In the previous in-depth article about BYD "Price Butcher Can Still Make Big Profits, Why Can BYD Fight Against All Odds?", Dolphin Jun discussed the advantages of deep vertical integration, especially in self-developed and self-produced batteries, as well as the cost-driven vertical integration technology choices that bring BYD a gross margin advantage.

The following article focuses more on the business choices of vertical integration itself, strategic thinking in the latter part of the integration, and based on this, attempts to understand the certainty of BYD's future business and valuation.

In this article, Dolphin Jun's analysis of BYD mainly revolves around the following key questions:

1. Is BYD easy to replicate? Is there a second BYD?

2. The latter part of vertical integration in electric vehicles: Lowering prices to gain market share, dividends, or smart car vertical integration?

3. How to understand the valuation of BYD?

Below is the main content:

1. Can Anyone Recreate Another BYD?

Through the analysis in the previous article, the core advantage of BYD's gross margin is actually the extreme cost reduction strategy in the choice of technology/engineering path (choosing cheaper lithium iron batteries for batteries, and lower production difficulty square batteries; hybrid technology using lower cost single-gear series-parallel), and the most in-depth vertical integration industrial layout choice.

If the former is just a difference in technical path selection, and the technical gap between hybrid technologies is getting smaller and smaller, the real question is how difficult it is to imitate the layout of vertical integration, especially now that more and more OEMs have started to build their own battery capacity.

1) Characteristics of the Vertical Integration Industry - Downstream: Strong Demand + Oligopoly; Upstream: Long Chain + Heavy Capital + Medium Technology

In the industries covered or monitored by Dolphin Jun, leading companies in photovoltaics and complete vehicles have a strong tendency towards vertical integration. Industries that are most suitable for vertical integration generally have several characteristics:

a. Stable end-user demand, with industry monopolies or oligopolies, and stable market share of leading companies. Stable user demand downstream, stable prices, and high market share, with the ultimate goal being the heavy asset investment of vertical integration forming existing capacity that can surpass cycles and ensure capacity utilization;

b. The industry chain is long with capital barriers, as well as certain technological barriers, but the technological barriers are not high enough to directly block new entrants; When (a-b) are put together, it means that for end users, the product is a necessity and needs to be used frequently, so users demand low prices. Therefore, enterprises providing these products and services have enough motivation to continuously lower prices. If the industrial technological barriers are too high and difficult to enter, integration is also not possible.

Having financial barriers and certain technological barriers means that major players can enter while smaller players cannot. After major players establish production capacity, they can use economies of scale at the front end to lower procurement costs, increase production capacity utilization, and dilute the sunk costs of heavy asset investments. After costs are reduced, they can have a reverse effect on lowering product prices at the front end and increasing market share.

In traditional industries, oil is a typical example of vertical integration: from exploration, development, refining, transportation to retail, the industry chain is very long. There are high financial barriers and certain technological barriers. The most important thing is that the demand for end-use oil is almost a necessity, whether it is the three major oil companies in China or overseas oil companies, they are all obvious oligopolies.

There are many industries with long upstream chains, financial barriers, and technological barriers. Just to name a few: cloud computing, with both financial and technological barriers. However, the manufacturing and design barriers for upstream computing power are so high that it is difficult to enter, so cloud computing companies can only heavily rely on NVIDIA and TSMC. Therefore, there are certain barriers here, but not so high that the industry leaders are in a position of complete integration and cannot be entered at all.

And more importantly, the downstream: heavy investment in building production capacity requires downstream demand certainty. Therefore, it is best for the downstream to be a necessity and absolutely monopolistic. If the downstream products are not necessities and vertically integrated companies do not have a high market share as compensation for a stable state, then during industry downturns, heavy asset investments in vertical integration may lead to a "poison" of company cash flow interruption. Whether it is cloud services or oil, for end users who ultimately use them, they are basically necessities + monopolistic/oligopoly markets.

