Profit companies

NIO Stock: Proceed with Caution (NYSE: NIO)

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NIO (NYSE: NIO) the stock has rallied lately. Up 67% over the past month, it has outperformed US and Chinese stock markets.

Since the last time I covered NIO, a lot has changed. In my Previous article, I rated NIO as a hold mainly due to its high valuation and competition in its market. However, the image has improved. The company won rave media coverage. Lockdowns in China are over. Shanghai has reaches zero COVID cases. More importantly, NIO stock was supported by a favorable policy shift in China.

The stock’s most recent decline was caused by a massive lockdown in China that shuttered some of its factories. This month, the lockdown was eased, leading NIO to completely reverse its earlier trend overnight. Investors believe the company’s earnings will be better in the future than they were in the past. Even in the first quarter – when shutdowns were in full swing – NIO managed 25% revenue growth. With lockdowns no longer affecting its production, it looks like NIO could thrive in the coming quarters.

Indeed, I think NIO’s earnings for the next few quarters should be good. I believe this strongly enough to have actually bought a small number of NIO shares during the recent decline. The company is a small cap with solid growth and well-reviewed products, so it holds promise.

It is for this reason that I changed my NIO rating to buy. It is promising enough for growth investors to merit a small weighting in a diversified portfolio. However, there are a few caveats to keep in mind. First of all, my position is tiny. Second, much of the bullish thesis on Chinese equities does not apply to this specific company. People who like Chinese stocks like them because of their high margins, clean balance sheets, and cheapness. Few of these factors apply to NIO. It’s not profitable, so the “high margins” thing is out, and the price to operating cash flow ratio of 120 doesn’t speak of a bargain.

Instead, the NIO’s thesis revolves primarily around growth potential. Its revenue growth rate over the past 12 months is 66%, and that’s with a lockdown-fueled deceleration in the picture. Fundamentally, it’s a growth opportunity, not a value play – so it’s different from other Chinese stocks like Ali Baba (BABA), which are really cheap. In the best-case scenario, the NIO stock could increase dramatically. But there are many risks and challenges to be aware of. For this reason, I rate the stock as a buy, but not a strong buy. In this article, I’ll explain my thesis on the stock, specifically why it deserves a small weighting in a growth-oriented portfolio.

Competitive landscape

To look at NIO objectively, you need to consider the competitive landscape in which it operates. NIO operates in China, where there is already a big player –BYD (OTCPK:BYDDY)–and several smaller ones. You’re here (TSLA) is also present on the Chinese market. Compared to some of the biggest names in town, NIO is a small player in the industry. BYD shipped 593,000 cars last year, about six times the amount of NIO. Additionally, BYD manufactures transit vehicles, allowing it to lock in recurring government revenue. NIO, as a sedan manufacturer, does not have this advantage.

Tesla is another big player in China. In an average non-lockdown month, Tesla makes more than 20,000 cars a month in China. They are not all sold locally but the vast majority are. According to Inside EVs, Tesla sold 104,000 electric vehicles in China in the first quarter of 2022. That’s more than NIO is doing now. Of course, NIO has a very fast growth rate, so it will gain market share over time. But it is currently behind two other companies in China.

Then we have NIO’s smaller competitors. NIO has a number of smaller competitors in China, including:

  • XPeng (XPEV).

  • Li-Auto (LI).

Among China’s small EV companies, NIO ranks second. It recorded 91,000 deliveries in 2021, compared to 98,000 for XPEV and 90,000 for Li Auto. NIO is quite well positioned among the smaller players, but remains far behind the leaders of the Chinese electric vehicle market.

With respect to the electric vehicle industry as a whole:

It has strong growth but is very competitive. It has grown rapidly in the past and is expected to grow at 19% CAGR in the future. Sounds like a positive, but you have to keep the competition in space in mind. Everyone wants to participate in the trend of electric vehicles, which leads many companies to enter the market. You can’t rely on just any randomly chosen electric vehicle company to keep up with industry growth.

Product

To assess whether NIO can gain market share in the electric vehicle industry, we need to look at its products. Many companies are making electric vehicles, but not all of them are successful. Does NIO have any advantages that could make it a winner?

There seems to be at least one:

Interval.

According to NIO promotional material, its ET7 has a range of 1,000 kilometers (620 miles). That’s longer than the range of any vehicle Tesla offers, although some reviewers say NIO uses the CLTC test cycle, while Tesla uses the NEDC test cycle. So it’s not exactly an apples to apples comparison.

