China's top investment bank CICC Wednesday initiated coverage of Chinese EV maker Li Auto with an outperform rating and a target price of $21.50, meaning a 20 percent upside space from Wednesday's close.

CICC said analyzing the decision-making process of consumers buying Li ONE, Li Auto's only model on sale, they believe that a large part of the company's customers come from the traditional-fuel vehicle market rather than the new-energy vehicle.

They said extended range electric vehicle (EREV) technology is a natural choice for Li Auto , enabling Li ONE to have a larger potential customer base than battery-electric vehicles.

As the company expands its distribution channels into lower-tier markets, CICC believes that sales volume will continue growing and the company's profitability will improve rapidly if its cost declines and battery prices fall further.

Here is the full report:

We initiate coverage of Li Auto Inc. with an OUTPERFORM rating and TP of US$21.5, implying 2021E 7.9xEV/revenue.

Why an OUTPERFORM rating?

Selecting models based on demand: Focusing on segments with strong growth potential; Li Auto to achieve rapid growth.

The market of mid-size and larger sport utility vehicles (SUVs) has grown faster than the overall SUV market in recent years.

We believe the growth of such SUVs' sales volume will be driven by three major growth drivers: 1) a rising number of one-child families in China are having a second child; 2) the supply side of the market is improving; and 3) consumers are upgrading to higher-end products and services.

Li Auto's "Li ONE" (an extended-range electric SUV model) is a smart electric vehicle that differentiates the company from traditional automakers.

We believe Li Auto is more likely to achieve rapid growth in markets of mid-size and larger SUVs and smart electric vehicles.

Selecting technology based on vehicle models: EREV technology a natural choice for Li Auto; BEV still an option.

We believe new-energy vehicle (NEV) makers are unlikely to manufacture battery-electric mid-size and larger SUVs priced at about RMB 0.3mn/unit in the near term.

However, it is less difficult for them to develop and manufacture extended-range electric vehicles (EREVs) due to simpler system structure.

EREV technology is similar to battery-electric vehicle (BEV) technology, making it possible for Li Auto to shift to the BEV in the future, in our opinion.

Financial analysis: Break-even a priority for Li Auto since day 1.

Despite the impacts from the COVID-19 outbreak, Li Auto reported positive gross margin in1Q20 (the first quarter when the company delivered vehicles to customers) and its gross margin rose to 13.3% in 2Q20, better than those of other emerging NEV makers in China.

Li Auto keeps expenses under strict control and the company's expense ratios are similar to those of Tesla in 2014.

In 2Q20, Li Auto's expenses per vehicle were even lower than those of Tesla. We believe this shows Li Auto's strong ability to manage corporate finances.

Li Auto: A smart-EV maker focusing on family needs

An emerging NEV maker focusing on vehicles for family needs

Li Auto is a new-energy vehicle (NEV) company founded by LI Xiang, the founder of Autohome, in July 2015.

The company focuses on vehicles for family needs. Li Auto developed a low-speed small electric vehicle (SEV) project in its early days and later shifted focus to mid-size and larger SUVs. The company has been delivering its first model Li ONE (an extended-range electric SUV model) to customers since late 2019.

The history of Li Auto

In October 2018, the company launched its smart electric vehicle brand "Li Auto" and its extended-range electric SUV model Li ONE.

In the same year, the company acquired Chongqing Lifan Automobile for RMB 0.65bn to obtain an automobile manufacturing license.

Preorders for the company's Li ONE began in April 2019 and the company's first five retail centers opened for business in November 2019.

As of June2020, Li Auto has delivered more than 10,000 units of Li ONE to customers. On July 30, 2020, the company completed an IPO on Nasdaq.

Li Auto's founder LI Xiang is also the company's actual controller; he holds more than two-thirds of voting rights in the company.

Li Auto adopts the variable interest entity (VIE) model to control Beijing CHJ, which operates LiAuto's major businesses.

According to Li Auto's IPO prospectus, Li Auto founder LI Xiang's stake in the company fell to 21.0% after the IPO but his voting rights in the company rose to 72.7%. WANG Xing (Meituan CEO) is another import ant shareholder of Li Auto.

After Li Auto's IPO, WANG Xing and related parties held a 24.0% stake in Li Auto and 8.3% of voting rights in the company.

Li ONE: A smart electric vehicle eliminating range anxiety; a reflection of Li Auto's deep understanding of consumers in China's automobile market.

