Shinoken: this is what value looks like

You have to be prepared to look in some strange places to find cheap stocks these days, and one of them is small-cap Japan. This can be a pain for a number of reasons (language, filings/disclosures, liquidity, etc) but what’s a guy to do? The S&P chart looks like this:

Screenshot 2019-08-14 12.09.04

Meanwhile the Topix 1000 (broad-based Japanese stock benchmark) looks like this:

Screenshot 2019-08-14 12.07.42

This is only a 1yr chart, but I could pull them both back over 5yrs (or 10yrs, or longer) and show you that Japan has massively underperformed the US rally. There are many good reasons for this – lack of buybacks, lack of aligned managers, structurally lower RoEs, structurally lower growth, etc etc – and this will not be an examination of those issues. Rather, this is simply to say that there are a) lots of cheap stocks in Japan (so a good place to look for bargains in an expensive investing world); and b) Shinoken (8909.JT) is one of the cheapest and most attractive of the bunch, in my view.

So this is really just a post about one really cheap stock, Shinoken, that happens to be a Japanese small-cap. If that is not for you…no problem 🙂

Meet Shinoken

Shinoken is a Tokyo-based real estate developer. They focus mostly on apartments (in the Japanese context this means low-rise buildings of 2-3 floors), though they also do condominiums (high-rise, higher-ticket projects, called ‘mansions’ in Japan). They offer a fully turnkey solution where they select the land plot, buy the land; design the building, etc; construct the building (often using their own in-house general contractor); deliver the building to its owner, post construction; and then offer a full suite of management services for the owner to make their life easier (property management; rent guarantee; insurance; electricity/gas bill management; etc). The English-language IR section of the Shinoken homepage has some decent information on the company and its operations (of course the Japanese site has much more information).

Its worth spending at least a moment on the individual reporting segments at Shinoken because a key tenet of the investment thesis is that an increasingly large % of earnings comes not from pure development, but from ancillary services that are more recurring in nature (and thus would expect to garner a higher multiple from the market).

Business segments:

Development (61% of LTM revenues, 60% of LTM segment EBIT): development and sale of apartments and condominiums in select cities, as described above. Apartment and condominium have different business characteristics and capital requirements, but are lumped together into one segment (doesn’t make it easier for us, does it!). As you might expect, this is a lumpy number (both top and bottom lines) and has been under pressure in recent quarters due to market-wide pressures (more later), but has grown strongly over the longer-term.

Management (14% of LTM revs, but 25% of LTM EBIT): by nature higher margin recurring revenue, principally driven by the % of rents taken by the management company (around 5% of rents usually) in return for managing all aspects of the rental process on behalf of the landlord. EBIT in this segment has grown consistently in recent years whilst scaling (now printing low 20s % EBIT margins), as the company has consistently added services to its offering (rent guarantee, insurance, etc) and signed up more landlords for coverage as it delivers new units from its development pipeline. This business is extremely asset-light (simply managing more buildings on the same platform) and has highly desirable economic characteristics – as long as they can maintain occupancy in their existing managed fleet (and occupancy is 98% right now), earnings should be relatively stable even if the development business were to stop completely. Assuming development growth remains stagnant, Management EBIT as a share of total company earnings will continue to rise (suggesting improving business quality). My FY19E numbers suggest close to 4bn in EBIT from this segment alone – which even at a low multiple for this kind of quality business (say 12x) justifies close to double the current market cap (27bn today).

General contractor (21% of LTM revs, 12% of LTM EBIT): a small contractor that was acquired a few years ago at a very low multiple of today’s EBIT (around 1.5x run-rate EBIT today) and has expanded significantly beyond simply building Shinoken’s units (though this was the main purpose in acquiring it, to achieve integration and cost efficiencies). Today, ~80% of revenues are derived from external business, and while of course this is at risk related to the overall construction industry, further makes this revenue stream more independent from Shinoken’s core business and thus – from a valuation perspective – should help defray concentration risk in the earnings pie for the company, over time.

Energy and Life Care (combined, 3% of LTM revs and 5% of LTM EBIT): two small segments that I have combined – Energy relates to the provision of electricity/LPG services for Shinoken’s buildings (on behalf of landlords) and is ‘bolt-on’ service business related to the management segment; while Life Care provides assisted living services at a number of facilities throughout Japan (currently almost fully occupied). Many of the tenants are ex-Shinoken residents who have aged out of their apartments – thus providing a further leg to the Shinoken service flywheel. These businesses are both small but again, have consistently grown, and are, once again, somewhat independent of the core apartment development business (ie they would exist as semi-annuities even if development of new buildings stopped completely).

Putting it all together, the important takeaway is that the % of segment EBIT coming from OUTSIDE the development business has been rising, in absolute and relative terms, consistently over the last few years. Here is how it looks over the last 12 quarters (using my estimates for the rest of 2019):

Screenshot 2019-08-14 14.41.16

That is to say, non-development EBIT – much more recurring and repeatable in nature – will, by the end of this year, be closer to 50% of segment EBIT on a LTM basis (versus 20% a couple of years ago). Yes, a large contributor of this is the decline in earnings in the apartment segment – which we will presently discuss – but it is also due to the inexorable march higher of the recurring earnings in the service-type businesses (the orange bars above).

To conclude: Shinoken is becoming much more than just a typical real estate developer – its just that the slowdown in the apartment business has masked this (for now). I expect that to change in short order.

Shinoken’s development model

Of course, apartment development in Japan is highly competitive, so Shinoken’s success – and as we shall see they have been incredibly successful – has been built upon a few key advantages:

niche target customer: Shinoken specifically targets individual salarymen (and women) looking to acquire an investment property on a no/low money down, high LTV basis, for income.

land/site acquisition: Shinoken targets only very specific sites for development (<10 mins walk to nearest train station) in select cities (Tokyo, Osaka, Fukuoka, Nagoya, Sendai) where the % of single inhabitants is structurally growing. Since the majority of their apartments are smaller units that cater to solo inner-city dwellers, they are therefore running with the demographic tailwind only in certain cities.

scale, cost benefits: while Shinoken only supplies ~1% of new housing starts in Japan, they are one of the largest providers in their specific segment (apartment sales for investment purposes) given the fragmented nature of the market. Since acquiring a General Contractor in 2014, and growing rapidly thereafter, they have been able to achieve economies of scale in development (eg unified building designs from a set of templates) and construction (vertical integration) such that they can undercut slightly on offered rents (generally they under-price the extant market by 5%) to drive full occupancy and thus increase the perception – for both tenants and landlords – that Shinoken properties are desirable because they are always full.

financing: unlike some other outfits, Shinoken self-finances development and construction of their projects. This clearly increases asset intensity and limits growth rates given balance sheet constraints, but also allows much faster inventory turnaround times at scale (since they have developed construction capabilities over many years, a new apartment project can be fully constructed in 6-8mos). Most importantly, it also distinguishes the company from other operators who rely on their customers to finance development risk – a reliance that has led to bad behaviour by competitors (as we shall see).

high occupancy rates: Shinoken has maintained very high occupancy for its buildings (95-98% in recent years, versus the national average in the low 80s %). This is partially due to astute management (they manage the majority of properties they have developed); partially due to pricing (as described above); and partially due to general tightness in the market.

sales approach/customer acquisition: Shinoken does not cold call (common in the industry); most customers are either repeats or referrals, or garnered from TV advertising.

It is perhaps easier to let the financials do the talking. Over the last 9 years, Shinoken has compounded book equity at a 42% CAGR, growing book value from <2bn JPY (FY11) to 41bn JPY (FY19E) – ie a 20x increase – whilst generating average pre-tax ROICs of 20%. You probably don’t need to research many other Japanese companies (or Japanese real estate companies) to figure out that is exemplary by any measure:

Screenshot 2019-08-14 12.46.13

Putting aside questions of sustainability, normally you would expect to pay a substantial premium to book value for a company compounding at 40%, right? Conceptually, if we thought even 30% returns were sustainable, the implied P/B metric (assuming say a 10% cost of equity and no growth) would be 2x. How has the market valued Shinoken over the years?

