NIO - My Thoughts On NIO After Visiting A Tier-2 And Tier-5 City In China

2023-04-10 13:15:43 ET

Summary

• A recent trip to China after the country reopened for tourism gives a glimpse into how rapid NIO's presence has grown in the five years since SOP.
• Conversations with prospective buyers in the two diverse economic regions also highlight key barriers to EV adoption in China which NIO is well-positioned to address.
• The stock has likely sufficiently de-risked at current levels for both company-specific and macro-driven challenges in the near-term, with execution of longer-term growth initiatives key to waking a sustained rebound.

We recently had the opportunity to visit a tier 2 and tier 5 city in China after the country reopened for tourism. The observations allowed us to juxtapose EV market opportunities across two segments of China’s diverse economy. To better put into perspective the economic differences of the two tiers, one boasts a significantly larger population with asset valuations almost 5x higher than the other. A brand-new condo development in a tier 5 city costs about RMB 4,300 ($625) per square meter, or about RMB 400 per square footage. Meanwhile, a brand-new condo development in a tier 2 city costs about RMB 25,500 per square meter, or about RMB 2,360 per square footage. This means in a tier 5 county, a decent sized condo can be purchased for about $100,000 with change, while the same amount would barely make a downpayment in a tier 2 city.

With EVs largely still viewed as a luxury given its price imparity with ICEs, they remain largely absent in the lower-tier economic zones. When asked about EVs, the population in the tier 5 city we had visited would largely link the term with electric bikes and scooters instead of passenger cars. Admittedly, rapid economic development across China over the past decade has benefited the lower-tier economic zones, nonetheless, as evidenced by the dominance of passenger vehicles over electric bikes and scooters this time around compared to when we had last visited almost a decade ago. Critical infrastructure access – like toll highways – connecting the lower- and higher-tier economic zones have also been a key driver of wealth creation, and inadvertently, a transition in the dominant form of transportation from bikes to cars. Yet, battery electric and plug-in passenger cars remain a next level luxury, with mass market ICEs like those offered by Nissan ([[NSANY]], [[NSANF]]), Toyota ( TM ) and legacy BYD ([[BYDDF]], [[BYDDY]]) being the dominant choice still among the population residing in lower-tier economic zones.

Meanwhile, in the higher-tier economic zones like the tier 2 city we had visited, EVs represent a meaningful mix of the passenger car fleet on the road – about a quarter to a third of cars observed in parking lots are likely plug-ins, consistent with the average EV penetration rate reported by recent data from the China Passenger Car Association. But to our surprise, Tesla ( TSLA ) viewings were not any more frequent than its local born peers, with BYD’s newest electric offerings being the clear market leader. In fact, Tesla’s reputation among the population residing in the tier 2 city we had visited remains largely mixed, with many citing safety concerns and fickle pricing as main reasons for abstaining from the brand.

In NIO’s ( NIO ) case, the premium EV maker clearly commands a fair share of its target market, with prominent sightings of the brand’s SUVs across all parking lots – malls, restaurants, homes, etc. – and on the road, indicating a reasonable demand environment in higher-tier economic zones consistent with management commentary from recent earnings calls. The diverse observations we had gathered from recent visits to the tier 2 and tier 5 cities have reinforced a few thoughts – namely, the importance of NIO’s upcoming launch of the mass market sub-brands to improve penetration in lower-tier economic zones, the key of ramping up its sedan offerings to compete for share against rival premium offerings in the ongoing ICE to electric transition, and the business’ capital-intensive nature that will continue to weigh on profitability within the foreseeable future.

NIO in Tier 2

NIO has largely focused penetration into the more affluent tier 1 and tier 2 cities across China in recent years, with its premium SUV offerings holding a double-digit penetration rate in those regions across both the ICE and electric segments:

NIO's penetration in the Tier 1 and the Tier 2 cities in China has been growing at a much faster pace. In Shanghai, the first half of this year has witnessed our penetration in the premium SUV segment, reaching 13.7% among all ICE and the electric vehicles…This is already quite high and we have already achieved this in the Tier 1 city. So we believe this is a very good indicator for our next step to penetrating into more markets in different cities.

