One of the problems with a name like Nio (NYSE:NIO) stock is that there are seemingly no good answers. Take the bullish view, and you’re betting on a stock that’s already soared and now looks awfully expensive. Take the bearish side, and you’re joining a camp that has been far too conservative throughout the rally.
Personally, I’ve done both. It was only 18 months ago that I argued that NIO stock could hit zero. That analysis wasn’t necessarily wrong, given that Nio actually was late in paying salaries in February. It would take a dilutive capital raise, the moving of the company’s headquarters, and subsequent equity offerings (one below $6 per share) to get the company’s balance sheet fixed. But in hindsight, obviously the rewards were easily worth the risk.
Earlier this year, meanwhile, I argued that NIO stock looked like the best play in electric vehicles, albeit while expressing some skepticism toward the sector as a whole. At the time, NIO had rallied about 230% year-to-date. NIO now has gained an incredible 1,157% so far in 2020.
At this point, I’m ready to tiptoe back into the bearish camp. The issue is not so much the magnitude of the YTD rally. Nio stock deserved to soar. Again, balance sheet issues are fixed; the company closed the third quarter with more than $3 billion in cash. Delivery and revenue growth impressed. Nio has rightly won back the confidence of investors.
But there are real risks here, combined with a valuation that is sky-high by any measure. Skeptics, myself included, were wrong so far. That doesn’t mean they, and we, will be wrong forever.
Not Just Valuation
There are two ways to look at the seemingly insatiable appetite for growth stocks in this market. The first is to believe that there’s a bubble, or something close, going on. Between the Federal Reserve setting interest rates at essentially zero and the pandemic plus zero-commission trading bringing a new wave of retail investors into the market, fundamentals are out the window. And so this rally is unsustainable, and destined to end like the dot-com bubble of the late 1990s or the housing bubble of the mid-2000s.
The second is to view the focus on growth as logical, or at least mostly logical. There are massive trends at play in the worldwide economy, with the shift to electric vehicles one of the biggest. Meanwhile, the performance of past winners – multi-decade stretches of double-digit annualized returns – suggests that the market historically may have underpriced growth.
Put another way, the market is assigning massive valuations to unprofitable companies like Nio not because the fundamentals don’t matter, but because the future fundamentals are better understood. The market might actually be smarter than it’s been.
I’m actually somewhat sympathetic to the latter viewpoint. The fact that analysts are assigning price targets of 10x 2022 revenue to NIO stock on its face seems illogical. Given the size of the opportunity, however, it might not be. If Nio has decades of growth ahead of it, as may well be the case, 10x out-year sales at the least is not as crazy as it sounds. It could even, from a long-term perspective, prove to be cheap.
Two Key Risks
The issue from my perspective is not that Nio has risen 12-fold so far in 2020. It’s not that it’s unprofitable. It’s not that near-term multiples are much higher than those historically applied to growth companies.
Rather, it’s those factors combined with two key risks. The first is profit margins. Auto manufacturing is not a hugely profitable business. Nio is not an exception, particularly given that the company still doesn’t manufacture its own cars.
Nio itself projects gross margin of just 15 to 20%. Marketing and operating expenses will eat up much of the remainder. This is a company already valued at nearly $70 billion. It will take hundreds of billions of dollars in annual revenue to support that valuation plus acceptable annual returns going forward.
Maybe Nio can get there. The Chinese EV market will be worth a couple of trillion dollars someday. (It’s worth noting, however, that the country’s total gross domestic product for 2020 should be “only” about $15 trillion.) But the second key risk here is competition.
Nio obviously is going up against Tesla (NASDAQ:TSLA). But there’s also XPeng (NYSE:XPEV) and Li Auto (NASDAQ:LI). Established in-country firms like BYD (OTCMKTS:BYDDY) moved swiftly and successfully into EVs as well.
Between margins, competition and valuation, it certainly looks like perfection, or close, already is priced in.
NIO Stock Keeps Rising
Indeed, analysts raced to upgrade NIO stock after a strong third-quarter report last month. But even the raised price targets suggest modest upside from a current price.
Of course, this pattern plays out over and over again. TSLA provides a perfect example. The stock looks expensive. Performance stays strong. Wall Street races to catch up. The stock keeps rising.
The pattern, almost by definition, can’t continue forever. At some point, the rallies at least need to slow. I can’t help but believe that we’ve reached that point with NIO stock. But I, and many others, have been wrong before.
On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article.
After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.