BYD: Don't be fooled by its "mask"!

As of the second half of 2024, after the latest round of financial reports, the extent of devastation among the new energy companies covered by Dolphin is unparalleled, even compared to other Chinese concept stocks. With Tesla leading the pack, companies like Li Auto, Leapmotor, and others in the new energy vehicle sector have almost been wiped out, and even BYD, which has always had a dominant gross profit margin, has not been spared.

In particular, BYD's lagging single-car prices, declining gross profit margins, and dwindling profits... at first glance, it seems that no matter how many more units it sells, it cannot escape the curse of the competitive "red ocean".

However, if you are willing to spend more time focusing on BYD and dig a little deeper, you will find that BYD's path in the new energy vehicle industry is not entirely the same as that of its peers.

In Dolphin's view, its uniqueness lies in its "bone structure," which is the most strictly vertical integration. In other words, while the declining gross profit margins of others are real declines, BYD's gross profit margin, which has fluctuated from the beginning, is to some extent due to the "mask" brought about by its vertical integration "framework". So:

1) What exactly is this "mask"?

2) By uncovering the mask, what is the true nature behind BYD?

3) How does this affect investment decisions?

This article, as a derivative discussion of the previous in-depth analysis "BYD: The Final Battle!" and the recent financial report interpretation "BYD: Struggling with Upscale, From King to Mediocrity?", will focus on how the excessive and rapid capital investment cycle under the heavy asset layout of vertical integration distorts the profit performance of asset-heavy companies, and how to assess the true profit capability and investment value of such companies.

1) BYD: What is the mask? It's just a mismatch between the heavy asset investment period and the depreciation period

For many people who follow BYD closely, a mystery may be why BYD's gross profit margin has always followed its own trend: it didn't rise when others did in the beginning, it didn't fall when others did later, and now it's falling when others are recovering.

The answer to this question, which is difficult to quantify and calculate with just the brain, is undoubtedly the scale advantage of sales volume, the first-mover advantage in hybrid technology, and so on. To this kind of answer, Dolphin can only say: correct but useless And this time, from a quantitative perspective, Dolphin will provide another idea. When a heavy-asset vertically integrated company invests heavily in capacity expansion for a period of time and combines it with the distortion of accounting amortization policies on the company's profit data.

Why is the analysis of capital expenditure and depreciation changes particularly important for BYD? Dolphin will briefly explain to everyone, and you will understand that for any company, to generate revenue, you must first invest, and pies will not fall from the sky.

As we all know, different financial treatment methods for expenses are different. Internal recruitment and external advertising to attract customers, user subsidies, these are generally directly included in current expenses. However, for fixed assets that can be used in the long term and intangible assets such as purchased copyrights, although a large amount of funds are paid at once, they can be gradually included in the cost and expense side.

This is a common practice that everyone knows and accepts, but the issue here is that for some more extreme companies, it will significantly distort the company's profit changes, for example:

Pinduoduo once complained during a conference call that the accounting policy was unreasonable when they were aggressively spending on marketing expenses. Their marketing expenses are essentially capital expenditures because they are spending cash in the current period, but can create long-term benefits in terms of user stickiness and brand awareness, so it is essentially an expense that should be amortized, and the results have indeed proven this.

If Pinduoduo considers marketing expenses as a capitalized expenditure (Capex: Capital expenditure) that should be treated as an operating expense (Opex), then BYD is a case where Capex expenditure is too high, and the capital expenditure cycle and amortization depreciation smoothing cycle are out of sync, leading to profit distortion.

Looking at the chart, Dolphin divides the cost of BYD's cars (including batteries) into amortized fixed costs and other variable costs. By removing the amortization cost, you will find that the trend of BYD's car gross profit margin after removing the amortization cost deviates significantly from the gross profit margin trend shown on the company's financial statements at two points: one is the first half of 2023, and the other is the first half of 2024. Both of these points show a decrease in the reported gross profit margin, while the actual gross profit margin (after removing the amortization cost) is rigidly increasing.

Dolphin retraces the reasons, and one very obvious problem is the change in depreciation rate: starting from 2023, the company changed the depreciation period for some production lines such as batteries from five years to three years, leading to a significant increase in the depreciation rate. This means that even with sales volume support, the depreciation per vehicle in the first half of 2023 is still significantly higher than in the second half of 2022, with no scale effect in depreciation showing up, and it is still accelerating in the first half of 2024.

Another reason is the mismatch between the peak period of capital expenditure and the peak period of depreciation: From the second half of 2021 to the end of 2023, BYD started to rapidly increase its fixed asset investment (expanding capacity of existing projects) and investment in projects under construction. By 2024, the new energy market began to visibly experience overcapacity, leading to a significant slowdown in BYD's investment in projects under construction and fixed capital.

Although BYD's capital expenditure has slowed down, the impact of the investment wave initiated in 2021 on profits will only fully manifest in 2023 and 2024. This is because the cumulative full amount of investment from 2021 to 2023 has entered the period of depreciation, causing the depreciation expense to increase rapidly.

