

A further 65 million krona went to holders of preference shares, which Volvo Cars has been issuing to its parent and other institutional investors. Meanwhile, another entity, Daqing Volvo Car Manufacturing, paid a dividend of 623 million krona to Hangzhou-based Zhejiang Geely. Together, dividends were one of the biggest drivers of Volvo’s negative free cash flow position.

Zhejiang Geely needs profitable subsidiaries to fund its ambitions. The parent has been on an acquisition spree totalling at least US$14bil in the past year that included buying stakes in a bank and a flying-car company. Much of that has been funded by short term loans.

Zhejiang Geely’s debt rose 10% in 2017. At the higher end of the potential valuation range, the parent will have to sell around 20% of Volvo Cars to fully offset the debt accumulated by Zhejiang Geely chairman Li Shufu, Robin Zhu of Bernstein Research estimates. Maybe that’s why the company is insisting on a US$30bil bottom line.

Volvo Cars has been a prudent borrower so far. But in June last year, the company took on a 1.3 billion euros revolving credit facility to replace a 660 million-euro line and to serve as a “back-up facility for general corporate purposes.”

Meanwhile, receivables last year from related entities “within the Geely sphere of companies” totalled 3.12 billion krona. At the reported range, Volvo Cars would trade at 14 times to 25 times earnings,” well above the forward multiples of most global car companies. Investors should give this valuation a careful test drive before buying.