Adding RLX Technology To My Long Term Value Portfolio

Today I’d like to introduce the second entry in my long term value portfolio: the Chinese vaping company RLX Technology (NYSE:RLX). This stock has been severely beaten down by a one – two punch of major changes in Chinese regulation and taxation regarding e-vaping. I’ll begin by reviewing these all important changes, but before doing so, here’s a chart showing the brutal price action since the company became public in January of 2021:

Chinese E-Vaping Regulations

Chinese E-vaping had once been operated in what could best be described as a “wild west” regulatory environment, i.e. one where almost anything went. However that changed beginning with new rules contemplated in 2021 and implemented in 2022. Since these changes are so important to understanding where RLX is now, I’ll excerpt a few commentaries from the best sources I could find.

Vaping360 has this summary (with my emphasis):

China had already banned online sales of vaping products in 2019, and following the takeover of vaping regulation by the STMA, additional planned rules were soon announced. Product standards laid out at that time included a domestic ban on open-system products; only closed, non-refillable devices would be allowed for sale in China. Additionally, there would be a ban on synthetic nicotine, and a maximum nicotine strength of 20 mg/mL, following the European Union limit.

[…]

In March 2022, the final draft of the technical standards added the flavor ban, which had been left unsettled in the previous draft. The new standards would prohibit all flavors except tobacco for products sold in China. The flavor ban was scheduled to begin May 1, but was postponed until October by the State Administration for Market Regulation, which granted final approval of the rules.

Thecontinuumofrisk has a much more detailed discussion, including changes to how products are reviewed technically, new warnings and packaging requirements which include:

The warnings are divided into three groups.

• Group 1: Smoking e-cigarettes is harmful to health. Do not smoke e-cigarettes in non-smoking places.
• Group 2: Quitting e-cigarettes as soon as possible is good for health. Quitting e-cigarettes can reduce health risks.
• Group 3: Discourage adolescents from smoking e-cigarettes. No e-cigarettes for primary and secondary school students.

The first group of warnings should always be used on the front (main visible panel), and the second and third groups of warnings are used alternately on the back. The regulation also makes detailed provisions on the location, area, font, etc., of the warning area.

There are also new quality spot checks, a unified trading platform and new rules on logistics.

Even without the new taxes, TechCrunch is incredibly negative on the impacts of regulatory changes to the industry saying (with my emphasis):

A ban on flavored vapes is like a death knell to the vaping industry. Tobacco-flavored products accounted for only an insignificant amount of e-cigarette sales, according to a survey conducted by Landong, a Chinese media publication focused on the vaping industry.

Other major measures from the regulations include a tobacco tax on e-cigarette sales and stringent new requirements on how a vape is made, from its battery, ceramic coil and nicotine content to fragrance. Meeting all these criteria could cost a fortune, which means the shoddy, scruffy type of vape sellers that were crowding the market before will struggle to survive.

As I’ll discuss below, I don’t agree with this assessment, but it certainly helps explain why RLX’s price chart looks the way it does.

New Taxes

China has also imposed new taxes, which consist of “a tax rate of 36% on the production or import of vapes and an 11% tax on the wholesale distribution of the products”.

RLX

As mentioned above, RLX is a Chinese e-vaping company which has been public for two years. Because there’s some seasonality in the market, I’m presenting both quarterly and trailing twelve month revenue and cash flow numbers below.

As can be seen, performance dropped substantially in the last quarter due to the regulatory changes. As such, I think it’s best to concentrate on the most recent comments from the company when trying to assess it.

First, from the latest earnings release, we learn that (with my emphasis):

During the third quarter of 2022, we remained dedicated to preparing for a smooth transition to the new national standards, which came into full effect on October 1, 2022. Specifically, we wound down shipments of our older products and gradually switched to the National Transaction Platform on a regional basis. We have now achieved full geographical coverage nationwide…

“We delivered net revenues of approximately RMB1.0 billion in the third quarter, recording a sequential decrease mainly due to the discontinuation of older products during the transition to the new national standards, as well as the second quarter’s high comparison basis mainly attributable to frontloading of sales in anticipation of the discontinuation of older products. We remain confident that our diversified portfolio will continue to satisfy adult smokers’ needs and that our sales will gradually recover,” said Mr. Chao Lu, Chief Financial Officer of RLX Technology. “Meanwhile, our continuous efforts to improve operational efficiency are proving effective, evidenced by a 30.9% quarter-over-quarter decrease in non-GAAP operating expenses. However, our profitability in the coming quarters will be adversely affected by the application of 36% consumption tax to e-cigarettes manufacturers since November 1, 2022. Cost control measures will remain at the forefront of our strategic initiatives as we navigate the evolving regulatory environment while maintaining our sustainable long-term growth.”

