Li Auto: What's Really Behind Massive Beat?

Unraveling the Ideal: Is the "Ideal" Really That "Ideal"?

Ideal Motors (LI.O) released its second-quarter earnings report for 2023 after the Hong Kong stock market closed and before the US stock market opened on the evening of August 8th, Beijing time. At first glance, Ideal's performance was outstanding across the board, but it is precisely this kind of performance that is most likely to deceive retail investors. Let's take a look at the key information:

1. Impressive Gross Margin in Q2: The gross margin of the automotive business in the second quarter performed well, reaching exactly 21%. The market's expectation was around 20.6%. Although the average unit price per vehicle decreased to 323,000 yuan, the decrease in fixed costs due to increased sales volume and cost reduction in materials resulted in a significant improvement in gross margin, with the unit cost per vehicle reduced to 255,000 yuan.

2. Sales Guidance in Line with Market Expectations: Ideal expects to deliver 100,000 to 103,000 vehicles in the third quarter, which is in line with market expectations. After delivering 34,000 vehicles in July, it implies a monthly delivery volume of 35,500 vehicles in August and September. Considering that Ideal's vehicle models have completed the entire transition, based on the previous monthly delivery volume growth trend, it is expected to be achieved without obstacles. However, it is already operating at full capacity, so there is limited room for exceeding delivery expectations in the future.

3. Limited Upside Potential for Gross Margin Implied by Revenue Guidance: The company's revenue guidance is between 32.33 billion and 33.3 billion yuan, implying an average unit price of about 317,000 yuan. Compared to the second quarter's 323,000 yuan, it continues to decline. This implies either an increasing proportion of low-priced vehicles, a high proportion of new models priced 30,000 yuan cheaper after L9, or some price reductions and concessions in the third quarter. In any case, it basically suppresses the imagination of a significant increase in gross margin in the third quarter.

4. The Demand Issue Behind the Higher-than-Expected Sales Expense Ratio: Ideal's ability to control expenses was evident in the past, but this quarter's sales expenses reached 2.3 billion yuan, a 40% increase compared to the previous quarter. The increase in sales volume in the second quarter was mainly achieved through improved efficiency of individual stores. With the slow expansion of stores in the second quarter and no major new car releases, the sales expense ratio did not decrease significantly due to the amplification of revenue. This raises the question of whether a portion of the high sales volume was achieved through increased marketing expenses, or in other words, even for Ideal, demand is not so rigid.

Dolphin's Overall View:

If we look at the performance itself without considering the implied performance requirements in the stock price valuation, Ideal's performance can be described as explosive. Whether it is on a year-on-year or quarter-on-quarter basis, it is clear that during this transition from ONE to L in the car replacement cycle, although there were some setbacks, Ideal's rapid adaptability and strong organizational capabilities perfectly resolved the crisis, making it the undisputed leader among domestic new forces in the automotive industry.

However, when the stock price reached $45, the importance of marginal changes in the future far outweighed the performance itself in terms of aligning with pricing logic.And it is precisely in the marginal positive aspect of performance that Ideal's current state indicates that it has reached the peak of its growth cycle. However, there is not much room for further short-term growth beyond this peak, or the risk-reward ratio may not be as favorable. In such a situation, a price correction for Ideal's stock is reasonable.

The following is a detailed analysis:

As Ideal announces its sales on a weekly basis and with monthly deliveries already disclosed, the stock price has already been fully priced in after continuous surges. Even in recent trading days, there has been speculation about the performance exceeding expectations. Therefore, the marginal information from this performance is crucial and needs to be scrutinized with a magnifying glass.

The most significant marginal information includes: 1) Second-quarter gross profit margin; 2) Outlook for the second and third quarters.

1) Gross profit margin surpasses 21%, making money while generating buzz in the second quarter

It is a fact that Ideal's cars are selling well, but the key question is whether they are making money behind the buzz. Looking at the realization of the gross profit margin, the answer provided in the second quarter is resounding: there is both buzz and money.

