To The Moon

Summary

• We’re downgrading NIO to a sell as the price war in the EV market escalates.

• We think it will be difficult for NIO to improve its gross margin while ramping production output in 2H23.

• Additionally, we think China's weakening domestic macroeconomy will weigh on demand in 2H23 and possibly into 2024.

• The stock is up 15% since our buy rating in March, outperforming the S&P 500 by 7%.

• We think the risk-reward for the stock is no longer favorable; thus, we think retail investors should look for other better-positioned names to invest in for 2H23.

Chun han/E+ via Getty Images

We're downgrading NIO Inc. $NIO Inc.(NIO)$ to a sell; we think it'll now be increasingly difficult for the company to improve gross margins while ramping production output for new ES6, among other new models, in 2H23. We no longer see a favorable risk-reward scenario for the stock now due to two factors: first, continued macro uncertainty in China weighing on end demand, and second, gross margin contraction risks due to aggressive pricing by competition escalating the price wars that NIO now takes part in.

The stock is up roughly 12% YTD, underperforming the peer group and the S&P 500. The stock is up 15% since our buy rating in March, outperforming the S&P 500 slightly by 7%. NIO did run up in June and July due to a better monthly increase in sales and price cuts. While we previously expected NIO to be relatively resilient to the price war due to China's economic recovery and the company's expansion into Europe with BaaS, we no longer expect this thesis to play out in the near-term. China's economic recovery is slower-than-expected; the Chinese economy has fallen into deflation as the consumer price index fell 0.3% in July for the first time in two years. We think end demand remains weak, and competition in the Chinese EV space is heating up, forcing NIO to cut prices as a Hail Mary to keep up with the competition. Last quarter, NIO reported revenue of $1.55B, up 7.7% Y/Y but down 33.5% sequentially. We don't think the new strategy will play out in NIO's favor in 2H23 and recommend investors explore exit points at current levels.

The following graph outlines NIO's YTD performance against the S&P 500, Tesla $Tesla Motors(TSLA)$, and Li Auto $Li Auto(LI)$.

YCharts

Ramping production output & price cuts

We expect NIO to underperform the peer group in 2H23 and don't see the recent price cuts as a play on pricing power; instead, we believe the cuts signal just how weak end demand is as China's recovery lags. In June, NIO joined the price-cut wagon shaving the equivalent of $4,200 on all models while removing the battery swap service from a previously free service offered four to six times a month to a paid option. NIO joining the price wars is a significant shift in strategy from NIO CEO William Li's April remarks, "For us, we will certainly not join the price war." We're concerned about NIO's margins as the company ramps production while pushing price cuts; management noted that they would "ramp up the production of the All-New ES6 and other new models" on the earnings call in 1Q23.

NIO's gross margins percentage growth has been slowing QoQ over the past four quarters; in the most recent quarter, 1Q23, gross margin came in at 1.5% versus 14.6% in a year ago quarter, 3.9% in 4Q22, 13.3% in 3Q22 and 13% in 2Q22. We're seeing margins contract sharply and expect this to continue in the 2Q23 earning results scheduled for August 29th. Management expects relatively flat gross margins next quarter but forecasts double-digit growth in 3Q23 and over 15% in 4Q23. We don't see gross margin recovering in 2H23.

While we acknowledge the positive impact price cuts had on July sales, up 103.6% Y/Y to 20,462 vehicles, we believe price cuts could outpace cost reduction as NIO ramps production volume and faces a challenging Chinese market. We share a similar sentiment on Tesla's gross margins after the most recent price cuts in China, where the company reduced prices by up to 6.9% on some Models. We think NIO's risk-reward profile is no longer favorable as price wars escalate and the China macroeconomy slowdown impacts overall market demand.

Valuation and word on Wall Street

The stock is trading below the peer group at 2.68x EV/C2023 Sales versus the peer group average of 3.2x. While the EV market is a growth market, we don't see NIO outperforming the peer group. In spite of the attractive valuation, we don't recommend investors explore entry points into the stock.

Wall Street is bullish on the stock. Of the 30 analysts covering the stock, 20 are buy-rated, and the remaining are hold-rated. The stock is currently priced at $11 per share. The median and mean sell-side price targets are $14, with a potential 26% upside.

The following charts outline NIO's sell-side ratings and price targets.

TSP

What to do with the stock

We're downgrading NIO to a sell; we think the company will face an increasingly difficult macro environment in China and aggressive pricing from the competition. Expectations for gross margin percentage growth in 2Q23 remain low after price cuts and ramped production output, and we don't see the stock outperforming in the near-term due to competition and weaker-than-expected demand despite new releases. We recommend investors exit the stock at current levels as we believe investor money could be placed in better-positioned names to outperform in 2H23.

Source: Seeking Alpha