Screenshot 2019-08-14 13.01.53

Clearly Shinoken isn’t getting much credit. The stock trades at 0.7x book value today – well below historic averages (1.9x over this period) – and effectively implying a well-below cost of equity sustainable return going forward (maybe in the 6-7% range, judging from the 0.7x price/book multiple today). This is despite the company having printed 40% compound for almost a decade, and still printing 25% last year and 20% this year (in the face of significant delevering of the balance sheet)! In absolute terms, this seems somewhat crazy, and it is only in reference to the poorer returns (but still extremely positive and well north of cost of equity) of the last couple of years that we can begin to understand what the market is thinking.

Simply put, the market is telling you at this price that Shinoken’s model is broken, and that it will revert to a below-average earner in the very near future. Before digging in to why I think that is completely wrong, it’s worth examining what has changed in the apartment development industry in the last year or so.


An annus horribilis for Japan’s investment property developers

The last 18 months have been incredibly rough for the Japanese investment property industry, as the sector has been beset by a number of damaging scandals. In no particular order of importance, here are some of the main issues that have encountered the industry since the beginning of 2018:

  • the Suruga loan scandal: Suruga Bank, a regional bank based in Shizuoka prefecture, admitted to a wide-reaching scandal involving the forgery of loan applications for ‘share-house’ schemes (shared home ownership and co-habitation, often marketed towards single women). Simply put, bank executives had faked income and other data to support loans to unworthy borrowers, all to support unrealistic lending volume targets. Starting from April last year, the scandal culminated in the resignation of five senior bank executives (including the Chairman and President) in September; and Suruga ultimately being forced to seek assistance from Shinsei Bank, in May of this year after admitting that losses on illegitimate loans could top 1 trillion JPY. This FT article presents a reasonable summary of the issue – the main takeaway is that this has been an overhanging issue on the sector for most of the past 12+ months;
  • the Leopalace construction scandal: beginning in May/June last year, Leopalace, the builder and manager of over 30,000 apartment units in Japan, admitted that they had not maintained necessary building standards in the construction of some 200+ apartments (violating fireproofing and soundproofing standards). Shoddy construction techniques were likely employed to try to save costs. By February of this year, the number of shoddy units had been upsized to ~1300, and Leopalace was paying to move 14k residents out of these units to conduct repairs. Needless to say, Leopalace’s new construction business has collapsed; their occupancy rates have fallen; the share price has cratered; and many are wondering if the company ultimately survives (they have a levered balance sheet now given the remedial costs and, newly, a terrible reputation). Clearly this has been a further ongoing impediment to sentiment in the sector;
  • the Tateru loan scandal: perhaps most damaging for Shinoken directly, however, has been the Tateru scandal. Another property developer, Tateru admitted to falsifying loan documents on behalf of its customers (inflating incomes, forging bank balances etc), to achieve loan approvals from the banks. The scandal broke in September last year, and grew out of the Suruga scandal (in that a brighter light was being cast upon the industry, along with a surge in third-party investigative journalism). By June of this year – and despite the fact that Tateru’s business has fallen to near-zero as a result of the scandal – the government slapped a ‘Business Improvement Order’ against the company, effectively making it very difficult to continue operating in this particular line of business. Again, this was a long drawn-out affair, only really resolving itself by June of this year (hence, a further multi-quarter overhang on sentiment).


The cumulative impact of these three large scandals – involving banks, property developers, and constructors – was clearly to cast a pall over the entire sector. Tateru – one of Shinoken’s closest competitors – saw its stock price go down 90%, of course dragging down Shinoken by association. Meanwhile, all the banks (not just Suruga) have given the cold shoulder to apartment lending, decreasing loan volumes and tightening lending standards aggressively to make sure they don’t get caught up in the maelstrom.

Given the extent of the scandal, it has been hard for the market to assume (in the short-term) that other players in the space are operating differently, and this is why a company like Shinoken is available today at <4x earnings. But let’s take a closer look at the actual content of the issues, and why Shinoken may in fact have been the proverbial baby thrown out with the bathwater.

1) The Suruga scandal – the core of the issue here was inappropriate lending against shared-houses (co-habitation apartments). Shinoken does not, and has not, constructed these kinds of apartments. Moreover, Suruga’s home market (Shizuoka) is an area Shinoken does not have meaningful (or any) business, and furthermore, Shinoken confirmed subsequent to the Suruga scandal that they have not had more than a single mortgage issued by Suruga in the last three years, and that Suruga is not one of their key lending relationships. Conclusion: in the absence of any direct linkages, it is hard to see how Shinoken could be directly entangled in this particular imbroglio.

2) The Leopalace scandal – the issue here was shoddy construction and breaking building code standards in Japan. A harsh light has been shining on the industry for the better part of 1-1.5 years now, after the Leopalace issue first broke, and neither Shinoken nor its general contractor have had any issues crop up at all regarding quality. In fact, they appear to have maintained a very strong reputation for safety and trust with their tenants, as evidenced by the ongoing high occupancy rate (98%) of its buildings. We know that Leopalace’s shoddy construction was related to an inability to constrain costs – but Shinoken strategically brought a contractor in-house to achieve cost synergies through integration. Furthermore Shinoken does not try to maximize construction profits (gross margins in the apartment segment are lower than comps) and instead tries to focus on turning inventories faster and increasing the unit fleet to expand the base for recurring services). Conclusion: while in theory this could always crop up at some point (since I haven’t personally inspected the construction quality of all their buildings), if it hasn’t been an issue thus far with so many eyeballs focused on it, it seems unlikely to be a trigger event now. Furthermore, there are business model differences between Shinoken and Leopalace that could somewhat explain why these issues would be less likely to occur at Shinoken.

3) The Tateru scandal: Tateru is most similar to Shinoken in terms of business area (targeting low or no-money-down apartment sales for investment purposes), but utilized a different model to achieve higher growth unconstrained by its own balance sheet, and this is where the issue of moral hazard occurred. They relied on their customers to finance land acquisition, development and construction of the apartments (as opposed to Shinoken, which financed all development from its own balance sheet) – and they ‘helped’ their customers fill out all the necessary documents to get loans to allow purchases to occur. Clearly, in pursuit of growth, this model introduced temptations to Tateru employees which they could not resist. With regard to Shinoken, the company has maintained – post the Tateru scandal breaking – that they have far fewer opportunities to even handle customer loan application data; that they are not really involved in the preparation of loan documents for their customers; and that in any case they have failsafes to stop employees editing data in any case (encryption of the data; no USBs allowed for use by company employees, etc). Despite all this there have been some isolated reports in very fringe journals that some Shinoken employees sought to duplicate loan docs to enhance incomes – though these allegations were denied by the company. Conclusion: this is a tougher issue to get a complete handle on, given the business similarities between the two companies. However, again – it has now been well over a year since the Tateru scandal broke; the company has been subject to all kinds of examination; and the most that has come out have been some isolated and unconfirmed allegations of minor impropriety. While this issue may take further time to dissipate, the fact that the stock price now essentially values the apartment business at a negative value (as we shall see) suggests that at the very least, even an orderly diminution of the development segment would create positive value for shareholders.


Where does this all leave us?

Let’s go back to Shinoken’s fundamentals. It should be no surprise that in the midst of all these issues, the real estate development business – which houses the core apartment development franchise as well as the condominium development business – has seen earnings fall aggressively. Essentially banks have taken a much more circumspect approach to lending against investment properties, and – even for ‘good’, trusted developers like Shinoken – this has had a large impact on business. Revenues fell 14% YoY in 1Q, and 40% YoY in 2Q (lapping tougher comps as the scandal really only first hit the business in 4Q last year). I fully expect 3Q (ending Sept) to show another large decline YoY in the development segment, though the company has guided to a return to land acquisition and inventory build-up from 3Q, as they see a pipeline of interest returning this quarter, and expect bank attitudes to gradually improve. I should emphasize, however, that I do NOT expect earnings in the apartment segment to come roaring back for at least the next 2 quarters – both because the company has likely monetized some higher margin properties in the last couple of quarters (profits held up much better than I expected); and because construction lead times on new projects are at least 6-8 months, meaning new business consummated now won’t hit the PnL until next year at earliest.