Further, on the earnings call the progress on developing newly certified products was emphasized:

In addition to deepening our team’s understanding of the regulation, we also actively provided timely support for store owners and distributors during the transition period to ensure a smooth transition for the whole value chain. At the same time, we accelerated our research and development of the new GB product and actively apply for technical reviews and relevant licenses.

These efforts continue to bear fruit. As we reported last quarter, several of our GB products were among the first batch in the industry to achieve approval. These products have now been brought to market and are achieving steady sales. We have a healthy pipeline of products in the development and are carefully monitoring user feedback on newly released products to ensure that our future products meet their needs.

As of the end of last week we have obtained approval for 14 devices and 14 cartridges, expanding the number of our GD products and our ready-for-market pipeline.

Being in the forefront of having new products approved should be a competitive advantage, which is one significant reason I’m bullish not bearish on the company. Examples of these products are shown in the latest corporate presentation:

Finally, the near term outlook was also discussed on the earnings call:

With the application of a 36% consumption tax to e-cigarette manufacturers since November 1, 2022, we expect that the steady rollout of new products and the price hike necessitated by the consumption tax will impact both sales and profitability in the future.

And that end demand will take time to recover as customers estimate to the new flavors and form new tablets. Therefore, expected cost control measures will remain our priority in the short-term as we continue to stimulate sales with enticing new GB products for adult smokers.

Reason for My Optimism – Smoking Prevalence in China

During the earnings call, RLX also touched on the second reason for which I’m optimistic despite these changes in regulations and taxes Company:

We are convinced that e-vapor products will continue to play a vital role in harm reduction for adult smokers and that with our team’s hard work and innovation we will create and deliver satisfying GD products for adult smokers across China in the new regulatory area.

Contrary to what we’re used to in North America, smoking prevalence among adults is still very high in China, and vaping is certainly a less dangerous alternative. Hence there’s a huge market for RLX despite the recent negative changes in the operating environment. As a graphical representation, consider this chart from macrotrends which shows that 25.6% of adults in China are still smokers. And according to Wikipedia, 2016 China’s annual per capita cigarette consumption was 2,043 vs 1,016 for the US.

Valuation & Cash on Hand

With that extensive discussion of the company and the landscape it’s operating in out of the way, let’s turn to why I’ve included the company in my value portfolio.

First, here’s the helpful valuation summary from Seeking Alpha. While only sporting a “C+” overall, the price to earnings, PEG ratio and EV/EBIT ratios are all very attractive. However as we move forward, I’ll continue monitoring these valuation metrics to decide how long to hold the stock for.

Also very important to me is the balance sheet and the amount of cash on hand. From the most recent earnings release we see that the company has 1.57B US$ in cash and short term bank deposits. With 1.55B ADS outstanding, that translates to about $1 per share or 36% of the share price with the stock trading at $2.75. This sizable cash position reduces the risk of dilutive financings and gives the company a lot of flexibility in its operations. This latter point may be important as acquisition opportunities may arise due to the substantial changes in operating landscape.

Quant Ratings

Despite not having “A” factor grades across the board, Seeking Alpha awards RLX an almost perfect quant rating of 4.96. This also adds to my confidence in making RLX a member of my long term value portfolio.

Options

RLX trades options, which are relatively liquid (see open interest), so for those so inclined, it’s possible to get into a position via writing puts and then to generate income with covered calls (and of course many other more advanced strategies are also possible).

Risks

The risks here are multifold. Specific to RLX is the major change in operating environment that I’ve described at length above. While RLX may have a plan for dealing with it, consumers may react more negatively than expected to the higher taxes and the loss of flavored products. This could turn the company into a money loser.

There’s also a significant risk that applies to most Chinese companies, viz. that they operate as VIE’s and this makes shareholders rights close to non-existent. Thus should there be any malfeasance at the company, shareholders won’t have much hope in addressing them or recovering from their effects.

Summary

I have taken a full position in RLX which I intend to hold for the long term. I will be monitoring both the valuation numbers and Seeking Alpha’s quant rating; and should either profitability tank or the quant rating fall to “hold” or lower I may revisit my holding, perhaps selling a portion or even all of it.