Turning back to BYD: most of the characteristics of the upstream are basically met. The main issue is that the downstream automotive industry as a whole is not a necessity, only in the segmented product price range of 80,000-200,000 is it considered a semi-necessity. Fortunately, this price range market is large enough, coupled with a high market share, to justify the heavy investment in self-developed and self-built production capacity at the backend.

2) Is BYD's vertical integration easy to imitate? Not really.

In the traditional era of fuel vehicles, in terms of core technology for vehicle manufacturing, leading fuel vehicle manufacturers are basically self-developed and self-produced, and vertical integration in core technology is already very obvious.

The core change from fuel to electric vehicles, in the view of the author, is that the repeated refueling tank has become a rechargeable battery, and the cost of using the vehicle (money originally paid to the gas station) has been shifted to the cost of buying the car, leading to a huge change in the cost structure of vehicle manufacturing

If cars are still that means of transportation, in the era of electrification, it is obvious that the core of vertical integration is the upward shift in purchase cost, the largest value of car manufacturing, and the presence of technological/capital barriers. However, the technological barrier is not high enough to completely exclude others, especially in terms of batteries.

In the past two years, major capable car manufacturers have generally begun to independently research and produce batteries and invest in the core of battery production lines. The question is, is it easy for others to imitate this vertical integration, especially the vertical integration of batteries?

The core that can be established by imitation is still sales volume: According to a McKinsey report, in terms of economies of scale, when car production reaches 1.5 million vehicles and battery demand reaches 100 GWh, independently developed batteries will have a competitive advantage in the market. Through this advantage, prices can be reduced, market share can be increased, and a positive cycle from production capacity to market share can be formed. As of now, only BYD and Tesla meet the demand scale advantage on the battery side based on the 2023 sales volume of new energy vehicles.

Volkswagen, Geely, Changan, SAIC, GAC, and other car manufacturers have production scales that meet the breakeven threshold for independently developed batteries, but they are currently constrained by production experience. It is expected that they will gradually replace on a small scale after 2024-2025. Among the new forces, Xiaopeng and Nio have not yet reached the threshold for independently developed batteries, making it difficult for them to achieve self-supply on a medium-term scale.

Currently, BYD's early advantage in vertical integration of the entire industry chain has been confirmed: continuous price reductions without compressing gross margins have already indicated the basic confirmation of a positive cycle. If players competing with it in the same field of affordable cars cannot match its cost-effectiveness, catching up will not be easy.

This is also evident from the situation seen during the BYD DM 4.0 cycle from 2021 to 2023:

a. The first phase is the leading advantage in hybrid technology;

b. In the second phase, as the leading advantage narrows, BYD can provide this technology to users at a lower price without significantly sacrificing gross margins.

II. The latter part of the vertical integration of electric vehicles: reducing prices to gain market share, dividends, or vertical integration of smart cars?

Looking at the situation of the past three years, after the success of BYD's DM 4.0 technology, it has been continuously investing in the capacity for electrification. In terms of capital expenditure: intensive investment started in 2021 and 2022, with a threefold increase each year, reaching the peak of capital expenditure in 2023.

a) The basic end of the pre-investment period for production capacity However, starting from the fourth quarter of 2023, capital expenditure has shown signs of significant contraction. Although there was a slight increase in the first quarter of 2024, it has narrowed compared to the peak in 2023.

Looking at the construction projects, 2022-2023 was a period of concentrated implementation of construction projects, with the peak of new construction projects in the second half of 2022 and the first half of 2023. However, in the second half of 2023, there was a first decline in new construction projects, while the conversion of construction projects to fixed assets reached a historical high. With the acceleration of production capacity landing, the decline in new construction projects also indicates that BYD's current round of capacity expansion may have reached a phased conclusion, and the subsequent expansion speed will gradually slow down.

