To The Moon

At a very simple level, we can break every company down a company’s operating profit (or loss) into its components. The equation looks like this:

Operating Profit = Revenue - Variable Costs - Fixed Fixed Costs = Sales - COGS - Operating Expenses

It’s a simple equation, but its impact on investing is profound.

Here are a few more definitions that will help as we work through the concept of operating leverage.

• Gross Margin = Sales - Cost of Goods Sold

  • This can be expressed as a dollar figure or a %

• Operating Expenses = R&D and Sales, General & Administrative expenses

  • This is all of the overhead costs to operate the business like paying executives, accountants, the marketing team, R&D efforts, etc.

Depending on factors like gross margin rate and the level of operating expenses, companies can have very different leverage on their sales.

To dig into how leverage works, let’s start with the variable and fixed cost components and I’m going to use $Rivian Automotive, Inc.(RIVN)$ as an example. Rivian has about $4 billion in annual operating expenses (SG&A and R&D) that are relatively fixed. In time, management thinks they can get to a gross margin rate of 25%. Based on these numbers, the company’s fixed and variable costs look like this with revenue on the X-Axis:

In other words, to sell $2 billion of product, Rivian would have to incur $4 billion in operating costs and $1.5 billion in variable costs (raw materials, labor, etc).

Add the fixed and variable costs and you get Rivian’s total expenses in black below.

Here’s where we get to the leverage part. If you subtract total costs (black line) from revenue (X-Axis) you get the operating profit (yellow line) line that shows how quickly profits grow with revenue.

If we isolate the operating profit, we get the chart below. This is your operating leverage. The steeper the slope of the curve, the better you leverage each dollar of incremental revenue.

I’ve added two more gross margin scenarios of 20% and 15% because they’re more realistic for an automaker. You can see the profit line flattens out as gross margins go down. Even at $20 billion in revenue (4x the company’s revenue today) Rivian goes from $1 billion in operating profit at a 25% gross margin to a $1 billion loss at a 15% gross margin. This is why investors watch auto margins like a hawk.

Operating costs are like a hurdle for companies to overcome, and the lower gross margins are the harder it is to overcome the hurdle.

This is why investors like tech stocks so much. The gross margin for tech is generally 70%+, so any growth flows disproportionately to the bottom line. And tech revenue isn’t constrained by manufacturing capacity.

You can see that below at $Meta Platforms, Inc.(META)$ , where operating costs were held flat over the past two years while revenue is up at a 21.5% CAGR and operating income wildly outpaced that with a 65.4% CAGR. And without capacity constraints, the upside of winning in tech is orders of magnitude larger than in manufacturing.

Supply and Demand In Manufacturing

These operating leverage charts are important in EVs because the industry has high fixed costs. That’s the inherent nature of manufacturing.

And gross margin is dependent on pricing. And pricing — SURPRISE, SURPRISE — follows the laws of supply and demand.

Depending on price, customers will demand a certain amount of product. Raise the price, and demand falls. I’ve shown this supply and demand curve below.

• Supply Curve: Shows the quantity of goods producers are willing to sell at different prices.

  • In short, if the price of a product goes up, they’re happy to make more.

• Demand Curve: This shows the quantity consumers are willing to buy at different prices.

  • In short, if the price of a product goes down, they’re happy to buy more.

The simple supply and demand curve looks like this. A company with inelastic demand will have a very flat demand curve (ex. oil) and a company with a highly elastic demand curve will be more vertical (luxury goods).

If we stay with Rivian for this example, the company is in an equilibrium of supply and demand at $50,000 per vehicle and producing 50,000 vehicles per year.

They have excess demand if they produce 40,000 vehicles and charge $50,000 for each vehicle.

But if Rivian increases production to 100,000 units and maintains a $50,000 price point, they have an excess supply of 50,000 units because there are only 50,000 units of demand at that price point.

The options Rivian has in an oversupplied environment are both terrible for the company’s economics:

1. Cut production, causing the company to run less efficiently and eat the cost of excess capacity.

2. Lower prices, reducing gross margin per vehicle.

This is the reality of the EV business today. Supply is growing faster than demand. Companies aren’t cutting back their expansion plans — because they can’t maintain the money-losing status quo — and the supply/demand imbalance will get worse.

You can see evidence of this dynamic in Tesla’s numbers. You can see below that Tesla likely had excess demand through the end of 2022 (helped by pandemic demand) when it produced 1.3 million vehicles. But in 2023, the company increased capacity to about 2 million vehicles and needed to lower prices to sell products. Tesla was in a state of oversupply and margins and operating income fell as a result.

Tesla is the one EV company that’s reached scale, but others want to follow. What happens to the market when Rivian, Lucid, Polestar, Xpeng, BYD, GM, Ford, and others ALL increase EV production?

Supply goes up and unless demand follows at the same rate…

PRICES ARE GOING TO FALL!!!

Margins are going to get worse.

The operating profit curve is going to flatten. And who can make money in that scenario? Maybe Tesla???

The logical conclusion is that most EV companies will go bankrupt.

https://asymmetric-investing.beehiiv.com/p/danger-in-ev-stocks