We are impressed by Li ONE from two perspectives. First, the vehicle has adopted the EREV technology. Second, the vehicle is equipped with premium software and hardware systems.

EREV technology to eliminate driving range anxiety; suitable for NEVs in China.

China's electric vehicle charging infrastructure remains weak. Due to high cost of batteries, prices of battery-electric vehicles (BEVs) tend to be high, which poses a major obstacle for the promotion of NEVs in China.

EREVs have advantages of both BEVs and traditional-fuel vehicles, and we believe the EREV technology is a suitable technology to promote the use of NEVs in China.

Premium software and hardware systems reflect Li Auto's deep understanding of Chinese consumers' preferences.

Li ONE is equipped with an innovative four-display interactive system. The inside of the vehicle is covered with quality materials and the vehicle is also equipped with premium hardware systems such as a seat ventilation system and laminated acoustic glass.

We believe the vehicle reflects Li Auto's deep understanding of Chinese consumers' preferences. We think that Li ONE has advantages in product competitiveness over its major competitors (e.g., Toyota's Highlander and Volkswagen's Teramont) despite Li Auto's disadvantage in brand recognition.

Li Auto's R&D, production and sales systems are maturing

R&D: Focusing on smart vehicle technologies. Li Auto has divided its R&D system into two parts: R&D for vehicles (e.g., R&D for traditional automotive systems and R&D for battery, electric motor and electric motor control systems) and R&D for smart vehicle technologies (e.g., R&D for smart in-car device technologies and autonomous driving technologies).

At the end of 2019, Li Auto had more than 1,000 R&D employees, of which 390 are focused on the R&D for smart vehicle technologies.

We believe technologies for smart networked vehicles and autonomous driving will be a focus of the automobile industry over the next several years, and related technological strengths will be crucial to the competitiveness of automakers and their products.

Therefore, we believe Li Auto will increase investment in smart vehicle technologies to stay competitive.

Production: Li Auto has its own production facilities and a high-standard quality control system.

Li Auto acquired Chongqing Lifan Automobile in 2018 to obtain the license for automobile manufacturing; the company started to build its own production facilities in the same year.

The company has completed the first phase of its Changzhou factory construction (planned annual production capacity: 200,000 vehicles).

The company has built a high-standard quality control system for its production facilities, and we believe the system will help the company improve product quality.

Sales: Combination of direct sales and online sales to improve efficiency. Li Auto has adopted a direct sales model similar to those of other NEV makers such as Tesla, and the company also focuses on online sales. Li Auto has opened 34stores for direct sales in 28cities by the end of July 2020.

However, Li Auto's store network expansion still lags behind those of other emerging NEV makers (for example, Nio has about 140 stores in July 2020) and traditional automakers (for example, Saic VW has over 1,000 stores in China).

We believe Li Auto's efforts to expand distribution channels into lower-tier markets and its efforts to combine direct sales with online sales will effectively boost the growth of the company's sales volume.

Selecting models based on demand: Focusing on segments with strong growth potential.

Li Auto has focused on the market of mid-size and larger SUVs.

We believe the sale volume growth of mid-size and larger SUVs will be driven by three major growth drivers: 1) a rising number of one-child families in China are having a second child (Figure 10); 2) the supply side of the market is improving; and 3) consumers are upgrading to higher-end products and services.

We believe this is why Li Auto has focused on the fast-growing mid-size and larger SUV market with large growth potential.

Decision-making process of consumers buying Li ONE different from that of consumers buying BEVs; a larger potential customer base; product competitiveness crucial to success.

Consumers that decide to buy BEVs tend to directly pick the models that they like. We believe the decision-making process of consumers buying Li ONE is different from that of consumers buying BEVs.

First, consumers buying Li ONE prefer vehicles with six or seven seats and large cabin space. Therefore, they decide to buy mid-size or larger SUVs.

Second, they decide on how much to spend on their vehicles.

Third, they compare prices, hardware and software systems, and technical parameters of vehicles, take a test drive, and make the final decision on which vehicle to buy.

Compared with BEVs, we believe Li ONE has a larger potential customer base, with consumers in both the traditional-fuel vehicle market and the NEV market potential buyers of Li ONE.

