CAR Inc. is the largest auto rental company in China providing vehicles to U-Car, a partner providing chauffeured car services in China. We have seen numerous local press reports detailing restrictions on online car hailing services. Generally these restrictions are in line with the controls that were released by the central government earlier in July but the greater detail in the controls should make it easier to enforce such rules on online car hailing services. While the news on the new regulations is only for a few major cities in China, we understand that all major cities will have such detailed regulations published by Nov 1 2016. Here are some examples of new city level controls/rules over online car hailing services.
　　Beijing: the local government has rolled out requirements on drivers being only local residents, which is in line with the local taxi administration rules. The drivers also need to be under 60 years old for male drivers, 55 years old for female drivers; they must obtain the online car hailing service driving license before registration, and have a good track record of driving （fewer than 5 breaches of the Road Traffic Safety rules and laws）。 The vehicles to be registered as online hailing service cars need to hold a Beijing license plate; fulfill the requirements on the wheelbase, engine capacity, type, and age; the vehicles must put up signs as an online hailing service car. The online platform must take responsibility for its fleet and drivers, and apply for license extension every 4 years.
　　Shanghai: the drivers have to fulfill the requirements that: they hold a driving license and have over 3 years’ driving experience; they need to be local residents in Shanghai, and don’t have a criminal record or have committed any traffic offences. The vehicles need to be registered as hailing service cars, car age of less than 8 years, and meet the standards set for the wheelbase, engine capacity, etc. The online platform must have the ability of providing both online and offline services, have a local branch in Shanghai, and all the data from the platform needs to be monitored by the government.
　　Shenzhen: The drivers need to be local residents or hold a temporary resident permit; have to pass the online car hailing service driver qualification test; and don’t have a record of getting driving licenses revoked in the past 3 years. The vehicles must have less than 2 years from initial registration to the application date on the road-worthiness certificate, and have to meet the standards for engine capacity, wheel base, etc.
　　So far 8 cities have released local detailed policies: Beijing, Shanghai, Tianjin, Guangzhou, Shenzhen, Chongqing, Hangzhou, Huizhou.
　　Our take on the new developments
　　Our conversations with CAR Inc management suggest that these restrictions are in line with what they have been expecting. These restrictions are coming earlier and more detailed than what we had been expecting. In our view, the national rules on online car hailing services are rather vague （perhaps deliberately so） and strict and specific local rules are the key to the improvement in the pricing power and margins of this business. Specifically, we also see:
　　·U-Car’s online car hailing services are focused on the high end market with commercial vehicles and likely to comply with all of the new rules. The main impact would be the control of less quality conscious rivals （and part-time participants） which should help the overall pricing power for U-CAR;·The key impact of any limitations would be the control of excessive supply and also lower the incentives for incumbents to offer steep discounts （why offer discounts if an operator does not have sufficient compliant vehicles）；·We should see more signs that subsides for online car hailing services would come down or be eliminated altogether over the next few months both as a result of these new restrictions as well as the merger of the operations of the two largest players in the market （DIDI and UBER）No changes in estimates for now - Financial impact of the new stricter local rules on CAR Inc. is difficult to predict at this time and we see no reason to change our estimates for now. Any impact that lowers supply of online car hailing vehicles / drivers should lift prospects for U-Car which may have a knock on impact on U-Car’s decision on the number of vehicles leased from CAR Inc. In addition, any increase in overall online car hailing prices to consumers should lower pricing pressure on the self-drive car rental market （benefiting CAR Inc.’s core business）。
　　The key is in fleet size growth - We have seen in the past that changes in the business environment have been reflected in the plan for net fleet additions. If the environment toughens for online car hailing or self-drive markets, CAR Inc. tends to lower the number of vehicles that it adds to its fleet in order to maintain / sustain its utilization and pricing levels. Therefore any improvements in the overall marketplace should be reflected in the net number of new vehicle additions （both planned and actual）。 We do not expect the company’s management to announce any changes in the near term as they need to see the impact of any new （and future） restrictions on online car hailing services before making any changes in the capital intensive decision for fleet additions. Our current estimate for fleet growth is very modest compared to prior years with only 11% Y/Y growth for 2017 and our estimates do not factor in any improvements in regulations / controls over online car hailing services.
　　Please see our latest note, “CAR Inc. : New PT of HK$11.2 - Stable growth for core rental fleet dated Aug. 23 2016 for more detailsInvestment Thesis
　　China Auto Rental Inc. （CAR） is the largest auto rental company in China. The company is benefiting from high growth, as this industry is still in its infancy, with growth driven by rising incomes and a greater propensity to travel in China for work and leisure. CAR has a strong brand built on a superior choice of vehicles offered to customers. It has a large pool of excess licenses and vehicles to expand in large, affluent cities. The company is utilizing its operating leverage to boost earnings as the fleet expands.
　　Valuation
　　Our Dec-17 PT is based on a DCF valuation that assumes a market risk premium of 6.0% and a risk-free rate of 4.2% （yield on 10-year government notes in China）。 We have assumed a beta of 1.2. Accordingly, WACC is assumed at 8.4%. We have estimated free cash flow for CAR until 2020 and assume a terminal growth rate of 3%. The terminal growth is based on the annual growth rate expected in 2020 （the final year of the estimate period） subject to a minimum of 3.0% and a maximum of 6.0% depending on the nature of the industry and the level of maturity in China.
　　Risks to Rating and Price Target
　　The key risks to our OW rating and price target include: （1） economic volatility, which may lead to a business slowdown; （2） lower barriers to entry, which add more price war risk; （3） lower-than-expected fleet utilization rate and service quality; （4） disposal risks for older vehicles; and （5） regulatory risk from the government.