Source: NIO 2Q21 Earnings Call Transcript

Consistent with observations in our latest visit to a tier 2 city in China, the bulk of NIO sightings remain SUV-heavy. Specifically, sightings of the recently introduced ET7 and ET5 sedans built on the higher-margin NT 2.0 platform were rare, and primarily concentrated in areas near the NIO studio. The first implication that comes to mind is that the ramp up of new demand for more recent sedan models potentially remains moderate, consistent with the relatively subdued EV market this year considering the lingering impacts of macroeconomic uncertainties and competition from lower-priced premium equivalents offered by market leader BYD. To our surprise though, sightings of NIO vehicles were no less than Tesla in the tier 2 city we had visited, potentially suggesting high concentration of Tesla vehicles in certain Chinese cities and an overall deceleration in market share gains by the EV pioneer in China.

The observations corroborate our understanding of NIO’s resilience, nonetheless, among stiff competition within the increasingly crowded EV landscape in China, alongside other macro-driven and industry-wide challenges like the modest post-pandemic recovery and lingering supply chain constraints. Despite a modest rebound in recent consumer spending, both industrial output and investments – critical to buoying GDP growth – remain subdued based on recent economic data, with gradually slumping automotive sales.

In addition to vehicle observations, we had also come across multiple NIO Swap stations and witnessed swift battery swaps in action, with efficient turnover to alleviate concerns of long wait times for the multi-car line-up. However, the NIO House studio we had come across was not as busy as expected. Marketed as an experience center aimed at bringing together a broader NIO ecosystem with sales of merchandise, food and drinks alongside, of course, its vehicles, the store was not any more busy than other in-mall showrooms installed by its EV peers. This indicates the costly lifestyle narrative, which big tech companies like Apple ( AAPL ) have successfully benefited from and NIO has been trying to replicate still needs some work.

However, our inquiries to several acquaintances that have test driven NIO vehicles were largely positive on the experience, including appreciation for the ride’s comfort and other in-vehicle technology features. Many have also pointed out the low cost of ownership as a plus, with less frequent trips to the service center for costly maintenance. There were only minor NIO-specific complaints, like how the placement of its NOMI in-vehicle smart assistant is awkwardly placed on the dashboard and somewhat in the way of the driver’s view of road conditions, unlike seamless integration of other in-vehicle smart assistants like BYD’s “ Xiao Di ” into the infotainment screen. But the main setback for pulling the trigger on EV purchases remain on restricted range capability relative to ICE vehicles, and the lack of public charging infrastructure availability.

With ICE vehicles still dominating the roads, and a set of tools and offerings in the pipeline to address some of the key roadblocks to adoption among prospective buyers, NIO remains well positioned for further market share gains among the more affluent economic zones. Specifically, NIO continues to demonstrate commitment towards the build-out of conveniently accessible charging solutions, including the recent “deployment of the third-generation Power Swap station” capable of serving more than 400 swaps per day, as well as accelerated expansion of its network with plans to “install 1,000 Power Swap stations in 2023”. We view the continued build-out of Swap stations across the country as a key driver for reinforcing demand by addressing key roadblocks to EV purchases facing prospective buyers, which would inadvertently complement NIO’s continued production capacity production efforts (e.g. NeoPark) over the longer-term and benefit margin expansion via economies of scale.

Importance of Mass Market Sub-Brands

Moving on to observations in the tier 5 county we had visited, EVs in general remain the minority on roads, which is not surprising given the high price of EVs. Although there are many more cars than electric bikes and scooters on the roads compared to a decade ago when the county was less connected to highways bridging critical city centers across China, the preference for EVs is low.

Despite the attractive less-than-$5,000 price tag on the Wuling Hongguang Mini , many residents of the tier 5 county shook their heads when asked if they would consider buying an EV as their next car, citing the lack of supporting charging infrastructure in the county. Admittedly, electricity is significantly less costly than gasoline in the region and the low total cost of EV ownership is generally attractive for those who reside in the lower-tier economic zones. And the Hongguang Mini makes an affordable option, with its range capability sufficient to address the travel needs of those residing in lower-tier economic zones, given their low exposure to long cross-country road trips. But with public charging solutions being harder to come by in most lower-tier economic zones, it makes even the highly affordable Hongguang Mini a hard pass, with many preferring mass market priced ICE vehicles instead.

