Andy Feng
The NIO stock (NYSE:NIO), alongside its domestic electric vehicle (“EV”) peers, have been whipsawed in recent months. The premium EV maker’s share price performance has been influenced by a slew of rapidly evolving and sometimes contradicting news, spanning positive notes like President Xi’s official support for expanding domestic technological expertise, strong 3Q22 delivery growth, and unverified reports of a potential COVID Zero exit in the near-term, to negative sentiment stemming from the central government’s unwavering embrace for common prosperity, health officials’ “unswerving” adherence to COVID Zero, and related disruptions to operations. The fluid environment continues to underscore the blight of both macro and industry-specific headwinds facing the Chinese EV sector, despite resilient demand and penetration.
Despite NIO’s in line 3Q22 sales, the drumbeat is growing louder on concerns over consumer weakness heading into the fourth quarter. COVID-induced mobility restrictions and production disruptions are hampering both supply and demand functions of the company’s profit and growth prospects, souring investors’ confidence in the stock. EV industry leader Tesla’s (TSLA) recent decision to pull the “pricing lever” in the region is also dialling up risks of a pricing war in China’s increasingly competitive EV market.
We believe China’s strict adherence to COVID Zero continues to be the top concern on investors’ minds when it comes to the raft of ever-evolving headwinds spanning regulatory clampdowns to delisting risks on U.S.-listed Chinese equities. Given NIO continues to fare better than rival Chinese EV start-ups on ramping up productions, gaining market share in the domestic premium EV market, and pressing forward with its international aspirations, the key near-term focus for investors will likely remain on how China’s economic and policy outlook unfolds instead, especially pertaining to the country’s approach on COVID Zero.
The COVID Overhang
China’s “unswerving” adherence to COVID Zero and the fast-spreading Omicron variant remains contradicting forces that continue to send turmoil throughout the global economy by shutting down economic activity across cities and provinces critical to the supply chains of major industries, including auto and EV production. Key Chinese manufacturing hub Guangzhou is currently reporting the highest number of COVID cases, unleashing a round of lockdowns across key districts that risks severing crucial supply chains and a repeat of the global economic turmoil experienced earlier in the year during Shanghai’s city-wide lockdown. NIO’s key production hub in Hefei, Anhui province also has not been spared from the grip of COVID Zero, with the company now having temporary suspended productions at both its JAC and NeoPark facilities with lacking visibility on a reopening timeline.
Supply Implications
While NIO reported in line sales performance for the third quarter, its forward prospects over coming months remain a function of growing macro and industry-specific uncertainties, which further weighs on investors’ confidence in the stock. On the supply front, the company’s recent allusion to anticipated volatility over the near-term due to sporadic COVID disruptions to production efforts in Hefei with no clear reopening timeline, alongside COVID Zero’s broader impact on domestic supply chains and logistics are expected to delay recovery and production ramp-up efforts this year.
This will inadvertently place an adverse impact on NIO’s margin expansion trajectory in the near-term, which stands to make matters worse as investors shun non-profitable operations under the current market climate. The company is already reeling from industry-wide inflationary pressures, including an increase in battery costs per unit. The cost pressures are further corroborated the company’s latest vehicle margin decline from 16.7% in 2Q22 to 16.4% in 3Q22, which likely played a role in its EPS miss by $0.14. It also deviates from management’s earlier plans to leverage the advantage of having two operating manufacturing facilities in the fourth quarter to support fulfilment of its full-year delivery target:
Previously, I’ve also mentioned that we will try our best to meet the delivery target for this year. Of course, this means that the fourth quarter is going to witness a lot of pressure and the challenges on our delivery and supply. We have already started to make the preparation for the delivery starting from the third quarter. We believe starting from the fourth quarter, we’re going to have the 2 factories are running to make sure we can support the delivery demand… So we believe in the fourth quarter, we are going to break record every month. And we are confident to achieve the record-breaking target for the fourth quarter, and we have been making active preparations to meet this target as well.
Demand Implications
Meanwhile, on the demand front, NIO will likely face a more prevalent impact from growing consumer weakness in China due to slowing economic activity in key GDP-contributing cities as a result of COVID Zero. Specifically, China’s retail sales continued to decelerate, with September exhibiting a mere 2.5% y/y growth, falling short of consensus expectations for 3.3% y/y growth and marking the slowest expansion in four months. Specifically, auto sales are expected to slow, with even the more resilient EV sector forecast to report a deceleration in October sales. The previous anticipation for seasonality-driven demand in the fourth quarter, and pull-forward sales as a result of extended regional tax breaks on eligible EV purchases and the looming end to the nation-wide EV purchase subsidy by year-end are likely further away from realization now as well given the increasingly bleak macroeconomic outlook.
This is further corroborated by Tesla’s recent decision to slash its EV prices by as much as 9% in China a few weeks back after CEO Elon Musk raised concerns over a potential “recession of sorts” that could weaken demand in the world’s second largest economy. The latest development also risks a “pricing war” that could dampen demand for NIO’s premium offerings in China as customers become increasingly price sensitive amid ongoing economic turmoil in the region, and/or squeeze NIO’s profit margins further, impacting the company’s targeted breakeven timeline by the end of 2023 and reach full-year profitability by 2024.
Although NIO management continues to hold an optimistic outlook on near-term revenue growth, we believe said resilience will continue to be maintained by the company’s backlogged order book. Looking ahead, NIO’s order book growth will likely experience some deceleration in the near-term as consumer purchase power wanes in response to a looming economic downturn. While NIO’s higher priced vehicles are viewed as a positive contributor to vehicle margins, risks of a pricing war as mentioned in the earlier section could partially offset said advantage. But the company’s upcoming debut of two mass market sub-brands could further bolster its competitiveness in expanding market share across the rapidly growing Chinese EV market.