In the second quarter, Ideal's automotive business achieved a gross profit margin of 21%, surpassing the market's and Dolphin's expectation of approximately 20.6% from foreign banks. It is approaching the 22%+ level seen during the peak sales period of the Ideal One.

Next, let's examine which factors contribute to the gross profit margin of individual cars through the scale effect:

1. Increased sales volume of L7 with a decrease in average selling price per car

In the second quarter, the average selling price per car was 323,000 yuan, 25,000 yuan lower than the previous quarter. Among the vehicle models, the pricing of the L7 and L8 Air versions decreased by 20,000 yuan, which significantly boosted sales volume. However, the increase in the proportion of lower-priced L7+L8 models in the product mix put downward pressure on the average selling price per car.

2. Decrease in per-car cost due to material cost reduction and dilution of depreciation

In the second quarter, Ideal's per-car cost was 255,400 yuan, 24,000 yuan lower than the previous quarter. Although Ideal does not disclose quarterly depreciation and amortization immediately, assuming it to be 400 million yuan, Dolphin will attempt to analyze the cost reduction effects brought by variable and fixed costs separately:

a. Looking at the amortization of depreciation expenses of 400 million yuan, the increase in platform capacity utilization in the second quarter diluted fixed costs, contributing to a 0.5 percentage point increase in gross profit margin compared to the first quarter.

b. The scale effect brought by increased sales volume, along with the reduction in material costs such as lithium carbonate, corresponds to a MoM gross profit margin boost of approximately 0.7%.

3. Although the revenue from bicycles decreased by 1,000 yuan, the advantage lies in the high sales volume.

In terms of profitability, the ideal gross profit for selling a bicycle in the second quarter is 68,000 yuan. Although it is less than the previous quarter, the decrease in unit price has led to a surge in sales volume. As a result, both the overall gross profit margin and the profit margin have increased. The overall gross profit margin for selling bicycles has increased from 19.8% in the previous quarter to 21% in the second quarter.

(Note: The data on the gross profit margin of automobile sales after deducting 800 million yuan in contract losses in the third quarter of last year)

II. Performance guidance for the second and third quarters, good but with hidden concerns

Although the second-quarter performance of the ideal company seems impressive, the market is not fully convinced based on the pre-market capital flow, and one important reason is that the implied gross profit margin expectation in the guidance is not particularly good.

a) Automobile sales: 100,000-103,000 units, good but within expectations

Due to the weekly adjustment of the buyer's sales expectations, while the seller's expectations are already outdated, when the ideal weekly sales reach 8,000 vehicles, the market capital has already priced the ideal stock price based on NIO's monthly sales of 35,000 vehicles in the third quarter and a delivery price of 35,000-40,000 vehicles in the fourth quarter.

Therefore, when the ideal company gives guidance of 100,000-103,000 units (in July, the ideal company has already achieved a delivery volume of 34,000 vehicles, implying a monthly delivery volume of 35,500 vehicles in August and September), it can only be said that the performance is strong, but it is already expected and priced, without any surprises.

With the current weekly sales already at 8,000 units, the future delivery elasticity mainly depends on production capacity, which can only be gradually expanded. Whether the target delivery volume of 40,000 vehicles in the fourth quarter can be achieved depends on the production capacity expansion plan. Overall, even if the demand is strong, the upward elasticity of the ideal company's deliveries this year is limited.

b) Implied gross profit margin expectation from unit price is not good

As we know, once the automobile platform is established, the range of gross profit margin for automobiles is already determined, and the only change is the pricing at the time of sale.

The ideal company's revenue guidance for the third quarter is 32.33 billion to 33.3 billion yuan, with other revenue accounting for about 2%. The unit price corresponding to the third-quarter guidance is about 317,000 yuan, which is significantly lower than the market expectation of 328,000 yuan.

Looking at the sales structure, the proportion of L7 with lower prices in the second quarter has reached 40%, and the unit price in the second quarter was 323,000 yuan. Based on the sales distribution weights of 15,000 units for L7 and 10,000 units each for L8 and L9 in the third quarter, the weight of the lower-priced L7 is only two percentage points higher than that of the third quarter, but the implied unit price in the guidance has decreased by 6,000 yuan.Unless the dimension of consideration is the decline in lithium ore driving down prices, the magnitude of this decline seems to imply that the gross profit margin in the third quarter may not be as good as market expectations.

