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Why Nio Stock Is Quite Risky

Luke Lango

It’s been a rough year for Chinese luxury-electric-vehicle maker NIO (NYSE:NIO). In 2019, Nio stock  price has dropped about 40% – versus an 18% gain for the S&P 500 – amid a deceleration of auto sales in China, a sharp reduction of China’s EV subsidies, and the sluggish growth of NIO’s EV sales.

Why Nio Stock Is Quite Risky

Source: Shutterstock

But Nio stock has shown surprising signs of life over the past month. From an early June low of roughly $2.40, NIO stock price has rallied around 47% over the past near month to levels just shy of $3.90.

Why the huge reversal of Nio stock price? A few simultaneous, positive developments have sparked a powerful rally by a depressed stock.

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The biggest question is: will this dynamic persist? That”s tough to say. There are a few tailwinds for Nio stock on the horizon. There are also a few headwinds on the horizon. Meanwhile, looking at the big picture, the long-term fundamentals of Nio stock are good, but not great. For Nio stock price to rise tremendously  a few tough-to-believe assumptions will have to be proven correct.

So investors shouldn’t be fooled by the recent rally of Nio stock price. It could be the start of something much bigger, but that’s probably not the case. Investors would be wise to wait for more clarity before buying Nio on its strength.

The Rebound Will Face Headwinds

The big rebound of Nio stock over the past month has been powered by a few things.

First, NIO’s U.S. counterpart, Tesla (NASDAQ:TSLA), reported much better-than-expected second-quarter delivery numbers, which broadly reaffirmed that the global EV growth trend remains alive and well despite sluggish early 2019 demand due to lower EV subsidies in the U.S. and China. Second, the U.S. and China agreed to a trade-war truce at the G-20 Summit. Third, the  rally of the U.S. dollar has stalled over the past month. Fourth, in June China’s auto sales grew year-over-year for the first time in 12 months.

The problem is that most of these tailwinds won’t last. The Tesla bump is in the rear-view mirror. The market is already largely pricing in a trade deal. The U.S. dollar could cool off going forward, but that’s a relatively weak positive. China auto sales bounced back in June, but that was powered by heavy discounting which isn’t expected to continue.

Thus, the tailwinds which have powered the strong rebound by Nio stock price over the past month will fade over the next few weeks. As the catalysts fade, this rebound will run into headwinds.

Specifically, China is slashing its EV subsidies at the same time that China’s auto market is contracting  and China’s economic expansion is slowing. Ultimately, that is likely to create an unfavorable EV sales backdrop for NIO. It also suggests that Nio’s  2019 numbers won’t be great.

By failing to post great 2019 numbers, NIO could short-circuit this rally of NIO stock. As a result, this rebound does not look sustainable.

Betting on  Nio Stock Over the Long-Term Is Highly Speculative

Nio stock does have a potential route to huge gains. But that route is unclear and uncertain.

NIO is exposed to two mega-trends: Chinese urbanization and the EV revolution. Those two mega-trends will unfold favorably over the next several years. As China’s middle class continues to expand and urbanize, China’s auto market will continue to grow.

Meanwhile, as the government continues to promote EV adoption, China’s EV market will expand its share of the growing China auto market. Consequently, China’s EV market will grow by leaps and bounds over the next several years.

NIO is a small player in that market, as it captured less than a 1% share of China’s EV market last year. As a smaller player, the company stands to be one of the bigger losers as the China government phases out EV subsidies. Further, NIO sells luxury vehicles, so its addressable market is inherently small. More competition is also arriving, and that’s a negative for NIO’s long-term growth trajectory.

Given these trends,  NIO’s market share probably won’t increase by much over the next several years. At best, NIO’s market share will reach 5% in a decade. More realistically, it won’t exceed 2%. Assuming  25% of vehicles sold in China are electric by then, NIO’s vehicles retail for roughly $50,000, its gross margins hover around 20%, and its operating-spending rate is about  10%, then NIO’s profits will likely hover anywhere between $500 million and $1 billion in a decade.

Based on a forward price-earnings ratio of 16, which is average for the market, and a 10% discount rate, that means that the valuation of Nio stock today should be somewhere between $3 billion  and $6 billion, depending on its market share in a decade. At this point in time, the lower end of the spectrum feels more likely, given the current subsidy reductions and forthcoming competition.

The Bottom Line on Nio Stock

The recent strength of Nio stock could be the start of something much bigger. But, at this point in time, the long-term bull thesis on NIO simply lacks credibility and evidence. Until it gains credibility (likely through a 2019 sales-volume ramp that is above and beyond expectations), NIO is best avoided, given its highly risky and speculative nature.

As of this writing, Luke Lango was long TSLA.

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