The quality of business is improving; and the stock is half the price

Why, then, am I so bullish now? Well, other than sensing the market turning before the fundamentals finally bottom, simply put, this is a much better business now than a couple of years ago, and it is available at half the price. That is to say, the deceleration in apartment business has only served to highlight how much better in absolute quality the overall business is becoming, with a much higher share of recurring revenues and earnings from management and services, and less reliance on lumpy development revenues. At the same time, the business is available at – I think – around 4x trough earnings (FY19E), or the cheapest it has ever traded, and still down 50% or so in absolute terms over the last year:

Screenshot 2019-08-19 11.18.11

In other words, we get a much better business, at half the price of the old business, with earnings likely to start growing again from next year. Oh, and we also get a near 4% div yield while we wait (well covered by recurring earnings alone), and management’s promise to pay 20% of earnings out in future years. On my numbers, this implies a growing 5% yield from next year – a very solid carry while this business continues to compound and sentiment retraces from extremely oversold levels. And of course we are paying a fraction of book value for a long-term compounder that – even with today’s deleveraged balance sheet – is still generating 20% RoEs.


A quick Sum of the Parts

We can think about the cheapness on the headline earnings level (4x current year EPS and returning to growth next year); on the multiple of book or invested capital relative to its returns on equity or invested capital (as discussed earlier, at 0.7x book value for a historical compounder at 40% of book and even today generating 20% RoEs); or, more completely, we can do a sum-of-the-parts (SoTP) analysis to see exactly what we are getting when we buy Shinoken. Here is my simplified view of the latter:

Screenshot 2019-08-19 11.30.31.png

It’s always important to be wary of assigning too much weight to a SoTP – especially in Japan where it is difficult to crystallize or extract the value in this way (by breaking up the parts). But I think it is instructive to see how much latent value there is here (and so how much margin of safety we have at the current price), considering the following:

  • I have assumed the RE Development business is only valued at Current Assets less ALL liabilities – essentially assuming it creates no further economic value beyond what is on the balance sheet (indeed, only the current assets!) today. This seems quite punitive (after all the business is still quite profitable today);
  • I value all the other businesses at the very low end of direct comps (including just a 12x multiple on the real estate management jewel, when listed REITS trade at >20x EBIT);
  • I capitalize corporate overhead at a relatively penal multiple (7x EBIT) despite the inherent truth that most corporate costs relate to the core development business (which, in this exercise, is effectively being valued at adjusted book and not considered a going concern);
  • and I ignore all long-term assets, optionality around the Indonesian REIT business, investments on B/S, etc as well).

Despite all these fairly punitive assumptions, it is not hard to get a value north of 2000 JPY/share, or basically 1.5x higher than where the stock trades today. Indeed even at that level, the stock would barely trade at 10x P/E on trough-ish earnings – hardly a demanding multiple, so I think this is very much a realistic mid-term target.


Final thoughts: real estate market risk

It would be remiss of me to write a full investment pitch about a real estate developer and manager without a few words at least about the general property market environment in Japan. However, I really don’t want to focus too much on the broader market – simply because I really don’t think it is at all central, or even that peripheral to this specific investment thesis (such has been the impact of idiosyncratic issues upon Shinoken’s cheapness today). Yes, if you buy this you are implicitly betting on the Japanese property market remaining buoyant – but again Shinoken is <1% of new housing starts in Japan and had, until recently, grown consistently in the pre- and post-Abenomics, ultra-low-rate environment so I don’t think you are necessarily beholden to current low rates as you may think. Having said all that, the attached report demonstrates a) there is still huge demand for investment properties in Japan (across all stripes, including residential); and b) that cap rates for residential real estate continue to compress. If you believe that ultra low rates persist in the medium term in Japan (a pretty safe bet given the trajectory of the last 30 years), then the broader secular risk regarding real estate in Japan are far, far down the name-specific risks related to this investment.


Disclosure: long Shinoken (8909.JT)







Is the market even semi-form efficient? The Aercap conundrum

Imagine I told you nothing about two different companies except their historical long-term earnings power (net income through the cycle; return on assets/equity %, etc) and capital structure (equity/total assets, debt/total capital, etc). I then told you they were both financial companies dependent upon access to capital markets for funding – making them somewhat comparable (both spread lending businesses but against different types of assets) if not exactly the same. Conceptually, could you come up with a valuation framework that seemed consistent with what the market was telling you?

Here is company A. Over the last 12 years this company has grown earnings (net income) at 15% per annum (per below). During the financial crisis earnings fell 20% year over year – pretty incredible for a financial company! – but bounced back within two years to new highs:

Screenshot 2019-08-04 19.06.04

Clearly a good deal of this growth was accomplished through acquisitions (note the step function higher in earnings from 2014-15), but importantly asset-level returns (as measured by RoA %) and capital structure (as measured by equity % of total assets) has not really changed much over this long period of time – which is why RoEs have remained remarkably steady in the 10-13% range in recent years:

Screenshot 2019-08-04 19.07.36

So, this company is earning essentially the same returns on its underlying assets (whatever they may be) as they did back in 2008. Pretty consistent, right? And while absolute earnings have declined the last few years, because asset- and equity-level returns have not changed much, the company must have been reducing the size of their balance sheet and returning capital – and indeed, when we look at book value per share, this has continued to grow (compounding at 16% per annum over the long-term, essentially in line with net income):

Screenshot 2019-08-04 19.10.16


Now let’s look at Company B. Clearly this is a much larger company to begin, but unlike Company A, this company saw much more downside volatility during the financial crisis – earnings fell 70% YoY – although they bounced back faster, and to new highs (again, it looks like a large acquisition hit the business). Much like Company A, earnings appeared to plateau 4 years or so ago and have not advanced in absolute terms since. It should be noted the scale of earnings growth is also lower (Company B grew at a 9% CAGR vs Company A at a 15% CAGR):

Screenshot 2019-08-04 19.14.57

Let’s look at the asset-level metrics and capital structure for Company B:

Screenshot 2019-08-04 19.18.56

While the 2008-2009 volatility in asset-level returns is notable, for the most part RoA has been pretty stable in the 1.1-1.2% range, as has the equity ratio (around 10-11%). The salient point – other than the outsized volatility exhibited during the GFC – is of course that the asset level return is much lower in absolute terms, and thus the required leverage to earn decent RoEs is so much higher (10% equity ratio or so for company B vs 20%+ equity ratio for company A). As you might expect, book value for Company B has compounded at a far lower rate – commensurate with the much slower growth in net income – and has only grown 8.4% CAGR over this time, or basically half as fast as Company A (admittedly Company B is a dividend payer whilst Company A is not, an important distinction but one that does not change the dynamics here meaningfully in this case).

To summarize, then: based on an extremely long-term record (12 years, spanning the pre- and post-financial crisis period), we can conclude the following:

  • Company A generated near-double the earnings growth of Company B and compounded book value at near-double the rate (15.5% vs 8.5%);
  • Company A saw much less downside earnings volatility during the financial crisis (20% vs 70%);
  • Company A manages more than double the asset level return over the long-term, and thus
  • Company A operates through the cycle with half the leverage of Company B (21% equity ratio vs 11% equity ratio).

All else equal, wouldn’t you think Company A would earn a far superior multiple (of book or earnings or whatever) to Company B?

And the winner is…

Pulling back the curtain, Company A is Aercap (AER), the world’s largest aircraft leasing company; and Company B is Wells Fargo (WFC), one of the world’s largest commercial and retail banks. Here is how each entity is valued by the market, first on a NTM P/E basis (going back over the last 12+ yrs):

Screenshot 2019-08-04 19.39.11

Now let’s look at P/B:

Screenshot 2019-08-04 19.41.38

As you can see, barring a very brief period in 2014 when P/B parity was almost achieved AER has traded at a very large and consistent discount (around 5 turns on average P/E, currently 3 turns) – despite the hard evidence of many, many, many years of superior financial (and operating performance).

How do we explain this? To be clear, this is much less about WFC (honestly I picked it somewhat randomly, I could have made the same argument with most any other listed financial). And of course, there are many other differences in these two businesses (access to capital, etc) that affect how these two assets should be relatively priced. But my contention is much more about AER and the way the market has perceived it over a very long and successful history, and I thought the comparison to a bank like WFC, even a spurious and simplistic one, provided some insight.

Normally, the market rewards consistency of performance; or it rewards consistency of growth; or it rewards consistency of capital returns. AER has aced all three of those tests for its entire listed history as a company: AER generates earnings well in excess of its cost of capital; it has grown earnings well ahead of the market; it didn’t lose money in the financial crisis (!); and it has returned a huge amount of excess capital. Yet it appears the market doesn’t care one iota.