Competitive landscape: Mainstream joint-venture automakers' SUVs are major competitors; Li ONE offers high value for money. Unlike mid-size and larger SUVs priced at more than RMB 0.7mn/unit (e.g., BMW X5 and Audi Q7), we believe Li ONE's major competitors are SUVs of mainstream joint-venture automakers ¾ SUVs priced at about RMB 0.3mn/unit provided by Toyota, Volkswagen and Buick.

We think that Li ONE's direct competitors are GAC Toyota's Highlander, SAIC Volkswagen's Teramont, SAIC General Motors' Enclave, and Chang'an Ford's Explorer. After comparing these vehicles, we believe Li ONE is a competitive product with high value for money and several advantages over competitors:

►Large cabin space and a low price;

►Eligible for government subsidies for NEVs;

►Advanced smart networked vehicle systems and in-vehicle infotainment systems;

►Equipped with premium software and hardware systems.

Selecting technology based on vehicle models: EREV technology a natural choice for Li Auto.

The electrification of larger SUVs: Higher costs or longer driving range?

In addition to Li ONE, Tesla's Model X and Nio's ES8 are also major new-energy mid-size and larger SUV models in the market. Tesla's Model X has along driving range as the model is equipped with a 100kWh battery pack but its selling price is also high (see Figure 14).

Nio's ES8 has adopted a battery pack with smaller capacity, and the model has a shorter driving range but also a lower selling price than Tesla's Model X.

Nio likely will launch a new version of ES8 equipped with a 100kWh battery pack in 4Q20, but customers will pay an extra RMB 58,000 for such a vehicle.

Li ONE has adopted the EREV technology and the model enjoys advantages over Tesla's Model X and Nio's ES8 in selling price and driving range.

Li Auto estimates that a BEV's bill of material (BOM) costs are 45%higher than those of a traditional-fuel vehicle due to high costs of BEVs' batteries, electric motors, electric motor controllers, and lightweight vehicle body.

However, an EREV's BOM costs are only 10% higher than those of a traditional-fuel vehicle equipped with a 3.0T engine, as EREVs are equipped with relatively small battery packs and they do not adopt lightweight parts on a large scale.

Transmission systems crucial in choosing between EREV and PHEV.

We believe the EREV technology is suitable for emerging NEV makers due to two factors.

First, EREVs tend to have low costs, as such vehicles do not require traditional transmission systems and their BOM costs are low. Second, it is relatively easy to develop EREVs, as engines and control systems of such vehicles tend to be simple.

Traditional automakers prefer the plug-in hybrid electric vehicle (PHEV) technology and we attribute this to two factors. First, the cost of developing PHEVs is relatively low for traditional automakers, as they can develop PHEVs based on their existing power train systems and vehicle models. Second, traditional automakers' capex for PHEVs tends to be low, as such vehicles can share production facilities of other vehicle models.

For consumers, we believe EREVs and PHEVs offer a similar driving experience. Therefore, we believe the EREV technology is suitable for Li Auto.

NEV makers unlikely to manufacture battery-electric mid-size and larger SUVs priced at about RMB 0.3mn/unit in the near term, even if battery prices fall.

We have calculated the gap between the cost of extended-range electric mid-size or larger SUVs and the cost of battery-electric mid-size or larger SUVs.

To extend the driving range of a mid-size or larger SUV to at least 500km, we believe a battery-electric mid-size or larger SUV needs to be equipped with at least a 100kWh battery pack that costs about RMB 58,800, while an extended-range electric mid-size or larger SUV needs to be equipped with an range extension system that costs about RMB 16,650. Therefore, to extend the driving range to at least 500km, we believe the cost of a battery-electric mid-size or larger

SUV will be about RMB 42,300 higher than that of an extended-range electric mid-size or larger SUV (even excluding possible additional spending on light weight parts of battery-electric mid-size or larger SUVs). We estimate that the gross margin of Li ONE will stabilize at 15% in the future; under this scenario, if the cost of an EREV is the same as the cost of a BEV, the ASP of the BEV's battery pack should fall to RMB 275/kWh. However, the current ASP of BEVs' battery packs stands at RMB 980/kWh. Therefore, we believe NEV makers are unlikely to manufacture battery-electric mid-size and larger SUVs priced at about RMB 0.3mn/unit in the near term. We believe this is also an important reason why Li Auto adopted the EREV technology for its Li ONE.