Valuation Implications
China’s COVID Zero overhang will likely continue to keep valuation multiples contracted on Chinese EV stocks like NIO when compared against U.S. counterparts. The injects further complexity on the cohort’s valuation prospects amidst ongoing opaqueness on China’s forward economic and policy agenda, especially with the central government now double-downing on common prosperity. We continue to view common prosperity as the root of ongoing regulatory uncertainties that will keep foreign investors on the side-lines, even when it comes to China’s darling EV industry:
Concerns over China’s prolonged zero-Covid policy have weighed on investor sentiment this year, which has led to a series of sell-offs of yuan-denominated assets…Foreign investors pulled US$8.8 billion of funds from Chinese stocks and bonds in October, reflecting changes in sentiment over geopolitical concerns and anxiety over Beijing’s zero-Covid policy, according to the Institute of International Finance (IIF). Outflows from Chinese equities reached $7.6 billion [in October], with the remaining $1.2 billion removed from bond markets.
Source: SCMP
The unprofitable nature of NIO’s operations – especially with a potential delay to its breakeven timeline as discussed in the earlier section – will also weigh on its shares’ performance in the near-term. Investors’ preference have largely shifted from “growth at all costs” to profitability under today’s dire market climate, which is further corroborated by broad-based underperformance observed across loss-incurring tech stocks this year given their cash flows are furthest away from realization, thus subjected to further discounting in value given surging interest rates:
Investors in technology companies are focused more than ever on profits, following an era when low interest rates drove a speculative frenzy in money-losing companies.
Unprofitable companies have underperformed this year and are likely to continue doing so, investors say. A slowing economy and the threat of recession make their stocks a riskier bet than usual, suggesting that the unwinding from the peak of pandemic-era speculation may not yet be done.
Source: Bloomberg
Yet, we view NIO’s relative resilience in terms of demand and overall operations compared to other domestic EV start-ups as a potential near-term reprieve. The company’s better-than-expected delivery forecast of 43,000 to 48,000 vehicles in the current quarter underscores its continued prudence in navigating through a challenging market and operating environment. This is further corroborated by its slight valuation premium (1.2x forward EV/sales) sustained to date when compared against peers (peer average 0.9x forward EV/sales) with similar growth and profitability prospects. We believe the slight premium is reasonably reflective of NIO’s favourable long-term outlook as well given continued progression on its multi-year growth initiatives ahead:
- Overseas expansion: NIO’s recent installation of its first overseas battery swap station in Germany is viewed as an inflection point on its ongoing Europe expansion efforts. With NIO’s Power Swap and its BaaS battery subscription service being a prominent feature for the brand, the construction of its first battery swapping station in Europe symbolizes the Chinese EV maker’s structural foothold in the region. Looking ahead, focus will remain on the success of NIO’s nascent subscription-based vehicle sales model in the region, measured by its impact on both sales growth and profit margin expansion.
- Leadership is Chinese premium EV sales: NIO has rapidly expanded its market share in the more affluent tier 1 and tier 2 cities across China in recent years. The continued realization of higher-priced vehicle sales with ongoing production ramp-up efforts are expected to place a favourable impact on NIO’s profit realization trajectory over the longer-term, especially with the recent roll-out of new vehicle models based on the NT 2.0 platform that boasts better economics than its predecessor. We believe NIO’s upcoming release of two new sub-brands aimed at penetrating mass market opportunities across tier 3 and lower cities across the country will also reinforce its competitiveness in vying for market share within the increasingly saturated EV landscape in China. And looking further into the latter leg of the decade, when critical battery supplies like lithium are expected to be squeezed further as a result of accelerating EV adoption, we view NIO’s recent acquisition of a 12% stake in Australian miner Greenwing Resources as a prudent move and competitive advantage to bolster global EV market share gains:
Tesla has repeatedly called out the procurement of lithium supply its “biggest challenge”, while peers like Rivian (RIVN) have echoed similar remarks. The EV industry is expected to suffer from a widespread lithium shortage by the end of the decade – representing the next big supply bottleneck following the ongoing chip shortages that have upended the automotive sector in recent years. Specifically, “all the world’s cell production combined represents well under 10% of what [EV makers] will need in 10 years, meaning 90% to 95% of the supply chain does not exist” at the moment. And regarding lithium-ion battery supplies, Tesla had recently estimated it will need “more than three terawatt hours for EVs and energy storage by 2030″, while the current global industry’s supply capacity is only at about one terawatt. Considering it can take up to 10 years to get a lithium mine set up, the industry-wide lithium supply deficit will likely be here to stay for the long haul.
NIO_-_Forecast_Financial_Information.pdf
Final Thoughts
From a long-view perspective, we remain optimistic that NIO can emerge with strong fundamentals as demand across core operating regions continues to benefit from a secular transition to electric. And specific to NIO’s internal operating advantages, the company’s continued commitment to technological innovations aimed at improving production economics – such as its latest introduction of new vehicle models based on the higher-margin NT 2.0 platform – paired with production ramp-up to scale also contributes positively towards its profit realization trajectory. The combination of global expansion, mass market penetration, and long-term supply procurement efforts also reinforces its outlook on becoming a prominent EV market share gainer over the longer-term when compared to rival domestic EV peers such as XPeng (XPEV) and Li Auto (LI).
However, investment risks remain elevated from a valuation perspective over the near-term. The outlook on multiple expansion within the foreseeable future appears grim for Chinese equities, given regulatory and geopolitical uncertainties over the cohort, as well as the lack of visibility on the country’s COVID Zero policy prospects. As such, we remain cautious of further volatility in the NIO stock over coming months as said macro and policy uncertainties unravel.
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