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

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