A discussion of gross margins and what they mean to a company

This is a discussion of gross margins which I feel may be necessary. Please read along with me.

A lot of our companies have a gross margin of about 70%. What this means is that the product that they are selling costs about 30% of the sale price. So if they have $100 million in sales they have $70 million left to cover Sales & Marketing, Research & Development, and general office expenses. If they spend only $50 million on those, they will have $20 million left of net profit, or a 20% net profit margin.

Some still successful companies may have only a 30% gross margin (for instance). The products they sell cost them 70% of the selling price to manufacture. So on $100 million of sales, they have only $30 million to cover S&M, R&D, general expenses, and to eke out a small net profit. If they sell enough product they can still have a successful business.

Still with me?

A company was recently presented to the board that was growing revenue truly like mad, and whose products (batteries) were much in demand, BUT they had a gross margin of minus 150%. What does that mean, you may ask.

It means that it costs them two and a half times the selling price to manufacture the product. If the sell $100 million of product, that product cost them $250 million to make. They already have lost $150 million, and that doesn’t even take into account what they spent on S&M, R&D, etc, which multiplies their loss even further. Actually, those currently come about twice their sales, to about $200 million more of expense on our hypothetical $100 million in sales, which brings the losses to about $350 million or three and a half times sales.

So how is this company raising the money to cover these losses, and more money to build more factories? They are selling stock and diluting current stockholders (but of course giving themselves enough stock-based compensation to not have to worry.)

Are you hanging on? I hope that I have been clear.

Okay, say they triple sales. Does that make them profitable? Well let’s say they are able to cut the price of manufacturing their product from $250 per $100 million in sales by a full third, down to $165 per $100 in sales. That improves their gross margin from a horrible minus 150% to just a horrible minus 65%.

Does that make them profitable??? Ha!!! It cuts their losses to $65 million on each $100 million in sales, for a total of a loss on product sold of $195 million (which is more than they lost before).

And then, of course, with tripling sales they will inevitably have greater S&M, R&D, general office expenses, etc. Let’s give them the benefit of the doubt, say they just increase all those expenses by 50% (although they are increasing sales by 200%). That’s $300 million more of losses.

I hope that you can see that this company won’t break even for maybe five years. And that I made a lot of optimistic assumptions (tripling sales, gross margins improved from minus 150% to minus 65%, expenses only rising by 50%, etc).

If you want to invest in this company please be cautious and only invest a very small part of your portfolio.

Best,

Saul

129 Likes

There is an infamous saying that fits this quite well:

We’re losing money on every sale, but we’ll make it up in volume.

There are plenty of investments we follow on this board that have plenty of upside with a much lower probability of going out of business.

DJ

12 Likes

Saul,

Your point is well taken. However, I do remember a CEO of a now defunct bookstore said of Amazon, “They loose 2 dollars on every book they sell, let them sell millions. “

So, while this company may not be a good investment today, it doesn’t mean they will never be a good investment.

Cheers
Qazulight

7 Likes

Amazon was my mental model too at first. But Bezos spent his profit margins on building out the business, not Cost of Goods Sold (cost to make or buy the product). The company in this case is spending more on materials and processes to make the product than they can sell for. Another factory building product they lose on won’t fix it. They must survive long enough to get their cost of products less than selling price by lower mfg costs or higher prices. Bezos didn’t have that problem.

18 Likes

Let me be clear. Any company whose products are so in demand has a reasonable chance of making it through eventually and becoming successful. That’s why I didn’t say “Don’t buy this company”. What I said was to be aware what a minus 150% gross margin means, and that it will be lots of dilution and lots of time until it’s profitable, so don’t sell the family jewels to load up on this stock.

The company may do much better than the stock for a while. In Sept 2022, a year and five months ago, shortly after coming public, they were selling at about $13. Now they are at $4. So they have lost roughly 70% of peak value even though sales are booming. That’s 70%! While most of our companies have been going up since late 2022.

Just be careful.

Saul

52 Likes

Thanks for the thought provoking exercise Saul! It’s given me some insights about if the gross margin for the company is reasonable at this early stage.

Some overall thoughts on the topic are,

I’d expect a SaaS company to have 70%+ gross margins or there are probably red flags there. Monday runs at 90% gross margin because they are almost a pure software play with little infrastructure. Cloudflare is at 78% and it’s lower because they have data centers to operate at the edge. Snowflake is at 68% because they are effectively a pass through to the cloud provider that the customer is using.

Just from those metrics I do not think its easy to say Monday > Cloudflare > Snowflake because of gross margins. They are just run on different business models, which all can potentially be successful depending on the scale they operate at.