In 2024, assuming that the average original value of fixed assets in the first half of 2024 is the same as in the first half of 2023, even with the increased depreciation rate, the depreciation expense in the first half of 2024 would be nearly 8.9 billion less. This 8.9 billion drag will reduce the net profit margin by approximately 3 percentage points in the first half of 2024! This means that the increase in fixed asset original value is the real reason affecting the gross profit margin in the first half of 2024.

The high increase in depreciation expenses is not only reflected in the absolute amount but also in the weight of this expense in BYD's (costs + three fees) overall expenditure structure. If we exclude variable costs such as raw materials, and only consider the three internal expenses of sales, research and development, and administration, the depreciation expense is already approximately half of the total of sales and R&D expenses, reaching around 30 billion every six months. With such a large absolute value that continues to rise, it can only be diluted by a sufficient number of sales, or in other words, these production capacities must have a high utilization rate and the output must be sold to generate actual sales revenue.

Looking at the single-car economy in recent half-year periods, in 2022, due to the release of BYD's sales volume and the early stage of the company's rapid production expansion, the absolute value of depreciation expenses per vehicle decreased every half year, supporting the gross profit margin.

However, after 2023, the depreciation expense per vehicle showed a month-on-month increase because as the cumulative value of fixed assets increased and the depreciation rate rose, the high sales volume could not offset the increase in depreciation expenses, and the depreciation cost per vehicle was basically used to drag down the gross profit margin In this situation, the driving factor for the gross profit margin of a single car becomes whether variable costs such as raw materials can decrease in the same proportion when the price of a single car decreases. If they cannot decrease in the same proportion, the profitability of a single car will be further affected by additional expenses, inevitably leading to a decrease in the gross profit margin.

2) Unveiling the true nature behind BYD's gross profit margin

If you still don't quite understand the explanation above, at least one conclusion that can be drawn is that the gross profit margin on BYD's financial statements is deceptive due to depreciation and investment cycles. Other new energy vehicle companies should carefully analyze their gross profit margins when compared to BYD, as their gross profit margins may be misleading.

So, what are the real issues that need to be studied behind the scenes? In the view of the Dolphin, they mainly revolve around the following questions:

a. Is the acceleration of depreciation passive or active?

b. How much longer will the capital investment cycle last?

c. What is the expected future capacity utilization rate, i.e., the asset turnover rate?

Below, the Dolphin provides its assessment of these three questions:

a. Is the acceleration of depreciation passive or active?

Regarding the first question of whether the acceleration of depreciation is passive or active, the Dolphin tends to believe it is passive, meaning that it is only more confidently done when there are sales.

This is mainly because, with the rapid iteration of battery technology under the 4C technology, the capacity originally arranged around the long blade is affected by the need to update capacity due to slow charging and discharging speeds, which affects the service life. However, with a three-year reduction, the Dolphin believes the risk is basically locked in. A three-year period equates to a depreciation of 33% per year, which is already sufficiently secure compared to the depreciation rate of around 20% for peer companies like CATL.

b. How much longer will the capital investment cycle last?

1. From the perspective of fixed asset purchases, fixed asset purchases have significantly slowed down. In the first half of 2024, fixed asset purchases were only 13.1 billion, and the ratio of fixed asset purchases to revenue dropped from around 13% in the first half of 2023 to about 4.3% in the first half of 2024.

2. Looking at the changes in construction in progress, both the addition of new construction in progress and the conversion of construction in progress to fixed assets showed a clear downward trend in the first half of 2024.

In terms of new construction in progress, the previous intensive additions to construction in progress began in the second half of 2021 and continued until the end of 2023, corresponding to the intensive investment period in BYD's automotive and battery capacity.

Considering BYD's current capacity planning (for specific battery and automotive capacity planning, please refer to the previous article: "The Price Butcher Can Still Make Big Profits, Why is BYD Ready to Fight Against All Odds?" -），By 2023, the domestic passenger car production capacity has reached 4.7 million units, which is more than sufficient for BYD's target of 4 million units this year. The current passenger car production capacity under construction is 1.97 million units (of which Dolphin King is expected to add 750,000 units of car production capacity in 2024, a significant decrease from the 1.6 million units added in 2023), totaling at least 6.6 million existing and under-construction capacities to meet passenger car demand until 2026-2027.

The battery production capacity is even more exaggerated: by the end of 2023, it is around 450 GWh. Even considering factors such as many factories operating multiple shifts, it has already significantly exceeded Dolphin King's estimated actual demand for Freddie batteries from internal and external customers. With the proportion of externally supplied batteries in total battery shipments not increasing significantly, the existing capacity of Dolphin King is expected to meet battery demand at least until 2027. It is expected that the pace of subsequent battery production capacity under construction will continue to slow down.