Furthermore, AER is not a small, under-covered stock: it has a $7bn+ market cap; it is incredibly liquid (trading >$50mm/day); it is listed on the largest stock exchange in the world (the NYSE); and it is covered by a large-ish number of sell-side analysts (at least 7). Frankly, it is not at all cheap for any spurious, non-fundamental reason. Rather, it seems to me that in AER’s case (and really most all the aircraft leasing space), the market simply perceives the riskiness of the business model to be many, many degrees greater than the long-term record would suggest.

And this to me is a real conundrum, because the market – as I understand it – is meant to be at least semi-form efficient (ie, it should value assets more or less correctly, most of the time). In this understanding, there are rewards to be had through demonstrated execution, and consistent performance over time (as the market pays up for businesses with a track record of success) – but in AER’s case the opposite appears to be happening (the business is getting de-rated more over time despite exemplary performance and lower risk today than at any time in its history).

Luckily there is a self-correcting mechanism, and one AER is pursuing today: buying back all its shares from Mr Market on the cheap. AER has retired >40% of its outstanding shares over the last 5yrs, and is on track to retire another 8-9% of the company this year as well. If the public markets never accord the value to the company it deserves, I fully expect the company to be taken private – either by strategics (a Japanese bank with a structurally low cost of capital?), or perhaps by astute management, once the float is de minimis in a few more years. Or maybe – if the valuation discount continues – sooner? For what is the point of putting up numbers, quarter after quarter, year after year after year, and yet permanently suffer from an unfairly high cost of equity? This is a financing business, after all…

Disclosure: long AER

(PB: I didn’t discuss the fundamentals of aircraft leasing in this post, but it is something I have discussed previously here and here; alternatively, this blog post by a respected peer goes into some detail as to why AER is interesting as well).












Tesla: we’re going to miss you when you’re gone

(Tesla (TSLA) filed their 2Q earnings report last night, and while I really should wait until they file their 10-Q to make this more complete, I really just can’t help myself.)

In late January, TSLA reported an optically-impressive Q4’18 result (91k deliveries, 24% automotive gross margins, $140mm in net profits), and on the post-Q conference call, Elon Musk confidently predicted a move towards the sunny uplands of sustained profitability and free cash flow…but at the end of his prepared remarks, the incumbent CFO and longtime lieutenant, Deepak Ahuja, announced he was leaving the company.

When it came time to report Q1, however, all we got was another massive loss ($700mm net), cash burn (-$900mm), and a big decline in automotive gross margins (to 20%). Not to worry, said Musk – 1Q was affected by ‘seasonality in the auto industry’, and ‘logistics hell’ (as the company started shipments of the Model 3 worldwide – 2Q would see a return to delivery growth, positive free cash flow, and perhaps modest profits. Musk doubled down on this prediction barely a month ago, when – in a leaked employee memo – he suggested ‘a record quarter on every level.’ This subsequently goosed the stock (which had been in semi-freefall) into a stunning rebound, pushing it from the $190-ish level at the time to $260+ before this most recent release.

Surprise surprise, TSLA’s latest report arrived with a dud. Despite record deliveries, they lost more money ($400mm net, $200mm operating); automotive gross margins fell further (to 19%), and they only generated some free cash by liquidating inventory ($400mm+ in the Q) and cutting capex to less than 50% below depreciation (something you never see from ‘growth’ companies). And in case you weren’t paying attention – it wasn’t mentioned in any press release, of course – the CTO, JT Straubel (and a 16yr veteran of the company), is quitting as well.

Of course, you needn’t worry – Musk once again proclaimed TSLA would make a profit in 3Q, and be sustainably FCF generating going forward…just like he said in the last three quarters 😉


Wider Implications

Snark aside, this quarter was quite important for bulls and bears alike, simply in that it demonstrated TSLA remains structurally unprofitable even at its current rate of record deliveries (around 100k a quarter). It’s quite easy to see why: as fast as COGS per unit are falling, ASPs are falling faster. Here is ASPs vs COGS, over the last 6qs:

Screenshot 2019-07-25 11.46.19

Per the above, blended ASP was 70k per car in 4Q but just 56k in this past quarter – hence, the improvement in COGS/unit (53k -> 46k) was more than undone by lower prices. This is a function of changing mix (more lower-priced Model 3s vs less Model Xs and Model Ss) but also something I have written about before – the ASP-destructive price cuts that TSLA has needed to drive volume. Since the company has further cut prices by another 4-5% at least early in 3Q, it is very difficult to see how this changes in the future (once you cut prices for a consumer product to drive volume it is nigh impossible to start raising prices again).

If gross profits – which, by the way, include all ZEV and non-ZEV credits, so I am giving TSLA for benefit for this non-operating high-margin revenue being viewed as sustainable – even remain flat, though, it is impossible to see how TSLA ever generates operating earnings. Because as per the below, despite significant and widely-publicized cost-cutting (‘efficiencies’ to the bulls, perhaps under-investment to the bears) in recent quarters, TSLA is clearly bumping up against the limits of its opex/unit leverage – even when it is delivering record volumes:

Screenshot 2019-07-25 11.52.51

Per the above – opex per unit troughed at just over $11k in 4Q, and is essentially there today, despite all the machinations (closing stores, cutting toilet paper budgets, firing staff, not paying worker bonuses, etc) the company has rolled out this year. And yet back in 4Q, they generated $17k of gross profit per car (hence the profit), versus the $10k today (hence the loss). Since ASPs are still going down (and volumes seem likely to moderate lower as well, despite the price cuts), it is therefore unfathomable to me how TSLA ever makes any money. Yet in today’s day and age, this entity is deemed worth $55bn by the capital markets…

Of course, bulls would posit that this is just the status quo, and that TSLA will continue to grow volumes beyond the current rate. Since, given the evidence, volume growth cannot be accomplished without cutting prices (another pretty obvious conclusion derived from the above and my last blog post), most if not all incremental volume would appear to have come from new models (such as the Model Y), or from China Model 3 demand. But in the former of these cases, unit economics would be highly dilutory from the current situation (since a new model incurs all manner of ramp costs, which the Model 3 launch ramp amply demonstrated), and in any case will not meaningfully affect the PnL until 2021. Meanwhile the China Model 3 volume ramp thesis appears founded much more in fantasy than reality, given that Elon is talking about selling 150k cars a year from the China factory into a market where demand for the car today is barely 40k units a year; where competition is already far higher than any other market they operate in (and is increasing); where government subsidies were massively cut mid this yr (and will tick lower again next year); and where pricing of the local model will not, supposedly, be much lower than it is already (in reality I think they will cut prices massively again if or when the China factory is up and running). Color me skeptical on the China bull thesis, then.

Again, none of this is really revolutionary or even that insightful, and I purposefully avoided getting into the weeds of TSLA’s dodgy accounting in this post, to avoid muddying the main issue, which is this – it is increasingly clear that TSLA is a structurally unprofitable operation, condemned to perpetually chasing volume growth in order to limit the losses it self-imposes by cutting prices to below cost to keep up the illusion of growth.

At this point, there is very little mystery in the fundamentals, or in the mechanics of this operation. The real mystery is why investors continue to support and fund this delusional, dangerous (to conusmers), wasteful (of capital), and ultimately pointless exercise. We live in a time of free money, credulity and fantasy – when the present value of a bullish pipedream drawn from many years hence has never been higher. Figuring out when the market actually cares about the underlying reality – that the dream is over, or more accurately that there was never a true hope of profitability – is the real trick to this investment, and the quest to solve that mystery goes on.

Disclosure: short TSLA












The never-ending story: Netflix and the ever-escalating cost of content

Regular readers will recall I have been following Netflix (NFLX) for many years (I wrote up some initial thoughts on this blog a few years ago), but as the service has grown from ‘challenger’ to ‘near-ubiquitous’, I find myself returning more often to the company, its growth philosophy, and the underlying existential question for any business: will it every be sustainably cash-generative?

This post was sparked by a recent discussion I had with a friend on the topic. More bullishly-inclined, he made the (reasonable) argument that NFLX was smart to swap profits/cashflows for more subscribers today, because once ‘at scale’ the company could trim its content (and marketing) spend and still provide a compelling service – so compelling, he thought, that NFLX could also raise prices substantially. My bearish counter was based upon two points: 1) the benefits of scale from this point have diminishing returns, because a huge amount of incremental content spend is not universal in demand (the incremental subscriber is not invariably a high-paying English-speaker and so needs unique local-language content that in most cases cannot be amortized globally); and 2) even if we granted them point 1) was theoretically possible, the recent history of the company – as it has grown from 50mm subscribers to 135mm in the last 5yrs – has actually demonstrated the opposite property: more incremental spend on content for less incremental benefit, not the other way around.

