EUR 850.00 For Business Accounts Only

Morningstar | With 6% Gross Margins, Buy Xiaomi Phones not the Stock. See Updated Analyst Note from 19 Nov 2018

Xiaomi’s third quarter was in line with our expectations at the top line with revenue up 49% but slightly below on profitability with underlying EBIT down 8%. Revenue was driven by strong growth in hardware with smartphones up 36% and Internet of Things and Lifestyle products up 90%. Our view that Xiaomi is predominantly a hardware company was backed-up with Internet services representing only 9% of revenue and the underlying operating profit margin of 5% is what we would expect from an electronics hardware supplier. We make only minor changes to our forecasts and retain our fair value estimate at HKD 10 per share. 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 enough developed to assign a moat to. Despite the stock moving down from the IPO price of HKD 17, it looks slightly overvalued at current levels with investors seemingly at least partly applying Internet services multiples to the stock. On our estimates, the stock trades on a 2019 price/earnings ratio of 27 times, a premium to most electronics companies which trade on low-double-digit multiples.

While we are dubious about the company’s Internet services credentials, its track record and success in supplying low price smartphones cannot be denied. The company shipped around 34.3 million smartphones in the third quarter, up from 28.3 million in the third quarter last year and 31.9 million in the second quarter, with an average selling price of around RMB 1,050 compared with RMB 957 in the same period last year. Xiaomi’s global market share of shipped smartphones increased from 8.4% in the first quarter of 2018 to 9.7% in the third quarter putting Xiaomi in fourth place on the global smartphone sales tables in terms of units. It was number one in India and number two in Indonesia.

The increase in ASP was mainly due to strong sales of its mid- to high-end models such as MIX 2S and Mi 8 in the China market. However, the gross profit margin for smartphones declined to 6.1% from 6.4% in the second quarter and 11.7% in the previous period due to a weak Chinese yuan and Indian rupee compared with the U.S. dollar in which many of its smartphone parts are priced. Continued increased prices for items such as memory also didn’t help the gross margin. The company seems unwilling, or unable, to increase the price of its smartphones in response to currency movements preferring to focus on other cost efficiencies.

The two big Chinese smartphone manufacturers, Xiaomi and Huawei, have taken market share over the past two years, Xiaomi has improved from 3.7% to 9.7% of the global market, with Huawei increasing from 10.6% to 14.6% replacing Apple as the number two manufacturer. While Samsung is still the leading smartphone manufacturer by volume, it has seen double-digit declines in volumes in the past two quarters with its share dropping from 23.4% to 20.3%. In September this year, Samsung announced plans to overhaul its smartphone strategy at the midrange price point in order to appeal more to millennials. Instead of introducing new technology in the flagship Galaxy S and Note series of devices, the company will look to bring in cutting-edge features to its cheaper models first. The first of the devices with the new strategy will be released later this year. We believe the recent success of Xiaomi and Huawei has been a big driver in this change of strategy and it may make it harder for these companies to continue to take market share.