I have written about capital structure arbitrage – trading the stock and bonds of one company against each other if the prices don’t make internal sense – previously with regard to Peabody Energy when it was about to file for bankruptcy (see here). I commented at the time that the equity price seemed insanely overvalued relative to what the debt was pricing in, and that the likely event path going forward suggested no value for the stock; Peabody subsequently filed for bankruptcy shortly thereafter.

Many on this blog will know I have been vocally bearish about Nio (Nasdaq: NIO), the Chinese EV player, having written it up here and here as a short. I remain extremely bearish on the company’s stock (at $1.7/shr right now, or a $1.8bn market cap) for many reasons – not least of which is the implied mispricing as evidenced in the capital structure of the company. Regular readers will know I am a ‘credit guy’ and generally consider the credit market to be more sophisticated than the equity market – simply put, many equity investors just don’t understand the signaling effect the credit market can often send about a distressed company, and that can provide an advantage to those who do. Now, when I see the kind of gargantuan misalignment between a company’s stock and bonds as we currently see with NIO, it really gets my juices going.

To take this further, consider the below abbreviated NIO capital structure (as of Jun’19, last reported financials, with adjustments to take us to Sep’19):

There are a fair few numbers here but I have tried to highlight the important ones. The main concept is that since the convertible holdco bonds trade at 27% of face – clearly a highly distressed level, implying imminent default (this is only 1.5yr paper at this point) – the market-implied EV through the bonds is around 3.5bn RMB (so call it $500mm USD) while the same measure implied through the equity – given the stock still sports a 12bn RMB ($1.8bn!!) market cap – is around 20bn RMB (call it $3bn USD). Simply put, the equity market is telling you the company is worth 6x, and $2.5bn in absolute terms, the value the debt markets think its worth…hmm.

Of course its not unusual to find inconsistencies between debt and equity pieces in a cap structure in a distressed situation – but I am hard pressed to recall any example as extreme in my multi-decade investing career. Putting the two competing market-implied cap structures side by side may help demonstrate how gargantuan this divide really is (note I have removed cash to show only the gross EV as easier to compare, it does not change the thrust of the analysis however):

You’ll see that the equity view of the world – the left hand bar – suggests the equity component is worth a staggering 60% of the gross EV of the company (incredibly high for a corporation exhibiting this level of distress – normally it would be under 20%); meanwhile the implied debt value (opco + holdco) through the equity view of the world is basically double that implied in the market.

So what to make of all this? Which view is correct? Well, no surprises for guessing I think the bonds have it more right than wrong, but I think there are a few other factors at work:

– the bonds are ‘busted converts’, likely largely sold to convertible arbitrage (ie, volatility) funds who owned them for their exposure to the underlying stock. Since, however, the stock is so much lower than the convert strike price (double digits, essentially impossibly far away), there is clearly no equity option value left and so the natural owner of these bonds has dumped them as credit quality and option value has dissipated. They have become extremely illiquid, and this may be depressing their price (relative to the equity).

– the bonds are also structurally subordinated – meaning you own only a claim against the offshore holding company (‘holdco’) that doesn’t actually house any of the operating/tangible assets of Nio China – rather, you simply have a ‘guarantee’ that the onshore (ie, in China) profits, and assets backing those profits, protect your security interest in the bonds (there are no profits here clearly, but you get the concept!). Of course this applies to the ADR stock as well – but creditors are likely to have a much deeper understanding of the limits of that ‘guarantee’ than equity speculators, since creditors need to think about these risks – the quality of a guarantee from one affiliated entity to another – as part of their daily craft. Stock investors typically don’t think about these things.

– the stock is a low-priced, highly-liquid instrument (trading >$50mm a day) and has become a favorite of day-traders and short-term speculators who likely care little (or don’t understand) the onshore/offshore divide, and the structural subordination, that offshore creditors seem to appreciate.

– since the company is effectively out of cash and needs to be recapitalized, the offshore creditors appear to realize that – with the only rescue financing a likely Chinese government entity – there is little or no incentive for the Chinese to make offshore foreigners whole when all they are really trying to do is keep the onshore operations going. In other words, creditors comprehend that a Chinese SOE won’t care one iota about the holdco bondholders (and, thus, by extension, ADR shareholders), and so ultimate recovery is likely to be very low.

– we are also dealing with an information vacuum from a recalcitrant management team that abruptly canceled the (heavily delayed) 2Q earnings call only to reinstate it under protest – a management team that will still neither confirm nor deny if the recently announced $200mm converts have closed. The lack of transparent communication is likely affecting creditors’ perception of the likelihood of imminent distress than that of equityholders (for now).

How does it all end? I speculated back in March that this story would end in tears, and I’m sticking by that conclusion. The onshore operating entity – Nio China – may end up getting recapitalized with new Chinese money, and thus remain operating for now – but it is very difficult, almost impossible, to see how that is a value-additive event for offshore money (both bonds and stock). The amount of $$ needed to recapitalize NIO China – well in excess of $1bn, to cover another 6mos of cash burn; Chinese opco bank debt; recall costs; and working capital normalization – is simply far too high to then throw in another $2bn of value to allow NIO ADR shareholders a return justifying the current price of the shares.

This is something the bond market appears to have figured out, and priced in appropriately. As for NIO stock? Not yet. But it will.

Disclosure: short NIO