NIO: A Classic Growth Trap

Summary

• NIO looks like an obvious growth trap to me, where the risk-reward ratio has shifted to the right side for investors looking for reversal stories in Chinese stocks.
• The problem with NIO is that its sales and book valuation multiples are all it can give us for comparison.
• What is happening to the company's operations can only alarm investors.
• Tesla will cut prices by 9% for Q4 2022 - let us imagine that NIO will make a similar move to avoid losing market share. Then it will make much less revenue than priced in today.
• Despite all the risks associated with my thesis, I believe that the stock market is inefficient in its assessment of the company's near-term growth prospects. NIO is a Sell.
• We're currently running a sale at my private investing ideas service, Beyond the Wall Investing, where members get access to portfolios, market alerts, real-time chat, and more. Learn More »

Andy Feng

Thesis

In my opinion, NIO Inc. (NYSE:NIO) has turned into a classic growth trap - its high valuation may no longer be justified by the growth investors were hoping for in 2018 when the company went public. Since the early 2021 highs, when the stock was trading above $60, NIO has fallen nearly 84% and has attracted a lot of bullish interest lately. However, I do not recommend buying it - literally and figuratively.

Why do I think so?

We know from the thousands of books on the same investing principles that valuation is only one ingredient in a stock's future growth. It is completely meaningless to ask how much revenue (P/S) a company is trading for or how many net income multiples it earns to return the market capitalization to investors (P/E) - the answers to these questions only matter if we know how the company is going to:

a) grow in revenue/EBITDA/earnings figures over the next 5-10-20 years,

b) how many shares it is going to buy back from the market,

c) what the demand for that company's stock will be in the future, and

d) what the company's policy is on returning capital to its shareholders.

You can think of many questions before proceeding with the valuation - the main thing is that the analysis of multiples is the final puzzle for making an investment decision.

I propose to reverse engineer this approach - let us start with the NIO's valuation and try to explain it in some way.

Seeking Alpha, NIO, Valuation [author's notes]

In the last 3 months, NIO quotes have dropped almost 50%, shifting the valuation factor (based on Seeking Alpha's Factor Grades rating) from "F" (very bad) to "D+" (just bad).

NIO's price-to-sales forward multiple of 2.3x looks quite good now, especially if you compare it to Tesla's (TSLA) 6.9x. The same applies to forward price-to-book comparison - 4.6x vs. 13.6x. The problem with NIO is that the sales and book valuation multiples are all it can give us for comparison.

What is happening to the company's operations can only alarm investors. NIO's total revenues in the latest quarter (Q3 2022) rose 20.2% year-over-year, while deliveries went up 29.3% to 31,607 units, according to the company's latest 6-K filing. However, the gross profit margin decreased by 7%, which, against the backdrop of a 34.7% and 123.7% increase in SG&A and R&D expenses, respectively (both year-on-year), resulted in a 1965-point decrease in EBIT margin (I did not mistype - from -10.1% to -29.8% in just 1 year).

The CEO William Li spoke at the past earnings call about how the store traffic has reached an all-time high in the face of strong demand, and how the improved competitiveness of the company's product lineup in every respect has helped NIO move into more premium segments. If so, then premium segments should fly in higher unit-economy metrics, right? If the answer is yes, then why are they falling?

Author's work, based on NIO's 6-K and SA data

Marginal revenue from 1 delivery [the way I calculate it above] may not be a reliable indicator for analysis - the company's revenue is not directly proportional to the number of deliveries. However, this approximation against the backdrop of a continuing decline in margins allows us to see the picture investors may not see during the earnings call - the demand side is weakening and competition is growing.

For one car delivered in September 2021, NIO received $62.22 thousand in revenue (this is a conditional calculation, not an actual average check per vehicle). This metric is down 7.1% year over year - just like the gross profit margin.

Let us assume that the company has roughly the same "revenue per car" ratio in Q4 2022 as it did in Q3 2022 (57.82) - then revenue should be $2.631 billion if NIO hits the midpoint of its forecast (from 43K to 48K vehicles). The resulting revenue is 70% higher than a year earlier, while, as you recall, Q3 2022 growth was only 20%.

I expect the "revenue per car" metric I developed to be even lower in Q4 2022 than it was in Q3 2022, largely due to increased competition and weaker demand.

Not long ago, Elon Musk announced that Tesla will lower prices for cars sold in China - this is not only an attempt to sway doubters towards Tesla but also a kind of barometer for market demand. If even Tesla, with its brand recognition, is forced to take these measures, what is left in the arsenal of players like NIO? In my opinion, they can only lower their selling prices and wait for demand to rise again.

Tesla will cut prices by 9% for Q4 2022 - let us imagine that NIO will make a similar move in order not to lose market share (very important especially for fast-growing companies). Then my model shows a 53.7% increase in NIO's revenue for Q4 2022 - sounds like a lot, but wait to conclude. The market is pricing 9.27% more in revenue growth:

Seeking Alpha, NIO, Earnings Estimates [author's notes]

The current situation does not bode well for the $16 billion market cap company, which, according to Wall Street analysts, will not break even until Q3 2024 (i.e., 2 more years). A slowdown in sales growth will most likely further delay the anticipated breakeven.

We have seen this before - exactly one year ago, on November 26, 2021, the Street expected NIO to earn $0.2 per share for the full FY2023. But since then, that forecast has dropped more than 10 times in a row to -$0.59 per share (as of today). And soon, this apparently will not be the end of the line - more corrections are likely to follow.

Seeking Alpha, NIO, Earnings Revisions [author's notes]

Therefore, a strong multiple contraction and a 6-fold decline in the share price are not a reason to buy NIO stock at its current levels - this is a classic growth trap, in my view, that asymmetrically holds more risks than potential gains for investors.

Where I can be wrong?

You may have read my articles on Alibaba (BABA) in which I expressed skepticism about the prospects for the Chinese economy. To this day, I believe that the CCP will not be able to quickly restore economic activity in the country to previous levels and attract foreign capital. However, analysts at Morgan Stanley (MS) disagree. They believe that Chinese stocks and government bonds will see positive inflows of foreign capital over the next 10 years:

Morgan Stanley, November 8, 2022 [author's notes]

But what happens if there is a hard decoupling from the West? MS also guesses this issue, and it is no longer so encouraging for the Chinese economy and the equities (like NIO) from this emerging market:

Morgan Stanley, November 8, 2022 [author's notes]

I may also be wrong about the peculiarities of NIO - perhaps this company can prove to all the bears that their business can grow faster and healthier. However, I do not see any convincing conditions for that now.

Bottom Line

Despite all the risks associated with my thesis, I believe that the stock market is inefficient in its assessment of the company's near-term growth prospects, which are threatened by increasing market competition and weakening demand.

NIO looks like an obvious growth trap to me, where the risk-reward ratio has shifted to the right side for investors looking for reversal stories in Chinese stocks.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.