Looking at the trend of fixed asset conversion from projects under construction, the conversion reached its peak in the second half of 2023 (accounting for an average of 104% of projects under construction), but it slowed down significantly in the first half of 2024. The amount of project conversion in progress was only 13.8 billion, accounting for a decrease to 35% of the average project under construction, showing a clear downward trend.

In an extreme scenario where BYD does not add new projects under construction, based on the current balance and conversion progress of projects under construction, it may take approximately 1-2 years to complete the conversion of all projects under construction.

In the first half of 2024, there is a clear downward trend in both the decrease in fixed asset purchases, the addition of new projects under construction, and the conversion of projects under construction. Looking at both battery and car production capacity, the current and future capacities under construction are sufficiently abundant (Dolphin King predicts a significant decline in new energy vehicle/battery production capacity under construction in 2024). It seems to imply that BYD's proactive investment in vertical integration has reached a temporary conclusion in this round.

c. What is the expected future capacity utilization rate, that is, the ability of asset turnover?

This question has now evolved into a study of sales and demand. As analyzed in the previous article "BYD: The Final Battle!" , Dolphin King believes that the key for BYD in the second half is to use sales in the mid-to-low-end market under the layout of vertical integration to increase market share and improve capacity utilization rate Dilution and amortized cost. The sporadic price reductions across various series of the company indicate that this is indeed the current strategy.

Moreover, with a current gross profit margin advantage of over 20%, compared to many other companies with negative gross margins or struggling to break even, it does have the ability to launch a dimensional attack.

3) How does this affect investment decisions?

By now, we should understand why the market's reaction to BYD's gross margin performance is sluggish, but sensitive to sales volume. It's because the company had previously invested too much capital too quickly, and the only way to improve asset turnover is through explosive sales growth. When sales volume morale declines, the punishment of vertical integration is doubled.

In this scenario, how should we evaluate the investment value of BYD? Before addressing this question, let's first discuss the potential impact of amortization factors on short-term performance:

Looking solely at the second half of 2024, as fixed asset investment has begun to slow down, Dolphin Jun will follow the trend of the first half of the year. The depreciation rate of fixed assets has been steadily increasing since 2023, indicating that BYD has adopted accelerated depreciation for fixed assets. We make two assumptions regarding the depreciation rate of fixed assets in the second half of the year:

① Fixed asset depreciation rate remains the same as the first half of 2024, at around 16.1%

② Fixed asset depreciation rate continues to increase by about 1% every half year, rising to around 17.1% in the second half of the year.

Looking at the revenue perspective, with the certainty of the DMI 5.0 new product launch in the second half of the year, we estimate sales volume to reach 4 million units for the whole year, representing a 48% increase compared to the first half of the year. The scale effect in the second half of the year will be unleashed.

The launch of DMI 5.0 from low to high prices, as well as the expected increase in overseas market share, are both expected to raise the average selling price in the second half of the year. Dolphin Jun predicts a 52% increase in car revenue in the second half of the year to 347.8 billion, and a 43% increase in total revenue to 429.5 billion.

We have tested the impact of these three assumptions on the revenue side (i.e., the profit side). Due to the slowdown in fixed asset capital expenditure in the second half of the year, the release of scale effects, and the increase in unit prices leading to total revenue growth, it is expected that the proportion of fixed asset depreciation to total revenue will decrease by 1.7-2.2 percentage points compared to the first half of 2024. In other words, the depreciation of fixed assets in the second half of the year, compared to the first half of 2024, can still help restore the gross profit margin by around two percentage points.

In the second half of 2024, as long as BYD progresses normally towards its sales targets, its gross profit margin can still see a slight recovery.

Looking at the long-term perspective, the impact of capital expenditure and depreciation on the financial statements mainly manifests in two aspects:

1. Due to the slowdown in capital expenditures leading to a slower growth in subsequent amortization expenses, and the release of economies of scale brought about by the increase in sales volume, the proportion of amortization expenses to revenue is expected to peak in the first half of 2024, followed by a downward trend year by year, leading to the release of profit on the financial statements.

2. Performance Observation: When sales volume is established or clearly defined, focus on the cash-based core profit, which is the core operating profit based on income - costs - three fees - asset/credit impairment/asset disposal gains. Also, pay attention to excluding amortization expenses to calculate a cash-like operating profit, to observe the company's true operating profit trend.

3. Look at the distorted real operating profit adjusted for amortization and capital investment, which is based on the above cash-based operating profit, then remove capital expenditures to see how much real retained profit can be distributed to shareholders.

Based on the current performance trend, Dolphin Jun's inference shows that BYD's real cash-based profit turning point has arrived, with the slowdown in capital expenditures in the second half of 2024, real cash-based profit is starting to turn positive. Dolphin Jun previously stated in "BYD: The Final Battle!" that only when real profits start to be released, BYD will have real retained earnings for continuous shareholder returns.

BYD's investment logic is gradually shifting from a growth logic to a leading company with shareholder return logic in business certainty. Growth funds may exit, but after the turnover is completed, value funds will also find BYD attractive.