After all, such a decline either means that Ideal has made certain price concessions to expand sales, or that the actual sales volume of L7 is higher than the current market expectations. In addition, there will be the release of the L9 Pro on August 3rd, with a price reduction of 30,000 yuan. These factors will exert certain pressure on the improvement of the gross profit margin in the third quarter.

Taking all these pieces of information together, we can understand why Ideal's performance this quarter has declined after the positive news has been realized. From the perspective of marginal changes:

a) There is very limited room left for sales volume to exceed expectations;

b) The guidance for the third quarter implies that the gross profit margin is not good;

c) The favorable impact of extended-range models is approaching its end, while more efforts are still needed in pure electric vehicles - investment in charging networks and the development of new vehicles (the complete delivery cycle of the MPV model to be launched in the second half of 2023 will be in 2024, and the expected increase in delivery volume is limited due to the high unit price).

Given the high stock price, Ideal's performance guidance for the third quarter implies an average gross profit margin, and profit-taking can also be understood. Of course, the key is to see how Ideal will guide the gross profit margin in the conference call.

III. Operating leverage release falls short of expectations

In addition, besides the seemingly flawless performance of Ideal this quarter, there is also a flaw: the release of operating leverage is not as perfect as expected.

At the current stage, Ideal needs to invest funds in the development of pure electric platforms and pure electric models. Although R&D expenses have exceeded market expectations, it is not surprising to Dolphin that R&D expenses have increased significantly.

What Dolphin believes is that the main reason for the release of operating leverage falling short of expectations this quarter is sales expenses. After all, in the market's expectations, sales expenses, especially those that need to be diluted by selling more.

Moreover, in the second quarter, Ideal did not open many new stores, but the average monthly sales volume per store increased significantly compared to the first quarter, which should have led to a significant dilution of sales expenses.

However, sales expenses in the second quarter reached 2.3 billion yuan, which is close to 100 million yuan higher than the already high market expectations, with a sales expense ratio of 8.1%, which did not meet Dolphin's expectations.

This inevitably makes Dolphin ponder a question: For Ideal's explosive sales volume, the market's original judgment was that the demand was too good to meet supply. But in the second quarter, without any major new car launch activities, why were sales expenses so high? Is there a possibility that Ideal conducted relatively large marketing activities to stimulate sales, resulting in actual price reductions, but more of it was recorded as marketing expenses?

If this logic is true, and considering the downward trend in car prices in the third quarter, it seems that the gross profit margin in the third quarter has not made the progress expected by buyers, and it is still being cleaned up. However, this logic is not favorable for Ideal's stock price.Any judgment of performance should be based on the implied performance delivery expectations in stock trading. Therefore, the ideal performance mentioned by Dolphin is also based on this logic. It may be nitpicking, but if the expectations are set too high, every corner should be carefully examined.

However, if we overlook these issues based on the implied expectations in stock prices and focus on the quality of the ideal performance itself, the company is undoubtedly the hope of China's new automotive forces, without a doubt. Let's take a look at the aspects that make competitors envy and jealous:

IV. Sales Outperforming Competitors

Through this complete transition from supply-driven to demand-driven industry contradictions, coupled with the company's own vehicle replacement cycle, Ideal has proven to be the most execution-oriented player among the new automotive forces. With the founder's background in Autohome, Ideal has a deep understanding of user needs and has achieved greater success in the single-car explosive model. Ideal's differentiated product competitiveness is achieved through extended range and clear product positioning.

1) Strong Sales: In the second quarter, Ideal delivered a total of 87,000 vehicles, exceeding the previously guided range of 76,000 to 81,000 vehicles by approximately 6,000 vehicles.

Ideal's differentiated product competitiveness, achieved through extended range and clear product positioning, has led to continued sales growth. After the complete delivery of the L7, L8 Pro, and Max versions in April, as well as the entry-level L7 and L8 Air versions in May, the product transition from Ideal One to the L series has been almost completed.