This second point in particular got me thinking – can we demonstrate, numerically, exactly how much more expensive it has been for NFLX to grow in recent years as the business has expanded beyond its home market (the US and English-speaking markets)? This is something I’ll explore in this post.

How much is a new subscriber worth? The ‘traditional’ method

Let’s start with some basics. For most subscription-based businesses, Silicon Valley types try to measure the value of the proposition by comparing the cost to acquire a new subscriber (‘customer acquisition cost’, or CAC) with the ‘lifetime value’ (LTV) of that acquired customer. CAC is quite easily defined: it is simply marketing expenses dividend by net new customers acquired in the period. This is how it looks for NFLX since 2014 (using TTM numbers to smooth quarterly fluctuations in marketing spend):

Screenshot 2019-07-08 15.55.44

So CAC has increased from <$50 to ~$75/paid member in the last 5yrs – not great, perhaps, but understandable in the context of a largely-penetrated home market that is subject to increasing competition (the US); and more aggressive international marketing in countries where NFLX was less well-known or where OTT TV was less understood (the rest of the world).

Of course, to provide meaning to the CAC, we need to compare it to LTV, since if LTV is similarly increasing, paying a higher CAC wouldn’t really be a problem. LTV, however, is slightly more complex to calculate than CAC, because we need to make an assumption regarding how many subscribers NFLX loses on an annual basis (‘churn’) – a number NFLX conveniently has declined to disclose since 2010. We also need to make an assumption regarding the future earnings power of each subscriber (measured in terms of gross profit per subscriber in a given period).

Still, we can take a shot at it. In the below, I have assumed annual churn is 25% (so just over 6% per quarter); this is actually lower than cable TV churn (around 7% a quarter), despite the fact that NFLX is cancellable any time without penalty, so I would argue this is not aggressive. I have also simply aggregated gross profits (again on a TTM basis to smooth quarterly fluctuations), and as a result LTV (over a similar period) looks something like this:

Screenshot 2019-07-08 16.04.01

You can see that despite the fall-off in LTV in recent quarters, the absolute number (around $180) is still well in excess of CAC ($75-80) – meaning when we plot the all-important LTV/CAC ratio chart, we see that despite the decline of late, growing subscribers still appears to be value additive to the enterprise (even if the pace of recent decline should be of some concern):

Screenshot 2019-07-08 16.07.54

So when measured in the ‘traditional’ way, NFLX’s astounding subscriber growth still appears to be generating net positive lifetime value per customer to the company (uncertainty around churn not withstanding), validating the bull thesis, right? Not so fast…

The increasing cost of content bogey and the need to adjust LTV accordingly

The main problem with the above approach is a conceptual one: once the customer has been acquired (through marketing spend), the assumption is made that – for those customers that don’t churn out – you don’t need to ‘re-acquire’ them – whatever you spent in marketing dollars to get them in the door, that is the total cost to you to keep them on board. But what about the cost of maintaining them as a subscriber? In many software/SaaS businesses (where this methodology originated), that may truly be a very small incremental cost. But NFLX makes no secret of the need to spend exponential amounts of money on new content that – purportedly – drives more eyeballs – but (and this is the key) in reality exists to maintain existing subscribers. I think it’s fair to consider incremental content spend by NFLX as an added cost to maintaining its subscriber base for three simple reasons: 1) not many people watch the same content twice (meaning once consumed, content needs to be replaced); 2) increasing engagement – something NFLX is ironically proud of – increases the velocity of needed content replacement, effectively driving up the maintenance flywheel against the company; and 3) alluding to my earlier point, a lot of the new content being created in recent years has a much smaller intended audience than earlier content (given increasing localization, etc).

In other words, the traditional metric associated with measuring the value of a customer needs to be modified, to account for the excess $$ being dedicated to growing the content pool which – even if amortized over an increasing number of paid users – should nevertheless be thought of as the cost to ‘re-acquire’ the customer, continually, to stop them quitting and going to another service (of which there are now many, and growing).

Here’s how I’m thinking about it. In the traditional LTV calculation, we look at gross profit per subscriber to estimate what the potential value that customer could bring in over its lifetime could be (before he/she churns out). ‘Gross profit’ is essentially average revenue per user (that is, average monthly subscription cost) less the total cost to deliver the content to the customer (the overwhelming majority of which is content amortization, in other words, content production costs spread over a 10yr assume content ‘life’).

But the strict income statement entry – ‘cost of revenue’ – is, as we have discussed, not the only run-rate cost of content to the company: NFLX has been spending more and more on content, in escalating fashion in recent years, and this is reflected in the difference between the content amortization cost in the income state (‘Cost of Revenues’ in the PnL) and the net incremental cash out spent on content costs (in the Cash flow statement).

Pulling it all together from NFLX’s financials, here is the incremental content spend (again TTM for smoothing) over the last five years:

Screenshot 2019-07-08 16.27.51

It’s worth dwelling on the significance of the above. Five years ago, NFLX was spending ~$500mm a year on content than it was currently amortizing; today that number is almost 10x greater ($4.5bn) and they are still guiding to spend more!

Of course, this escalating content spend has come along with massive subscriber growth so we need to relate the increased spend to the enlarged subscriber base. Below, I show the incremental content spend beyond the PnL, on a monthly basis (using the average TTM paying subscriber base as the denominator) – you can see that even on an equalized basis, NFLX is spending >3x the amount on incremental content beyond the PnL, per subscriber, than it was in 2014…

Screenshot 2019-07-08 16.34.02

Coming up with a modified LTV/CAC calculation

Considering the above, I think it’s fairly obvious that we need to modify the ‘traditional’ LTV/CAC metric to account for this increasing cash cost of content (even if it hasn’t made its way into the PnL yet). We can do this simply, by subtracting the incremental content spend, from the gross profits, per paying subscriber (we don’t need to change any of the CAC calcuation, since marketing costs don’t need adjustment). We do this, and voila, all of a sudden (what I would argue) the true LTV/CAC doesn’t look so rosy (including the ‘traditional’ LTV/CAC for comparative purposes):

Screenshot 2019-07-08 16.42.08

I consider the above chart fairly damning evidence against the NFLX bull narrative, as it demonstrates a) the business has essentially been adding negative value subscribers since late 2016 (when content spend really kicked into high octane); and b) the increasingly negative value nature of the proposition has been accelerating in recent quarters.

However if you were a bull, and even if you were willing to acknowledge my methodology had merit, you might push back in some or all of the following ways:

  1. this methodology doesn’t take into account future price increases;
  2. NFLX won’t have to spend current levels on content in the future;
  3. NFLX can increase revenues in other ways (advertising, etc).

Of these, I think 2) is fairly easy to dismiss, since NFLX has avowed publically they will continue to outspend all the competition on content, for the medium-term – and since competition is only increasing (Disney+, Hulu, Amazon Prime video, HBO go, CBS, Apple, etc etc), and since some of these competitors view OTT almost as a loss-leader (Amazon, etc), I don’t think it’s really credible to envisage a world in which NFLX voluntarily cuts content spend (as opposed to one in which the market forces them to slow down spending ). Similarly, 3) is fairly anathema to what NFLX is purportedly trying to create – ad-free high quality on-demand content – and I would expect churn would sky-rocket if they introduced ads onto the platform. And once again, given the competitive landscape, this seems unlikely unless most/all competitors move in a similar direction.

This leaves price hikes. I think the point is a reasonable one, and has been pursued by NFLX historically – the question is really one of scale. Certainly there is scope to hike prices somewhat, especially in developed markets; but NFLX is increasingly an international story (essentially all sub growth comes from outside the US now) where the legacy of high cable bills (and level of GDP wealth) is simply smaller. Today, over half the subscriber pie is international, and with the US mature, this ratio will only grow – limiting, I think, the upper bound of price for the increasing majority of subscribers

Moreover, we still need to question the scale of any price hikes in relation to the escalating content bill. The chart below shows the percentage of ARPU that is currently consumed by incremental content spend beyond the PnL: this number was 10% in 2014 but is nearly 30% today:

Screenshot 2019-07-08 16.57.14.png

That is to say – NFLX could manage to raise prices 30% across the board, unilaterally – and it would still only bring ARPU into line with the escalating cost of content (assuming it stopped where it is, which it won’t). That kind of price increase may be stomachable in the West (even at the cost of a big jump in churn, perhaps temporarily), but it would necessarily price out large portions of the emerging world (that NFLX needs for its growth story).

