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Morningstar | Looking for a Rebound in Xiaomi’s Smartphone Margin as Product Cycle Matures

Xiaomi’s first quarter was below our expectations at the operating profit line with revenue up 27%, in line with the fourth quarter last year but operating profit (ex-investment valuation gains) of CNY 1.15 billion was down 3% sequentially and 22% year on year. Management cited the frenetic smartphone launch activity with the company launching five new phones this quarter as having impacted on margins, although we note that margins were only slightly better than fourth-quarter 2018 when only two new smartphones were launched. Research and development expenses were also up around 50% which we see as a positive for the company longer term. Smartphone revenue increased quarter on quarter by 12% but declined year on year by 2%. Our view that Xiaomi is predominantly a hardware company was backed-up with Internet services again representing only 9.7% of revenue and the consolidated underlying operating profit margin of 2.6% is what we would expect from an electronics hardware supplier in a tough quarter. The company will need to more than double its quarterly operating profit run-rate in the remaining three quarters to hit our revised full-year operating profit forecasts.

We reduce our operating profit forecasts by around 15% and reduce our fair value to HKD 9.80 per share from HKD 10.50 per share previously with a weakened Chinese yuan also contributing. The value of the company’s investments increased by CNY 2.5 billion over the quarter adding around CNY 0.10 per share to our valuation. Our no-moat rating is also retained as we believe Xiaomi is predominantly an electronics hardware supplier with limited switching costs with its Internet services business not yet well developed enough to assign a moat to. The stock has moved down from its IPO price of HKD 17 and now looks reasonably valued to us although we would prefer a larger margin of safety before recommending it.

A recovery in the global smartphone market which, in shipment volume terms, was flat in 2017, down 4.4% in 2018 and down 6.6% in 2019, would certainly help the stock.
Customers are generally holding existing smartphones for longer with manufacturers hoping that 5G will provide compelling reasons for customers to upgrade their phones. On our estimates Xiaomi trades on a 2019 price/earnings ratio of 25 times, a premium to most electronics companies which trade on low-double-digit multiples but it boasts growing Internet of Things and Internet services revenue streams.

Xiaomi launched five key smartphones in the first quarter; Mi 9, Mi 9 SE, Redmi Note 7, Redmi Note 7 Pro, and Redmi 7. Initial demand for these has been strong with the sales volume of the flagship Mi 9 series reaching 1.5 million in early April, having been launched on Feb. 20. The shipments of the value RedmiNote 7 series exceeded 4 million units in the first quarter of 2019 having been launched on Jan. 10. Smartphone revenue was up 16.2% to CNY 27.0 billion; however, the gross profit margin for smartphones dropped to 3.3% from 6.1% in the fourth quarter last year and 5.8% in the corresponding period in 2018. Management put this down to product launches so we will be looking for a rebound in smartphone gross margin to drive the required operating profit improvement to hit out full-year consolidated operating profit forecasts.

Revenue from the Internet of Things and lifestyle products segment increased by 56% to CNY 12 billion in the first quarter. This was primarily due to strong sales growth in existing products, particularly smart TVs, laptops and artificial intelligence speakers and the continued launch of these types of products in new markets. Encouragingly, Internet of Things gross margins of 12% are well above smartphones and management put this down to a lower level of competition in the Internet of Things market. Smart TV shipments were up nearly 100% to 2.6 million and it ranked first for two consecutive quarters in mainland China.

Revenue from Internet services increased 32% to CNY 4.3 billion. Monthly active users, or MAUs, of its Mi User Interface increased to 261 million from 242 million at the end of 2018 implying that ARPU declined 5% sequentially. This is not surprising given we have seen many of the big Internet companies in China reporting slow advertising and gaming revenue and the company admitted that the short-term outlook for these was not positive given the trade dispute uncertainties. However, given the global nature of Xiaomi’s business it highlights that over 32% of its Internet services revenue is generated outside of gaming and smartphone revenue from Chinese smartphones. The recent CNY 2 trillion Government stimulus may also help boost the Chinese consumer market.

Consolidated cash flows were again weak with operating cashflow loss of CNY 117 million and net investing cash outflow of CNY 2.4 billion. However, management noted that the first two months of the year were weak due to Chinese New Year and operating cash flow in March and April were positive. The IPO last year helped support a strong balance sheet with net cash of CNY 18.4 billion and another CNY 8.7 billion of short-term liquid investments which should easily support the company’s growth plans.