Li Auto is open to BEV technical route

We believe an EREV can be considered as a BEV equipped with a traditional-fuel engine that generates electricity for battery and electric motor systems to extend the vehicle's driving range and reduce its BOM costs. Therefore, we believe the process of shifting from the EREV technology to the BEV technology can be simply considered as a process of removing the traditional-fuel engine. EREV technology is similar to BEV technology; therefore, we believe Li Auto's adoption of the EREV technology provides an option for a possible shift to BEV technology in the future.

Financial analysis: break-even a priority for Li Auto since day 1.

Sales volume in cities without license plate restrictions makes up a large share, a reflection of product competitiveness

Li Auto began to deliver Li ONE to customers in late 2019, with monthly sales volume of Li ONE rapidly exceeding 1,000 units. After theCOVID-19 outbreak in China was brought under control, the company's sales volume of Li ONE resumed rapid growth. As of July 2020, the sales volume of Li ONE totaled 12,918 units. Based on our analysis of the compulsory traffic accident liability insurance data, we believe the company's sales data is reliable.

Based on the compulsory traffic accident liability insurance data, we have analyzed the structure of demand for Li ONE.

► Individual consumers represented the major buyers of Li ONE (accounting for a 86% share) in 1H20 and corporate customers accounted for 14% of Li ONE buyers. None of Li ONE vehicles sold in 1H20 were registered as commercial vehicles.

► Li ONE's sales volume in cities without license plate restrictions for ICEV accounted for 52% of its total sales volume in 1H20. We believe consumers in cities without license plate restrictions pay more attention to the competitiveness of vehicles, and license plate policies have a small impact on their buying decisions. Therefore, we believe the fact that sales volume in cities without license plate restrictions makes up a large share of Li ONE's total sales volume is a reflection of the product's competitiveness.

We expect Li Auto's sales in 2020-22to equal 30,000, 55,000 and 92,000 vehicles. Li Auto will still focus on large-and medium-sized SUVs in the next three years. Among them, Li ONE is the only product for 2020 and 2021, and a full-size SUV will be launched in 2022according to the company. We base our sales forecasts based on the following three points:

►The market has large room for growth and is expected to increase rapidly: China's sales of large- and medium-sized SUVs were at 2.3 million in 2019, and sales of 7-seat SUVs were about 600,000 vehicles. We believe that given the increase in two-child families, large- and medium-sized SUV's increased supply and consumption upgrades, the segment in which Li Auto focuses will grow faster than the industry in China.

►Comparison of competing products: In the 7-seat SUV market segment, there are two benchmark-level competitors ¾ GAC Toyota Highlander and SAIC VW Teramont. Their sales in 2019 were 98,506 and 84,003, respectively. We believe that these two competing products have strong brand appeal, product recognition and sales &service coverage. Therefore, Li Auto's sales volume can be used as a single product sales ceiling in the segment, in our view. Since Li ONE has differentiated advantages in intelligent connectivity, favorable new energy policies and less fuel consumption compared with its competitors, we believe Li ONE can reach 30–60% of the sales of benchmark competitors in 2020–2021.

►The expansion of sales network brings definite increment: At present, Li Auto operates only 34 sales stores, a significant gap compared with Nio's 150 stores, GAC Toyota's 580 stores, and SAIC VW's1,121 stores. We believe that with the expansion of the Li Auto sales network, more consumers can touch and purchase the vehicle, which will bring more sales to the company.

Considering the above factors and the company's year-to-date delivery growth, we expect Li Auto to sell 30,000 units in 2020, 55,000 units in 2021, and 92,000 units in 2022 (see Figure 22).

Comparison of financial performance

Li Auto targets solid performance and a high gross margin via EREV technology and reasonable pricing. The company keeps costs and expenses under strict control, in our view, and earnings profits have been a priority for Li Auto since its first day.

►Profitability: Li Auto reported positive gross margin in 1Q20 (the first quarter in which the company delivered vehicles to customers) and its gross margin rose to13.3% in 2Q20, better than those of other emerging NEV makers in China.

►Expense ratio: Li Auto keeps costs and expenses under strict control, and the company's expense ratios are similar to those of Tesla in 2014.

►Expenses per vehicle: Li Auto's expenses per vehicle equaled about RMB 105,000 in 1Q20 and fell to about RMB 66,000 in 2Q20. Li Auto's expenses per vehicle in 2Q20 were lower than those of domestic peers and Tesla. R&D expenses account for a larger share of Li Auto's expenses per vehicle than selling and G&A expenses; we believe this demonstrates the company's efficient use of expenses.