Yet, these stories imply a significant opportunity for NIO as it prepares for the launch of its two lower-priced sub-brands aimed at gaining EV market share in the less penetrated tier 3 and below economic zones. With a growing volume of new condo developments in lower-tier economic zones to accommodate families that are moving out of the rural slums into the urban economic hubs, NIO faces an immense opportunity for expanding its network of public charging infrastructure to those areas. This is also consistent with management’s strategic build-out of its market share in lower-tier economic zones by focusing on the deployment of public charging infrastructure instead of vehicle showrooms or experience centers:

When it comes to the expansion into the sub-tier cities, we're not talking about the deployment of the NIO houses or NIO spaces. We believe that the more efficient way is to deploy the power swap stations in the sub-tier cities.

Source: NIO 4Q22 Earnings Call Transcript

And with the upcoming launch of two lower-priced sub-brands to better compete against its mass market priced ICE rivals, NIO is positioned to benefit from share gains among one of the most eager spending segments across China in coming years. Specifically, consumption across lower-tier cities are expected to triple in the decade leading up to 2030 from $2.3 trillion to $7 trillion, thanks to “lower living costs” in said regions, which is key to driving population growth, and inadvertently, demand. Improved “infrastructure connectivity” between the lower- and higher-tier cities as observed in our recent trip to the tier 2 county is also a key driver for EV TAM expansion in favour of NIO’s mass market ambitions.

Tier 3 and below cities currently account for more than a third of China’s population, and even converting a small number of the segment to electric would mean significant EV TAM expansion on the horizon still in the country. With the post-pandemic recovery in China currently underway, NIO’s planned start of production for its sub-brand vehicles next year will likely coincide with fresh demand from lower-tier economic zones. And again, incremental demand volume will be key to enhancing economies of scale in the company’s newly expanded production capacity at NeoPark, thus alleviating margin pressure associated with NIO’s capital-intensive growth investments over the near- to medium-term.

The Bottom Line

NIO’s ongoing growth initiatives likely remain years out from ramp-up to scale, making it clear its profitability in the near-term will continue to be less attractive relative to global peers like Tesla and BYD. The continued challenge of moving forward with capital-intensive investments to ensure adequate capitalization of longer-term market opportunities also sheds persistent uncertainties on NIO’s timeline for achieving GAAP-based profitability. But considering NIO’s observed progress in establishing the brand’s awareness and presence across China so far, alongside opportunities ahead as it scales volumes in its core tier 1 and tier 2 target markets, and readies for penetration in the budding tier 3 and below markets, the company’s longer-term prospects in the ongoing electrification of transportation remains optimistic.

Even with incremental consideration for lingering macroeconomic headwinds and persistent geopolitical and regulatory challenges facing Chinese equities, the stock likely remains undervalued at current levels as investors remain risk-off on capital-intensive and unprofitable investments amid the persistently uncertain macroeconomic backdrop. Based on our latest forecast for NIO, taking into consideration its first quarter deliveries and recent developments in the Chinese EV space, even a conservative perpetual growth rate of 1.5% at NIO, which is below the currently projected GDP expansion across its core markets and projected EV TAM expansion in China and globally to reflect its still modest market share, would be sufficient to drive upside potential towards at least $17 apiece – almost doubling returns from current levels.

NIO_-_Forecasted_Financial_Information.pdf

Admittedly, NIO’s capital-intensive business and unprofitable state does not bode favourably with China’s shaky post-pandemic recovery, potentially subjecting the stock to further volatility in the near-term. Ongoing regulatory and geological risks facing the broader cohort of Chinese investments will also remain a drag on NIO’s optimal valuation prospects relative to its global peers in the west. However, NIO’s continued progress in penetrating new market share and capitalizing on demand opportunities across China’s segmented economy remains supportive of a recovery in the stock from current levels. Looking ahead, we remain focused on consistent developments pertaining to NIO’s mass market sub-brand offerings, public charging infrastructure build-out, and production ramp-up to scale as key drivers to restoring investors’ confidence in the stock.

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