V. Leading the Pack

Based on the already announced sales figures, Ideal's total revenue in the second quarter was 28.65 billion yuan, mainly due to higher unit prices than expected.

Among them, automotive sales revenue reached 28 billion yuan, with a year-on-year growth of 230%, driven by both higher unit prices (up 9% YoY) and increased sales volume (up 202% YoY). Although the low base in the same period last year was due to the impact of the pandemic on Ideal's vehicle sales, the YoY growth rate indicates the successful transition from Ideal One to the L series.

VI. Improved Profitability, but not Significantly

Ideal's net profit in the second quarter reached 2.3 billion yuan, which is significantly higher than the previously recorded net profit within one billion yuan. However, Dolphin is not particularly concerned about this figure, as many of these profits cannot be judged as sustainable non-operating income.

On the heavy-weighted operating profit front, the absolute value increased from 330 million in the first quarter to 1.51 billion in the second quarter, which is quite good but not particularly outstanding.

The operating profit margin increased from 1.8% in the first quarter to 5.3%, which is lower than Dolphin's original estimate of 5.5%. Looking at the core, although the gross profit margin was relatively high in the second quarter, the leverage of operations, both in terms of research and development and sales, was not ideal.

7. Continuous Investment

In addition, the operating cash flow in the second quarter performed strongly, reaching 11.1 billion, but capital expenditures increased compared to the previous quarter, and free cash flow reached 9.6 billion.

Behind the lower free cash flow compared to operating cash flow lies the success of Ideal's ambitious plan. The pure electric journey has just begun, and the investment cannot be stopped:

1) Stepping into 2023, compared to its peers, Ideal needs to make up for the shortcomings in pure electric vehicles, including infrastructure such as pure electric vehicles and charging piles, as well as capital investment in capacity expansion. This may have a certain impact on performance. At the same time, as the prices of pure electric vehicle models decrease and the battery costs increase, there may be a risk of continued decline in Ideal's profit margin in the later stage.

The company will launch a brand-new pure electric MPV model (code-named Whale 1) in the second half of 2023, entering the pure electric track. The expected price of the first pure electric vehicle model is about 460,000 to 500,000 yuan, which will be produced in the Beijing factory. The planned production capacity is currently 100,000 vehicles, and the complete delivery cycle will be in 2024. However, this expensive pure electric vehicle model is expected to contribute limited delivery volume.

The L platform plans to launch a smaller-sized L6 model, with an expected price lower than 300,000 yuan, to seize market share in the price range of 200,000 to 300,000 yuan with cost-effectiveness advantages. Compared to the price range of 300,000 to 500,000 yuan, the 200,000 to 300,000 yuan range will face a broader market and more diverse car purchasing demands, but it will also face more intense competition and lower profit margin levels.

Ideal started relatively late in the field of pure electric vehicles. Although entering the pure electric track will increase delivery volume, the high battery costs of pure electric vehicles may drag down its gross profit margin compared to extended-range vehicles.

4) Both charging and research and development need to catch up: In order to catch up with pure electric competitors who already have a first-mover advantage, Ideal needs to invest heavily in research and development to build the product strength of pure electric vehicles. At the same time, it needs significant capital investment in charging pile infrastructure. Faced with potential strong demand, the implementation of automobile production capacity becomes particularly important. Ideal also needs to invest capital in expansion plans, which may have a certain impact on future performance.

Currently, in terms of research and development, Ideal has its own 800V high-voltage pure electric platform and 5C-rate battery. In terms of charging network layout, by the end of this year, Ideal will complete the construction of more than 300 supercharging stations, and by 2025, there will be more than 3,000. However, compared to Xiaopeng's 816 self-operated supercharging stations and NIO's 1,337 self-operated supercharging stations, Ideal's number is still insufficient.In terms of production capacity, according to markline data, Longbridge currently has two production bases. The Jiangsu Changzhou base is expected to have a capacity of 400,000 vehicles, while the Beijing base is temporarily planned for a capacity of 100,000 vehicles (for electric vehicle production). Further expansion will be needed as sales of pure electric vehicle models increase.