Financial forecasts: Li Auto likely to break even in 2022; abundant cash on hand.

Revenue to maintain rapid growth. We believe the sales volume of Li ONE will continue growing thanks to the company's efforts to expand distribution channels into lower-tier markets and the growth of the mid-size and larger SUV market. We estimate sales volume of Li ONE will be 30,000 units in 2020 and 55,000units in 2021; accordingly, the company's revenue should reach RMB 8.68bn in2020 and RMB 15.26bn (+76% YoY) in 2021. Longer term, the company plans to launch its next new product (a full-size extended-range electric SUV) in 2022, and it also plans to develop new vehicles such as mid-size and compact SUV models. We believe launches of new products will be major growth drivers for the company's sales volume and revenue after 2022.

EREV technology to effectively control cost; high ASP to push up gross margin.

As shown in Figure 28, EREV technology could effectively keep the cost of NEV models under control, in our opinion. The ASP of the company's mid-size and larger SUVs (about RMB 0.3mn/unit) is relatively high, in our view, and likely will boost the company's future profits. We expect Li Auto's gross margin to remain at about 15% in 2020 and 2021; it should continue rising after2022 if the company launches new products with higher prices and growing sales volume dilutes its costs.

Selling expenses to stay at a low level; R&D expenses to rise. Li Auto keeps its G&A expenses under strict control. We believe the company's selling expenses likely will remain at a low level, possibly because it does not need to spend on advertising to promote a luxury brand image as the number of competitors in the mid-size and larger SUV market is small. However, we believe the company's R&D expenses will rise, driven by its efforts to develop smart networked vehicle and autonomous driving technologies. We believe the company's overall expense ratio will be manageable.

Valuation

Emerging EV makers such as Li Auto are still in the early stage of their growth; thus, their earnings tend to be volatile. Therefore, we do not use valuation methods that are directly related to earnings. We believe the company's future sales are more predictable and are crucial to its survival; thus, we adopt a sales-related valuation method to value emerging EV makers.

Valuation multiple: Compared with Tesla, we believe Nio and Li Auto should be valued at lower valuation multiples

As a leading global NEV maker, Tesla has made impressive achievements in developing electric and smart vehicles. Tesla's sales volume is growing rapidly and the company has been profitable for four consecutive quarters. We believe Tesla should be considered as a benchmark for valuations of NEV makers. Li Auto and Nio are also emerging NEV makers focusing on smart electric vehicles, but their R&D capabilities, products, sales volume, and profits still lag behind those of Tesla. Therefore, we believe Nio and Li Auto should be valued at lower valuation multiples than Tesla.

Regarding Nio and Li Auto, we believe Nio should be valued at a higher valuation multiple than Li Auto, mainly due to three factors.

1.  Nio has generally established a high-end brand image and is promoting its "Batteries as a Service (BaaS)" business to generate revenue from existing Nio vehicles. We believe this will further boost the company's profitability.

2. Nio has made detailed planning for its future models and we expect the company's sales volume to grow rapidly thanks to its efforts in expanding its presence into low-price vehicles. However, we believe Li Auto will remain focused on the mid-size and larger SUV market before 2022–2023, and the company's sales volume growth may be weaker than that of Nio in the next several years.

3. If Li Auto shifts to BEV technology in the future, the process will involve some costs. Although it may be relatively easy to shift from EREV technology to BEV technology, we believe the process still involves costs related to product development and production facilities construction.

Considering relative multiples of Tesla and Nio, we value Li Auto at 2021E 7.9x EV/revenue. We initiate coverage with an OUTPERFORM rating and TP of US$21.5, offering 32% upside.

Risks

1. The company's singles product risk: The Li ONE will be the only product in next two years for the company. If sales volume growth of Li ONE disappoints, company's earnings and valuation can be largely affected.

2. Launches of new vehicles and market response to new vehicles could miss expectations.

3. Product quality issues negatively affect the reputation of, and sales volume for, Li Auto's products.

4. Smart networked vehicle technologies and autonomous driving technologies are developing rapidly; uncertainties exist with such technologies. If the company lags behind competitors in these technologies, we believe its sales volume and valuation will be negatively affected.