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Morningstar | Weak quarter for Xiaomi smartphones but new releases should help a rebound

Xiaomi’s fourth quarter was below our expectations at the top line with revenue up 27% after growing at 64% in the first 9 months. Operating profit of CNY 1.185 billion was also down sharply on the CNY 2.532 billion reported in the third quarter. The revenue slowdown was driven by smartphone revenue which slowed to 7% year-on-year growth and fell 28% sequentially from the third quarter. The two key reasons given for the weak smartphone performance were a focus on the Redmi brand separation from Xiaomi and lack of new product launches in the quarter. After launching five new products in first quarter 2019, management expressed confidence in a strong rebound in smartphone performance in both the first quarter and full year 2019. Our view that Xiaomi is predominantly a hardware company was backed-up with Internet services again representing only 9.1% of revenue and the underlying operating profit margin of 2.7% is what we would expect from an electronics hardware supplier in a tough quarter. We make only minor changes to our forecasts but increase our fair value to HKD 10.50 from HKD 10 per share previously on a strengthening CNY. 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 developed enough to be  assigned a moat. Despite the stock moving down from the IPO price of HKD 17 it is still slightly overvalued at current levels, with investors seemingly partly applying Internet services multiples to the stock. According to our estimates the stock trades on a 2019 price/earnings ratio of 24 times, a premium to most electronics companies which trade on low double-digit multiples.

While Xiaomi’s trends in the smartphone market have been strong after it increased its quarterly handset shipments by 150% over the two years to third quarter 2018, its fourth quarter 2018 was below expectations. The company shipped 28.6 million smartphones in the fourth quarter, up only 1.8% on the same quarter a year ago. The company still outperformed the global market, which was down 4.9% year on year but its growth slowed drastically from the 53% growth reported in the first three quarters of the year. Xiaomi’s global market share of shipped smartphones decreased from 9.7% in the third quarter of 2018 to 7.6% in the fourth quarter, with Xiaomi dropping to fifth place on the global smartphone sales tables in terms of units, from fourth place. Management pointed toward the separation of the budget Redmi brand from the premium Xiaomi brand and the lack of new product launches in the fourth quarter as key reasons for the weaker smartphone performance. However, the company launched five new products so far in 2019 including Mi 9 and Redmi Note series, and initial demand has been strong. Management is confident about a much stronger performance in the smartphone market in both the first quarter of 2019 and the full year in general. The gross profit margin for smartphones remained at 6.1% in the fourth quarter, flat on the third quarter but down from 7.2% in the corresponding period in 2017 due to weak CNY and Indian Rupee compared with the USD in which many of its smartphone parts are priced. Continued increased prices for items such as memory also didn’t help the gross margin although these should be reversing with DRAM Exchange estimating the price of DRAM fell by about 30% in the first quarter 2019. Xiaomi seems unwilling, or unable, to increase the price of its smartphones in response to currency movements preferring to focus on other cost efficiencies.

Revenue from the IoT and lifestyle products segment increased 75% to CNY 14.9 billion in the fourth quarter. This was primarily because of strong sales growth in existing products, particularly smart TVs and laptops. Encouragingly, the gross margins of 10.6% for Internet of Things are well above smartphones. Revenue from Internet services increased 39% to CNY 4.04 billion but actually fell sequentially from CNY 4.7 billion in the third quarter. Monthly Active Users, or MAUs, of its Mi User Interface increased to 242 million from 224 million at the end of September 2018, indicating even greater sequential ARPU decline than revenue decline. The weaker Internet advertising and gaming markets in China in the fourth quarter were likely to be partly to blame for the sequential slowdown.

Management has pledged that hardware margins (net after tax) would not rise above 5% as part of its commitment to supporting the growth of Internet access globally. The audited margin in 2018 was less than 1%, which implies some potential upside if the company’s brands can support raising this margin over time. Consolidated cashflows were weak, with an operating cashflow loss of CNY 1.4 billion and net investing cash outflow of CNY 7.5 billion. The IPO helped to support a strong balance sheet with net cash of CNY 22 billion and other liquid investments which should easily support the company’s growth plans.