Additionally many of the SaaS companies while having great gross margins, spend what seemed like an excessive amount when scaling their platform through sales and marketing. Monday, Confluent, and SentinelOne all had sales and marketing expenses well above revenue for considerable periods, and it’s only recently they have come down to sales and marketing spend be closer to 50% of revenue. I’m pointing this out because I think SaaS and hardware companies scale in different ways when they are ramping up.

For the two hardware companies I own, Nvidia has a 71% gross margin and Super Micro is at 15%. That’s really incredible from Nvidia to be able to run at the scale they do, and have that type of margin.

With Super Micro I went back and looked up what their gross margin has been since they went public in 2006. It’s effectively hovered between 15-25% and tightly range bound for the entire public existence. Effectively their business model is to use a buildings block approach to creating AI optimized servers and selling them at a slight markup.

It’s interesting to me a company like Meta is coming to Super Micro for its server needs. Why are they not building them in house with all their resources? It points to the value they get from paying Super Micro to build the machines is superior to building the machines themselves. In some ways this acts a protective moat or monopoly for Super Micro. Most companies are not going to be attracted by getting in a 15% margin business when they can pay someone to do the work at a reasonable markup.

With Amprius one thing I highlighted was they say this on pricing in the last quarter,

We have significant leverage in terms of product selling price because this is the only product which can perform at the desired level

I don’t know if that means they can double or triple the price of the battery and still make the sales as easily. They aren’t really quantifying any of those metrics. However, I’d assume the company is not planning to run at loss forever once they scale up.

One important thing to know about they company is they are effectively a subsidiary of Airbus. I cannot find the passage again where I saw it, but I believe Airbus owns over 50% of the shares. I was looking up why Airbus would have majority ownership but not outright buy the company. It appears like it is mostly for regulatory reasons to be able to operate in the US as a European company.

I’m not sure how Airbus diluting the shares intentionally makes sense unless they think it will be good long term for themselves. From looking at the current dilution that has gone on in the past year, I believe the increase in shares comes from the IPO which was roughly one year ago. So the numbers reflect the capital raised for a long runway on scaling up. Possibly a cause for concern and some yellow flags, but it doesn’t stand out to me as egregious.

The company sounds confident in reaching their goal of scaling from 2 Megawatts, to 1 Gigawatt. This is a plan to scale 500x from currently levels (1000 MW = 1 GW). From how they describe it, they sound confident with reaching this goal. If they can reach this goal that would mean their revenue would go from 3M quarterly to 1.5B. If they are able to raise prices, and gain operating leverage I’d think the outcome would be good for investors.

I believe Airbus and AeroVironment are “strategic investors” in this company because they understand the company will have pricing leverage of them in the future, if it’s indeed the only battery which can operate at the specs they want. It’s going to be hard for Airbus or AeroVironment to then switch back to regular batteries with a lower run time once their own customers get used to the longer flight times which are possible. Also Airbus and AeroVironment are selling to governments and militaries which are known to overspend for cutting edge defense. There is currently a secular trend towards more defense spending worldwide.

With all that being said I am presenting a lot of best case scenarios and targets the company will need to hit to stay successful, and this is the reason I’m starting out tiny with this company myself on adding shares.

From what I can gather they are roughly 3 months behind from their scaling targets in the S1. I think they were planning for 2 MW capacity before the end of 2023 and they got it right after the new year. It sounds like they wanted to sign a lease a few months earlier then they did for their Colorado plant, but there were some regulatory issues to sort out.

I’m liking the risk/reward here because the market seems to doubt their plans, and evidenced by the price drop since the IPO. I’m not seeing a 65% price drop being warranted by getting 3 months behind schedule, or maybe other investors are doubtful about the gross margins and leverage they actually have.

I’ll be tracking the gross margin closely going forward because it does indeed seem like a key metric to track for this company to become a success.

17 Likes

Amprius is a venture capital stage company that has no business being a public company. We are not VC investors, and we don’t get the access that VC investors get.

With that said, they are essentially pre-revenue and are hand-building their product in Fremont on what is currently really an engineering line and supplying tons of samples (free likely) to prospective customers. Having a huge negative Gross Margin is not unusual for a pre-revenue company. They are burning money. They seem to have customers and demand IF and WHEN they can delivery volume production from a manufacturing plant yet to be built. They have a ton to prove yet.

I think Saul’s point is that until they can produce parts in some volume and establish that track record, this is not really what this board would call an investable stock. To go off and start comparing their GM to companies such as Monday or SNOW is not the point. The point really is “we have no idea if they can produce batteries in volume and deliver them at a profit”. Analysts are stating 2025-6 would be break even, but I’m not sure they know much more than we do.

And much like the battery company that “PT Barnum” (my quote in a past thread) is running, a lot remains to be seen. There is a huge amount of investment happening and there will be a few winners and a bunch of losers.

For this company, a major milestone would be that they complete the factory and build it out and achieve production status in volume.

35 Likes