Where does that leave us?

This has been a long exploration, but I’m fairly confident reiterating my early prognostication: NFLX is an amazing service, but I really can’t see how it will ever generate sustainable free cash flow, let alone an adequate return on capital – let alone a return adequate to justify the current $180bn valuation (!). That doesn’t make it a short (and I’m not), but unless you expect an uber-benign future where NFLX is free to raise prices with impunity whilst reining in the excessive content spend it and its competitors have been enacting exponentially, it certainly doesn’t make it a long either.

Disclosure: no position in NFLX











Tesla’s unit growth, and the art of spurious comparisons

There’s a fairly fundamental concept in most retail industries: the concept of same-store sales (‘like-for-like sales’, ‘equivalent-store sales’, ‘existing-store sales’, etc). This is a pretty intuitive concept, but to recapitulate by example, let’s say I’m a McDonald’s franchisor, and last year I had 100 stores that did $100mm in revenues ($1mm/store), and sold 250k Big Macs at $4 a pop (this is a very minimalist hypothetical McDonald’s :)). That’s great but I want to grow, so let’s say I open another 100 stores. Unfortunately though I over-estimated demand for Big Macs, such that the new stores underperform and draw traffic from my existing footprint (there are lots of other burger joints out there, of course), and I am forced to cut prices on my burgers to $3.5 each to maintain growth in my burger volume (necessary to keep all those grills in the new and old stores busy). At the end of the year I report 350k burgers sold and $122.5mm in revenues – both new ‘records’ for my franchise operation – but clearly a large decline in same-store-sales, and, as a result, profits (I doubled the store count and a huge component of fixed costs but only increased revenues 22%). It’s quite easy in this example to see how revenue growth for its own sake actually destroys value.

Which brings me to Tesla (TSLA), which just reported ‘record’ quarterly deliveries of 95k vehicles, versus the Q4’18 performance of 91k deliveries. Bulls are busy trumpeting this as proof that demand is strong and sustainable; but I think if you break down this theoretical record by analyzing the geographic footprint of where the sales are coming from actually suggests the opposite. Once you realize that unit volume is being driven by a combination of new market entries and price-cutting, it’s pretty clear that TSLA’s unit growth is only so many empty calories.

The analogy to a hypothetical burger chain is not perfect (because TSLA isn’t opening new factories in all of its new locales and therefore doesn’t face the same fixed cost burden on incremental sales), but conceptually it is somewhat instructive. Lost in the bullish headlines this morning is the simple reality that in Q4’18, TSLA was only selling the Model 3 in the US (its core market); by now the Model 3 is available worldwide (with the exception of some very small right-hand drive markets) – tenuously equivalent to opening a vast number of new ‘stores’ to achieve a marginal increase in sales. Instead, if we look purely at the US market, where the Model 3 has been out for the entire year (both 2H 2018 and 1H 2019), the unit performance looks unimpressive to say the least: Model 3 deliveries fell 42% half-on-half in 1H’19 versus 2H’18 (67k vs 116k, per InsideEVs). Incidentally, this half-on-half decline is mirrored in the performance of the Model S (-52% HoH) and Model X (-46%) as well.

In other words, in Tesla’s most mature market – and despite significant price cuts and the introduction of the much lower-priced Model 3 SR+ – unit sales are falling rapidly half-on-half. It is hard to argue there is any seasonality involved, either: since 2014, the average HoH change in US SAAR is negligible (see below), so it’s not as if there is an external reason for the large decline in ‘same-market sales’ in the US:

Screenshot 2019-07-03 10.33.36

Rather, it seems fairly self-explanatory what happened: there was a large, one-time surge in demand last year in 2H, as all the pent-up demand for the Model 3 was fulfilled in 2 voracious quarters; thereafter, run-rate demand (in the US) seems to have moderated to much lower levels, even at lower prices (actually there are still one-time pull-forward effects in the US in 2Q, like the halving of the Federal Tax Credit once again, but let’s leave this aside for now). This is not readily apparent in the gross numbers, because of the aforementioned opening up of new markets. But as we lap 2H’19 comps, and as Europe/China mature in the coming quarters, it will most certainly become much clearer (and signs are already pretty bad re run-rate demand in Europe, especially, as daily registrations have rolled over much faster than was seen in the US).

Thus in recent quarters, TSLA has found itself somewhat in the situation of our hypothetical burger franchisor: wanting, needing to show growth (to defend the stock price) but with underlying unit growth receding in its existing core, having to continuously open new markets, as well as cut prices, to maintain gross unit momentum.

The effect of price cuts should be readily understood, but is something the bulls conveniently ignore. Taking the simplest measure of average selling price (total automotive revenue divided by unit deliveries), TSLA’s ASP’s have been declining fairly consistently over the last 5 quarters (ignoring 2Q for now as we haven’t seen the print yet, though I expend the trend to continue):

Screenshot 2019-07-03 11.13.53.png

While of course a good chunk of this is due to the introduction of the Model 3 progressively from 2Q last year, we also know TSLA has cut prices at least 3 times in the last six months on all its models; and has been known to push large end-of-quarter discounts to clear inventory (as happened in 1Q).  Finally, it demonstrates the futility of TSLA achieving unit growth for its own sake, at the price of ASPs. Consider that in this 2Q, ASPs only declined modestly from 1Q (and thus are around $60k blended), TSLA will have shipped 5k more units than in 4Q’18 – a quarter that was only very marginally profitable ($200mm), excluding subsidies – but at the cost of 5k x ~$10000 gross margin per vehicle, or $500mm in total and thus putting the company back squarely in loss-making territory. That doesn’t sound much like a record quarter, to me…but it is a trick Elon and co will have to repeat, ad nauseam, to satisfy a stockmarket pricing in ongoing aggressive unit growth in the coming years.

Since we all learnt in Economics 101 that demand is a function of price, this all goes to the heart of the bull/bear debate and why the bear position – one I occupy – is so intractable. Any fool can tell you that if you sell Rolexes for $500 a pop your unit growth will be incredible; you’d also be hard pressed to find someone arguing such an idea would be a smart business move. Selling something, anything, of value demonstrably below cost will undoubtedly move units – but to confuse this with creating economic value is borderline insanity. If you are marketing a consumer product that is currently unprofitable (check), that has demonstrably sold its highest ASP products ever (check check) and cannot grow units on a like-for-like basis without cutting prices (check check check), how will it be possible to ever generate sustainable profits (let alone an adequate return on capital)? The market may close its eyes and bathe in the glow of ‘record unit volume’ for a day, a month, or longer, but in the end if the business proposition is unsustainable, the stock will follow.

Disclosure: short TSLA






NIO follow-up: fun and games in the 20-F

Due to the enthusiastic response to my first missive on NIO, I thought I would delight all my fans 🙂 with a quick follow-up post the 20-F (annual report) filing today. Here are my main takeaways; the overarching conclusion remains ‘alarm bells are ringing’ and if anything I think the cash needs at the company are more intense than I first anticipated.

In no particular order, here’s what jumped out at me from the filing (with pagination so you can find it within the doc if you like): –

Capex: they are guiding to $600mm in calendar year 2019, a good deal higher than my baseline $500mm cash burn/qtr run-rate estimated (I had been assuming capex would actually fall a little from last year’s level, $400mm, since they decided to kill the manufacturing plant). In other words, if they hit their capex spend and all other assumptions stay the same, quarterly cash burn is more like $570mm (not the $500mm I anticipated). The nature of the capex, too, seems of questionable value: only $26mm was spent on power solutions/infrastructure for their energy network, with ‘R&D equipment’ being a key expenditure (amongst tooling, office equipment, leasehold improvements, etc). They do not disclose how much R&D they are effectively capitalizing in this way. They explicitly mention that equity/debt financing will be conducted if the proceeds of their convert offering are insufficient to cover capex needs (p113).