Still, critics seem to be receiving the ET7 well. It got 4 out of 5 stars in an Autocar review, other reviewers also rated it highly. Autocar’s review touted these features:

  • Improved styling.

  • Dolby Atmos sound system.

  • Acceleration of 4.3 seconds to 62 miles per hour.

  • Built-in AR and VR functionality.

The review above is fairly representative of what ET7 reviewers are saying; they usually give it high but not perfect marks. So, NIO seems to have a solid product on hand.

finance

After reviewing NIO’s competitive position and product quality, we can now turn to its finances. This is an area where the company stands out. NIO already has positive operating cash and intermittently positive free cash flow (“FCF”). Its profits are negative, but the losses are decreasing as a percentage of turnover.

Over the past 12 month period, NIO has delivered:

  • $6 billion in revenue.

  • $1 billion in gross profit.

  • -$1 billion operating profit.

  • -$1.186 billion net profit.

  • $309 million in operating cash.

Over the past 12 months, revenue, CFO and gross profit have increased, although operating loss has worsened by -$707 million.

Generally speaking, NIO losses decrease as a percentage of revenue. From 2018 to 2021, NIO revenue decreased from $719 million to $6 billion, while EBIT loss decreased from -$1.395 billion to -$1 billion. Thus, the loss as a percentage of revenue decreased by more than the gross percentage change in the loss itself.

It’s a good sign. The decrease in losses indicates the potential for future profit. In addition, NIO’s balance sheet is very healthy. It has $1.75 billion in long-term debt, $5.9 billion in equity, $10 billion in current assets, and $5 billion in current liabilities. From this, we get a current ratio of 2 and a debt-to-equity ratio of 0.29, suggesting high liquidity and solvency.

Evaluation

Armed with NIO’s financial data, we can move on to valuation. This is perhaps the biggest challenge to my bullish thesis on the stock. NIO is definitely not cheap. For the last 12 months, it sported the following multiples:

  • Price/sales: 6.

  • Price/book: 7.

  • EV/sales: 5.72.

  • Operating price/cash flow: 120.

These multiples are all quite high. They’re lower than Tesla’s, but certainly more typical of an EV company than your average Chinese tech name. Many investors are excited about the “China opportunity” – the chance to buy high-quality, profitable technology companies at rock-bottom prices. The opportunity is real, but NIO is not really part of this specific business. In terms of valuation, he’s more typical of his sector than his country, and that’s something investors should consider in today’s value-driven market.

Risks and Challenges

So far we’ve seen that NIO is a cash flow positive company with strong growth and a decent (but not amazing) standing in its industry. Given its small market cap, it could rebound significantly at the best of times. However, there are significant risks and challenges that investors should be aware of, including:

  • COVID outbreaks. The recent COVID outbreak in Shanghai and Beijing caused NIO’s revenue growth to decelerate to 25%. Previously, its revenue was up 122% year over year. If more COVID outbreaks occur in China, they will likely prompt the government to implement more lockdowns. If blockages occur in areas where NIO manufactures vehicles, then they could hamper the company’s growth.

  • Competition. Competition in the EV space is fierce. In addition to Tesla and the previously mentioned Chinese competitors, there are also volkswagen (OTCPK:VWAGY), small electric vehicle startups and traditional automakers entering the space. The more competitors enter an industry, the lower the margins tend to be. Traditional gas-powered vehicles aren’t exactly a growth industry right now, and we could one day see electric vehicles come to the same place, especially if the competition intensifies.

  • Dilution. NIO shares have been diluted in the past. The number of shares has grown every year, with a particularly strong increase in 2019, when the number nearly tripled. In recent years, the dilution of NIO has been much slower. However, it continues and it creates an expense that offsets the company’s otherwise impressive operating cash flow.

Conclusion

When you put it all together, NIO looks like a worthy addition to a growth-oriented portfolio, albeit with a small weighting. It is suitable for investors with certain needs, for example those who want a small “high risk/high return” position in a core portfolio and a satellite portfolio. The best-case scenario with this company is extremely good, so a little exposure could be a good thing. But these aren’t the kinds of stocks you want to overweight or “go all-in” on. It’s really risky, and it’s relatively expensive by the standards of Chinese equities these days. Thus, a portfolio weighting of less than 1% would be appropriate.