From BYD's capacity planning perspective (for specific battery and vehicle capacity planning, please refer to the previous article: "Price Butcher Can Still Make Big Profits, Why Can BYD Fight Against the Heroes?"), the domestic passenger vehicle available capacity in 2023 has reached 4.7 million vehicles, which is more than enough to meet BYD's target production of 4 million vehicles this year. Currently, the under-construction passenger vehicle capacity is 1.97 million vehicles, totaling more than 6.6 million of existing and under-construction capacity, which can at least meet the passenger vehicle demand until 2026-2027.

The battery capacity is even more exaggerated: by the end of 2023, it was around 450 GWh, even considering factors such as many factories operating multiple shifts, it has clearly exceeded the actual demand estimated by Dolphin for Freddie Battery, without a significant increase in the proportion of external battery shipments. The existing capacity estimated by Dolphin can already meet the battery demand until at least 2027, indicating that BYD's forward investment in vertical integration in this round has reached a phased conclusion, and it is expected that the pace of subsequent under-construction battery capacity will continue to slow down.

b) False profits end, are real profits coming faster?

Taking a look at the actual financial cost corresponding to this wave of capacity expansion: using 2023 as an example, BYD reported a net profit of 31.3 billion RMB, and after adding back non-cash expenses related to depreciation/amortization/disposal of assets, Dolphin estimates the real operating profit to be approximately 76 billion RMB.

However, the capital expenditure for the year 2023 surged to 120 billion RMB, meaning that BYD invested all its profits into expanding reproduction that year, and even this was not enough. The main reason BYD's cash flow frequently hits new highs is mainly due to the use of upstream funds in operations, which is the funds of the supply chain.

In other words, due to capacity expansion, BYD's reported profits are illusory, and the so-called profits are achieved through the capitalization accounting method of fixed asset investment. After selling the vehicles, the actual earnings come from the operational funds occupied upstream

When a) and b) are put together, the main focus is on two questions: one regarding operations: as the production phase comes to an end, what's next? The other is about capital allocation, whether to wait for real profits to gradually emerge, increase shareholder returns, or invest in new areas?

Let's start by addressing the first question:

a) Operations: What's next after the production phase ends?

The answer to this question is quite simple. With production completed, the next step is inevitably to find ways to increase production capacity utilization, especially given the situation where BYD's production capacity is widely distributed due to government investment attraction, leading to insufficient capacity utilization which could have serious repercussions.

Reducing prices to gain market share at the front end and increasing production capacity utilization at the back end are the inevitable choices. Among traditional car manufacturers, only BYD seems to be able to fully leverage its integrated advantages at this scale (as other traditional car manufacturers like Geely generally lack sufficient sales volume, and new players like Nio and Tesla lack deep vertical integration).

Therefore, it's easy to speculate on BYD's potential strategies in selling cars in the future:

① With a certain technological gap still present in DM 5.0 and sufficient orders for BYD, they can use this technological advantage to sell cars. However, Dolphin estimates that this technological gap will likely only last for a year, as competitors like Geely will introduce similar technology in the second half of this year, with cars hitting the market next year.

② After competitors catch up, offering "the same technology at a lower price" and leveraging their own vertical integration scale advantage, BYD can use a price reduction strategy to ensure sufficient production capacity utilization at the back end, increase market share, especially in the price range of 100,000 to 200,000 yuan where demand is sensitive and where the profit margin is superior enough to support price reductions.

Looking at the internal structure of car price segments, the 100,000 to 200,000 yuan price range remains the most popular segment in the car market this year (accounting for 60-70% of total passenger car sales).

This price range is almost like BYD's "dominant area." In this price range, the overall penetration rate of new energy vehicles in the first 5 months of 2024 is only 35%, still lower than the 20-30 thousand yuan price range dominated by pure electric vehicles (with an overall penetration rate of 49%) and the 30 thousand yuan and above price range dominated by hybrid vehicles (with an overall penetration rate of 44%).

