RLX - RLX Technology: A Positive Side To New Chinese Vaping Regulations

Summary

• RLX Tech has been pressured this year amid a shifting e-cigarette regulatory environment in China.
• The company is repositioning its brand portfolio to comply with updated national vaping standards, which may help it consolidate its market share.
• We are bullish on the stock, which is supported by overall solid fundamentals and a positive long-term growth outlook.

RLX Technology Inc ( RLX ) is a leader in the Chinese e-cigarette market with products distributed at over 24,000 retail locations. This is a segment that has seen impressive growth in recent years although the story in 2022 has been defined by macro headwinds and changes to local industry regulations. The Chinese government has imposed stricter standards aimed at protecting minors and improving quality. The result has been a more challenging operating environment, with RLX forced to discontinue certain products and reset expansion efforts.

On the other hand, we're witnessing an impressive rebound in the stock, with shares nearly tripling off their lows supported by an improving outlook. With the new standards taking effect, RLX has already introduced an updated and compliant brand portfolio at a time when other manufacturers are struggling to adapt. In our view, RLX is well-positioned to consolidate its market share as a winner from the regulatory fallout. We like the stock which presents good fundamentals including recurring positive earnings and a solid balance sheet.

RLX Key Metrics

RLX Tech last reported its Q3 earnings on November 16th with the headline net revenue of RMB 1.044 billion representing approximately $147 million, down -38% from the period last year. The context here was a suspension of new store placements and the loss of sales from older non-compliant products.

Nevertheless, the gross margin climbed to reach 50%, a company record and up from 39.1% in the period last year, based on the shift in the distribution channels while the company also cut back on promotional activities. Net income of RMB 505 million, or $71 million declined from RMB 976 million in Q3 2021 although the takeaway here is that RLX has been able to maintain profitability .

In terms of the balance sheet, the company ended the quarter with RMB 16.4 billion across cash, deposits, and investments representing $2.3 billion as total "capital resources". This is a level that has climbed since the start of the year based on positive operating cash flows year to date, despite the weaker trend in Q3. RLX does not carry any long-term financial debt as a strong point in its investment profile.

China e-Cigarette National Standards

A major theme for the company this quarter has been its response to the new national standards including a renewed effort at research and development. For context, updated regulations were first announced back in March following years of speculation the local industry, once described as a free-for-all, would finally be reined in. Some of the major changes in the new legislation include:

• Higher standards for product design and raw materials of e-cigarette devices officially went into effect on October 1st.
• A ban on the sale of flavors other than tobacco.
• Updated labeling meant to not appeal to minors.
• Requirement of product child safety mechanisms.
• Refillable cartridges were made illegal.
• Retailers are blocked from entering exclusive distribution or marketing agreements.

This last point was particularly important for RLX Tech as its distribution model had counted on partnerships with independent retailers that exclusively sold its products. In other words, those same stores must now carry alternative devices and competing brands. Separately, a new tax regime has gone into effect in China imposing a 36% ad valorem tax on the production or import of e-cigarettes. There is also an 11% tax on wholesale distribution.

Overall, the setup here highlights what have been major but important changes for the Chinese vaping market that helps it converge with global standards. RLX Tech management is confident that the result is positive for the industry long-term, particularly as it relates to clarity compared to the uncertainty of recent years beyond the near-term financial impact. From the earnings conference call :

We firmly believe that the new regulatory framework will benefit all industry participants’ long-term development. And as always, we will strictly comply with all applicable regulations. At the same time, the new fast evolving operating environment creates some challenges for industry participants, as well as a short-term adverse impact on our performance, as we actively adjust our products and operations.

Despite these near-term obstacles, we remain confident in our business's resilience and the growth potential of e-vapor industry. We believe RLX well-automated benefit from the more structured regulatory environment and emerge stronger after we adjust our business and adapt our products and strategies for success in this new era.

Is RLX A Good Stock?

The attraction of RLX Tech comes down to its targeted exposure to China's vaping market. While the industry has seen strong growth in recent years, the data suggest that vaping in China estimated to be at around 1.5% of the smoking population is still at a much lower penetration compared to developed markets like the U.S., U.K, and Japan at levels above 30%.

With more than 300 million current smokers in China, the upside here is significant with an expectation that more of that group converts over time towards vaping devices that are at least recognized as less harmful compared to traditional cigarettes.

For RLX as the domestic leader through its "RELX" brand, the case we make is that the regulations and higher standards can work to consolidate the market by pushing out the smaller players. The idea here draws parallels to the concept of "regulatory capture" where higher barriers to entry end up benefiting the companies best positioned to adapt. To be clear, there are other manufacturers and the competition will remain intense, but RLX has a head start given its brand recognition and logistical scale.

According to consensus estimates, RLX is expected to reach full-year sales of $786 million this year, declining by about 10% in 2023 to $711 million, followed by a stronger rebound of 28% in 2024 to $910 million. Similarly, a forecasted EPS of $0.15 for this year, with a downside to $0.14 in 2023 is expected to re-accelerate towards $0.18 in 2024.

The forward P/E of 20x on the 2023 consensus EPS is reasonable in the context of the growth momentum in place going forward and long-term opportunities. We can take an optimistic view and see the upside to these estimates as part of the bullish case for the stock.

RLX Stock Price Forecast

Looking at the stock chart, the first point is that RLX has surged more than 250% since hitting a low of around $1.00 in late October while shares are still off more than 40% year to date. This ongoing reversal with more positive momentum suggests the market is encouraged by the latest Q3 results and the company's roadmap to move forward in the new regulatory environment.

The other dynamic at play considers what has been more favorable headlines out of China with the government easing its Covid-Zero policies to support a stronger outlook for consumer spending and broader economic activity in the region. RLX is a winner within that theme.

We're bullish on shares and expect RLX to be trading higher over the next year. We rate the stock as a buy with an initial price target of $3.30 implying a 22x forward P/E multiple on the current year consensus EPS. The only hesitation at this point considers the extreme rally that has already occurred in recent weeks, opening the door for a return of volatility. Patient traders may be able to pick up shares a bit lower as the stock consolidates recent gains as a better tactical entry point.

The risks to watch include headlines related to broader economic conditions. A deterioration of the economic outlook in China or adverse headlines related to stricter regulations in e-cigarettes or even retail in general would undermine the bullish case. Monitoring points over the next few quarters include the top-line momentum and financial margins.

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