Users on their app: I thought the disclosure around their user base was a little…strange. The bulls like to talk about the ‘800k+ community of Nio app users’ as evidence the company has built meaningful scale. Here is the precise disclosure from the 20-F (p. 69): We aim to engage with users and create an environment conducive for user interaction both online and offline. Our mobile application had over 760,000 registered users as of December 31, 2018 and over 190,000 daily active users on peak days in 2018 (my emphasis). Clearly this is not the standard definition of ‘daily active users’ as they don’t even specify the time period (typically this number would be calculated monthly or quarterly with the peak usage only incorporated on this basis). Putting aside how they define ‘active’, though, if they only had 190k users on peak days, who knows what the real DAU number is, 100k? 50k? In any case it is suggestive of a far smaller fanclub than the 800k number bandied about by the sell-side. Anytime the company can’t give you a simple number on a standard metric like DAUs, it’s a concern.

Expensing of points: they disclose that one of the ways they get people to sign in to their app is for ‘Nio Credits’ which can be used to then get merchandise, other discounts, etc. There is one tiny disclosure on the cost of this program (F-19, in the notes to the financials) – they expensed 144mm CNY in 2018 on this program. This constituted the bulk of their Sales & Marketing expense (218mm CNY in 2018). But in any case, these Nio Credits alone meant that they spent $22mm to acquire their app users, oh which they had only 190k active on ‘peak days’ and thus, assuming 50-100k real DAUs, customer acquisition cost (CAC) from this cost line item alone is $220-440. This seems incredibly high…especially as it takes into account only a tiny part of the brand-building expenses actually being incurred (Nio Houses, etc).

JAC manufacturing fees/cost absorption: they disclosed a total of 223mm CNY payments to JAC, their manufacturing partner, in 2018 – broken down as 97mm CNY of manufacturing fees and 126mm of loss reimbursement. This equates to 8k CNY of manufacturing fee per unit prouction (fixed per vehicle), and 17k of loss reimbursement per unit. The most interesting thing about this is that they had accrued 65mm of loss reimbursements as of end June 18 – meaning 60mm CNY or so of losses related to 2H last year. This is a problem because it means their outsourced manufacturing solution is still unprofitable even with higher volumes (25k annualized run-rate production in 2H’18) and suggests they will be gross margin negative for 2019 as well (lower volumes on ES8, ramp/higher costs on the new model from 3Q).

Reservations: they stopped disclosing ES8 reservations in the filings (this was mentioned on the conference call at 4Q earnings) so not a surprise but there is nothing written down about ES6 reservations in hand either. These were specifically discussed on a conference call, and ES8 reservation numbers formed a meaningful part of the (written) IPO narrative. Furthermore the rationale given on the call for stopping disclosing ES8 reservations was that the vehicle was already in production. But that clearly doesn’t apply to the ES6, so why the unwillingness to put reservation numbers down on a formal filing? Are they suffering many cancellations? Are they worried about getting in trouble with the SEC?

Employees: this one really needs an explanation. In the detailed discussion of why expenses were up so much in 2018 vs 2017 (p108), they say an increase in the number of our research and development employees (including employees of our product and software development teams) by approximately 75% from 2017 to 2018 was one of the main factors. The only problem is according to their own disclosures later in the document, R&D employees only went up by 14% yoy (from 3052 to 3492) – that doesn’t sound like ‘approximately 75%’ to me. Overall employee numbers did skyrocket (+40% yoy to around 9800) but the vast majority of these were in ‘Sales, marketing & service’ – ie customer facing roles, which, primarily in China, you would think garner only a fraction of the salary of engineers. Notably, the overseas R&D employee numbers – where a bulk of the very high comp would theoretically sit – didn’t change that much (844 vs 724, so +16% yoy).

I am not sure if this is a big deal or not – but I was already concerned they were massively over-spending on R&D and now it appears they are at the very least unintentionally saying they’ve hired a ton more engineers than they really have. Who knows where the spending is really going – but if the reported numbers are to believed then average R&D employee salaries went from $49k to $79k in a single year, while average company-wide salaries went from $41k to $62k (+50% yoy, not bad)…and remember this is almost all in cash, stock comp was but a very small part of total comp (just 7% of total opex).

So all in all, many more yellow flags and not much to really assuage my worries that they will hit the market for another $1bn+ in cash as soon as practicable. Clearly stock has rallied (my timing is always impeccable ;)) but still a high conviction short.

Disclosure: short NIO

NIO: this will end in tears

Forget where the stock has come from and the fact that it is already down 50% from the highs. NIO (NIO, listed on the NYSE), the recently-listed Chinese BEV name, is a hype-driven, cash-incinerating JOBS-act IPO that may qualify as the best poster child for ZIRP’s distortionary capital allocation effect when the history books get written years from now (great blog here on this topic by the way). In the meantime, it’s a great short because it has no moat, de minimis brand, competes in the world’s most crowded EV market, has a structurally high-cost model that is a big competitive disadvantage longer-term, has disclosed weaknesses in internal controls along with black-box cost accounting and a number of other oddities, and will suffer badly from just announced cuts to Chinese EV subsidies. However, you can throw that all out if you like and just focus on the main thing: NIO is a cash-incinerating machine par excellence: since founding barely 4yrs ago they have run up $5bn in accumulated deficits, are currently burning around $500m PER QUARTER, and have no clear path to profitability in the near-term. The scale of the cash burn is such that they had to rush out a convert offering to raise $700mm, just 3mos after the IPO raised $1bn…relying on the artificially-inflated stock price during the pre-lockup period. This prompted numerous lawsuits (the bonds have since cratered with the stock) but the upshot is now, no matter what, they need to come back to market for another $1bn in 6mos (or sooner), such is the scale of their cash burn (I judge they’ve already burnt most of the convert cash they raised).

So to my mind you have multiple ways to win with this short. If China blows up, this gets crushed and/or disappears (luxury auto highly sensitive to the macro economy). As or when they run out of cash, there is a real chance there will be a ‘run’ on the company, perhaps by its suppliers (working capital is already massively negative), the Chinese banks (who are already significant lenders) or as the market realizes the US-listed paper is worthless. Or they simply need to come back to market in 6mos and raise another $1bn at whatever price the market is willing to bear (hint – its not a $5bn EV for a company burning $2bn cash a year). The convert window is now closed (given what happened recently, the extant bonds now trade at 9% yield) so that option is gone. It is hard to say what downside is in this market; I think the shares are worthless but a realistic target this year is still closer to 1x revenue I feel, so >60% downside from here.

The stock is incredibly liquid and borrow is readily available at 2%, so this is actionable for most investors. This writeup will focus on three main points (yes my wife is a management consultant):

– NIO is a bad ‘business’

– Cash burn rate is so intense it trumps everything else

– Accounting oddities/other yellow flags


Nio is structurally a bad ‘business’:

Perhaps lost in the IPO hype (until recently) were some of the more glaring structural impediments to NIO’s long-term success. What I mean by that is, NIO looks and feels like an automotive OEM but actually it is a different kind of business model: they appear to take on half the characteristics of a capital-intensive, operationally-geared auto company, but at the same time they defer to outsource key parts of the business. For example, they purchase all their own raw materials, they build their own tooling; and they design the vehicles – but they don’t actually manufacture their own cars. Rather, JAC, a government-owned ‘third-tier’ (sell-side assessment) OEM manufactures their vehicles for them, on a contract basis, at their own factories, using their own workers (supervised by a much smaller number of NIO managers).

This is a fairly strange arrangement, to put it mildly. I am not sure anyone noticed this in the IPO docs, but NIO agreed to reimburse JAC for any operating losses suffered in the first three years of operation – opening NIO up to potentially being on the hook for an escalating burden if demand doesn’t scale with JAC’s production capacity – and perhaps more importantly, they have agreed to pay JAC a fixed, per-vehicle fee to produce each car. They don’t disclose what this fee is, but my rough estimate is somewhere around 10-15k CNY per car – which, when you consider the ASP of their one model launched so far (the ES8) is only 430k, constitutes perhaps 3% of ASP and so a very significant headwind against scaling gross margins.

Thus, for all intensive purposes they take on many of the downside characteristics of a capital-heavy business – they still carry raw materials, tooling and inventory; they still have operational exposure to low utilization of their partner’s production lines – but without as much of the upside (due to the fixed per-vehicle fee). Perhaps this is why the business, small scale though it is, exhibited less than expected operating leverage at the gross margin line in the most recent quarter.