In this price range, the penetration in 2024 is mainly driven by hybrids. The main reason behind this is that in this price range, users have stricter requirements for cost-effectiveness, and the price difference between hybrid and pure electric versions of the same model is generally lower for hybrid models due to lower battery costs, making hybrid models generally priced 3,000 to 40,000 yuan lower than pure electric models In addition, plug-in hybrid models do not have range anxiety, while potential users in this price range for pure electric vehicles are generally in second or third-tier cities or below, where charging facilities are inconvenient and the short battery life is obvious. Within the core price range of 100,000 to 150,000 RMB, hybrid vehicles are a more economical choice when considering range, both in terms of purchase cost (compared to pure electric vehicles) and operating economy (compared to fuel vehicles).

Currently, there are significant "bugs" in the range of 50,000 to 150,000 RMB for pure electric vehicles (the price of global 800V products cannot come down). Without a technological breakthrough in electrochemical materials, it will be difficult for pure electric vehicles to engage in price wars in this price range. In the 2024 market segment of 50,000 to 150,000 RMB, Dolphin estimates that plug-in hybrids will still be the main battlefield for accelerating the replacement of fuel vehicles.

Therefore, Dolphin estimates that BYD in 2024-2025 will use two powerful tools - technology (DM 5.0) and price reduction (Honor/Champion Edition) to accelerate the phase-out of fuel vehicles in the market segment of 50,000 to 200,000 RMB, regaining some lost market share from 2023.

b) Capital Allocation: Wait for real profits to slowly emerge, increase shareholder returns, or invest in new areas?

In response to this question, let's first refer to Toyota, a stable "cosmic car factory":

Firstly, a very obvious feature is that even in the stable period, as a heavy asset industry, there is still a considerable amount of capital expenditure on equipment maintenance and replacement every year. Although the amount invested is still greater than the depreciation and amortization, the gap between annual depreciation and amortization and annual capital expenditure decreases as stability is reached.

Looking at the depreciation and amortization and capital expenditure, which represent the real cash profits available for distribution, Toyota probably allocates 70%-80% each year to return to shareholders. After going through the capacity expansion period, Toyota, with global annual sales of 8-9 million units, is a solid dividend stock.

Looking at BYD, the recent high capital investment over the past three years has led to an impact on the depreciation and amortization, coupled with the real capital expenditure outflow, resulting in negative real profits, making it theoretically difficult to pay dividends.

Therefore, BYD's past dividends have been more of a symbolic gesture. However, the dividend announced at the end of 2023 was significantly increased: 9 billion RMB, which is actually quite good considering its negative real profits However, based on the current trend of declining capital investment, according to Dolphin, BYD will soon see disposable profits for shareholders by 2025 instead of using all profits to expand production. At that time, whether BYD will transition from growth to a company with stable growth and dividend-driven logic similar to US stocks is worth looking forward to.

Of course, in terms of fund allocation, BYD currently has a very clear tendency: after the capital expenditure for capacity expansion comes to an end, expenses on intelligent development to fill the gaps are significantly increasing. This is particularly evident in the financial report for the first quarter of this year ("BYD: Automotive gross margin "killing in all directions", successfully crossing the trough?").

However, Dolphin observed that research and development expenditure is not on the same scale as capital expenditure: BYD's annual capital expenditure exceeds one trillion, while research and development expenditure is only 25 billion per year. Even if research and development expenditure increases, the cash flow saved from the decline in capital expenditure will still be very significant.

Overall, Dolphin still tends to believe that BYD is not far from the logic transition to high-quality dividend assets.

III. How to understand the valuation of BYD?

If the previous rise of BYD was mainly driven by industry Beta, or more precisely by the product cycle of DM 4.0, and the logic was more industry Beta dividend-oriented, then combined with the analysis above (I-II), Dolphin tends to believe that the driving force for BYD's future stock price will come more from the Alpha logic of deep integration refining, returning to market share improvement, and shareholder expectations improvement.