There are other aspects of NIO’s offering that appear troubling. Clearly they operate in an (already) very crowded market, and they have no infrastructure/charging advantange. According to NIO’s own IPO docs, there are already 15 different BEV cars on the market in China today, driven (until recently) by generous subsidies and forcing NIO into a small niche of an already small market – this number is likely to double in the next year or so as new models continually enter the market. I am bearish on TSLA, but if you were to cite perhaps the two strongest elements of the bull case for TSLA you would suggest the lead they have in the US on other BEVs (essentially no competition in the mass market, for now); and also its market-leading supercharger infrastructure network. NIO, however, very clearly has no proprietary charging network (they make it clear they rely on public infrastructure), and instead have invested in battery swapping points in strategic locations to enable drivers to conduct long drives from, say, Shenzhen to Shanghai. Upon closer examination, however, the prospectus discloses the total cumulative investment in battery swap locations and facilities was only $10.3mm as of June 2018 – hardly suggesting a sustainable competitive advantage over time. Perhaps proving this point, services revenue – of which battery swapping is a part – has remained de minimis even as deliveries have ‘ramped’ over the last couple of quarters.

OK, so sub-optimal production model, no moat and plenty of competition. What, then, has NIO actually spent its money on? Well, other than two arguably cool-looking SUVs, they have progressively hired swathes of engineers, all over the world – despite a purely China focus both today and in the future. The company has discrete ‘R&D centres’ in Silicon Valley, the UK, Munich, and China – four different R&D locations despite no overseas businesses or ambitions, and having sold a total of only ~10k cars or so (as of Dec’18). These overseas locations, by the way, are no one or two-man outposts: Silicon Valley has 560 employees (8% of company total at time of IPO) across two offices; Munich has 170 (90% of whom are engineers); and the UK has over 33 (at least spread over two offices, London and Oxford). I am not really sure why a domestic Chinese company with no brand nor ambitions beyond China needs to spend oodles of money to hire expensive engineers all over the world – it seems superfluous and unnecessary at best and there is a nefarious explanation at worst. . Otherwise, they are spending a lot of $$ on brand building, for example by developing an app to market the ‘NIO lifestyle’ and have opened a number of ‘NIO houses’, basically a combination of showroom/health club/daycare centre in Chinese cities to credentialize the aspirational nature of the brand. So far all this has generated a grand total of 11k deliveries and maybe another 15k in reservations…so colour me skeptical.

In any case, its worth keeping in mind just how much they are spending in absolute dollars: in the year leading up to the IPO, NIO spent 6.1bn CNY – around $900mm – in total opex, of which basically half was R&D. By way of contrast, when TSLA IPO’d – at a similar stage of development with zero automotive revenues – they spent $50mm in R&D that year and ~$65mm in total opex, or 1/13th the number. Hmm…note also that >90% of these expenses are cash expenses – perhaps not surprisingly, only a small % of compensation has come via stock options/RSUs, and so there are real cash consequences to all these hires – again, this is a bit unusual for a venture-stage company, in that normally equity/non-cash comp is (in my experience) a good deal higher than 5-10% of total opex. Maybe all those new hires don’t want company stock because they don’t think it’s worth anything?

This is probably the right time to mention that this is a Chinese JOBS Act IPO, listed in the US, not China (#thechinahustle) with an admitted uncured failure in internal controls – so alarm bells should be ringing. But let’s come back to that point later. The main point for now is that a huge amount of R&D and SG&A spend is on salaries, is cash-based, and, therefore, very close to fixed costs (per the prospectus, 40% of R&D and SG&A, respectively, were for salaries). They have continued to hire with abandon, as recent disclosures suggest the employee count is up to 9k (versus 7k at the time of the IPO, last September). Even if the topline eventually grows, these fixed costs necessarily limitt the ability to scale profitably such that I think they would need to sustainably sell 100k units/yr to generate operating profits…

It’s worth mentioning at this stage the most recent regulatory changes (announced yesterday). Basically, the Chinese government cut subsidies on EV purchases for cars with a range >250km (ie, including NIO’s two models) by 50%, after a transition period; including the elimination of some local subsidies, the total subsidy amount will decline say 65%, increasing the cost of the average car by around $5k lets say (against NIO’s ES8’s current ASP of $67k, so this is pretty meaningful). This is bad, of course, but its not as if NIO was selling many cars before this cut so while I don’t think it helps I also don’t think the thesis rests on the macro here at all. Instead, this thesis is all about cash burn…


NIO is incinerating cash at an amazing rate:

The main reason I like this trade – and even if you think they have a shot at building a viable brand, or like the car, or whatever – is because even if that happens eventually, they will need to raise so much $$ in the meantime that supply/demand in the stock alone is likely to send the price lower from here. Consider the following:

– NIO has burnt >$5bn in 4+ yrs of operation, ie >$1bn/yr on average;

– they burnt $1bn (my estimates) in its first two quarters as a public company, just after raising $1bn in the IPO – cash burn is increasing because of the aforementioned big increase in hiring and cash nature of those expenses;

– the accelerated burn rate forced them to raise ANOTHER $700mm in convert debt before the IPO lock-up expired (with no new disclosures as it was an overnight deal), that was promptly followed by a guidance cut;

– Q1/Q2 delivery guidance implies at least $500mm/qtr in further cash burn and gross cash today (allowing for the convert but before 1Q cash burn) is maybe $1.9bn.

In other words, assuming nothing changes, by June 30th – we are already half-way there – gross cash should be below $1bn, ASSUMING no deterioration in working capital (which has blown out to negative $500mm due to a big spike in payables and accruals in the most recent quarter) which seems at least partially likely given the elevated levels in Q4 and the guided big sequential decline in revenues. In reality we should see at least some normalization of working capital which would imply gross cash well under $1bn – ie less than 2 quarters of runway from there – and, with subsidies going lower in 2H, no guarantee that orders/deliveries/demand will ramp.

Since they still owe the Chinese banks 3bn CNY, or $450mm, I think the minimum cash balance they would allow would be at least $500m (given how Chinese banks like to be collateralized by cash, cf TSLA), meaning realistically NIO may be operating with barely 1 quarter’s worth of cash, run-rate, as soon as mid-summer. Clearly that would precipitate a hugely dilutive offering of – I think – at least $750mm-$1bn, basically at any price the market would accept (in my view, much lower than $5). This is likely to be in the context of souring EV-related demand more generally (as I think TSLA well and truly cracks by then) and since NIO will very much be a price taker, I cannot see how they can pull the same trick twice (essentially using the hype to raise capital at the wrong price) since the convert deal bombed so very badly. We have seen how the stock took the advent of IPO lock-up related selling recently; how do you think it will react to a price-insensitive further $1bn in stock being pushed into the market?


Other accounting yellow flags:

I don’t want to spend too much time on the conspiracy theory (though I have alluded to it slightly throughout the writeup). Suffice to say you also have the following going for you on the short side:

– this is a JOBS act IPO;

– the IPO disclosed material weakness in internal controls in both 2016 and 2017, that may or may not have been fixed (not mandatory because of JOBS act IPO provisions);

– this was a Chinese co IPO’ing in the US, raising new money from offshore, mostly US/European institutions and not domestic onshore Chinese investors;

– the only non-Chinese executive, Padsmaree Warrior, quit the board shortly after the IPO;

– the founder, Bin Li, has no experience in automotive manufacturing or indeed any manufacturing (his previous venture, Bitauto, is an ecommerce business);

– the $ value of PP&E, considering that the company does not have its own factory, seems very high ($550mm) and there is minimal disclosure around what is capitalized here versus expensed;

– ditto for the R&D expenses (other than salaries), there is minimal disclosure and no idea why the $$ amounts are so high relative to other start-up auto companies;

– the co shoves a lot of standard payables into ‘Accrued and other Liabilities’ (things like payables for R&D, salaries, accrued expenses);

– standard onshore/offshore VIE treatment for ADR owners (essentially you own nothing of the onshore assets), so if anything goes wrong, you’re more screwed than usual (par for the course with Chinese ADRs).

In other words, I am not saying this is another China fraud, but the conditions clearly exist for it to be a fraudulent enterprise, defrauding offshore investors to the benefit of Chinese entrepreneurs. I don’t think you need it to be a fraud to win, however.

Disclosure: short NIO