In this case, Dolphin assumes:

a. The progress of BYD's high-end pure electric vehicles in China is relatively slow. BYD mainly uses price advantages (no increase in unit price, even a decrease) to continuously maintain market share in the essential price segment (higher sales market share).

b. Overseas: Compared to Tesla focusing on Europe and China for its overseas expansion, BYD's overseas strategy is more "scattered" due to difficulties in market access in the US and tariff suppression in Europe, focusing on markets other than Europe, America, Japan, and Korea

In terms of BYD's overseas sales forecast, due to the 100% export tariff in the United States, BYD is expected to focus on local factory assembly production.

When entering Europe, due to Europe's anti-subsidy surcharge on BYD, the overall tax rate reaches 27.4%. After calculation, the gross profit margin of BYD's main models (Atto 3 as the main export model) in the European market is expected to decrease from the original 29% to around 14% after the tax increase. It is predicted that BYD will gradually shift from the whole vehicle export model to the local factory model in the European market.

Overall, Dolphin predicts that BYD's overall sales will increase from 3.02 million vehicles in 2023 to approximately 8 million vehicles by 2028, approaching the sales champion Toyota by about 1 million units in the same positioning of "affordable" models. This gap is mainly due to the European and American markets, but is partially offset by higher market share in the domestic market and other overseas markets.

Referring to Toyota's gross profit margin, a similar ultimate gross profit margin expectation was made (note that there is no premium. In comparison, Tesla's guidance for its ultimate gross profit margin is to be several percentage points higher than that of traditional fuel vehicles).

However, considering that BYD actually has an internal battery business, the long-term gross profit margin is very likely to exceed that of Toyota. Based on this conservative estimate, Dolphin estimates that excluding the contribution of the battery business to the gross profit margin, BYD's vehicle manufacturing gross profit margin is even slightly lower than Toyota's stable gross profit margin.

In this case, Dolphin's estimated DCF valuation for BYD in a stable state is approximately HKD 325 per share.

Due to the product cycle-driven nature of the automotive industry, Dolphin also provides a PE valuation for reference. The basic range is based on the valuation range of assets, without considering net cash and BYD Electronics valuation. Only valuing the core assets of batteries and automotive business, the safety margin of BYD is basically around HKD 200. If all factors are considered, BYD clearly has a good upside potential

The above value calculation is for reference only. However, the bottom line is that as the industry's penetration dividend gradually disappears, the natural price competition brought about by the reduction in raw material costs is also coming to an end. When the market truly needs to clear excess capacity, BYD's advantage in competitive de-escalation becomes more apparent. The endgame gradually becomes clear, under this circumstance, Dolphin Jun begins to focus on BYD's deep integration, returning to the dual-line drive of market share improvement and shareholder expectations improvement, driven by Alpha logic.

Dolphin Jun's Historical Articles:

In-depth

July 4, 2024, "Can the Price Butcher still make big profits? Why is BYD fighting against all odds?"

August 10, 2021, "BYD Shares (Part 2): After the surge, seeking stability in wealth?"

July 23, 2021, "BYD Shares: The best battery-making car manufacturer | Dolphin Research"

Financial Report Season

April 29, 2024, Financial Report Review, "BYD: Automotive business gross profit margin "kills in all directions", successfully crossing the trough?"

March 27, 2024, Financial Report Review, "The "Price Butcher" BYD: Fighting with shining weapons, dawn is not far away" March 29, 2024 conference call " 24-year sales target increased by 20% on the basis of 23 years"

October 30, 2023 financial report review " BYD, crazy about "money", is it enough?"

August 28, 2023 financial report review " BYD: The embarrassment after the "windfall", what ace is left?"

August 29, 2023 conference call " Under the price war, company profitability is not a problem, Sany's third-quarter profit will be even better (BYD minutes)"

April 28, 2023 financial report review " BYD: In the electric car price war, making money is the real skill"